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Cray Inc  (NASDAQ:CRAY)
Q4 2018 Earnings Conference Call
Feb. 12, 2019, 4:30 p.m. ET

Contents:

Prepared Remarks:

Operator

Good afternoon. My name is Erica and I will be your conference operator today.

At this time, I would like to welcome everyone to the Fourth Quarter and Full Year 2018 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.

Mr. Paul Hiemstra, Vice President and Treasurer, you may begin your conference.

Paul Hiemstra -- Corporate Treasurer

Thank you. Good afternoon. I'd like to thank everyone for joining us today. Participating from Cray are Peter Ungaro, President and Chief Executive Officer; and Brian Henry, Executive Vice President and Chief Financial Officer.

Today's press release is available on the Investor Relations section of our website at www.cray.com. This call is being broadcast live on the Internet and recorded for replay purposes. A telephonic replay will be available shortly after the call. You can access it by dialing 1-855-859-2056. International callers can dial 1-404-537-3406, you must then enter the access code 1869079. A replay will also be available in the Investor Relations section of the Cray website for 180 days.

I would like to remind each of you that today's conference call will contain forward-looking statements that are based on our current expectations. Forward-looking statements include statements about our financial guidance and expected future operating results, our product development, sales and delivery plans, the future growth of markets for our products, our ability to expand and penetrate our addressable market and other statements that are not historical facts. Those statements are only predictions and actual results may materially vary from those projected. Please refer to Cray's earnings press release dated today and Quarterly Report (ph) on Form 10-K for the period ended December 31st 2018 as well as Cray's documents filed with the SEC from time to time, concerning factors that could affect the Company and these forward-looking statements.

Our presentation includes certain non-GAAP financial measures in an effort to provide additional information to investors. Non-GAAP measures, other than non-GAAP outlook have been reconciled to their related GAAP measures in accordance with SEC rules. Our non-GAAP measures adjust for certain non-cash unusual and infrequent items included in our GAAP results. Typical adjusting items include, stock-based compensation, amortization of purchased and other intangibles and purchase accounting adjustments. When applicable, we also adjust our book tax provision for certain items including the impact of non-cash items such as benefits principally related to our net operating loss. You can find a reconciliation of these non-GAAP financial measures to GAAP financial measures and a discussion of our non-GAAP outlook in our earnings press release, which is posted on our website and which is included with a related 8-K furnished to the SEC.

With that, I would like to turn the call over to Peter Ungaro.

Peter J. Ungaro -- President and Chief Executive Officer

Thanks, Paul and thank you all for joining the call today.

I'll start with some comments on our fourth quarter and full year performance, then turn it over to Brian, who will go through our financial results and outlook. I'll wrap up by discussing our focus areas for 2019, then open the call for Q&A.

As we announced in January, we finished the year on a strong note, completing the acceptances we were targeting for the quarter. We exceeded our revenue target for the fourth quarter and full year and overall delivered solid annual revenue growth of 16%. While disappointed that with a down market we are not profitable for the year, we are confident that the investments we're making will deliver differentiated products and solutions to drive strong growth and profitability over time.

Now let me take you through some of the highlights from each of our product groups. We had a good quarter in Supercomputing and Storage highlighted by one of our largest commercial customer acceptances ever. Installing an XC50 Supercomputer as well as the Cray ClusterStor solution at a major energy company. They're using their Cray systems to model at even higher resolutions for exploration and discovery in the pursuit of new energy deposits.

The same company is working with us on its integration of AI techniques, such as machine and deep learning to improve their modeling even further and they've added a new Cray Urika system in the quarter to expand these efforts. It's a great example of what we've been talking about with the convergence of AI and supercomputing modeling and simulation. We installed additional clusters at an aerospace customer here in the U.S. and at a large commercial customer in our Asia-Pacific region.

Overall, our revenue from commercial customers grew nicely for the year, more than doubling in revenue and finishing the year at over 20% of our total revenues, our highest percentage ever. Commercial growth is a big part of expanding our TAM and we're very pleased with the progress we've made here.

Our Asia-Pacific region also had a strong quarter, driven by multiple systems in Korea. We installed a large CS500 cluster at the Korean Institute of Science and Technology Information, also known as KISTI. This is 128-rack system is now the largest supercomputer in South Korea, providing world-class supercomputing services for universities, research institutes and industry. We installed an XC50 with ClusterStor at the Institute for Basic Sciences in Korea to be used for climate research and a broad range of other disciplines.

In AI and big data analytics, we completed several installations around the world, including a CS500 cluster at a U.S. government customer to be used for deep analytics as well as a GPU based CS-Storm cluster at an international government customer for Internet security. The U.S. Geological Survey selected Urika-CS for multiple use cases, including for the analysis of animal movements, the recognition and identification of fish species and forest fire modeling and risk analysis.

Also in the quarter, we announced major upgrades to our Urika software, expanding on our Urika-CS and XC analytic capabilities. These expanded software suites will include unique Cray developed libraries to leverage hyper parameter optimizations to intelligently optimize machine learning models for performance and scalability.

We also integrated additional AI tools and frameworks commonly used by data scientists. These tools are designed to allow AI models to be trained more accurately and in less time than with commonly used solutions and to provide an easy integrated environment to run analytics and AI on Cray supercomputers.

With that, I'll turn it over to Brian to take you through the numbers.

Brian C. Henry -- Executive Vice President and Chief Financial Officer

Thank you Pete. I'll start with our fourth quarter results, most of my comments will be on the full year, which is really the best way to look at our Company, as the variability in any given quarter is typically very large given the nature of our business, then I will take you through our 2019 outlook.

For the fourth quarter, revenue was $163 million and as anticipated, we reported a net loss. Product revenue was $127 million and service revenue was $36 million. As a reminder, we focus on non-GAAP measures, which we believe are a better way to look at our Company and its progress. Total GAAP and non-GAAP gross profit margin for the quarter was about 25% with product margin coming in at 18% and service margin at 48%.

Non-GAAP operating expenses for the fourth quarter were $51 million compared to $42 million in the fourth quarter of 2017.

Non-GAAP net loss for the quarter was $9 million or $0.22 per share. On a GAAP basis, net loss was $13 million or $0.33 per share.

Our fourth quarter operating results include $3.6 million for depreciation, pre-tax items excluded for non-GAAP purposes worth $300,000 for amortization of intangibles and $3.5 million for stock compensation.

Now shifting to our full year 2018 results. As Pete mentioned, total revenue grew 16% to $456 million for the year. Product revenue was $313 million, a 25% increase, primarily driven by growth in our Systems business. The Cluster portion was especially strong for the year, representing a larger percentage of revenue than usual. Service revenue was $143 million, roughly flat compared to 2017.

For the year, our non-GAAP net loss was $58 million or $1.42 per share compared to a net loss of $41 million or $1.01 per share in 2017. On a GAAP basis, our net loss was $72 million or $1.76 per share compared to a net loss of $134 million or $3.33 per share for 2017. You may recall that a portion of our 2017 GAAP loss was driven by two tax items that we recorded in the fourth quarter of 2017. First, the impact of the new U.S. tax law and second, the recording of a valuation allowance against all of our U.S. deferred tax assets. We excluded these infrequent accounting adjustments from our non-GAAP results.

For the year, total non-GAAP gross profit was 29% compared to 34% in 2017. Product margin was 20% compared to 25% in 2017. Product margin was lower than we typically target, largely due to a higher mix of clusters. These systems are typically more commodity based and as a result, tend to carry lower gross margins than our higher end supercomputers and storage. Service margin was flat year-over-year at 49%.

Non-GAAP operating expenses totaled $191 million compared to $177 million in 2017. The increase was driven primarily by higher research and development cost associated with investments in our next generation computing platform.

Shifting to the balance sheet. Cash and investments and restricted cash at the end of the year totaled $246 million, an increase of nearly $100 million compared to the end of 2017. As you likely know, your -- our cash balances tend to be volatile due to multiple factors and we encourage investors to focus on working capital, which is less volatile. Driven largely by our net loss for the year, working capital decreased by $63 million to finish at $291 million. Despite this drop, our working capital ratio increased to a strong 3.25%.

Inventory was $80 million at the end of the year, a decrease of $106 million compared to the prior year. A significant portion of this decrease was driven by a couple of large systems that were in inventory at the end of 2017. At the end of 2018, approximately $16 million was out of customer sites and in the acceptance process.

I would now like to take a moment to discuss our outlook. For 2019, while a wide range of results remains possible, we continue to expect revenue to grow modestly compared to 2018. Revenue is expected to be about $70 million in the first quarter and to be weighted heavily toward the second half of the year. Overall, 2019 is expected to be a transition year as we plan to begin shipping our next generation supercomputer known as Shasta. As a result, clusters are expected to again represent a high percentage of the overall product mix.

Total non-GAAP gross margin for the year is expected to be in the 30% range, slightly higher than we finished for 2018. Non-GAAP operating expenses for 2019 are definitely expected to grow, primarily driven by ongoing investments with Shasta. At this point, the growth rate for 2019 operating expenses remains uncertain due to a variety of factors, including incentive-based compensation, the level of R&D credits and development cost associated with Shasta, especially the ASICs we are developing for our new system interconnect.

For 2019, adjusting items from GAAP to derive non-GAAP results are expected to be about $15 million. Based on this outlook, even though we're experiencing -- expecting substantial loss, we're anticipating nominal tax expense for the year, primarily driven by international taxes on a non-GAAP and non -- on a GAAP and non-GAAP basis. For earnings per share purposes, share count should be about 41.5 million, though it is dependent on a number of factors.

In conclusion, our competitive position remains strong and we are making significant investments to deliver even more differentiation in the future. I remain very confident in our ability to drive long-term revenue growth and shareholder value.

With that, I'll turn it back over to Pete.

Peter J. Ungaro -- President and Chief Executive Officer

Thanks, Brian.

We have three key focus areas for 2019. The first is to win new business for this year and beyond. The second is to finish development and begin shipping Shasta. And the third is to continue to expand our key growth areas of commercial customers and big data solutions.

On the first one, winning new business, we are trending well. Bidding activity was significantly higher in 2018 and we are continuing to see strong momentum in the market. While it can be lumpy quarter-to-quarter, backlog grew significantly for the year, driven by bookings which exceeded $600 million. As you may recall that our target market, the high-end supercomputing market, went through a significant downturn in 2016 and 2017 with bidding activity less than half what it was previously.

The market has begun to rebound with customers starting procurements for new systems and an overall improved velocity of deals, as opportunities move through the sales process at a more normalized rate. While momentum in the market is improving, a significant portion of the opportunities continue to be for delivery in 2020 and beyond. As a result, while we continue to expect 2019 revenue growth to be modest, it has a potential to be another strong year for bookings.

Our second focus area is to begin shipping our Shasta systems before year end. Shasta is our next generation platform, which will dramatically expand our current supercomputing offerings, adding an entirely new level of flexibility, performance and scalability. It will incorporate our new system interconnect, called Slingshot, which will feature revolutionary performance and add Ethernet compatibility for data center integration.

From a development standpoint, there are significant challenges to bringing out this exciting combination of unique Cray technology, across both software and hardware, all of which we've been working on for some time now. In software, we are designing a common operating environment for both Shasta form factors, the 19-inch, air or liquid-cooled standard data center cluster rack and our larger high density liquid-cooled cabinet. This full software stack will dramatically improve the ease of use of the system, as well as performance at scale.

In hardware, there are multiple deliverables, including an entirely new packaging infrastructure, as well as the Slingshot interconnect. This is a substantial undertaking, with a Cray-designed ASIC sitting at the heart of the solution. We have the first prototypes in-house and are actively testing them. Our goal is to begin shipping Shasta based systems by the end of this year with revenue targeted to begin ramping in 2020. I look forward to updating you as the year progresses, and at this point, we're on track with our goal.

Our third focus area for 2019 is to continue to expand into the commercial and big data markets. In commercial, we are pursuing several avenues to drive growth. First, we're leveraging our core technology to deliver scale and performance that commercial customers need to analyze ever expanding amounts of data and in new application areas such as AI, IoT and cyber security.

Second, we're investing to improve the ease of use of our systems and make them more adaptable for commercial customer environments. And third, we're working with partners to develop application and segment specific solutions around Cray's unique technology.

While our existing systems deliver many of these capabilities at some level today, Shasta will dramatically advance and expand on each of them and will be key to our efforts going forward. With Shasta, customers will be able to start on a smaller-sized system and build up over time, making it easier and more economical to leverage the advantages of Cray solutions.

Our long-term goal remains to drive a third of our total revenue from the commercial markets. I'm excited as this opportunity continues to unfold, and by our prospects to serve a growing set of customers. As I mentioned earlier, we did over 20% of our 2018 revenues with commercial customers, so we've made good progress on this goal.

In big data, we're focused on three high growth areas; analytics, high performance storage, and artificial intelligence, including machine and deep learning. In storage, our ClusterStor solution leads to market at the high end, delivering the most powerful, robust, and cost effective solution on the market. On the analytics and AI front, our Urika-CS and XC software allows our customers to run their analytics and AI workloads right on their Cray supercomputers versus having to purchase a separate system.

Over time, Shasta's data-centric design and Ethernet compatibility will allow us to expand further into commercial data centers and play a larger role in evolving computing workflows that leverage AI and big data techniques.

Before I wrap up, as with last quarter, I understand that many investors are focused on the Department of Energy's CORAL-2 program. This program is for exascale supercomputers in the 2021 to 2023 time frame, covering two systems with an option for a potential third and an announced budget of over $1 billion. As you may know, we submitted proposals for this procurement in late May of 2018. At this point, we're still not able to comment any further regarding this program.

I'll wrap up by saying that I firmly believe we are making the right investments today to build the best future possible for Cray. While challenging in the near-term, we believe that by sticking with our strategy, we'll be in an excellent position as our market grows to new highs with its expected rebound over the next few years.

With that, I'd now like to turn the call over to the operator to begin the Q&A.

Questions and Answers:

Operator

(Operator Instructions) And your first question comes from Alex Kurtz with KeyBanc Capital Markets.

Alex Kurtz -- KeyBanc Capital Markets. -- Analyst

Yeah, thanks guys. Can you hear me OK?

Peter J. Ungaro -- President and Chief Executive Officer

Yeah. Hi, Alex.

Alex Kurtz -- KeyBanc Capital Markets. -- Analyst

Hey. So when we think about 2019 from a Cluster perspective, Peter, I mean what I'm hearing is that because we're transitioning to Shasta that XC is going to basically go to very small volume, and I mean would it be fair to say Cluster could be 50% of your Supercomputing business this year, just as a ballpark?

Peter J. Ungaro -- President and Chief Executive Officer

Yeah. Alex, we definitely think that with the transition to Shasta, we're going to continue to see more clusters as we did in 2018. So, I don't know if we'll get to 50% but we think that it will remain a pretty high percentage of our overall business this year.

Alex Kurtz -- KeyBanc Capital Markets. -- Analyst

And Cluster, would you say outperformed your expectations for Q4 and that's where the margin miss occurred from basic -- where your expectations were?

Peter J. Ungaro -- President and Chief Executive Officer

Yeah, that's definitely one area for us was that product mix.

Alex Kurtz -- KeyBanc Capital Markets. -- Analyst

Okay. I'll jump back in the queue. Thanks.

Peter J. Ungaro -- President and Chief Executive Officer

All right. Thanks, Alex.

Operator

And your next question comes from Aaron Rakers with Wells Fargo.

Aaron Rakers -- Wells Fargo -- Analyst

Yeah, thanks. A couple of questions, if I can. You know, first of all, as you kind of lay out the framework of modest growth for 2019, I'm just curious, now that you've had a little bit of time, how much have you kind of scrubbed your potential customer pipeline of opportunities around whether or not they would wait for Shasta or go ahead with maybe projects that they have previously planned?

Peter J. Ungaro -- President and Chief Executive Officer

Yeah, Aaron. That's a great question. So we've obviously spent a ton of time working with our customers on and pretty much individual basis, as they're thinking about their next procurements. And we have a set of customers that need capabilities prior to Shasta and we believe we have great solutions for them with both our XC and Cluster product lines. We have some customers that can wait and will wait and start with Shasta, probably in 2020, in next year and move forward from there.

And then we have some customers that will bridge, so that they need a little bit of capability in this year and then will upgrade to Shasta and build out more capability in 2020 and beyond. So we have customers kind of in all areas of that and that transition into Shasta is obviously a pretty tricky one for us to manage, but one that we feel like we're working through with each of our customers independently and I think we've got a plan across the board.

Aaron Rakers -- Wells Fargo -- Analyst

Okay. A couple quick follow-up. Any update on the possibility, I know this might be a longer-term kind of thought process for the Company, but the possibility of looking at Slingshot as an external potential monetization opportunity?

And then any kind of a quick update on the relationship with Microsoft? I think there was announcement back in November, I'm just curious of how we should think about that.

Peter J. Ungaro -- President and Chief Executive Officer

Yeah. So, first of all on the Slingshot opportunity. So we're obviously very actively developing Slingshot in -- nothing is really going to happen until we start shipping Slingshot. So we've got a little bit of time in front of us here. But we're continuing to evaluate the opportunity of shipping Slingshot separately from our systems. We've developed it from the ground up with an architecture that makes that very possible. So it's modular, it's not built into the overall system. So, it's something that we're not planning on today, but something that we're definitely evaluating and -- but it wouldn't happen until after we start shipping, obviously. So it's something that's a year or two years away from where we are today.

As far as Microsoft goes, we continue to have a great partnership with Microsoft. We recently put out a system on the Microsoft Network, so in the Azure cloud, and that's a Cray XC system, Cray XC-50, and we're just bringing -- getting ready to bring our first customer on-board to that system in a trial basis. So, it's now up and running and we're working on it, bringing on our first customers to do it as a trial basis.

So, we're excited with that and we're hopeful that over time that Cray systems together with the Azure cloud is going to be a good opportunity for customers there. Surely a lot of interest out there in it and we'll see how that plays out kind of from a sales and revenue perspective over time.

Aaron Rakers -- Wells Fargo -- Analyst

Okay. And then one final real quick one for me. You mentioned in your prepared remarks the long-term path of what I think you quoted as being healthy profitability. Peter, I'm just curious as you kind of look at the model and understanding the variables in play here right now, but how do you define healthy profitability?

Peter J. Ungaro -- President and Chief Executive Officer

So from my perspective, healthy profitability is generating kind of an increasing amount of profit with our growth and getting a model that's leveraged over time. Aaron, right now, as you well know, we're -- our market's quite far down from where it was and our revenues are quite far down from where they were. And so in order for us to really start to grow and become profitable again, we have to get our revenues up into the range that where we left them in the $700 million plus range and we think that we can do that with the technology that we have and grow from there. And we think that with that growth, we can bring more and more of that down to the bottom line and have a nice model that's very accretive to the Company. We haven't set any specific targets publicly, but it is something that we feel like we have to get to a -- more than a little and hopefully even in the double-digits over time.

Aaron Rakers -- Wells Fargo -- Analyst

Okay. Thank you very much.

Peter J. Ungaro -- President and Chief Executive Officer

Yeah. Thanks, Aaron.

Operator

(Operator Instructions) Your next question comes from Chad Bennett with Craig-Hallum.

Chad Michael Bennett -- Craig-Hallum Capital Group LLC -- Analyst

Great. Thanks for taking my questions.

Brian C. Henry -- Executive Vice President and Chief Financial Officer

Hi, Chad.

Chad Michael Bennett -- Craig-Hallum Capital Group LLC -- Analyst

Hey, Brian. So maybe just a follow-up for you, Brian on the gross margin question from earlier, product gross margin for the quarter. I think at least a couple of quarters this year, maybe all of them, we've had some legacy kind of contract cost or penalties that have dinged us on the product gross margin line. Did we have any of those this quarter? And do we expect any going forward?

Brian C. Henry -- Executive Vice President and Chief Financial Officer

We continue to have some kind of aggressive bids and some lower gross margins than we'd like to have on a regular basis, again in the fourth quarter. We never bid them to be the way they are and I think the environment is getting a little better from -- excuse me -- commodity point of view. So we might have less surprises there. But there are other uncertainties out there, ranging from tariffs and things and it's a competitive environment and a transition year. So we're not expecting a significant improvement next year.

Chad Michael Bennett -- Craig-Hallum Capital Group LLC -- Analyst

Okay. And (multiple speakers).

Peter J. Ungaro -- President and Chief Executive Officer

This year.

Chad Michael Bennett -- Craig-Hallum Capital Group LLC -- Analyst

It's for '19.

Brian C. Henry -- Executive Vice President and Chief Financial Officer

Yeah, this year now, '19, yes, sorry.

Chad Michael Bennett -- Craig-Hallum Capital Group LLC -- Analyst

Yeah. And then maybe for Pete. So Mellanox reported the other week and actually in -- on the InfiniBand side of their business, which is largely HPC, not all but largely. They had a really good a December quarter and we're actually quite bullish about their prospects or HPC's prospects for this year. And just kind of any kind of comment or puts and takes there and they were obviously highlighting their HDR 200 Gig product coming out, I think soon and the potential there for distincting (ph) themselves in the interconnect market?

Peter J. Ungaro -- President and Chief Executive Officer

Yeah, Chat. I mean, Mellanox is obviously important partner of ours, our entire Cluster business is built on Mellanox and OPA and we have a definitely a higher percentage of systems that are shipping with Mellanox today than ever. And so -- and HDR, I think is a really solid product for the Cluster space. So they're doing great in the marketplace. We continue to be partnered with them on many opportunities and I think HDR is another good example of that. Of course, we developing our own interconnect in Slingshot, we have our current Aries systems out there. And what we've really focused on is real performance at high scale. And so that's been a difference between our networks and Mellanox of how we handle that in very, very large systems and we think that Slingshot will be another good step forward there for us and we're very excited about it.

So it's one of those areas where we partner very closely with Mellanox, they are an important partner of ours, but we also are building some of our own technology to handle some unique needs from a customer basis that we think we can be advantageous on. So that it's both a partnership in a little bit of competition.

Chad Michael Bennett -- Craig-Hallum Capital Group LLC -- Analyst

Okay. And then maybe one last one if I may. I obviously -- we're just talking about '19 now and getting our arms around how that's going to shape up and Shasta (inaudible) introduction is still ways away and there's more work to be do (ph), but based on kind of how you think about next year, and in particular Shasta from again, if everything's on plan from a revenue impact, not necessarily bookings impact, do you feel like 2020 will be a material revenue year for Shasta?

Peter J. Ungaro -- President and Chief Executive Officer

Yeah, that's a great question, Chad. So we -- as I mentioned on the call, as you correctly stated, we expect to start shipping Shasta at the very end of this year with revenues ramping in '20. Shasta has a lot of different technologies and we'll roll those technologies out over time. So it will take a couple years before all of those technologies are in the market, but we definitely believe that we'll start to have more material growth in 2020 and beyond with Shasta. That's the main reason why we're doing all this. So we feel very bullish about that in that time frame. It's really just 2019 being this transition year that -- that's the more than challenging year for us.

Chad Michael Bennett -- Craig-Hallum Capital Group LLC -- Analyst

Okay, great. Thanks, guys.

Peter J. Ungaro -- President and Chief Executive Officer

Yeah. Thanks, Chad.

Operator

And there are no further questions at this time, I'll turn the call back over to you for any closing comments or remarks.

Peter J. Ungaro -- President and Chief Executive Officer

Thanks. I just wanted to thank you all for joining the call today and for your continued support of Cray. Have a great evening.

Brian C. Henry -- Executive Vice President and Chief Financial Officer

Thank you very much.

Operator

Thank you. This does conclude today's conference call. You may now disconnect.

Duration: 35 minutes

Call participants:

Paul Hiemstra -- Corporate Treasurer

Peter J. Ungaro -- President and Chief Executive Officer

Brian C. Henry -- Executive Vice President and Chief Financial Officer

Alex Kurtz -- KeyBanc Capital Markets. -- Analyst

Aaron Rakers -- Wells Fargo -- Analyst

Chad Michael Bennett -- Craig-Hallum Capital Group LLC -- Analyst

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