Supercomputer Glitch

By Lawrence Carrel

SmartMoney.com

January 29, 2004

Cray Inc. (CRAY)

"There's no question we are in a market environment where you can't disappoint on either the top or bottom line," says Chad Bennett, an analyst at Miller Johnson Steichen Kinnard, a Minneapolis brokerage. "And in technology, you better be at the high end of guidance when you guide forward." Cray missed on both counts.

While fourth-quarter net income came in at $45.4 million, or 56 cents a share, far better than last year's $1.3 million, or two cents, profits were inflated by a big one-time gain. Exclude the deferred-tax asset of $42.2 million and a restructuring charge of $4 million, and Cray's operating income adds up to $7.2 million, or nine cents a share. Though that was on par with Thomson First Call's consensus estimate, some analysts still interpreted it as a profit miss. Revenue rose 71% to $67.2 million.

"The consensus really was what the earnings per share would be as if Cray had a fully taxed rate of 35%," says Alan Robinson, an analyst at Delafield Hambrecht, a Seattle-based investment bank. "I think when you actually strip out the restructuring charges of $4 million, you get a fully taxed profit of six cents, so the company missed by three cents, or 33%." Though that was bad in its own right, Robinson says what really put the Street in a tizzy were Cray's projections for 2004. The company predicted operating profits of 8% to 12%, on an expected $300 million in sales. First Call had forecast revenue of $312 million. Revenue for 2003 was $237 million.

"I believe my peers and I had predicted operating margins in a range of 15% to 20%," says Robinson. "Clearly, the consensus for 2004 was way too high."

Alan Davis, an analyst at McAdams Wright Ragen, agreed: "With regard to 2004, Wall Street may have been a little overoptimistic." Davis says Cray has effectively lowered guidance for 2004 earnings to between 30 cents and 33 cents a share. Prior to the warning, the First Call consensus was 49 cents. (Davis doesn't own shares of Cray; McAdams Wright Ragen has an investment-banking relationship with the company.)

Cray's ability to achieve even the lowered targets may hinge on the successful introduction of two new products, which have lower margins. The new Cray X1E supercomputer and the commercialized Red Storm systems, which can perform 40 trillion calculations per second, are expected to hit the market in the second half of 2004. The company also needs to maintain momentum with its current customer base, including the U.S. government.

Some observers think Cray can prosper this year.

"This is a buying opportunity," says Michael Markowski, director of research at StockDiagnostics.com, an independent research firm focusing on cash flow. "I'm saying this stock is going to outperform the market."

Pretty strong words, considering StockDiagnostics warned its subscribers last Oct. 14 to "avoid Cray's shares at any price." The firm said Cray had negative operating cash flow and predicted it would have difficulties continuing its trend of record quarterly earnings. The prior day the stock closed at $13.34, with Wall Street analysts rating the shares either a Strong Buy or Buy.

But from a mid-October high of $13.50, the stock plunged in November and bottomed out around $8.50 by mid-December. The recent rally in tech stocks sent Cray back up above $11 over the past six weeks.

"Now the Street has beaten up the stock," says Markowski. "I look at 10 times its operating cash flow per share, which is cheap for a company with a 70% growth rate. Now, the cash flow is kicking in. It's growing sequentially, and it looks healthy. Inventories are going down, payables are going down, and receivables are flat even though revenues are growing. Those are all positive signs, and I think the stock will go to a new high." (Markowski doesn't own shares of Cray; StockDiagnostics doesn't have a business relationship with the company.)

While most analysts aren't as enthusiastic as Markowski, after the massive sell-off some are seeing the stock in a more attractive light.

"They've taken out a lot of the negativity in the stock today," says Miller Johnson's Bennett, "but there is still a little bit of risk. We need to see bookings and orders come through to validate the $300 million guidance." (Bennett doesn't own shares of Cray; Miller Johnson has an investment-banking relationship with the company.)

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"The bright spot is that Cray products are still being sold, arguably with more price competition," says Delafield Hambrecht's Robinson. "It will take more effort to sell, but the model isn't broken. It still has very compelling products, but clearly this will be a 2005 story. It will have subdued margin growth in 2004 because of the launch of two new product lines, and the real earnings growth will come in 2005, when it gets the product launches behind it." (Robinson doesn't own shares of Cray; Delafield Hambrecht doesn't have an investment-banking relationship with the company.)