U.S. Markets closed

Edited Transcript of CRAY earnings conference call or presentation 31-Jul-18 8:30pm GMT

Q2 2018 Cray Inc Earnings Call

SEATTLE Aug 1, 2018 (Thomson StreetEvents) -- Edited Transcript of Cray Inc earnings conference call or presentation Tuesday, July 31, 2018 at 8:30:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Brian C. Henry

Cray Inc. - CFO & Executive VP

* Paul Hiemstra

* Peter J. Ungaro

Cray Inc. - CEO, President & Director

================================================================================

Conference Call Participants

================================================================================

* Aaron Christopher Rakers

Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst

* Alexander Kurtz

KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst

* Chad Michael Bennett

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good afternoon. My name is Sonya and I will be your conference operator today. At this time, I would like to welcome everyone to the second quarter 2018 financial results conference call. (Operator Instructions) Thank you. Mr. Paul Hiemstra, Corporate Treasurer and IR contact, you may begin your conference.

--------------------------------------------------------------------------------

Paul Hiemstra, [2]

--------------------------------------------------------------------------------

Thank you. Good afternoon. I would like to thank you, 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 in 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 9872838. 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; and Future growth of markets for our products; our ability to expand and penetrate our addressable market; and other statements that are not historical facts. These 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 on Form 10-Q for the period ended June 30, 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 noncash, 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 noncash 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, Cray Inc. - CEO, President & Director [3]

--------------------------------------------------------------------------------

Thanks, Paul, and thank your all for joining the call today. I'll start with some comments on our second quarter 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 the rest of the year and then open the call for Q&A.

While I'm always disappointed when we lose money, overall, we had a solid quarter, highlighted by the completion of several large supercomputer and storage systems around the world as well as a continued push towards our goal to drive growth. Our revenue for the quarter came in somewhat higher than the target we previously laid out, driven by a couple of acceptances we're able to pull into to the second quarter. Though not at the same level as last quarter, we were awarded a number of new contracts during the second quarter and are maintaining a healthy phase ahead of our expectations this year. I'd like to take you through our progress we made during the quarter in each of our product groups. In supercomputing, we completed the installation of several large XC and CS systems, the largest of which was at the Japanese Meteorological Agency and is one of the largest systems we ever deployed in Japan. This is the second larger phase of their new XC50 system. The first phase is accepted in Q1 this year.

Also in Japan, we completed large installation at the National Institute for Quantum and Radiological Science and Technology also known as QST. This XC50 will serve as the institute's new flagship system, more than doubling the performance of their previous system.

We also had a strong quarter with our CS line of cluster supercomputers installing one of the largest CS systems at the U.S. government customer as well as other systems at various universities and across multiple commercial customers. In storage, we announced a new flash-based storage solution, which will dramatically reduce the runtime of applications. The L300F integrates with our other ClusterStor models to provide a comprehensive industry-leading hybrid storage architecture.

In AI and big data analytics, we completed the acceptance process on 2 Urika-GX systems for government customer to use to expand its research capabilities. We launched a new way for customers to jump start their efforts with new AI and analytics workflow software suite for a line of CS clusters called Urika CS.

We've also introduced a Accel AI reference system configurations to help both IT and AI teams get a faster time to value for their efforts. By supporting the most popular AI and analytics tools and framework, these options make it easier for customers to get started on their AI journey with proof-of-concept projects and pilot-to-production use.

From awards perspective in analytics, we were selected to deliver Urika-GX to a government customer, and an existing university customer selected in New York our Urika XC software for their AI workload. We had a number of additional wins on the AI side, securing orders for 5 new CS-Storm systems over the last few months, including orders from 2 large commercial companies, government customers and a weather center in Europe. With that, I'll turn it over to Brian to take you through the numbers.

--------------------------------------------------------------------------------

Brian C. Henry, Cray Inc. - CFO & Executive VP [4]

--------------------------------------------------------------------------------

Thank you, Pete. Before I get to our outlook, let me first take you through our second quarter financial results.

For the quarter, revenue was $120 million. And as anticipated, we've reported a net loss. Product revenue was $83 million and service revenue was $37 million. Please note that the majority of my remaining comments will be focused on our non-GAAP measurements, which we feel that it is the best way to look at our progress. We also encourage investors to focus on our results over several quarters, as the variability in any given quarter is typically very large given the nature of our business.

Total non-GAAP gross profit for the quarter was about 32%, with product margin coming in at 22% and service margin at 54%. Product margin was lower than we typically target in part to the final phase of a loss contract on which we recognized revenue during the second quarter at 0 gross margin.

You may recall that we discussed this contract on last quarter's call. GAAP operating expenses for the quarter were $50 million. Non-GAAP operating expenses were $47 million, both results are about $10 million higher than in the prior year's second quarter. This was driven primarily by lower R&D costs reimbursements in the quarter compared to the second quarter of 2017.

R&D reimbursements are generally milestone-driven producing significant variability from quarter-to-quarter as the timing of expenses and reimbursements often do not match up.

General and administrative costs benefited in the second quarter from lower legal expenses related to our patent litigation, which has progressed positively.

Our GAAP net loss was $11 million for the quarter compared to $7 million in the prior year period, with the difference driven in part by a significant income tax benefit in last year's second quarter. As we have discussed previously, we are not currently recording a potential future tax benefit from our loss.

On a non-GAAP basis, our net loss for the quarter was $8 million or $0.20 per share, which was the same as the second quarter of 2017. Our second quarter GAAP operating results included $3.7 million for depreciation, $3.2 million for stock-based compensation and $300,000 for amortization.

Shifting to the balance sheet. Cash investments, restricted cash at the end of the second quarter totaled $144 million. As you likely know, our cash balances tend to be volatile due to multiple factors, and we encourage investors to focus on working capital, which is less volatile. Working capital decreased by $7 million to $325 million at the end of the quarter compared to the end of the first quarter of 2018.

Inventory decreased by $33 million in the quarter to $148 million with 45% or $66 million out at customer sites and in the acceptance process. I would now like to take a moment to discuss our outlook.

For 2018, while a wide range of results remains possible, we expect 2018 revenue to be in the range of $450 million, which is at the high end of our previous outlook. Revenue for the third quarter is expected to be about $90 million.

Overall, non-GAAP gross margin for 2018 is expected to be in the low 30% range. We expect non-GAAP operating expenses for the year to be in the range of $190 million. Adjusting items for GAAP to derive non-GAAP results [in] predominantly driven by stock compensation and are expected to total about $14 million for 2018 with about $2 million of that going to cost of sales and $12 million to operating expenses. Based on this outlook, even though we are anticipating a loss, we're anticipating nominal tax expense for the year on a GAAP and non-GAAP basis. For EPS purposes, shares should be about $41 million, though it is dependent on a number of factors. For 2019, while a wide range of results remains possible and it is still early in the planning process, we currently expect revenue to grow modestly compared to our 2018 outlook. In conclusion, we're making progress towards our goals for the year, and I remain confident in our ability to drive long-term revenue growth and shareholder value. With that, I'll turn it over to Pete.

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [5]

--------------------------------------------------------------------------------

Thanks, Brian. We have 2 key focus areas for the rest of the year: The first is to win new business for 2018 and beyond, and the second is to continue to expand into our key growth areas of commercial customers and big data solutions. We're off to a great start on the first one. While we have work left to do to continue to win new awards, we're trending nicely against this goal for the year.

The sets us up solidly for the rest of 2018 and begins to build a good base as we head into next year. It can be difficult to predict the exact timing of customer acceptances and we'll definitely have several, which will come in late in the year. However, we now have over 90% of the contracts we need in order to achieve our outlook for 2018. So we'll be focused on closing the remaining contracts we need as well as executing against each of them before year-end. Though it is still early in the recovery cycle, our target market at the high end of supercomputing is continuing to show signs of a rebound. Customer plans for new systems are firming up, creating new opportunities in the market. This is increasing the velocity of opportunities through our sales pipeline, and as you may recall, that was a key factor in the slowdown in our market over the last couple of years. So it's good to see deal flow picking -- beginning to pickup pace. I'm also pleased to see improvements across of our various market segments, as well as across our 4 regions around the world. As a result, our bidding activity has been high this year. In fact, we're still on track to bid on more than 3x the potential revenue we bid in 2017. Some of these bids are for revenue opportunities in the next year or 2, but some of the largest opportunities are slated for 2020 and beyond. So our bidding activity is strong, because much of it is for future years, we believe that the market rebound will be slower over the next year or 2, as we've been discussing in previous calls. That being said, based on what we're seeing today and as Brian mentioned, we expect to grow modestly in 2019, as we indicated in our outlook.

From a technology perspective, 2019 and 2020 is shaping up to be great years for new products, both from our technology partners as well as our own development programs. I expect it to be very exciting time.

Our second focus area for the year is to continue to expand into commercial customers and big data markets. The commercial market is continuing to improve, driven in large part by a rebound in the energy segment. Energy has been a significant driver in our commercial business over the past few years. As the price of oil has improved recently, our customers are more confident in their capital plans, which includes supercomputer and storage solutions. In fact, we expect revenue from commercial customers to grow strongly in 2018 compared to last year, potentially representing more than 15% of our total revenues for the year. Growing in the commercial markets has been a key goal of ours so it's great to see this kind of expected year-over-year improvement.

In big data, we're focused on some 3 specific areas: Analytics, high-performance storage and artificial intelligence and deep learning. Each of these segments are growing fast and are expected to represent a larger percentage of our customers' technology budgets over time.

In storage, we're focused on expanding our leadership position, delivering the most powerful robust and cost-effective storage solutions on the market. Cray ClusterStor continues to lead the market at the high end with the 30% share of the top 100 most powerful supercomputers in the world, delivered both by Cray and by our partners and reseller channel.

On the analytics and AI front, our new Urika-CS and Urika XC software allows us to take another big step in our vision around the convergence of supercomputing and big data, by allowing all of our customers to run their analytics and AI workloads right on their Cray XC and CS supercomputers, versus having to purchase a separate system.

As our customers are working to integrate new techniques to improve their results on traditional modeling and simulation, as well as to gain new insights from their data through analytics and AI, these tools will become more and more important and help us dry market expansion by playing in a larger part of our customers' workloads.

Before I wrap up, 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 2 systems with an option for a potential third and expected budget of over $1 billion. As you likely know, responses were due in late May and we submitted proposals for this procurement. At this point, we're not able to comment any further regarding this program.

In conclusion, I'm pleased with where we are at the half away point of the year. Our competitiveness remains strong, and we're well positioned to deliver on our outlook with an exciting roadmap to drive long-term growth. With that, I would now like to turn the call over to operator and begin the Q&A.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Your first question comes from the line of Chad Bennett from Craig-Hallum.

--------------------------------------------------------------------------------

Chad Michael Bennett, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [2]

--------------------------------------------------------------------------------

Nice job on the quarter and it's good to see you levitating up to the high-end of the range for the year. Yes. So I guess, I'm sure I won't be the only one to ask about the 2019 language now that it's out there, but I'll take a shot at it. In terms of modest growth, I guess, how would you define that relative to the growth you are seeing this year, Pete?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [3]

--------------------------------------------------------------------------------

Chad, it's really early in the time frame, and we wanted to give everybody a view that we do expect this rebound to continue and that we will continue to make progress, along with the market. As the market rebounds, we believe that our business is going to rebound. But as I mentioned, a lot of the bids that we're doing right now, especially the larger ones, are for 2020 and beyond. And so we do expect, both this year and next year, to be slower in the rebound phase. And so I'm not going to define it exactly. But obviously, we are not expecting high-growth. It is modest number that we expect next year. And hopefully as the market rebounds further, we'll be able to grow faster and faster with the market.

--------------------------------------------------------------------------------

Chad Michael Bennett, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [4]

--------------------------------------------------------------------------------

Okay. I appreciate it. And then maybe this ties in little bit. Intel said on their call last week, they gave, I guess, some incremental color around 10-nanometer, their 10 nanometers chip and timing. And It sounds like the data center, 10 nanometers chip is a possibility not going to be a 2019 event and might be more of a 2020. I guess, how does that impact you -- if at all -- I guess, impact your '19 outlook? And then how does that impact the timing of Shasta and so forth?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [5]

--------------------------------------------------------------------------------

Yes. Great question, Chad. We're obviously huge partner with Intel, and they're a very important component provider and partner for us in going after the market. As we came up with our guidance for this year and next year, and as we think about it for the next few years, we obviously strongly consider their roadmap as part of that. And as I mentioned, I think over the next couple of years, we are going to get some interesting product, not just from Cray for our future solutions, and you mentioned Shasta, which is our next-generation platform that we're working hard to develop, but also from our technology providers such as Intel. So it was considered in the numbers and I think is part of the slower rebound that we're seeing over the next couple of years. So I would just say that it was considered as we gave our guidance.

--------------------------------------------------------------------------------

Chad Michael Bennett, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [6]

--------------------------------------------------------------------------------

Okay. Fair enough. Then maybe last one for me, for Pete or anybody for that matter. How should we think about -- I mean you talk about bid activity coming back significantly this year. And I think you've seen some pretty good activities so far. But when it comes to bookings activity. If you are to kind of think about the second half of the year bookings activity for the first half -- versus the first half, how should we think about the magnitude of the second half versus the first half? Based on what you see today, not that you'll -- everything will get down the way you think it will.

--------------------------------------------------------------------------------

Brian C. Henry, Cray Inc. - CFO & Executive VP [7]

--------------------------------------------------------------------------------

Pete pointed to me. Look, there is a wide range of opportunities in the second half. And it has been that. We're active and we'll see how it evolves. But as Peter said, we think the market, in general, is improving. Some of the bid activity that we expect in the second half will be for periods beyond 2019.

--------------------------------------------------------------------------------

Chad Michael Bennett, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [8]

--------------------------------------------------------------------------------

Right. Right.

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [9]

--------------------------------------------------------------------------------

I think the way to think about it and kind of characterize what we're just seeing broadly, Chad, is that, if you remember for the past couple of years in the dip of the market, we were feeling like we had a lot of opportunities in our overall pipe, they just weren't moving through the pipe. So the deal flow was really slow. Now we're seeing that deal flow happen. We're seeing it happened across kind of all of our [geos] and across most all of our segments, vertical segments. And so that's very positive. And so we are expecting that we're going to continue to see improvements in increasing deal flow over -- not just the second half, but into next year and beyond. And so we're feeling good that we're going to have a good solid continued deal flow as well as wins that go along with that. As Brian said, I think it's very early, but we're feeling -- we're feeling pretty very good about things right now.

--------------------------------------------------------------------------------

Operator [10]

--------------------------------------------------------------------------------

Your next question comes from the line of Alex Kurtz from KeyBanc markets.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [11]

--------------------------------------------------------------------------------

Couple of questions here. So Pete, could you talk to us about your -- CORAL 1 the original that is being respun? Is there an update there? And any detail would be helpful on that.

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [12]

--------------------------------------------------------------------------------

Yes. Alex, great question. For those that don't know CORAL 1 was a contract that we won with Intel. Intel was the prime and we were a partner of Intel's on that contract for a large system at Argonne National Laboratory. That system was canceled and the Department of Energy has come out and said that they're expecting to move that system into being the first Exascale system that will be delivered to the marketplace. And that hasn't been -- that is not a contract yet and there is work to be done there, but we're still hopeful that that's going to happen and come out later. But as of right now, we can't really comment more than what Department of Energy has said publicly.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [13]

--------------------------------------------------------------------------------

Okay. CORAL-1 CORAL-2, so I mean, are we still thinking these are opportunities to be brought or at least exposed to the market by the DOE in 2018? Even if it's late 2018?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [14]

--------------------------------------------------------------------------------

That's a great question and that's very dependent on the government's time lines and stuff. So I can't really comment on the government's time lines and what they're ultimately going to do there.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [15]

--------------------------------------------------------------------------------

Okay. When we think about -- let me ask you this -- the growth question this way. What would it take to get back to $700 million run rate business? I know that's where we were back in '15, and I know you guys think you can do it without Exascale. What has to come together for that to put those kinds of numbers back into the revenue?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [16]

--------------------------------------------------------------------------------

Yes. That's a great question, Alex. From our perspective, we're seeing the market rebound, and we're feeling very confident that market rebound is going to continue and get back, not just where the market was, but even beyond where the market was, and that's not including Exascale. I would like to think about Exascale as kind of icing on the cake versus the cake. And with the market -- the general market being the cake. We really just need to see that market continue to grow and get back to the size that it was. And we feel like that technology and the roadmap that we have, especially now with both a stronger storage lineup with our acquisition of ClusterStor team and bringing that in-house with our storage team, and what we're seeing in these early AI wins and such, I think we have a really good chance of not just getting back to that, but hopefully beyond that. And that will be our goal. But it's really -- I think the market has got to get back to where it was. It came down pretty substantially at the very high end. You might remember a couple of quarters ago, we estimated that it was -- it had come down by 60% or little over 60%. So it was significant down from where it was at its peak. So it's just got to get back there and it's going to take a few years to do that, but we're pretty confident it's going in that direction.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [17]

--------------------------------------------------------------------------------

As you just think about the '19 guide -- and I think you were mentioning this in the response to the prior question, but this is your initial take. And as you go through September and December, it sounds like, as you better understand the pipeline, there could be a different view of it. Is that the right interpretation?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [18]

--------------------------------------------------------------------------------

Yes. I think we'll continue to refine that as we get more information. I can't project how much more information we'll have next quarter versus this quarter. But as we get more information, we'll definitely give you guys an updated view of that. We always try and give a perspective. This year, we're able to give an earlier perspective than normal, just because we're seeing the momentum in the market, and we're feeling pretty good about that's going to play out.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [19]

--------------------------------------------------------------------------------

Last question. In your prepared remarks, Pete, I missed it, did you say what percentage of the years already kind of booked or backlogged? I thought maybe you mentioned that or maybe I misheard it.

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [20]

--------------------------------------------------------------------------------

Yes. I did. I said over 90%.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [21]

--------------------------------------------------------------------------------

Okay. So the rest of it is turns and rev rec.

--------------------------------------------------------------------------------

Operator [22]

--------------------------------------------------------------------------------

Your next question comes from the line of Aaron Rakers from Wells Fargo.

--------------------------------------------------------------------------------

Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [23]

--------------------------------------------------------------------------------

Couple of questions, if I can. Can you hear me, okay?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [24]

--------------------------------------------------------------------------------

Yes.

--------------------------------------------------------------------------------

Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [25]

--------------------------------------------------------------------------------

okay. Perfect. A couple of questions, maybe just on the backlog comment there real quick, given that there is a quantified metric in the 10-Q. When we look at the $465 million of backlog, Brian, can you just remind us, again, how we think about that relative to the progression into the model as far as revenue is concerned?

--------------------------------------------------------------------------------

Brian C. Henry, Cray Inc. - CFO & Executive VP [26]

--------------------------------------------------------------------------------

We disclosed -- actually, we disclosed how much over the next 18 months is likely to be revenue of that $465 million and it's about 80%, and that's up from 70% in the last quarter or so. It's kind of a similar view, but 1 quarter later in terms of that kind of revenue that we have in backlog now. As Pete said, the timing of booking sometimes is quite volatile that comes from the bids that we do. But we're pleased with the progress we've made year-to-date, and we have a lot of opportunities out there to continue to improve that as we go forward and build a stronger position as we go forward into future years.

--------------------------------------------------------------------------------

Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [27]

--------------------------------------------------------------------------------

Okay. And as a quick follow-up, you're starting, it sounds like, get increasing confidence in the commercial growth. If I just did some quick math and I look at your U.S. revenue, excluding the revenue you disclosed as far as contributions from the U.S. government, it looks like you grew about 80% year-over-year in the first half of the calendar year. I know that you're talking about 15% contribution looking out exiting this year. I guess, 2 questions on that. One, how do I think about the diversity within that commercial customer base? I know you mentioned the energy verticals seem to be kicking in, but I think you're also might be seeing some diversification there. And then if we do see the recovery that you think can materialize over the next couple of years, how do we think about that commercial contribution looking out 3 years from now or even 2 years from now for that matter?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [28]

--------------------------------------------------------------------------------

Yes. Great question, Aaron. And we're -- look, we're super excited about to the see the commercial growth. We think that's a huge part of our growth story overall, over the next few years, because that really expands our market as we go forward. It was -- as the market was going down and the price of oil was very low, that went down to very small number over the last couple of years. So it's bounced back nicely. And you asked about diversity. I would still tell you it -- while it's not, of course, all in the energy vertical, energy is still by far our strongest vertical. But we have diversified by customer within that vertical. So we have quite a few number of customers now in that vertical and both with, not just compute solutions, but with storage solutions and even AI solutions. I feel like we're really getting nice diversity by customer and workloads, where if you went back -- even if you went back when energy was strong for us a couple of years ago before the market dip, it was very consolidating in just a couple of customers. And so that diversification is super important for us. I would also tell you there is some diversification across geographies even within that vertical, so that's another positive there. I mentioned in my prepared remarks that we expect it to get back over 15% this year and that's a great number for us. I believe it can be higher than that. I mean, we have a goal over time that we get that to be maybe even up to 1/3 of our business over time, but we definitely want to see that number grow. I don't think it will grow just consistently year-over-year, it's going to go up and down, kind of the lumpiness of our business that's just kind of natural for us. But we want to see that trend line heading in the right direction and I think it could go well above the 15% that we are seeing today. So I'm pretty excited about the progress that we're making there. I also think our progress in AI and analytics is really important for the commercial customers. And we're also doing a number of things in our future compute and storage products that I think is going to be very important for commercial customers. So I feel pretty good that we understand what we need to do to be successful in that market, and we're starting to get some more diversification and breadth in that marketplace.

--------------------------------------------------------------------------------

Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [29]

--------------------------------------------------------------------------------

Okay. Final real quick question for me. As you have now seemed to be worked through the 0% gross margin contract, can you just remind us how we should think about your product gross margin going forward? Do we see a product gross margin that can get back into that 30-plus percent range?

--------------------------------------------------------------------------------

Brian C. Henry, Cray Inc. - CFO & Executive VP [30]

--------------------------------------------------------------------------------

Yes. It may not happen immediately and part of that is, is we've had over recent times pretty heavy mix of cluster systems that tend to carry, on average, lower margins. But with the things we are doing in our development and the technology we have coming forward and I think our relative competitive position as a technology evolves, we should be able to more consistently get into the 30-plus percent range. And of course, our goal is mid-30s or better on the products in total. Some of that will depend on mix, but both storage and our high-end machines, plus what we do in analytics, should could carry pretty strong comparative margins as we go forward. Services was strong. It was 54% this last quarter. That probably will average in the ballpark of 50% over time. It was a strong quarter here but it varies a little bit for variety of things and by quarter, the way we account for things. But I think that combination means that the overall gross margins can be back up into the mid-30s versus the low 30s right now.

--------------------------------------------------------------------------------

Operator [31]

--------------------------------------------------------------------------------

(Operator Instructions) Your next question comes from the line of Alex from KeyBanc Capital Markets.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [32]

--------------------------------------------------------------------------------

Pete, just want to clarify on the commercial side. You're talking about being at or above 15% for the year. And I guess, how is that -- are you at the level in Q2? And then how we think -- we should think about it from a linear perspective through the rest of the year?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [33]

--------------------------------------------------------------------------------

Yes. That's a great question, Alex. I don't know the percentage that that we are at for the first half of the year. I don't have that on top of my head. But I would say, we're probably little below that number for the first half of the year based on what we have -- our expectations for the second half. So we're probably a little bit below that number for the first half. And -- but we should get there for the full year. And that's how I think about it. Did you ask about next year?

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [34]

--------------------------------------------------------------------------------

No. Well, I think you said in Aaron's question you expect to be a higher percentage of mix next year, right?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [35]

--------------------------------------------------------------------------------

Well, I expect it to be -- look, I expect it to go up and down, based on the deals and exactly how they hit in the year. So I don't expect it to be always up, up, up, up, up. But I do expect it to trend up across a 24 month or something like that, kind of process. I do expect that we are going to continue to grow in commercial and grow past the 15% number into the twenties and maybe even into the 30s if we keep going.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [36]

--------------------------------------------------------------------------------

And commercial is being driven primarily by energy?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [37]

--------------------------------------------------------------------------------

Yes. Today, I would say that continues to be our strongest segment and they have a very challenging problem in energy that they need to do it upstream. And I think as we start to see a lot of energy customer starting to think about how do they blend kind of artificial intelligence and deep learning technologies into their mix, I think that's gets really challenging workflow. And that's always a good thing for us. The good challenging problem is a good place for us to go to work.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [38]

--------------------------------------------------------------------------------

Well I think from an investor perspective and from my perspective, given how much you're talking about commercial, Pete. Can we just as we go through future calls, have that number? So we can disclose that on the call so we can really start to track that, if you guys would consider that at least.

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [39]

--------------------------------------------------------------------------------

Yes. We will think about, Alex. We appreciate that comment. I appreciate that.

--------------------------------------------------------------------------------

Alexander Kurtz, KeyBanc Capital Markets Inc., Research Division - Senior Research Analyst [40]

--------------------------------------------------------------------------------

And then last question is that competition you're seeing in artificial intelligence markets. Who are you seeing there the most? And what are you seeing more at the low end with your cluster business?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [41]

--------------------------------------------------------------------------------

Yes. I think in the AI space, I would say it's not really a consistent competitor that we're running into. I think a lot of people are -- start off with the NVIDIA DGX products, which are kind of underneath where our offering starts. So they're kind of more on the single node, a few nodes that they do. And I think that's the one that we see the most. But we don't really compete in that space. In fact, we encourage customers to start along that path because we're a nice evolution from that path as they start to scale up more and more. We have seen some success with our Accel AI solutions, which are prepackaged solutions for customers that look and feel more like the prepackagedness of DGX kind of solution, although in a rack instead a single node. That's what we mostly see out there. And then I would just say, out of individual customers, sometimes we're seeing just a mix of all competitors. I wouldn't say we're seeing somebody consistently across the board. And then in our cluster business, I would say probably the company we see the most is either HP or Dell are the 2 companies we see the most in that business.

--------------------------------------------------------------------------------

Operator [42]

--------------------------------------------------------------------------------

Your next question comes from the line of Aaron Rakers from Wells Fargo.

--------------------------------------------------------------------------------

Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [43]

--------------------------------------------------------------------------------

I can't let Alex have the only a follow-up questions. I have to get on. So I just wanted to clarify one thing and make sure I heard it correctly, and then ask 1 related question. In response to Alex's question, I think even Alex said it is that, as you look at the market and the recovery after being down 60%, you believe you can get back to the levels of revenue that we saw back in '15 or even '16 hopefully '15, without the Exascale products kicking in the '20, '21, '22 time frame. Is that the correct commentary?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [44]

--------------------------------------------------------------------------------

Yes. Into what time frame did you say?

--------------------------------------------------------------------------------

Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [45]

--------------------------------------------------------------------------------

I guess, I'm thinking about the Exascale platforms being kind of really hitting the market 2021, 2022 time frame?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [46]

--------------------------------------------------------------------------------

Yes. Yes, that's kind of are -- that is our view right now. So we believe that the market is going to take a while to get back up to the levels that it was like in 2015 when we were kind of at our peak of revenue. So it'll take few years to a bounce back to that level. But once it does, that we think we can be achieving those kind of numbers that we had and hopefully a little bit higher than that.

--------------------------------------------------------------------------------

Brian C. Henry, Cray Inc. - CFO & Executive VP [47]

--------------------------------------------------------------------------------

And if you think about it, I think the market will have expanded in that time frame. Our service business is larger than it was in that time frame. These all position us to have the opportunity to get back there and beyond, and that's without any -- aim for some of these big Department of Energy opportunities.

--------------------------------------------------------------------------------

Aaron Christopher Rakers, Wells Fargo Securities, LLC, Research Division - MD of IT Hardware & Networking Equipment and Senior Analyst [48]

--------------------------------------------------------------------------------

And, I guess, the kind of the follow-up to that is that if we start to see the pipeline visibility improve towards progressing the model for that level. I know prior to downturn there was point of time where you talked about expanding manufacturing footprint capacity in your Chippewa Falls facility. Is there a scenario that you see where that might have to be back on the table? And if so how far in advance would you typically see that type of required manufacturing expansion?

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [49]

--------------------------------------------------------------------------------

Yes. I will start and let Brian jump in because he looks at this a lot. We definitely see -- I mean, if the growth continues and we see the market rebound just like we were pretty much about to do before the downturn, we probably will have to expand our manufacturing capability. Brain, I'll let you jump in, but that's probably a year or 1.5 in advance that we need to really be planning out pretty aggressively and get that done. Is that a good, fair view for Aaron?

--------------------------------------------------------------------------------

Brian C. Henry, Cray Inc. - CFO & Executive VP [50]

--------------------------------------------------------------------------------

Well. Yes, I think we can get it done faster if we choose to do it, because we did put plans in place. Right now we -- at the current level, we're fine in getting things done. As we grow, we may need more space. One of the things going forward in the processors use more power and therefore, there is more heat cooling. So they effectively reduce capacity little bit in those 2 areas. And so we continually monitor where we are at, what the kind of evolution of the systems are and what we need to do. No decisions now, but once we make a decision we can move pretty fast.

--------------------------------------------------------------------------------

Operator [51]

--------------------------------------------------------------------------------

There are no further questions at this time. I will turn the call back over to the presenters.

--------------------------------------------------------------------------------

Peter J. Ungaro, Cray Inc. - CEO, President & Director [52]

--------------------------------------------------------------------------------

Thank you. I will close by reiterating that we remain confident that the recovery is happening and expect that we'll look back on 2017 as the bottom of our market. While we still have a lot of work left to do, we're in good position to drive growth for 2018 and beyond. Thank you all for joining the call today and for your continued support of Cray. Have a great evening. Thanks.

--------------------------------------------------------------------------------

Brian C. Henry, Cray Inc. - CFO & Executive VP [53]

--------------------------------------------------------------------------------

Thank you.

--------------------------------------------------------------------------------

Operator [54]

--------------------------------------------------------------------------------

This concludes today's conference call. You may now disconnect.