Sometimes the stock market makes you just shake your head. Shares of Cray (CRAY) plunged 17 percent in early May after first quarter earningsapparently disappointed investors. To be fair, revenue did dip sharply year-over-year, and a 13 cent per share profit in Q12012 turned into a 20 cent per share loss in Q12013. And Cray had put together a very strong bull run -- rising all the way from $5 per share in October 2011 -- which perhaps led to some profit-taking:
All that said, the post-earnings drop made little sense. First off, Cray's main business is designing supercomputers; much of its revenues come from major projects, making quarter-to-quarter comparisons not only difficult but, often, essentially worthless. When revenues from those large installations is recognized is far less important than whether those revenues are recognized at all. Indeed, as the company itself points out on nearly every piece of financial information, "Actual results for any future period are subject to large fluctuations given the nature of Cray's business."
Making the drop more irrational, at least on a fundamental basis, Q1 sales of $79.5 actually came in ahead of the company's previous guidance of $70 million. And full-year guidance for 2013 given after Q1 was identicalto that given with the release of 2012 full-year results in February. All that changed, according to the Q1 conference call, was that a few mid-sized projects projected to be booked in Q2 were instead recognized in the first quarter. Yet that led to Cray's market capitalization falling by over $100 million in a single day.
Since then, as the chart above shows, CRAY has slowly but surely regained most of the losses from that day; at Friday's close of $19.23, it seems on its way to filling the gap from the May 1st decline and re-gaining levels of $21 per share or higher. And longer term, the stock should have even further to rise.
On a purely fundamental basis, Cray's value is not readily apparent. Using the company's guidance for 2013, the company's earnings appear likely to come in at relatively modest levels (all figures in millions):
CRAY 2013 Guidance
| Revenue | $500MM |
| Gross Margin* | 35.0% |
| Gross Profit | $175MM |
| Operating Expenses | $160MM |
| GAAP Operating Income | $15MM |
| Non-GAAP Adjustments | ($10MM) |
| Non-GAAP Operating Income | $25MM |
| GAAP Tax Rate | 40.0% |
| Non-GAAP Tax Rate** | 8.5% |
| GAAP Net Income | $9MM |
| Non-GAAP Net Income | $22.88MM |
| Shares Outstanding*** | 37.335MM |
| GAAP EPS | $0.24 |
| Non-GAAP EPS | $0.61 |
* -- from company guidance for gross margin in "mid-thirties"
** -- midpoint of guidance for non-GAAP tax rate of 7-10%
*** -- diluted share count at end of Q1
Even using non-GAAP figures, Cray shares are trading at over 30 times FY13 guidance, a high multiple given that earnings are actually expected to drop from 2012, when non-GAAP income came in at 88 cents per share. On a GAAP basis, the drop will be even steeper, as Cray's GAAP income for 2012 came in at $4.27 per diluted share. Most of the 2012 income came from a gain on Cray's sale of its interconnect hardware development business to Intel (INTC) for $140 million in April of last year.
Yet Cray shares have far more value than appears, simply looking at 2013 earnings. For one, the company has a cash-heavy balance sheet; cash per share came in at $6.72 per share at the end of the first quarter, and that figure should rise. Working capital came in at over $7 per share, a figure the company recommends using because of the lumpiness in revenue recognition and cash usage. Backing out that cash, the company's earnings multiple comes in closer to 20.
While that multiple isn't enough, in and of itself, to recommend CRAY stock, there is a lot of evidence that the current share price doesn't fully value the company's future prospects. To begin with, 2013 earnings are being depressed by a sharp jump in operating expenses, which are guided to rise over 30 percent year-over-year. According to a May presentationby CFO Brian Henry, the rise comes from Cray's decision to increase both R&D and sales and marketing spend, investing in big data and storage products that still make up a small percentage of Cray sales but are targeted for future growth. Had the company held the line on operating expenses, non-GAAP earnings would be guided for over $1.50 per share, showing the current earnings power of Cray's supercomputer business.
Yet Cray management is not content to simply rest on the laurels of that business, instead looking to storage and "big data" applications to drive additional growth and remove some of the dependency on the uneven, government-focused legacy supercomputer segment. Storage, in particular, has been mentioned by management as a key driver of growth going forward; in the Q1 conference call CEO Peter Ungaro said the company was targeting a 25-50 percent growth rate for storage this year. Margins are expected to expand in the segment as well; after posting a gross margin of 29 percent in 2012, according to the 10-K, the segment saw margin rise to 44 percent in the first quarter. Longer term, management has targeted a gross margin rate in the "mid-to-high thirties" for the segment, according to both Ungaro and Henry on the Q1 call. At the low end of the company's range -- 25 percent revenue growth at 35 percent gross margin -- storage growth alone has the potential to add $4 million in gross profit annually, or roughly 10 cents per share in net income each year. Similarly, "big data" analytics -- offered through the company's YarcData division -- don't provide much revenue yet, but offer potential revenue growth and margin expansion as the company rolls out new products and the market continues to develop.
All told, Cray should continue to expand its business from its legacy position as a provider of supercomputers primarily to the US government and higher education providers. That business is still key to Cray -- 68 percent of 2012 revenue came from the US government, according to the 10-K -- but the initiatives in storage, cluster computing, and big data offer the potential for continued revenue growth and potential margin expansion. (Net sales are projected to increase nearly 20 percent year-over-year, to a level better than double that of 2011.) The addressable market for Cray continues to expand as well; the movement into storage and cluster computing allows the company to target more commercial customers. Similarly, "big data" has the potential to impact industries as diverse as health care, oil and gas exploration, and financial services and trading.
To be sure, the "big data" space has yet to move the needle for Cray, and there are some observers questioning whether the hype surrounding "big data" has become a bit overblown. But, given its current earnings power, Cray's valuation doesn't require a home run in big data or massive growth in storage. If Cray can compete in those segments, it seems certain to boost growth over the next few years, move cash up toward the $10 per share level and earnings per share near or over the $1 per share level. And if the company can reach those fundamentals, it seems highly likely that shares will have broken the $20 level, and then some.
And Cray almost definitely will be able to compete in those spaces, because it remains a cutting-edge company. The Titan supercomputer built by Cray at Oak Ridge National Laboratory in Tennessee has been declared the world's fastest computer, besting installations from IBM (IBM), among others. The company's namesake, Seymour Cray, has been called "the father of supercomputing" and Cray has a long history of working with the US government, including the National Security Agency. And while that agency has been under scrutiny as of late, it seems likely that the need for Cray services and computing power will not diminish any time soon. Rather, escalating fears about cyberwarfare and Chinese hacking of US government and commercial targets seem likely to make computing development a key national security priority. Indeed, Wired magazine has reported that the NSA is already aiming for exaflop speed (one quintillion, or 1018 operations per second), and noted that a bipartisan group of senators has pushed President Obama to fund those computing initiatives despite the constraints imposed by the sequestration process.
There are risks; Cray's reliance on a number of small projects means one misstep can turn a full-year profit into a loss. Similarly, the concentration of revenues in the US government could impact revenues going forward, as cuts forced by the sequestration process and possible additional future reductions in defense and research spending hurt government demand for supercomputers. Indeed, Cray's R&D spending has risen of late, in large part due to the expiration of R&D reimbursements from the federal government. Cray executives have argued that the effects of the recent federal government cuts have been minimal, but as new large projects are contemplated under a new, more cost-conscious mindset, Cray could see orders become downsized or outright shelved.
But CRAY shares seem well worth those risks. Cray remains reasonably valued based on its current earnings power, even assuming a slight discount for the lumpiness of its revenue and its dependence on the federal government. And yet the company has a variety of paths, across different segments and toward different addressable markets, to grow revenue and profits substantially over the next few years. Cray remains a leader in its space, it has a rock-solid balance sheet, and still has federal tax carryforwards of some $153 million. It is a great company selling at a reasonable price, a price that is a little cheaper due to an irrational market move last month. Investors should take advantage.
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