Taking Stock: Supercomputers Aren't A Surefire Super Stock

Taking Stock - March 15, 2004
It's been a long time since I've written about Cray, one of the market leaders in high-performance computer systems, also known as supercomputers. There wasn't much to write about after it was bought by Silicon Graphics in 1996. Now that Cray is a standalone company again, after it was spun off of SGI in 2000, I believe its financial prospects may start to improve.

High-performance hardware was about a $2 billion market in 2003, according to IDC. IBM still has more than a 40% market share for supercomputers, with Cray at about 16%, IDC says. High-performance deal sizes tend to be around $20 million to $100 million, usually for high-end commercial applications or government and lab use.

When you invest in hardware companies, it's always good to look at new-product cycles since new products are the most-likely means to bring stronger revenue and earnings growth in the near term. Cray is in the process of developing its Red Storm massively parallel processing system (up to 10,000 processors in a mesh-based architecture tied to a proprietary router chip). It will be sold as a low-cost enterprise-class supercomputer and is expected to be rolled out in the second half of 2004. To keep costs down, the system will use Advanced Micro Devices' Opteron microprocessor. The price for these systems may be as low as $1 million. In addition, Cray will roll out the X-1e, with as many as 8,192 processors, this year or in 2005.

Some big changes have come in the way of personnel. The most recent change was the crossover of key IBM sales personnel: Ulla Thiel, former head of IBM's European supercomputer sales, and Peter Ungaro, one of IBM's best supercomputer salesmen. With their experience and sales connections, new product sales could be surprisingly robust.

The reason I believe this may be more compelling than usual is that the stock has recently been hit hard from a combination of the decline in the Nasdaq and investors' concerns over Cray's recent purchase of OctigaBay Systems, a provider of lower-end high-performance computers, for 12.7 million shares (valued at $7.84 per share of Cray at the time of acquisition) and about $15 million in cash. Investors may be concerned about an acquisition that is likely to dilute earnings per share in the near term. Also, Cray's products compete head on with those from Hewlett-Packard, IBM, and Sun Microsystems. The company will likely have to expand sales-force and marketing resources to meet the needs of an expanding product line. With the addition of more than 13% additional shares to the overall outstanding share count but little sense of how the acquisition will add to the generation of revenue or profits near term, you can see why investors may be skittish.

The company generated 2003 sales of $237 million and earned 23 cents per share. In 2003, $175.1 million was in product revenue (74%) and $61.9 million in maintenance and service revenue (26%). Gross margin overall was at 41.7%, with product gross margin at 44.3% and service gross margin at 34.4%. Consensus Wall Street earnings estimates for 2004 and 2005 are 23 cents and 44 cents per share, respectively. The company has no debt. It sure is nice to see Cray doing what it does best again.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected]. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.

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