Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Preliminary Note Regarding Forward-Looking Statements
This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or if they prove incorrect, could cause our actual results to differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to them. In some cases you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “continue,” “estimates,” “projects,” “predicts” and “potential” and similar expressions, but the absence of these words does not mean that a statement is not forward-looking. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, and examples of forward-looking statements include any projections of earnings, revenue or other results of operations or financial results; any statements of the plans, strategies, objectives and beliefs of our management; any statements concerning proposed new products, technologies or services; any statements regarding future research and development or co-funding for such efforts; any statements regarding future expansions of our facilities and offices; any statements regarding future economic conditions; and any statements of assumptions underlying any of the foregoing. These forward-looking statements are subject to the safe harbor created by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Item 1A. Risk Factors in Part II and other sections of this report and our other filings with the U.S. Securities and Exchange Commission, or SEC. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this report. You should read this report completely and with the understanding that our actual future results may be materially different from what we expect. We assume no obligation to update these forward-looking statements, whether as a result of new information, future events, or otherwise, except as otherwise required by law.
Overview
We design, develop, manufacture, market and service the high-end of the high performance computing, or HPC, market, primarily categories of systems commonly known as supercomputers and provide storage and data analytics solutions. We also provide software, system maintenance and support services and engineering services related to supercomputer systems and our storage and data analytics solutions. Our customers include domestic and foreign government and government-funded entities, academic institutions and commercial entities. Our key target markets are the supercomputing portion of the HPC market and the expanding big data storage and analytics market. We provide customer-focused solutions based on three models: (1) tightly integrated supercomputing and/or storage solutions, complete with highly tuned software, that stress capability, scalability, sustained performance and reliability at scale; (2) flexible commodity-based “cluster” supercomputing and storage solutions based upon utilizing best-of-breed components and working with our customers to define solutions that meet specific needs; and (3) integrated data analytics solutions that combine industry standard tools for large-scale data analytics with our Cray Graph Engine. All of our solutions also emphasize total cost of ownership, scalable price-performance and data center flexibility as key features. Our continuing strategy is to gain market share in the supercomputer market segment, extend our technology leadership and differentiation, maintain our focus on execution and profitability and grow by continuing to expand our share and addressable market in areas where we can leverage our experience and technology, such as in high performance storage systems and powerful analytic tools for large volumes of data, popularly referred to as “big data”. We also meet diverse customer requirements by combining supercomputing, cluster supercomputing, storage and analytics technologies described above, into unique solutions offerings that work in a workflow-driven datacenter environment.
Summary of First
Nine
Months of
2016
Results
Total revenue
decrease
d
$174.0 million
for the first
nine
months of
2016
compared to the first
nine
months of
2015
, from
$457.2 million
to
$283.2 million
, due mainly to lower product revenue. Product revenue was
$180.3 million
higher in the first nine months of 2015 as compared to the first nine months of 2016 as a result of the acceptance of multiple Cray systems by a customer in Saudi Arabia and several significant sales to commercial customers in the first nine months of 2015. In addition, in the first nine months of 2015, we had customer acceptances of two large systems for which we had previously anticipated acceptance to occur in the fourth quarter of 2014. The year over year decrease in product revenue was also partly driven by the timing of system acceptances as a result of the later availability of two new processors in 2016, relative to 2015 and decreased order activity. Our product revenue is subject to significant quarter-to-quarter fluctuations and can be concentrated in particular quarters, often the fourth quarter. It is dependent on factors such as the timing of new product releases, the timing of customer acceptances, the timing and level of customer procurements and budgets, and the availability of certain key components, among other factors.
Net
loss
for the first
nine
months of
2016
was
$41.2 million
compared to net
income
of
$7.2 million
for the same period in
2015
. The year over year change was primarily attributable to lower revenue and a
$24.4 million
increase in operating expenses
resulting primarily from increased spending on research and development. These amounts were partially offset by an improved gross margin percentage and a
$16.7 million
increase in income tax benefit.
Net cash
used in
operating activities was
$133.5 million
for the first
nine
months of
2016
compared to net cash
provided by
operating activities of
$68.6 million
for the first
nine
months of
2015
. Net cash
used in
operating activities in the first
nine
months of
2016
was primarily driven by an increase of
$133.6 million
in inventory as a result of system builds for future acceptances.
Market Overview and Challenges
Significant trends in the HPC industry include:
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supercomputing with many-core commodity processors driving increasing scalability requirements;
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•
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increased micro-architectural diversity, including increased usage of many-core processors and accelerators, as the rate of increases in per-core performance slows;
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•
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data IO and capacity needs growing much faster than computational needs;
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•
|
technology innovations in memory and storage allowing for faster data access such as NVRAM, SSDs and flash devices;
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•
|
the commoditization of HPC hardware, particularly processors and system interconnects;
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•
|
the growing concentration of very large suppliers of key computing and storage components in the industry;
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•
|
the growing commoditization of software, including plentiful building blocks and more capable open source software;
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•
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electrical power requirements becoming a design constraint and driver in total cost of ownership determinations;
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•
|
increasing use of analytics technologies (Hadoop, Spark, NoSQL and Graph) in both the HPC and big data markets;
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•
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cloud computing as a solution for loosely-coupled HPC applications; and
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•
|
significant variability of market demand quarter-to-quarter and year-to-year.
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Several of these trends have resulted in the expansion and acceptance of loosely-coupled cluster systems using processors manufactured by Intel, AMD and others combined with commercially available, commodity networking and other components, particularly in the middle and lower segments of the HPC market. These systems may offer higher theoretical peak performance for equivalent cost, and “price/peak performance” is sometimes the dominant factor in HPC procurements. Vendors of such systems often put pricing pressure on us, resulting in lower margins in competitive procurements.
In the market for the largest, and most scalable systems, those often costing in excess of $3 million, the use of generally available network components can result in increasing data transfer bottlenecks as these components do not balance processor power with network communication and system software capability. With the arrival of increasing processor core counts due to new many-core processors, these unbalanced systems will typically have lower productivity, especially in larger systems running more complex applications. We and others augment standard microprocessors with other processor types, such as graphics processing units and many-core attached processors, in order to increase computational power, further complicating programming models. In addition, with increasing scale, bandwidth and processor core counts, large computer systems use progressively higher amounts of power to operate and require special cooling capabilities.
To position ourselves to meet the market’s demanding needs, we concentrate our research and development efforts on technologies that enable our supercomputers to perform at scale - that is, to continue to increase actual performance as systems grow ever larger in size - and in areas where we can leverage our core expertise in other markets whose applications demand these tightly-coupled architectures. We also have demonstrated expertise in system software and several processor technologies. We expect to be in a comparatively advantageous position as larger many-core processors become available and as multiple processing technologies become integrated into single systems in heterogeneous environments. In addition, we have continued to expand our addressable market by leveraging our technologies, customer base, the Cray brand and by introducing complementary products and services to new and existing customers, as demonstrated by our emphasis on strategic initiatives, such as storage and data management and “big data” analytics.
In storage, we are developing and delivering high value products for the high performance storage market. Our storage products are primarily positioned to enable tight integration of storage to computing solutions and/or utilize parallel file processing technologies and facilitate storage across multiple data tiers. We support open source parallel file systems and protocols such as Lustre and we are a founding member of the OpenSFS (Open Scalable File System) consortia for Lustre.
In analytics, we are developing and delivering high performance data discovery and advanced analytics solutions. These solutions compete with open source software, running on commodity cluster systems. Although these competitive systems have low acquisition costs, the total cost of ownership, or TCO, is driven up by management, power and efficiency challenges. We concentrate our efforts on developing solutions that minimize the TCO, delivering faster time-to-solution and advanced capabilities that are key drivers for many of our data analytics customers. We support open source technologies such as Hadoop and Spark
and partner with UC Berkeley’s AMPLab and Berkeley Lab’s National Energy Research Scientific Computing Center to design large-scale data analytics stacks that simplify analyses of scientific and commercial applications.
We have also expanded our addressable market by providing cluster systems and solutions to the supercomputing market that allow us to offer flexible platforms to incorporate best of breed components to allow customers to optimize the system to fit their unique requirements.
Key Performance Indicators
Our management monitors and analyzes several key performance indicators in order to manage our business and evaluate our financial and operating performance, including:
Revenue.
Product revenue generally constitutes the major portion of our revenue in any reporting period and, for the reasons discussed in this quarterly report on Form 10-Q or in our annual report on Form 10-K, is subject to significant variability from period to period. In the short term, we closely review the status of customer proposals, customer contracts, product shipments, installations and acceptances in order to forecast revenue and cash receipts. In the longer-term, we monitor the status of the pipeline of product sales opportunities and product development cycles. We believe product revenue growth measured over several quarters is a better indicator of whether we are achieving our objective of increased market share in the supercomputing market. The introduction of new generations of Cray XC and Cray CS products, along with our longer-term product roadmap are efforts to increase product revenue. We have been increasing our business and product development efforts in storage and data management along with big data analytics. We have also been increasing the size of our sales force. Service revenue related to our maintenance offerings is more constant in the short term and assists, in part, to offset the impact that the variability in product revenue has on total revenue.
Gross profit margin.
Gross profit margin is impacted by revenue and our cost to build and deliver our products and services. Our services tend to carry higher gross profit margins than our products. We monitor the cost of components, manufacturing, and installation of our products. In assessing our service gross profit margin, we monitor headcount levels and third-party costs.
Operating expenses.
Our operating expenses are driven primarily by headcount, contracted third-party research and development services, and incentive compensation expense. As part of our ongoing expense management efforts, we monitor headcount levels in specific geographic and operational areas.
Liquidity and cash flows.
Due to the variability in product revenue, new contracts, customer acceptance and payment terms, our cash position also varies significantly from quarter-to-quarter and within a quarter. We monitor our expected cash levels, particularly in light of increased inventory purchases for large system installations and the risk of delays in product shipments and customer acceptances and, longer-term, in product development. Cash receipts generally lag customer acceptances.
Results of Operations
Our revenue, results of operations and cash balances fluctuate significantly from period-to-period. These fluctuations are due to such factors as the high average sales prices and limited number of sales of our products with variable gross margin levels, the timing of purchase orders and product deliveries, the availability of components, the revenue recognition accounting policy of generally not recognizing product revenue until customer acceptance and other contractual provisions have been fulfilled, the timing of payments for product sales, maintenance services, government research and development funding, the impact of the timing of new products on customer orders, and purchases of inventory during periods of inventory build-up. As a result of these factors, revenue, gross margin, expenses, cash, receivables, inventory and other related financial statement items have in the past varied, and are expected to continue to vary, significantly from quarter-to-quarter and year-to-year.
Revenue and Gross Profit Margins
Our revenue, cost of revenue and gross profit margin for the
three and nine months ended September 30, 2016 and 2015
, respectively, were (in thousands, except for percentages):
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Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Product revenue
|
|
$
|
47,685
|
|
|
$
|
157,692
|
|
|
$
|
188,024
|
|
|
$
|
368,370
|
|
Less: Cost of product revenue
|
|
33,552
|
|
|
105,242
|
|
|
125,189
|
|
|
266,787
|
|
Product gross profit
|
|
$
|
14,133
|
|
|
$
|
52,450
|
|
|
$
|
62,835
|
|
|
$
|
101,583
|
|
Product gross profit margin
|
|
30
|
%
|
|
33
|
%
|
|
33
|
%
|
|
28
|
%
|
Service revenue
|
|
$
|
29,766
|
|
|
$
|
33,721
|
|
|
$
|
95,211
|
|
|
$
|
88,848
|
|
Less: Cost of service revenue
|
|
20,298
|
|
|
20,289
|
|
|
58,322
|
|
|
50,928
|
|
Service gross profit
|
|
$
|
9,468
|
|
|
$
|
13,432
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|
|
$
|
36,889
|
|
|
$
|
37,920
|
|
Service gross profit margin
|
|
32
|
%
|
|
40
|
%
|
|
39
|
%
|
|
43
|
%
|
Total revenue
|
|
$
|
77,451
|
|
|
$
|
191,413
|
|
|
$
|
283,235
|
|
|
$
|
457,218
|
|
Less: Total cost of revenue
|
|
53,850
|
|
|
125,531
|
|
|
183,511
|
|
|
317,715
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|
Total gross profit
|
|
$
|
23,601
|
|
|
$
|
65,882
|
|
|
$
|
99,724
|
|
|
$
|
139,503
|
|
Total gross profit margin
|
|
30
|
%
|
|
34
|
%
|
|
35
|
%
|
|
31
|
%
|
Product Revenue
Product revenue for the
three and nine months ended September 30, 2016 and 2015
was primarily from sales of our Cray XC and Cray CS supercomputing systems and Sonexion storage systems. Product revenue was
$110.0 million
higher for the
three months ended September 30, 2015
, as compared to the
three months ended September 30, 2016
, primarily due to several significant sales to commercial customers during the
three months ended September 30, 2015
. Product revenue was
$180.3 million
higher in the first nine months of 2015 as compared to the first nine months of 2016 as a result of the acceptance of multiple Cray systems by a customer in Saudi Arabia and several significant sales to commercial customers in the first nine months of 2015. In addition, in the first nine months of 2015, we had customer acceptances of two large systems for which we had previously anticipated acceptance to occur in the fourth quarter of 2014. The decrease in product revenue for the
three and nine months ended September 30, 2016 and 2015
was also partly driven by the timing of system acceptances as a result of the later availability of two new processors in 2016 relative to 2015 and decreased order activity.
Service Revenue
Service revenue for the
three months ended September 30, 2016
was
$29.8 million
compared to
$33.7 million
for the same period in
2015
. Service revenue for the
nine months ended September 30, 2016
was
$95.2 million
compared to
$88.8 million
for the same period in
2015
. Maintenance revenue, which has continued to benefit from our larger installed system base, increased in both 2016 periods whereas engineering services revenue was higher in both 2015 periods as a result of the completion of certain milestones in 2015.
Cost of Product Revenue and Product Gross Profit
Cost of product revenue
decrease
d by
$71.7 million
for the
three months ended September 30, 2016
compared to the same period in
2015
, and by
$141.6 million
for the
nine months ended September 30, 2016
compared to the same period in
2015
. The decrease in both periods was driven by lower product revenue. For the
three months ended September 30, 2016
, product gross profit margin
decrease
d
3
percentage points to
30%
from
33%
in the same period in
2015
, driven by certain lower margin deals in the
three months ended September 30, 2016
. For the
nine months ended September 30, 2016
, product gross profit margin
increase
d
5
percentage points to
33%
from
28%
in the same period in
2015
. The product gross profit margin for the
nine months ended September 30, 2015
was considered low and was impacted by higher costs on a few large contracts that were not anticipated at the time of bidding, driven both by economic factors and technical issues. Product gross profit margin in any one period may not be indicative of future results as product gross profit margin can vary significantly between contracts for many reasons.
Cost of Service Revenue and Service Gross Profit
For the
three months ended September 30, 2016
, cost of service revenue was largely unchanged from the same period in
2015
despite lower service revenue. This was primarily the result of $2.5 million of costs incurred to replace a high-value third party component in a customer system during the
three months ended September 30, 2016
. For the
nine months ended September
30, 2016
, cost of service revenue
increase
d by
$7.4 million
compared to the same period in
2015
. The increase for the nine month period was driven by a larger installed base of systems which also resulted in higher service revenue and $3.0 million of costs incurred to replace a high-value third party component in a customer system that is under a service contract. Service gross profit margin for the
three months ended September 30, 2016
decrease
d by
8
percentage points to
32%
compared to
40%
in the same period in
2015
. Service gross profit margin for the
nine months ended September 30, 2016
decrease
d by
4
percentage points to
39%
compared to
43%
in the same period in
2015
. The
decrease
in service gross profit margin for the three and nine months ended September 30, 2016 was primarily the result of the $2.5 million and $3.0 million, respectively, of costs incurred to replace a high-value third party component in a customer system that is under a service contract, higher headcount and compensation expense, and higher third party costs.
Research and Development Expenses
Research and development expenses for the
three and nine months ended September 30, 2016 and 2015
, respectively, were (in thousands, except for percentages):
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Three Months Ended
September 30,
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|
Nine Months Ended
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Gross research and development expenses
|
|
$
|
32,427
|
|
|
$
|
34,519
|
|
|
$
|
94,403
|
|
|
$
|
87,777
|
|
Less: Amounts included in cost of revenue
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|
(2,241
|
)
|
|
(6,348
|
)
|
|
(8,967
|
)
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|
(12,754
|
)
|
Less: Reimbursed research and development (excludes amounts in cost of revenue)
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|
(1,102
|
)
|
|
(3,182
|
)
|
|
(3,113
|
)
|
|
(7,741
|
)
|
Net research and development expenses
|
|
$
|
29,084
|
|
|
$
|
24,989
|
|
|
$
|
82,323
|
|
|
$
|
67,282
|
|
Percentage of total revenue
|
|
38
|
%
|
|
13
|
%
|
|
29
|
%
|
|
15
|
%
|
Gross research and development expenses in the table above reflect all research and development expenditures. Research and development expenses include personnel expenses, depreciation, allocations for certain overhead expenses, software, prototype materials and third party contractor engineering expenses.
For the
three months ended September 30, 2016
, gross research and development expenses
decrease
d by
$2.1 million
compared to the same period in
2015
. For the
nine months ended September 30, 2016
, gross research and development expenses
increase
d by
$6.6 million
compared to the same period in
2015
. The decrease in gross research and development expenses for the
three months ended September 30, 2016
resulted primarily from lower incentive compensation expense and lower third party costs. The increase in gross research and development expenses for the
nine months ended September 30, 2016
was due to increased investments in the development of new products and higher costs related to our engineering services contracts, which included higher third party costs. We increased our average headcount, which resulted in compensation costs increasing by $0.6 million and $5.3 million for the
three and nine months ended September 30, 2016
, respectively, compared to the same periods in 2015.
Net research and development expenses
increase
d by
$4.1 million
for the
three months ended September 30, 2016
, compared to the same period in
2015
. Net research and development expenses
increase
d by
$15.0 million
for the
nine months ended September 30, 2016
, compared to the same period in
2015
. In addition to higher gross research and development expenses, we had lower reimbursements and amounts included in cost of revenue. The amount and timing of research and development costs related to engineering development contracts and the level of reimbursement from third parties for research and development projects varies significantly from period to period, and can have a significant impact on net reported research and development expense in any period.
Sales and Marketing and General and Administrative Expenses
Our sales and marketing and general and administrative expenses for the
three and nine months ended September 30, 2016 and 2015
, respectively, were (in thousands, except for percentages):
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|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Sales and marketing
|
|
$
|
15,010
|
|
|
$
|
16,132
|
|
|
$
|
46,391
|
|
|
$
|
42,096
|
|
Percentage of total revenue
|
|
19
|
%
|
|
8
|
%
|
|
16
|
%
|
|
9
|
%
|
General and administrative
|
|
$
|
7,968
|
|
|
$
|
6,729
|
|
|
$
|
24,325
|
|
|
$
|
19,304
|
|
Percentage of total revenue
|
|
10
|
%
|
|
4
|
%
|
|
9
|
%
|
|
4
|
%
|
Sales and Marketing
.
Sales and marketing expense for the
three months ended September 30, 2016
,
decrease
d by
$1.1 million
from the same period in
2015
. Sales and marketing expense for the
nine months ended September 30, 2016
,
increase
d by
$4.3 million
from the same period in
2015
. The decrease in sales and marketing expense for the
three months ended September 30, 2016
, was a result of lower incentive compensation expense compared to the prior year period. We increased our average headcount which resulted in higher compensation costs of $2.4 million for the
nine months ended September 30, 2016
, compared to the prior year period.
General and Administrative
. General and administrative expense for the
three months ended September 30, 2016
,
increase
d by
$1.2 million
from the same period in
2015
. General and administrative expense for the
nine months ended September 30, 2016
,
increase
d by
$5.0 million
from the same period in
2015
. The increase for the three months ended September 30, 2016, was largely attributable to increased legal costs related to our ongoing litigation with Raytheon, which is described in Note 11, “Contingencies” in the notes to our condensed consolidated financial statements. The increase for the nine months ended September 30, 2016, was largely attributable to the increased legal costs and a $2.3 million termination fee for our St. Paul facility. Due to our ongoing litigation with Raytheon, we expect legal expenses to remain at above historical levels through at least the first quarter of 2017.
Other Income (Expense), net
For the
three and nine months ended September 30, 2016
, we recognized net other expense of
$0.3 million
and
$1.2 million
, respectively, compared to net other expense of
$0.2 million
and net other income of
$0.3 million
, respectively for the same periods in
2015
. Net other income and expense for the
three and nine months ended September 30, 2016 and 2015
included gains and losses from foreign currency transactions, investments and disposals of assets.
Interest Income, net
Our interest income and interest expense for the
three and nine months ended September 30, 2016 and 2015
, respectively, were (in thousands):
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Interest income
|
|
$
|
548
|
|
|
$
|
344
|
|
|
$
|
1,597
|
|
|
$
|
1,132
|
|
Interest expense
|
|
(4
|
)
|
|
(7
|
)
|
|
57
|
|
|
(18
|
)
|
Interest income, net
|
|
$
|
544
|
|
|
$
|
337
|
|
|
$
|
1,654
|
|
|
$
|
1,114
|
|
Interest income, net for the
three and nine months ended September 30, 2016
increase
d as compared to the same periods in
2015
due to increased interest income from our sales-type lease.
Taxes
Our effective tax rates were approximately
18%
and
22%
for the
three and nine months ended September 30, 2016
, compared to
40%
and
41%
for the
three and nine months ended September 30, 2015
. The primary reason for the difference between the expected statutory tax rate of
35%
and the actual tax rates of
18%
and
22%
for the
three and nine months ended September 30, 2016
, was a reduction in our business outlook with respect to the current year which substantially increased the impact that our research and development tax credit had on our effective tax rate. Other significant reconciling items that impacted our effective tax rate included state taxes and excess tax benefits attributable to equity related compensation. Prior to the adoption of ASU 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09), excess tax benefits did not impact our effective tax rate. The adoption of ASU 2016-09 has resulted in increased volatility
in our effective tax rate. The primary reason for the difference between the expected statutory tax rate of
35%
and the actual tax rates of
40%
and
41%
for the
three and nine months ended September 30, 2015
was state taxes.
New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers: Topic 606 (ASU 2014-09), to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. Adoption of ASU 2014-09 was initially required for fiscal and interim reporting periods beginning after December 15, 2016 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined per ASU 2014-09.
In August 2015, FASB issued Accounting Standards Update No. 2015-14, Revenue from Contracts with Customers - Deferral of the Effective Date: Topic 606 (ASU 2015-14) that deferred the effective date of ASU 2014-09 by one year. Application of the new revenue standard is permitted for fiscal and interim reporting periods beginning after December 15, 2016 and required for fiscal and interim reporting periods beginning after December 15, 2017. We are currently evaluating the potential impact of the pending adoption of ASU 2014-09 on our consolidated financial statements.
In July 2015, FASB issued Accounting Standards Update No. 2015-11, Simplifying the Measurement of Inventory: Topic 330 (ASU 2015-11) to amend Topic 330, Inventory. Topic 330 currently requires an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. ASU 2015-11 requires that inventory measured using either the first-in, first-out ("FIFO") or average cost method be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Adoption of ASU 2015-11 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years. We do not expect the adoption of ASU 2015-11 to have a material impact on our consolidated financial statements.
In November 2015, FASB issued Accounting Standards Update No. 2015-17, Balance Sheet Classification of Deferred Taxes: Topic 740 (ASU 2015-17). Current GAAP requires the deferred taxes for each jurisdiction to be presented as a net current asset or liability and net noncurrent asset or liability. This requires a jurisdiction-by-jurisdiction analysis based on the classification of the assets and liabilities to which the underlying temporary differences relate, or, in the case of loss or credit carryforwards, based on the period in which the attribute is expected to be realized. Any valuation allowance is then required to be allocated on a pro rata basis, by jurisdiction, between current and noncurrent deferred tax assets. The new guidance requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. As a result, each jurisdiction will now only have one net noncurrent deferred tax asset or liability. The guidance does not change the existing requirement that only permits offsetting within a jurisdiction. Adoption of ASU 2015-17 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years, and either prospective or retrospective application is permitted. Early adoption of ASU 2015-17 is permitted. At the time of adoption, all of our deferred tax assets and liabilities, along with any related valuation allowance, will be classified as noncurrent on our Consolidated Balance Sheet. Currently, we do not plan to early-adopt ASU 2015-17.
In January 2016, FASB issued Accounting Standards Update No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities: Topic 825 (ASU 2016-01). The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. Adoption of ASU 2016-01 is required for fiscal reporting periods beginning after December 15, 2017, including interim reporting periods within those fiscal years. We are currently evaluating the potential impact of the pending adoption of ASU 2016-01 on our consolidated financial statements.
In February 2016, FASB issued Accounting Standards Update No. 2016-02, Leases: Topic 842 (ASU 2016-02) that replaces existing lease guidance. The new standard is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet. Under the new guidance, leases will continue to be classified as either finance or operating, with classification affecting the pattern of expense recognition in the Consolidated Statement of Operations. Lessor accounting is largely unchanged under ASU 2016-02. Adoption of ASU 2016-02 is required for fiscal reporting periods beginning after December 15, 2018, including interim reporting periods within those fiscal years with early adoption being permitted. The new standard is required to be applied with a modified retrospective approach to each prior
reporting period presented with various optional practical expedients. We are currently evaluating the potential impact of the pending adoption of ASU 2016-02 on our consolidated financial statements.
In March 2016, FASB issued Accounting Standards Update No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09). The updated guidance simplifies and changes how companies account for certain aspects of share-based payment awards to employees, including accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of certain items in the statement of cash flows. Adoption of ASU 2016-09 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years with early adoption being permitted. We early-adopted ASU 2016-09 at the beginning of the first quarter of 2016.
At the time of adoption, we recognized $16.6 million in deferred tax assets for all excess tax benefits that had not been previously recognized because the related tax deduction had not reduced taxes payable. This was accomplished through a cumulative-effect adjustment to accumulated deficit. All excess tax benefits and all tax deficiencies generated in the current and future periods will be recorded as income tax benefit or expense in our Consolidated Statement of Operations in the reporting period in which they occur. This will result in increased volatility in our effective tax rate. We have determined that none of the other provisions of ASU 2016-09 will have a significant impact on our consolidated financial statements.
In August 2016, FASB issued Accounting Standards Update No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (ASU 2016-15). The updated guidance clarifies how companies
present and classify certain cash receipts and cash payments in the statement of cash flows. Adoption of ASU 2016-15 is required for fiscal reporting periods beginning after December 15, 2017, including interim reporting periods within those fiscal years with early adoption being permitted. We are currently evaluating the potential impact of the pending adoption of ASU 2016-15 on our consolidated financial statements.
Liquidity and Capital Resources
We generate cash from operations predominantly from the sale of supercomputing systems and related services. We typically have a small number of significant contracts that make up the majority of total revenue. We have also entered into a sales-type lease agreement with a customer, under which we will receive quarterly payments over the term of the lease, which expires in September 2020. Material changes in certain of our balance sheet accounts were due to the timing of product deliveries and customer acceptances, contractually determined billings, timing and level of inventory purchased for future deliveries, timing and level of incentive compensation and cash collections. Working capital requirements, including inventory purchases and normal capital expenditures, are generally funded with cash from operations.
We previously contemplated expanding our manufacturing capabilities in Chippewa Falls, Wisconsin in order to increase our manufacturing capacity. This project has now been suspended. The decision of when and whether to undertake this project in the future will be dependent on our expectations of future needs. If undertaken, we estimate that this project will require total capital expenditures in the range of $25.0 million. We may choose to externally finance these activities.
Cash and cash equivalents
decrease
d by
$122.2 million
from
December 31, 2015
to
September 30, 2016
. As of
September 30, 2016
, we had working capital of
$363.9 million
compared to
$415.2 million
as of
December 31, 2015
. During the
nine months ended September 30, 2016
, our net investments in debt securities decreased by $14.3 million and we had a total of
$0.7 million
in debt security investments as of
September 30, 2016
.
Cash flow information included the following (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended
September 30,
|
|
|
2016
|
|
2015
|
Cash provided by (used in):
|
|
|
|
|
Operating Activities
|
|
$
|
(133,489
|
)
|
|
$
|
68,641
|
|
Investing Activities
|
|
$
|
12,043
|
|
|
$
|
11,272
|
|
Financing Activities
|
|
$
|
(641
|
)
|
|
$
|
(2,629
|
)
|
Operating Activities.
Net cash
used in
operating activities was
$133.5 million
for the first
nine
months of
2016
compared to net cash
provided by
operating activities of
$68.6 million
for the first
nine
months of
2015
. Net cash
used in
operating activities in the first
nine
months of
2016
was primarily driven by an increase of
$133.6 million
in inventory as a result of system builds for future acceptances.
For the
nine months ended September 30, 2015
, net cash
provided by
operating activities was primarily driven by net income of
$7.2 million
, an increase of
$83.1 million
in deferred revenue related to a significant collection of an advanced billing from a customer, an increase of
$22.2 million
in our accounts payable balance due to inventory purchases and the timing of payments, and collections from customers that resulted in a decrease of
$19.4 million
in accounts and other receivables from December 31, 2014 to September 30, 2015. These amounts were partially offset by an increase of
$92.7 million
in inventory as a result of systems builds for future acceptances.
Investing Activities.
Net cash
provided by
investing activities was
$12.0 million
for the
nine months ended September 30, 2016
, compared to
$11.3 million
net cash
provided by
investing activities for the same period in
2015
. Net cash
provided by
investing activities for the
nine months ended September 30, 2016
was due to sales and maturities of debt securities of
$30.3 million
, partially offset by purchases of debt securities of
$16.2 million
. For the
nine months ended September 30, 2015
, net cash
provided by
investing activities was due to sales and maturities of debt securities of
$16.2 million
and a release of
$15.1 million
in restricted cash related to a prepayment on a system from a customer that was released at the time of delivery, partially offset by purchases of debt securities of
$15.0 million
and purchases of property and equipment of
$5.1 million
.
Financing Activities.
Net cash
used in
financing activities for the
nine months ended September 30, 2016
was
$0.6 million
compared to
$2.6 million
net cash
used in
financing activities for the same period in
2015
. Net cash flows from financing activities for both periods resulted primarily from statutory tax withholding amounts made in exchange for the forfeiture of common stock by holders of vesting restricted stock awards, offset by cash received from the issuance of common stock from the exercise of options and from the issuance of stock through our employee stock purchase plan.
In addition, we lease certain equipment and facilities used in our operations under operating leases in the normal course of business and have contractual commitments under certain development arrangements. The following table summarizes our contractual obligations as of
September 30, 2016
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amounts Committed by Year
|
Contractual Obligations
|
Total
|
|
2016
(Less than
1 Year)
|
|
2017-2018
|
|
2019-2020
|
|
Thereafter
|
Development agreements
|
$
|
25,163
|
|
|
$
|
15,195
|
|
|
$
|
9,943
|
|
|
$
|
25
|
|
|
$
|
—
|
|
Operating leases
|
61,616
|
|
|
1,461
|
|
|
13,857
|
|
|
13,209
|
|
|
33,089
|
|
Total contractual cash obligations
|
$
|
86,779
|
|
|
$
|
16,656
|
|
|
$
|
23,800
|
|
|
$
|
13,234
|
|
|
$
|
33,089
|
|
On April 21, 2016, we entered into a new operating lease for facilities in Bloomington, Minnesota that will principally be staffed with teams from software development, sales and service. This new lease will replace our existing lease in St. Paul, Minnesota. The new lease is for a minimum period of eight years beginning on May 1, 2017. Minimum contractual obligations under the new lease total $31.9 million. We paid an early termination fee of approximately $2.3 million to terminate our existing lease in St. Paul, Minnesota which was recorded as an operating expense in the second quarter of 2016. We received a one-time lease incentive payment of $2.3 million as part of our new lease agreement to cover the termination fee, which will be amortized over the term of the new lease. We anticipate that spending on leasehold improvements for the new facilities will be approximately $7.0 million.
On January 7, 2016, we entered into an Amended and Restated Credit Agreement, or Amended Credit Agreement, with Wells Fargo Bank, National Association which provides a revolving line of credit, or Credit Facility, through December 1, 2017, for up to
$50.0 million
to be used for general corporate purposes, including working capital requirements and capital expenditures. The Credit Facility will also support the issuance of letters of credit. The Credit Facility is secured by a first priority lien in all of our accounts receivable and other rights to payment, general intangibles, inventory and equipment.
Any borrowings under the Credit Facility bear interest at either a fluctuating rate equal to the daily one month LIBOR rate plus a margin of
1.25%
or a fixed interest rate for one, three or six months equal to the LIBOR rate for the applicable period plus a margin of
1.25%
. We are also required to pay the lender customary letter of credit fees, and a commitment fee of
0.18%
per annum in respect of the unutilized commitment amount under the Credit Facility. The Credit Facility requires that we maintain certain financial ratios.
The Amended Credit Agreement restates and replaces the Restated Credit Agreement with Wells Fargo Bank, National Association dated as of October 1, 2012, as amended, which provided a
$10.0 million
line of credit to secure letters of credit and foreign currency exchange hedging transactions.
We made no draws and had no outstanding cash borrowings on any lines of credit as of
September 30, 2016
.
As of
September 30, 2016
, we had $5.3 million in USD equivalent value in outstanding letters of credit and $1.7 million in restricted cash associated with certain letters of credit to secure customer prepayments and other customer related obligations.
In our normal course of operations, we have development arrangements under which we engage third-party engineering resources to work on our research and development projects. For the
nine months ended September 30, 2016
, we incurred
$10.1 million
for such arrangements.
At any particular time, our cash position is affected by the timing of cash receipts for product sales, maintenance contracts, government co-funding for research and development activities and our payments for inventory, resulting in significant fluctuations in our cash balance from quarter-to-quarter and within a quarter. Our principal sources of liquidity are our cash and cash equivalents, short-term investments and cash from operations. We expect our cash resources to be adequate for at least the next twelve months.
Critical Accounting Policies and Estimates
This discussion, as well as disclosures included elsewhere in this quarterly report on Form 10-Q, are based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingencies. In preparing our financial statements in accordance with GAAP, there are certain accounting policies that are particularly important. These include revenue recognition, inventory valuation, accounting for income taxes, research and development expenses and share-based compensation. Our significant accounting policies are set forth in Note 2 to the Consolidated Financial Statements included in our
2015
annual report on Form 10-K and should be reviewed in conjunction with the accompanying Condensed Consolidated Financial Statements and notes thereto as of
September 30, 2016
in this quarterly report on Form 10-Q, as they are integral to understanding our results of operations and financial condition in this interim period. In some cases, these policies represent required accounting. In other cases, they may represent a choice among acceptable accounting methods or may require substantial judgment or estimation.
Additionally, we consider certain judgments and estimates to be significant, including those relating to the estimated selling price determination used in revenue recognition, percentage of completion accounting, estimates of proportional performance on co-funded engineering contracts, collectibility of receivables, determination of inventory at the lower of cost or market, the value of used equipment returned or to be returned associated with customer contracts, useful lives for depreciation and amortization, determination of future cash flows associated with impairment testing of long-lived assets, including goodwill and other intangibles, determination of the implicit interest rate used in the sales-type lease calculation, estimated warranty liabilities, determination of the fair value of stock options and other assessments of fair value, evaluation of the probability of vesting of performance-based restricted stock and restricted stock units, calculation of deferred income tax assets, including estimates of future financial performance in the determination of the likely recovery of deferred income tax assets, our ability to utilize such assets, potential income tax assessments, the outcome of any legal proceedings and other contingencies. We base our estimates on historical experience, current conditions and on other assumptions that we believe to be reasonable under the circumstances. Actual results may differ materially from these estimates and assumptions.
Our management has discussed the selection of significant accounting policies and the effect of judgments and estimates with the Audit Committee of our Board of Directors.
Revenue Recognition
We recognize revenue, including transactions under sales-type leases, when it is realized or realizable and earned. We consider revenue realized or realizable and earned when we have persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Delivery does not occur until the products have been shipped or services provided to the customer, the risk of loss has transferred to the customer, and, where applicable, a customer acceptance has been obtained. The sales price is not considered to be fixed or determinable until all material contingencies related to the sales have been resolved. We record revenue in the Condensed Consolidated Statements of Operations net of any sales, use, value added or certain excise taxes imposed by governmental authorities on specific sales transactions. In addition to the aforementioned general policy, the following are our statements of policy with regard to multiple-element arrangements and specific revenue recognition policies for each major category of revenue.
Multiple-Element Arrangements.
We commonly enter into revenue arrangements that include multiple deliverables of our product and service offerings due to the needs of our customers. Products may be delivered in phases over time periods which can be as long as five years. Maintenance services generally begin upon acceptance of the first equipment delivery and future deliveries of equipment generally have an associated maintenance period. We consider the maintenance period to commence upon acceptance of the product, or installation of the product where a formal acceptance is not required, which may include a warranty period and accordingly allocate a portion of the arrangement consideration as a separate deliverable which is recognized as service revenue over the entire service period. Other services such as training and engineering services can be delivered as a discrete delivery or
over the term of the contract. A multiple-element arrangement is separated into more than one unit of accounting if the following criteria are met:
|
|
•
|
The delivered item(s) has value to the customer on a standalone basis; and
|
|
|
•
|
If the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control.
|
If these criteria are met for each element, the arrangement consideration is allocated to the separate units of accounting based on each unit’s relative selling price. If these criteria are not met, the arrangement is accounted for as one unit of accounting which would result in revenue being recognized ratably over the contract term or being deferred until the earlier of when such criteria are met or when the last undelivered element is delivered.
We follow a selling price hierarchy in determining the best estimate of the selling price of each deliverable. Certain products and services are sold separately in standalone arrangements for which we are sometimes able to determine vendor specific objective evidence, or VSOE. We determine VSOE based on normal pricing and discounting practices for the product or service when sold separately.
When we are not able to establish VSOE for all deliverables in an arrangement with multiple elements, we attempt to establish the selling price of each remaining element based on third-party evidence, or TPE. Our inability to establish VSOE is often due to a relatively small sample of customer contracts that differ in system size and contract terms which can be due to infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history, such as in the case of certain advanced and emerging technologies. TPE is determined based on our prices or competitor prices for similar deliverables when sold separately. However, we are often unable to determine TPE, as our offerings usually contain a significant level of customization and differentiation from those of competitors and we are often unable to reliably determine what similar competitor products’ selling prices are on a standalone basis.
When we are unable to establish selling price using VSOE or TPE, we use estimated selling price, or ESP, in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a standalone basis. In determining ESP, we use the cost to provide the product or service plus a margin, or consider other factors. When using cost plus a margin, we consider the total cost of the product or service, including customer-specific and geographic factors. We also consider the historical margins of the product or service on previous contracts and several factors including any changes to pricing methodologies, competitiveness of products and services and cost drivers that would cause future margins to differ from historical margins.
Products
. We most often recognize revenue from sales of products upon delivery or customer acceptance of the system. Where formal acceptance is not required, we recognize revenue upon delivery or installation. When the product is part of a multiple element arrangement, we allocate a portion of the arrangement consideration to product revenue based on estimates of selling price.
Services
. Maintenance services are provided under separate maintenance contracts with customers. These contracts generally provide for maintenance services for one year, although some are for multi-year periods, often with prepayments for the term of the contract. We consider the maintenance period to commence upon acceptance of the product or installation in situations where a formal acceptance is not required, which may include a warranty period. When service is part of a multiple element arrangement, we allocate a portion of the arrangement consideration to maintenance service revenue based on estimates of selling price. Maintenance contracts that are billed in advance of revenue recognition are recorded as deferred revenue. Maintenance revenue is recognized ratably over the term of the maintenance contract.
Revenue from engineering services is recognized as services are performed.
Project Revenue
. Revenue from design and build contracts is recognized under the percentage-of-completion (or POC method). Under the POC method, revenue is recognized based on the costs incurred to date as a percentage of the total estimated costs to fulfill the contract. If circumstances arise that change the original estimates of revenues, costs, or extent of progress toward completion, revisions to the estimates are made. These revisions may result in increases or decreases in estimated revenues or costs, and such revisions are recorded in income in the period in which the circumstances that gave rise to the revision become known by management. We perform ongoing profitability analyses of our contracts accounted for under the POC method in order to determine whether the latest estimates of revenue, costs and extent of progress require updating. If at any time these estimates indicate that the contract will be unprofitable, the entire estimated loss for the remainder of the contract is recorded immediately.
We record revenue from certain research and development contracts which include milestones using the milestone method if the milestones are determined to be substantive. A milestone is considered to be substantive if management believes there is substantive uncertainty that it will be achieved and the milestone consideration meets all of the following criteria:
|
|
•
|
It is commensurate with either of the following:
|
|
|
•
|
Our performance to achieve the milestone; or
|
|
|
•
|
The enhancement of value of the delivered item or items as a result of a specific outcome resulting from our performance to achieve the milestone.
|
|
|
•
|
It relates solely to past performance.
|
|
|
•
|
It is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.
|
The individual milestones are determined to be substantive or non-substantive in their entirety and milestone consideration is not bifurcated.
Revenue from projects is classified as Product Revenue or Service Revenue, based on the nature of the work performed.
Nonmonetary Transactions
. We value and record nonmonetary transactions at the fair value of the asset surrendered unless the fair value of the asset received is more clearly evident, in which case the fair value of the asset received is used.
Inventory Valuation
We record our inventory at the lower of cost or market. We regularly evaluate the technological usefulness and anticipated future demand for our inventory components. Due to rapid changes in technology and the increasing demands of our customers, we are continually developing new products. Additionally, during periods of product or inventory component upgrades or transitions, we may acquire significant quantities of inventory to support estimated current and future production and service requirements. As a result, it is possible that older inventory items we have purchased may become obsolete, be sold below cost or be deemed in excess of quantities required for production or service requirements. When we determine it is not likely we will recover the cost of inventory items through future sales, we write-down the related inventory to our estimate of its market value.
Because the products we sell have high average sales prices and because a high number of our prospective customers receive funding from U.S. or foreign governments, it is difficult to estimate future sales of our products and the timing of such sales. It also is difficult to determine whether the cost of our inventories will ultimately be recovered through future sales. While we believe our inventory is stated at the lower of cost or market and that our estimates and assumptions to determine any adjustments to the cost of our inventories are reasonable, our estimates may prove to be inaccurate. We have sold inventory previously reduced in part or in whole to zero, and we may have future sales of previously written-down inventory. We also may incur additional expenses to write-down inventory to its estimated market value. Adjustments to these estimates in the future may materially impact our operating results.
Accounting for Income Taxes
Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and operating loss and tax credit carryforwards and are measured using the enacted tax rates and laws that will be in effect when the differences and carryforwards are expected to be recovered or settled. A valuation allowance for deferred tax assets is provided when we estimate that it is more likely than not that all or a portion of the deferred tax assets will not be realized through future operations. This assessment is based upon consideration of available positive and negative evidence, which includes, among other things, our recent results of operations and expected future profitability. We consider our actual historical results over several years to have stronger weight than other more subjective indicators, including forecasts, when considering whether to establish or reduce a valuation allowance on deferred tax assets. We have significant difficulty projecting future results due to the nature of the business and the industry in which we operate.
Our deferred tax assets increased by $16.6 million as a result of the adoption of ASU 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09). No changes were required to previously recorded valuation allowances at the time of adoption. ASU 2016-09 will result in increased volatility in our effective tax rate.
As of September 30, 2016, we had approximately $102 million of net deferred tax assets, against which we provided a $10 million valuation allowance, resulting in a net deferred tax asset of $92 million. The assessment of our ability to utilize our deferred tax assets included an assessment of all known business risks and industry trends as well as forecasted domestic and international earnings over a number of years. Our ability to forecast results significantly into the future is severely limited due to the rapid rate of technological and competitive change in the industry in which we operate.
We continue to provide a valuation allowance against specific U.S. deferred tax assets and a full valuation allowance against deferred tax assets arising in a limited number of foreign jurisdictions as the realization of such assets is not considered to be more likely than not at this time. In a future period our assessment of the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance could change based on an assessment of all available evidence, both positive and
negative in that future period. If our conclusion about the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance changes in a future period we could record a substantial tax provision or benefit in our Condensed Consolidated Statement of Operations when that occurs. We recognize the income tax benefit from a tax position only if it is more likely than not that the tax position will be sustained on examination by the applicable taxing authorities, based on the technical merits of our position. The tax benefit recognized in the financial statements from such a position is measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement.
Estimated interest and penalties are recorded as a component of interest expense and other expense, respectively.
Research and Development Expenses
Research and development expenses include costs incurred in the development and production of our hardware and software, costs incurred to enhance and support existing product features, costs incurred to support and improve our development processes, and costs related to future product development. Research and development costs are expensed as incurred, and may be offset by co-funding from third parties. We may also enter into arrangements whereby we make advance, non-refundable payments to a vendor to perform certain research and development services. These payments are deferred and recognized over the vendor’s estimated performance period.
Amounts to be received under co-funding arrangements with the U.S. government or other customers are based on either contractual milestones or costs incurred. These co-funding milestone payments are recognized in operations as performance is estimated to be completed and are measured as milestone achievements occur or as costs are incurred. These estimates are reviewed on a periodic basis and are subject to change, including in the near term. If an estimate is changed, net research and development expense could be impacted significantly.
We do not record a receivable from the U.S. government prior to completing the requirements necessary to bill for a milestone or cost reimbursement. Funding from the U.S. government is subject to certain budget restrictions and milestones may be subject to completion risk, and as a result, there may be periods in which research and development costs are expensed as incurred for which no reimbursement is recorded, as milestones have not been completed or the U.S. government has not funded an agreement. Accordingly, there can be substantial variability in the amount of net research and development expenses from quarter to quarter and year to year.
We classify amounts to be received from funded research and development projects as either revenue or a reduction to research and development expense based on the specific facts and circumstances of the contractual arrangement, considering total costs expected to be incurred compared to total expected funding and the nature of the research and development contractual arrangement. In the event that a particular arrangement is determined to represent revenue, the corresponding costs are classified as cost of revenue.
Share-based Compensation
We measure compensation cost for share-based payment awards at fair value and recognize it as compensation expense over the service period for awards expected to vest. We recognize share-based compensation expense for all share-based payment awards, net of an estimated forfeiture rate. We recognize compensation cost for only those shares expected to vest on a straight-line basis over the requisite service period of the award.
Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We utilize the Black-Scholes options pricing model to value the stock options granted under our options plans. In this model, we utilize assumptions related to stock price volatility, stock option term and forfeiture rates that are based upon both historical factors as well as management’s judgment.
The fair value of restricted stock and restricted stock units is determined based on the number of shares or units granted and the quoted price of our common stock at the date of grant.
We grant performance vesting restricted stock and performance vesting restricted stock units to executives as one of the ways to align compensation with shareholder interests. Vesting of these awards is contingent upon achievement of certain performance conditions. Compensation expense for these awards is only recognized when vesting is deemed to be “probable”. Awards are evaluated for probability of vesting during each reporting period.