Cray Annual Report 2006 | Quarterlytics

Plain-text annual report

2006 Annual ReportNotice of 2007 Annual Meetingand Proxy StatementFellowShareholders:2006wasadefiningyearforCray.Weachievedanumberofimportantmilestones,mostnotablyover$300millioninnewproductcontracts,includingthefirstannouncedpetaflops(1,000trillionfloatingpointoperationspersecond)supercomputerintheworldwiththeDepartmentofEnergy’sOakRidgeNationalLaboratory.Wesigneda$250milliondevelopmentcontractwiththeUnitedStatesDefenseAdvancedResearchProjectsAgency(DARPA),whichwillaccelerateandenhanceourcutting-edgeproductroadmap.Andwecappedofftheyearwithasolidlyprofitablefourthquarter.Theprogresswemadein2006wasexemplifiedbyamorethandoublingofourstockpriceandthesuccessfulcompletionofan$81millionequityfinancing,whichwebelieveprovidesthecapitalnecessarytotakeadvantageofthegrowthopportunitiesthatlieahead.Ouroverridinggoalhasnotchanged:todrivegrowthandprofitabilitybyprovidingworld-classsupercomputers,serviceandsupport.Witharenewedfocusoninnovationandexecution,wehavedemonstratedthatCrayhasthevision,resourcesandcommitmenttobesuccessful.Wetookamajorstepforwardin2006andarepositionedtocontinuetogrowandachievesustainedprofitability.ADefiningYearByleveragingastrengtheningproductline-upandcontinuedfocusoninnovation,wegainedmarketshareandgrewrevenuein2006.TheCrayXT3TMsupercomputerledtheway,andourCrayX1ETMvectorsystemaddedappreciablytoourimprovedfinancialperformance.Geographically,our2006growthwasfueledbycontinuedsuccessonagloballevel,withalmosthalfofour2006revenueattributabletointernationalcustomers—includinggreatprogressinkeyhighperformancecomputing(HPC)marketssuchasJapan,KoreaandtheUnitedKingdom.Ourfocusonexecutionbenefitedourcompanyacrossthebroadestspectrumofoperatingresults.Weimprovedgrossmarginsbyover75%,reducedoperatingexpensesbynearly$14millionandimprovedourbottom-lineoperatingresultsbyover85%,year-over-year.Additionally,weendedtheyearwithcashbalancesofjustover$140million,drivenbystrongpositivecashflowandthesuccessfulequityoffering.ResearchanddevelopmentagainemergedasoneofCray’sdistinctivestrengths.In2006wedeliveredourfirstdual-coreCrayXT3system,alongwithseveraldual-coreupgradestoinstalledCrayXT3systems—highlightedbyanupgradeatSandiaNationalLaboratoriesmakingtheirRedStormsystemthesecondfastestsupercomputerintheworld,accordingtotheTop500list,atover100teraflops(100trillionfloatingpointoperationspersecond).WealsobeganshippingtheCrayXT4TMsupercom-puter,whichleveragesasecondgenerationCraySeaStar2TMinterconnectandprovidesanupgradepathfromthecurrentdual-coreAMDOpteronTMprocessorstofutureversions,givingourcustomersbuilt-intotalcostofownershipadvantages.Additionally,weannouncedtheCrayXMTTMplatform,amassivelymultithreadedsupercomputerthathasthepotentialforopeningsomeveryexcitingnewopportunitiesforCrayandourcustomersintheareasofdataanalysisandpredictiveanalytics.Inearly2006weunveiledourAdaptiveSupercomputingvision,whichcallsforintegratingandtightlycouplingavarietyofadvancedprocessingtechnologiesintoasingle,hybridsystem.Onthemeritofthisvisionandanintegratedproductroadmapthatextendsbeyondtheendofthedecade,wewereawardedthe$250millionDARPAPhaseIIIcontract.Withthecombinationoftremendousindustryvalidation,alongwiththemonetaryaspectsofthisaward,wehavestrengthenedourtechnologyleadershippositionandourabilitytomaintainthatpositiongoingforward.WeareveryexcitedtobeworkingwithDARPA,theirmissionpartners,andourothercustomersaroundtheworldindrivingtheAdaptiveSupercomputingvisiontorealization.Finally,2006wasarecordyearfornewcontracts.InadditiontothepetaflopssystematOakRidgeNationalLaboratory,weannouncedsignificantnewwinsattheNationalEnergyResearchScientificComputingCenter(NERSC),AWEplcintheU.K.,CSCFinland,andSandiaNationalLaboratories.Shareholder LetterWe’vecontinuedtomaintainthismomentumin2007,withanewcontractattheU.S.ArmyEngineerResearchandDevelopmentCenter,alongwithalargewinintheU.K.,wherewewilldeliverahybridsupercomputertosupporttheEngineeringandPhysicalSciencesResearchCouncil’sHighEndCom-putingTerascaleResourcesproject,widelyknownasHECToR.BuildingonourSuccessOurgoalin2007istoaccelerateprogresstowardachievingmarketleadershipandsustainedprofitability.Withabusinessmodelthathasbeenrefinedsignificantlyoverthepasttwoyears,andstrongordermomentumin2006thathascarriedinto2007,wearewellpositionedtocontinuetomakestrides.Keyaspectsofourstrategygoingforwardinclude:(cid:129)GainingshareinourcoreHPCmarket.Withourfocusontheuniquecustomerneedsatthehigh-endoftheHPCmarketandthetrendsweareseeing,webelievewearepositionedtogainmarketshare,aswedidinboth2005and2006.(cid:129)Maintainingourfocusonexecutionandprofitability.Thoughgrowthandmarketsharearekeymeasuresofsuccess,thebottomlineismostimportant.Wehaveshownaclearcommitmenttofinancialdiscipline—andwearecommittedtoachievingsustainedprofitabilityonanannualbasis.(cid:129)Extendingourtechnologyleadership.Weareaninnovationdrivencompanyinatechnologydrivenmarketplace.OurintentionistomaintainandextendourtechnologyleadershippositionbyinvestinginResearchandDevelopmentandpartneringwithkeycustomerswhosegoalsarealignedstronglywithours.(cid:129)Expandingourtotaladdressablemarket.Overtime,weintendtoleverageourtechnology,customerbaseandtheCraybrandinnewsegmentstoexpandouraddressablemarket.WebelievewehavetheopportunitytocompeteinabroaderportionoftheHPCmarketaswellasselectivemarketsoutsideofHPC.AsproudasIamofouraccomplishmentsin2006,Iamevenmoreexcitedaboutwhatliesahead.Wehaveagreatteamandplaninplacetocontinuetoimproveourbusinessandachieveouroperationalandstrategicgoals.OnbehalfofourChairman,SteveKiely,ourBoardofDirectorsandmanagement,Iwouldliketothankallofourcustomers,partners,employeesandshareholdersforyourcontinuedsupportandloyaltytothemostinnovativesupercomputingcompanyintheworld.PETERJ.UNGAROPresidentandChiefExecutiveOfficerShareholder LetterNOTICEOF2007ANNUALMEETINGOFSHAREHOLDERSDearCrayInc.Shareholder:YouarecordiallyinvitedtoattendtheAnnualMeetingofShareholdersofCrayInc.,whichwillbeheldatourofficeslocatedat1340MendotaHeightsRoad,MendotaHeights,Minnesota55120,onMay16,2007,at10:00a.m.AttheAnnualMeeting,shareholderswillhavetheopportunitytovoteonthefollowingmatters:1.Toelecteightdirectors,eachtoserveaone-yearterm;and2.Toconductanyotherbusinessthatmayproperlycomebeforethemeeting,andanyadjournmentofthemeeting.IfyouwereashareholderofrecordonMarch19,2007,therecorddatefortheAnnualMeeting,youareentitledtovoteonthesematters.AttheAnnualMeeting,wewillreviewourperformanceduringthepastyearandcommentonouroutlook.YouwillhaveanopportunitytoaskquestionsaboutCrayandouroperations.Regardlessofthenumberofsharesyouown,yourvoteisimportant.Youmayvoteusinganyofthefollowingmethods:(cid:129)byInternet;(cid:129)bytelephone;(cid:129)byproxycard;or(cid:129)inpersonattheAnnualMeeting.VotingbytheInternetorbytelephoneisfast,convenientandyourvoteisimmediatelyconfirmedandtabulated.Youalsohelpusreducepostageandproxytabulationcosts.Oryoumaysignandreturntheproxycardintheenclosedenvelope.EvenifyouplantoattendtheAnnualMeeting,weurgeyoutovoteatyourearliestconveniencesoweavoidfurthersolicitationcosts.Anyshareholderattendingthemeetingmayvoteinpersonevenifheorshehasvotedpreviously.DetailsofthebusinesstobeconductedattheAnnualMeetingaremorefullydescribedintheaccompanyingProxyStatement.Welookforwardtoseeingyou.ThankyouforyourongoingsupportofandinterestinCray.Sincerely,PETERJ.UNGAROPresidentandChiefExecutiveOfficerSeattle,WashingtonMarch30,2007Proxy StatementPROXYSTATEMENTTABLEOFCONTENTSPageInformationAbouttheAnnualMeetingandVoting......................................1OurCommonStockOwnership.....................................................5Section16(a)BeneficialOwnershipReportingCompliance................................6TheBoardofDirectors............................................................6Independence..................................................................6Meetings.....................................................................7TheCommitteesoftheBoard......................................................7ChairmanoftheBoard...........................................................9DirectorAttendanceatAnnualMeetings..............................................9ShareholderCommunications,DirectorCandidateRecommendationsandNominationsandOtherShareholderProposals..........................................................9CompensationofDirectors........................................................10CompensationoftheExecutiveOfficers...............................................13CompensationDiscussionandAnalysis...............................................13CompensationCommitteeReport...................................................22CompensationTables............................................................23CompensationCommitteeInterlocksandInsiderParticipation..............................30TransactionswithRelatedPersons...................................................30IndependentRegisteredPublicAccountingFirms.......................................30ChangeinIndependentRegisteredPublicAccountingFirms................................30InformationRegardingOurIndependentRegisteredPublicAccountingFirms...................31Reportonthe2006FinancialStatementsandIndependentPublicAccountantsbytheAuditCommittee..................................................................34ElectionofEightDirectorsForOne-YearTerms........................................35OtherBusiness..................................................................37IMPORTANTWhetherornotyouexpecttoattendtheAnnualMeetinginperson,weurgeyoutovoteatyourearliestconvenience.YoumayvotebyInternetorbytelephone,orsign,dateandreturntheenclosedproxycard.PromptlyvotingbyInternetorbytelephoneorreturningtheproxycardwillsaveustheexpenseandextraworkofadditionalsolicitation.Ifyouwishtoreturntheproxycardbymail,anaddressedenvelopeforwhichnopostageisrequiredifmailedintheUnitedStatesisenclosedforthatpurpose.VotingbyInternetorbytelephoneorsendinginyourproxycardwillnotpreventyoufromvotingyoursharesatthemeetingifyoudesiretodoso,asyoumayrevokeyourearliervote.Proxy StatementCRAYINC.411FirstAvenueSouth,Suite600Seattle,Washington98104-2860PROXYSTATEMENTFORANNUALMEETINGOFSHAREHOLDERSToBeHeldAt:1340MendotaHeightsRoadMendotaHeights,Minnesota5512010:00A.M.May16,2007INFORMATIONABOUTTHEANNUALMEETINGANDVOTINGQ:WhydidyousendmethisProxyStatement?A:WesentyouthisProxyStatementandtheenclosedproxycardbecauseourBoardofDirectorsissolicitingyourproxytovoteyoursharesofcommonstockatthe2007AnnualMeetingofShareholders.Thisproxymayalsobeusedatanyadjournmentofthatmeeting.ThisProxyStatementsummarizestheinformationregardingthematterstobevoteduponattheAnnualMeeting.YoudonotneedtoattendtheAnnualMeetingtovoteyourshares.YoumayvotebyInternetorbytelephoneorcomplete,signandreturntheenclosedproxycard.WebegansendingthisProxyStatementoutonoraboutMarch30,2007,toallshareholdersentitledtovote.IfyouownedsharesofourcommonstockatthecloseofbusinessonMarch19,2007,therecorddatefortheAnnualMeeting,youareentitledtovotethoseshares.Ontherecorddate,therewere32,413,834sharesofourcommonstockoutstanding,ouronlyclassofstockhavinggeneralvotingrights.Q:HowmanyvotesdoIhave?A:Youhaveonevoteforeachshareofourcommonstockthatyouownedontherecorddate.Theproxycardindicatesthenumberofsharesyouownedontherecorddate.Q:HowcanIvote?A:YoumayvotebyusingtheInternet,bytelephone,byreturningtheenclosedproxycardorbyvotinginpersonattheAnnualMeeting.Q:HowdoIvotebyInternetorbytelephone?A:ForSharesRegisteredDirectlyinYourName:Ifyoursharesareregistereddirectlyinyourname,youmayvoteontheInternetorbytelephonethroughservicesofferedbyourtransferagent,MellonInvestorsServicesLLC.Internetvotingisavailableatthefollowingaddress:http://proxyvoting.com/cray.YoushouldreadthisProxyStatementandbepreparedtovote,andhaveavailableyour11-digitcontrolnumberlocatedontherightsideatthebottomofyourproxycard.Tovotebytelephone,pleaseuseatouch-tonephoneandcall1-866-540-5760(toll-free).Youwillbeaskedtoenteryour11-digitcontrolnumberlocatedonyourproxycard.YoumayvotebyInternetorbytelephone24hoursaday,7daysaweekuntil11:59p.m.EasternDaylightTime/8:59p.m.PacificDaylightTimeonMay15,2007,thedaybeforetheAnnualMeeting.ForSharesRegisteredintheNameofaBrokerageFirmorBank:Anumberofbrokeragefirmsandbanksparticipateinaprogramforsharesheldin“streetname”thatoffersInternetandtelephonevotingoptions.ThisprogramisdifferentfromtheprogramprovidedbyMellonInvestorServicesLLC,forsharesregistereddirectlyinthenameoftheshareholder.IfyoursharesareheldinanaccountProxy Statementatabrokeragefirmorbankparticipatinginthisprogram,youmayvotethosesharesbyusingthewebsiteorcallingthetelephonenumberreferencedonyourvotingformandfollowingtheinstructionsprovidedbyyourbrokerorbanker.Q:HowdoIvotebyproxy?A:Ifyouproperlyfillinyourproxycardandsendittousintimetovote,your“proxy”(oneoftheindividualsnamedonyourproxycard)willvoteyoursharesasyouhavedirected.Ifyousigntheproxycardbutdonotmakespecificchoices,yourproxywillvoteyoursharesasrecommendedbytheBoard“for”electingtheeightnomineesfordirector,eachtoserveone-yearterms.Ifanyothermatterispresented,yourproxywillvoteinaccordancewithhisbestjudgment.AtthetimeweprintedthisProxyStatement,weknewofnomattersthatneededtobeactedonattheAnnualMeetingotherthanthosediscussedinthisProxyStatement.Q:MayIchangemyvoteorrevokemyproxy?A:Yes.IfyouchangeyourmindafteryouhavevotedbyInternetortelephoneorsentinyourproxycardandwishtorevote,youmaydosobyfollowingtheseprocedures:1.VoteagainbyInternetorbytelephone;2.Sendinanothersignedproxywithalaterdate;3.SendaletterrevokingyourvoteorproxytoourCorporateSecretaryatourofficesinSeattle,Washington;or4.AttendtheAnnualMeetingandvoteinperson.Wewilltabulatethelatestvalidvoteorinstructionthatwereceivefromyou.Q:HowdoIvoteifIholdsharesinmyCray401(k)account?A:SharesofCraystockheldintheCray401(k)SavingsPlanandTrust(the“401(k)Plan”)areregisteredinthenameoftheTrusteeofthe401(k)Plan,FidelityManagementTrustCompany.Nevertheless,underthe401(k)PlanparticipantsmayinstructtheTrusteehowtovotethesharesofCraycommonstockallocatedtotheiraccounts.Thesharesallocatedunderthe401(k)PlancanbevotedbysubmittingvotinginstructionsbyInternet,bytelephoneorbymailinginaspecialproxycardwithrespecttothesharesheldintheparticipant’saccount;thiscardhasabluestripeatthetop.Votingofsharesheldinthe401(k)PlanmustbecompletedbythecloseofbusinessonFriday,May11,2007.ThesesharescannotbevotedattheAnnualMeetingandpriorvotinginstructionscannotberevokedattheAnnualMeeting.Otherwise,participantscanvotethesesharesinthesamemannerasdescribedaboveforshareshelddirectlyinthenameoftheshareholder.TheTrusteewillcastvotesforsharesinthe401(k)Planaccordingtoeachparticipant’sinstructions.IftheTrusteedoesnotreceiveinstructionsfromaparticipantintimefortheAnnualMeeting,theTrusteewillvotetheparticipant’sallocatedsharesinthesamemannerandproportionastheshareswithrespecttowhichvotinginstructionswerereceived.Q:HowdoIvoteinperson?A:IfyouplantoattendtheAnnualMeetingandvoteinperson,wewillgiveyouaballotwhenyouarrive.Ifyoursharesareheldinthe“streetname”ofyourbankorbrokeragefirm,youmustobtaina“legalproxy”fromthebankorbrokeragefirmthatholdsyourshares.Youshouldcontactyourbankorbrokerageaccountexecutivetolearnhowtoobtainalegalproxy.Q:Whatisthequorumrequirementforthemeeting?A:Thequorumrequirementforholdingthemeetingandtransactingbusinessisamajorityoftheoutstandingsharesentitledtobevoted.Thesharesmaybepresentinpersonorrepresentedbyproxyatthemeeting.Bothabstentionsandbrokernon-votesarecountedaspresentforthepurposeofdeterminingthepresenceofaquorum.Proxy Statement2Q:Whatvoteisrequiredtoelecteightdirectorsforone-yearterms?Theeightnomineesfordirectorwhoreceivethemostvoteswillbeelected.Accordingly,ifyoudonotvoteforanominee,oryouindicate“withholdauthoritytovote”foranomineeonyourproxycard,yourvotewillnotcounteither“for”or“against”thenominee.Q:Whatistheeffectofbrokernon-votes?A:Ifyourbrokerholdsyoursharesinits“streetname”anddoesnotreceivevotinginstructionsfromyou,yourbrokerneverthelessmayvoteyoursharesontheelectionofeightdirectors.Ifabrokerdoesnotvoteforaparticularproposal,thatisconsideredabrokernon-vote.Brokernon-voteswillbecountedforthepurposeofdeterminingthepresenceofaquorum.Abrokernon-votewouldhavenoeffectontheoutcomeoftheelectionofdirectorsasonlyapluralityofvotescastisrequiredtoelectadirector.Q:Whowillcountthevote?A:RepresentativesofMellonInvestorServicesLLC,ourtransferagent,willserveastheInspectorofElectionsandcountthevotes.Q:Isvotingconfidential?A:Wekeepalltheproxies,ballotsandvotingtabulationsprivateasamatterofpractice.WeletonlyourInspectorofElections(MellonInvestorServicesLLC)examinethesedocuments.Wewillnotdiscloseyourvotetoourmanagementunlessitisnecessarytomeetlegalrequirements.Wewillforwardtomanagement,however,anywrittencommentsthatyoumakeontheproxycardorelsewhere.Q:WhopaysthecostsofsolicitingproxiesfortheAnnualMeeting?A:Wewillpayallthecostsofsolicitingtheseproxies.Althoughwearemailingtheseproxymaterials,ourofficersandemployeesmayalsosolicitproxiesbytelephone,byfax,viatheInternetorotherelectronicmeansofcommunication,orinperson.Noadditionalcompensationwillbepaidtoofficersoremployeesfortheirassistanceinsolicitingproxies.Wewillreimbursebanks,brokers,nomineesandotherfiduciariesfortheexpensestheyincurinforwardingtheproxymaterialstoyou.W.F.Doring&Co.,Inc.mayhelpsolicitproxiesforanapproximatecostof$4,500plusreasonableexpenses.Q:IreceivemultiplecopiesoftheProxyStatementandAnnualReportonForm10-K,andotherdocumentsfromCray.CanIreducethenumberofcopiesthatIreceive?A:Yes,ifyouownsharesthroughabrokeragefirm,bankorothernominee.Householding,aprocessthatreducesthenumberofcopiesoftheannualmeetingmaterialsandothercorrespondenceyoureceivethroughus,hasbeenimplementedforshareholderswhosharethesamelastnameandaddressandholdsharesin“streetname,”wherethesharesareheldthroughthesamebrokeragefirm,bankorothernominee.Thishassavedussendingover23,000additionalcopiesthisyear.Ifyouholdyoursharesinstreetnameandwouldliketostarthouseholding,orifyouparticipateinhouseholdingandwouldliketoreceiveaseparateannualreportorproxystatement,pleasecall1-800-542-1061fromatouch-tonephoneandprovidethenameofyourbroker,bankorothernomineeandyouraccountnumber(s),orcontactKennethW.Johnson,CorporateSecretary,atCrayInc.,411FirstAvenueSouth,Seattle,WA98104-2860.Wewilldeliverpromptlyuponwrittenororalrequestaseparatecopyoftheannualmeetingmaterialstoashareholderatasharedaddresstowhichasinglecopyofsuchmaterialshadbeendelivered.Q:Asaregisteredshareholder,canIviewfutureproxystatements,annualreportsandotherdocumentsovertheInternet,andnotreceiveanyhardcopiesthroughthemail?A:Yes.Ifyouwishtoelecttoviewfutureproxystatements,annualreportsandotherdocumentsonlyovertheInternet,pleasevisittheMellonInvestorServiceDirectwebpage,www.melloninvestor.com/isd/,andfollowtheinstructionsforestablishingapersonalidentificationnumberandobtainingyourdocumentselectronically.YourelectiontoviewthesedocumentsovertheInternetwillremainineffectuntilyourevokeit.PleasebeProxy Statement3awarethatifyouchoosetoaccessthesematerialsovertheInternet,youmayincurcostssuchastelephoneandInternetaccesschargesforwhichyouwillberesponsible.Q:WhomshouldIcallifIhaveanyquestions?A:IfyouhaveanyquestionsabouttheAnnualMeetingorvoting,oryourownershipofourcommonstock,pleasecontactKennethW.Johnson,ourCorporateSecretary,at(206)701-2000.Mr.Johnson’semailaddressisken@cray.com.Proxy Statement4OURCOMMONSTOCKOWNERSHIPThefollowingtableshows,asofMarch19,2007,thenumberofsharesofourcommonstockbeneficiallyownedbythefollowingpersons:(a)allpersonsweknowtobebeneficialownersofatleast5%ofourcommonstock,(b)ourdirectors,(c)theexecutiveofficersnamedintheSummaryCompensationTableand(d)alldirectorsandexecutiveofficersasagroup.AsofMarch19,2007,therewere32,413,834sharesofourcommonstockoutstanding.NameandAddress*(1)CommonSharesOwnedOptionsExercisableWithin60DaysTotalBeneficialOwnershipPercentage5%ShareholdersWellsFargo&Company(2).......................4,518,002—4,518,00213.94%420MontgomeryStreetSanFrancisco,CA94104IndependentDirectorsWilliamC.Blake...............................2505,0005,250**JohnB.Jones,Jr.(3).............................7,54212,08319,625**StephenC.Kiely(3).............................21,18232,25053,432**FrankL.Lederman(3)............................9,72815,00024,728**SallyG.Narodick(3).............................8,45112,50020,951**DanielC.Regis(3)..............................11,39912,50023,899**StephenC.Richards(3)...........................13,45112,50025,951**NamedExecutivesPeterJ.Ungaro(4)...............................223,953399,999623,9521.90%BrianC.Henry(4)...............................122,430124,999247,429**MargaretA.Williams(4)..........................125,80375,000200,803**StevenL.Scott(4)...............................22,849129,943152,792**JanC.Silverman(4).............................45,50312,50058,003**Alldirectorsandexecutiveofficersasagroup(14persons)(4)..................................679,9201,021,3021,701,2225.09%*Unlessotherwiseindicated,alladdressesarec/oCrayInc.,411FirstAvenueSouth,Suite600,Seattle,WA98104-2860.**Lessthan1%(1)Thistableisbaseduponinformationsuppliedbythenamedexecutiveofficers,directorsand5%shareholders,includingfilingswiththeSecuritiesandExchangeCommission(the“SEC”).Unlessotherwiseindicatedinthesenotesandsubjecttocommunitypropertylawswhereapplicable,eachofthelistedshareholdershassolevotingandinvestmentpowerwithrespecttothesharesshownasbeneficiallyownedbysuchshareholder.Thenumberofsharesandpercentageofbeneficialownershipincludessharesofcommonstockissuablepursuanttostockoptionsheldbythepersonorgroupinquestion,whichmaybeexercisedonMarch19,2007,orwithin60daysthereafter.(2)Theinformationunderthecolumn“CommonSharesOwned”isbasedonaSchedule13GfiledwiththeSEConFebruary9,2007,regardingownershipasofDecember31,2006.InthatSchedule13G,WellsFargo&Company,asparentcompany,reportedbeneficialownershipof4,518,002shares,withsolevotingpowerover4,463,775shares,sharedvotingpowerover750shares,soledispositivepowerover4,323,501sharesandshareddispositivepowerover2,000shares,withonesubsidiary,WellsCapitalManagementIncorporated,reportingsolevotingpowerover1,126,969shares,andsoledispositivepowerover4,241,987shares,andProxy Statement5anothersubsidiary,WellsFargoFundsManagement,LLC,reportingsolevotingpowerover3,336,725sharesandsoledispositivepowerover81,213shares.(3)ThenumberofsharesofcommonstockshownfortheindicateddirectorsincludesrestrictedshareswhichvestonJune7,2007,andJune7,2008,respectively,andwhichareforfeitableincertaincircumstances,asfollows:Mr.Jones(2,751and2,751shares),Mr.Kiely(3,091and3,091shares),Dr.Lederman(2,989and2,989shares),Ms.Narodick(3,601and3,600shares),Mr.Regis(4,450and4,449shares)andMr.Richards(3,601and3,600shares).(4)Thenumberofsharesofcommonstockshownfortheindicatedexecutiveofficersincludesrestrictedshareswhichvestonthedatesindicated,andareforfeitableincertaincircumstances,asfollows:Mr.Ungaro—June30,2007—150,000,November15,2008—31,575andNovember15,2010—31,575shares;Mr.Hen-ry—June30,2007—87,500,November15,2008—17,375andNovember15,2010—17,375shares;Ms.Williams—June30,2007—87,500,November15,2008—17,375andNovember15,2010—17,375shares;Mr.Scott—November15,2008—11,050andNovember15,2010—11,050shares;Mr.Silverman—June30,2007—37,500,November15,2008—3,950andNovember15,2010—3,950shares;andotherexecutiveofficers—June30,2007—27,500,November15,2008—4,725andNovember15,2010—4,725shares.Section16(a)BeneficialOwnershipReportingComplianceSection16(a)oftheSecuritiesExchangeActof1934(the“ExchangeAct”)requiresthatourdirectors,executiveofficersandgreater-than-10%shareholdersfilereportswiththeSEContheirinitialbeneficialownershipofourcommonstockandanysubsequentchanges.Theymustalsoprovideuswithcopiesofthereports.WearerequiredtotellyouinthisProxyStatementifweknowaboutanyfailuretoreportasrequired.Wereviewedcopiesofallreportsfurnishedtousandobtainedwrittenrepresentationsthatnootherreportswererequired.Basedonthis,webelievethatallofthesereportingpersonscompliedwiththeirfilingrequirementsfor2006exceptthatwefiledoneForm5reportlatecoveringtwo2005purchasesofourcommonstockbyMs.Williamsunderouremployeestockpurchaseplan.THEBOARDOFDIRECTORSThegoalsofourBoardofDirectorsaretobuildlong-termvalueforourshareholdersandtoassureourvitalityforourcustomers,employeesandothersthatdependonus.OurBoardhasadoptedandfollowscorporategovernancepracticesthatourBoardandourseniormanagementbelievepromotethesepurposes,aresoundandrepresentbestpractices.TothisendwehaveadoptedchartersforourAudit,CompensationandCorporateGovernanceCommittees,CorporateGovernanceGuidelinesandaCodeofBusinessConductthatappliestoallofourdirectors,officersandemployees.WeperiodicallyreviewthesegovernancepracticesagainstrequirementsoftheSEC,thelistingstandardsoftheNasdaqGlobalMarketSystem(“Nasdaq”),thelawsoftheStateofWashingtonandpracticessuggestedbyrecognizedcorporategovernanceauthorities.TheBoardofDirectorsoverseesourbusinessandaffairsandmonitorstheperformanceofmanagement.Inaccordancewithcorporategovernanceprinciples,theBoarddoesnotinvolveitselfinday-to-dayoperations.ThedirectorskeepthemselvesinformedthroughdiscussionswiththeChiefExecutiveOfficer,otherkeyexecutivesandourprincipalexternaladvisers(legalcounselandoutsideauditors),byreadingthereportsandothermaterialsthatwesendthemregularlyandbyparticipatinginBoardandcommitteemeetings.IndependenceCurrentlyourBoardhaseightmembers.TheBoardrecentlydeterminedthatthesevendirectorsidentifiedontheCommonStockOwnershiptableaboveas“independentdirectors”meettheNasdaqandSECstandardsforindependence.OnlyindependentdirectorsmayserveonourAudit,CompensationandCorporateGovernanceCommittees.AssetforthinourCorporateGovernanceGuidelines,theBoardbelievesthatatleasttwo-thirdsoftheBoardshouldconsistofindependentdirectorsandthat,absentcompellingcircumstances,theBoardshouldnotcontainProxy Statement6morethantwomembersfromourmanagement.Currently,sevenofeightdirectorsareconsideredindependentandonememberofmanagement,Mr.Ungaro,ourChiefExecutiveOfficerandPresident,isontheBoard.Indeterminingtheindependenceofourdirectors,theBoardaffirmativelydecideswhetheranon-managementdirectorhasarelationshipthatwouldinterferewiththatdirector’sexerciseofindependentjudgmentincarryingouttheresponsibilitiesofbeingadirector.Incomingtothatdecision,theBoardisinformedoftheNasdaqandSECrulesthatdisqualifyapersonfrombeingconsideredasindependent,considerstheresponsestoanannualquestionnairefromeachdirectorandreviewstheapplicablestandardswitheachBoardmember.Inmakingdecisionsaboutindependence,theBoardreviewedtwoseparatetransactionsthatitdetermineddidnotaffecttheindependenceofthedirectorsinvolved.InconnectionwiththesuccessfuldefenseagainstthefederalandstatecourtderivativesecuritieslitigationfiledagainstcertainmembersofourcurrentandpastBoardandmanagement,weretainedthelawfirmofLanePowellPCinlate2005throughourlastfavorabledecisioninstatecourtinNovember2006.Ms.Narodick’shusbandisapartnerofthatfirmbutwasnotinvolvedintheprovisionofthelegalservicestous.LanePowellwasonanapprovedpaneloflawfirmsbyourinsurerandtheamountofitsfeeswasnotmaterialinamount.TheBoardalsoreviewedapotentialbusinessrelationshipbyuswithInteractiveSupercomputing,Inc.,ofwhichMr.BlakeisnowtheChiefExecutiveOfficer.Todate,however,wehavehadnobusinessrelationshipwiththatfirm.MeetingsTheBoardmet13timesandtheBoard’sstandingcommitteesheldatotalof34meetingsduring2006.Eachdirectorattendedatleast95%ofthemeetingsoftheBoardandrelevantstandingcommitteesonwhichsuchdirectorserved.Theaverageattendancein2006foralldirectorsatBoardandstandingcommitteemeetingswasover98.5%.TheCommitteesoftheBoardTheBoardhasestablishedanAuditCommittee,aCompensationCommitteeandaCorporateGovernanceCommitteeasstandingcommitteesoftheBoard.Inaddition,inFebruary2007,theBoardestablishedaStrategicTechnologyAssessmentCommitteeasastandingcommittee.Noneofthedirectorswhoserveasmembersofthesecommitteesis,orhaseverbeen,oneofouremployees.AuditCommittee.ThecurrentmembersoftheAuditCommitteeare:DanielC.Regis(Chair),SallyG.NarodickandStephenC.Richards.TheAuditCommitteeandtheBoardhavedeterminedthateachmemberoftheAuditCommitteeis“independent,”asthattermisdefinedinSECandNasdaqrulesandregulations,andthatMr.Regisisan“auditcommitteefinancialexpert,”asthattermisdefinedinSECregulations.TheAuditCommitteehad22meetingsduring2006.TheAuditCommitteeassiststheBoardofDirectorsinfulfillingitsresponsibilityforoversightof:(cid:129)thequalityandintegrityofouraccountingandfinancialreportingprocessesandtheauditsofourfinancialstatements,(cid:129)thequalificationsandindependenceofthepublicauditingfirmengagedtoissueanauditreportonourfinancialstatements,(cid:129)theperformanceofoursystemsofinternalcontrols,disclosurecontrolsandinternalauditfunctions,and(cid:129)ourproceduresforlegalandregulatorycompliance,riskassessmentandbusinessconductstandards.TheAuditCommitteeisdirectlyandsolelyresponsibleforappointing,determiningthecompensationpayableto,overseeing,terminatingandreplacinganyindependentauditorengagedbyusforthepurposeofpreparingorissuinganauditreportorperformingotheraudit,revieworattestservicesforus.TheAuditCommitteecharterandtheCodeofBusinessConductareavailableonourwebsite:www.cray.comunder“Investors—CorporateGovernance—CommitteeCharters”and“—GovernanceDocuments,”respec-tively.ThereportoftheAuditCommitteeregardingitsreviewofthefinancialstatementsandothermattersissetforthbelowonpage34.Proxy Statement7CompensationCommittee.ThecurrentmembersoftheCompensationCommitteeare:FrankL.Lederman(Chair),JohnB.Jones,Jr.,StephenC.KielyandStephenC.Richards.Inaddition,untilhisdeathinearlyFebruary2007,KennethW.Kennedy,Jr.servedontheCompensationCommittee.TheCompensationCommitteeandtheBoardhavedeterminedthateachmemberoftheCompensationCommitteeis“independent,”asthattermisdefinedinNasdaqrulesandregulations.TheCompensationCommitteeheld8meetingsin2006.TheCompensationCommitteeassiststheBoardofDirectorsinfulfillingitsresponsibilitiesfortheoversightof:(cid:129)ourcompensationpolicies,plansandbenefitprograms,(cid:129)thecompensationoftheChiefExecutiveOfficerandotherseniorofficers,and(cid:129)theadministrationofourequitycompensationplans.Ourcompensationpolicies,plansandprogramsaredesignedtoattractandretainahighlyskilledworkforceandtomotivateandrewardemployeebehaviorsothatweachieveourgoalsandmaintainandenhanceourcompetitiveposition.Weseektofosteranenvironmentthatrewardshighperformanceandalignstheinterestsofouremployeestothelong-terminterestsofourshareholdersthroughequityincentives.TheCompensationCommitteehastheauthoritytodeterminethecompensationofourseniorofficersotherthantheChiefExecutiveOfficer.TheBoard(actinginexecutivesessionwithoutthepresenceoftheChiefExecutiveOfficer)determinesthecompen-sationoftheChiefExecutiveOfficerbasedontherecommendationoftheCommittee.TheCompensationCommitteeadoptedacharterthathasbeenapprovedbytheBoardofDirectors.TheCompensationCommitteecharterisavailableonourwebsite:www.cray.comunder“Investors—CorporateGovernance—CommitteeCharters.”TheCompensationCommittee’sReportontheCompensationDiscussionandAnalysisissetforthbelowonpage22.CorporateGovernanceCommittee.ThecurrentmembersoftheCorporateGovernanceCommitteeare:StephenC.Kiely(Chair),FrankL.LedermanandDanielC.Regis.TheCorporateGovernanceCommitteeandtheBoardhavedeterminedthateachmemberoftheCorporateGovernanceCommitteeis“independent,”asthattermisdefinedinNasdaqrulesandregulations.TheCorporateGovernanceCommitteeheld4meetingsin2006.TheCorporateGovernanceCommitteehastheresponsibilityto:(cid:129)developandrecommendtotheBoardasetofcorporategovernanceprinciples,(cid:129)recommendqualifiedindividualstotheBoardfornominationasdirectors,(cid:129)leadtheBoardinitsannualreviewoftheBoard’sperformance,and(cid:129)recommenddirectorstotheBoardforappointmenttoBoardcommittees.TheCorporateGovernanceCommitteehasadoptedacharterandCorporateGovernanceGuidelines,bothofwhichhavebeenapprovedbytheBoardofDirectors.TheCorporateGovernanceCommitteecharterandtheCorporateGovernanceGuidelinesareavailableonourwebsite:www.cray.comunder“Investors-CorporateGovernance—CommitteeCharters”and“—GovernanceDocuments,”respectively.StrategicTechnologyAssessmentCommittee.ThecurrentmemberoftheStrategicTechnologyAssessmentCommitteeisWilliamC.Blake(Chair).TheBoardwilladdadditionalmembersinduecourse.TheBoardhasdeterminedthatMr.Blakeis“independent,”asthattermisdefinedinNasdaqrulesandregulations,althoughsuchindependenceisnotarequirementformembershiponthisCommittee.TheStrategicTechnologyAssessmentCommitteehastheresponsibility:(cid:129)toassisttheBoardinitsoversightofourtechnologydevelopment,includingourproductdevelopmentroadmap,and(cid:129)toassesswhetherourresearchanddevelopmentinvestmentsaresufficientandappropriatetosupportthecompetitivenessofourofferingsinthemarketplace.Fromtimetotime,theBoardestablishesothercommitteesonanad-hocbasistoassistinitsoversightresponsibilities.Proxy Statement8ChairmanoftheBoardMr.KielyhasservedasChairmanoftheBoard,anon-executiveposition,sinceAugust2005.AsChairman,Mr.KielyconsultswithMr.Ungaro,asChiefExecutiveOfficer,regardingagendaitemsforBoardmeetings;chairsexecutivesessionsoftheBoard’sindependentdirectors;communicatesconcernsoftheindependentdirectorstotheChiefExecutiveOfficer;andperformssuchotherdutiesastheBoarddeemsappropriate.DirectorAttendanceatAnnualMeetingsWeencouragebutdonotrequireourdirectorstoattendtheAnnualMeetingofShareholders.WeusuallyschedulearegularBoardmeetingonthemorningbeforetheAnnualMeeting.In2006,ourAnnualMeetingwasdelayedandwasnotheldinconnectionwithaBoardmeeting.Nevertheless,fiveofourdirectorsattendedthe2006AnnualMeeting.ShareholderCommunications,DirectorCandidateRecommendationsandNominationsandOtherShare-holderProposalsCommunications.TheCorporateGovernanceCommitteehasestablishedaprocedureforourshareholderstocommunicatewiththeBoard.Communicationsshouldbeinwriting,addressedto:CorporateSecretary,CrayInc.,411FirstAvenueSouth,Suite600,Seattle,WA98104-2860,andmarkedtotheattentionoftheBoardoranyofitsindividualcommitteesortheChairmanoftheBoard.Copiesofallcommunicationssoaddressedwillbepromptlyforwardedtothechairmanofthecommitteeinvolved,inthecaseofthecommunicationsaddressedtotheBoardasawhole,totheCorporateGovernanceCommitteeor,ifaddressedtotheChairman,totheChairmanoftheBoard.DirectorCandidates.ThecriteriaforBoardmembershipasadoptedbytheBoardincludeaperson’sintegrity,knowledge,judgment,skills,expertise,collegiality,diversityofexperienceandothertimecommitments(includingpositionsonothercompanyboards)inthecontextofthethen-currentcompositionoftheBoard.TheCorporateGovernanceCommitteeisresponsibleforassessingtheappropriatebalanceofskillsbroughttotheBoardbyitsmembers,andensuringthatanappropriatemixofspecializedknowledge(e.g.,financial,industryortechnology)isrepresentedontheBoard.OncetheCorporateGovernanceCommitteehasidentifiedapotentialdirectornominee,theCommitteeinconsultationwiththeChiefExecutiveOfficerevaluatestheprospectivenomineeagainstthespecificcriteriathattheBoardhasestablishedandassetforthinourCorporateGovernanceGuidelines.IftheCorporateGovernanceCommitteedeterminestoproceedwithfurtherconsideration,thenmembersoftheCorporateGovernanceCommittee,theChiefExecutiveOfficerandothermembersoftheBoard,asappropriate,interviewtheprospectivenominee.Aftercompletingthisevaluationandinterview,theCorporateGovernanceCommitteemakesarecom-mendationtothefullBoard,whichmakesthefinaldeterminationwhethertoelectthenewdirector.TheCorporateGovernanceCommitteewillconsidercandidatesfordirectorrecommendedbyshareholdersandwillevaluatethosecandidatesusingthecriteriasetforthabove.Shareholdersshouldaccompanytheirrecommendationsbyasufficientlydetaileddescriptionofthecandidate’sbackgroundandqualificationstoallowtheCorporateGovernanceCommitteetoevaluatethecandidateinlightofthecriteriadescribedabove,adocumentsignedbythecandidateindicatinghisorherwillingnesstoserveifelectedandevidenceofthenominatingshareholder’sownershipofourcommonstock.Suchrecommendationanddocumentsshouldbesubmittedinwritingto:CorporateSecretary,CrayInc.,411FirstAvenueSouth,Suite600,Seattle,WA98104-2860,markedtotheattentionoftheCorporateGovernanceCommittee.Inaddition,ourBylawspermitshareholderstonominatedirectorsatashareholders’meeting.Inordertonominateadirectoratashareholders’meeting,ashareholdermakinganominationmustnotifyusnotfewerthan60normorethan90daysinadvanceofthemeetingor,iflater,bythe10thbusinessdayfollowingthefirstpublicannouncementofthemeeting.Inaddition,theproposalmustcontaintheinformationrequiredinourBylawsfordirectornominations,including:(cid:129)thenominatingshareholder’snameandaddress,(cid:129)arepresentationthatthenominatingshareholderisentitledtovoteatsuchmeeting,Proxy Statement9(cid:129)thenumberofsharesofourcommonstockwhichthenominatingshareholderownsandwhenthenominatingshareholderacquiredthem,(cid:129)arepresentationthatthenominatingshareholderintendstoappearatthemeeting,inpersonorbyproxy,(cid:129)thenominee’sname,age,addressandprincipaloccupationoremployment,(cid:129)allinformationconcerningthenomineethatmustbedisclosedaboutnomineesinproxysolicitationsundertheSECproxyrules,and(cid:129)thenominee’sexecutedconsenttoserveasadirectorifsoelected.TheChairmanoftheBoard,inhisdiscretion,maydeterminethataproposednominationwasnotmadeinaccordancewiththerequiredproceduresand,ifso,disregardthenomination.ShareholderProposals.Inorderforashareholderproposaltobeconsideredforinclusioninourproxystatementforthe2008AnnualMeeting,wemustreceivethewrittenproposalnolaterthanDecember3,2007.SuchproposalsalsomustcomplywithSECregulationsregardingtheinclusionofshareholderproposalsincompany-sponsoredproxymaterials.Inorderforashareholderproposaltoberaisedfromthefloorduringthe2007AnnualMeeting,writtennoticeoftheproposalmustbereceivedbyusnotlessthan60normorethan90dayspriortothemeetingor,iflater,bythe10thbusinessdayfollowingthefirstpublicannouncementofthemeeting.TheproposalmustalsocontaintheinformationrequiredinourBylawsforshareholderproposals,including:(cid:129)abriefdescriptionofthebusinesstheshareholderwishestobringbeforethemeeting,thereasonsforconductingsuchbusinessandthelanguageoftheproposal,(cid:129)theshareholder’snameandaddress,(cid:129)thenumberofsharesofourcommonstockwhichtheshareholderownsandwhentheshareholderacquiredthem,(cid:129)arepresentationthattheshareholderintendstoappearatthemeeting,inpersonorbyproxy,and(cid:129)anymaterialinteresttheshareholderhasinthebusinesstobebroughtbeforethemeeting.TheChairmanoftheBoard,ifthefactssowarrant,maydirectthatanybusinesswasnotproperlybroughtbeforethemeetinginaccordancewithourBylaws.IfyouwishtoobtainafreecopyofourBylaws,pleasecontactKennethW.Johnson,CorporateSecretary,CrayInc.,411FirstAvenueSouth,Suite600,Seattle,WA98104-2860.TheBylawsareavailableonourwebsite:www.cray.comunder“Investors—CorporateGovernance—GovernanceDocuments.”CompensationofDirectorsWeuseacombinationofcashandstock-basedincentivecompensationtoattractandretainqualifiedcandidatestoserveonourBoard.Insettingdirectorcompensation,theCorporateGovernanceCommitteeconsidersthesignificantamountoftimethatdirectorsexpendinfulfillingtheirduties,theskilllevelrequiredofmembersoftheBoard,andageneralunderstandingofdirectorcompensationatcompaniesofsimilarsizeandcomplexity.WedonotcompensateemployeedirectorsfortheirserviceontheBoard.CashCompensationEachnon-employeedirectorreceivesanannualretainerof$10,000,paidquarterly,andafeeof$2,500foreachmeetingoftheBoardattendedinpersonor$1,500($1,000priortoApril1,2006)ifattendedtelephonically.Wepayanannualfee,paidquarterly,totheChairmanoftheBoard($4,000),andthechairsoftheAudit($6,000),Compensation($2,000),theCorporateGovernance($2,000)andtheStrategicTechnologyAssessment($2,000)committees,andeachdirectorreceivesafeeof$2,000($1,000priortoApril1,2006)foreachcommitteemeetingattended,whetherinpersonortelephonically.WhentheBoardcreatescommitteesotherthanthestandingcommitteesidentifiedabove,theBoarddetermineswhethertoextendthesamecommitteefeestructuretotheProxy Statement10membersofsuchcommittees.Wereimburseallexpensesrelatedtoparticipationinmeetingsoftheshareholders,Boardandcommittees.EquityCompensationStockOptions.Eachnon-employeedirector,uponhisorherfirstelectiontotheBoard,isgrantedanoptionfor5,000shares,vestingimmediately,withanexercisepriceequaltothefairmarketvalueofourcommonstockonthedateofsuchfirstelection.Priorto2005,eachnon-employeedirector,onthedateoftheAnnualMeeting,wasgrantedanon-qualifiedoptionfor5,000sharesofourcommonstock,vestingmonthlyoverthenexttwelvemonthsandwithanexercisepriceequaltothefairmarketvalueofourcommonstockonthedateoftheAnnualMeeting.In2005,alloptionsgrantedtonon-employeedirectorsvestedinfullonDecember31,2005.Beginningin2006,weceasedgrantingstockoptionstocontinuingdirectors,andcommencedissuingrestrictedstock,asdiscussedbelow.RestrictedStockAwards.CommencingwiththeAnnualMeetingin2006,wegrantedtoeachcontinuingnon-employeedirectorelectedbytheshareholdersrestrictedsharesofcommonstockwithavalueequaltothatdirector’sfeesearnedinthepreviousfiscalyear.Thepersharevalueofsharesgrantedisdeterminedbyusingthefairmarketvalueofourcommonstockonthedateofsuchelection.One-halfofthesharesarerestrictedagainstsaleortransferforaperiodofoneyearfromdateofgrant;thebalancearerestrictedagainstsaleortransferforaperiodoftwoyearsfromthedateofgrant.Thenon-employeedirectorsmayvoteandreceivedividendsontherestrictedshareswhiletherestrictionsremaininplace;wehavenotgrantedanydividendsonourcommonstockandhavenoplanstodoso.Therestrictedsharesvestinfullifanon-employeedirectorcannolongerserveduetodeathorDisabilityorif,followingaChangeofControl,thenon-employeedirectorisremovedfromtheBoardorisnotnominatedtocontinuetoserveasaDirector.Therestrictedsharesareforfeitedif,whileunvested,anon-employeeDirectorresignsorretiresfromtheBoard(otherthanwiththeexpressapprovaloftheCorporateGovernanceCommittee),isaskedtoleavetheBoardbytheCorporateGovernanceCommitteeforCauseorisnotnominatedbytheBoardtocontinueasaDirectorotherthanfollowingaChangeofControl.OwnershipGuidelines.TheBoardhasestablishedstockownershipguidelinespursuanttowhich,nolaterthantwoyearsafterreceivingrestrictedsharesundertherestrictedstockawardprogramthatcommencedin2006,non-employeedirectorsshouldholdsharesofcommonstockwithatleastavalue,basedonvalueatacquisition,equaltoone-year’sBoardretainerandBoardattendancefees.Thefollowingtablesetsforthinformationregardingcompensationprovidedbyustoournon-employeedirectorsduringtheyearendedDecember31,2006.Mr.Ungaroisnotincludedinthistableasheisanemployeeandhereceivesnocompensationforhisserviceasadirector.HiscompensationasanemployeeisshownintheSummaryCompensationTableonpage23.DirectorCompensationfor2006NameFeesEarnedorPaidinCash(1)StockAwards(2)OptionAwards(3)Total(4)WilliamC.Blake.........................$21,5000$22,058$43,558JohnB.Jones,Jr..........................$57,500$10,6730$68,173KennethW.Kennedy,Jr....................$49,000$10,1450$59,145StephenC.Kiely..........................$63,000$11,9920$74,992FrankL.Lederman........................$58,500$11,5960$70,096SallyG.Narodick.........................$66,000$13,9680$79,968DanielC.Regis..........................$86,500$17,2620$103,762StephenC.Richards.......................$80,500$13,9680$94,468(1)Reflectsfeesearnedforservingasadirectorandattendingmeetingsin2006,evenifpaidin2007.(2)Theamountsshownreflecttheexpenseforthe2006fiscalyearwithrespecttoalloutstandingrestrictedstockawardsheldbyeachdirector,disregardinganyadjustmentsforestimatedforfeitures,andotherwiseasrecordedProxy Statement11onour2006financialstatements;theamountsshowndonotreflectanamountpaidtoorearnedorrealizedbyanydirector.SeetheNotestoConsolidatedFinancialStatementsinourAnnualReportonForm10-KforthefiscalyearendedDecember31,2006,foradescriptionofthevaluationoftheserestrictedstockawardsunderFinancialAccountingStandardsBoardStatementNo.123(R),Share-BasedPayment(“FAS123R”).Pursuanttothepolicydescribedunder“RestrictedStockAwards”above,onJune7,2006,wegrantedtheindicatednumberofsharesofrestrictedstocktothefollowingdirectors,halfofwhichvestsonJune7,2007,andhalfofwhichvestsonJune7,2008;thefollowingalsoshowsthegrantdatefairvalueofthoseawardsindollarscomputedinaccordancewithFAS123R:JohnB.Jones,Jr........................................5,502shares—$37,854KennethW.Kennedy,Jr...................................5,230shares—$35,982StephenC.Kiely.......................................6,182shares—$42,532FrankL.Lederman......................................5,978shares—$41,129SallyG.Narodick.......................................7,201shares—$49,543DanielC.Regis........................................8,899shares—$61,225StephenC.Richards.....................................7,201shares—$49,543Theamountanydirectorrealizesfromtheserestrictedstockawards,ifany,willdependonthefuturemarketvalueofourcommonstockwhenthesesharesaresoldandthereisnoassurancethatthedirectorswillrealizeamountsatornearthevaluesshown.(3)Theamountsshownreflectthedollaramountrecognizedasanexpenseforfinancialstatementreportingpurposesforthe2006fiscalyearinaccordancewithFAS123Rregardingoutstandingstockoptionsheldbyeachdirector.Optionsgrantedtodirectorsin2005andearlierallvestedpriorto2006,andwerecognizednoexpensein2006foroptionsgrantedin2005andearlier.WilliamC.BlakejoinedourBoardonJune7,2006,andpursuanttothepolicydescribedunder“StockOptions”above,receivedanimmediatelyvestedstockoptionfor5,000shareswithanexercisepriceof$7.52pershare,thepersharefairmarketvalueofourcommonstockonthatdate.Asthestockoptionwasvestedimmediatelyupongrant,thefullgrantdatefairvalueofthatoption,computedinaccordancewithFAS123R,of$22,058wasthenrecognizedonourfinancialstatements.SeetheNotestoConsolidatedFinancialStatementsinourAnnualReportonForm10-KforthefiscalyearendedDecember31,2006,foradescriptionofthevaluationofthesestockoptions,includingkeyassumptions,undertheBlack-ScholespricingmodelpursuanttoFAS123R;thevaluesdeterminedbytheBlack-Scholespricingmodelarehighlydependentontheseassumptions,particularlyregardingvolatilityofthemarketpriceforourcommonstockandexpectedexercisedatesofthisoption.Therecanbenoassurancethattheoptionswilleverbeexercised,inwhichcasenovaluewouldberealizedbyMr.Blake.TheamountMr.Blakerealizes,ifany,fromthisoptiongrantdependsonthefutureexcess,ifany,ofthemarketvalueofourcommonstockovertheexercisepriceoftheoptionwhenhesellstheunderlyingshares,andthereisnoassurancethatthevaluerealizedbyhimwillbeatornearthevalueshown.(4)Theamountsshownreflectthesumoftheamountsshowninthecolumnsforfeespaid,stockawardsandoptionawards,asrequiredbySECrulesandregulations.Becausethesesumscombinecashpaymentsearnedbyandmadetothedirectorsandamountsnotearnedbyorpaidtothedirectorsbutratheramountsrecordedbyusonour2006financialstatementsasanexpenseforrestrictedstockawardsandoptiongrantstothedirectors,theactualtotalamountearnedin2006byadirectordependsonfutureeventsand,forthereasonsdescribedinfootnotes(2)and(3)above,thereisnoassurancethatthedirectorswillrealizeatotalsumatornearthevaluesshowninthiscolumn.Proxy Statement12Thefollowingtablesetsforththenumberofoutstandingoptionsandsharesofrestrictedstockheldbyournon-employeedirectorsasofDecember31,2006.Alloptionsshownarefullyvested.One-halfoftherestrictedstockawardsshownvestonJune7,2007,andtheremaininghalfvestonJune7,2008,exceptasnotedbelow.NameOptionsOutstandingDecember31,2006RestrictedStockAwardsOutstandingDecember31,2006WilliamC.Blake................................5,0000JohnB.Jones,Jr.................................12,0835,502KennethW.Kennedy,Jr...........................28,2505,230StephenC.Kiely................................32,2506,182FrankL.Lederman...............................15,0005,978SallyG.Narodick................................12,5007,201DanielC.Regis.................................12,5008,899StephenC.Richards..............................12,5007,201Eachofthesenon-employeedirectorshasbeennominatedforelectiontoaone-yeartermattheAnnualMeetingofShareholderstobeheldonMay16,2007,exceptforDr.KennedywhodiedinearlyFebruary2007andwhoserestrictedsharesvestedinfulluponhisdeath.Iftheseindividualsareelectedforanotheryear,theneachwillreceiveadditionalsharesofcommonstockthatwillvest50%oneyearaftergrantandtheremaining50%twoyearsaftergrant,pursuanttothediscussionunder“EquityCompensation—RestrictedStockAwards”above.Thenumberofsuchsharesissuedwillbedeterminedbydividingtheamountofthecashfeessetforthinthetableregardingdirectorcompensationin2006bythefairmarketvalueofourcommonstockonthedateofthe2007AnnualMeeting.See“ElectionofEightDirectorsForOne-YearTerms”below.COMPENSATIONOFTHEEXECUTIVEOFFICERSCompensationDiscussionandAnalysisThefollowingdiscussiondescribesthematerialelementsofcompensationforourseniorofficers,includingtheexecutiveofficersidentifiedinthe“SummaryCompensationTable”below(the“NamedExecutiveOfficers”).Asdescribedaboveunder“TheBoardofDirectors—TheCommitteesoftheBoard—CompensationCommit-tee,”theCompensationCommitteeassistsourBoardofDirectorsinfulfillingitsresponsibilitiesfortheoversightofourcompensationpolicies,plansandbenefitprograms,thecompensationofourChiefExecutiveOfficerandotherseniorofficers,andtheadministrationofourequitycompensationplans.TheCompensationCommittee,withtheassistanceofourHumanResourcespersonnel,usespubliclyavailableprofessionalcompensationsurveysandlabormarketstudiestomakeinformeddecisionsregardingouroverallcompensationandbenefitpractices.TheCommitteealsoconsidersinternalandexternalrelativeparityamongseniormanagement,andcompetitiveinformationobtainedinconnectionwithnewhiresand,whenpossible,fromdepartingemployees.TheCom-pensationCommitteehasnotretainedcompensationconsultantstoadviseit.TheCompensationCommitteehastheauthoritytodeterminetheannualcompensationforourseniorofficers,otherthanfortheChiefExecutiveOfficer,aftersolicitingtherecommendationsofourChiefExecutiveOfficer,andrecommendsthecompensationofourChiefExecutiveOfficertothefullBoard.Inpractice,ourfullBoardreviewsandapprovesthecompensationofallofourseniorofficersinexecutivesessionsofnon-employeedirectors.PhilosophyandObjectivesOurcompensationphilosophyforallemployees,includingourseniorofficers,istoprovidepolicies,plansandprogramsdesignedtoattract,retainandmotivatethebestpersonnelatalllevelstoallowustoachieveourgoalsandProxy Statement13maintainandenhanceourcompetitiveposture.Pursuanttothisoverallapproach,ourcompensationprogramhasthefollowingobjectives:(cid:129)Toattractandretainahighly-skilledworkforce—wemustremaincompetitivewiththecompensationandbenefitsofferedbyotheremployersthatcompetewithusfortalent.Inallmarketswefacecompetitionforouremployeesfrommanysources,oftenincludingtechnologycompanieswithfargreaterresources.Thiscompetitivepressurehasincreasedtheneedtoimproveouroverallcompensation,eveninthelightoffinanciallossesduringthelastthreeyears.(cid:129)Tomotivateandrewardemployeebehaviorthatfostersahighperformanceculture—ourcompensationisbasedonthelevelofjobresponsibility,individualperformanceandourperformance.Asemployeesassumegreaterlevelsofresponsibility,anincreasingproportionoftheircompensationislinkedtoperformanceandshareholderreturn.(cid:129)Toprovidestability—wehaveprovidedretentionincentivesforemployeesandofficerswherewebelieveappropriate.(cid:129)Toaligntheinterestsofouremployeeswiththelong-terminterestsofourshareholders—weusegrantsofstockoptionsandrestrictedstockwithlonger-termvestingperiods.CompensationProgramComponentsWebelievethecomponentsofourcompensationprogramprovideanappropriatemixoffixedandvariablepay,balanceshorter-termoperationalperformancewithlong-termincreasesinshareholdervalue,reinforceahighperformancecultureandencouragerecruitmentandretentionofouremployeesandofficers.Wereviewourcompensationprogramperiodicallyandmakeadjustmentsasneededorappropriateinordertomeetourobjectives.Ourcompensationprogramforallofouremployees,includingourseniorofficers,hasthefollowingprincipalcomponents:(cid:129)Basesalary,whichisfixedannualcashcompensationreviewedforincreasesannually,withthepurposeofprovidingbasecompensationthatiscompetitivewiththemarketfortheskillsandexperiencenecessarytomeettherequirementsoftheemployee’srolewithus.(cid:129)Anannualcashincentiveplan,whichprovidesperformance-basedcashincentivesbasedoncompanyandindividualperformanceagainstspecifictargets,withthepurposeofmotivatingandrewardingachievementofourcriticalstrategicandfinancialgoals,thusfosteringahighperformanceculture.(cid:129)Long-termequityawards,throughthegrantofstockoptionsandrestrictedstockawardsgenerallyvestingoverfouryears,withthepurposeofaligningtheinterestofrecipientswithourshareholders,motivatingandrewardingrecipientstoincreaseshareholdervalueoverthelong-termandprovidingaretentionincentive.(cid:129)Aqualifiedemployeestockpurchaseplan,pursuanttowhichallemployeesareabletopurchasesharesofourcommonstock,withthepurposeofprovidingaconvenientmeansbywhichemployeesmaypurchasesharesofourcommonstockandamethodbywhichwecanassistandencourageemployeestobecomeshareholders.(cid:129)Retirementsavingsthrougha401(k)savingsplan,pursuanttowhichallU.S.employeescanchoosetodefercompensationforretirementandtowhichwemakeamatchingcontribution,withthepurposeofencour-agingemployeestosavefortheirretirement,withaccountbalancesaffectedbycontributionsandinvestmentdecisionsmadebytheparticipant.(cid:129)Healthandwelfarebenefits,afixedcomponentwiththesamebenefits(medical,dental,vision,disabilityinsuranceandlifeinsurance)availableforallfull-timeU.S.employees,withthepurposeofprovidingbenefitstomeetthehealthandwelfareneedsofouremployeesandtheirfamiliesandtoprovideatotalcompetitivecompensationpackage.(cid:129)Retention,severanceandchangeofcontrolagreementsandplanspursuanttowhichweprovideadditionalpaymentsandbenefitstocertainofficers,withthepurposeoffacilitatingourabilitytoattractandretainProxy Statement14officersinacompetitivemarketplacefortalentand,withthechangeofcontrolprovisions,toencourageofficerstoremainfocusedonourbusinessintheeventofrumoredoractualfundamentalcorporatechanges.TheforegoinggenerallydescribesourcompensationprogramforallemployeesintheUnitedStates.Subjecttolocallawsandpractices,weattempttoprovidethesameorsubstantiallyequivalentprogramsandbenefitstoouremployeeslocatedinothercountries.Weprovidenodeferredcompensationorspecialretirementorpensionplansandnoperquisitesforourofficers,includingourNamedExecutiveOfficers.DeterminationofCompensationLevelsOverallCompositionWebelievethat,asemployeesassumegreaterlevelsofresponsibility,anincreasingproportionoftheirpayshouldbelinkedtoperformanceandshareholderreturn.Instructuringtotalcompensationin2006forourseniorofficers,weusedthefollowinggeneralguidelines,recognizingthatvaluationsofequityawardsdeterminedpursuanttotheBlack-Scholespricingmodelmayhavelittlerelationtotheactualrealizedvalue,ifany,oflonger-termequityawards,whicharenecessarilydependentonfutureevents.In2006,formostofficers,basepayapproximatedthree-fifthstotwo-thirdsoftheirtotaltargetedcompensation,withthebalancesplitingenerallyequalportionsbetweenone-yearcashincentivecompensationplanawardsattargetandlonger-termequityawards.AsfortheNamedExecutiveOfficers,andexcludingtheeffectofpaymentsundertheRetentionAgreementsdescribedbelow:forMr.ScottandMr.Silverman,basepayapproximatedhalfoftheirtotaltargetedcompensation,withthebalancesplitingenerallyequalportionsbetweenone-yearcashincentivecompensationawardsattargetandlonger-termequityawards;forMs.WilliamsandMr.Henry,basepayapproximatedjustovertwo-fifthsoftargetedtotalcompensation,withone-quarterbasedonone-yearcashincentivecompensationawardsattargetandone-thirdonlonger-termequityawards;andforMr.Ungaro,basepayapproximatedslightlylessthanone-quarteroftargetedtotalcompensation,withone-thirdbasedonone-yearcashincentivecompensationawardsattargetandovertwo-fifthsonlonger-termequityawards.BaseSalaryInmakingindividualbasesalarydecisionsforourseniorofficers,theCommitteeconsiderseachofficer’sduties,thequalityoftheofficer’sperformance,theofficer’spotential,marketcompensationpractices,thecontributiontheofficerhasmadetoouroverallperformance,ourfinancialstatusandsalarylevelsincomparablehightechnologycompanies.TheCommitteealsocomparesthesalaryofeachofficerwithotherofficers’salaries,eachofficer’semploymentrecordandhistory,thepossibilityoffuturepromotionsandtheextentandfrequencyofpriorsalaryadjustments.In2005,ourseniorexecutiveteamwassignificantlyrestructured,includingpromotingPeterJ.UngarofirsttoPresidentandlatertoChiefExecutiveOfficer,andaddingMargaretA.Williams,BrianC.Henry,StevenL.ScottandJanC.Silverman,constitutingallofourNamedExecutiveOfficers,tokeyexecutiveofficerpositions.Whileeachhirewasnegotiatedseparately,principalconsiderationwasgiventoprovidingcompetitivecompensationinordertoattractthemtocomeandtoremainwithuswhileattemptingtostaywithinourgeneralcompensationstructure.WehavenotincreasedthebasesalarylevelsforanyNamedExecutiveOfficerineither2007or2006fromtheirnegotiated2005levels,sothatanincreasinglyhigherpercentageoftheirtotalcompensationisatriskpursuanttoourincentivecompensationmeasures.AnnualCashIncentiveCompensationPlanOurcashincentiveplanisamaterialelementoftheannualcompensationprogramforourseniorofficers,includingtheNamedExecutiveOfficers.Wealsoincludeotherofficersandseniormanagersinthisplan,exceptforthosewithsalesfunctionswhoareonasalescommissionplan.Nopaymentsweremadeunderour2004or2005planssinceapre-conditiontoanypaymentinthoseyearswaspositivenetoperatingincome.For2006anawardwasbased75%uponourconsolidatedresultsfromoperations(beforetaxes,interestandforeigncurrencyeffects),adjustedasdescribedbelow,and25%onmeetingpersonalgoals.WeusedresultsfromoperationsbecauseweProxy Statement15believeitistheprimarydriverofnetincome,whichweexpecttoimpactourstockprice,anditismoredirectlyinfluencedbyrevenuegeneratedandcostsincurred,factorsmorereadilyattributabletomanagementaction.NoincentiveawardwaspayableunlessresultsfromoperationsreachedabaselevelsetbytheBoard,exclusiveofanyincentiveaward.For2006,inrecognitionofourstatusaftersignificantoperatinglossesin2004and2005,thebaselevelwassetatanimproved,thatis,asignificantlyreduced,levelofoperatingloss.Inaddition,noincentiveawardwaspayableunless2006bookings(definedasfirmcontractsfornewproductsalesexpectedtoberecognizedasrevenuepriortoDecember31,2007,whichwerecontractedforin2006),reachedapre-determinedminimumlevel;weusedthisfactortoemphasizetheneedforcontinuedrevenueoveralongerterm.Eachparticipantwasassignedapercentageofhisorherbasesalaryasatargetincentiveaward.Inlinewithincreasingthepercentageoftotalcompensationbeingat-riskandbasedonperformance,andcoupledwiththeabsenceofincreasesinbasesalary,thesepercentageswereincreasedover2005levels.FortheNamedExecutiveOfficers,the2006targetawardpercentageswere:Mr.Ungaro,ChiefExecutiveOfficer—150%;Mr.Henry,ExecutiveVicePresidentandChiefFinancialOfficer—60%;Ms.Williams,SeniorVicePresidentresponsibleforhardwareandsoftwareresearchanddevelopment—60%;Mr.Scott,ChiefTechnologyOfficerandSeniorVicePresident—50%;andMr.Silverman,SeniorVicePresidentresponsibleforcorporatestrategyandbusinessdevelopment—50%.Incentiveawardsin2006werepayableat25%oftargetawardoncetheadjustedresultsfromoperationsreachedapre-approvedminimumlevelandotherconditionsweremet,andincreasedupto150%ofthetargetawardifspecifiedlevelsofadjustedresultsfromoperationsestablishedbytheBoardwerereached.Incentiveawardscouldnotexceed100%oftargetunless2006bookingswereatleastatapre-determinedlevel(higherthanthethresholdlevel).Anyincentiveawardhigherthan150%oftargetwasattheBoard’sdiscretion.Forpurposesofcalculatingtheresultsfromoperations,anychargesduetoFAS123Rstockcompensation,restructuringefforts,401(k)matchingcontributions,incentiveawardsandretentionincentiveswereexcluded.Totheextenttherewereotherunplannedsignificanttransactionsorcharges,thentheCompensationCommitteehadtheauthoritytodeterminewhatadjustments,ifany,wouldbeappropriateindeterminingtheresultsfromoperationsforpurposesofdeterminingtheamountoftheincentiveawards.TheChiefExecutiveOfficer,subjecttofinalapprovalbytheCompensationCommittee,retainedtherighttoadjusttheformulaincentiveaward(from0%to125%)foreachofficer.TheBoard,inexecutivesession,approvedthefinalincentiveawardfortheChiefExecutiveOfficerandapprovedtheawardsfortheotherNamedExecutiveOfficers.In2006,wemettherequiredstandardsfor100%ofcashincentivetargetawardsforourseniorofficers.CashawardswerepaidinFebruary2007.TheawardsfortheNamedExecutiveOfficersfor2006aresetforthonthe“SummaryCompensationTable”belowandthe2006targetawardsaresetforthonthe“GrantsofPlan-BasedAwards”tablebelow.The2007cashincentiveplanisamodificationofthe2006planandthoseofearlieryears.Inrecognitionofourfinancialprogressandtotieseniorofficercompensationtoreturntoourshareholders,noawardwillbemadeunderthe2007planunless,followingtheawardsandallotherexpensesrecordedundergenerallyacceptedaccountingprinciples,wehavenetincomeonourauditedfinancialstatementsfor2007;thisconditionalsoappliestoallincentivecompensationforallemployeesfor2007.Whilethe2006planfocusedonresultsfromoperations,overallbookingsandpersonalgoals,the2007planfollowsabalancedscorecardapproach,withdifferentperformancegoalsweighteddifferentlyforeachseniorofficer,includingeachNamedExecutiveOfficer,dependingontheirareasofresponsibilityandfactorsonwhichtheyhavethemostinfluence.Formostseniorofficers,theprincipalfinancialtargetsincludeproductbookings(definedasfirmcontractsfornewproductsalesexpectedtoberecognizedasrevenuepriortoDecember31,2008,whicharecontractedforin2007),grossmargindollarsandpre-awardoperatingincome:bookingsemphasizetheneedforrevenueoveratermlongerthanayear;ourgrossmarginsinrecentyears,althoughimproving,havenotbeenasdesiredandwehavetargetedimprovementofthosegrossmarginsasadrivertoprofitability;andoperatingincomefocusesourneedtocontrolexpensesaswellasincreasinggrossmargincontributions.Seniorofficers,includingNamedExecutiveOfficers,responsiblefortechnicalareashavesimilarfinancialgoalsandspecificproductdevelopmentandmarketinggoalsfortheyear,weightedasappropriatefortheirrespectiveareasofresponsibility.ThetargetawardpercentagesofbasesalaryforeachNamedExecutiveOfficerremainthesamefor2007astheywerefor2006.Thebaseforincentiveawardshasincreased,however,from25%to50%oftargetasathreshold,Proxy Statement16tomakeitmoredifficultforseniorofficerstoreceiveanincentiveaward,andrangesto75%oftargetformeetingaBoardapprovedplan,to100%formeetingtargetsestablishedaboveplanandtoamaximumof150%formeetingspecifiedstretchgoals.Anypayoutover100%oftargetrequiresaspecifiedlevelofbookings.Inaddition,Mr.Ungaro,Mr.HenryandMs.Williamsareeligibletoreceiveadditionalcashpaymentsof$250,000,$75,000and$75,000,respectively,if2007pre-awardresultsfromoperationsexceedapre-determinedabove-planlevel.Indeterminingresultsfromoperations(pre-tax,pre-interestandpre-foreigncurrencyeffects)forpurposesofmeasuringanyspecificgoalsandtheadditionalcashpayments,chargesduetoFAS123Rstockcompensation,newrestructuringplans,incentiveplanawards,retentionincentivesandannualbonusesareexcluded;the401(k)matchisbudgetedfor2007andisnotanadjustmentfactorasitwasin2006.Totheextentthereareotherunplannedsignificanttransactionsorcharges,thentheCompensationCommitteewoulddeterminewhatadjustments,ifany,areappropriateindeterminingtheresultsfromoperationsforpurposesofdeterminingthepaymentsunderthe2007plan.Again,theChiefExecutiveOfficer,subjecttofinalapprovalbytheCompensationCommittee,retainstherighttoadjusttheformulaincentiveaward(from0%to125%)foreachofficer.TheBoard,inexecutivesession,approvesthefinalincentiveawardfortheChiefExecutiveOfficer.WebelievethatourBoardhassetperformancetargetsbasedonplansthatareachievablebutrequiresignificantefforttobemetsothatperformanceawardsbasedonBoardplanareatsubstantialrisk,andthatincentiveawardsaboveBoardplanareverydifficulttorealize.Previously,wepaidnocashincentiveawardsfor2001,2004or2005,paidabove-targetawardsfor2002and2003,andpaidat-targetawardsfor2006.Long-TermEquityAwardsIndeterminingtheamountofequitycompensationtobeawardedtoofficersinafiscalyearunderourshareholderapprovedplans,theCompensationCommitteeconsidersthecurrentstockownershipoftheofficer,theretentivenatureoflonger-termawards,theimpactoftheofficer’scontribution,eachofficer’semploymentrecordandhistory,thepossibilityoffuturepromotions,theextentandfrequencyofprioroptiongrantsandrestrictedstockawards,theofficer’sunvestedstockoptionandrestrictedstockpositionandtherangeofoutstandingoptionswithexercisepricesbelowornearthecurrentmarketpriceforourcommonstock.Before2005,aswithoptionsgrantedtoallemployees,optionsweregrantedtoofficersatfairmarketvalueupongrantandwithfour-yearvestingperiods.In2005,stockoptionsweregrantedtoofficersuponconsiderationofthesefactors,althoughcertainoptionsweregrantedwithexercisepriceshigherthanthegrantdatefairmarketvalue.InparttoreducetheimpactofFAS123Ronourfinancialstatementsinfutureyears,alloptionsgrantedin2005toemployees,includingofficers,vestedinfullonorbeforeDecember31,2005,andthevestingofexistingoptionsheldbyemployees,includingofficers,wasacceleratedin2005.OnDecember19,2006ourBoard,actingupontherecommendationsoftheCompensationCommittee,grantedequityawardstoallofficers,includingtheNamedExecutiveOfficers,atthesametimeaswegrantedequityawardstoemployeesgenerally.Indeterminingthetimingofthesegrants,theCompensationCommitteebalancedacommitmenttoouremployeestograntequityawardsduring2006,thecompletionofourunderwrittenpublicofferingonDecember13,2006,andtheconsequentdisclosureofmaterialinformationthroughthatpublicofferingtothegeneralmarket,andadesiretohaveemployeegrantsbeatthesamepriceandsamegeneraltermsasofficergrants.TheCompensationCommitteeisconsideringthetimingoffuturegrantsandwhethertocontinuetomakeallgrantsatthesametimeortoseparatethetimingofgrantstoofficersfromthosetoemployeesgenerally.Inordertoprovidebothincentiveandretentiongoals,allDecember2006grantstoofficers,includingeachoftheNamedExecutiveOfficers,consistedofanequalnumberofstockoptionsandsharesofrestrictedstock.Thisdeterminationwasmadeafterconsiderationofsuchfactorsasthecontemporaneousgrantofstockoptionstoasignificantnumberofouremployees,themarketpriceincentiveofstockoptions,theretentionincentiveofrestrictedstockandthetotalnumberofequityawardsavailableforgrant.Detailsofeachtypeofgrantaredescribedbelow.StockOptions.Webelievethatstockoptionsgenerallyalignshareholderandoptioneeinterests.Asafinancialgainfromstockoptionsisonlypossibleifthemarketpriceforourcommonstockincreasesafterdateofgrant,webelieveoptiongrantsencourageofficersandotheremployeestofocusonperformanceandinitiativesthatshouldleadtoanincreaseinthemarketpriceofourcommonstock,whichbenefitsallofourshareholders.InorderProxy Statement17toprovidelonger-termincentives,thestockoptionsgrantedinDecember2006generallytoallemployees,includingtheNamedExecutiveOfficers,hadten-yeartermsandfour-yearvestingschedules,with25%vestingafteroneyearandtheremainingbalancevestingmonthlyoverthenext36months.Alloptionsgrantedin2006hadexercisepricesequalto100%ofgrantdatefairmarketvalue.Underouroptionplans,wemaynotgrantstockoptionsatadiscounttothefairmarketvalueofourcommonstockor,exceptundercertainolderplans,reducetheexercisepriceofoutstandingoptionsexceptinthecaseofastocksplitorotherrecapitalizationevents.Wedonotgrantstockoptionswithaso-called“reload”featureandwedonotloanfundstoemployeestoenablethemtoexercisestockoptions.ThenumberofsharesofcommonstockunderlyingtheDecember2006optiongrantstotheNamedExecutiveOfficersisreflectedonthe“GrantsofPlan-BasedAwards”tablebelow.RestrictedStock.Awardsofrestrictedstockaredesignedtoincreaseeachrecipient’sownershipofourcommonstock,therebyaligningtheirinterestswithshareholderinterestsand,withalonger-termvestingschedule,toprovideasignificantlong-termretentionincentive.Ourfirstawardsofrestrictedstock,inDecember2005,had18-monthvestingschedules,sothattheyvestattheendofJune2007.TheDecember2006restrictedstockawards,includingthosetotheNamedExecutiveOfficers,havelongervestingschedules,with50%ofthegrantedsharesvestingaftertwoyearsandtheremaining50%vestingafterfouryears(theactualvestingdatesareNovember15,2008,and2010,whicharedesignedtobeduringopentradingwindowperiodsfollowingfilingofourquarterlyreportsonForm10-QwiththeSEC).ThenumberofsharesofcommonstockissuedasrestrictedstockawardstoNamedExecutiveOfficersisreflectedonthe“GrantsofPlan-BasedAwards”tablebelow.RetentionAgreementsOnDecember20,2005,ourBoardofDirectorsapprovedretentionagreementswitheachofthreeNamedExecutiveOfficers:Mr.Ungaro,PresidentandChiefExecutiveOfficer;Mr.Henry,ExecutiveVicePresidentandChiefFinancialOfficer;andMs.Williams,SeniorVicePresidentresponsibleforhardwareandsoftwareresearchanddevelopment.TheseagreementsreflectedtheBoard’sawarenessthateachoftheseindividualsarewellknownandhighlysought,thattheyeachhavecontributedsignificantlytousintheirpositionswithussince2005andthatthelossofanyoftheseindividualsduringtheperiodcoveredbytheretentionagreementsparticularlywouldmateriallyadverselyaffectus.TheagreementsprovidethatiftheofficerremainsemployedbyusonDecember31,2006,andDecember31,2007,heorshewillreceiveacashretentionbonus.Theamountofthecashbonusisequalto,for2006,100%ofthesumoftheofficer’sbasepayin2006plustargetbonusassuming100%oftargetisreachedand,for2007,50%ofthesumoftheofficer’sbasepayin2007plustargetbonusassuming100%oftargetisreached.Theretentionbonusfor2006waspaidinJanuary2007toeachoftheseexecutiveofficersandisreflectedinthe“SummaryCompensationTable”belowunderthe“Bonus”caption.BenefitsWebelieveourbenefitplansprovideanimportantelementtooverallemployeecompensation.Theseplansaredesignedtoenableustoattractandretainourworkforceinacompetitivemarketplaceand,withcertainplans,toencourageownershipofourcommonstock.Allourseniorofficers,includingalltheNamedExecutiveOfficers,areeligibletoparticipateinaqualifiedemployeestockpurchaseplan,a401(k)definedcontributionplanandourhealthandwelfareplansonthesamebasisasallU.S.employees.EmployeeStockPurchasePlan.Weprovideallemployees,includingofficers,withaconvenientmeanstopurchasesharesofourcommonstockunderanEmployeeStockPurchasePlanqualifiedunderSection423oftheU.S.InternalRevenueCode,andamethodbywhichwecanassistandencourageemployeestobecomeshareholders.Participantsmaycontributefrom$50permonthupto15%oftheirgrosspayandpurchasesharesinthree-monthofferingperiods.Sincemid-December2005,thepurchasepriceformulahasbeen95%ofthemarketvalueofourcommonstockattheendofeachofferingperiod.Qualified401(k)DefinedContributionRetirementPlan.OuronlyretirementplanforallU.S.employees,includingtheNamedExecutiveOfficers,isaqualified401(k)planunderwhichemployeesmaycontributeaportionoftheirsalaryonapre-taxbasis.Participantsmayinvestinalimitednumberofmutualfunds,butmaynotdirectthepurchaseofsharesofourcommonstock.Through2004,wematchedparticipantcontributionsata25%rate,withhalfofthematchpaidincashonaquarterlybasisduringtheyearandthebalancepayableaftertheendoftheyearinProxy Statement18cashand/orourcommonstock,althoughusuallypaidinsharesofourcommonstock.Therearenorestrictions,otherthanthoseimposedbythesecuritieslawsregardinginsidertrading,onparticipantstransferringthevalueofourcommonstockintheiraccountstootherpermittedinvestments.In2005,inrecognitionofourfinanciallosses,weceasedmatchingcontributionsforthesecondhalfoftheyearsothatthematchfor2005wasatarateof12.5%ofparticipantcontributionsandwasmadeusingbothcashandsharesofourcommonstock.In2006,wereinstatedourmatchingprogram,withamatchat6.25%of2006participantcontributions,whichhasbeenpaidinsharesofourcommonstock.For2007,ourmatchhasreturnedto25%ofparticipantcontributions,withhalfofthematchpaidinsharesofcommonstockonaquarterlybasisduringtheyearandthebalancepaidafteryear-endincashand/orsharesofcommonstock,asourBoarddecides.HealthandWelfarePlans.Wehavehealthandwelfareplansavailableonanon-discriminatorybasistoallemployeesintheUnitedStates,includingourNamedExecutiveOfficers,designedtomeetthehealthandwelfareneedsofouremployeesandtheirfamiliesandtoprovideatotalcompetitivecompensationpackage.Theseplansincludegroupmedical,dentalandvisionplans,lifeinsurance,long-termcare,shortandlong-termdisability,supplementalincomeprotection,aretireemedicalplan,flexiblespendingaccountsforhealthcareanddependentcare,anemployeeassistanceplanandtravelassistance.PensionPlansWedonothaveanypensionplanforanyofourU.S.employees,includingourNamedExecutiveOfficers.OuronlyretirementplanforourU.S.employeesisour401(k)plan.Non-QualifiedDeferredCompensationWedonothaveanyplanforanyofouremployees,includingourNamedExecutiveOfficers,thatprovidesforthedeferralofcompensationonanon-qualifiedbasisundertheInternalRevenueCode.StockOwnershipGuidelinesWehavenotimplementedformalstockownershipguidelinesforourofficers.WeexpectthatourexecutiveofficerswilldiscusspotentialsalesofourcommonstockwithourChiefExecutiveOfficer.Wecontinuetoreviewthepracticesregardingsuchguidelinesandmayre-evaluateourpositionwithrespecttostockownershipguidelinesforofficers.SecuritiesTradingPoliciesOursecuritiestradingpoliciesstatethatdirectors,officersandemployeesmaynotpurchaseorsellputsorcallstosellorbuyourcommonstock,engageinshortsaleswithrespecttoourcommonstock,orbuyourcommonstockonmarginorpledgesharesofourcommonstockand,exceptpursuanttoapprovedRule10b5-1plans,ourpoliciesrestricttradinginourcommonstockbydirectors,officersandcertainspecifiedemployeestoopenwindowperiodsfollowingthereleaseofourquarterlyfinancialresults.TaxDeductibilitySection162(m)oftheInternalRevenueCodelimitsto$1millionperpersontheamountthatwemaydeductforcompensationpaidtoourChiefExecutiveOfficerandthenextfourmosthighlycompensatedofficersinanyyear.Thislimitationdoesnotapply,however,to“performance-based”compensation,asdefinedintheInternalRevenueCode.Stockoptionsandannualincentiveawardsgenerallyqualifyas“performance-based”compensationandmaybefullydeductible.Thedeductibilityofsometypesofcompensationpaymentsdependsuponthetimingoftheawardsandthevestingorexerciseofpreviouslygrantedrights.Interpretationsofandchangesinapplicabletaxlawsandregulations,aswellasotherfactorsbeyondourcontrol,alsocanaffectdeductibilityofcompensation.Althoughdeductibilityofcompensationispreferred,taxdeductibilityisnotaprimaryobjectiveofourcompensationprograms,particularlygivenourconsiderablenetlosscarry-forwardpositionforU.S.taxpurposes.Rather,wemaintaintheflexibilitytostructureourcompensationprogramsinwaysthatpromotethebestinterestsofourshareholders.Proxy Statement19PotentialPaymentsUponTerminationofEmploymentorChangeofControlWedonothaveemploymentagreementswithanyofourNamedExecutiveOfficers.WehaveanExecutiveSeverancePolicyforourofficersregardingpaymentuponterminationoftheiremploymentandmanagementcontinuationagreementswithcertainofficersapplicabletoaterminationfollowingachangeofcontrol.AllourNamedExecutiveOfficersareeligibletoreceivepaymentsandbenefitsunderthispolicyandtheseagreements.Inaddition,ourstockoptionplans,therestrictedstockagreementswithourofficers,includingtheNamedExecutiveOfficers,andtheretentionagreementswithMr.Ungaro,Mr.HenryandMs.Williams,containprovisionsregardingemploymentterminationsandchangesofcontrol.Webelievetheseprovisionsfacilitateourabilitytoattractandretainofficersinacompetitivemarketplacefortalentand,withthechangeofcontrolprovisions,encourageofficerstoremainfocusedonourbusinessintheeventofrumoredoractualfundamentalcorporatechanges.Furtherinformationregardingtheseprovisionsfollows.ExecutiveSeverancePolicyInOctober2002ourBoardofDirectorsadoptedanExecutiveSeverancePolicythatcoversourofficers,includingtheNamedExecutiveOfficers.ThispolicyappliestoterminationsofemploymentwithoutCauseorresignationsforGoodReason,assuchtermsaredefinedinthepolicy;thispolicydoesnotapplyiftheManagementContinuationAgreementsdescribedbelowareapplicableanddoesnotapplytoemploymentterminationsduetodeath,Disability,retirement,CauseorresignationsotherthanforGoodReason.Weconsideritlikelythatitwilltakemoretimeforofficerstofindnewemployment,andthusofficersgenerallyarepaidseveranceandreceivehealthandwelfarebenefitsforalongerperiod.OurChiefExecutiveOfficerreceivesthesumof200%ofthetotalofhisbasesalaryfortwelvemonthsandannualincentiveawardbasedonthetargetestablishedbytheBoardforeachyearifhisemploymentwereterminatedbeforetheendofMarch2008,and100%ofsuchcompensationthereafter.Seniorvicepresidentsgenerallyreceivesalarycontinuation,exclusiveofanyincentiveawardsorotherbonuses,inanamountequaltotheirbasesalaryforaperiodofninemonthsplusonemonthforeachyearofserviceasanofficeruptoamaximumoftwelvemonths;andothervicepresidentsreceivesalarycontinuation,exclusiveofanyincentiveawardsorotherbonuses,inanamountequaltotheirbasesalaryforaperiodofsixmonthsplusonemonthforeachyearofserviceasanofficeruptoamaximumofninemonths.OurofferlettertoMr.HenryprovidedthatifhewereterminatedotherthanforCause,hewouldreceiveapaymentequaltohisannualbasesalaryandhisannualincentiveawardattarget,andourofferlettertoMs.WilliamsprovidedthatifshewereterminatedotherthanforCauseduringthefirsttwoyearsofemployment,shewouldreceiveaseverancepaymentequaltotwotimesherannualbasesalary.Amountsarepaidinaccordancewithourstandardsalarypaymentproceduresgenerallyforsuchperiods,althoughtheBoardcanmodifytheperiodoverwhichsuchamountsarepaid.Thepolicyalsoprovidesforcontinuedpaymentofourportionofmedical,dental,visionandlifeinsurancebenefits,extensionoftheperiodtoexercisestockoptionsandexecutiveoutplacementservicesfortheperiodtheformeremployeereceivessalarycontinuationpayments(theprovisionofbenefitsterminatesearlieriftheformerofficerisofferedsuchbenefitsbyasubsequentemployer).Toreceivethesebenefitstheofficermustprovideuswithageneralreleaseandcontinuetocomplywithhisorherconfidentialityandotheragreementswithus.OurobligationsunderthispolicyareunfundedandourBoardhastheexpressrighttomodifyorterminatethispolicyatanytime.ManagementContinuationAgreementsWehaveenteredintomanagementcontinuationagreementswithcertainofourofficers,includingtheNamedExecutiveOfficers.Paymentsaremadeundertheseagreementsonlyiftwoeventsoccur(oftenreferredtoasa“double-trigger”form):first,thereisaChangeofControl,asdefined,and,secondly,withinthreeyearsaftertheChangeofControl,theofficer’semploymentisterminatedotherthanforCause,death,Disability,retirementorresignationotherthanforGoodReason,assuchtermsaredefinedintheagreement.Ifbothsucheventsoccur,thentheofficeristoreceiveanamountequaltotwotimestheofficer’sannualcompensation,payableinalump-sumwithin30daysoftermination,continuationofhealthanddisabilitybenefitsandgrouptermlifeinsurancefor24monthsfollowingterminationandtheaccelerationofvestingforallstockoptionsheldandtheoptioneehas12monthstoexercisetheoptionsafterterminationor,ifearlier,untiltheoptionsexpire.Ifsuchofficersreceivecompensationthatconstitutes“excessparachutepayments”forfederalincometaxpurposes,wehaveagreedtopaywithrespecttocompensationandbenefitsreceivedundertheseagreementsanyexcisetaxesduewithrespecttoProxy Statement20those“excessparachutepayments,”andanyfurtherexcisetaxesandfederalandstateincometaxesdueregardingtheseexcisetaxpaymentssothattheofficerwouldreceivethesameafter-taxcompensationandbenefitsundertheseagreementstheofficerwouldhavereceivedifnoexcisetaxeshadbeenimposed.WehavealsoagreedtopaythelegalfeesandothercostsincurredwithrespecttoanychallengebytheIRStothesecalculationsandpayments.Underthemanagementcontinuationagreements,“annualcompensation”meansoneyearofbasesalary,atthehighestbasesalaryratethatwaspaidtotheofficerinthe12-monthperiodpriortothedateofhisorherterminationofemployment,plustheincentiveplanawardsattargetthattheofficerwaseligibletoreceiveinthat12-monthperiod.StockOptionPlansOurstockoptionplansprovidethatuponterminationofemployment,otherthanforCause,deathorpermanentandtotaldisability(asdefinedintheInternalRevenueCode),theoptionsceasevestingandtheoptioneehasthreemonthstoexercisetheoptionor,ifearlier,untiltheoptionexpires.IfanofficerreceivesthebenefitoftheExecutiveSeverancePolicyandhisorheremploymentisterminatedwithoutCauseorduetoaresignationforGoodReason,assuchtermsaredefinedinthePolicy,thentheofficerwouldreceiveanextendedperiodinwhichtoexercisehisorheroptions,asdescribedaboveunder“ExecutiveSeverancePolicy.”IftheoptioneeisterminatedforCauseor“resignsinlieuofdismissal”(thatis,aresignationafterwehavenotifiedtheoptioneethatheorshewouldbeterminatedforCause),theoptionisdeemedtohaveterminatedatthetimeofthefirstactthatledtosuchtermination.Uponterminationfordeathordisability,theoptionsvestinfullandtheoptionee(orhisorhersuccessor)has12monthstoexercisetheoptionsor,ifearlier,untiltheoptionsexpire.Intheeventofamerger,consolidation,saleofallorsubstantiallyalloftheassetsorliquidation,unlesstheexistingoptionsarecontinuedorassumedbythesuccessorentity,ifany,withappropriateadjustments,thenthestockoptionsterminateupontheeffectivedateofsuchtransaction,andeachoptioneewouldbeprovidedtheopportunitytoexercisehisorheroptionsinfull,includinganyportionnotthenvested.OurBoardmayextendtheperiodinwhichtoexerciseanoption,butnotbeyondtheoriginalexpirationdateoftheoption.RestrictedStockAgreementsUnderourrestrictedstockagreementsenteredintoin2005and2006,therestrictedstockvestsinfulluponthedeathorDisabilityoftherecipientorif,followingaChangeofControl,inadditiontodeathorDisability,therecipientisterminatedwithoutCauseorresignsforGoodReason;therestrictedstockisforfeitedif,priortotherestrictedstockotherwisevesting,therecipientisterminatedforCause.Underthe2005agreements,whichhaveaJune30,2007,vestingdate,therestrictedstockvestsifpriortovestingtheemployeeisterminatedwithoutCauseorresignsforGoodReason,butisforfeitediftherecipientretiresorresignswithoutGoodReason.Underthe2006agreements,whichhavealongervestingperiod,withaNovember15,2008,vestingdatefor50%oftherestrictedstockandaNovember15,2010,vestingdatefortheremaining50%,therestrictedsharesareforfeitedifarecipientisterminatedwithoutCauseorresignsforanyreason,provided,however,iftherecipienthasheldtherestrictedstockfor18monthsandhisorheremploymentisterminatedforanyreasonotherthanCauseortherecipientretiresafterreachingage62,thentherecipientreceivesapro-rataportionoftheunvestedshares;theChiefExecutiveOfficermaylowertheholdingperiodtooneyearandtheretirementageto591⁄2inhisdiscretionandmayrequestanon-competitionagreementinexchange.Inaddition,intheeventofamerger,consolidation,saleofallorsubstantiallyalloftheassetsorliquidation,therestrictedstockvestsinfullifwefailtohavetherestrictedstockagreementscontinuedorassumedbythesuccessorentity.RetentionAgreementsIntheeventoneoftheofficerswhoisapartytoaretentionagreementisterminatedwithoutCauseorterminateswithGoodReason,assuchtermsaredefinedintheretentionagreement,thefollowingpaymentswouldbemade:Mr.HenryandMs.Williamswouldreceivepaymentundertheirretentionagreementand,ifapplicable,apaymentunderourExecutiveSeverancePolicydescribedabove,andMr.UngarowouldreceivethehigherofthepaymentunderhisretentionagreementortheExecutiveSeverancePolicy;ifthepaymentweremadeunderhisretentionagreementhewouldreceivethebenefitoftheotherprovisionsoftheExecutiveSeverancePolicy.Paymentsundertheretentionagreementsaremadeinalumpsumassoonasispracticableaftertheyear-end.AnProxy Statement21officerwouldnotreceiveapaymentundertheretentionagreementifheorshewereterminatedforCause,died,retired,terminatedemploymentforotherthanforGoodReasonorbecauseofDisability,assuchtermsaredefinedintheretentionagreement.IftherewereaChangeofControl,ourBoardthenwoulddetermine,priortotheChangeofControltransactionbecomingeffective,whetherpaymentsundertheretentionagreementswouldbemadeinadditiontotheManagementContinuationAgreementsdescribedabove.DefinitionsThefollowingtermshaveessentiallythesamemeaningsfortheforegoingseverancepolicy,stockoptionplansandagreements:“ChangeofControl”includesamergerorconsolidationbetweenusandanyothercorporation(otherthantochangeourstateofincorporationorwhichdoesnoteffectasubstantialchangeinownership),completeliquidationoranagreementforthesaleordispositionofallorsubstantiallyallofourassets;theacquisitionbyanypersonorentity,directlyorindirectly,ofoursecuritiesrepresenting50%ormoreofthetotalvotingpowerrepresentedbyourthenoutstandingvotingsecuritiesexceptpursuanttoanegotiatedagreementwithusandpursuanttowhichsuchsecuritiesarepurchasedfromus;or,exceptforourstockoptionplans,amajorityofourBoardinofficeatthebeginningofany36-monthperiodisreplacedduringthecourseofsuch36-monthperiod(otherthanbyvoluntaryresignationofindividualdirectorsintheordinarycourseofbusiness)andsuchreplacementwasnotinitiatedbytheBoardasconstitutedatthebeginningofsuch36-monthperiod.“Cause”meansaterminationofemploymentresultingfromagoodfaithdeterminationbyourBoardofDirectorsthattherehasbeenawillfulfailureorrefusalinamaterialrespecttofollowreasonablepoliciesordirectivesortoattendtomaterialdutiesorobligations(otherthananysuchfailureresultingfromincapacityduetophysicalormentalillness),whichhasnotbeencorrectedwithinareasonableperiodfollowingwrittennotice;anactinvolvingwrongfulmisconductwhichhasademonstrableadverseimpactonormaterialdamagetous,orwhichconstitutesamisappropriationofourassets;theunauthorizeddisclosureofconfidentialinformation;theprovisionofservicesforanothercompanyorpersonwhichcompeteswithus,withoutthepriorwrittenapprovalofourPresident;or,exceptforourstockoptionplans,amaterialbreachofobligationsunderagreementswithus.“Disability”meansthat,atthetimetheofficer’semploymentisterminated,theofficerhasbeenunabletoperformthedutiesofhisorherpositionforaperiodofsixconsecutivemonthsasaresultoftheofficer’sincapacityduetophysicalormentalillness.“GoodReason”meansareductioninsalaryorbenefits(otherthanreductionsapplicabletoemployeesgenerally);amaterialchangeordiminutioninjobresponsibilities;arequesttorelocate,exceptforofficerelocationsthatwouldnotincreasetheofficer’sone-waycommutebymorethan25miles;orthefailurebyustoobtaintheassumptionoftherelevantagreementbyoursuccessor.CompensationCommitteeReportTheCompensationCommitteehasreviewedanddiscussedwithmanagementtheaboveCompensationDiscussionandAnalysis.Basedonthatreviewanddiscussion,theCompensationCommitteehasrecommendedtotheBoardofDirectorsthattheCompensationDiscussionandAnalysisbeincludedinthisproxystatement.TheCompensationCommitteeFrankL.Lederman,ChairmanJohnB.Jones,Jr.StephenC.KielyStephenC.RichardsProxy Statement22CompensationTablesThetablesonthisandthefollowingpagesdescribe,withrespecttoourNamedExecutiveOfficers,thesalaries,bonuses,incentiveawardsandothercompensationearnedduring2006,cashandequityplanawardsgrantedin2006,valuesofoutstandingequityawardsasofyear-end2006,exercisesofstockoptionsin2006,andpotentialpaymentsuponterminationofemploymentandfollowingaChangeofControl.SummaryCompensationThefollowingtablesummarizesthecompensationofourChiefExecutiveOfficer,ourChiefFinancialOfficerandourthreehighestpaidotherexecutiveofficersforthefiscalyearendedDecember31,2006.SummaryCompensationTableNameandPrincipalPositionYearSalaryBonus(1)StockAwards(2)OptionAwards(3)Non-EquityIncentivePlanCompensation(4)AllOtherCompensation(5)Total(6)PeterJ.Ungaro..........2006$350,000$875,000$591,607$2,537$525,000$1,345$2,345,489ChiefExecutiveOfficer&PresidentBrianC.Henry..........2006$325,000$520,000$344,927$1,396$195,000$1,626$1,387,949ChiefFinancialOfficer&ExecutiveVicePresidentMargaretA.Williams.....2006$300,000$480,000$344,927$1,396$180,000$1,613$1,307,936SeniorVicePresidentStevenL.Scott..........2006$300,000$0$1,882$888$150,000$22,278$475,048SeniorVicePresident&ChiefTechnologyOfficerJanC.Silverman.........2006$250,000$0$106,873$317$112,500$3,185$472,875SeniorVicePresident(1)TheamountsshownreflectpaymentsundertheRetentionAgreementswitheachoftheapplicableNamedExecutiveOfficersandareshownasearnedin2006althoughpaidinJanuary2007.See“DeterminationofCompensationLevels—RetentionAgreements”intheCompensationDiscussionandAnalysisabove.(2)Theamountsshownreflectourexpenseforthe2006fiscalyearwithrespecttoalloutstandingrestrictedstockawardsheldbyeachNamedExecutiveOfficer,disregardinganyadjustmentsforestimatedforfeitures,andotherwiseasrecordedonour2006financialstatements;theamountsshowndonotreflectanamountpaidtoorearnedorrealizedbyanyNamedExecutiveOfficer.TheseamountsincludeawardsmadeinDecember2005,whichvestonJune30,2007,andawardsmadeonDecember19,2006,whichvestinNovember2008andNovember2010.See“DeterminationofCompensationLevels—Long-TermEquityAwards—RestrictedStock”intheCompensationDiscussionandAnalysisaboveandthe“OutstandingEquityAwardsatFiscalYear-End”tablebelowforamorecompletedescriptionoftheseawards,includingeventsthatcauseforfeitures.SeetheNotestoConsolidatedFinancialStatementsinourAnnualReportonForm10-KforthefiscalyearendedDecember31,2006,foradescriptionofthevaluationoftheserestrictedstockawardspursuanttoFAS123R.TheamountanyNamedExecutiveOfficerrealizesfromtheserestrictedstockawards,ifany,willdependonthefuturemarketvalueofourcommonstockwhenthesesharesaresoldandthereisnoassurancethattheNamedExecutiveOfficerswillrealizeamountsatornearthevaluesshown.(3)Theamountsshownreflectourexpenseforthe2006fiscalyearwithrespecttoalloutstandingstockoptionsheldbyeachNamedExecutiveOfficer,disregardinganyadjustmentsforestimatedforfeitures,andotherwiseasrecordedonour2006financialstatements.AllstockoptionsgrantedtotheNamedExecutiveOfficersbefore2006vestedinfullbefore2006,andwerecognizednoexpenseforsuchpre-2006stockoptiongrants.Thereforethiscolumnreflectsonlyourrecordedexpensein2006forthestockoptionsgrantedonDecember19,2006.See“DeterminationofCompensationLevels—Long-TermEquityAwards—StockOptions”intheCompensa-tionDiscussionandAnalysisaboveandthe“GrantsofPlan-BasedAwards”tablebelowforamorecompletedescriptionoftheseoptiongrants.SeetheNotestoConsolidatedFinancialStatementsinourAnnualReportonProxy Statement23Form10-KforthefiscalyearendedDecember31,2006,foradescriptionofthevaluationofthesestockoptions,includingkeyassumptions,undertheBlack-ScholespricingmodelpursuanttoFAS123R;thevaluesdeterminedbytheBlack-Scholespricingmodelarehighlydependentontheseassumptions,particularlyregardingvolatilityofthemarketpriceforourcommonstockandexpectedexercisedatesoftheseoptions.Therecanbenoassurancethattheoptionswilleverbeexercised,inwhichcasenovaluewillberealizedbytheNamedExecutiveOfficer.TheamountanyNamedExecutiveOfficerrealizes,ifany,fromtheseoptionsdependsonthefutureexcess,ifany,ofthemarketvalueofourcommonstockovertheexercisepriceoftheoptionswhentheNamedExecutiveOfficersellstheunderlyingshares,andthereisnoassurancethattheNamedExecutiveOfficerswillrealizeamountsatornearthevaluesshown.(4)TheamountsshownreflecttheamountspaidinFebruary2007underourAnnualCashIncentiveCompensationPlanfor2006.See“DeterminationofCompensationLevels—AnnualCashIncentiveCompensationPlan”intheCompensationDiscussionandAnalysisaboveforadescriptionofthe2006planandawards.(5)“AllOtherCompensation”for2006includespremiumsforgrouptermlifeinsurancepolicies(Mr.Ungaro—$425,Mr.Henry—$688,Ms.Williams—$675,Mr.Scott—$405,andMr.Silverman—$1,935)andourmatchingcontributionsunderour401(k)Plan(Mr.Ungaro—$920,Mr.Henry—$938,Ms.Williams—$938,Mr.Scott—$938,andMr.Silverman—$1,250).TheamountshownforMr.Scottalsoincludes$20,935forthecostofrentinganapartmentin2006inSeattle,Washington,forMr.Scottandhiswifewho,atourrequest,temporarilymovedfromtheirhomeinWisconsininordertobecomemorefamiliarwithourSeattle-basedengineersandtheirwork.(6)Theamountsshownreflectthesumoftheamountsshowninthecolumnsforsalary,bonus,stockawards,optionawards,non-equityincentiveplancompensationandallothercompensation,asrequiredbySECrulesandregulations.BecausethesesumscombinecashpaymentsearnedbyandmadetotheNamedExecutiveOfficersandamountsnotearnedbyorpaidtotheNamedExecutiveOfficerbutratheramountsrecordedbyusonour2006financialstatementsasanexpenseforrestrictedstockawardsandoptiongrantstotheNamedExecutiveOfficers,theactualtotalamountearnedin2006byaNamedExecutiveOfficerdependsonfutureeventsand,forthereasonsdescribedinfootnotes(2)and(3)above,thereisnoassurancethattheNamedExecutiveOfficerswillrealizeatotalsumatornearthevaluesshowninthiscolumn.GrantsofPlan-BasedAwardsin2006ThefollowingtablesetsforthcertaininformationwithrespecttograntsofcashincentiveawardsandequityawardsduringtheyearendedDecember31,2006,totheNamedExecutiveOfficers.GrantsofPlan-BasedAwardsNameAwardGrantDateThresholdTargetMaximumAllOtherStockAwards(2)(shares)AllOtherOptionAwards(2)(underlyingshares)ExercisePriceofOptionAwards(3)($pershare)StockOptionsEstimatedPossiblePayoutsunderNon-EquityIncentivePlanAwards(1)GrantDateFairValue(4)PeterJ.Ungaro......04/29/06$131,250$525,000$787,50012/19/0663,15063,150$10.56$666,864$383,952BrianC.Henry......04/29/06$48,750$195,000$292,50012/19/0634,75034,750$10.56$366,960$211,280MargaretA.Williams..04/29/06$45,000$180,000$270,00012/19/0634,75034,750$10.56$366,960$211,280StevenL.Scott......04/29/06$37,500$150,000$225,00012/19/0622,10022,100$10.56$233,376$134,368JanC.Silverman.....04/29/06$31,250$125,000$187,50012/19/067,9007,900$10.56$83,424$48,032(1)Representsthreshold,targetandmaximumpayoutlevelsunderourAnnualCashIncentiveCompensationPlanfor2006.TheactualamountofincentivepaymentearnedbyeachNamedExecutiveOfficerin2006,whichwaspaidinFebruary2007,isreportedunderthe“Non-EquityIncentivePlanCompensation”columninthe“SummaryCompensationTable”above.AdditionalinformationregardingthedesignandtermsoftheAnnualProxy Statement24CashIncentiveCompensationPlanisincludedunder“DeterminationofCompensationLevels—AnnualCashIncentiveCompensationPlan”intheCompensationDiscussionandAnalysisabove.(2)ReflectsthenumberofrestrictedstockawardsandsharesofcommonstockunderlyingstockoptionsgrantedtoeachNamedExecutiveOfficeronDecember19,2006,pursuanttoourshareholderapprovedequityincentiveplans.HalfoftheserestrictedstockawardsgrantedtoeachNamedExecutiveOfficervestonNovember15,2008,andtheremaininghalfvestonNovember15,2010,andareforfeitableuponcertainevents.RestrictedstockawardsalsovestinfulluponthedeathorDisabilityoftherecipient,anduponcertainotherevents.Twenty-fivepercentofthestockoptionsgrantedtotheNamedExecutiveOfficersin2006vestonDecember19,2007,withtheremainingbalancevestingmonthlyoverthenext36months,sothatalloptionswillbevestedonDecember19,2010.VestingofstockoptionsisaccelerateduponthedeathorDisabilityoftheoptionee,andmaybeaccelerateduponcertainotherevents.Additionalinformationregardingthedesignandtermsoftheselong-termequityawardsisincludedunder“DeterminationofCompensationLevels—Long-TermEquityAwards”and“PotentialPaymentsUponTerminationofEmploymentorChangeofControl—StockOptionPlans”and“—RestrictedStockAgreements”intheCompensationDiscussionandAnalysisabove.(3)Reflects100%ofthefairmarketvalueofourcommonstockonDecember19,2006,thegrantdate.Indeterminingthegrantdatefairmarketvalue,weusethemostrecentclosingpriceforourcommonstockpriortotheapplicableCommitteeorBoardmeeting.Ifmeetingsareheldinthemorning,thenweusetheclosingpriceontheimmediatelyprecedingtradingdate.Ifthemeetingsareheldafter1:00p.m.,PacificTime,onatradingday,weusetheclosingpriceonthedateofthemeeting,whichwasthecasefortheDecember19,2006,Boardmeeting.(4)ThegrantdatefairvalueoftherestrictedstockawardsandstockoptiongrantswascomputedinaccordancewithFAS123Randrepresentsourtotalprojectedexpenseforfinancialreportingpurposesofthoseawardsandgrants.SeetheNotestoConsolidatedFinancialStatementsinourAnnualReportonForm10-KforthefiscalyearendedDecember31,2006,foradescriptionofthevaluationoftheserestrictedstockawardsandstockoptiongrants,includingkeyassumptionsundertheBlack-Scholespricingmodelfordeterminingvaluesofstockoptions;thevaluesdeterminedbytheBlack-Scholesmodelarehighlydependentontheseassumptions,particularlyregardingvolatilityofthemarketpriceforourcommonstockandexpectedexercisedatesofthestockoptions.Therecanbenoassurancethatthestockoptionswilleverbeexercised,inwhichcasenovaluewillberealizedbytheNamedExecutiveOfficer.TheamountanyNamedExecutiveOfficerrealizes,ifany,fromtheserestrictedstockawardsandstockoptiongrantsdependsonthemarketvalueofourcommonstockinthefuturewhentheNamedExecutiveOfficersellstherestrictedsharesorthesharesunderlyingthestockoptions,asthecasemaybe,andthereisnoassurancethattheNamedExecutiveOfficerswillrealizeamountsatornearthevaluesshown.Proxy Statement25OutstandingEquityAwardsonDecember31,2006ThefollowingtablesetsforthcertaininformationwithrespecttooutstandingequityawardsatDecember31,2006,heldbyourNamedExecutiveOfficers.OutstandingEquityAwardsatFiscalYear-EndNameExercisable(1)Unexercisable(2)OptionExercisePrice($pershare)(3)OptionExpirationDateNumberofSharesThatHaveNotVestedMarketValueofSharesThatHaveNotVested(6)NumberofSharesUnderlyingUnexercisedOptionsOptionAwardsStockAwardsPeterJ.Ungaro........124,999$36.0007/29/2013150,000(4)$1,782,00025,000$27.5602/05/201463,150(5)$750,22275,000$14.7609/20/201443,750$8.0005/11/201543,750$10.0005/11/201543,750$12.0005/11/201543,750$14.0005/11/201563,150$10.5612/19/2016BrianC.Henry........124,999$5.9205/23/201587,500(4)$1,039,50034,750$10.5612/19/201634,750(5)$412,830MargaretA.Williams...12,500$8.3204/27/201587,500(4)$1,039,50012,500$10.0004/27/201534,750(5)$412,83012,500$11.6404/27/201512,500$13.3204/27/20156,250$8.0005/11/20156,250$10.0005/11/20156,250$12.0005/11/20156,250$14.0005/11/201534,750$10.5612/19/2016StevenL.Scott........547$20.0007/01/201022,100(5)$262,548948$10.1202/07/20117,292$10.3604/29/20123,907$16.4007/12/201212,499$27.5602/05/20146,250$14.7609/20/20146,250$8.0005/11/20156,250$10.0005/11/20156,250$12.0005/11/20156,250$14.0005/11/201573,500$3.8009/26/201522,100$10.5612/19/2016JanC.Silverman.......12,500$4.6411/01/201537,500(4)$445,5007,900$10.5612/19/20167,900(5)$93,852(1)Allstockoptionslistedinthiscolumnarefullyvested.(2)Withrespecttothestockoptionslistedinthiscolumn,25%oftheoptionsvestonDecember19,2007,withtheremainingbalancevestingmonthlyoverthenext36months,sothatalloptionswillvestinfullonDecember19,2010.VestingofstockoptionsisaccelerateduponthedeathorDisabilityoftheoptionee,andmaybeaccelerateduponcertainotherevents.Additionalinformationregardingthedesignandtermsofthesestockoptiongrantsisincludedunderthecaptions“DeterminationofCompensationLevels—Long-TermEquityAwards—StockOptions”and“PotentialPaymentsUponTerminationofEmploymentorChangeofCon-trol—StockOptionsPlans”intheCompensationDiscussionandAnalysisabove.(3)Theoptionexercisepricesweresetat100%ofthefairmarketvalueofourcommonstockontherespectivedatesofgrant,exceptfortheoptionsexpiringonApril27,2015,andMay11,2015,thatweregrantedwithperProxy Statement26shareexercisepriceshigherthanthegrantdatefairmarketvaluesof$8.32pershareand$5.88pershare,respectively.(4)TheserestrictedstockawardsvestinfullonJune30,2007,andareforfeitableuponcertainevents.RestrictedstockawardsvestinfulluponthedeathorDisabilityoftherecipient,anduponcertainotherevents.Additionalinformationregardingthedesignandtermsoftheselong-termequityawardsisincludedunder“DeterminationofCompensationLevels—Long-TermEquityAwards—RestrictedStock”and“PotentialPaymentsUponTerminationofEmploymentorChangeofControl—RestrictedStockAgreements”intheCompensationDiscussionandAnalysisabove.(5)HalfoftheserestrictedstockawardsvestonNovember15,2008,andtheremaininghalfvestonNovember15,2010,andareforfeitableuponcertainevents.RestrictedstockawardsalsovestinfulluponthedeathorDisabilityoftherecipient,anduponcertainotherevents.Additionalinformationregardingthedesignandtermsoftheselong-termequityawardsisincludedunder“DeterminationofCompensationLevels—Long-TermEquityAwards—RestrictedStock”and“PotentialPaymentsUponTerminationofEmploymentorChangeofControl—RestrictedStockAgreements”intheCompensationDiscussionandAnalysisaboveandinthe“GrantsofPlan-BasedAwards”tableabove.(6)Basedonthereportedclosingpriceof$11.88pershareforourcommonstockonDecember29,2006,thelasttradingdayof2006,ontheNasdaqGlobalMarket.2006OptionExercisesandStockVestedThefollowingtablesetsforthcertaininformationwithrespecttostockoptionexercisesduringtheyearendedDecember31,2006bycertainNamedExecutiveOfficers.Norestrictedstockawardsvestedin2006.OptionExercisesandStockVestedNameNumberofSharesAcquiredonExerciseValueRealizedonExercise(1)NumberofSharesAcquiredonVestingValueRealizedonVestingOptionAwardsStockAwardsPeterJ.Ungaro.......................NoneNoneNoneNoneBrianC.Henry.......................NoneNoneNoneNoneMargaretA.Williams..................NoneNoneNoneNoneStevenL.Scott.......................1,500$11,449NoneNoneJanC.Silverman......................12,500$112,127NoneNone(1)AseachoftheNamedExecutiveOfficerswhoexercisedstockoptionsin2006alsosoldinmarketsalesallofthesharesofcommonstockacquiredontheexerciseofthestockoptionsonthesamedayasexercise,thiscolumnreflectstheaggregatesalespriceoftheunderlyingsharesofcommonstockactuallyreceivedlesstheexercisepriceoftheoptions.TerminationofEmploymentOtherThanFollowingaChangeofControlThefollowingtablereflectstheamountofcompensationthatwouldhavebeenpayabletoeachoftheNamedExecutiveOfficersintheeventofterminationofsuchexecutive’semploymentasofDecember29,2006,thelastbusinessdayoftheyear,otherthanfollowingaChangeofControl.Exceptasindicatedinthefootnotesbelow,thistableassumesthattheNamedExecutiveOfficerwasterminatedwithoutCauseorterminatedforGoodReason.NospecialpaymentsaredueiftheNamedExecutiveOfficerterminatesvoluntarilywithoutGoodReasonorretires,exceptasindicatedinthefootnotesbelow,oristerminatedforCause(asisthecaseforallterminations,aterminatedemployeereceivesaccruedandunpaidsalary,anyaccruedandunpaidvacationandisabletoreceivethebalanceinhisorher401(k)planaccount).Generally,stockoptionsceasevestinguponterminationofemploymentandanoptioneehasthreemonthsafterterminationtoexercisetheoptions.Iftheemployee’semploymentisterminatedduetodeathorpermanentandtotaldisability,thenhisorherstockoptionsandrestrictedstockawardsvestinfullandtheestateortheemployeehas12monthsafterterminationtoexercisethestockoptions.ForadescriptionoftheProxy Statement27applicableprovisions,see“PotentialPaymentsUponTerminationofEmploymentorChangeofControl”intheCompensationDiscussionandAnalysisabove.TheactualamountstobepaidtoandthevalueofanyvestingofrestrictedstockandstockoptionsheldbyaNamedExecutiveOfficeruponsuchterminationofemploymentcanbedeterminedonlyatthetimeofsuchtermination,andaredependentonthefactsandcircumstancesthenapplicable.NameSeverancePayment(1)RestrictedStockAwards(2)StockOptions(3)ContinuedBenefitPlanCoverage(4)PeterJ.Ungaro.......................$1,750,000$1,782,000$257,652$26,208BrianC.Henry.......................$1,040,000$1,039,500$141,780$30,895MargaretA.Williams..................$1,080,000$1,039,500$141,780$21,068StevenL.Scott.......................$300,0000$90,168$27,206JanC.Silverman......................$208,333$445,000$32,232$26,856(1)TheamountsshownforMr.Ungaro,Mr.ScottandMr.SilvermanaretheamountsdueundertheExecutiveSeverancePolicy.TheamountsshownforMr.HenryandMs.WilliamsarethesumsdueundertheExecutiveSeverancePolicy,asamendedbytheirrespectiveofferletters($520,000and$600,000,respectively),andtheirrespectiveRetentionAgreements($520,000and$480,000,respectively);ifMr.HenryandMs.WilliamsterminatedtheiremploymentforGoodReason,thentheamountsduethemundertheExecutiveSeverancePolicywouldbe$325,000and$300,000,respectively.TheamountsdueundertheExecutiveSeverancePaymentareassumedtobepaidoutoveraperiodofmonths(12monthsforMr.Ungaro,Mr.Henry,Ms.WilliamsandMr.Scott,10monthsforMr.Silverman)inaccordancewithournormalpayrollpaymentpractices;theamountstobepaidundertheapplicableRetentionAgreementsarepayableinalumpsumassoonaspracticableafterthetermination.(2)ReflectsthevalueoftheNamedExecutiveOfficer’soutstandingrestrictedsharesgrantedin2005withvestingacceleratedtoDecember29,2006,basedontheclosingmarketpriceof$11.88pershareonDecember29,2006,thelasttradingdatein2006,assumingtheemploymentoftheNamedExecutiveOfficerhadbeenterminatedwithoutCauseorforGoodReason.Insuchevent,theNamedExecutiveOfficer’srestrictedstockgrantedin2005wouldhavevestedbuttherestrictedstockgrantedin2006wouldnothavevested.IftheterminationonsuchdatehadbeenduetodeathorDisability,insteadoftheamountsshowninthiscolumninthetableabove,thevalueoftherestrictedstockgrantedin2005and2006thatwouldhavevestedwouldhavebeen:Mr.Ungaro—$2,532,222;Mr.Henry—$1,452,330;Ms.Williams—$1,452,330;Mr.Scott—$262,548;andMr.Silverman—$539,352.Seethediscussionunder“PotentialPaymentsUponTerminationofEmploy-mentorChangeofControl—RestrictedStockAgreements”intheCompensationDiscussionandAnalysisandthe“OutstandingEquityAwardsatFiscalYear-End”tableaboveforadescriptionoftheseawards.(3)ReflectsthevalueoftheaccelerationofunvestedstockoptionsiftheterminationwereduetodeathorpermanentandtotaldisabilitythatoccurredonDecember29,2006.Seethe“OutstandingEquityAwardsatFiscalYear-End”tableandthediscussionunder“PotentialPaymentsUponTerminationofEmploymentorChangeofControl—StockOptionPlans”intheCompensationDiscussionandAnalysisaboveforadescriptionofthesestockoptions.UndertheBlack-ScholespricingmodelfordeterminingoptionvaluesunderFAS123R,weusedtheactualexercisepriceofeachoption,afairvalueof$11.88persharewhichwastheclosingmarketpriceonDecember29,2006,thelasttradingdayoftheyear,aone-yearperiodinwhichtoexercisetheoptions,andotherassumptionsassetforthintheNotestoConsolidatedFinancialStatementsinourAnnualReportonForm10-KforthefiscalyearendedDecember31,2006.IftheofficerwereterminatedwithoutCauseorresignedforGoodReason,pursuanttoourExecutiveSeverancePolicytheoptionexerciseperiodforalloutstandingandvestedstockoptionswouldbeextendedbyseventoninemonthsandthevalueofthatextensionforeachNamedExecutiveOfficer,basedonandsubjecttothelimitationsoftheBlack-Scholespricingmodel,wouldbe,insteadoftheamountsshowninthiscolumn:Mr.Ungaro—$428,363;Mr.Henry—$67,481;Ms.Williams—$101,531;Mr.Scott—$62,531;andMr.Silverman—$2,604.(4)EstimatedvalueofthecontinuedpaymentundertheExecutiveSeverancePolicyofourportionofmedical,dental,visionandlifeinsurancebenefitsfor12monthsforMr.Ungaro,Mr.Henry,Ms.WilliamsandMr.ScottProxy Statement28andfor10monthsforMr.Silverman,plus$8,500foroutplacementservices.Thesepaymentswouldceaseif,beforethesetimeperiodswerecompleted,aNamedExecutiveOfficerbecomesemployedwithanothercompanythatofferssuchbenefits.ChangeofControlandSubsequentTerminationofEmploymentThefollowingtablereflectstheamountofcompensationthatwouldhavebeenpayabletoeachoftheNamedExecutiveOfficersintheeventofterminationofsuchexecutive’semploymentfollowingaChangeofControlandassumingthatsuchterminationwaseffectiveasofDecember29,2006,thelastbusinessdayoftheyear.ThistableassumesthattheNamedExecutiveOfficerhasbeenterminatedwithoutCauseorhasterminatedforGoodReason.NospecialpaymentsaredueiftheNamedExecutiveOfficerterminatesvoluntarilywithoutGoodReasonorretires,oristerminatedforCause(asisthecaseforallterminations,aterminatedemployeereceivesaccruedandunpaidsalary,anyaccruedandunpaidvacationandisabletoreceivethebalanceinhisorher401(k)planaccount).Generally,stockoptionsceasevestinguponterminationofemploymentandanoptioneehasthreemonthsafterterminationtoexercisetheoptions.Ifasuccessorentityhasnotcontinuedorassumedthestockoptionsandrestrictedstockheldbyanemployeethen,uponaChangeofControl,regardlessofwhethertheemploymentoftheemployeeisterminated,anyunvestedstockoptionsvestinfullandtheoptioneehastheopportunitytoexercisetheoptionspriortotheChangeofControlbecomingeffectiveandallrestrictedstockvestsinfull.Foradescriptionoftheapplicableprovisions,see“PotentialPaymentsUponTerminationofEmploymentorChangeofControl”intheCompensationDiscussionandAnalysisabove.TheactualamountstobepaidtoandthevalueofanyvestingofrestrictedstockandstockoptionsheldbyaNamedExecutiveOfficerwouldbedeterminedonlyatthetimeofterminationofeachNamedExecutiveOfficerfollowingaChangeofControl,andaredependentonthefactsandcircumstancesthenapplicable.NameSeverancePayment(1)RestrictedStockAwards(2)StockOptions(3)ContinuedBenefitPlanCoverage(4)TaxGross-Up(5)PeterJ.Ungaro.............$1,750,000$2,532,222$83,358$34,539$676,268BrianC.Henry.............$1,040,000$1,452,330$45,870$43,441$363,124MargaretA.Williams........$960,000$1,452,330$45,870$24,774$353,658StevenL.Scott.............$900,000$262,548$29,172$36,4510JanC.Silverman............$750,000$539,352$10,428$42,758$279,852(1)TheamountsreflectedarepaymentsunderourManagementContinuationAgreements.Theseamountsarepayableinalumpsumwithin30daysfollowingterminationofemployment.ForMr.Ungaro,Mr.HenryandMs.Williams,ourBoardofDirectorswoulddetermine,priortotheChangeofControltransactionbecomingeffective,iftheseexecutiveofficerswouldalsoreceivepaymentsfor2006of$875,000,$520,000and$480,000,respectively,undertheirrespectiveRetentionAgreements.Seethetableunder“TerminationofEmploymentOtherThanFollowingaChangeofControl”above.(2)ReflectsthevalueoftheNamedExecutiveOfficer’soutstandingrestrictedshareswithvestingacceleratedtoDecember31,2006,basedontheclosingmarketpriceof$11.88pershareonDecember29,2006,thelasttradingdayin2006.Seethe“OutstandingEquityAwardsatFiscalYear-End”tableaboveforadescriptionoftheseawards.(3)TheseamountsassumethattherehasbeenaChangeofControl,thesuccessorcompanyhasnotcontinuedorassumedtheoutstandingunvestedstockoptions,andtheofficerexercisedtheoptionsonDecember29,2006,becauseinsuchcircumstancestheoptionsvestinfullandterminateupontheChangeofControlbecomingeffective.Theamountsshownarethedifferencebetween$11.88pershare,theclosingmarketpriceonDecember29,2006,thelasttradingdayin2006,andtheexercisepriceoftheotherwiseunvestedoptionsheldbytheNamedExecutiveOfficer.Seethe“OutstandingEquityAwardsatFiscalYear-End”tableandthediscussionunder“PotentialPaymentsUponTerminationofEmploymentorChangeofControl—StockOptionPlans”intheCompensationDiscussionandAnalysisaboveforadescriptionofthesestockoptions.(4)Estimatedpresentvalueofthecontinuedpaymentofourportionofmedical,dental,vision,disabilityandlifeinsurancebenefitsfor24monthsforeachNamedExecutiveOfficer.Proxy Statement29(5)ReflectswhatwewouldhavepaidundertheManagementContinuationAgreementspursuanttowhichwehaveagreedtopayanyexcisetaxesduewithrespectto“excessparachutepayments,”andanyfurtherexcisetaxesandfederalandstateincomeandassociatedpayrolltaxesdueregardingthoseexcisetaxpaymentswithrespecttotheamountsreceivedundertheManagementContinuationAgreements.Forpurposesofdeterminingtheestimatedtaxgross-upamount,thebaseamountcalculationswerebasedontaxablewagesfortheapplicablenumberofyearsthrough2006,withannualizedcompensationforMr.Ungaroin2003andforMr.Henry,Ms.WilliamsandMr.Silvermanin2005.Allexecutiveswereassumedtobesubjecttoafederaltaxrateof35%,aFICArateof1.45%,andthehighestmarginalrateunderapplicablestateincometaxlawsforMr.ScottandMr.Silverman.CompensationCommitteeInterlocksandInsiderParticipationThecurrentmembersoftheCompensationCommitteeareFrankL.Lederman(chair),JohnB.Jones,Jr.,StephenC.Kiely,StephenC.Richards,and,untilhisdeathinearlyFebruary2007,KennethW.Kennedy,Jr.NomemberoftheCompensationCommitteewasanofficeroremployeeofCrayInc.oranyofoursubsidiariesin2006orformerly.Inaddition,noneofourexecutiveofficersservedontheboardofdirectorsorcompensationcommitteeofanyentitywhoseexecutiveofficersincludedanyofourdirectors.TRANSACTIONSWITHRELATEDPERSONSWerecognizethattransactionsbetweenusandanyofoursignificantshareholders,directors,executiveofficersandemployeescanpresentpotentialoractualconflictsofinterestandcreatetheappearancethatourdecisionsarebasedonconsiderationsotherthanthebestinterestsofusandourshareholders.Therefore,asageneralmatterandinaccordancewithourCodeofBusinessConduct,itisourpreferencetoavoidsuchtransactions.Nevertheless,werecognizethattherearesituationswheresuchtransactionsmaybein,ormaynotbeinconsistentwith,ourbestinterests.OurBoardofDirectorshasadoptedawrittenRelatedPersonTransactionPolicywhichrequirestheAuditCommitteeofourBoardtoreviewand,ifappropriate,toapproveorratifyanysuchtransactions.Specifically,pursuanttothepolicy,theAuditCommitteewillreviewanytransactioninwhichweareorwillbeaparticipantandtheamountinvolvedexceeds$120,000,andinwhichanyofour5%shareholders,directorsorexecutiveofficershasadirectoranindirectmaterialinterest.AfteritsreviewtheAuditCommitteewillonlyapproveorratifythosetransactionsthatarein,orarenotinconsistentwith,ourbestinterests,astheCommitteedeterminesingoodfaith,andtheCommitteemay,initssolediscretion,imposesuchconditionsasitdeemsappropriateonusortherelatedpersoninconnectionwithapprovalofthetransaction.AcopyofourRelatedPersonTransactionPolicyisavailableonourwebsite:www.cray.comunder“Investors—CorporateGovernance—GovernanceDocuments.”INDEPENDENTREGISTEREDPUBLICACCOUNTINGFIRMSChangeinIndependentRegisteredPublicAccountingFirmsOnApril11,2005,Deloitte&ToucheLLP(“D&T”)informedtheChairmanofourAuditCommitteethatD&Twouldnotstandforre-electionasourindependentregisteredpublicaccountingfirmforthefiscalyearendingDecember31,2005.D&Thadbeenourindependentauditorssince1987.D&Tcontinuedtobeengagedtoprovideitsattestationreportonmanagement’sassessmentofourinternalcontroloverfinancialreportingrequiredbyItem308(b)ofRegulationS-KforfilinginanamendmenttoourAnnualReportonForm10-KfortheyearendedDecember31,2004,andtoreviewourinterimfinancialinformationtobeincludedinourQuarterlyReportonForm10-QforourfirstquarterendedMarch31,2005.D&TcompleteditsservicesforuswiththefilingonMay10,2005,ofourQuarterlyReportonForm10-QforourfirstquarterendedMarch31,2005.D&Tinformedusthatitsdecisionnottostandforre-electionwasnottheresultofanydisagreementsbetweenD&Tandusonmattersofaccountingprinciplesorpractices,financialstatementdisclosureorauditscopeorprocedures.Proxy Statement30TheauditreportsofD&TonourfinancialstatementsforfiscalyearsendedDecember31,2004,and2003,containednoadverseopinionordisclaimerofopinion,andwerenotqualifiedormodifiedastouncertainty,auditscopeoraccountingprinciples.AssetforthunderItem9AofourForm10-K/AfiledwiththeSEConMay3,2005,D&T’sreportoninternalcontroloverfinancialreportingdisclaimedanopiniononmanagement’sassessmentoftheeffectivenessofourinternalcontroloverfinancialreportingbecauseofascopelimitationandexpressedanadverseopinionontheeffectivenessofourinternalcontroloverfinancialreportingbecauseofmaterialweaknessesandtheeffectsofthescopelimitation.WereceivedanunqualifiedauditreportfromD&TontheconsolidatedfinancialstatementscontainedinourAnnualReportonForm10-KforthefiscalyearendedDecember31,2004.DuringtheperiodfromJanuary1,2003,throughMay10,2005,whenD&Tcompleteditsservices,therewerenodisagreementsbetweenusandD&Tonanymatterofaccountingprinciplesorpractices,financialstatementdisclosureorauditscopeorprocedurewhich,ifnotresolvedtoD&T’ssatisfaction,wouldhavecausedittomakeareferencetothesubjectmatterofthedisagreementinconnectionwithitsreports.DuringtheperiodfromJanuary1,2003,throughMay10,2005,therewerenoreportableeventsasdefinedinItem304(a)(1)(v)ofRegulationS-K,exceptasfollows:(cid:129)InconnectionwiththeperformanceofitsauditofourfinancialstatementsfortheyearendedDecember31,2003,D&TreportedtoourAuditCommitteethatareportableconditionexistedwithrespecttothelackofpoliciesandproceduresrelatingtoaccountingfornon-revenuerelatedcontractswiththirdparties,spe-cificallycontractsenteredintowithouttheknowledgeofand/orreviewbyouraccountingdepartmenttoproperlyassessandaccountfortherelatedcontract;(cid:129)WithrespecttothematerialweaknessesininternalcontroloverfinancialreportingdescribedunderItem9AofourForm10-KfiledwiththeSEConApril1,2005;and(cid:129)WithrespecttothematerialweaknessesininternalcontroloverfinancialreportingdescribedunderItem9AofourForm10-K/AfiledwiththeSEConMay3,2005.OnJune30,2005,ourAuditCommitteeengagedthefirmofPetersonSullivanPLLC(“PetersonSullivan”)ofSeattle,Washington,toactasourindependentregisteredpublicaccountingfirm.DuringthefiscalyearsendedDecember31,2003,and2004andtheinterimperiodtoJune30,2005,wedidnotconsultwithPetersonSullivanforanyservices,includingeither:(i)theapplicationofaccountingprinciplestoaspecifiedtransaction,eithercompletedorproposed,orthetypeofauditopinionthatmightberenderedonourfinancialstatements;or(ii)anymatterthatwaseitherthesubjectofadisagreementorareportableevent.InformationRegardingOurIndependentRegisteredPublicAccountingFirmsPetersonSullivancommencedservingasourindependentauditorsonJune30,2005,andauditedour2005and2006financialstatements,includingreviewingourinterimfinancialstatementsincludedinourQuarterlyReportsonForm10-QbeginningwiththequarterendedJune30,2005.OurAuditCommitteehasselectedPetersonSullivantoserveasourindependentauditorsfor2007.Asstatedabove,D&TservedasourindependentauditorsthroughMay10,2005,auditedour2004financialstatementsandreviewedourfinancialstatementsthatappearedinourQuarterlyReportonForm10-QforthequarterendedMarch31,2005.RepresentativesofPetersonSullivanareexpectedtobepresentattheAnnualMeeting,andwillhavetheopportunitytomakeastatementandtorespondtoappropriatequestions.Proxy Statement31ServicesandFeesThefollowingtableliststhefeesforservicesrenderedbyD&TthroughMay10,2005(exceptforperformanceofstatutoryauditsofcertainforeignsubsidiariesafterthisdate):Services2005AuditFees(1).........................................................$173,000Audit-RelatedFees(2)...................................................—TaxFees(3)..........................................................45,000AllOtherFees(4)......................................................—Total...............................................................$218,000ThefollowingtableliststhefeesforservicesrenderedbyPetersonSullivanfromJune30,2005,throughDecember31,2005andfor2006:Services20052006AuditFees(1)...............................................$911,394$605,000Audit-RelatedFees(2).........................................——TaxFees(3).................................................——AllOtherFees(4)............................................——Total......................................................$911,394$605,000(1)Auditservicesbilledin2005consistedof:auditofourannualfinancialstatementsforthe2004fiscalyearbyD&Tandforthe2005fiscalyearbyPetersonSullivan,auditsofourassessmentofourinternalcontroloverfinancialreportingandtheeffectivenessofourinternalcontroloverfinancialreportingunderSection404oftheSarbanes-OxleyActforthe2004fiscalyearbyD&Tandforthe2005fiscalyearbyPetersonSullivan,reviewsofourquarterlyfinancialstatements,statutoryandregulatoryaudits,consents,comfortlettersandotherservicesrelatedtofilingswiththeSECandcapitalraisingofferings.(2)Noaudit-relatedserviceswerebilledin2005or2006.(3)Notaxserviceswerebilledin2006;taxservicesbilledin2005consistedoftaxcomplianceandtaxplanningandadvicebyD&Tasfollow:(cid:129)Feesfortaxcomplianceservicestotaled$30,000in2005.Taxcomplianceservicesareservicesrendered,baseduponfactsalreadyinexistenceorcompletedtransactions,todocument,computeandobtaingovernmentapprovalforamountstobeincludedintaxfilings.Suchservicesconsistedoffederal,stateandlocalincometaxreturnassistance,salesanduse,propertyandothertaxreturnassistance,assistancewithtaxreturnfilingsincertainforeignjurisdictionsandtransferpricingdocumentation.(cid:129)Feesfortaxplanningandadviceservicestotaled$15,000in2005.Taxplanningandadviceareservicesrenderedwithrespecttoproposedtransactionsorthatstructureatransactiontoobtainaparticulartaxresult.Suchservicesconsistedoftaxadvicerelatedtoresearchanddevelopmenttaxcreditsandtaxadvicerelatedtointra-grouprestructuring.(4)Therewerenofeesbilledforotherservicesin2006or2005byeitherD&TorPetersonSullivan.TheAuditCommitteehasdeterminedthattheprovisionofnon-auditservicesbyD&Tforusin2005werecompatiblewithsuchfirmmaintainingitsindependence.TheAuditCommitteeapprovedthefollowingnon-auditservicesperformedbyD&Tin2005:(cid:129)ConsultationsandconsentsrelatedtoSECfilingsandregistrationsstatements,(cid:129)Statutoryauditsrequiredbyourforeignsubsidiariesandconsultationofaccountingmatters,and(cid:129)TaxplanningandtaxcompliancefortheU.S.andforeignincomeandothertaxes.PetersonSullivantodatehasnotperformedanynon-auditservicesforus.Proxy Statement32AuditCommitteePre-ApprovalPolicyAllaudit,taxandotherservicestobeperformedforusbyourindependentregisteredpublicaccountantmustbepre-approvedbytheAuditCommittee.TheAuditCommitteereviewsthedescriptionoftheservicesandanestimateoftheanticipatedcostsofperformingthoseservices.Servicesnotpreviouslyapprovedcannotcommenceuntilsuchapprovalhasbeengranted.Pre-approvalusuallyisgrantedatregularlyscheduledmeetings.Ifunan-ticipateditemsarisebetweenmeetingsoftheAuditCommittee,theAuditCommitteehasdelegatedapprovalauthoritytotheChairmanoftheAuditCommittee,inwhichcasetheChairmancommunicatessuchpre-approvalstothefullCommitteeatitsnextmeeting.During2006,allservicesperformedbyPetersonSullivanwerepre-approvedbytheAuditCommitteeinaccordancewiththispolicy.Proxy Statement33Reportonthe2006FinancialStatementsandIndependentPublicAccountantsbytheAuditCommitteeTheAuditCommitteeoftheBoardofDirectorshasfurnishedthefollowingreport:ThemanagementofCrayInc.(the“Company”)hastheresponsibilityforthefinancialstatementsandfortheirintegrityandobjectivity.Tohelpfulfillthisresponsibility,managementmaintainsasystemofinternalcontrolsdesignedtoprovidereasonableassurancethatassetsaresafeguardedagainstlossorunauthorizeduseandthattransactionsareexecutedinaccordancewithmanagement’sauthorizationsandarereflectedaccuratelyinourrecords.TheAuditCommitteeoverseesthefulfillmentbymanagementofitsresponsibilitiesoverfinancialcontrolsandthepreparationofthefinancialstatements.TheAuditCommitteehasreviewedtheCompany’sauditedfinancialstatementsforthefiscalyearendedDecember31,2006,anddiscussedsuchstatementswithmanagementandtheCompany’sindependentauditors,PetersonSullivanPLLC,includingdiscussionsconcerningthequalityofaccountingprinciples,reasonablenessofsignificantjudgmentsanddisclosuresinthefinancialstatements.TheAuditCommitteealsohasdiscussedwiththeCompany’sindependentauditorssuchmattersrelatingtotheperformanceoftheauditasarerequiredtobediscussedbyStatementofAuditingStandardsNo.61(Commu-nicationswithAuditandFinanceCommittees,asamended).Additionally,theAuditCommitteehasdiscussedwiththeindependentauditorstheirindependencewithrespecttotheCompanyandconsideredwhethertheirprovisionofnon-auditservicesiscompatiblewithmaintainingthatindependence.Inthisconsideration,theAuditCommitteereviewedthefeesbilledbytheindependentauditorsasdisclosedabove.TheCompanyhasreceivedthewrittendisclosuresandtheletterfromtheindependentauditorsrequiredbytheIndependenceStandardsBoardStandardNo.1.Inrelianceonthereviewsanddiscussionsreferredtoabove,theAuditCommitteehasrecommendedtotheBoardofDirectorsthattheauditedfinancialstatementsbeincludedintheAnnualReportonForm10-KfortheyearendedDecember31,2006,forfilingwiththeSecuritiesandExchangeCommission.TheAuditCommitteeDanielC.Regis,ChairmanSallyG.NarodickStephenC.RichardsProxy Statement34ELECTIONOFEIGHTDIRECTORSFORONE-YEARTERMSOurBylawsfixthenumberofmembersofourBoardateight.EightdirectorspresentlyserveonourBoardofDirectorsfortermsendingatthe2007AnnualMeeting.TheBoardhasnominatedMs.NarodickandMessrs.Blake,Jones,Kiely,Lederman,Regis,RichardsandUngaroforre-electiontotheBoard,eachtoholdofficeuntiltheAnnualMeetingin2008.KennethW.Kennedy,Jr.,whojoinedourBoardin1989,diedinearlyFebruary2007.UntilhisdeathheservedonourCompensationCommittee.Dr.KennedywastheJohnandAnnDoerrUniversityProfessorofComputationalEngineeringatRiceUniversityandtheDirectoroftheCenterforHighPerformanceSoftwareResearchatRiceUniversity.DuringhislongtenureonourBoardheprovidedinvaluableassistancetoourBoard,ourmanagementandourengineersthroughhisvastknowledgeandexperiencewithhighperformancecomputing.OurGovernanceCommitteehasnotdeterminedwhethertoaddanindividualtoourBoard.Weknowofnoreasonwhyanynomineemaybeunabletoserveasadirector.Ifanynomineebecomesunabletoserve,yourproxymayvoteforanothernomineeproposedbytheBoard,ortheBoardmayreducethenumberofdirectorstobeelected.Ifanydirectorresigns,diesorisotherwiseunabletoserveouthisorherterm,ortheBoardincreasesthenumberofdirectors,theBoardmayfillthevacancy.BoardRecommendation:TheBoardofDirectorsrecommendsthatyouvote“for”theelectionofallnomineesfordirector.Informationabouteachnomineefordirectorissetforthbelow.WilliamC.BlakeMr.Blake,57,joinedourBoardinJune2006.Mr.Blakeisa25-yearveteranoftheHighPerformanceComputingindustry.HecurrentlyservesastheChiefExecutiveOfficerofInteractiveSupercomputing,Inc.,asoftwarecompanythatdevelopsandsellsaninteractiveparallelcomputingplatformthatextendsexistingdesktopsimulationtoolsforparallelcomputingonaspectrumofcomputingarchitectures.BeforeassumingthispositioninJanuary2007,heservedastheSeniorVicePresident,ProductDevelopmentofNetezzaCorporation,whichdevelops,marketsandsellsdatawarehouseappliances.PriortojoiningNetezzain2002,hewaswithCompaqComputerCorporationfornineyears,managingbothCompaq’sworldwideHighPerformanceTechnicalCom-putingbusinessanditssoftwaredevelopmentgroupfrom1996to2002,whichincludedbeingresponsibleforcompilerdevelopmentfortheAlphaprocessor;from1993to1996hewasCompaq’sdirectorofsoftwareproductsdevelopmentandlong-rangeoperatingsystemstrategy.Mr.BlakepreviouslyheldvariouskeyengineeringmanagementpositionswithDigitalEquipmentCorporationfrom1981to1993.Mr.BlakeisamemberoftheBoardofDirectorsofEtnus,Inc.,aproviderofdebuggingandanalysissolutionsforcomplexcomputercodes,andisamemberoftheInstituteofElectricalandElectronicsEngineersandtheAssociationforComputingMachinery.HereceivedaB.S.fromLowellTechnologicalInstitute.JohnB.Jones,Jr.Mr.Jones,62,joinedourBoardinDecember2004.Hewasaleadinghightechnologyequityresearchanalystfornearlytwentyyears.Untilhisretirementinthefallof2004,Mr.JoneswasaSeniorManagingDirectoratSchwabSoundViewCapitalMarkets.HejoinedSoundViewin2002asaSeniorEquityResearchAnalyst.From1992to2002,Mr.JoneswasaManagingDirectorandSeniorAnalystatSalomonBrothers,SalomonSmithBarneyandCitibank,wherehecoveredtheServerandEnterpriseHardware,PrinterandTest&Measurementindustries.From1985to1992,hewasapartnerandsenioranalystatMontgomerySecurities.Priortohiscareerasanequityresearchanalyst,Mr.JonesheldvariouspositionsinthecomputerindustryatStratusComputer,WangLaboratoriesandIBM.HeisadirectorofStratusTechnologiesInc.,aprovideroffaulttolerantcomputerservers,technologiesandservices.HereceivedaB.S.fromtheUniversityofOregon.StephenC.KielyMr.Kiely,61,joinedourBoardin1999,wasappointedLeadDirectorinJanuary2005andChairmanoftheBoardinAugust2005.HeisChairmanofStratusTechnologiesInc.,aprovideroffaulttolerantcomputerservers,Proxy Statement35technologiesandservices.Mr.KielyhasservedinhispresentpositionatStratusTechnologiessince1999whenStratuswaspurchasedfromAscendCommunicationsandheservedasChiefExecutiveOfficerofStratusTechnologiesfrom1999throughJune2003.Mr.KielyjoinedStratusin1994andheldvariousexecutivepositionswithStratus,becomingPresidentoftheStratusEnterpriseComputerdivisionin1998.PriortojoiningStratus,Mr.Kielyheldanumberofexecutivepositionswithseveralinformationtechnologycompanies,includingEONCorporation,BullInformationSystems,Prisma,Inc.,PrimeComputerandIBM.Mr.KielyisapastmemberoftheAdvisoryCouncilfortheSchoolofEngineeringatRiceUniversity,hasservedasaboardmemberoftheMassachusettsTechnologyParkCorporationandwasamemberofanadvisoryboardtothePresidentoftheStateUniversityofNewYorkatNewPaltz.Mr.KielyreceivedaB.A.fromFairfieldUniversityandaM.S.inManagementfromtheStanfordUniversityGraduateSchoolofBusiness.FrankL.LedermanDr.Lederman,57,joinedourBoardinMay2004.HeservedasaVicePresidentandChiefTechnicalOfficerofAlcoa,Inc.,from1995tohisretirementin2002.From1988to1995,Dr.LedermanwaswithToronto-basedNorandaInc.,whereheservedasSeniorVicePresident,Technology.HisresponsibilitiesincludeddirectingtheNorandaTechnologyCenterinMontreal.BeforejoiningNoranda,hewaswithGeneralElectricCompanyfrom1976to1988servinginanumberofpositionsinmanagementandasaphysicist,includingasmanagerofelectronicsresearchprogramsandresourcesintheCorporateResearchandDevelopmentCenterinSchenectady,N.Y.Dr.LedermanreceivedaB.S.andM.S.fromCarnegie-MellonUniversityandaM.S.andPh.D.inPhysicsfromtheUniversityofIllinois,andwasaPost-DoctoralFellowinElectricalEngineeringattheUniversityofPennsylvania.SallyG.NarodickMs.Narodick,61,joinedourBoardinOctober2004.Sheisaretirededucationaltechnologyande-learningconsultant.From2000to2004shewasPresidentofNarodickConsulting,ane-learningconsultingfirm.From1998to2000,sheservedasChiefExecutiveOfficerofApexOnlineLearning,anInterneteducationalsoftwarecompany.Previously,Ms.Narodickservedasaneducationtechnologyconsultant,bothindependentlyandfortheConsumerDivisionofIBMfrom1996to1998.From1989to1996,Ms.NarodickservedasChairmanandChiefExecutiveOfficerofEdmarkCorporation,aneducationalsoftwarecompanysoldtoIBMin1996.From1973to1987,sheservedinavarietyoffinancialmanagementcapacitiesatSeafirstCorporationandSeafirstBank,andwasasecuritiesanalystatPaineWebberfrom1970to1973.ShealsoservesasaBoardmemberofPenfordCorporation,PugetEnergy,Inc.,SolutiaInc.andSumTotalSystems.Ms.NarodickchairstheauditcommitteeofPugetEnergy,Inc.andisamemberoftheauditcommitteeofSolutiaInc.AgraduateofBostonUniversity,Ms.NarodickreceivedaM.A.inTeachingfromTeachersCollege,ColumbiaUniversity,andaM.B.A.fromNewYorkUniversity.DanielC.RegisMr.Regis,67,joinedourBoardin2003.HecurrentlyisManagingDirectorofDigitalPartners,aventurecapitalfundspecializinginNorthwestemergingtechnologycompanies,whichheco-foundedin2000.From1996to1999,hewasPresidentofKirlanVentureCapital,Inc.,wherehemanagedsimilarlyfocusedtechnologyfunds.Priortothat,Mr.Regisspentover30yearswithPriceWaterhouseLLP,includingservingasmanagingpartneroftheSeattleofficeandpreviouslyoftheNorthwestandPortland,Oregonoffices.HeisadirectorofColumbiaBankingSystem,Inc.,andChairmanofArtTechnologyGroup,Inc.HeisamemberoftheauditcommitteesofColumbiaBankingSystems,Inc.andArtTechnologyGroup,Inc.HereceivedaB.S.fromSeattleUniversity.StephenC.RichardsMr.Richards,53,joinedourBoardinOctober2004andiscurrentlyaprivateinvestor.PreviouslyheservedasChiefOperatingOfficerandChiefFinancialOfficerofMcAfee,Inc.,theleadingproviderofintrusionpreventionandriskmanagementsolutions,apositionheheldforfouryearsuntilhisretirementinDecember2004.HeservedasChiefOnlineTradingOfficerofE*TRADEGroup,Inc.,apositionheheldfromMarch1999toJune2000.From1998toFebruary1999,heservedasSeniorVicePresident,CorporateDevelopmentandNewVenturesatE*TRADE,followingtwoyearsasE*TRADE’sSeniorVicePresidentofFinance,ChiefFinancialOfficerandProxy Statement36Treasurer.PriortojoiningE*TRADEinApril1996,hewasManagingDirectorandChiefFinancialOfficerofCorrespondentClearingatBearStearns&Companies,Inc.,VicePresident/DeputyControllerofBeckerParibasandFirstVicePresident/ControllerofJefferiesandCompany,Inc.Mr.RichardsisamemberoftheBoardofDirectorsofTradestationGroupInc.,andZantaz,Inc.,andisatrusteefortheUCDavisFoundation.Mr.RichardsisaCertifiedPublicAccountant.HereceivedaB.A.fromtheUniversityofCaliforniaatDavisandaM.B.A.inFinancefromtheUniversityofCaliforniaatLosAngeles.PeterJ.UngaroMr.Ungaro.38,hasservedasChiefExecutiveOfficerandasamemberofourBoardofDirectorssinceAugust2005andasPresidentsinceMarch2005;hepreviouslyservedasSeniorVicePresidentresponsibleforsales,marketingandservicessinceSeptember2004andbeforethenservedasVicePresidentresponsibleforsalesandmarketingfromwhenhejoinedusinAugust2003.Priortojoiningus,heservedasVicePresident,WorldwideDeepComputingSalesforIBMsinceApril2003.Priortothatassignment,hewasIBM’svicepresident,worldwideHPCsales,apositionheheldsinceFebruary1999.HealsoheldavarietyofothersalesleadershippositionssincejoiningIBMin1991.Mr.UngaroreceivedaB.A.fromWashingtonStateUniversity.OTHERBUSINESSTheBoardknowsofnoothermatterstobebroughtbeforetheAnnualMeetingofShareholders.If,however,othermattersareproperlypresentedatthemeeting,theindividualsdesignatedontheproxycardwillvoteyoursharesaccordingtotheirjudgmentonthosematters.OurAnnualReportonForm10-KforthefiscalyearendedDecember31,2006,includingfinancialstatementsandschedules,formsapartofour2006AnnualReportthatwasmailedtoshareholderswiththisProxyStatement.TheAnnualReportisavailableonourwebsite:www.cray.comunder“Investors—Financials—SECFilings.”Additionalcopiesofthe2006AnnualReportonForm10-KmaybeobtainedwithoutchargebywritingtoKennethW.Johnson,CorporateSecretary,CrayInc.,411FirstAvenueSouth,Suite600,Seattle,WA98104-2860.ByorderoftheBoardofDirectors,KENNETHW.JOHNSONCorporateSecretarySeattle,WashingtonMarch30,2007Proxy Statement37(This page intentionally left blank)SECURITIESANDEXCHANGECOMMISSIONWashington,D.C.20549FORM10-K¥ANNUALREPORTPURSUANTTOSECTION13OR15(d)OFTHESECURITIESEXCHANGEACTOF1934FortheFiscalYearEndedDecember31,2006nTRANSITIONREPORTPURSUANTTOSECTION13OR15(d)OFTHESECURITIESEXCHANGEACTOF1934FortheTransitionPeriodFromto.CommissionFileNumber:0-26820CRAYINC.(Exactnameofregistrantasspecifiedinitscharter)Washington93-0962605(StateorOtherJurisdictionofIncorporationorOrganization)(I.R.S.EmployerIdentificationNo.)411FirstAvenueSouth,Suite600Seattle,Washington(AddressofPrincipalExecutiveOffice)98104-2860(ZipCode)Registrant’sTelephoneNumber,IncludingAreaCode:(206)701-2000SecuritiesRegisteredPursuanttoSection12(b)oftheExchangeAct:NONESecuritiesRegisteredPursuanttoSection12(g)oftheExchangeAct:CommonStock,$.01parvalueIndicatebycheckmarkiftheRegistrantisawell-knownseasonedissuer,asdefinedinRule405oftheSecuritiesAct:YesnNo¥IndicatebycheckmarkiftheRegistrantisnotrequiredtofilereportspursuanttoSection13orSection15(d)oftheAct:YesnNo¥IndicatebycheckmarkwhethertheRegistrant(1)hasfiledallreportsrequiredtobefiledbySection13or15(d)oftheSecuritiesExchangeActof1934duringthepreceding12months(orforsuchshorterperiodthattheRegistrantwasrequiredtofilesuchreports),and(2)hasbeensubjecttosuchfilingrequirementsforthepast90days:Yes¥NonIndicatebycheckmarkifdisclosureofdelinquentfilerspursuanttoItem405ofRegulationS-Kisnotcontainedherein,andwillnotbecontained,tothebestofregistrant’sknowledge,indefinitiveproxyorinformationstatementsincorporatedbyreferenceinPartIIIofthisForm10-KoranyamendmenttothisForm10-K.¥Indicatebycheckmarkwhethertheregistrantisalargeacceleratedfiler,anacceleratedfiler,oranon-acceleratedfiler.Seedefinitionof“acceleratedfilerandlargeacceleratedfiler”inRule12b-2oftheExchangeAct.(Checkone):LargeacceleratedfilernAcceleratedfiler¥Non-acceleratednIndicatebycheckmarkwhethertheregistrantisashellcompany(asdefinedinRule12b-2oftheExchangeAct)YesnNo¥TheaggregatemarketvalueoftheCommonStockheldbynon-affiliatesoftheRegistrantasofJune30,2006,wasapproximately$224,200,000,basedupontheclosingpriceof$9.95persharereportedforsuchdateontheNasdaqGlobalMarketSystem.AsofMarch2,2007,therewere32,397,023sharesofCommonStockissuedandoutstanding.DOCUMENTSINCORPORATEDBYREFERENCEPortionsoftheProxyStatementtobedeliveredtoshareholdersinconnectionwiththeRegistrant’sAnnualMeetingofShareholderstobeheldonMay16,2007,areincorporatedbyreferenceintoPartIII.Form 10-KCRAYINC.FORM10-KForFiscalYearEndedDecember31,2006INDEXPagePARTIItem1.Business..............................................................1Item1A.RiskFactors...........................................................14Item1B.UnresolvedStaffComments...............................................24Item2.Properties.............................................................24Item3.LegalProceedings......................................................24Item4.SubmissionofMatterstoaVoteofSecurityHolders.............................24ItemE.O.ExecutiveOfficersoftheCompany..........................................25PARTIIItem5.MarketfortheCompany’sCommonEquity,RelatedShareholderMattersandIssuerRepurchasesofEquitySecurities............................................27Item6.SelectedFinancialData..................................................30Item7.Management’sDiscussionandAnalysisofFinancialConditionandResultsofOperations............................................................31Item7A.QuantitativeandQualitativeDisclosuresAboutMarketRisk.......................44Item8.FinancialStatementsandSupplementaryData..................................46Item9.ChangesinandDisagreementswithAccountantsonAccountingandFinancialDisclosure............................................................47Item9A.ControlsandProcedures..................................................47Item9B.OtherInformation.......................................................49PARTIIIItem10.Directors,ExecutiveOfficersandCorporateGovernance..........................50Item11.ExecutiveCompensation..................................................50Item12.SecurityOwnershipofCertainBeneficialOwnersandManagementandRelatedShareholderMatters.....................................................50Item13.CertainRelationshipsandRelatedTransactions,andDirectorIndependence............50Item14.PrincipalAccountantFeesandServices.......................................50PARTIVItem15.ExhibitsandFinancialStatementSchedules....................................51CrayandCray-1arefederallyregisteredtrademarksofCrayInc.,andCrayT3E,CrayX1,CrayX1E,CrayXT3,CrayXT4,CrayXMTandCrayXD1aretrademarksofCrayInc.Othertrademarksusedinthisreportarethepropertyoftheirrespectiveowners.AllnumbersofsharesofourcommonstockinthisAnnualReportonForm10-K,aswellaspershareandsimilarcalculationsinvolvingourcommonstock,reflecttheone-for-fourreversestockspliteffectedonJune8,2006.Form 10-KForward-LookingStatementsThisAnnualReportonForm10-Kcontainsforward-lookingstatementsthatinvolverisksanduncertainties,aswellasassumptionsthat,iftheynevermaterializeorproveincorrect,couldcauseourresultstodiffermateriallyfromthoseexpressedorimpliedbysuchforward-lookingstatements.Allstatementsotherthanstatementsofhistoricalfactarestatementsthatcouldbedeemedforward-lookingstatements,includinganyprojectionsofearnings,revenueorotherfinancialitems;anystatementsoftheplans,strategiesandobjectivesofmanagementforfutureoperations;anystatementsconcerningproposednewproducts,servicesordevelopments;anystatementsregardingfutureeconomicconditionsorperformance;statementsofbeliefandanystatementofassumptionsunderlyinganyoftheforegoing.Weassumenoobligationtoupdatetheseforward-lookingstatements.Therisks,uncertaintiesandassumptionsreferredtoaboveincludethefollowing:significantlyfluctuatingoperatingresultswiththepossibilityofperiodiclosses;theneedforincreasedproductrevenueandmargin,particularlyfromourCrayXT4andsuccessormassivelyparallelsystems;completionofthedevelopmentoftheCrayXMTandBlackWidowsystemsintimeforshipmentandcustomeracceptancesinlate2007;ourrelianceonthird-partysupplierstobuildandtimelydelivercomponentsthatmeetourspecifications;thetechnicalchallengesofdevelopingnewsupercomputersystemsontimeandbudget;competitivepressuresfromestablishedcompanieswellknowninthehighperformancecomputermarketandsystembuildersandresellersofsystemsconstructedfromcommoditycomponents;thetimingandlevelofgovernmentsupportforsupercomputersystempurchasesanddevelopment;avolatilestockprice;ourabilitytoattract,retainandmotivatekeyemployeesandotherrisksthataredescribedfromtimetotimeinourreportsfiledwiththeSecuritiesandExchangeCommission(“SEC”or“Commission”),includingbutnotlimitedtotheitemsdiscussedin“RiskFactors”setforthinItem1AbelowinthisAnnualReportonForm10-K,andinsubsequentlyfiledreports.Inthisreport,werelyonandrefertoinformationandstatisticsregardingthemarketsforvariousproducts.Weobtainedthisinformationfromthird-partysources,discussionswithourcustomersandourowninternalestimates.Webelievethatthesethird-partysourcesarereliable,butwehavenotindependentlyverifiedthemandtherecanbenoassurancethattheyareaccurate.PARTIItem1.BusinessGeneralWedesign,develop,manufacture,marketandservicehighperformancecomputing(“HPC”)systems,commonlyknownassupercomputers.Oursupercomputersystemsprovidecapability,capacityandsustainedperformancefarbeyondtypicalserver-basedcomputersystemsandaddresschallengingscientificandengineeringcomputingproblems.Webelievewearewell-positionedtomeettheHPCmarket’sdemandingneedsbyprovidingsuperiorsupercomputersystemswithperformanceandcostadvantageswhensustainedperformanceonchallengingapplicationsandtotalcostofownershiparetakenintoaccount.Wedifferentiateourselvesfromourcompetitorsprimarilybyconcentratingourresearchanddevelopmenteffortsontheprocessing,interconnectandsoftwarecapabilitiesthatenableoursystemstoscale—thatis,tocontinuetoincreaseperformanceasoursystemsgrowinsize.Purpose-builtforthesupercomputermarket,oursystemsbalancehighlycapableprocessors,highlyscalablesoftwareandveryhighspeedinterconnectandcommunicationscapabilities.Wefocusoursalesandmarketingactivitiesongovernmentagencies,industrialcompaniesandacademicinstitutionsthatpurchasehighendHPCsystems.WesellourproductsprimarilythroughadirectsalesforcethatoperatesthroughouttheUnitedStatesandinCanada,Europe,JapanandAsia-Pacific.Oursupercomputersystemsareinstalledatmorethan100sitesinover20countries.WewereincorporatedunderthelawsoftheStateofWashingtoninDecember1987underthenameTeraComputerCompany.WechangedourcorporatenametoCrayInc.inconnectionwithourApril2000acquisitionoftheCrayResearchoperatingassetsfromSiliconGraphics,Inc.OurcorporateheadquarterofficesarelocatedatForm 10-K1411FirstAvenueSouth,Suite600,Seattle,Washington,98104-2860,ourtelephonenumberis(206)701-2000andourwebsiteaddressis:www.cray.com.ThecontentsofourwebsitearenotincorporatedbyreferenceintothisAnnualReportonForm10-KorourotherSECreportsandfilings.OurHistoryInmanywaysourcurrenthistorybeganonApril1,2000,whenwe,asTeraComputerCompany,acquiredtheoperatingassetsoftheCrayResearchdivisionfromSiliconGraphics,Inc.(“SGI”)andrenamedourselvesCrayInc.TeraComputerCompanywasfoundedin1987withthepurposeofdevelopinganewsupercomputersystembasedonmultithreadedarchitecture.Inearly2000wewerestillinthedevelopmentstagewithlimitedrevenueandapproximately125employees,almostallofwhomwerelocatedinourSeattleoffice.CrayResearch,Inc.,foundedin1972bySeymourCray,pioneeredtheuseofsupercomputersinavarietyofmarketsectorsanddominatedthesupercomputermarketinthelate1970’sand1980’s.CrayResearchintroducedaseriesofvector-basedsystemswithproprietaryprocessorsandleadinghigh-bandwidthmassivelyparallelsystemsusingthird-partyprocessors.In1996SGIacquiredCrayResearch.In1998SGIandtheDepartmentofDefense(“DOD”)enteredintoacost-sharingcontractforthedevelopmentoftheCrayX1system(thencode-namedtheCraySV2).In1999SGIannouncedthatitwouldconsiderofferstopurchasetheCrayResearchunit.CrayResearchAcquisitionOnApril1,2000,weacquiredfromSGItheCrayproductlines,theCrayX1developmentprojectandrelatedcost-sharingcontract,aworldwideserviceorganizationsupportingCraysupercomputersinstalledatcustomersites,integrationandfinalassemblyoperations,softwareproductsandrelatedexperienceandexpertise,approximately775employees,productandserviceinventory,realpropertylocatedinChippewaFalls,Wisconsin,andtheCraybrandname.Pursuanttoatechnologyagreement,SGIassignedtousvariouspatentsandotherintellectualpropertyandlicensedtoustherightstootherpatentsandintellectualproperty.Post-AcquisitionDevelopmentsFollowingtheCrayacquisition,weintegratedourapproximately900employeesintoonecompany;weeitherhadservice,salesandothercontractsassignedtousorenteredintonewcontractswithcustomersandvendors;andwecontinuedthedevelopmentoftheCrayX1systemandcontinuedtosellthethen-existingCrayproducts.In2001and2002wefocusedourdevelopmenteffortsontheCrayX1system;initialdeliveriesoftheCrayX1systembeganinlate2002.TheCrayX1system,designedforthehighendofthesupercomputermarket,wastheonlynewproductweweresellingin2003andthefirstthreequartersof2004.In2004wedevelopedtheCrayX1Esystemthatsignificantlyincreasedthesystem’sprocessorspeedandcapability.ThefirstCrayX1Esystemcustomershipmentoccurredattheendof2004andweplantoshipthelastCrayX1/X1Esysteminthesecondquarterof2007.Inmid-2002webeganourRedStormdevelopmentprojectwithSandiaNationalLaboratories(“Sandia”)todesignanddeliveranewhigh-bandwidth,massivelyparallelprocessingsupercomputersystem.WorkingwithSandia,wedevelopedandinstalledsystemsoftwaredesignedtorunapplicationsacrosstheentiresystemofover10,000processors.Afterfurtherupgradesin2006,theRedStormsystemwasrankedasthesecondmostpowerfulsupercomputerintheworldontheNovember2006“Top500”list.TheRedStormprojectprovidedthedevelopmentbasisforacommercialproduct,ourCrayXT3system,targetingtheneedforhighlyscalable,high-bandwidth,commodityprocessor-basedsupercomputers.TheCrayXT3systeminitialcustomershipmentoccurredinthefourthquarterof2004,withfullproductionrampinthefirsthalfof2005;inlate2006wefirstshippedthissystem’ssuccessor,theCrayXT4system.WeexpectthattheCrayXT4systemwillprovideasubstantialmajorityofourproductrevenuein2007andthatitandplannedsuccessorsystemswillbeanimportantrevenuecontributorinsucceedingyears.Inmid-2002wealsobeganworkunderacontractawardedbytheDefenseAdvancedResearchProjectsAgency(“DARPA”)pursuanttoPhaseIofitsHighProductivityComputingSystems(“HPCS”)programtodevelopasystemcapableofsustainedperformanceinexcessofonepetaflops(1,000trillionfloatingpointoperationspersecond),whichwecallourCascadeprogram.Inmid-2003,webeganPhaseII(theresearchphase),whichweForm 10-K2completedinearlyJuly2006.OnNovember21,2006,wewereawardeda$250millioncontractfromDARPAforPhaseIII,whichcallsfordeliveryofprototypesystemsby2010.OursuccessfulproposalwasbasedonourAdaptiveSupercomputingvisiontoexpandtheconceptofhybridcomputingtoafullyintegratedviewofbothhardwareandsoftwaresupportingmultipleprocessingtechnologieswithinasingle,highlyscalablesystem.WebelievetheDARPAawardvalidatesourAdaptiveSupercomputingvision.Thisawardwillco-fundourCascadedevelopmentprojecttoimplementthisvision.OnApril1,2004,weacquiredOctigaBaySystemsCorporation(“OctigaBay”),aprivately-heldcompanylocatedinBurnaby,B.C.,Canada.OctigaBaywasdevelopingabalanced,high-bandwidthsystemtargetedforthemidrangemarket.WerenamedtheOctigaBayproductastheCrayXD1system.InitialcommercialshipmentsoftheCrayXD1systembeganlateinthethirdquarterof2004,withfullproductionrampinthefirsthalfof2005.WeexpecttoshipthefinalCrayXD1systeminthefirsthalfof2007.WehaveincorporatedmanysoftwarefeaturesoftheCrayXD1systemintoourCrayXT4systemandcertainfeaturesoftheCrayXD1’sinterconnectsystemwillbeincorporatedintotheCrayXT4’ssuccessor,thecode-namedBakersystem.In2005,ourmanagementchangedsignificantlywithanewchiefexecutiveofficerandnewleadersintechnology,engineering,finance,marketing,operationsandcustomersupport.Underournewmanagementteam,wehaveexpandedourworldwidecustomerbase,refinedourproductroadmap,establishedaloweroperatingcostmodelandsharpenedourfocusonexecutiontomeetcustomerexpectationsandimproveourfinancialoperatingresults.IndustryBackgroundSinceSeymourCrayintroducedtheCray-1systemin1976,supercomputershavecontributedsubstantiallytotheadvancementofknowledgeandthequalityofhumanlife.Scientistsandengineerstypicallyrequirevastcomputingresourcestoaddressproblemsofmajoreconomic,scientificandstrategicimportance.Muchofthedevelopmentofnewproductsandtechnologies,aswellasimprovementsofexistingproductsandtechnologies,wouldnotbepossiblewithoutthecontinuedimprovementofsupercomputercomputationalspeeds,interconnecttechnologies,scalablesystemsoftwareandoverallperformance.TheHPCMarketTheoverallservermarketisestimatedbytheInternationalDataCorporation(“IDC”),initsreportsentitledWorldwideandU.S.Server2006-2010ForecastandWorldwideTechnicalComputingSystems2006-2010Forecast,issuedinAprilandMay2006,respectively,tohavebeen$51.3billionworldwidein2005.Accordingtothesereports,theHPCmarket,whichisasub-sectoroftheoverallservermarket,totaled$9.2billionin2005.WetargetthehighendoftheHPCmarket,whichincludesthecapabilitysegmentandaportionoftheenterprisesegment,asthesesegmentsaredefinedbyIDC.Webelieveourcurrenttotaladdressablemarketwithinthesesegmentsisapproximately$1.5billioninannualproductsales.Thecapabilitysegmentischaracterizedbyintensiveresearchanddevelopmentnecessarytodeliversystemscapableofsolvingtheworld’slargestandmostdemandingproblems.Theenterprisesegmentiscomposedprimarilyofsystemsmeetingthehighcapacityrequirementsofmanysmallandmedium-sizedtechnicalapplicationsrunningconcurrentlyinahigh-throughputmodeofoperation.Systemsinthesetwomarketsegmentsrangeinpricefrom$1millionto$50millionormore.VendorsthatcompeteinthehighestendoftheHPCmarketmustcommitsignificantresourcestodevelopproprietarytechnologiesandcomputingelementstomeettheexactingneedsoftheircustomers.Webelievethatthetechnicalrequirementsandhighcostsrequiredtocompeteinthismarketaresignificantbarrierstoentry.ManyofourpotentialcompetitorsfocusonthelowersegmentsoftheHPCmarket.Thesesegmentscomprisealargermarketthatisincreasinglycompetitiveandinwhichitisdifficultforvendorstoaddsignificantvalueduetothecommoditizationoftheproductssoldinthatmarket.Form 10-K3IncreasingDemandforSupercomputingPowerSupercomputerusersareseekinganswerstosomeoftheworld’smostcomplexproblemsinscienceandengineering.Addressingthesechallengescanrequirefrom10toupto1,000timesormorethecomputingcapabilitycurrentlyavailablewithexistingcomputersystems.Usersrequireverylargepowerfulcomputingresourcesthataremassivelyscalable,flexibleandmanageable,andcandeliverhighlevelsofsustainedperformance.Webelievetherearethreeprincipalfactorsdrivingthedemandforsupercomputingpower:first,theincreasingneedforadvanceddesignandsimulationcapabilityinindustry,governmentagenciesandweatherandclimatecenters;second,continuingconcernsaboutnationalsecurityissues,heightenedbyanemphasisonterrorismprevention;and,third,therecognizednationalinterestsofmanycountriestoadvancescientificresearchtoenableinnovationstobettercompetegloballyandachievebreakthroughsinnewenergytechnologies,biologicalsystems,nanotechnologies,particlephysicsandothernaturalphenomena.Designandsimulationofnewproductsbeforetheyarebuiltareinvaluabletoolstoimprovetime-to-market,productqualityanddifferentiationforgovernment,industrialandacademicusers.Theneedforsupercomputerswithingovernmentlaboratoriesandagenciesandindustrialfirmsisdrivenbytheincreasinglycomplexapplicationrequirementsofcomputer-aidedengineering,full-systemsanalysis,materialbehaviorincompositematerialsandreal-timestress-strainbehavior.Supercomputersarecriticalforincreasinglyrefinedsimulationsofbothautomotiveandaeronauticalperformancedynamics.Weatherforecastingandclimatecentersrequiresupercomputerstoprocesslargevolumesofdatatoproducemoreaccurateshort-termandmedium-rangeforecastsandtofurtherourunderstandingofthelong-termimpactofvariouspollutantsontheenvironmentandtheeffectsofglobalwarming.Governmentshaveawiderangeofongoingandyetunmetsecurityneeds,rangingfromburgeoningcryptanalysisanddataminingrequirementstorapidandaccurateanalysisofdatafromadiverseandgrowingnumberofdisparatesources.Inaddition,governmentsconstantlyseekbettersimulationandmodelingofmissilesandotherweaponssystemsandthemaintenanceandreliabilityofnuclearstockpiles.Theyalsousesupercomputerstosimulaterealworldbattlefieldconditionsrapidlyandinincreasinglevelsofdetail.Competitionbetweencountriestoacquirethebestsupercomputingtechnologytoenhancetheirworldwidecompetitivenesshasincreased.TheU.S.governmentanditsvariousagencieshavedeterminedthatitisinthebesteconomicandsecurityinterestofthecountrytoestablishandmaintainaleadershippositioninthedevelopmentofsupercomputingtechnologies.OnesuchinitiativeistheDARPAHPCSinitiative,underwhichwehavereceivedfundingforourCascadeprojectsince2002andhaveacontracttoreceivefundingforourCascadeprogramthrough2010.TheDARPAprogramisdesignedtoprovidegovernmentsupporttodevelopbreakthroughsinhighproductivitysupercomputingsystemsforthenationalsecurityandindustrialusercommunities.ThisinitiativehasbecomeincreasinglyimportantduetothetrendtowardscommoditizationintheHPCmarket,whichisnotexpectedtoprovidetheadvancedsupercomputingcapabilitiesnecessaryfortheUnitedStatestoachieveimportantgoalsandmissions.OthercountriessuchasJapan,ChinaandmembersoftheEuropeanUnionalsohaveprogramsinplacetoincreasetheirworldwidecompetitivenessthroughtheaggressiveuseofsupercomputers.LimitationsofExistingandEmergingSolutionsDespitethedemandforincreasedsupercomputingpower,systemscapableofexploitinghighendopportunitieshavebecomelesscommon.Today’sHPCmarketisrepletewithlowbandwidthclustersystemsthatareoftenlimitedinperformancebeyondcertainsystemsizeandcapability.Thesesystemslooselylinktogether,orcluster,multiplecommodityserversusingwidelyavailableprocessorsbymeansofcommerciallyavailableinterconnectproducts.Withstandardcommercialinterconnectcomponents,lowbandwidthclustersystemsarenotwell-balanced—theymayhavefastprocessors,butperformanceisseverelylimitedbytherateatwhichdatacanbemovedthroughoutthesystem,suchastoandfrommemoryandamongprocessorsovertheinterconnectionnetwork.Becauseofthelackofspecializedcommunicationandsoftwarecapabilities,thesesystemsdonotscalewell—thatis,asthesesystemsgrowinsizetheirfullsystemandperprocessorefficienciesdegradesignificantly.Additionally,asthesesystemsgrowinsize,theymaybecomeunreliablebecausetheylackthenecessarymanagementsoftwareandbuilt-inhardwareredundanciestominimizedisruptions.Form 10-K4Lowbandwidthclustersystemsmayofferhighertheoreticalpeakperformance,forequivalentcost,thandooursystems,butoftenlackinsustainedperformancewhenrunningrealapplicationsatscale.Theoreticalpeakperformanceisthehighesttheoreticalpossiblespeedatwhichacomputersystemcould,butneverdoes,operate;thismeasureisobtainedsimplybymultiplyingthenumberofprocessorsbytheirpeak-ratedspeedandthenumberoffloatingpointoperationspercycleitcancompute,assumingzerocommunicationsbottlenecksorsysteminefficiencies.Sustainedperformance,alwayslowerthanpeak,istheactualspeedatwhichasupercomputersystemrunsanapplicationprogram.Thesustainedperformanceoflowbandwidthclustersystemsoncomplexapplicationsfrequentlyisasmallfraction,oftenlessthan5%to10%,oftheirtheoreticalpeakperformance—asthesesystemsbecomelarger,theirefficiencydeclinesevenfurther,sometimesbelow1%forthemostchallengingapplicationsatscale.Therecentintroductionofdual-coreprocessorsandplannedquad-coreandmulti-coreprocessors,whichincorporatemorethanoneprocessingcoreonthesameintegratedcircuit,willfurtherstressthecapabilitiesoflowbandwidthclustersystems,resultingindecreasedperprocessorutilizationduetotheabsenceofbalancednetworkandcommunicationcapabilitiesinsuchsystems.Multi-coreprocessorswillalsoincreasethepowerandcoolingrequirementsforthesesystems,makingpackaginganincreasinglycriticalelement.Giventheselimitations,lowbandwidthclustersystemsarebettersuitedforapplicationsthatcanbepartitionedeasilyintodiscretetasksthatdonotneedtocommunicateoftenwitheachother,suchassmallproblemsandlargerproblemslackingcommunicationscomplexity;usersofsuchapplicationscomprisethemajorityofthemidrangeandlowendoftheHPCmarket.Theeffectivenessoflowbandwidthclustersystemsinourtargetmarket,thehighendofHPC,islimitedtoday,andwebelievewillbecomeincreasinglymorelimitedinthefuture.OurRoadmapWehaveconcentratedourproductroadmaponbuildingbalancedsystemsthatarepurpose-builtforsuper-computerusers.ThesesystemsaddressthecriticalcomputingresourcechallengesHPCusersfacetoday:achievingmassivescalingtotensofthousandsofprocessors,easeofuse,andveryhighlevelsofsustainedperformanceonrealapplications.Wedothisbydesigningsupercomputersthatcombinehighlycapableprocessors,whetherdevelopedbyusorbyothers,highspeedinterconnecttechnologyformaximumcommunicationefficiency,innovativepackagingtoaddressincreasedcooling,powerandreliabilityrequirements,andscalablesoftwarethatenablesperformanceandusabilityatscale.OursupercomputersutilizecomponentsandtechnologiesdesignedtosupportthedemandingrequirementsofhighendHPCusers.Incontrast,lowbandwidthclustersystemvendorsuseprocessors,interconnectsandsoftwaredesignedtomeettherequirementsofthesignificantlylargergeneralpurposeservermarketandthenattempttoleveragethesecommercially-orientedproductsintotheHPCmarket.Animportantbenefitofourpurpose-builtapproachissignificantlyhighersustainedperformanceonrealapplications,withactualapplicationperformanceimprovementsontheorderof1.5to10timesthatofourcompetitors.Withoursupercomputers,HPCusersareabletofocusontheirprimaryobjectives:advancingscientificdiscovery,increasingindustrialcapabilitiesandimprovingnationalsecurity.Oursupercomputersystemsofferseveraladditionalbenefits:(cid:129)upgradepathsthatallowcustomerstoleveragetheirinvestmentsoverlongerperiodsoftimeandprovideenhancedtotalcostsofownership;(cid:129)customhardwaredesignofproprietaryprocessorsandinterconnectsystems;(cid:129)flexibilityofprocessortype,memoryandnetworkconfigurationandsoftwaretoolsdevelopedtowardsimplementationofourAdaptiveSupercomputingvision;and(cid:129)theCraybrandname,synonymouswithsupercomputing,thatbringswithitaprovenresearchanddevelopmentteamandaglobalsalesandserviceorganizationdedicatedtotheneedsofHPCusers.Weexpecttheemergenceofmulti-coreprocessorstobeadvantageoustous,complementingourtechnicalstrengthsinnetworking,scalingsoftware,andcoolingandpowermanagementtechnologies.Additionalcoreswillamplifythescalingissuesthatcustomersfacetodaybyputtingincreasedstressonallaspectsofthesystem.OurForm 10-K5balancedapproachtosystemdesignwilllikelybecomeincreasinglycriticalinenablingcustomerstotakeadvantageofthebenefitsofmulti-coreprocessing.OurTargetMarketandCustomersOursupercomputersystemsareinstalledatmorethan100sitesinover20countries.Ourtargetmarketsfor2007andbeyondprincipallyincludenationalsecurity,scientificresearch,earthsciences,andcomputer-aidedengineering,consistingprimarilyofautomotive,aerospaceandmanufacturingcompanies.Incertainofourtargetedmarkets,suchasthenationalsecurityandscientificresearchmarkets,customershavetheirownapplicationprogramsandareaccustomedtousingnew,lessprovensystems.Othertargetcustomers,suchasautomotiveandaerospacefirmsandsomegovernmentalagencies,requirethird-partyapplicationprogramsdevelopedbyinde-pendentsoftwarevendorsrunningonmorematuresystems.NationalSecurity.Classifiedworkingovernmentagencieshasrepresentedanimportantcustomermarketforusovermanyyears.Certaingovernmentaldepartmentscontinuetoprovidefundingsupportforourresearchanddevelopmenteffortstomeettheirobjectives.Weexpectlong-termspendingonnationalsecurityanddefensetoincrease.CurrentandtargetcustomersforourproductsincludeanumberofDepartmentofDefense-relatedclassifiedcustomers,theNationalNuclearSecurityAdministrationoftheDepartmentofEnergy,andcertainforeigncounterparts.ScientificResearch.Scientificresearchincludesbothunclassifiedgovernmentalandacademicresearchlaboratoriesandcenters.TheDepartmentofDefense,throughitsHighPerformanceComputingModernizationProgram,fundsanumberofresearchorganizationsthataretargetcustomers.TheOfficeofScienceintheDepartmentofEnergyanditslaboratoriesarekeytargetcustomers,asaretheNationalScienceFoundationandtheNationalAeronauticsandSpaceAdministration,andrelatedagenciesaroundtheworld.EarthSciences.Weatherforecastingandclimatemodelingapplicationsrequireincreasingspeedandlargervolumesofdata.Forecastingmodelsandclimateapplicationshavegrownincreasinglycomplexwithanever-increasingnumberofinteractivevariables,makingimprovedsupercomputingcapabilitiesincreasinglycritical.WehaveanumberofcustomersdoingweatherandclimateapplicationsandwebelievethattheCrayX1EsysteminstalledattheKoreaMeteorologicalAdministrationiscurrentlythemostpowerfuloperationalweatherforecastingsystemintheworld.Computer-AidedEngineering.Supercomputersareusedtodesignlighter,saferandmoredurablevehicles,aswellastostudywindnoiseandairflowaroundthevehicle,toimproveairplaneflightcharacteristicsandinmanyothercomputer-aidedengineeringapplicationsinordertoimprovetime-to-marketandproductquality.Wecurrentlyhavecustomersineachoftheautomotive,aerospaceandmanufacturingareas.AgenciesoftheU.S.government,directlyandindirectlythroughsystemintegratorsandotherresellers,accountedforapproximately48%ofour2006revenue,55%ofour2005revenueand74%ofour2004revenue.Significantcustomerswithover10%ofourannualrevenueweretheKoreaMeteorologicalAdministrationandAWEPlcin2006,OakRidgeNationalLaboratoryin2005andSandiathroughtheRedStormprojectin2004.Internationalcustomersaccountedfor48%ofourtotalrevenuein2006,32%ofourtotalrevenuein2005and17%in2004.RecentCustomerContractWinsWehavehadsignificantrecentcustomercontractwinsthatwebelieveareindicativeofthevaluethatwebringtoourcustomers.Thefollowingrepresentrecentlyannouncedcontractwinswithdeliveriesscheduledin2007andbeyond:HighEndComputingTerascaleResourcesproject,sponsoredbytheUnitedKingdom’sEngineeringandPhysicalSciencesResearchCouncil,isoneofEurope’slargestandmostambitiousHPCprojectsandwillserveasthenextgenerationHPCresourcefortheUKacademiccommunity.Pursuanttomulti-phasecontractsvaluedat$85millionforproducts,maintenanceservicesandassociatedprofessionalservices,weexpecttodeliver,beginninginthethirdquarterof2007,ourCrayXT4system,tobesubsequentlyenhancedin2008withanintegratedBlackWidowvectorsystem.Thecontractalsoincludesanext-generationBakersystemtobedeliveredin2009thatForm 10-K6willfurtherboostsustainedapplicationperformance.ThedesignleveragesourAdaptiveSupercomputingvision,whichincorporatesmultiplesupercomputingprocessortechnologiesintoasinglescalablesystem.ThecontractswereannouncedinFebruary2007.TheEngineerResearchandDevelopmentCenter(“ERDC”)oftheU.S.ArmyCorpsofEngineerslocatedinVicksburg,Mississippi,signedamulti-phasecontractcoveringanupgradetoitsexistingCrayXT3systemtoover40teraflops(40trillionfloatingoperationspersecond)inthefirstquarterof2007andanewCrayXT4systemwithapeakperformanceofapproximately80teraflopswithdeliveryscheduledforlate2007.ThetwosystemswillsecureERDC’spositionasoneofthemostcapableHPCcentersintheworldandwillbeusedbyERDCtosupportmilitaryandcivilengineeringprojectsintheUnitedStatesandaroundtheworldonbehalfoftheDODHighPerformanceComputingModernizationProgram.ThiscontractwinwasannouncedinJanuary2007.CSCFinland(“CSC-F”),theinformationtechnologycenterforscienceinFinland,willacquireaCrayXT4systemdeliveringover70teraflopsofcomputepower.Thesystemisbeinginstalledinstages,withthefirstdeliveryinlate2006withdeliveriescontinuingthrough2008.CSC-Fprovidesinformationtechnologyinfrastructure,skillsandspecialistservicesforuniversities,polytechniccolleges,researchinstitutionsandcompaniesacrossFinland,andcollaborateswithvariousresearchinstitutionsworldwide.TheCrayXT4systemwillbeusedforresearchinareassuchasphysics,chemistry,nanotechnology,linguistics,bioscience,appliedmathematicsandengineering.WeunderstandthatCSC-FselectedtheCrayXT4systemafteranextensiveacquisitionprocessthatinvolvedsurveying35differentresearchgroups,closelyanalyzingtheavailabletechnologiesandbenchmarkingcompetingsystems.ThecontractwasannouncedinOctober2006.NationalEnergyResearchScientificComputingCenter(“NERSC”),alaboratoryoftheU.S.DepartmentofEnergy’sOfficeofScience,awardedusa$52millioncontractforproductsandservicestodeliverourCrayXT4systeminthefirsthalfof2007,withoptionstopurchasefutureequipmentthatcouldquadrupletheperformanceofthesystemandboostperformancetoonepetaflopsandbeyond.NERSCisoneofthelargestscientificcomputingfacilitiesintheworlddevotedtoprovidingcomputationalresourcesandexpertiseforabroadbaseofunclassifiedresearch.Weunderstandthatourproposalwasselectedbecauseofitsprice/performanceandoveralleffectiveness,asdeterminedbyNERSC’scomprehensiveevaluationcriteriaofmorethan40measures.ThiscontractwinwasannouncedinAugust2006.OakRidgeNationalLaboratory(“ORNL”),thelargestlaboratoryoftheDepartmentofEnergy’sOfficeofScienceanditscurrent“LeadershipComputing”center,awardedusa$200millioncontractforproductsandservicestobeprovidedinprogressiveupgradestoORNL’sexistingCrayXT3supercomputerandfuturesystemsbeingdevelopedunderourCrayXT4andBakerprograms.TheBakersystem,plannedfordeliveryinearly2009,isexpectedtoprovidepeakperformanceofonepetaflops.ORNLisaninternationalleaderinresearchareasthatincludeneutronscience,newenergysources,biologicalsystems,nanoscalematerialsscienceandnationalsecurity.ThiscontractwinwasannouncedinJune2006.CurrentProductsandProductsinDevelopmentOursupercomputersprovidecapability,capacityandsustainedperformancefarbeyondtypicalserver-basedcomputersystems,allowinguserstoaddresschallengingscientificandengineeringcomputingproblems.Purpose-builtforthesupercomputingmarket,oursystemsbalancehighlycapableprocessors,highlyscalablesoftwareandveryhighspeedinterconnectandcommunicationscapabilities.Weplantoutilizeincreasinglycommoninfra-structure,componentsandsystemsoftwarepursuanttoourAdaptiveSupercomputingvision.Ourgoalistobringnewproductsand/ormajorenhancementstomarketevery12to24months.Form 10-K7Thefollowingtablelistsourcurrentproductsandproductsindevelopmentbyinternalcodenames:FirstCustomerShipmentProcessorTechnologyMarketSegmentRepresentativeApplicationsCurrentProductsCrayXT4Q42006AMDOpteronDualandQuad-CoreCapabilityandEnterpriseScientificresearch;nuclearstockpilestewardship;defense;structuralengineering;computer-aidedengineeringCrayXT3Q42004AMDOpteronSingleandDual-CoreCapabilityandEnterpriseScientificresearch;nuclearstockpilestewardship;defense;structuralengineeringCrayX1EQ42004Custom—VectorCapabilityNationalsecurity;earthscience;aerospacedesignCrayXD1Q32004AMDOpteronSingleandDual-CoreEnterpriseandlowerCrashtesting;computationalfluiddynamics;imageprocessingInDevelopmentBlackWidowExpectedlate2007Custom—VectorCapabilityNationalsecurity;earthscience;computationalfluiddynamicsCrayXMTExpectedlate2007Custom—MultithreadedCapabilityandDataAnalysisNationalsecurity;large,unstructureddatasets;graphalgorithmsBakerExpected2009AMDOpteronMulti-CoreCapabilityandEnterpriseScientificresearch;nuclearstockpilestewardship;defense;structuralengineering;computer-aidedengineeringCurrentProductsCrayXT4System.OurCrayXT4systemcombinesthecapabilitiesofourCrayXT3systemandmanysoftwarefeaturesofourCrayXD1systemtoprovideanextgenerationmassivelyparallelprocessorsupercomputersystem.OurCrayXT4systemusesdual-coreOpteronprocessorsfromAdvancedMicroDevices,Inc.,(“AMD”)whicharefield-upgradeabletoquad-core,runningalightweightLinuxoperatingsystemandconnectedtoourproprietarysecondgenerationhighspeednetwork.TheCrayXT4systemishighlyscalableandisdesignedtoprovidesignificantimprovementsinpeakandsustainedperformance.WeshippedourfirstCrayXT4systeminNovember2006.WeexpectthattheCrayXT4systemwillprovideasubstantialmajorityofour2007productrevenue.CrayXT3System.TheCrayXT3systemusesAMDsingle-coreanddual-coreOpteronprocessorsconnectedviaourproprietaryhighbandwidthinterconnectnetwork.Itincorporatesamassivelyparalleltailoredoperatingsystemandastandards-basedprogrammingenvironmentdesignedtodeliververyhighsustainedapplicationperformanceinconfigurationsfrom100toover30,000processors.TheCrayXT3system,basedontheRedStormarchitectureweco-developedwithSandia,featuresatightlyintegratedmanagementsystemtoprovidehighreliabilityandenablefull-systemapplicationstoruntocompletion.WebeganshipmentsofearlyversionsoftheCrayXT3systeminthefourthquarterof2004,withfullproductionrampinthefirsthalfof2005.OursellingfocusfortheCrayXT3systemhascoveredarangeofpeakperformancefromonetoover100teraflops.Wearenowconcentratingoursellingeffortsonthesuccessorsystem,theCrayXT4system,andweexpectthat2007CrayXT3systemdeliverieslargelywillbeupgradesoradditionstoexistinginstalledsystems.CrayX1ESystem.Inlate2002wecompletedhardwaredevelopmentoftheCrayX1system,whichincorporatesinitsdesignbothvectorandmassivelyparallelprocessingcapabilities.Wecommenceddeliveringproductionsystemslateinthefourthquarterof2002andhadfullproductionrampin2003.TheCrayX1Esystem,firstshippedinDecember2004,nearlytripledthepeakperformanceoftheCrayX1systempercabinetandfeaturedoneoftheworld’smostpowerfulprocessors,at18gigaflops.ThelastsystemshipmentoftheCrayX1/X1Esupercomputerisexpectedtooccurinthesecondquarterof2007.Form 10-K8CrayXD1System.TheCrayXD1system,designedforthemidrangeHPCmarket,usesaLinux-basedoperatingsysteminconcertwithourautomatedmanagementinfrastructureandprovidestheopportunitytoaccelerateapplicationperformancethroughtheuseoffieldprogrammablegatearrays.WeplantocombinethecapabilitiesoftheCrayXD1andCrayXT4systemsintoourBakersystemindevelopment.Weshippedourlastmulti-cabinetCrayXD1systeminthefirstquarterof2007andexpecttocompletedeliveriesofCrayXD1systemsinthefirsthalfof2007.ProductsinDevelopmentBlackWidow.OurBlackWidowprogramisdirectedatdevelopingournextgenerationvector-basedsuper-computerasasuccessortoourCrayX1Esystem.TheBlackWidowsystemisdesignedtoprovidemajorimprovementsinsinglethreadscalarperformanceandoverallpriceperformanceasmeasuredonbothpeakandsustainedbases.TheBlackWidowsystemwillbetightlycoupledwithourCrayXTsystemssothattheuserseesaunifiedenvironmentandfilesystemacrossbothproducts,representinganimportantstepinourprogramtowardsprovidingaheterogeneouscomputingenvironment.TheBlackWidowprogramisco-fundedbytheU.S.government.CrayXMT.OurCrayXMTprogramisdirectedatdevelopingathirdgenerationmultithreadedsupercom-puter,whichoffersglobalsharedmemoryandhighlatencytolerance,with128threadsperprocessor.TheCrayXMTsystemwillutilizeourCrayXTinfrastructureandisasignificantsteptowardsimplementingourAdaptiveSupercomputingvision.TheCrayXMTprogramisco-fundedbytheU.S.government.Baker.OurBakerprogramisdirectedatcreatingthesuccessortoourCrayXT4systemandtoextendourleadershippositioninmassivelyparallelcomputing.TheBakersystemwillutilizeanewhighlyconfigurableinterconnectsystemthatcombinestheinterconnecttechnologiesoftheCrayXTandCrayXD1systemsandnextgenerationquad-coreandmulti-coreAMDOpteronprocessorsinamoredenselypackagedairand/orliquid-cooledcabinet.TheBakersystemisexpectedtoprovidebeyondonepetaflopspeakperformance.OurJune2006contractwithOakRidgeNationalLaboratorywasthefirstannouncedcontractforapetaflopsperformancesystemandisbasedonourBakersystem.OurAdaptiveSupercomputingVisionandCascadeProgramOurAdaptiveSupercomputingvisionsupportstheanticipatedfutureneedsofHPCcustomers.WithAdaptiveSupercomputing,weexpecttoexpandtheconceptofheterogeneouscomputingtoafullyintegratedviewofbothhardwareandsoftwaresupportingmultipleprocessingtechnologieswithinasingle,highlyscalablesystem.OurplanistoincreasinglyintegratetheseprocessingtechnologiesintoasingleLinux-basedplatform.Weexpecttoincludepowerfulcompilersandrelatedsoftwarethatwillanalyzeandmatchapplicationcodestothemostappropriateprocessingelements—weexpectthiscapabilitywillenableprogrammerstowritecodeinamorenaturalway.WebelievetheNovember2006DARPA$250millionawardtousvalidatesthisvision,whichwasthecenterofourDARPAHPCSPhaseIIIproposal.OurAdaptiveSupercomputingvisionincorporatesmanyofourtechnicalstrengths—systemscalability,multipleprocessingtechnologies,includingcustomprocessors,andhighbandwidthnetworks—intoasinglesystemthatwebelievewillmakesupercomputingcapabilitiesaccessibletoalargersetofend-users.OurCascadedevelopmentprogramimplementsourAdaptiveSupercomputingvisionbyeasingthedevel-opmentofparallelsoftwarecodes,supportingglobaladdressspacemodelswhichexploitsharedmemoryandprovidingfornewhighproductivitylanguages.Weplantodevelopanadaptive,configurablesystemthatcanmatchtheattributesofawidevarietyofapplications,whetherscalar,vector,multithreadedorothercoprocessors(suchasfieldprogrammablegatearrays)inordertomaximizeperformance.SystemsdevelopedundertheCascadeprogramwillutilizesingleandmulti-cabinetdesignsthatcanleverageavarietyofnetworkcardsandprocessorblades,thusprovidingsystemflexibility.OurCascadeeffortsareco-fundedbytheU.S.governmentthroughtheNovember2006awardtousundertheDARPAHPCSprogram.Form 10-K9TechnologyOurleadershipinsupercomputingisdependentuponthesuccessfuldevelopmentandtimelyintroductionofnewproducts.Wefocusourresearchanddevelopmentactivitiesondesigningsystemarchitecture,hardwareandsoftwarenecessarytoimplementourproductroadmap.ArchitectureWebelievewearetheonlycompanyintheworldwithsignificantdemonstratedexpertiseinfourprimaryprocessortechnologies:vectorprocessing,massivelyparallelprocessing,multithreadingandco-processingwithfieldprogrammablegatearrays.CrayResearchpioneeredtheuseofvectorsystems.Thesesystemstraditionallyhaveamoderatenumberofveryfastcustomprocessorsutilizingsharedmemory.Vectorprocessingisthecomputationofavectororstringofnumberswithasingleoperation.Thistechnologyhasproventobehighlyeffectiveformanyscientificandengineeringapplicationsinareassuchasweatherforecasting,cryptanalysisandcomputationalfluiddynamics.VectorprocessingisthebasisforourexistingCrayX1EsystemandoursuccessorBlackWidowproduct.Massivelyparallelprocessingarchitecturestypicallylinkhundredsorthousandsofcommodityprocessorsandlocalordistributedmemorytogetherinasinglesystem.Thesesystemsarebestsuitedforlargecomputingproblemsthatcanbesegmentedintomanypartsanddistributedacrossalargenumberofprocessors.Wefocusonbuildingsystemswithhighlyscalablearchitecturesusinghighbandwidthinterconnectnetworks.TheCrayXT3,CrayXT4,CrayXD1andtheBakersystemsarebasedonthisarchitecture.Multithreadingisdesignedtoprovidelatencytolerancebysupportingalargenumberofexecutablethreadsperprocessor,andquicklyswitchingtoanotherthreadwhenathreadwaitsfordatatobecomputedortoreturnfromglobalsharedmemory.Thesesystemsareparticularlyeffectiveforirregularaccesstolargedatasetsandgraph-basedalgorithms.WearecurrentlydevelopingathirdgenerationmultithreadingsystemaspartofourCrayXMTproject.Fieldprogrammablegatearrayscanbereconfiguredorreprogrammedtoimplementspecificfunctionalitymoresuitablyandmoreefficientlythanonageneral-purposeprocessor.TheCrayXD1systemintroducedtheconceptofreconfigurablecomputingwithfieldprogrammablegatearraystoourproductportfolio,andwehavearoadmapthatwillbringreconfigurablecomputingtoourCrayXTandsuccessorsystems.HardwareWehaveextensiveexperienceindesigninghardwarecomponentsofHPCsystems—processors,memorycontrollers,interconnectsystems,I/Osubsystemsandcooling,power,andpackaginginfrastructures—andintegratingthemintoasinglesystem.Ourhardwareresearchanddevelopmentexperienceincludes:(cid:129)Integratedcircuitdesign.Wehaveexperienceindesigningcustomandstandardcellintegratedcircuits,includingvectorandmultithreadedprocessors.Ourprocessorsandotherintegratedcircuitshavespecialfeaturesthatletthemusehighavailablememorybandwidthefficiently.(cid:129)Highspeedinterconnectsystems.WedesignhighspeedandhighbandwidthinterconnectsystemsusingacombinationofcustomI/Ocircuits,highdensityconnectors,carefullychosentransmissionmediaandhighlyoptimizedlogic.(cid:129)Packagingandcooling.Weuseverydensepackaginginordertoproducesystemswithhighprocessingcapabilitiesandcomplementarybandwidth.Thispackaginggeneratesmoreheatperunitvolume.Weusespecializedcoolingtechniquestoaddressthisissue,includingliquidcoolingandhighvolumeaircooling.OurhardwareengineersarelocatedprimarilyinourChippewaFalls,Wisconsin,andSeattle,Washington,offices.Form 10-K10SoftwareWehaveextensiveexperienceindesigninganddevelopingsoftwareforHPCsystems.Thisincludestheoperatingsystem,thehardwaresupervisorysystemandtheprogrammingenvironment.Overtimeweplantotransitiontoacommonsystemsoftwareandacommonprogrammingenvironmentacrossallofourplatforms,animportantaspectofourAdaptiveSupercomputingvision.Oursoftwareresearchanddevelopmentexperienceincludes:(cid:129)OperatingSystems.ForourCrayXT3,CrayXT4andCrayXD1systems,wemakeuseofandenhancecommerciallyavailableversionsoftheLinuxoperatingsystem.Additionally,onourCrayXT3,CrayXT4andBlackWidowsystems,wedevelopedandsupportalightweightkernelforthecomputeresources.OntheCrayX1EandCrayXMTsystems,weutilizeandsupportseparateUNIX-basedoperatingsystems.Inthefuture,weanticipatethatallofoursystemswillexploittheLinuxoperatingsystemforallnodearchitectures.(cid:129)HardwareSupervisorySystems(“HSS”).Forallofoursystems,weprovideascalablehardwarecontrolinfrastructureformanaginghardware,includingpowercontrol,monitoringofenvironmentaldataandhardwarediagnostics.Inthefuture,weanticipateprovidingacommonHSSinfrastructureforallofoursystems.(cid:129)ProgrammingEnvironment.ForourCrayXT3,CrayXT4andCrayXD1systems,weusecommerciallyavailablecompilers,librariesandtools.WealsoprovideCraydevelopedlibrariesandtoolsthatmakeoursystemseasiertooptimizeandmorerobust.ForourCrayX1E,BlackWidowandCrayXMTsystems,wedevelopourowncompilers,librariesandtools.Wepurchaseorlicensesoftwaretechnologiesfromthirdpartieswhennecessarytoprovideappropriatesupporttoourcustomers,whilefocusingourownresourceswherewebelieveweaddthehighestvalue.OursoftwarepersonnelarelocatedprincipallyinourMendotaHeights,MinnesotaandSeattle,Washingtonoffices.ServicesOurworldwideserviceorganizationprovidesuswithacompetitiveadvantageandapredictableflowofrevenueandcash.Supportservicesareimportanttoourcustomers,andwegenerallylocateoursupportpersonnelatornearcustomersitesglobally,supportedbyacentralserviceorganizationlocatedinChippewaFalls,Wisconsin,andMendotaHeights,Minnesota.Inrecentyears,annualservicerevenuehasrangedfromapproximatelyone-quartertoone-thirdoftotalrevenue.Oursupportservicesincludefacilityanalysis,systeminstallation,applicationporting,tuningandsupport,hardwaremaintenanceandoperatingsystemsupport.Supportservicesareprovidedunderseparatemaintenancecontractswithourcustomers.Thesecontractsgenerallyprovideforsupportservicesonanannualbasis,althoughsomecovermultipleyears.Whilemostcustomerspayforsupportonanannualbasis,otherspaymonthlyorquarterly.Customersmayselectlevelsofsupportandresponsetimes,rangingfrompartsonlyto24x7coveragewithtwo-hourresponse.OurCrayTechnicalServicesofferings,whichincludeproductintegration,advancedcomputertraining,projectmanagementservices,siteengineering,applicationanalystsupportandcustomerhardwareandsoftwareengineering,areprovidedonaproject-by-projectbasis.SalesandMarketingWefocusoursalesandmarketingactivitiesongovernmentagencies,industrialcompaniesandacademicinstitutionsthatpurchaseHPCsystems.WesellourproductsprimarilythroughaseasonedsupercomputingdirectsalesforcethatoperatesthroughouttheUnitedStatesandinCanada,Europe,JapanandAsia-Pacific.Weservesmallerandremotemarketsthroughsalesrepresentativesandresellers.AbouthalfofoursalesforceislocatedintheUnitedStatesandCanada,withtherestoverseas.Amajorityofoursalesaredrivenbyaformalrequest-for-proposalprocessforHPCsystems.Weutilizepre-salestechnicalexpertstodeveloptechnicalproposalsthatmeetthecustomerrequirementsandbenchmarkingteamsForm 10-K11todemonstratetheadvantagesofourparticularsupercomputingproductsbeingproposed.Foramajorityofsalesopportunities,thetermsofourproposals,includingsystemsize,options,pricingandothercommitments,areindividuallyreviewedandapprovedbyourseniorexecutives.Whileweoftentailoroursupercomputersolutionsforeachcustomer,thereissubstantialcommonalityintheunderlyingcomponentsandsystems,allowingustomitigatepotentialimpactsonmanufacturingandprocurementoperations.Asgovernmentagenciesandgovernmentfundedscientificresearchinstitutionscomprisealargeportionofourcustomerbase,ourgovernmentprogramsofficeisanintegralpartofouroverallsalesandmarketingstrategy.OurgovernmentprogramsstaffactivelymanagesourrelationshipwithU.S.governmentagenciesandCongress.Ourmarketingstaffisresponsibleforproductmarketing,marketingcommunicationsandbusinessdevelop-ment.Productmarketingbridgesourresearchanddevelopmentorganizationandoursalesstafftohelpensurethatourproductsmeetthedemandsandrequirementsofourkeycustomersandabroadersetofprospects.Marketingcommunicationsfocusonouroverallbrandmessaging,pressreleases,conferences,tradeshowsandmarketingcampaigns.Businessdevelopmentfocusesonprovidingproductsandservicestospecificcustomersets,suchasearthsciencesandcomputer-aidedengineering.IntellectualPropertyWeattempttoprotectourtradesecretsandotherproprietaryrightsthroughformalagreementswithouremployees,customers,suppliersandconsultants,andthroughpatentprotection.Althoughweintendtoprotectourrightsvigorously,therecanbenoassurancethatourcontractualandothersecurityarrangementswillbesuccessful.Ourgeneralpolicyistoseekpatentprotectionforthoseinventionsandimprovementslikelytobeincorporatedintoourproductsandservicesortogiveusacompetitiveadvantage.Wehaveanumberofpatentsandpendingpatentapplicationsrelatingtoourhardwareandsoftwaretechnologies.Whilewebelieveourpatentsandapplicationshavevalue,nosinglepatentorgroupofpatentsisinitselfessentialtousasawholeortoanyofourkeyproducts.Anyofourproprietaryrightscouldbechallenged,invalidatedorcircumventedandmaynotprovidesignificantcompetitiveadvantage.WelicensecertainpatentsandotherintellectualpropertyfromSGIaspartofouracquisitionoftheCrayResearchoperations.Theselicensescontainrestrictionsonouruseoftheunderlyingtechnology,generallylimitingtheusetohistoricCrayproducts,vectorprocessorcomputersandtheCrayX1/X1Esystem.Wehavealsoenteredintocross-licensearrangementswithothercompaniesinvolvedintheHPCindustry.See“Wemaynotbeabletoprotectourproprietaryinformationandrightsadequately”and“Wemayinfringeorbesubjecttoclaimsthatweinfringetheintellectualpropertyrightsofothers”inItem1A.“RiskFactors”below.ManufacturingandProcurementWesubcontractthemanufactureofamajorityofthehardwarecomponentsforallofourproducts,includingintegratedcircuits,printedcircuitboards,connectors,cables,powersuppliesandmemoryparts,onasoleorlimitedsourcebasistothird-partysuppliers.Weusecontractmanufacturerstoassembleourcomponentsforallofoursystems.Ourmanufacturingstrategycentersonbuild-to-ordersystems,focusingonobtainingcompetitiveassemblyandcomponentcostsandconcentratingonthefinalassembly,testandqualityassurancestages.Thisstrategyallowsustoavoidthelargecapitalcommitmentandoverheadassociatedwithestablishingfull-scalemanufacturingfacilitiesandtomaintaintheflexibilitytoadoptnewtechnologiesastheybecomeavailablewithouttheriskofequipmentobsolescence,providenearreal-timeconfigurationchangestoexploitfasterand/orlessexpensivetechnologies,andprovideahigherleveloflargescalesystemquality.Weperformfinalsystemintegration,testingandcheckoutofourhardwaresystems.OurmanufacturingpersonnelarelocatedprimarilyinChippewaFalls,Wisconsin.Oursystemsincorporatesomecomponentsthatareavailablefromsingleorlimitedsources,oftencontainingourproprietarydesigns.Suchcomponentsincludeintegratedcircuits,interconnectsystemsandcertainmemorydevices.Priortodevelopmentofaparticularproduct,proprietarycomponentsarecompetitivelybidtoashortlistoftechnologypartners.Thetechnologypartnerthatprovidesthebestsolutionforthecomponentisgenerallyawardedthecontractforthelifeofthecomponent.Oncewehaveengagedatechnologypartner,changingourproductForm 10-K12designstoutilizeanothersupplier’sintegratedcircuitscanbeacostlyandtime-consumingprocess.Wealsohavesoleorlimitedsourcesforlesscriticalcomponents,suchasperipherals,powersupplies,coolingandchassishardware.WeobtainkeyintegratedcircuitsfromIBMforourCrayX1EandCrayXTsystems,fromTexasInstrumentsIncorporatedforourBlackWidowprojectandfromTaiwanSemiconductorManufacturingCompany(“TSMC”)forourCrayXMTsystem,andprocessorsfromAMDforourCrayXT,CrayXD1andsuccessorsystems.Ourprocurementsfromthesevendorsareprimarilythroughpurchaseorders.Wehavechosentodealwithsolesourcesinspecificcasesduetotheavailabilityofspecifictechnologies,economicadvantagesandotherfactors.Relianceonsingleorlimitedsourcevendorsinvolvesseveralrisks,includingthepossibilityofshortagesofkeycomponents,longleadtimes,reducedcontroloverdeliveryschedulesandchangesindirectionbyvendors.See“Ourrelianceonthird-partysuppliersposessignificantriskstoourbusinessandprospects”inItem1A.“RiskFactors”below.CompetitionTheHPCmarketisverycompetitive.ManyofourcompetitorsareestablishedcompanieswellknownintheHPCmarket,includingIBM,NEC,Hewlett-Packard,SGI,Dell,BullS.A.andSunMicrosystems.Mostofthesecompetitorshavesubstantiallygreaterresearch,engineering,manufacturing,marketingandfinancialresourcesthanwedo.WealsocompetewithsystemsbuildersandresellersofsystemsthatareconstructedfromcommoditycomponentsusingprocessorsmanufacturedbyIntel,AMD,IBMandothers.Thesecompetitorsincludethepreviouslynamedcompaniesaswellassmallerfirmsthatbenefitfromthelowresearchanddevelopmentcostsneededtoassemblesystemsfromcommerciallyavailablecommodityproducts.Thesecompanieshavecapitalizedondevelopmentsinparallelprocessingandincreasedcomputerperformanceincommodity-basednetworkingandclustersystems.Whilethesecompanies’productsaremorelimitedinapplicabilityandscalability,theyhaveachievedgrowingmarketacceptanceastheyoffersignificantpeak/priceperformanceonlargerproblemslackingcomplexity.Suchcompanies,becausetheycanofferhighpeakperformanceperdollar,canputpricingpressureonusincertainprocurements.Internationally,wecompeteprimarilywithIBM,Hewlett-Packard,SunMicrosystems,BullS.A.,SGIandNEC.Whilethefirstfivecompaniesofferlargesystemsbasedoncommodityprocessors,NECalsooffersvector-basedsystemswithalargesuiteofportedapplicationprograms.AsintheUnitedStates,commodityHPCsupplierscanoffersystemswithsignificantlybetterpeak/priceperformanceoncertainapplications.Inaddition,totheextentthatIntel,IBMandotherprocessorsuppliersdevelopprocessorswithgreatercapabilitiesthantheprocessorsweusefromAMD,ourCrayXTsystems,includingupgradesandsuccessorproducts,maybeatacompetitivedisad-vantagetosystemsutilizingsuchotherprocessors.Wecompeteprimarilyonthebasisofproductperformance,breadthoffeatures,price/performance,scalability,quality,reliability,upgradeability,serviceandsupport,corporatereputation,brandimageandaccountrelationships.Ourmarketapproachismorefocusedthanourcompetitors,asweconcentrateonsupercomputingwithproductsdesignedfortheneedsofthisspecificmarket.Weoffersystemsthatprovidegreaterperformanceonthelargest,mostdifficultcomputationalproblemsandsuperiorprice/performanceonmanyimportantapplicationsinthecapabilitymarket.Oursystemsoftenoffersuperiortotalcostofownershipadvantagesastheytypicallyuselesselectricpowerandcoolingandoccupylessspacethanlowbandwidthclustersystems.EmployeesAsofDecember31,2006,wehad768employees.Wehavenocollectivebargainingagreementwithouremployees.Wehavenotexperiencedaworkstoppageandbelievethatouremployeerelationsareverygood.AvailableInformationOurannualreportsonForm10-K,quarterlyreportsonForm10-Q,currentreportsonForm8-KandamendmentstothosereportsfiledorfurnishedpursuanttoSection13(a)or15(d)oftheSecuritiesExchangeActof1934(the“ExchangeAct”)areavailablefreeofchargeatourwebsiteatwww.cray.comassoonasreasonablypracticableafterwefilesuchreportswiththeSECelectronically.Inaddition,wehavesetforthourCodeofForm 10-K13BusinessConduct,CorporateGovernanceGuidelines,thechartersoftheAudit,CompensationandCorporateGovernanceCommitteesofourBoardofDirectorsandothergovernancedocumentsonourwebsite,www.cray.com,under“Investors—CorporateGovernance.”Item1A.RiskFactors.Thefollowingfactorsshouldbeconsideredinevaluatingourbusiness,operations,prospectsandcommonstock;theymayaffectourfutureresultsandfinancialconditionandtheymayaffectaninvestmentinoursecurities.Ouroperatingresultsmayfluctuatesignificantlyandwemaynotachieveprofitabilityinanygivenperiod.Ouroperatingresultsaresubjecttosignificantfluctuationsduetothefactorslistedbelow,whichmakeestimatingrevenueandoperatingresultsforanyspecificperiodverydifficult,particularlyastheproductrevenuerecognizedinanygivenquartermaydependonaverylimitednumberofsystemsalesplannedforthatquarter,thetimingofproductacceptancesbycustomersandcontractualprovisionsaffectingrevenuerecognition.Forexample,weexpectasubstantialportionofourpotentialproductrevenueinthefirsthalfof2007tocomefromafewprincipaltransactions,andasignificantportionofourproductrevenueinlate2007tocomefromupgradestotheCrayXT4systemutilizingquad-coreAMDOpteronprocessorswithnewscalablesystemsoftwareaswellastheCrayXMTandBlackWidowsystems,eachofwhichcurrentlyisindevelopment.Delaysinrecognizingrevenuefromanyofthosetransactionscouldhaveamaterialadverseeffectonouroperatingresultsforthosequarters,andcouldshiftassociatedrevenue,marginandcashreceiptsintoasubsequentquarterorfiscalyear.Weexperiencednetlossesineachfullyearofourdevelopment-stageoperationspriorto2002.For2002wehadnetincomeof$5.4millionandfor2003wehadnetincomeof$63.2million,includinganincometaxbenefitof$42.2millionsubstantiallyallofwhichcamefromthereversalofavaluationallowanceagainstdeferredtaxassets.For2004wehadanetlossof$207.4million,includinganexpenseforin-processresearchanddevelopmentof$43.4millionandanincometaxexpenseof$59.1million,ofwhich$58.9millionrelatedtotheestablishmentofavaluationallowanceagainstdeferredtaxassets.For2005wehadanetlossof$64.3million,andfor2006wehadanetlossof$12.1million,withnetlossesinthefirstthreequartersoftheyearoffsettingnetincomeof$8.7millioninthefourthquarter.Whetherwewillbeabletoincreaseourrevenueandachieveandsustainprofitabilityonaquarterlyandannualbasisdependsonanumberoffactors,including:(cid:129)successfullysellingtheCrayXT4system,includingupgradesandsuccessorsystems,andnewproductsbasedonourBlackWidowprojectandCrayXMTsystem,andthetimingandfundingofgovernmentpurchases,especiallyintheUnitedStates;(cid:129)thelevelofrevenuerecognizedinanygivenperiod,particularlywithveryhighaveragesalespricesandlimitednumberofsystemsalesinanyquarter,thetimingofproductacceptancesbycustomersandcontractualprovisionsaffectingthetimingofrevenuerecognition;(cid:129)thelevelofproductmargincontributioninanygivenperiodduetoproductmix,strategictransactions,productlifecycleandcomponentcosts;(cid:129)thelevelandtimingofmaintenancecontractrenewalswithexistingcustomers;(cid:129)maintainingourproductdevelopmentprojectsonscheduleandwithinbudgetarylimitations;(cid:129)revenuedelaysorlossesduetocustomerspostponingpurchasestowaitforfutureupgradedornewsystems,delaysindeliveryofupgradedornewsystemsandlongerthanexpectedcustomeracceptancecycles;(cid:129)ourexpenselevels,includingresearchanddevelopmentnetofgovernmentfunding,whichmaybeaffectedbythelevelandtimingofsuchfunding;(cid:129)thetermsandconditionsofsaleorleaseforourproducts;and(cid:129)theimpactofexpensingourshare-basedcompensationunderFinancialAccountingStandardsBoard(“FASB”)StatementNo.123(R),Share-BasedPayment(“FAS123R”).Form 10-K14Thetimingofordersandshipmentsimpactourquarterlyandannualresultsandareaffectedbyeventsoutsideourcontrol,suchas:(cid:129)thetimelyavailabilityofacceptablecomponentsinsufficientquantitiestomeetcustomerdeliveryschedules;(cid:129)thetimingandlevelofgovernmentfundingforproductacquisitionsandresearchanddevelopmentcontracts;(cid:129)theavailabilityofadequatecustomerfacilitiestoinstallandoperatenewCraysystems;(cid:129)generaleconomictrends,includingchangesinlevelsofcustomercapitalspending;(cid:129)theintroductionorannouncementofcompetitiveproducts;(cid:129)currencyfluctuations,internationalconflictsoreconomiccrises;and(cid:129)thereceiptandtimingofnecessaryexportlicenses.Becauseofthenumerousfactorsaffectingourrevenueandresultsofoperations,wecannotassureourinvestorsthatwewillhavenetincomeonaquarterlyorannualbasisinthefuture.Weanticipatethatourquarterlyresultswillvarysignificantly,andincludelosses.Delaysinproductdevelopment,receiptofordersorproductacceptancescouldhaveasubstantialadverseeffectonourquarterlyandfullyearresultsin2007andinfutureyears.FailuretosellCrayXT4systemsinplannedquantitiesandatexpectedgrossmarginscouldadverselyaffectrevenueandoperatingresultsin2007andfutureperiods.Weexpectthatasubstantialmajorityofourproductrevenuein2007willcomefromalimitednumberofsalesofCrayXT4systemsintheUnitedStatesandoverseas.WeshippedthefirstCrayXT4systeminlateNovember2006,andwereceivedthefirstcustomeracceptanceofaCrayXT4systeminthefirstquarterof2007.Wewillrequiretimelyavailabilityofquad-coreAMDOpteronprocessorsinthesecondhalfof2007andtimelycompletionofscalablesystemsoftwareforlargesystemsifwearetoreceiveproductacceptancesplannedforthefourthquarterof2007.WealsofacesignificantmarginpressureforourCrayXT4systemfromcompetitors.Ifwedonotsellthesesystemsinplannedquantitiesandatexpectedgrossmargins,our2007revenueandoperatingresultswouldbeadverselyaffected.Inordertocommandhighermarginsin2007andbeyond,weneedincreasedperformancedifferentiationfromourcompetitorsinourCrayXT4andBakermassivelyparallelproducts.Themarketforsuchproductsislargerbutisrepletewithlowbandwidthclustersystemsofferedbylargercompetitorswithsignificantresourcesandsmallercompanieswithminimalresearchanddevelopmentexpenditures.Potentialcustomersmaybeabletomeettheircomputingneedsthroughtheuseofsuchsystems,andarewillingtoacceptlowercapabilityandlessaccuratemodelinginreturnforloweracquisitioncosts.Vendorsofsuchsystems,becausetheycanofferhighpeakperformanceperdollar,putpricingpressureonusincertaincompetitiveprocurements.Ourlong-termsuccessmaybeadverselyaffectedifwearenotsuccessfulinmaintainingthevalueofourbalancedhighbandwidthsystemswiththecapabilityofsolvingchallengingproblemsquicklytoamarketbeyondourcoreofcustomers,largelycertainagenciesoftheU.S.andothergovernments,thatrequiresystemswiththeperformanceandfeaturesweoffer.OurinabilitytocompletethedevelopmentofourCrayXMTandBlackWidowsupercomputersystemswouldadverselyaffectourrevenueandoperatingresultsin2007.Our2007plancontemplatessignificantproductrevenueandgrossmarginfromsalesoftheCrayXMTandourBlackWidowsystems.Thesesystemsarestillindevelopment,andarenotplannedforgeneralavailabilityuntillatein2007.Thesehardwareandsoftwaredevelopmenteffortsarelengthyandtechnicallychallengingprocesses.Wemustre-spinintegratedcircuitsfortheBlackWidowsystemandtheCrayXMTsystem.Delaysinsuccessfullycompletingthedesignandproductionofthesehardwarecomponents,includingseveralcustomintegratedcircuitsandnetworkcomponents;delaysindetectingandcorrecting,ifpossible,designerrorsinsuchintegratedcircuitsandcomponents;and/ordelaysindevelopingrequisitesystemsoftwareandneededsoftwarefeaturesandintegratingandstabilizingthefullsystemswouldmakeitdifficultforustodevelopthesesystemstimelyandsuccessfullyintimeforrevenuerecognitionduring2007.Ourrelianceonthird-partysuppliersposessignificantriskstoourbusinessandprospects.Wesubcontractthemanufactureofamajorityofallofthehardwarecomponentsforallofourproducts,includingForm 10-K15integratedcircuits,printedcircuitboards,connectors,cables,powersuppliesandmemoryparts,onasoleorlimitedsourcebasistothird-partysuppliers.Weusecontractmanufacturerstoassembleourcomponentsforallofoursystems.Wealsorelyonthirdpartiestosupplykeycapabilities,suchasfilesystemsandstoragesubsystems.Wearesubjecttosubstantialrisksbecauseofourrelianceonlimitedorsolesourcesuppliers.Forexample:(cid:129)ifasupplierdoesnotprovidecomponentsthatmeetourspecificationsinsufficientquantitiesontime,thenproductionandsalesofoursystemswouldbedelayed,adverselyaffectingrevenueandcashflow—theserisksareaccentuatedduringsteepproductionrampperiodsasweintroduceneworsuccessorproducts;(cid:129)ifaninterruptionofsupplyofourcomponentsoccurs,becauseofasignificantproblemwithasupplierprovidingpartsthatlaterprovetobedefectiveorbecauseasingle-sourcesupplierimposesallocationsonitscustomers,decidestonolongerprovidethosecomponentstousorincreasesthepriceofthosepartssignificantly,itcouldtakeusaconsiderableperiodoftimetoidentifyandqualifyalternativesuppliers,toredesignourproductsasnecessaryandtobeginmanufactureoftheredesignedcomponents.Insomecases,wemaynotbeabletoredesignsuchcomponents.Defectivecomponentsmayneedtobereplaced,whichmayresultinincreasedcostsandobsoleteinventory.SeealsotheRiskFactorcaptioned“Wefacelast-timebuydecisionsaffectingallofourcurrentproducts,whichmayadverselyaffectourrevenueandoperatingresults,”below;(cid:129)ifasuppliercannotprovideacompetitivekeycomponent,oursystemsmaybelesscompetitivethansystemsusingcomponentswithgreatercapability;and(cid:129)someofourkeysuppliersaresmallcompanieswithlimitedfinancialandotherresources,andconsequentlymaybemorelikelytoexperiencefinancialandoperationaldifficultiesthanarelarger,well-establishedcompanies.OurCrayXT4andsuccessorsystemsutilizeAMDOpteronprocessorsaswillplannedupgradeandsuccessorproducts.Ourperformanceinthefourthquarterof2007dependsinpartonthetimelyavailabilityofquad-coreOpteronprocessorsfromAMD,andadelayinavailabilityoftheseprocessorscouldhaveamaterialadverseeffectonourrevenue,earningsandcashflow.TotheextentthatIntel,IBMorotherprocessorsuppliersdevelopprocessorswithgreatercapabilities,evenforashorttime,ourCraysystems,includingupgradesandsuccessorproducts,maybeatacompetitivedisadvantagetosystemsutilizingsuchotherprocessors.OurCrayXMTsystemisbasedoncustomprocessorsmanufacturedforusbyTSMC.Ifanyofourintegratedcircuitsupplierssuffersdelaysorcancelsthedevelopmentofenhancementstoitsprocessors,ourproductrevenuewouldbeadverselyaffected.Changingourproductdesignstoutilizeanothersupplier’sintegratedcircuitswouldbeacostlyandtime-consumingprocess.Ourproductsmustmeetdemandingspecifications.Forexample,integratedcircuitsmustperformreliablyathighfrequenciestomeetacceptancecriteria.Fromtimetotimeduringthelastthreeyears,weincurredsignificantdelaysinthereceiptofkeycomponentswhichdelayedproductshipmentsandacceptances.Thedelaysinproductshipmentsandacceptancesadverselyaffectedrevenueandmarginsinthoseyears,and,totheextentthatweexperiencesimilarproblemsinthefuture,suchdelaysmayadverselyaffect2007andfuturerevenueandmargins.Wehavealsoreceivedpartsthatlaterproveddefective,particularlyfortheCrayXD1andCrayXT3systems,whichadverselyaffectedourproductandservicemarginsandcustomerconfidence.IftheU.S.governmentpurchasesfewersupercomputers,ourrevenuewouldbereducedandouroperatingresultswouldbeadverselyaffected.Historically,salestotheU.S.governmentandcustomersprimarilyservingtheU.S.governmenthaverepresentedasignificantmarketforsupercomputers,includingourproducts.FromJanuary1,2001,throughDecember31,2003,approximately81%ofouraggregateproductrevenuewasderivedfromsalestovariousagenciesoftheU.S.government;in2004,2005and2006approximately81%,55%and45%,respectively,ofourproductrevenuewasderivedfromsuchsales.Our2007andfutureplanscontemplatesignificantsalestoU.S.governmentagencies.Salestogovernmentagenciesmaybeaffectedbyfactorsoutsideourcontrol,suchaschangesinprocurementpolicies,budgetaryconsiderations,domesticcrises,andinternationalpoliticaldevelopments.ThePresidentsignedagovernmentfiscalyear2007appropriationsbillformostgovernmentdepartmentsandagencies,includingtheDepartmentofEnergyandtheNationalScienceFoundation,inmid-February2007;itwilltakesometimeforindividualagenciesandprojectstoknowthescopeoftheirfunding,andthisdelayandanyresultingshortfallmayadverselyaffectthelevelandtimingofsupercomputerForm 10-K16acquisitionsandtheamountandtimelinessofcashreceiptsintheremainderofthisgovernmentalfiscalyear.IfagenciesanddepartmentsoftheUnitedStatesorothergovernmentsweretostop,reduceordelaytheiruseandpurchasesofsupercomputers,ourrevenueandoperatingresultswouldbeadverselyaffected.Ifwelosegovernmentsupportfordevelopmentofoursupercomputersystems,ournetresearchanddevelopmentexpendituresandcapitalrequirementswouldincreaseandourabilitytoconductresearchanddevelopmentwoulddecrease.Afewgovernmentagenciesandresearchlaboratoriesfundasignificantportionofourdevelopmentefforts,includingourBlackWidow,CrayXMTandCascadeprojects,whichsignificantlyreducesourreportedlevelofnetresearchanddevelopmentexpenses.OurdevelopmentprojectsforourBlackWidowandmultithreadedprojectsareexpectedtobefundedthroughSeptember2007butthetimingofcurrentfundingaswellasfuturefundingfortheseprojectsmaybeatrisk.Thiscouldresultinsignificantquarterlyfluctuationsinresearchanddevelopmentexpense.AgenciesoftheU.S.governmenthistoricallyhavefacilitatedthedevelopmentof,andhaveconstitutedamarketfor,newandenhancedveryhighperformancecomputersystems.U.S.governmentagenciesmaydelayordecreasefundingofourfutureproductdevelopmenteffortsduetoproductdevelopmentdelays,achangeofpriorities,internationalpoliticaldevelopments,overallbudgetaryconsiderationsorforanyotherreason.Anydelayordecreaseinothergovernmentalsupportwouldcauseanincreasedneedforcapital,increasesignificantlyourresearchanddevelopmentexpendituresandadverselyimpactouroperatingresultsandourabilitytoimplementourproductroadmap.Failuretoovercomethetechnicalchallengesofcompletingthedevelopmentofoursupercomputersystemsonourproductroadmapwouldadverselyaffectourrevenueandoperatingresultsinsubsequentyears.InadditiontodevelopingtheCrayXMTandBlackWidowsystemsforgeneralavailabilityandscalablesystemsoftwareforquad-coreCrayXT4systemsinthesecondhalfof2007,wecontinueworkonourproductroadmap,includingtheBakerprojectasthesuccessortotheCrayXT4systemandourCascadeprogramundertheDARPAHPCSPhaseIIIawardtoimplementourAdaptiveSupercomputingvision.Thesehardwareandsoftwaredevelopmenteffortsarelengthyandtechnicallychallengingprocesses,andrequireasignificantinvestmentofcapital,engineeringandotherresources.Ourengineeringandtechnicalpersonnelresourcesarelimited.Unan-ticipatedperformanceand/ordevelopmentissuesmayrequiremoreengineers,timeortestingresourcesthanarecurrentlyavailable.Engineeringresourcesdirectedtosolvingcurrentissuesmayadverselyaffectthetimelydevelopmentofsuccessororfutureproducts.Giventhebreadthofourengineeringchallengesandourlimitedresources,weperiodicallyreviewtheanticipatedcontributionsandexpenseofourproductprogramstodeterminetheirlong-termviability.Wemaynotbesuccessfulinmeetingourdevelopmentschedulesfortechnicalreasonsand/orbecauseofinsufficienthardwareandsoftwareengineeringresources,whichcouldcausealackofconfidenceinourcapabilitiesamongourkeycustomers.Totheextentweincurdelaysincompletingthedesign,developmentandproductionofhardwarecomponents,delaysindevelopmentofrequisitesystemsoftwareoruncoverstabilityissues,whetherforsoftwareorhardware,ourrevenue,resultsofoperationsandcashflows,andthereputationofsuchsystemsinthemarketcouldbeadverselyaffected.Futuresalesofourproductsmaybeadverselyaffectedbyanyofthesefactors.Wehavesufferedsignificantlyfromproductdelaysinthepast,especiallyin2004and2005,thatadverselyaffectedourfinancialperformance,andwecontinuetoincursomestabilityissuestypicalofnewlargeinstallations.Wemayincursimilardelaysandstabilityissuesin2007andsubsequentyears,whichcouldadverselyaffectourrevenueandoperatingresultsinthoseperiods.Theachievementofourbusinessplanishighlydependentonincreasedproductrevenueandmargins.Productrevenueinrecentyearshasbeenadverselyaffectedbydelaysinproductshipmentsduetodevelopmentdelays,includingsystemsoftwaredevelopmentforlargesystems,andattimesbytheavailabilityofkeycomponentsfromthird-partyvendors.Systemstabilityissuestypicalofnewlargesystemspreviouslyhaveaffectedthetimingofsystemacceptances,whichadverselyaffectsourrevenue,resultsofoperationsandcashflows.Inthepast,productmarginshavebeenadverselyimpactedbycompetitivepressures,lowervolumesthanplannedandhigherthananticipatedmanufacturingvariances,includingscrap,reworkandexcessandobsoleteinventory.Wesometimesdonotmeetallofthecontractrequirementsforcustomeracceptanceofoursystems,whichhaveresultedincontractpenalties.Mostoftenthesepenaltiesadverselyaffectthegrossmarginonasalethroughtheprovisionofadditionalequipmentandservicestosatisfydeliverydelaysandperformanceshortfalls,althoughthereistheriskofcontractdefaultsandproductreturn.TheriskofcontractpenaltiesisincreasedwhenwebidfornewForm 10-K17businesspriortocompletionofproductdevelopment.Toimproveourfinancialperformance,weneedtolimitnegativemanufacturingvariances,contractpenaltiesandotherchargesthatadverselyaffectproductmargin.Wefacelast-timebuydecisionsaffectingallofourcurrentproducts,whichmayadverselyaffectourrevenueandoperatingresults.Weplacedlast-timebuyordersforpartsusedtomanufactureourCrayX1/X1EandCrayXD1productsin2006andplacedalast-timebuyorderinthefirstquarterof2007forakeycomponentforourCrayXT4andCrayXMTsystemsandourBlackWidowproject.Suchlast-timebuyordersandinventorypurchaseswereplacedbeforewecouldknowallpossiblesalesprospectsfortheseproducts.Indetermininglast-timebuyordersandinventorypurchases,weeithermayhaveestimatedlow,inwhichcasewelimitedthenumberofpossiblesalesofproductsandreducedpotentialrevenue,perhapssubstantially,orwemayhaveestimatedtoohigh,andmayincurinventoryobsolescencecharges.Eitherway,ouroperatingresultscouldbeadverselyaffected.Theselast-timebuydecisionsadverselyimpactshort-termcashflowandincreaseinventorybecausetheitemsarepaidforwellinadvanceofcustomerrevenue.Forexample,inthelastthreemonthswehaveplacedordersforapproximately$12.0millionofcertaincomponentsforwhichweexpectdeliveryin2007butdonotexpecttosellthemajorpartoftheproductscontainingthesecomponentsuntilsometimein2008.IfweareunabletocompetesuccessfullyintheHPCmarket,ourrevenuewilldecline.Theperformanceofourproductsmaynotbecompetitivewiththecomputersystemsofferedbyourcompetitors.ManyofourcompetitorsareestablishedcompanieswellknownintheHPCmarket,includingIBM,NEC,Hewlett-Packard,SGI,Dell,BullS.A.andSunMicrosystems.Mostofthesecompetitorshavesubstantiallygreaterresearch,engineering,manufacturing,marketingandfinancialresourcesthanwedo.WealsocompetewithsystemsbuildersandresellersofsystemsthatareconstructedfromcommoditycomponentsusingprocessorsmanufacturedbyIntel,AMD,IBMandothers.Thesecompetitorsincludethepreviouslynamedcompaniesaswellassmallerfirmsthatbenefitfromthelowresearchanddevelopmentcostsneededtoassemblesystemsfromcommerciallyavailablecommodityproducts.Thesecompanieshavecapitalizedondevelopmentsinparallelprocessingandincreasedcomputerperformanceincommodity-basednetworkingandclustersystems.Whilethesecompanies’productsaremorelimitedinapplicabilityandscalability,theyhaveachievedgrowingmarketacceptance.Theyoffersignificantpeak/priceperformanceonlargerproblemslackingcomplexity.Suchcompanies,becausetheycanofferhighpeakperformanceperdollar,canputpricingpressureonusincertaincompetitiveprocurements.Inaddition,totheextentthatIntel,IBMandotherprocessorsuppliersdevelopprocessorswithgreatercapabilitiesthantheprocessorsweusefromAMD,ourCrayXT4systemsandsuccessorproductsmaybeatacompetitivedisadvantagetosystemsutilizingsuchotherprocessors.InternationallywecompeteprimarilywithIBM,Hewlett-Packard,SunMicrosystems,BullS.A.,SGIandNEC.Whilethefirstfivecompaniesofferlargesystemsbasedoncommodityprocessors,NECalsooffersvector-basedsystemswithalargesuiteofportedapplicationprograms.AsintheUnitedStates,commodityHPCsupplierscanoffersystemswithsignificantlybetterpeak/priceperformance.PeriodicannouncementsbyourcompetitorsofnewHPCsystemsorplansforfuturesystemsandpriceadjustmentsmayreducecustomerdemandforourproducts.Manyofourpotentialcustomersalreadyownorleaseveryhighperformancecomputersystems.Someofourcompetitorsmayoffertrade-inallowancesorsubstantialdiscountstopotentialcustomers,andengageinotheraggressivepricingtactics,andwehavenotalwaysbeenabletomatchthesesalesincentives.Wehaveinthepastandmayagainberequiredtoprovidesubstantialdiscountstomakestrategicsales,whichmayreduceoreliminateanypositivemarginonsuchtransactions,ortoprovideleasefinancingforourproducts,whichcouldresultinadeferralofourreceiptofcashandrevenueforthesesystems.Thesedevelopmentslimitourrevenueandresourcesandreduceourabilitytobeprofitable.Ourmarketischaracterizedbyrapidlychangingtechnology,acceleratedproductobsolescenceandcontin-uouslyevolvingindustrystandards.Oursuccessdependsuponourabilitytosellourcurrentproducts,andtodevelopsuccessorsystemsandenhancementsinatimelymannertomeetevolvingcustomerrequirements,whichmaybeinfluencedbycompetitiveofferings.Wemaynotsucceedintheseefforts.Evenifwesucceed,productsortechnologiesdevelopedbyothersmayrenderourproductsortechnologiesnoncompetitiveorobsolete.Abreakthroughintechnologycouldmakelowbandwidthclustersystemsevenmoreattractivetoourexistingandpotentialcustomers.Suchabreakthroughwouldimpairourabilitytosellourproductsandreduceourrevenueandoperatingresults.Form 10-K18PhaseIIIoftheDARPAHPCSprogramwillaffectouroperations.OurproposalforPhaseIIIoftheDARPAHPCSprogramwasacceptedonNovember21,2006,forthedevelopmentofourCascadeproject.Thisawardcallsforthedeliveryofprototypesystemsbylate2010,andprovidesforacontributionbyDARPAtousofupto$250millionpayableoverapproximatelyfouryears,assumingwemeettenmilestones,ofwhichtodatewehavemetone.Ifwedonotmeetanyoftheremainingmilestones,ourcashflowswouldbeadverselyimpactedandourproductdevelopmentprogramswouldbeatrisk.DARPA’sfuturefinancialcommitmentsaresubjecttosubsequentCongressionalaction,andourCascadedevelopmenteffortswouldbeadverselyimpactedifDARPAdidnotreceiveexpectedfundingordecidedtoterminatetheprogrambeforecompletion.Wemustcontributeatleast$125milliontowardstheproject’stotaldevelopmentcost;failuretodosowouldresultinalowerlevelofDARPAcontributionandcouldresultinaterminationofthecontract.Thisawardlikelywillresultinincreasednetresearchanddevelopmentexpendituresbyusforthecost-sharingportionoftheprogramandadverselyaffectourcashflow,particularlyinthelateryearsoftheprogram.Ourstockpriceisvolatile.Thestockmarkethasbeenandissubjecttopriceandvolumefluctuationsthatparticularlyaffectthemarketpricesforsmallcapitalization,hightechnologycompanieslikeus.Thetradingpriceofourcommonstockissubjecttosignificantfluctuationsinresponsetomanyfactors,includingourquarterlyoperatingresults(particularlyiftheyarelessthanouroranalysts’previousestimates),changesinanalysts’estimates,ourcapitalraisingactivities,announcementsoftechnologicalinnovationsbyusorourcompetitorsandgeneralconditionsinourindustry.Ifwecannotretain,attractandmotivatekeypersonnel,wemaybeunabletoeffectivelyimplementourbusinessplan.Oursuccessalsodependsinlargepartuponourabilitytoretain,attractandmotivatehighlyskilledmanagement,technical,marketing,salesandservicepersonnel.Thelossofandfailuretoreplacekeyengineeringmanagementandpersonnelcouldadverselyaffectmultipledevelopmentefforts.Recruitmentandretentionofseniormanagementandskilledtechnical,salesandotherpersonnelisverycompetitive,andwemaynotbesuccessfulineitherattractingorretainingsuchpersonnel.Aspartofourstrategytoattractandretainpersonnel,weofferequitycompensationthroughstockoptionsandrestrictedstockgrants.However,potentialemployeesmaynotperceiveourequityincentivesasattractive,andcurrentemployeeswhohavesignificantoptionswithexercisepricessignificantlyabovecurrentmarketvaluesforourcommonstockmayseekotheremployment.Inaddition,duetotheintensecompetitionforqualifiedemployees,wemayberequiredtoincreasethelevelofcompensationpaidtoexistingandnewemployees,whichcouldmateriallyincreaseouroperatingexpenses.Lowerthananticipatedsalesofnewsupercomputersandtheterminationofmaintenancecontractsonolderand/ordecommissionedsystemsmayreduceourservicerevenueandmarginsfrommaintenanceservicecontracts.OurHPCsystemsaretypicallysoldwithmaintenanceservicecontracts.Thesecontractsgenerallyareforannualperiods,althoughsomeareformulti-yearperiods,andprovideapredictablerevenuebase.Ourrevenuefrommaintenanceservicecontractsdeclinedfromapproximately$95millionin2000toapproxi-mately$42millionin2005whileincreasingtoapproximately$50millionin2006.Weexpectthat2007maintenanceservicerevenuemaydeclinefromthislevel.Wemayhaveperiodicrevenueandmargindeclinesasourolder,highermarginservicecontractsareendedandnewer,lowermargincontractsareestablished,basedonthetimingofsystemwithdrawalsfromservice.Addingservicepersonneltonewlocationswhenwewincontractswherewehavepreviouslyhadnopresenceandservicinginstalledproductsifwediscoverdefectivecomponentsinthefieldcreateadditionalpressureonservicemargins.ExpansionofourTechnicalServiceseffortscouldreduceourservicemargins.WeplantoexpandourcapabilitiestodeliverCrayTechnicalServicesin2007throughtheadditionofexperiencedmanagersandpersonnelandmarketingoftheseservices.Theseservicesusuallyarerenderedonaproject-by-projectbasis.Totheextentthatweincuradditionalexpensesinthiseffortpriortoreceivingadditionalrevenue,ourservicemarginswillbeadverselyaffected.TheadoptionofFAS123Rhasandwillcontinuetoadverselyaffectouroperatingresultsandmayadverselyaffectthemarketpriceofourcommonstock.Wehaveusedshare-basedcompensation,primarilystockoptionsandanemployeestockpurchaseplan,asakeycomponentinouremployeecompensation.Inpreviousyearswegrantedstockoptionstoeachnewemployeeandtoallemployeesonanannualbasis,andin2005wevestedalmostallexistingstockoptions.For2003through2005,aswehavereportedinthenotestoourfinancialForm 10-K19statements,weestimatedthatourstockoptionandemployeestockpurchaseprograms,asthenstructured,wouldhaveaddedapproximately$7millionto$26millionofadditionalnon-cashexpenseannually.TheseestimateswerebasedonuseoftheBlack-Scholesvaluationmethod,whichprovidessignificantlydifferentvaluesdependingoncertainassumptions.Beginningin2006,inlightoftheadoptionofFAS123R,weawardedoptionandstockawardstoalimitednumberofnewemployeesandgrantedoptionsandrestrictedstocktolessthanamajorityofemployees,almostallwithfour-yearvestingperiods.Wealsochangedthepurchasepriceunderouremployeestockpurchaseplanto95%oftheclosingmarketpriceonthefourthbusinessdayaftertheendofeachofferingperiodinordertodesignatetheplanasnoncompensatory,andtherebyavoidexpensewhichwouldhaveotherwisebeenincurredunderFAS123R.Werecordedapproximately$2.1millionasnon-cashcompensationexpensein2006forstockoptionsandrestrictedstockgrants,andanticipatethatthisamountwillincreaseinfutureyears.Wedonotknowhowanalystsandinvestorswillreacttotheadditionalexpenserecordedinourstatementsofoperationsratherthandisclosedinthenotesthereto,andthussuchadditionalexpensemayadverselyaffectthemarketpriceofourcommonstock.Wemayinfringeorbesubjecttoclaimsthatweinfringetheintellectualpropertyrightsofothers.Thirdpartiesinthepasthaveasserted,andmayinthefutureassertintellectualpropertyinfringementclaimsagainstus,andsuchfutureclaims,ifproved,couldrequireustopaysubstantialdamagesortoredesignourexistingproductsorpayfeestoobtaincross-licenseagreements.Regardlessofthemerits,anyclaimofinfringementwouldrequiremanagementattentionandcouldbeexpensivetodefend.U.S.exportcontrolscouldhinderourabilitytomakesalestoforeigncustomersandourfutureprospects.TheU.S.governmentregulatestheexportofHPCsystemssuchasourproducts.Occasionallywehaveexperienceddelaysforuptoseveralmonthsinreceivingappropriateapprovalsnecessaryforcertainsales,whichhavedelayedtheshipmentofourproducts.Delayordenialinthegrantingofanyrequiredlicensescouldmakeitmoredifficulttomakesalestoforeigncustomers,eliminatinganimportantsourceofpotentialrevenue.Weincorporatesoftwarelicensedfromthirdpartiesintotheoperatingsystemsforourproductsandanysignificantinterruptionintheavailabilityofthesethird-partysoftwareproductsordefectsintheseproductscouldreducethedemandforourproducts.TheoperatingsystemsoftwarewedevelopforourHPCsystemscontainscomponentsthatarelicensedtousunder“opensource”softwarelicenses.Ourbusinesscouldbedisruptedifthissoftware,orfunctionalequivalentsofthissoftware,wereeithernolongeravailabletousornolongerofferedtousoncommerciallyreasonableterms.Ineithercasewewouldberequiredtoredesignouroperatingsystemsoftwaretofunctionwithalternatethird-partysoftware,ordevelopthesecomponentsourselves,whichwouldresultinincreasedcostsandcouldresultindelaysinproductshipments.Furthermore,wemightbeforcedtolimitthefeaturesavailableinourcurrentorfutureoperatingsystemsoftwareofferings.OurCrayXT4andsuccessorsystemsutilizesoftwaresystemvariantsthatincorporateLinuxtechnology.TheSCOGroup,Inc.hasfiledandthreatenedtofilelawsuitsagainstcompaniesthatoperateLinuxforcommercialpurposes,allegingthatsuchuseofLinuxinfringesitsrights.Theopensourcelicensesunderwhichwehaveobtainedcertaincomponentsofouroperatingsystemsoftwaremaynotbeenforceable.Anyrulingbyacourtthattheselicensesarenotenforceable,orthatLinux-basedoperatingsystems,orsignificantportionsofthem,maynotbecopied,modifiedordistributedasprovidedinthoselicenses,wouldadverselyaffectourabilitytoselloursystems.Inaddition,asaresultofconcernsaboutthislitigationandopensourcesoftwaregenerally,wemaybeforcedtoprotectourcustomersfrompotentialclaimsofinfringement.Inanysuchevent,ourfinancialconditionandresultsofoperationsmaybeadverselyaffected.Wealsoincorporateproprietarysoftwarefromthirdparties,suchasforfilesystems,jobschedulingandstoragesubsystems.Wehaveexperiencedsomefunctionalissuesinthepastwithimplementingsuchsoftwarewithoursupercomputersystems.Theseissues,ifrepeated,mayresultinadditionalexpensebyusinintegratingthissoftwaremorefullyand/orlossofcustomerconfidence.WearerequiredtoevaluateourinternalcontroloverfinancialreportingunderSection404oftheSarbanes-OxleyActof2002attheendofeachfiscalyear,andanyadverseresultsfromsuchfutureevaluationscouldresultinalossofinvestorconfidenceinourfinancialreportsandhaveanadverseeffectonourstockprice.PursuanttoSection404oftheSarbanes-OxleyActof2002,wearerequiredtofurnishareportbyourmanagementonourinternalcontroloverfinancialreportinginourAnnualReportonForm10-K.Suchreportmustcontain,amongotheritems,anassessmentoftheeffectivenessofourinternalcontroloverfinancialreportingForm 10-K20asoftheendofthefiscalyear,includingastatementastowhetherornotourinternalcontroloverfinancialreportingiseffective.Thisassessmentmustincludedisclosureofanymaterialweaknessesinourinternalcontroloverfinancialreportingidentifiedbymanagement.Suchreportmustalsocontainastatementthatourindependentregisteredpublicaccountingfirmhasissuedanattestationreportonmanagement’sassessmentofsuchinternalcontrol.Wereceivedfavorableopinionsfromourindependentregisteredpublicaccountingfirmandwereportednomaterialweaknessesfor2005and2006,althoughwereportedmaterialweaknessesandreceivedadisclaimedauditopinionfor2004.Eachyear,wemustcontinuetomonitorandassessourinternalcontroloverfinancialreportinganddeterminewhetherwehaveanymaterialweaknesses.Dependingontheirnatureandseverity,anyfuturematerialweaknessescouldresultinourhavingtorestatefinancialstatements,couldmakeitdifficultorimpossibleforustoobtainanauditofourannualfinancialstatementsorcouldresultinaqualificationofanysuchaudit.Insuchevents,wecouldexperienceanumberofadverseconsequences,includingourinabilitytocomplywithapplicablereportingandlistingrequirements,alossofmarketconfidenceinourpubliclyavailableinformation,delistingfromtheNasdaqGlobalMarket,lossoffinancingsourcessuchasourlineofcredit,andlitigationbasedontheeventsthemselvesortheirconsequences.Ourindebtednessmayadverselyaffectourfinancialstrength.InDecember2004wesold$80.0millioninaggregateprincipalamountofour3.0%ConvertibleSeniorSubordinatedNotesdue2024(the“Notes”).HoldersmayrequireustopurchaseallorapartoftheirNotesforcashatapurchasepriceof100%oftheprincipalamountoftheNotesplusaccruedandunpaidinterestonDecember1,2009,2014,and2019,orupontheoccurrenceofcertaineventsprovidedintheindenturegoverningtheNotes.AsofDecember31,2006,wehadnootheroutstandingindebtednessformoneyborrowedandnomaterialequipmentleaseobligations.Wehavea$25.0millioncashsecuredcreditfacilitywhichsupportstheissuanceoflettersofcreditandforwardcurrencycontracts.AsofDecember31,2006,wehadapproximately$24.8millionavailabletoborrowunderthiscreditfacility.OurcurrentcreditfacilityconstitutesseniordebtwithrespecttotheNotes.Wemayincuradditionalindebtednessformoneyborrowed,whichmayincludeborrowingundernewcreditfacilitiesortheissuanceofnewdebtsecurities.Overtime,thelevelofourindebtednesscould,amongotherthings:(cid:129)increaseourvulnerabilitytogeneraleconomicandindustryconditions,includingrecessions;(cid:129)requireustousecashfromoperationstoserviceourindebtedness,therebyreducingourabilitytofundworkingcapital,capitalexpenditures,researchanddevelopmenteffortsandotherexpenses;(cid:129)limitourflexibilityinplanningfor,orreactingto,changesinourbusiness,includingmergerandacquisitionopportunities;(cid:129)placeusatacompetitivedisadvantagecomparedtocompetitorsthathavelessindebtedness;and(cid:129)limitourabilitytoborrowadditionalfundsthatmaybeneededtooperateandexpandourbusiness.WemaynothavethefundsnecessarytopurchasetheNotesuponafundamentalchangeorotherpurchasedateandourabilitytopurchasetheNotesinsucheventsmaybelimited.OnDecember1,2009,December1,2014andDecember1,2019,holdersoftheNotesmayrequireustopurchasetheirNotesforcash.Inaddition,holdersmayalsorequireustopurchasetheirNotesuponafundamentalchange,asdefinedintheindenturegoverningtheNotes,whichincludesamongothermattersachangeofcontrol.OurabilitytorepurchasetheNotesinsucheventsmaybelimitedbylawandbythetermsofotherindebtedness,includingthetermsofseniorindebtedness,wemayhaveoutstandingatthetimeofsuchevents.WhileourexistingcreditfacilitydoesnotprohibitusfromrepurchasinganyoftheNotes,anysubsequentcreditfacilitymayincludesuchacovenantorarequirementforpriorwrittenconsentfromthelender.Ifwedonothavesufficientfunds,wewillnotbeabletorepurchasetheNotestenderedtousforpurchase.Ifarepurchaseeventoccurs,wemayrequirethird-partyfinancingtorepurchasetheNotes,butwemaynotbeabletoobtainthatfinancingonfavorabletermsoratall.OurfailuretorepurchasetenderedNotesatatimewhentherepurchaseisrequiredbytheindenturewouldconstituteadefaultundertheindenture.Inaddition,adefaultundertheindenturewouldconstituteadefaultunderourexistingseniorsecuredcreditfacilityandcouldleadtodefaultsunderotherexistingandfutureagreementsgoverningourindebtedness.Inthesecircumstances,thesubordinationprovisionsintheindenturegoverningtheNotesmaylimitorprohibitpaymentstoNoteholders.If,duetoadefault,therepaymentoftherelatedindebtednessweretobeForm 10-K21acceleratedafteranyapplicablenoticeorgraceperiods,wemaynothavesufficientfundstorepaytheindebtednessorrepurchasetheNotes.Wewillrequireasignificantamountofcashtorepayourindebtednessandtofundplannedcapitalexpenditures,researchanddevelopmenteffortsandothercorporateexpenses.Ourabilitytomakepaymentsonourindebtedness,includingthepotentialrepurchaseoftheNotesinDecember2009,andtofundplannedcapitalexpenditures,researchanddevelopmenteffortsandothercorporateexpenseswilldependonourfutureoperatingperformanceandoneconomic,financial,competitive,legislative,regulatoryandotherfactors.Manyofthesefactorsarebeyondourcontrol.Ourbusinessmaynotgeneratesufficientcashfromoperationsandfutureborrowingsmaynotbeavailabletousinanamountsufficienttoenableustopayourindebtedness,includingtheNotes,ortofundourotherneeds.Ifweareunabletogeneratesufficientcashtoenableustopayourindebtedness,wemayneedtopursueoneormorealternatives,suchasreducingouroperatingexpenses,reducingordelayingcapitalexpendituresorresearchanddevelopment,sellingassets,raisingadditionalequitycapitaland/ordebt,andseekinglegalprotectionfromourcreditors.Anyreductioninoperatingexpenses,reductionordelayincapitalexpenditures,orsaleofassetsmaymateriallyandadverselyaffectourfuturerevenueprospects.Inaddition,wemaynotbeabletoraiseadditionalequitycapitalordebtoncommerciallyreasonabletermsoratall.Anyoftheaboveactionsmaynotprovidesufficientcashtorepayourindebtedness,includingtheNotes.Inaddition,ourissuanceofadditionalequityordebtthatisconvertibleintoequitycoulddiluteourexistingshareholders.NewenvironmentalrulesinEuropeandotherjurisdictionsmayadverselyaffectouroperations.In2006membersoftheEuropeanUnion(“EU”)andcertainotherEuropeancountrieshavebegunimplementingtheRestrictionsonHazardousSubstances(“RoHS”)Directive,whichprohibitsorlimitstheuseinelectricalandelectronicequipmentofthefollowingsubstances:lead,mercury,cadmium,hexavalentchromium,polybrominatedbiphenyls,andpolybrominateddiphenylethers.AfterJuly1,2006,acompanyshippingproductsthatdonotcomplywithRoHStotheEUorsuchotherEuropeancountriescouldhaveitsproductsdetainedandcouldbesubjecttopenalties.WedecidednottoshipanyCrayX1EorCrayXD1systemstoEuropeafterJuly1,2006,becauseoftheserestrictions,andweareworkingwithoursupplierstoassureRoHScompliancewithrespecttoourotherproducts.WebelieveweareRoHS-compliantwithourCrayXT4systemwhichbeganshippinginthefourthquarterof2006andourCrayXMTandBlackWidowsystemswhichweplantoshipforgeneralavailabilityinlate2007.IfaregulatoryauthoritydeterminesthatoneofourproductsisnotRoHS-compliant,wewillhavetoredesignandrequalifycertaincomponentstomeetRoHSrequirements,whichcouldresultinincreasedengineeringexpenses,shipmentdelays,penaltiesandpossibleproductdetentionsorseizures.AseparateEUDirectiveonWasteElectricalandElectronicEquipment(“WEEE”)wasscheduledtobecomeeffectiveinAugust2005,butmanyEUmemberstateshavedelayeditsimplementation.UndertheWEEEDirective,companiesthatputelectricalandelectronicequipmentontheEUmarketmustregisterwithindividualmemberstates,marktheirproducts,submitannualreports,providerecyclerswithinformationaboutproductrecycling,andeitherrecycletheirproductsorparticipateinorfundmandatoryrecyclingschemes.Inaddition,someEUmemberstatesrequirerecyclingfeestobepaidinadvancetoensurefundsareavailableforproductrecyclingattheendoftheproduct’susefullifeorde-installation.WehavebeguntomarkourproductsasrequiredbytheWEEEDirectiveandareregisteringwiththoseEUmemberstateswhereourproductsaresold.EachEUmemberstateisresponsibleforimplementingtheWEEEDirectiveandsomememberstateshavenotyetestablishedWEEEregistrarsorestablishedorendorsedtherecyclingschemesrequiredbytheWEEEDirective.WearemonitoringimplementationoftheWEEEDirectivebythememberstates.CompliancewiththeWEEEDirectivecouldincreaseourcostsandanyfailuretocomplywiththeWEEEDirectivecouldleadtomonetarypenalties.OtherjurisdictionsareconsideringadoptionofrulessimilartotheRoHSandWEEEregulations.TotheextentthatanysuchrulesdifferfromtheRoHSandWEEEregulations,theymayresultinadditionalexpenseforustoredesignandrequalifyourproducts,andmaydelayusfromshippingproductsintosuchjurisdictions.Wemaynotbeabletoprotectourproprietaryinformationandrightsadequately.Werelyonacombinationofpatent,copyrightandtradesecretprotection,nondisclosureagreementsandlicensingarrangementsForm 10-K22toestablish,protectandenforceourproprietaryinformationandrights.Wehaveanumberofpatentsandhaveadditionalapplicationspending.Therecanbenoassurance,however,thatpatentswillbeissuedfromthependingapplicationsorthatanyissuedpatentswillprotectadequatelythoseaspectsofourtechnologytowhichsuchpatentswillrelate.Despiteoureffortstosafeguardandmaintainourproprietaryrights,wecannotbecertainthatwewillsucceedindoingsoorthatourcompetitorswillnotindependentlydeveloporpatenttechnologiesthataresubstantiallyequivalentorsuperiortoourtechnologies.ThelawsofsomecountriesdonotprotectintellectualpropertyrightstothesameextentorinthesamemannerasdothelawsoftheUnitedStates.Additionally,undercertainconditions,theU.S.governmentmightobtainnon-exclusiverightstocertainofourintellectualproperty.Althoughwecontinuetoimplementprotectivemeasuresandintendtodefendourproprietaryrightsvigorously,theseeffortsmaynotbesuccessful.Asubstantialnumberofoursharesareeligibleforfuturesaleandmaydepressthemarketpriceofourcommonstockandmayhinderourabilitytoobtainadditionalfinancing.AsofDecember31,2006,wehadoutstanding:(cid:129)32,236,888sharesofcommonstock;(cid:129)1,334,852sharesofcommonstockissuableuponexerciseofwarrants;(cid:129)3,867,415sharesofcommonstockissuableuponexerciseofoptions,ofwhichoptionstopurchase3,144,887sharesofcommonstockwerethenexercisable;and(cid:129)Notesconvertibleintoanaggregateof4,144,008sharesofcommonstockor,undercertaincircumstancesspecifiedintheindenturegoverningtheNotes,amaximumof5,698,006sharesofcommonstock.Almostallofouroutstandingsharesofcommonstockmaybesoldwithoutsubstantialrestrictions,withcertainexceptionsincluding846,243sharesheldbyBoardmembers,executiveofficersandkeymanagersthatmaybeforfeitedandarerestrictedagainsttransferuntilvested.Inaddition,anaggregateof684,729sharesbeneficiallyownedbyourexecutiveofficersanddirectorsaresubjecttolock-upagreementswiththeunderwritersinconnectionwithourDecember2006publicofferingandcannotbesoldinthepublicmarketuntilMarch14,2007,whichmaybeextendedupto18daysincertainevents.Almostallofthesharesofcommonstockthatmaybeissuedonexerciseofthewarrantsandoptionswillbeavailableforsaleinthepublicmarketwhenissued,subjectinsomecasestovolumeandotherlimitations.ThewarrantsoutstandingatDecember31,2006,consistedofwarrantstopurchase50,000sharesofcommonstock,withanexercisepriceof$6.60pershare,whichhassincebeenexercisedinfull,andwarrantstopurchase1,284,852sharesofcommonstock,withanexercisepriceof$10.12pershare,expiringonJune21,2009.TheNotesarenotnowconvertible,andonlybecomeconvertibleupontheoccurrenceofcertaineventsspecifiedintheindenturegoverningtheNotes.Salesinthepublicmarketofsubstantialamountsofourcommonstock,includingsalesofcommonstockissuableupontheexerciseorconversionofwarrants,optionsandNotes,maydepressprevailingmarketpricesforthecommonstock.Eventheperceptionthatsalescouldoccurmayimpactmarketpricesadversely.Theexistenceofoutstandingwarrants,optionsandNotesmayprovetobeahindrancetoourfuturefinancings.Further,theholdersofwarrants,optionsandNotesmayexerciseorconvertthemforsharesofcommonstockatatimewhenwewouldotherwisebeabletoobtainadditionalequitycapitalontermsmorefavorabletous.Suchfactorscouldimpairourabilitytomeetourcapitalneeds.Wealsohaveauthorized5,000,000sharesofundesignatedpreferredstock,althoughnosharesofpreferredstockcurrentlyareoutstanding.ProvisionsofourRestatedArticlesofIncorporationandBylawscouldmakeaproposedacquisitionthatisnotapprovedbyourBoardofDirectorsmoredifficult.ProvisionsofourRestatedArticlesofIncorporationandBylawscouldmakeitmoredifficultforathirdpartytoacquireus.Theseprovisionscouldlimitthepricethatinvestorsmightbewillingtopayinthefutureforourcommonstock.Forexample,ourRestatedArticlesofIncorporationandBylawsprovidefor:(cid:129)removalofadirectoronlyinlimitedcircumstancesandonlyupontheaffirmativevoteofnotlessthantwo-thirdsofthesharesentitledtovotetoelectdirectors;(cid:129)theabilityofourboardofdirectorstoissuepreferredstock,withoutshareholderapproval,withrightsseniortothoseofthecommonstock;Form 10-K23(cid:129)nocumulativevotingofshares;(cid:129)therightofshareholderstocallaspecialmeetingoftheshareholdersonlyupondemandbytheholdersofnotlessthan30%ofthesharesentitledtovoteatsuchameeting;(cid:129)theaffirmativevoteofnotlessthantwo-thirdsoftheoutstandingsharesentitledtovoteonanamendment,unlesstheamendmentwasapprovedbyamajorityofourcontinuingdirectors,whoaredefinedasdirectorswhohaveeitherservedasadirectorsinceAugust31,1995,orwerenominatedtobeadirectorbythecontinuingdirectors;(cid:129)specialvotingrequirementsformergersandotherbusinesscombinations,unlesstheproposedtransactionwasapprovedbyamajorityofcontinuingdirectors;(cid:129)specialprocedurestobringmattersbeforeourshareholdersatourannualshareholders’meeting;and(cid:129)specialprocedurestonominatemembersforelectiontoourboardofdirectors.Theseprovisionscoulddelay,deferorpreventamerger,consolidation,takeoverorotherbusinesstransactionbetweenusandathirdpartythatisnotapprovedbyourBoardofDirectors.Item1B.UnresolvedStaffCommentsNone.Item2.PropertiesOurprincipalpropertiesasofMarch1,2007,wereasfollows:LocationofPropertyUsesofFacilityApproximateSquareFootageChippewaFalls,WI..................Manufacturing,hardwaredevelopment,centralserviceandwarehouse227,800Seattle,WA........................Executiveoffices,hardwareandsoftwaredevelopment,salesandmarketing59,600MendotaHeights,MN................Softwaredevelopment,salesandmarketing55,300Weown179,000squarefeetofmanufacturing,development,serviceandwarehousespaceinChippewaFalls,Wisconsin,andleasetheremainingspacedescribedabove.Wealsoleaseatotalofapproximately7,100squarefeet,primarilyforsalesandserviceoffices,invariousdomesticlocations.Inaddition,variousforeignsalesandservicesubsidiarieshaveleasedanaggregateofapproximately14,100squarefeetofofficespace.Webelieveourfacilitiesareadequatetomeetourneedsatleastthrough2007.Item3.LegalProceedingsWehavenomaterialpendinglitigation,andwepreviouslyreportedtheterminationofpreviouslitigationinourQuarterlyReportonForm10-QforthequarterendedSeptember30,2006.Item4.SubmissionofMatterstoaVoteofSecurityHoldersNomattersweresubmittedtoavoteofourshareholdersduringthefourthquarterof2006.Form 10-K24ItemE.O.ExecutiveOfficersoftheCompanyOurexecutiveofficers,asofMarch1,2007,wereasfollows:NameAgePositionPeterJ.Ungaro...................38ChiefExecutiveOfficerandPresidentBrianC.Henry...................50ExecutiveVicePresidentandChiefFinancialOfficerChristopherJehn..................63VicePresidentKennethW.Johnson...............64SeniorVicePresident,GeneralCounselandCorporateSecretaryStevenL.Scott...................40SeniorVicePresidentandChiefTechnologyOfficerJanC.Silverman..................56SeniorVicePresidentMargaretA.Williams..............48SeniorVicePresidentOurexecutiveofficersareelectedannuallybytheBoardofDirectorsandserveattheBoard’sdiscretion.Therearenofamilyrelationshipsamonganyofourdirectors,nomineesfordirectorsorexecutiveofficers.PeterJ.UngarohasservedasChiefExecutiveOfficerandasamemberofourBoardofDirectorssinceAugust2005andasPresidentsinceMarch2005;hepreviouslyservedasSeniorVicePresidentresponsibleforsales,marketingandservicessinceSeptember2004andbeforethenservedasVicePresidentresponsibleforsalesandmarketingfromwhenhejoinedusinAugust2003.Priortojoiningus,heservedasVicePresident,WorldwideDeepComputingSalesforIBMsinceApril2003.Priortothatassignment,hewasIBM’svicepresident,worldwideHPCsales,apositionheheldsinceFebruary1999.HealsoheldavarietyofothersalesleadershippositionssincejoiningIBMin1991.Mr.UngaroreceivedaB.A.fromWashingtonStateUniversity.BrianC.HenryjoinedusinMay2005asExecutiveVicePresidentandChiefFinancialOfficer.Hehas20yearsofexperienceasatechnologycompanychieffinancialofficer.Mr.HenryjoinedusafterhavingservedasExecutiveVicePresidentandChiefFinancialOfficerofOnyxSoftwareCorporation,afullsuitecustomerrelationshipmanagementcompany,whichhejoinedin2001.Hepreviouslyservedfrom1999to2001asExecutiveVicePresidentandChiefFinancialOfficerofLanteCorporation,apublicinternetconsultingcompanyfocusedone-marketsandcollaborativebusinessmodels.From1998to1999hewasChiefOperatingOfficer,InformationManagementGroup,ofConvergysCorporation,whichhehelpedspin-offfromCincinnatiBellInc.,adiversifiedservicecompanywhereheservedasExecutiveVicePresidentandChiefFinancialOfficerfrom1993to1998.From1983to1993hewaswithMentorGraphicsCorporationinkeyfinancialmanagementroles,servingasChiefFinancialOfficerfrom1986to1993.Mr.HenryreceivedhisB.S.fromPortlandStateUniversityandanM.B.A.fromHarvardUniversitywherehewasaBakerScholar.ChristopherJehnservesasVicePresidentresponsibleforgovernmentprograms,apositionhehasheldsincejoiningusinJuly2001.HeservedastheAssistantDirectorforNationalSecurityintheCongressionalBudgetOfficefrom1998to2001.From1997to1998,hewasamemberoftheCommissiononServicemembersandVeteransTransitionAssistance,andalsoservedin1997astheExecutiveDirectoroftheNationalDefensePanel.Mr.JehnwasaSeniorVicePresidentatICFKaiserInternational,Inc.,from1995to1997.Priorto1995,heheldexecutivepositionsattheInstituteforDefenseAnalysesandtheCenterforNavalAnalysesandservedasAssistantSecretaryofDefenseforForceManagementandPersonnelfrom1989to1993.HereceivedaB.A.fromBeloitCollegeandaMaster’sfromtheUniversityofChicago.KennethW.JohnsonservesasSeniorVicePresident,GeneralCounselandCorporateSecretary.HehasheldthepositionofGeneralCounselandCorporateSecretarysincejoiningusinSeptember1997.FromSeptember1997toDecember2001healsoservedasVicePresidentFinanceandChiefFinancialOfficerandheagainservedasChiefFinancialOfficerfromNovember2004toMay2005.Priortojoiningus,Mr.JohnsonpracticedlawinSeattlefor20yearswithStoelRivesLLPandpredecessorfirms,wherehispracticeemphasizedcorporatefinance.Mr.JohnsonreceivedanA.B.fromStanfordUniversityandaJ.D.fromColumbiaUniversityLawSchool.StevenL.ScotthasservedasSeniorVicePresidentsinceSeptember2005.Heoriginallyservedasanemployee,havingjoinedCrayResearchin1992,throughmid-July2005,andrejoinedusinSeptember2005.HewasnamedasChiefTechnologyOfficerinOctober2004andthenagaininSeptember2005.Heisresponsiblefordesigningtheintegratedinfrastructurethatwilldriveournextgenerationofsupercomputers.PriortohisForm 10-K25appointmentasChiefTechnologyOfficer,Dr.Scottheldavarietyoftechnologyleadershippositions.HewasformerlythechiefarchitectoftheCrayX1systemandwasinstrumentalinthedesignoftheRedStormsupercomputersystem.Dr.Scottholds17U.S.patentsintheareasofinterconnectionnetworks,cachecoherence,synchronizationmechanisms,andscalableparallelarchitectures.Dr.ScotthasservedonnumerousprogramcommitteesandasanassociateeditorfortheIEEETransactionsonParallelandDistributedSystems,andisanotedexpertinHPCarchitectureandinterconnectionnetworks.In2005hewastherecipientofboththeSeymourCrayComputingAwardfromtheIEEEComputerSocietyandtheMauriceWilkesAwardfromtheAssociationofComputingMachinery.HereceivedhisB.S.inelectricalandcomputingengineering,M.S.incomputerscienceandPh.D.incomputerarchitectureallfromtheUniversityofWisconsinwherehewasaWisconsinAlumniResearchFoundationandHertzFoundationFellow.JanC.SilvermanjoinedusinNovember2005asSeniorVicePresidentresponsibleforcorporatestrategyandbusinessdevelopment.Inthiscapacity,heisresponsibleforourbusinessandmarketingstrategiesandleadsourproductmanagementandmarketingorganizations.Mr.Silvermanhas20yearsofcomputersystemsexperience.From1999to2005heheldseniormarketingpositionsatSGI,includingSeniorVicePresidentStrategicInitiativesfrom2004to2005,SeniorVicePresidentandGeneralManager,IndustrySolutionsandServiceGroupin2003,SeniorVicePresidentWorldwideMarketingfrom2000to2003andVicePresidentProductMarketingresponsibleforservers,storageandgraphicsfrom1999to2000.BeforejoiningSGI,Mr.SilvermanwaswithHewlett-Packardfrom1989to1999,holdingseniorproductmarketingpositionsinHewlett-Packard’sserverandworkstationgroupsandalsoleditsearlyInternetprogramandprocessorstrategy.PriortoHewlett-Packard,hewaswithApolloComputerandLockheedMartininmanagementandresearchanddevelopmentpositions.Mr.SilvermanholdsaB.S.fromRensselaerPolytechnicInstituteandanM.S.incomputersciencefromLehighUniversity.MargaretA.“Peg”WilliamsisSeniorVicePresidentresponsibleforoursoftwareandhardwareresearchanddevelopmentefforts,includingourcurrentandfutureproductsandprojects.Dr.Williams,whohasmorethan20yearsofexperienceintheHPCindustry,joinedusinMay2005.From1997through2005,sheheldvariouspositionswithIBM,includingVicePresidentofDatabaseTechnologyandDirectorandthenVicePresidentofHPCSoftwareandAIXDevelopment.ShealsoledtheusersupportteamattheMauiHighPerformanceComputingCenterfrom1993through1996.From1987through1993,Dr.WilliamsheldvariouspositionsinhighperformancecomputingsoftwaredevelopmentatIBM.Dr.WilliamsholdsaB.S.inmathematicsandphysicsfromUrsinusCollegeandanM.S.inmathematicsandaPh.D.inappliedmathematicsfromLehighUniversity.Form 10-K26PARTIIItem5.MarketfortheCompany’sCommonEquity,RelatedShareholderMattersandIssuerRepurchasesofEquitySecuritiesPriceRangeofCommonStockandDividendPolicyOurcommonstockistradedontheNasdaqNationalMarketunderthesymbolCRAY.OnMarch2,2007,wehad32,397,023sharesofcommonstockoutstandingthatwereheldby726holdersofrecord.Thequarterlyhighandlowsalespricesofourcommonstockfortheperiodsindicatedareasfollows:HighLowYearEndedDecember31,2005:FirstQuarter..........................................................$19.64$8.32SecondQuarter........................................................$11.00$4.72ThirdQuarter.........................................................$5.64$3.40FourthQuarter.........................................................$6.92$3.56YearEndedDecember31,2006:FirstQuarter..........................................................$10.16$5.20SecondQuarter........................................................$10.16$5.88ThirdQuarter.........................................................$14.36$9.95FourthQuarter.........................................................$13.45$8.36Wehavenotpaidcashdividendsonourcommonstockandwedonotanticipatepayinganycashdividendsonourcommonstockintheforeseeablefuture.EquityCompensationPlanInformationThefollowingtableprovidesinformationasofDecember31,2006,withrespecttocompensationplansunderwhichsharesofourcommonstockareauthorizedforissuance,includingplanspreviouslyapprovedbyourshareholdersandplansnotpreviouslyapprovedbyourshareholders.PlanCategoryNumberofSharesofCommonStocktobeIssuedUponExerciseofOutstandingOptions,WarrantsandRightsWeighted-AverageExercisePriceofOutstandingOptions,WarrantsandRightsNumberofSharesofCommonStockAvailableforFutureIssuanceUnderEquityCompensationPlans(ExcludingSharesReflectedin1stColumn)Equitycompensationplansapprovedbyshareholders(1)................3,078,389$15.782,680,895Equitycompensationplansnotapprovedbyshareholders(2).......789,026$10.37112,323Total..........................3,867,415$14.682,793,218(1)Theshareholdersapprovedour1988,1995IndependentDirector,1995,1999and2003stockoptionplans,our2004long-termequitycompensationplan,our2006long-termequitycompensationplanandour2001employeestockpurchaseplan;the1988,the1995IndependentDirectorandthe1995stockoptionplanshavebeenterminatedandnomoreoptionsmaybegrantedunderthoseplans.Pursuanttothesestockoptionplans,incentiveandnonqualifiedoptionsmaybegrantedtoemployees,officers,directors,agentsandconsultantswithexercisepricesatleastequaltothefairmarketvalueoftheunderlyingcommonstockatthetimeofgrant.WhiletheBoardmaygrantoptionswithvaryingvestingperiodsundertheseplans,mostoptionsgrantedtoemployeesvestoverfouryears,with25%oftheoptionsvestingafteroneyearandtheremainingoptionsvestingmonthlyoverthenextthreeyears,andmostoptiongrantstonon-employeedirectorsvestmonthlyoverthetwelvemonthsaftergrant.In2005,thevestingofallemployeestockoptionswithpershareexercisepricesForm 10-K27of$5.88orhigherwasaccelerated;thevestingofstockoptionsgrantedtonon-employeedirectorsandcontractorswasnotaccelerated.Mostoptionsgrantedin2005vestedinfullonorbeforeDecember31,2005.Underthe2004and2006long-termequitycompensationplans,theBoardmaygrantrestrictedandperfor-mancestockgrantsinadditiontoincentiveandnonqualifiedstockoptions.AsofDecember31,2006,undertheseoptionandequitycompensationplansapprovedbyshareholdersunderwhichwemaygrantstockoptions,anaggregateof2,207,605sharesremainedavailableforgrantasoptionsand,undertheoptionandequitycompensationplansapprovedbyshareholdersunderwhichwemaygrantrestrictedandbonusawards,anaggregateof1,522,006shareswereavailableforsuchawards.Underthe2001employeestockpurchaseplan,allemployeesareeligibletoparticipate.EffectiveDecember16,2005,theformulafordeterminingthepurchasepriceofsharesunderthisplanwaschangedto95%ofthefairmarketvalueofourcommonstockonthefourthbusinessdayaftertheendofeachofferingperiod.The2001employeestockpurchaseplancoversatotalof1,000,000shares;atDecember31,2006,wehadissuedatotalof526,710sharesunderthe2001planandhadatotalof473,290sharesavailableforfutureissuance.Thefirsttwocolumnsdonotincludethesharestobeissuedunderthe2001employeestockpurchaseplanfortheofferingperiodthatbeganonDecember16,2006andwillendonMarch15,2007,asneitherthenumberofsharestobeissuedinthatofferingperiodnortheofferingpricearenowdeterminable.(2)Theshareholdersdidnotapprovethe2000non-executiveemployeestockoptionplan.Underthe2000non-executiveemployeestockoptionplanapprovedbytheBoardofDirectorsonMarch30,2000,anaggregateof1,500,000sharespursuanttonon-qualifiedoptionscouldbeissuedtoemployees,agentsandconsultantsbutnottoofficersordirectors.Otherwise,the2000non-executiveemployeestockoptionplanissimilartothestockoptionplansdescribedinfootnote(1)above.AtDecember31,2006,underthe2000non-executiveemployeestockplanwehadoptionsfor731,342sharesoutstandingandoptionsfor112,323sharesavailableforfuturegrant.OnApril1,2004,inconnectionwiththeacquisitionofOctigaBay,subsequentlyrenamedCrayCanadaInc.,weassumedthatcompany’skeyemployeestockoptionplan,includingexistingoptions.OptionscouldbegrantedtoCrayCanadaemployees,directorsandconsultants.OtherwisetheCrayCanadakeyemployeestockoptionplanissimilartothestockoptionplansdescribedinfootnote(1)above.OnMarch8,2006,theCrayCanadaplanwasterminated,whichendedfuturegrantsbutdidnotaffectthenoutstandingoptions.UndertheCrayCanadakeyemployeestockoptionplan,wehad57,684optionsoutstandingasofDecember31,2006.Fromtimetotimewehaveissuedwarrantsascompensationtoconsultantsandothersforserviceswithoutshareholderapproval.AsofDecember31,2006,wehadnosuchwarrantsoutstanding.UnregisteredSalesofSecuritiesWehadnounregisteredsalesofoursecuritiesin2006notpreviouslyreported.IssuerRepurchasesWedidnotrepurchaseanyofourequitysecuritiesinthefourthquarterof2006.Form 10-K28STOCKPERFORMANCEGRAPHThegraphbelowcomparesthecumulativetotalreturntoshareholdersforourcommonstockwiththecomparablereturnoftheNasdaqStockMarket(U.S.companies)IndexandtheNasdaqComputerManufacturerStocksIndex.Thegraphassumesthatashareholderinvested$100inourcommonstockonDecember31,2001,andthatalldividendswerereinvested.Wehaveneverpaidcashdividendsonourcommonstock.Allreturninformationishistoricalandisnotnecessarilyindicativeoffutureperformance.COMPARISONOFCUMULATIVETOTALRETURNAMONGOURCOMMONSTOCK,THENASDAQSTOCKMARKET(U.S.COMPANIES)INDEXANDTHENASDAQCOMPUTERMANUFACTURERSTOCKSINDEXTHROUGHDECEMBER31,20060100200300400500600700800900200620052004200320022001DOLLARSCray Inc.Nasdaq Stock Market (U.S.) Nasdaq Computer Manufacturer Stocks 12/31/0112/31/0212/31/0312/31/0412/30/0512/29/06CrayInc.100.0410.2531.0249.271.1158.8NasdaqStockMarket(U.S.)100.069.1103.4112.5114.9126.2NasdaqComputerManufacturerStocks100.066.392.2120.5123.3126.3Form 10-K29Item6.SelectedFinancialDataThefollowingtablepresentsselectedhistoricalconsolidatedfinancialdataforCrayInc.anditssubsidiaries,whichisderivedfromourauditedconsolidatedfinancialstatements:20022003200420052006YearEndedDecember31,(Inthousands,exceptforpersharedata)OperatingData:Productrevenue......................$76,519$175,004$95,901$152,098$162,795Servicerevenue......................78,55061,95849,94848,95358,222Totalrevenue......................155,069236,962145,849201,051221,017Costofproductrevenue................41,18797,354104,196139,518124,728Costofservicerevenue................42,58140,78030,33829,03232,466Totalcostofrevenue................83,768138,134134,534168,550157,194Grossmargin........................71,30198,82811,31532,50163,823Researchanddevelopment,net..........32,86137,76253,26641,71129,042Salesandmarketing...................20,33227,03834,94825,80821,977Generalandadministrative..............8,92310,90819,45116,14518,785Restructuring,severanceandimpairment...1,8784,0198,1829,7501,251In-processresearchanddevelopmentcharge...........................——43,400——Income(loss)fromoperations...........7,30719,101(147,932)(60,913)(7,232)Otherincome(expense),net.............3,1041,496(699)(1,421)(2,141)Interestincome(expense),net...........(2,832)444365(3,462)(2,095)Income(loss)beforeincometaxes........7,57921,041(148,266)(65,796)(11,468)Provision(benefit)forincometaxes.......2,176(42,207)59,092(1,488)602Netincome(loss)....................$5,403$63,248$(207,358)$(64,308)$(12,070)Netincome(loss)percommonshareBasic..............................$0.45$3.77$(9.95)$(2.91)$(0.53)Diluted............................$0.40$3.25$(9.95)$(2.91)$(0.53)WeightedaverageoutstandingsharesBasic..............................11,99216,77520,84722,12522,849Diluted............................13,60419,46520,84722,12522,849CashFlowData:Cashprovidedby(usedin):Operatingactivities.................$(8,689)$(8,713)$(52,656)$(36,705)$12,608Investingactivities..................(5,992)(41,169)(29,908)41,731(27,372)Financingactivities.................25,33565,07984,153(137)83,909Depreciationandamortization...........15,36415,86017,17919,57816,181Purchasesofpropertyandequipment......6,0386,59912,5183,9822,611Form 10-K3020022003200420052006YearEndedDecember31,(Inthousands,exceptforpersharedata)BalanceSheetData:Cash,cashequivalents,restrictedcashandshort-terminvestments.................$23,916$74,343$87,422$46,026$140,328Workingcapital(a)......................27,351115,81593,61652,204136,324Totalassets...........................145,245291,589310,504273,005337,503Obligationsundercapitalleases............39315282315431Totaldebt............................4,144—80,00080,00080,000Shareholders’equity....................58,615222,633121,96565,947141,374(a)Workingcapitaliscalculatedbysubtractingcurrentliabilitiesfromcurrentassets.Item7.Management’sDiscussionandAnalysisofFinancialConditionandResultsofOperationsForward-LookingStatementsTheinformationsetforthin“Management’sDiscussionandAnalysisofFinancialConditionandResultsofOperations”belowincludes“forward-lookingstatements”withinthemeaningofSection27AoftheSecuritiesActof1933,asamended,andSection21EoftheExchangeAct,andissubjecttothesafeharborcreatedbythoseSections.Factorsthatrealisticallycouldcauseresultstodiffermateriallyfromthoseprojectedintheforward-lookingstatementsaresetforthinthissectionandearlierinthisreportunderItem1A.“RiskFactors,”beginningonpage14.ThefollowingdiscussionshouldalsobereadinconjunctionwiththeConsolidatedFinancialStatementsandaccompanyingNotesthereto.OverviewandExecutiveSummaryWedesign,develop,manufacture,marketandserviceHPCsystems,commonlyknownassupercomputers.Oursupercomputersystemsprovidecapability,capacityandsustainedperformancefarbeyondtypicalserver-basedcomputersystemsandaddresschallengingscientificandengineeringcomputingproblems.Webelievewearewell-positionedtomeettheHPCmarket’sdemandingneedsbyprovidingsuperiorsupercomputersystemswithperformanceandcostadvantageswhensustainedperformanceonchallengingapplicationsandtotalcostofownershiparetakenintoaccount.Wedifferentiateourselvesfromourcompetitorsprimarilybyconcentratingourresearchanddevelopmenteffortsontheprocessing,interconnectandsoftwarecapabilitiesthatenableoursystemstoscale—thatis,tocontinuetoincreaseperformanceasoursystemsgrowinsize.Purpose-builtforthesupercomputermarket,oursystemsbalancehighlycapableprocessors,highlyscalablesoftwareandveryhighspeedinterconnectandcommunicationscapabilities.In2005,ourmanagementchangedsignificantlywithanewchiefexecutiveofficerandnewleadersintechnology,engineering,finance,marketing,operationsandcustomersupport.Underournewmanagementteam,wehaveexpandedourworldwidecustomerbase,refinedourproductroadmap,establishedaloweroperatingcostmodelandsharpenedourfocusonexecutiontomeetcustomerexpectationsandimproveourfinancialoperatingresults.Inearly2006weannouncedourAdaptiveSupercomputingvisiontoexpandtheconceptofhybridcomputingtoafullyintegratedviewofbothhardwareandsoftwaresupportingmultipleprocessingtechnologieswithinasingle,highlyscalablesystem.WebelievethatourNovember2006$250millionawardfromtheDARPAunderitsHPCSprogramvalidatesourAdaptiveSupercomputingvision.Thisawardwillco-fundourCascadedevelopmentprojecttoimplementthisvision.Summaryof2006ResultsRevenueincreasedby$20.0millionor10%in2006from2005duetoa$10.7millionincreaseinproductrevenue,principallyfromCrayXT3systemsales,anda$9.3millionincreaseinservicerevenue.Form 10-K31Lossfromoperationsimprovedtoalossof$7.2millionin2006fromalossof$60.9millionin2005.Theimprovementwasprimarilyduetoa$31.3millionincreaseingrossmarginanda$22.4millionreductioninoperatingexpensesdrivenbylowerresearchanddevelopmentandrestructuring,severanceandimpairmentcosts.Netcashprovidedbyoperationsin2006was$12.6millioncomparedtoauseofcashof$36.7millionin2005.Cashbalances,includingrestrictedcashbalances,increased$94.3millionduring2006andwedidnotborrowamountsunderourlineofcreditagreements.TheincreaseincashbalancesprincipallyresultedfromourpublicstockofferinginDecember2006andcashfromoperations.MarketOverviewandChallengesThemostsignificanttrendinthehighperformancecomputingmarketisthecontinuingexpansionandacceptanceoflow-bandwidthandclustersystemsusingprocessorsmanufacturedbyIntel,AMD,IBMandotherswithcommerciallyavailablecommoditynetworkingandothercomponentsthroughoutthehighperformancecomputingmarket,especiallyincapacitycomputingsituations.Thesesystemsmayofferhighertheoreticalpeakperformanceforequivalentcost,andvendorsofsuchsystemsoftenputpricingpressureonusincompetitiveprocurements,evenattimesincapabilitymarketprocurements.Tocompeteagainstthesesystemsinthelongerterm,weneedtoincorporategreaterperformancedifferen-tiationacrossourproducts.Webelievewewillhavesuchdifferentiationthroughournewvector-basedproductbeingdevelopedinourBlackWidowprojectandournewmultithreadedCrayXMTsystem.Theseproducts,whichfocusinitiallyonanarrowermarketthanourcommodityprocessorproducts,areexpectedtobeavailableinlate2007.Oneofourchallengesistobroadenthemarketsfortheseproducts.Wemustaddgreaterperformancedifferentiationtoourhigh-bandwidthmassivelyparallelcommodityprocessor-basedproducts,suchastheCrayXT4andsuccessorsystems,whilebalancingthebusinessstrategytrade-offsbetweenusingcommodityparts,whichareavailabletoourcompetitors,andproprietarycomponents,whicharebothexpensiveandtime-consumingtodevelop.OurStrategyOurgoalistobecometheleadingproviderofsupercomputersinthemarketsthatwetarget.Keyelementsofourstrategyinclude:GainShareinOurCoreHPCMarket.Weintendtoleverageourstrongproductportfolio,productroadmapandbrandrecognitioninthehighendoftheHPCmarkettogainmarketshare.WebelievethatmostofourcompetitorsareprimarilyfocusedonthelowerendoftheHPCmarketwherelow-bandwidthclustersystemsdominate.WeplantoremainfocusedonthecapabilityandenterprisesegmentsoftheHPCmarket.MaintainFocusonExecutionandProfitability.Wearecommittedtoachievingsustainedprofitabilityonanannualbasis.Weintendtocontinuetorefineourproductroadmap,convergeourtechnologiesanddevelopmentprocesses,improveourabilitytodeliverhighqualityproductsontimeandonbudgetandcontinueourcommitmenttofinancialdiscipline.ExtendTechnologyLeadership.Weareaninnovationdrivencompanyinatechnologydrivenmarket.Weplantomaintainatechnologyleadershippositionbyinvestinginresearchanddevelopmentandpartneringwithkeycustomerswithinterestsalignedstronglywithours.Wewillrelyinpartongovernmentfundingforourresearchanddevelopmentefforts.WeintendtoexecuteonourproductroadmapandimplementourAdaptiveSupercomputingvisiontorealizetheconceptofsupportingmultipleprocessingtechnologieswithinasingle,highlyscalableLinux-basedsystem.ExpandTotalAddressableMarket.Overtime,weintendtoleverageourtechnologies,customerbaseandCraybrandinnewsegmentsandexpandouraddressablemarket.WebelievewehavetheopportunitytocompeteinabroaderportionoftheHPCmarketaswellasselectivemarketsoutsideofHPC.Form 10-K32KeyPerformanceIndicatorsOurmanagementmonitorsandanalyzesseveralkeyperformanceindicatorsinordertomanageourbusinessandevaluateourfinancialandoperatingperformance,including:Revenue.Productrevenuegenerallyconstitutesthemajorportionofourrevenueinanyreportingperiod,andforthereasonsdiscussedelsewhereinthisAnnualReportonForm10-Kissubjecttosignificantvariabilityfromperiodtoperiod.Intheshortterm,wecloselyreviewthestatusofproductshipments,installationsandacceptancesinordertoforecastrevenueandcashreceipts;longer-term,wemonitorthestatusofthepipelineofproductsalesopportunitiesandproductdevelopmentcycles.Revenuegrowthisthebestindicatorofwhetherweareachievingourobjectiveofincreasedmarketshareinthemarketsweaddress.Ournewproductsscheduledfor2007andourlonger-termAdaptiveSupercomputingvisionareeffortstoincreaseproductrevenue.Productrevenuevariessignificantlyfromquartertoquarter.Servicerevenueismoreconstantintheshortrunandassists,inpart,tooffsettheimpactthatthevariabilityinproductrevenuehasontotalrevenue.Grossmargins.Ouroverallproductmarginsin2006were23%.Afteradjustingfortheeffectofourlow-marginRedStormandDARPAPhaseIIdevelopmentprojects,whichwereincludedasproductrevenue,overallproductmarginswere26%.Tobesuccessful,weneedtoincreaseproductgrossmargins,whichwebelieveisbestachievedthroughincreasedproductdifferentiation.Wealsomonitorservicemarginsandhavebeenproactiveinreducingservicecostswherepossible.Ourmid-termobjectiveistoachieveoverallmargins,asapercentageofrevenue,from35%to40%orbetter.Recentincreasesingrossmarginshaveledtoimprovedoperationalresults.Operatingexpenses.Ouroperatingexpensesaredrivenlargelybyheadcount,contractedresearchanddevelopmentservicesandthelevelofco-fundedresearchanddevelopment.Wehadtwomajorheadcountreductionsin2005.Aspartofourongoingeffortstocontroloperatingexpenses,wemonitorheadcountlevelsinspecificgeographicandoperationalareas.During2006wereceivedincreasedlevelsofco-fundingforourresearchanddevelopmentprojects.OurNovember2006DARPAPhaseIIIawardisinlinewithourlong-termdevelopmentpath.Thisawardlikelywillresultinsomeincreaseingrossandnetresearchanddevelopmentexpendituresbyusinfutureperiodsduetothesizeoftheoverallprogramandthecost-sharingrequirementonourpart.Ouroveralloperatingexpensessignificantlydecreasedin2006comparedto2005,especiallyinresearchanddevelopment.Our2006operatingexpenses,excludingcostofrevenue,asapercentofrevenuewere32%,comparedto46%in2005.Ourmid-termobjectiveisforoperatingexpenses,asapercentageofrevenue,tobeintherangeof25%to30%.Meetingthisobjectiveisdependentonourabilitytoincreaserevenueinthefuture.Liquidityandcashflows.Duetothevariabilityinproductrevenue,ourcashpositionalsovariesfromquartertoquarterandwithinaquarter.Wecloselymonitorourexpectedcashlevels,particularlyinlightofpotentialincreasedinventorypurchasesforlargesysteminstallationsandtheriskofdelaysinproductshipmentsandacceptancesand,longer-term,inproductdevelopment.OurDecember2006commonstockofferingisconsistentwithourgoaltobuildourcashpositiontoprovideadditionalworkingcapitalandtoimproveouroperationalandstrategicflexibilitywhileatthesametimeloweringthebusinessrisktoshareholders.Sustainedprofitabilityoverannualperiodsisourprimaryobjective,whichshouldimproveourcashpositionandshareholdervalue.CriticalAccountingPoliciesandEstimatesThisdiscussionaswellasdisclosuresincludedelsewhereinthisAnnualReportonForm10-Karebaseduponourconsolidatedfinancialstatements,whichhavebeenpreparedinaccordancewithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica(“U.S.GAAP”).Thepreparationofthesefinancialstatementsrequiresustomakeestimatesandjudgmentsthataffectthereportedamountsofassets,liabilities,revenueandexpenses,andrelateddisclosureofcontingencies.InpreparingourfinancialstatementsinaccordancewithU.S.GAAP,therearecertainaccountingpoliciesthatareparticularlyimportant.Theseincluderevenuerecognition,inventoryvaluation,goodwillandintangibleassets,incometaxes,accountingforlosscontractsandstock-basedcompensation.WebelievetheseaccountingpoliciesandotherssetforthinNote3—SummaryofSignificantAccountingPoliciesoftheNotestoConsolidatedFinancialStatementsshouldbereviewedastheyareintegraltounderstandingourresultsofoperationsandfinancialcondition.Insomecases,thesepoliciesrepresentrequiredaccounting.Inothercases,theymayrepresentachoicebetweenacceptableaccountingmethodsormayrequiresubstantialjudgmentorestimation.Form 10-K33Additionally,weconsidercertainjudgmentsandestimatestobesignificant,includingthoserelatingtothefairvaluedeterminationusedinrevenuerecognition,percentageofcompletionaccountingontheRedStormcontract,estimatesofproportionalperformanceonco-fundedengineeringcontracts,determinationofinventoryatthelowerofcostormarket,usefullivesfordepreciationandamortization,determinationoffuturecashflowsassociatedwithimpairmenttestingforgoodwillandlong-livedassets,determinationofthefairvalueofstockoptionsandassessmentsoffairvalue,estimationofrestructuringcosts,calculationofdeferredincometaxassets,potentialincometaxassessmentsandothercontingencies.Webaseourestimatesonhistoricalexperience,currentconditionsandonotherassumptionsthatwebelievetobereasonableunderthecircumstances.Actualresultsmaydifferfromtheseestimatesandassumptions.OurmanagementhasdiscussedtheselectionofsignificantaccountingpoliciesandtheeffectofjudgmentsandestimateswiththeAuditCommitteeofourBoardofDirectors.RevenueRecognitionWerecognizerevenuewhenitisrealizedorrealizableandearned.InaccordancewiththeSecuritiesandExchangeCommissionStaffAccountingBulletin(“SAB”)No.104,RevenueRecognitioninFinancialStatements,weconsiderrevenuerealizedorrealizableandearnedwhenwehavepersuasiveevidenceofanarrangement,theproducthasbeenshippedortheserviceshavebeenprovidedtoourcustomer,thesalespriceisfixedordeterminable,nosignificantunfulfilledobligationsexistandcollectibilityisreasonablyassured.WerecordrevenueinourStatementsofOperationsnetofanysales,use,valueaddedorcertainexcisetaxesimposedbygovernmentalauthoritiesonspecificsalestransactions.Inadditiontotheaforementionedgeneralpolicy,thefollowingarethespecificrevenuerecognitionpoliciesforeachmajorcategoryofrevenueandformultiple-elementarrangements.Products.Werecognizerevenuefromourproductlinesasfollows:(cid:129)CrayX1/X1EandCrayXT3/XT4ProductLines.Werecognizerevenuefromproductsalesuponcustomeracceptanceofthesystem,whenwehavenosignificantunfulfilledobligationsstipulatedbythecontractthataffectthecustomer’sfinalacceptance,thepriceisfixedordeterminableandcollectionisreasonablyassured.Acustomer-signednoticeofacceptanceorsimilardocumentisrequiredfromthecustomerpriortorevenuerecognition.(cid:129)CrayXD1ProductLine.WerecognizerevenuefromproductsalesofCrayXD1systemsuponshipmentto,ordeliveryto,thecustomer,dependinguponcontractterms,whenwehavenosignificantunfulfilledobligationsstipulatedbythecontract,thepriceisfixedordeterminableandcollectionisreasonablyassured.Ifthereisacontractualrequirementforcustomeracceptance,revenueisrecognizeduponreceiptofthenoticeofacceptanceandwhenwehavenounfulfilledobligations.Revenuefromcontractsthatrequireustodesign,develop,manufactureormodifycomplexinformationtechnologysystemstoacustomer’sspecificationsisrecognizedusingthepercentageofcompletionmethodforlong-termdevelopmentprojectsunderAmericanInstituteofCertifiedPublicAccountants(“AICPA”)StatementofPosition81-1,AccountingforPerformanceofConstruction-TypeandCertainProduction-TypeContracts.Percentageofcompletionismeasuredbasedontheratioofcostsincurredtodatecomparedtothetotalestimatedcosts.Totalestimatedcostsarebasedonseveralfactors,includingestimatedlaborhourstocompletecertaintasksandtheestimatedcostofpurchasedcomponentsorservices.Estimatesmayneedtobeadjustedfromquartertoquarter,whichwouldimpactrevenueandmarginsonacumulativebasis.Totheextenttheestimateoftotalcoststocompletethecontractindicatesaloss,suchamountisrecognizedinfullintheperiodthatthedeterminationismade.Services.Maintenanceservicesareprovidedunderseparatemaintenancecontractswithourcustomers.Thesecontractsgenerallyprovideformaintenanceservicesforoneyear,althoughsomeareformulti-yearperiods,oftenwithprepaymentsforthetermofthecontract.Weconsiderthemaintenanceperiodtocommenceuponinstallationandacceptanceoftheproduct,whichmayincludeawarrantyperiod.Weallocateaportionofthesalespricetomaintenanceservicerevenuebasedonestimatesoffairvalue.Revenueforthemaintenanceofcomputersisrecognizedratablyoverthetermofthemaintenancecontract.Maintenancecontractsthatarepaidinadvancearerecordedasdeferredrevenue.WeconsiderfiscalfundingclausesascontingenciesfortherecognitionofrevenueForm 10-K34untilthefundingisvirtuallyassured.RevenuefromCrayTechnicalServicesisrecognizedastheservicesarerendered.Multiple-ElementArrangements.Wecommonlyenterintotransactionsthatincludemultiple-elementarrangements,whichmayincludeanycombinationofhardware,maintenanceandotherservices.InaccordancewithEmergingIssuesTaskForceIssueNo.00-21,RevenueArrangementswithMultipleDeliverables,whensomeelementsaredeliveredpriortoothersinanarrangementandallofthefollowingcriteriaaremet,revenueforthedeliveredelementisrecognizedupondeliveryandacceptanceofsuchitem:(cid:129)Theelementcouldbesoldseparately;(cid:129)Thefairvalueoftheundeliveredelementisestablished;and(cid:129)Incaseswithanygeneralrightofreturn,ourperformancewithrespecttoanyundeliveredelementiswithinourcontrolandprobable.Ifallofthecriteriaarenotmet,revenueisdeferreduntildeliveryofthelastelementastheelementswouldnotbeconsideredaseparateunitofaccountingandrevenuewouldberecognizedasdescribedaboveunderourproductlineorservicerevenuerecognitionpolicies.Weconsiderthemaintenanceperiodtocommenceuponinstallationandacceptanceoftheproduct,whichmayincludeawarrantyperiodandaccordinglyallocateaportionofthesalespriceasaseparatedeliverablewhichisrecognizedasservicerevenueovertheentireserviceperiod.InventoryValuationWerecordourinventoryatthelowerofcostormarket.Weregularlyevaluatethetechnologicalusefulnessandanticipatedfuturedemandofourinventorycomponents.Duetorapidchangesintechnologyandtheincreasingdemandsofourcustomers,wearecontinuallydevelopingnewproducts.Additionally,duringperiodsofproductorinventorycomponentupgradesortransitions,wemayacquiresignificantquantitiesofinventorytosupportestimatedcurrentandfutureproductionandservicerequirements.Forexample,wehaveplacedalast-timebuyorderonakeycomponentforourCrayXT4andCrayXMTsystemsandBlackWidowproject.Asaresult,itispossiblethatolderinventoryitemswehavepurchasedmaybecomeobsolete,besoldbelowcostorbedeemedinexcessofquantitiesrequiredforproductionorservicerequirements.Whenwedetermineitisnotlikelywewillrecoverthecostofinventoryitemsthroughfuturesales,wewritedowntherelatedinventorytoourestimateofitsmarketvalue.WearenearingtheendofthelifecyclefortheCrayXT3systemandhavemadecertainestimatesofthefuturedemandforthisproduct.Theseestimatesaresubjecttoriskintheneartermandcouldrequireawrite-downofinventoryiftheactualdemandislowerthancurrentlyestimated.During2006,wewrote-offapproximately$1.3millionofCrayXT3inventorydeemedinexcessofcurrentdemand.Becausetheproductswesellhavehighaveragesalespricesandcompetitiveproductlivesofgenerallyonetotwoyears,andbecauseahighnumberofourprospectivecustomersreceivefundingfromU.S.orforeigngovernments,itisdifficulttoestimatefuturesalesofourproductsandthetimingofsuchsales.Italsoisdifficulttodeterminewhetherthecostofourinventorieswillultimatelyberecoveredthroughfuturesales.Whilewebelieveourinventoryisstatedatthelowerofcostormarketandthatourestimatesandassumptionstodetermineanyadjustmentstothecostofourinventoriesarereasonable,ourestimatesmayprovetobeinaccurate.Wehavesoldinventorypreviouslyreducedinpartorinwholetozero,andwemayhavefuturesalesofpreviouslywrittendowninventory.Wealsomayhaveadditionalexpensetowritedowninventorytoitsestimatedmarketvalue.Adjustmentstotheseestimatesinthefuturemaymateriallyimpactouroperatingresults.GoodwillandOtherIntangibleAssetsApproximately17%ofourtotalassetsasofDecember31,2006consistedofgoodwillresultingfromouracquisitionoftheCrayResearchbusinessunitassetsfromSGIin2000andouracquisitionofOctigaBayinApril2004.Wenolongeramortizegoodwillassociatedwiththeseacquisitions,butwearerequiredtoconductperiodicanalysesoftherecordedamountofgoodwillincomparisontoitsestimatedfairvalue.Wecurrentlyhaveoneoperatingsegmentandreportingunit.Assuch,weevaluateanypotentialgoodwillimpairmentbycomparingournetassetsagainstthemarketvalueofouroutstandingsharesofcommonstock.WeperformedanannualimpairmenttesteffectiveJanuary1,2007,anddeterminedthatourrecordedgoodwillwasnotimpaired.Form 10-K35Theanalysisofwhetherthefairvalueofrecordedgoodwillisimpairedandthenumberandnatureofourreportingunitsinvolvesasubstantialamountofjudgment.Futurechargesrelatedtotheamountsrecordedforgoodwillcouldbematerialdependingonfuturedevelopmentsandchangesintechnologyandourbusiness.Inconnectionwithour2004acquisitionofOctigaBay,weassigned$6.7millionofvaluetocoretechnology.InDecember2005weannouncedplanstofurtherintegrateourtechnologyplatforms,andcombinetheCrayXD1andtheCrayXT3productsintoaunifiedproductoffering.Wedeterminedthatthecoretechnologyassetwasimpairedandrecordedachargeof$4.9millionchargein2005to“Restructuring,SeveranceandImpairment”intheConsolidatedStatementsofOperations.Inconnectionwiththischarge,wereversedtheremainingdeferredtaxliabilityof$1.5millionthatwasestablishedinthepurchaseaccountingasamortizationofthisintangibleassetwasnotdeductibleforincometaxpurposes.AccountingforIncomeTaxesDeferredtaxassetsandliabilitiesaredeterminedbasedondifferencesbetweenfinancialreportingandtaxbasesofassetsandliabilitiesandoperatinglossandtaxcreditcarryforwardsandaremeasuredusingtheenactedtaxratesandlawsthatwillbeineffectwhenthedifferencesandcarryforwardsareexpectedtoberecoveredorsettled.InaccordancewithStatementofFinancialAccountingStandards(“FAS”)No.109,AccountingforIncomeTaxes(“FAS109”),avaluationallowancefordeferredtaxassetsisprovidedwhenweestimatethatitismorelikelythannotthatalloraportionofthedeferredtaxassetsmaynotberealizedthroughfutureoperations.Thisassessmentisbaseduponconsiderationofavailablepositiveandnegativeevidence,whichincludes,amongotherthings,ourmostrecentresultsofoperationsandexpectedfutureprofitability.Weconsiderouractualhistoricalresultstohavestrongerweightthanothermoresubjectiveindicatorswhenconsideringwhethertoestablishorreduceavaluationallowanceondeferredtaxassets.Theprovisionfororbenefitfromincometaxesrepresentstaxespayableorreceivableforthecurrentperiodplusthenetchangeindeferredtaxassetsandliabilitiesandvaluationallowanceamountsduringtheperiod.In2003,wereversed$58.0millionofthevaluationallowanceagainstdeferredtaxassets,principallyU.S.losscarryfor-wards,basedprimarilyuponourconsiderationofourmostrecentprofitableoperatingperformanceaswellasourreasonablyexpectedfutureperformance.Baseduponourjudgmentofthepositiveandnegativeevidence,weconcludedthatwewouldmorelikelythannotbeabletoutilizemostofournetdeferredtaxasset.Inlate2004,weestablishedavaluationallowanceandrecordedanincometaxexpenseof$58.9millionbasedonourlossesfromoperationsin2004andbasedonourrevisedprojectionsindicatingcontinuedchallengingfinancialresults.Baseduponourmostrecentnegativeoperatingresults,whichweconsiderasastrongindicatorofourfutureabilitytoutilizeourdeferredtaxassets,weestablishedavaluationallowanceoncertaindeferredtaxassets,principallyU.S.losscarryforwards,createdduring2006inaccordancewithFAS109.AsofDecember31,2006,wehadapproximately$140.7millionofdeferredtaxassets,againstwhichweprovideda$140.0millionvaluationallowance.Thenetdeferredtaxassetsweregeneratedinforeignjurisdictionswherewebelieveitismorelikelythannotthatwewillrealizetheseassetsthroughfutureoperations.FortheyearsendedDecember31,2006,and2005werecognizedincometaxexpenseof$602,000andincometaxbenefitof$1.5million,respectively.Incometaxexpenseinallperiodswasrelatedtotaxesinforeignandcertainstateandlocaljurisdictions.AccountingforLossContractsInaccordancewithourrevenuerecognitionpolicy,certainproductioncontractsareaccountedforusingthepercentageofcompletionaccountingmethod.Werecognizerevenuebasedonameasurementofcompletioncomparingtheratioofcostsincurredtodatewithtotalestimatedcostsmultipliedbythecontractvalue.Inherentintheseestimatesareuncertaintiesaboutthetotalcosttocompletetheproject.Iftheestimatetocompleteresultsinalossonthecontract,wewillrecordtheamountoftheestimatedlossintheperiodthedeterminationismade.Onaregularbasis,weupdateourestimatesoftotalcosts.Changestotheestimatemayresultinachargeorbenefittooperations.AsofDecember31,2006,ourestimateoflossontheRedStormcontractwasconsistentwithourestimateofsuchlossasofDecember31,2005,whichwasacumulativelossof$15.3million,allofwhichwasrecordedinpriorperiods.AsofDecember31,2006and2005,theRedStormlosscontractaccrualbalancewasForm 10-K36$157,000and$5.7million,respectively,andisincludedin“Otheraccruedliabilities”inourConsolidatedBalanceSheets.ResearchandDevelopmentExpensesResearchanddevelopmentcostsincludecostsincurredinthedevelopmentandproductionofourhardwareandsoftware,costsincurredtoenhanceandsupportexistingsoftwarefeaturesandexpensesrelatedtofutureproductdevelopment.Researchanddevelopmentcostsareexpensedasincurred,andmaybeoffsetbyco-fundingfromtheU.S.government.Amountstobereceivedunderco-fundingarrangementswiththeU.S.governmentarebasedoneithercontractualmilestonesorcostsincurred.Theseco-fundingmilestonepaymentsarerecognizedasanoffsettoresearchanddevelopmentexpensesasperformanceisestimatedtobecompletedandismeasuredasmilestoneachievementsorascostsareincurred.WedonotrecordareceivablefromtheU.S.governmentpriortocompletingtherequirementsnecessarytobillforamilestoneorcostreimbursement.FundingfromtheU.S.governmentissubjecttocertainbudgetrestrictionsandassuch,theremaybeperiodsinwhichresearchanddevelopmentcostsareexpensedasincurredforwhichnoreimbursementisrecorded,asmilestoneshavenotbeencompletedortheU.S.governmenthasnotfundedanagreement.Weclassifyamountstobereceivedfromfundedresearchanddevelopmentprojectsaseitherrevenueorareductiontoresearchanddevelopmentexpense,basedonthespecificfactsandcircumstancesofthecontractualarrangement,consideringtotalcostsexpectedtobeincurredcomparedtototalexpectedfundingandthenatureoftheresearchanddevelopmentcontractualarrangement.Intheeventthataparticulararrangementisdeterminedtorepresentrevenue,thecorrespondingresearchanddevelopmentcostsareclassifiedascostofrevenue.Share-BasedCompensationOnJanuary1,2006,weadoptedthefairvaluerecognitionprovisionsofFAS123R.PriortoJanuary1,2006,weaccountedforshare-basedpaymentsundertherecognitionandmeasurementprovisionsofAPBOpinionNo.25,AccountingforStockIssuedtoEmployees(“APB25”),andrelatedInterpretations,aspermittedbyFASNo.123,AccountingforStock-BasedCompensation(“FAS123”).InaccordancewithAPB25,nocompensationcostwasrequiredtoberecognizedforoptionsgrantedthathadanexercisepriceequaltothemarketvalueoftheunderlyingcommonstockonthedateofgrant.CertainofthestockoptionsgrantedinconnectionwiththeOctigaBayacquisitionin2004hadexercisepricesbelowthefairmarketvalueofourcommonstockatthegrantdateandaccordinglywehaverecordedcompensationexpenseoverthevestingperiodbasedontheintrinsicvaluemethod.WeadoptedFAS123Rusingthemodified-prospectivetransitionmethod.Underthattransitionmethod,compensationcostrecognizedfortheyearendedDecember31,2006,includes:(a)compensationcostforallshare-basedpaymentsgrantedpriorto,butnotyetvested,asofJanuary1,2006,basedonthegrant-datefairvalueestimatedinaccordancewiththeoriginalprovisionsofFAS123,and(b)compensationcostforallshare-basedpaymentsgrantedsubsequenttoJanuary1,2006,basedonthegrant-datefairvalueestimatedinaccordancewiththeprovisionsofFAS123R.Thefinancialresultsforthepriorperiodshavenotbeenrestated.EstimatesoffairvalueofstockoptionsarebasedupontheBlack-Scholesoptionpricingmodel.Weutilizeassumptionsrelatedtostockpricevolatility,stockoptiontermandforfeitureratesthatarebaseduponbothhistoricalfactorsaswellasmanagement’sjudgment.RecentAccountingPronouncementsInJune2006,theFASBissuedInterpretationNo.48,AccountingforUncertaintyinIncomeTaxes(“FIN48”).FIN48clarifiestheaccountingforuncertaintyinincometaxesandprescribesarecognitionthresholdandmeasurementattributeforthefinancialstatementrecognitionandmeasurementofataxpositiontakenorexpectedtobetakeninataxreturn.FIN48iseffectiveforfiscalyearsbeginningafterDecember15,2006.WedonotexpecttheadoptionofFIN48tobesignificantbutitwillrequireustoprovideadditionaldisclosuresabouttaxuncertainties.Form 10-K37InSeptember2006,theFASBissuedFASNo.157,FairValueMeasurements(“FAS157”).FAS157definesfairvalue,establishesaframeworkformeasuringfairvalueandexpandsdisclosuresaboutfairvaluemeasurementsbutdoesnotrequireanynewfairvaluemeasurements.FAS157iseffectiveforfinancialstatementsissuedforfiscalyearsbeginningafterNovember15,2007,andinterimperiodswithinthosefiscalyears.WedonotexpecttheadoptionofFAS157tohaveasignificantimpactonourfinancialstatements.InSeptember2006,theFASBissuedFASNo.158,Employers’AccountingforDefinedBenefitPensionandOtherPostretirementPlans(“FAS158”).FAS158requiresanemployertorecognizetheoverfundedorunder-fundedstatusofadefinedbenefitpostretirementplan(otherthanamultiemployerplan)asanassetorliabilityinitsbalancesheetandtorecognizechangesinthatfundedstatusintheyearinwhichthechangesoccurthroughcomprehensiveincome.WeadoptedFAS158asofDecember31,2006,andthisadoptiondidnothaveamaterialimpactonourfinancialposition.InFebruary2007,theFASBissuedFASNo.159,TheFairValueOptionforFinancialAssetsandFinancialLiabilities,(“FAS159”).FAS159permitsentitiestochoosetomeasuremanyfinancialinstrumentsandcertainotheritemsatfairvalue.Theobjectiveistoimprovefinancialreportingbyprovidingentitieswiththeopportunitytomitigatevolatilityinreportedearningscausedbymeasuringrelatedassetsandliabilitiesdifferentlywithouthavingtoapplycomplexhedgeaccountingprovisions.FAS159iseffectiveforfinancialstatementsissuedforfiscalyearsbeginningafterNovember15,2007.WehavenotyetdeterminedtheimpactofadoptingFAS159onourfinancialstatements.ResultsofOperationsRevenueandGrossMarginsOurproductandservicerevenuefortheindicatedyearsendedDecember31were(inthousands,exceptforpercentages):200420052006YearEndedDecember31,Productrevenue....................................$95,901$152,098$162,795Less:Costofproductrevenue..........................104,196139,518124,728Productgrossmargin................................$(8,295)$12,580$38,067Productgrossmarginpercentage........................(9)%8%23%Servicerevenue....................................$49,948$48,953$58,222Less:Costofservicerevenue..........................30,33829,03232,466Servicegrossmargin................................$19,610$19,921$25,756Servicegrossmarginpercentage........................39%41%44%Totalrevenue......................................$145,849$201,051$221,017Less:Totalcostofrevenue............................134,534168,550157,194Totalgrossmargin..................................$11,315$32,501$63,823Totalgrossmarginpercentage.........................8%16%29%ProductRevenueProductrevenuein2006increased$10.7million,or7%,over2005duetoincreasedsalesofCrayXT3systemswhichoffsetsalesdecreasesofCrayX1EandCrayXD1systems.RevenuefromtheDARPAPhaseIIandRedStormdevelopmentprojectstotaled$21.4millionin2006comparedto$22.1millionin2005.Theincreasein2005productrevenueover2004levelswasduetoincreasedsalesofallthreeofourprincipalproducts,theCrayX1E,theCrayXT3andtheCrayXD1systems.In2005werecordedapproximately$22.1millioninproductrevenuefromtheDARPAPhaseIIandRedStormdevelopmentprojectswhichwasareductionofForm 10-K38$27.4millioncomparedto2004duetoreducedexpendituresandassociatedrevenue,inparticularontheRedStormdevelopmentproject.Forthefullyear2007,weexpectstrongproductsalesgrowth,offsetinpartbyanearly$20millionreductioninlowmargindevelopment-relatedprojectrevenue.The2007revenuelevelisdependentonthesuccessoftheCrayXT4systemandthetimingandsuccessoftheCrayXMTandBlackWidowsystems.TheCrayXT4systemiscurrentlyavailablewithanupgradetoquad-coreprocessorsandsystemsoftwareexpectedtobeavailableinthesecondhalfof2007whiletheCrayXMTandBlackWidowsystemsarenotexpectedtoreachgeneralavailabilityuntillate2007.ServiceRevenueServicerevenuefor2006increased$9.3million,or19%,over2005,duetoagrowthinmaintenancerevenuefromnewcontractsandrevenuefromCrayTechnicalServices.Servicerevenuein2005decreasedslightlyfrom2004duetolowerrevenueonmaintenancecontractsasoldersystemswerewithdrawnfromservice.RevenuefromCrayTechnicalServicesin2005increasedby$2.8millionfrom$3.7millionin2004dueprincipallytoaservicecontracttorefurbishcertaincomponentsforacustomer.Whileweexpectourmaintenanceservicerevenuetostabilizeoverthenextyear,wemayhaveperiodicrevenueandmargindeclinesasourolder,highermarginservicecontractsend.Ournewerproductswilllikelyrequirelesshardwaremaintenanceandthereforegeneratelessmaintenancerevenuethanourhistoricvectorsystems.Overallservicerevenuemaydeclinein2007duetotheendofaCrayTechnicalServicesrefurbishmentcontractin2006.ProductGrossMarginProductgrossmarginimproved15percentagepointsfor2006comparedto2005.Thisimprovementinproductgrossmarginwasduetoincreasedgrossmarginsacrossallproductlines,includinglowerchargesforexcessandobsoleteinventoryandnoamortizationofcoretechnologyintangibleassetsthatwerewrittenoffduringthefourthquarterof2005.Additionally,grossmarginsfor2005werenegativelyimpactedbya$7.7millionlossontheRedStormproject.Productgrossmarginin2005,althoughimprovedcomparedto2004,wasimpactedbyseveralfactors,includinghighersalesofthelowermarginCrayXD1product,a$7.7millionchargeforachangeintheestimatetocompletetheRedStormprojectdueprincipallytotheadditionofhardwaredeliverablestosettlecontractandperformanceissues,and$5.8millionofchargesforinventorywrite-downs,whichincludedscrapandobsoleteinventory.TheRedStormandDARPAPhasesIandIIresearchanddevelopmentcosts,totaling$19.8million,$28.6millionand$57.3millionin2006,2005and2004,respectively,arereflectedonourfinancialstatementsascostofproductrevenueandtherelatedreimbursementsarerecordedinourfinancialstatementsasproductrevenue.Excludingtheselowmargindevelopmentprojects,productgrossmarginwouldhavebeen26%,15%and(1%),respectively.Revenuefor2006,2005and2004included$256,000,$2.1millionand$498,000,respectively,fromthesaleofobsoleteinventoryrecordedatazerocostbasis.In2005,thisamountconsistedmainlyofthesaleofarefurbishedCrayT3Esupercomputer,oneofourlegacysystems.Withminimallow-margin,development-relatedproductrevenueexpectedin2007andtheexpectedbenefitofthreenewproductintroductions,overallproductgrossmarginsshouldincreasein2007ascomparedto2006.ServiceGrossMarginServicegrossmarginimproved3percentagepointsin2006comparedto2005duetotheincreasesinmaintenanceandCrayTechnicalServicesrevenuewhileincreasingcostsatalowerrate.Inboth2005and2004,ourservicegrossmarginwasfavorablyimpactedbyhighmarginCrayTechnicalServicescontracts,servicecostreductionsimplementedinthefourthquarterof2003andthesecondhalfofbothForm 10-K392004and2005,andtheloweramortizationexpenseoflegacysparepartsinventory,offsetin2005inpartbyincreasedcostsincurredtoachievecustomeracceptancesoflargeCrayXT3systems.Servicegrossmarginpercentagefor2007isexpectedtodecreasesomewhatfrom2006levelsasrevenuefromcertainhighmarginCrayTechnicalServicescontractsisexpectedtodecrease,andweexpecttoincuradditionalcostsassociatedwithexpandingourCrayTechnicalServicesofferings.OperatingExpensesResearchandDevelopmentResearchanddevelopmentexpensesfortheindicatedyearsendedDecember31wereasfollows(inthousands):200420052006December31,Grossresearchanddevelopmentexpenses..................$98,843$96,257$99,061Less:Amountsincludedincostofproductrevenue...........(22,970)(19,724)(17,012)Less:Reimbursedresearchanddevelopment(excludesamountsinrevenue).......................................(22,607)(34,822)(53,007)Netresearchanddevelopmentexpenses...................$53,266$41,711$29,042Percentageoftotalrevenue...........................37%21%13%Grossresearchanddevelopmentexpensesinthetableabovereflectallresearchanddevelopmentexpendi-tures,includingexpensesrelatedtoourresearchanddevelopmentactivitiesontheRedStormandDARPAPhasesI,IIandIIIprojects.ResearchanddevelopmentexpensesontheRedStormandDARPAPhasesIandIIprojectsarereflectedinourStatementsofOperationsascostofproductrevenue,andgovernmentco-fundingonourotherprojects,includingDARPAPhaseIII,isrecordedinourStatementsofOperationsasreimbursedresearchanddevelopment.Researchanddevelopmentexpensesincludepersonnelexpenses,depreciation,allocationsforcertainoverheadexpenses,software,prototypematerialsandoutsidecontractedengineeringexpenses.Wehavereceivedincreasedgovernmentco-fundingeachperiod.For2006,netresearchanddevelopmentexpensesdecreasedascomparedto2005dueprincipallytoincreasesinreimbursementforourBlackWidow,CrayXMTandDARPAprojectsandreducedresearchanddevelopmentexpensesfortheCrayXD1productlinewhichwasoffsetbya$2.8millionchargerelatedtoanintellectualpropertylicenseagreement.In2005,netresearchanddevelopmentexpensesdecreasedascomparedto2004duetoincreasedgovernmentfundingforourBlackWidowproject,andtheeffectofapayreductionprograminthesecondhalfof2005,partiallyoffsetbyoptionexpenseasweacceleratedvestingonoptionsissuedinconnectionwiththeOctigaBayacquisitionatthebeginningofthesecondquarterin2004.Weanticipatebothgrossresearchanddevelopmentexpensesandthetotallevelofgovernmentfundingtoincreasein2007,withnetresearchanddevelopmentexpenseslikelyhigherthan2006levelsduetothecost-sharingportionoftheDARPAPhaseIIIaward,withpossiblefurtherincreasesinnetresearchanddevelopmentexpensesiftheU.S.governmentceasesco-fundingonourBlackWidoworCrayXMTprojectsearlierthananticipated.Weexpectthatresearchanddevelopmentco-funding,includingamountsundertheDARPAPhaseIII,BlackWidowandCrayXMTfundingagreements,willberecordedasareductiontoresearchanddevelopmentexpensein2007,basedoncontract-specificterms.Form 10-K40OtherOperatingExpensesOursalesandmarketing,generalandadministrativeandrestructuring,severanceandimpairmentchargesfortheindicatedyearsendedDecember31were(inthousands):200420052006YearEndedDecember31,Salesandmarketing....................................$34,948$25,808$21,977Percentageoftotalrevenue.............................24%13%10%Generalandadministrative...............................$19,451$16,145$18,785Percentageoftotalrevenue.............................13%8%8%Restructuring,severanceandimpairment....................$8,182$9,750$1,251Percentageoftotalrevenue.............................6%5%G1%SalesandMarketing.Thedecreaseinsalesandmarketingexpensesfor2006comparedto2005wasprimarilyduetoadecreaseinheadcountandrelatedexpensesasaresultofapersonnelreductionthattookplacein2005,offsetinpartbyhighercommissionexpenseonincreasedproductrevenues.Thedecreasein2005salesandmarketingexpensescomparedto2004wasduetolowerheadcount,thepayreductionprograminthesecondhalfof2005andlowerdiscretionaryspending,offsetinpartbyhighercommissionsonincreasedproductrevenue.Weexpectthat2007salesandmarketingexpenseswillbehigherthan2006levelsprimarilyduetoincreasedsalescommissionsonhigheranticipatedproductsales.GeneralandAdministrative.Theincreaseingeneralandadministrativecostsfor2006over2005wasprimarilyduetoincreasesinexpenseforvariablepayandretentioncompensationprogramsandinnon-cash,stock-basedcompensationincurredinconnectionwithrestrictedstockawardsandstockoptiongrants,whichwerepartiallyoffsetbyageneraldecreaseinheadcountexpensesandlowercostsforexternalaudit,Sarbanes-Oxleycomplianceandlegalfees.Thedecreaseingeneralandadministrativeexpensein2005comparedto2004wasprimarilyduetotheeffectsofourreduction-in-force,aswellasthepayreductionprograminthesecondhalfof2005,savingsfromwhichwereoffsetinpartbyincreasedfeesforexternalaudit,Sarbanes-Oxleycomplianceandlegalfees.Weexpect2007generalandadministrativeexpensestobesimilarandpotentiallylowerthan2006expenselevels.Restructuring,SeveranceandImpairment.Restructuring,severanceandimpairmentchargesincludecostsrelatedtooureffortstoreduceouroverallcoststructurebyreducingheadcount.During2005,wereducedourworkforcebyapproximately150employees.WeincurredadditionalseverancechargesprimarilyfortheretirementofourformerChiefExecutiveOfficer,JamesRottsolk,inthethirdquarterof2005.During2006,weincurredseveranceandotherexitcostsrelatedtoour2005actionsof$1.3million.Inconnectionwiththe2004acquisitionofOctigaBay,weallocated$6.7millionofthepurchasepricetoacoretechnologyintangibleasset,whichwasassociatedwiththeCrayXD1system.Inconnectionwiththefourthquarter2005decisiontoincorporatetheCrayXD1systemtechnologyintotheCrayXT3line,aswellaslimitedexpectedfuturebenefitsofthecoretechnologyobtainedintheacquisition,weevaluatedthecarryingvalueoftheunamortizedbalanceoftheintangibleassetof$4.9millionanddeterminedthatthecarryingvalueoftheassetwasimpairedandaccordinglyrecordedachargeforthe$4.9millioninthefourthquarterof2005.The2004costsprimarilyrepresentedseveranceexpensesrelatedtotheterminationof114employeesintheUnitedStatesandanadditional20employeesthroughouttherestoftheworldinthesecondhalfof2004.In-ProcessResearchandDevelopmentChargeAspartoftheacquisitionofOctigaBay,weincurredanexpenseassociatedwithacquiredin-processresearchanddevelopmentof$43.4millioninthesecondquarterof2004.Form 10-K41OtherIncome(Expense),NetFortheyearsendedDecember31,2006,2005and2004,werecognizednetotherexpenseof$2.1million,$1.4millionand$699,000,respectively.NetotherexpensefortheyearendedDecember31,2006,wasprincipallytheresultofforeignexchangelossesinconnectionwithaforwardforeignexchangecontract,whilenetotherexpensefortheyearsendedDecember31,2005and2004wasprincipallyforeigncurrencylossesontheremeasurementofforeigncurrencybalances,principallyintercompanybalances.InterestIncome(Expense),NetOurinterestincomeandinterestexpensefortheindicatedyearsendedDecember31were(inthousands):200420052006YearEndedDecember31,Interestincome.........................................$666$741$2,525Interestexpense.........................................(301)(4,203)(4,620)Netinterestincome(expense)...............................$365$(3,462)$(2,095)Interestincomeincreasedin2006comparedto2005asaresultofhigheraverageinvestedcashbalancesandhighershort-terminterestrates.Interestexpenseforboth2006and2005principallyconsistedof$2.4millionofinterestonourNotes.Additionally,interestexpenseconsistedof$1.6millionand$1.0million,respectively,ofnon-cashamortizationoffeescapitalizedinconnectionwithbothourlineofcreditwithWellsFargoFoothill,Inc.(“WFF”)andourlong-termdebtofferingcosts.Wealsorecorded$390,000and$765,000,respectively,ofinterestandrelatedfeesonourlineofcreditwithWFF.Theinterestexpensefor2004reflectsapproximatelyonemonthofinterestonourNotes,onemonthofamortizationoftherelatedcapitalizedissuancecostsandinterestonourcapitalleases.TaxesTaxexpensewas$602,000in2006whichreflectsestimatedcurrenttaxexpenseforlocal,stateandforeigntaxjurisdictions.Benefitfromincometaxesin2005was$1.5million,whichconsistedofa$2.3millionbenefitforforeigndeferredtaxes,partiallyoffsetbycurrenttaxexpenseforlocal,stateandforeigntaxjurisdictions.Werecordedanincometaxprovisionof$59.1millionin2004,principallyrelatedtotheestablishmentofa$58.9millionvaluationallowanceagainstdeferredtaxassets,consistingprimarilyofaccumulatednetoperatinglosses.UnderthecriteriasetforthinFAS109,managementconcludedthatitwasunlikelythatthefuturebenefitsofthesedeferredtaxassetswouldberealized.TherehasbeennocurrentprovisionforU.S.federalincometaxesforanyperiodpresented.Wehaveincometaxescurrentlypayableduetoouroperationsincertainforeigncountries,particularlyinCanadaandcertainEuropeanandAsiancountriesandincertainstates.AsofDecember31,2006,wehadtaxnetoperatinglosscarryforwardsofapproximately$290millionthatwillbegintoexpirein2010ifnotutilized.NetIncome(Loss)Netlosswas$12.1millionin2006,$64.3millionin2005and$207.4millionin2004.The2006lossincludedlowgrossmarginonproductrevenuerecognizedforourCrayX1/X1EinstallationattheKoreaMeteorologicalAdministration,$1.6millionininventorywrite-downsanda$2.8millionchargeforanintellectualpropertylicenseagreement.The2005lossincludeda$7.7millionchargeforadditionalestimatedlossesidentifiedduring2005ontheRedStormdevelopmentcontractandrestructuring,severanceandimpairmentchargesof$9.8million,whichincludesa$4.9millionwrite-downforcoretechnologyimpairment.Form 10-K42The2004netlossincludedsignificantchargesconsistingofincometaxexpenseof$59.1million,principallyrelatedtotheestablishmentofavaluationallowanceagainstdeferredtaxassets,a$43.4millionwrite-offofin-processresearchanddevelopmentacquiredaspartoftheOctigaBayacquisition,a$7.6millionchargetorecognizetheinitiallossestimatedontheRedStormfixed-pricecontract,an$8.2millionrestructuringcharge,andan$8.5millionwrite-downofinventory.Whiletherecontinuestobeawiderangeofpotentialoutcomes,webelievetotalrevenueof$230millionto$260millionfor2007isthemostrelevantrange.Withinthistargetrevenuerange,weanticipate2007operatingincomeofapproximately3to7percentofrevenue,includingabout$3millionofanticipatednon-cashstockcompensationexpense.Quarterlyresultsarelikelytobequitevariableduetothetimingofalimitednumberoflargecustomercontracts.Webelievethatyear-over-yearchangesinnetincomearenotnecessarilypredictiveofourfutureresults.LiquidityandCapitalResourcesCash,cashequivalents,restrictedcashandaccountsreceivabletotaled$185.1millionasofDecember31,2006,comparedto$101.1millionasofDecember31,2005;cash,cashequivalentsandrestrictedcashincreasedby$94.3millionwhileaccountsreceivabledecreasedby$10.3million.AsofDecember31,2006,wehadworkingcapitalof$136.3millioncomparedto$52.2millionasofDecember31,2005.NetcashprovidedbyoperatingactivitiesfortheyearendedDecember31,2006was$12.6millioncomparedtoauseof$36.7millionforthesameperiodin2005.FortheyearendedDecember31,2006,cashprovidedbyoperatingactivitieswasprincipallytheresultofnon-cashdepreciationandamortizationbeinggreaterthanournetlossfortheyearandcashgeneratedfromchangesinoperatingassetsandliabilities.FortheyearendedDecember31,2005,cashusedbyoperatingactivitieswasprincipallytheresultofournetlossfortheperiodandincreasesininventoryandaccountsreceivable,partiallyoffsetbyanincreaseindeferredrevenue.For2004,netoperatingcashwasusedprimarilybyournetoperatinglossandanincreaseininventory,offsetinpartbyincreasesindeferredrevenueandaccountspayableandadecreaseinaccountsreceivable.Netcashusedininvestingactivitieswas$27.4millionin2006.Netcashprovidedbyinvestingactivitiesin2005was$41.7million.In2004,netcashusedininvestingactivitieswas$29.9million.During2006,netcashusedininvestingactivitieswasprincipallyasaresultofanincreaseinrestrictedcash,requiredundertheprovisionsofournewlineofcreditagreementwithWellsFargoBank,N.A.FortheyearendedDecember31,2005,netcashprovidedbyinvestingactivitiesconsistedofthesaleofshort-terminvestments,partiallyoffsetbythepurchasesofshort-terminvestmentsandequipmentaswellasadecreaseinrestrictedcash.In2004,netcashusedininvestingactivitiesconsistedprimarilyof$12.5millionofcapitalexpenditures,an$11.4millionincreaseinrestrictedcashand$6.3millionusedfortheacquisitionofOctigaBay(whichconsistedof$15.9millionincashusedinconnectionwiththeacquisitionnettedagainst$9.6millionincashweacquiredfromOctigaBay),offsetbynetsalesof$317,000ofshort-terminvestments.Netcashprovidedbyfinancingactivitieswas$83.9millionin2006.Netcashusedinfinancingactivitieswas$137,000in2005.Netcashprovidedbyfinancingactivitieswas$84.2millionin2004.FortheyearendedDecember31,2006,cashprovidedbyfinancingactivitiesincludes$81.3millionfromourDecember2006commonstockofferingand$2.6millionofproceedsfromemployeeexercisesofstockoptions.FortheyearendedDecember31,2005,netcashusedinfinancingactivitiesconsistedprimarilyof$755,000paidforlineofcreditissuancecostsand$731,000forpaymentsoncapitalleases,offsetby$1.3millioninproceedsfromtheissuanceofcommonstockthroughtheemployeestockpurchaseplanandexerciseofstockoptions.The2004netcashprovidedbyfinancingactivitieswasprimarilyrelatedtoourNoteofferinginwhichwereceivednetproceedsof$76.6million.In2004wealsoreceivedapproximately$8.3millionthroughstockoptionandwarrantexercisesaswellasthroughtheissuanceofcommonstockinconnectionwithouremployeestockpurchaseplan.Overthenexttwelvemonths,oursignificantcashrequirementswillrelatetooperationalexpenses,consistingprimarilyofpersonnelcosts,costsofinventoryandspareparts,outsideengineeringexpenses,particularlyaswecontinuedevelopmentofourCrayXT4andsuccessorsystemsandinternallyfundaportionoftheexpensesonourCascadeprojectpursuanttotheDARPAPhaseIIIaward,interestexpenseandacquisitionofpropertyandequipment.Our2007capitalbudgetforpropertyandequipmentisapproximately$14million.Inaddition,weleaseForm 10-K43certainequipmentandfacilitiesusedinouroperationsunderoperatingorcapitalleasesinthenormalcourseofbusiness.ThefollowingtablesummarizesourcontractualcashobligationsasofDecember31,2006(inthousands):ContractualObligationsTotalLessThan1Year1-3Years3-5YearsThereafterAmountsCommittedbyYearDevelopmentagreements.....................$12,965$12,922$43$—$—Capitalleaseobligations.....................3232———Operatingleases...........................7,0163,2153,36941022Totalcontractualcashobligations..............$20,013$16,169$3,412$410$22Wehave$80.0millioninaggregateprincipalamountofoutstandingNotesduein2024.TheNotesbearinterestatanannualrateof3.0%,or$2.4millionperyear,andholdersoftheNotesmayrequireustopurchasetheNotesonDecember1,2009,December1,2014andDecember1,2019orupontheoccurrenceofcertaineventsprovidedintheindenturegoverningtheNotes.Additionally,wehaveatwo-yearrevolvinglineofcreditforupto$25.0million,whichexpiresinDecember2008.NoamountswereoutstandingunderthislineasofDecember31,2006.Asofthesamedate,wewereeligibletoborrow$24.8millionagainstthislineofcredit;theborrowinglimitationrelatestorestrictionsfromouroutstandinglettersofcredit.Inournormalcourseofoperations,wehavedevelopmentarrangementsunderwhichweengageoutsideengineeringresourcestoworkonourresearchanddevelopmentprojects.ForthetwelvemonthsendedDecem-ber31,2006,weincurred$23.9millionforsucharrangements.Atanyparticulartime,ourcashpositionisaffectedbythetimingofcashreceiptsforproductsales,maintenancecontracts,governmentco-fundingforresearchanddevelopmentactivitiesandourpaymentsforinventory,resultinginsignificantfluctuationsinourcashbalancefromquarter-to-quarterandwithinaquarter.Ourprincipalsourcesofliquidityareourcashandcashequivalents,operationsandcreditfacility.Evenassumingacceptancesandpaymentforlargenewsystemstobesoldandthebenefitfromour2004and2005restructuringsandotherrecentcostreductionefforts,ourcashflowfromoperationsmaybenegativefor2007asawhole,largelytosupportworkingcapitalrequirements,althoughawiderangeofresultsispossible.WiththeproceedsofourDecember2006publicoffering,andtheneartermexpectedcashflowfromourDARPAPhaseIIIaward,wedonotanticipateborrowingfromourcreditlineandweexpectourcashresourcestobeadequateforatleastthenexttwelvemonths.Wehavebeenfocusingonexpensecontrols,negotiatingsalescontractswithadvancepartialpaymentswherepossible,implementingtighterpurchasingandmanufacturingprocessesandimprovingworkingcapitalmanage-mentinordertomaintainadequatelevelsofcash.Additionally,theadequacyofourcashresourcesisdependentontheamountandtimingofgovernmentfundingaswellasourabilitytosellourproducts,particularlytheCrayXT4,BlackWidowandCrayXMTsystems,withadequatemargins.Beyondthenexttwelvemonths,theadequacyofourcashresourceswilllargelydependonoursuccessinre-establishingprofitableoperationsandpositiveoperatingcashflowsonasustainedbasis.SeeItem1A.“RiskFactors”above.Item7A.QuantitativeandQualitativeDisclosuresAboutMarketRiskWeareexposedtofinancialmarketrisks,includingchangesininterestratesandequitypricefluctuations.InterestRateRisk:Weinvestouravailablecashininvestment-gradedebtinstrumentsofcorporateissuersandindebtinstrumentsoftheU.S.governmentanditsagencies.Wedonothaveanyderivativeinstrumentsinourinvestmentportfolio.Weprotectandpreserveinvestedfundsbylimitingdefault,marketandreinvestmentrisk.Investmentsinbothfixed-rateandfloating-rateinterestearninginstrumentscarryadegreeofinterestraterisk.Fixed-ratesecuritiesmayhavetheirfairmarketvalueadverselyaffectedduetoariseininterestrates,whilefloating-ratesecuritiesmayproducelessincomethanexpectedifinterestratesfall.Dueinparttothesefactors,ourfutureinvestmentincomemayfallshortofexpectationsduetochangesininterestratesorwemaysufferlossesinprincipalifforcedtosellsecurities,whichhavedeclinedinmarketvalueduetochangesininterestrates.AtDecember31,2006,weheldaportfolioofhighlyliquidinvestments,allwhichweretomatureinlessthan90daysfromthedateofinitialinvestment.Form 10-K44ForeignCurrencyRisk:WesellourproductsprimarilyinNorthAmerica,AsiaandEurope.Asaresult,ourfinancialresultscouldbeaffectedbyfactorssuchaschangesinforeigncurrencyexchangeratesorweakeconomicconditionsinforeignmarkets.OurproductsaregenerallypricedinU.S.dollars,andastrengtheningofthedollarcouldmakeourproductslesscompetitiveinforeignmarkets.WhilewecommonlysellproductswithpaymentsinU.S.dollars,ourproductsalescontractsoccasionallycallforpaymentinforeigncurrenciesandtotheextentwedoso,orengagewithourforeignsubsidiariesintransactionsdeemedtobeshort-terminnature,wearesubjecttoforeigncurrencyexchangerisks.Fromtimetotime,weenterintoforwardforeignexchangecontractstohedgeanticipatedcashreceiptsonspecificsalescontracts.During2006,weenteredintoonesuchcontractfor£15million.Allrelatedcashreceiptswerereceivedin2006andthehedgewassettled.Ourforeignmaintenancecontractsarepaidinlocalcurrenciesandprovideanaturalhedgeagainstforeignexchangeexposurerelatedtoourforeignlocalexpenses.TotheextentthatwewishtorepatriateanyofthesefundstotheUnitedStates,however,wearesubjecttoforeignexchangerisks.AsofDecember31,2006,a10%changeinforeignexchangeratescouldimpactourannualearningsandcashflowsbyapproximately$950,000.Form 10-K45Item8.FinancialStatementsandSupplementaryDataINDEXTOFINANCIALSTATEMENTS*ConsolidatedBalanceSheetsatDecember31,2005andDecember31,2006.....................F-1ConsolidatedStatementsofOperationsfortheyearsendedDecember31,2004,2005and2006.......F-2ConsolidatedStatementsofShareholders’EquityandComprehensiveIncome(Loss)fortheyearsendedDecember31,2004,2005and2006............................................F-3ConsolidatedStatementsofCashFlowsfortheyearsendedDecember31,2004,2005and2006......F-4NotestoConsolidatedFinancialStatements.............................................F-5ReportsofIndependentRegisteredPublicAccountingFirms.................................F-29*TheFinancialStatementsarelocatedfollowingpage57.Form 10-K46QUARTERLYFINANCIALDATA(Unaudited,inthousands,exceptpersharedata)ThefollowingtablepresentsunauditedquarterlyfinancialinformationforthetwoyearsendedDecember31,2006.Intheopinionofmanagement,thisinformationcontainsalladjustments,consistingonlyofnormalrecurringadjustments,necessaryforafairpresentationthereof.Certain2005quarterlyreclassificationshavebeenmadetoconformtothe2006presentation.Theoperatingresultsarenotnecessarilyindicativeofresultsforanyfutureperiods.Quarter-to-quartercomparisonsshouldnotberelieduponasindicatorsoffutureperformance.Thefollowingdatashouldbereadinconjunctionwith“Management’sDiscussionandAnalysisofFinancialConditionandResultsofOperations”includedelsewhereinthisAnnualReportonForm10-Kandconsolidatedfinancialstatementsandrelatednotesthereto.FortheQuarterEnded3/316/309/3012/313/316/309/3012/3120052006Revenue...................$37,634$53,419$44,741$65,257$48,515$38,513$32,565$101,424Costofrevenue..............33,92748,74136,55149,33134,37026,00021,16975,655Grossmargin...............3,7074,6788,19015,92614,14512,51311,39625,769Researchanddevelopment,net...13,03213,4276,4728,7807,2156,3719,6925,764Salesandmarketing...........6,5997,5745,7785,8574,9855,6824,9246,386Generalandadministrative......4,2674,6073,6173,6545,5944,6004,1344,457Restructuring,severanceandimpairment...............(215)1,9471,2016,8177385493(39)Netincome(loss)............(21,035)(23,796)(10,250)(9,227)(5,305)(7,173)(8,324)8,732Netincome(loss)percommonshare,basic...............$(0.95)$(1.08)$(0.46)$(0.42)$(0.24)$(0.32)$(0.37)$0.36Netincome(loss)percommonshare,diluted..............$(0.95)$(1.08)$(0.46)$(0.42)$(0.24)$(0.32)$(0.37)$0.33Sincethesecondhalfof2004,wehavereviewedourworkforcerequirementsinlightofouroperatingresultsandengagedinworkforcereductions,particularlyinsecondandfourthquartersof2005.The2005fourthquarteralsoreflectsa$4.9millionchargerelatedtoimpairmentofacoretechnologyintangibleasset.Dilutednetincomepercommonshareforthefourthquarterof2006includesapproximately5millionequivalentsharesforoutstandingemployeestockoptions,warrants,unvestedrestrictedstockgrantsandsharesissuableiftheNoteswereconverted.Theseitemsareantidilutiveinanyperiodwithanoverallnetloss.Additionally,theNotes’fourthquarter2006interestexpenseandissuancefeeamortizationof$770,000hasbeenaddedbacktonetincometodeterminedilutednetincomepercommonshareundertheif-convertedmethod.Ouroperatingresultsaresubjecttoquarterlyfluctuationsasaresultofanumberoffactors.SeeItem1A.“RiskFactors”above.Item9.ChangesinandDisagreementswithAccountantsonAccountingandFinancialDisclosureNone.Item9A.ControlsandProceduresDisclosureControlsandProceduresWemaintaindisclosurecontrolsandproceduresthataredesignedtoensurethatinformationrequiredtobedisclosedinourreportsundertheExchangeActisrecorded,processed,summarizedandreportedwithinthetimeperiodsspecifiedintheSEC’srulesandforms,andthatsuchinformationisaccumulatedandcommunicatedtomanagement,asappropriate,toallowtimelydecisionsregardingrequireddisclosure.Ourmanagement,withtheparticipationandsupervisionofourChiefExecutiveOfficer,ChiefFinancialOfficerandChiefAccountingOfficer/CorporateController,evaluatedtheeffectivenessofourdisclosurecontrolsandproceduresasoftheendoftheperiodcoveredbythisreportanddeterminedthatourdisclosurecontrolsandprocedureswereeffective.Form 10-K47ChangesinInternalControloverFinancialReportingAsdisclosedinour2004AnnualReportonForm10-K/A,andinourQuarterlyReportsonForm10-Qforeachofthefirstthreequartersof2005,wereportedmaterialweaknessesinourinternalcontrolsoverfinancialreporting.AsofDecember31,2005,wehadremediatedthepreviouslyreportedmaterialweaknessesininternalcontrolsoverfinancialreporting,asreportedinour2005AnnualReportonForm10-K.Therehavebeennochangesinourinternalcontrolsoverfinancialreportingduringthe2006fourthquarterthathavemateriallyaffected,orarereasonablylikelytomateriallyaffectourinternalcontrolsoverfinancialreporting.Management’sReportonInternalControlOverFinancialReportingOurmanagementisresponsibleforestablishingandmaintainingadequateinternalcontroloverfinancialreportingasdefinedbyRule13a-15(f)undertheExchangeAct.InternalcontroloverfinancialreportingisaprocessdesignedtoprovidereasonableassuranceregardingthereliabilityoffinancialreportingandthepreparationoffinancialstatementsforexternalpurposesinaccordancewithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica.Ourinternalcontroloverfinancialreportingincludesthosepoliciesandproceduresthat(i)pertaintothemaintenanceofrecordsthat,inreasonabledetail,accuratelyandfairlyreflectourtransactionsanddispositionsofassets;(ii)providereasonableassurancethattransactionsarerecordedasnecessarytopermitpreparationoffinancialstatementsinaccordancewithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica,andthatourreceiptsandexpendituresarebeingmadeonlyinaccordancewithauthorizationsofourmanagementanddirectors;and(iii)providereasonableassuranceregardingpreventionortimelydetectionofunauthorizedacquisition,use,ordispositionofourassetsthatcouldhaveamaterialeffectonthefinancialstatements.Becauseofitsinherentlimitations,internalcontroloverfinancialreportingmaynotpreventordetectmisstatements.Also,projectionsofanyevaluationofeffectivenesstofutureperiodsaresubjecttotheriskthatcontrolsmaybecomeinadequatebecauseofchangesinconditions,orthatthedegreeofcompliancewiththepoliciesorproceduresmaydeteriorate.Ourmanagementconductedanevaluationoftheeffectivenessofourinternalcontroloverfinancialreportingbasedontheframeworkin“InternalControl—IntegratedFramework”issuedbytheCommitteeofSponsoringOrganizationsoftheTreadwayCommission(“COSO”).Basedonthisevaluation,ourmanagementconcludedthatourinternalcontroloverfinancialreportingwaseffectiveasofDecember31,2006.Management’sassessmentoftheeffectivenessofourinternalcontrolsoverfinancialreportingasofDecem-ber31,2006hasbeenauditedbyPetersonSullivanPLLC,anindependentregisteredpublicaccountingfirm,asstatedinthatfirm’sreportwhichisincludedbelowandexpressedanunqualifiedopiniononmanagement’sassessmentandontheeffectivenessofourinternalcontroloverfinancialreportingasofDecember31,2006.REPORTOFINDEPENDENTREGISTEREDPUBLICACCOUNTINGFIRMTotheBoardofDirectorsandShareholdersCrayInc.Wehaveauditedmanagement’sassessment,includedintheaccompanyingManagement’sReportonInternalControlOverFinancialReporting,thatCrayInc.andSubsidiaries(“theCompany”)maintainedeffectiveinternalcontroloverfinancialreportingasofDecember31,2006,basedoncriteriaestablishedinInternalControl—IntegratedFrameworkissuedbytheCommitteeofSponsoringOrganizationsoftheTreadwayCommission(COSO).TheCompany’smanagementisresponsibleformaintainingeffectiveinternalcontroloverfinancialreportingandforitsassessmentoftheeffectivenessofinternalcontroloverfinancialreporting.Ourresponsibilityistoexpressanopiniononmanagement’sassessmentandanopinionontheeffectivenessoftheCompany’sinternalcontroloverfinancialreportingbasedonouraudit.Form 10-K48WeconductedourauditinaccordancewiththestandardsofthePublicCompanyAccountingOversightBoard(UnitedStates).Thosestandardsrequirethatweplanandperformtheaudittoobtainreasonableassuranceaboutwhethereffectiveinternalcontroloverfinancialreportingwasmaintainedinallmaterialrespects.Ourauditincludedobtaininganunderstandingofinternalcontroloverfinancialreporting,evaluatingmanagement’sassessment,testingandevaluatingthedesignandoperatingeffectivenessofinternalcontrol,andperformingsuchotherproceduresasweconsiderednecessaryinthecircumstances.Webelievethatourauditprovidesareasonablebasisforouropinion.Acompany’sinternalcontroloverfinancialreportingisaprocessdesignedtoprovidereasonableassuranceregardingthereliabilityoffinancialreportingandthepreparationoffinancialstatementsforexternalpurposesinaccordancewithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica.Acompany’sinternalcontroloverfinancialreportingincludesthosepoliciesandproceduresthat(1)pertaintothemaintenanceofrecordsthat,inreasonabledetail,accuratelyandfairlyreflectthetransactionsanddispositionsoftheassetsofthecompany;(2)providereasonableassurancethattransactionsarerecordedasnecessarytopermitpreparationoffinancialstatementsinaccordancewithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica,andthatreceiptsandexpendituresofthecompanyarebeingmadeonlyinaccordancewithauthorizationsofmanagementanddirectorsofthecompany;and(3)providereasonableassuranceregardingpreventionortimelydetectionofunauthorizedacquisition,use,ordispositionofthecompany’sassetsthatcouldhaveamaterialeffectonthefinancialstatements.Becauseofitsinherentlimitations,internalcontroloverfinancialreportingmaynotpreventordetectmisstatements.Also,projectionsofanyevaluationofeffectivenesstofutureperiodsaresubjecttotheriskthatcontrolsmaybecomeinadequatebecauseofchangesinconditions,orthatthedegreeofcompliancewiththepoliciesorproceduresmaydeteriorate.Inouropinion,management’sassessmentthattheCompanymaintainedeffectiveinternalcontroloverfinancialreportingasofDecember31,2006,isfairlystated,inallmaterialrespects,basedoncriteriaestablishedinInternalControl—IntegratedFrameworkissuedbytheCommitteeofSponsoringOrganizationsoftheTreadwayCommis-sion(COSO).Alsoinouropinion,theCompanymaintained,inallmaterialrespects,effectiveinternalcontroloverfinancialreportingasofDecember31,2006,basedoncriteriaestablishedinInternalControl—IntegratedFrame-workissuedbytheCommitteeofSponsoringOrganizationsoftheTreadwayCommission(COSO).Wehavealsoaudited,inaccordancewiththestandardsofthePublicCompanyAccountingOversightBoard(UnitedStates),theconsolidatedbalancesheetsoftheCompanyasofDecember31,2006and2005andtherelatedconsolidatedstatementsofoperations,shareholders’equityandcomprehensiveincome(loss),andcashflowsfortheyearsthenended,andourreportdatedMarch5,2007,expressedanunqualifiedopiniononthoseconsolidatedfinancialstatements./s/PETERSONSULLIVANPLLCSeattle,WashingtonMarch5,2007Item9B.OtherInformationNone.Form 10-K49PARTIIICertaininformationrequiredbyPartIIIisomittedfromthisReportaswewillfileadefinitiveproxystatementfortheAnnualMeetingofShareholderstobeheldonMay16,2007,pursuanttoRegulation14A(the“ProxyStatement”)notlaterthan120daysaftertheendofthefiscalyearcoveredbythisReport,andcertaininformationincludedintheProxyStatementisincorporatedhereinbyreference.OnlythosesectionsoftheProxyStatementwhichspecificallyaddresstheitemssetforthhereinareincorporatedbyreference.Item10.Directors,ExecutiveOfficersandCorporateGovernanceInformationwithrespecttoourdirectorsissetforthinthesectiontitled“TheBoardofDirectors”andinthesectiontitled“ElectionofEightDirectorsForOne-YearTerms”inourProxyStatement.Suchinformationisincorporatedhereinbyreference.InformationwithrespecttoexecutiveofficersissetforthinPartI,ItemE.O.,beginningonpage25above,underthecaption“ExecutiveOfficersoftheCompany.”InformationwithrespecttocompliancewithSection16(a)oftheExchangeActbythepersonssubjecttheretoissetforthunderthesectiontitled“OurCommonStockOwnership—Section16(a)BeneficialOwnershipReportingCompliance”intheProxyStatementandisincorporatedhereinbyreference.OurBoardofDirectorshasadoptedaCodeofBusinessConductapplicabletoallofourdirectors,officersandemployees.TheCodeofBusinessConduct,ourCorporateGovernanceGuidelines,chartersfortheAudit,CompensationandCorporateGovernanceCommitteesandothergovernancedocumentsmaybefoundonourwebsite:www.cray.comunder“Investors—CorporateGovernance.”Item11.ExecutiveCompensationTheinformationintheProxyStatementsetforthinthesectiontitled“TheBoardofDirectors—Compen-sationofDirectors”and“CompensationofExecutiveOfficers”isincorporatedhereinbyreference.Item12.SecurityOwnershipofCertainBeneficialOwnersandManagementandRelatedShareholderMattersTheinformationintheProxyStatementsetforthinthesection“OurCommonStockOwnership”isincorporatedhereinbyreference.InformationregardingsecuritiesauthorizedforissuanceunderourequitycompensationplansissetforthinPartII,Item5above.Item13.CertainRelationshipsandRelatedTransactions,andDirectorIndependenceTheinformationintheProxyStatementsetforthinthesectionstitled“TheBoardofDirectors”and“TransactionsWithRelatedPersons”isincorporatedhereinbyreference.Item14.PrincipalAccountantFeesandServicesTheinformationsetforthinthesectiontitled“IndependentRegisteredPublicAccountingFirms”intheProxyStatementisincorporatedhereinbyreference.Form 10-K50PARTIVItem15.ExhibitsandFinancialStatementSchedules(a)(1)FinancialStatementsConsolidatedBalanceSheetsatDecember31,2005andDecember31,2006ConsolidatedStatementsofOperationsfortheyearsendedDecember31,2004,2005and2006ConsolidatedStatementsofShareholders’EquityandComprehensiveIncome(Loss)fortheyearsendedDecember31,2004,2005and2006ConsolidatedStatementsofCashFlowsfortheyearsendedDecember31,2004,2005and2006NotestoConsolidatedFinancialStatementsReportsofIndependentRegisteredPublicAccountingFirms(a)(2)FinancialStatementSchedulesScheduleII—ValuationandQualifyingAccounts—ThefinancialstatementschedulefortheyearsendedDecember31,2006,2005,and2004shouldbereadinconjunctionwiththeconsolidatedfinancialstatementsofCrayInc.filedaspartofthisAnnualReportonForm10-K.Schedulesotherthanthatlistedabovehavebeenomittedsincetheyareeithernotrequired,notapplicable,orbecausetheinformationrequiredisincludedintheconsolidatedfinancialstatementsorthenotesthereto.(a)(3)ExhibitsTheExhibitslistedintheExhibitIndex,whichappearsimmediatelyfollowingthesignaturepageandcertificationsandisincorporatedhereinbyreference,arefiledaspartofthisAnnualReportonForm10-K.EachmanagementcontractorcompensatoryplanoragreementlistedontheExhibitIndexisidentifiedbyanasterisk.Form 10-K51SIGNATURESPursuanttotherequirementsofSection13or15(d)oftheSecuritiesExchangeActof1934,theCompanyhasdulycausedthisreporttobesignedonitsbehalfbytheundersigned,thereuntodulyauthorized,intheCityofSeattle,StateofWashington,onMarch8,2007.CRAYINC.By/s/PETERJ.UNGAROPeterJ.UngaroChiefExecutiveOfficerandPresidentEachoftheundersignedherebyconstitutesandappointsPeterJ.Ungaro,BrianC.HenryandKennethW.Johnsonandeachofthem,theundersigned’strueandlawfulattorney-in-factandagent,withfullpowerofsubstitution,fortheundersignedandinhisorhername,placeandstead,inanyandallcapacities,tosignanyorallamendmentstothisAnnualReportonForm10-Kandanyotherinstrumentsordocumentsthatsaidattorneys-in-factandagentsmaydeemnecessaryoradvisable,toenableCrayInc.tocomplywiththeSecuritiesExchangeActof1934andanyrequirementsoftheSecuritiesandExchangeCommissioninrespectthereof,andtofilethesame,withallexhibitsthereto,withtheSecuritiesandExchangeCommission,grantinguntosaidattorneys-in-factandagentsandeachofthemfullpowerandauthoritytodoandperformeachandeveryactandthingrequisiteandnecessarytobedone,asfullytoallintentsandpurposesastheundersignedmightorcoulddoinperson,herebyratifyingandconfirmingallthateachsuchattorney-in-factandagent,orhissubstitute,maylawfullydoorcausetobedonebyvirtuehereof.PursuanttotherequirementsoftheSecuritiesExchangeActof1934,thisreporthasbeensignedbelowbythefollowingpersonsonbehalfoftheCompanyandinthecapacitiesindicatedonMarch8,2007.SignatureTitleBy/s/PETERJ.UNGAROPeterJ.UngaroChiefExecutiveOfficer,PresidentandDirectorBy/s/BRIANC.HENRYBrianC.HenryPrincipalFinancialOfficerBy/s/KENNETHD.ROSELLIKennethD.RoselliPrincipalAccountingOfficerBy/s/WILLIAMC.BLAKEWilliamC.BlakeDirectorBy/s/JOHNB.JONES,JR.JohnB.Jones,Jr.DirectorBy/s/STEPHENC.KIELYStephenC.KielyDirectorBy/s/FRANKL.LEDERMANFrankL.LedermanDirectorBy/s/SALLYG.NARODICKSallyG.NarodickDirectorForm 10-K52SignatureTitleBy/s/DANIELC.REGISDanielC.RegisDirectorBy/s/STEPHENC.RICHARDSStephenC.RichardsDirectorForm 10-K53EXHIBITINDEXExhibitNumberDescription3.1RestatedArticlesofIncorporation(1)3.2AmendedandRestatedBylaws(8)4.1FormofCommonStockPurchaseWarrantsdueJune21,2009(14)4.2IndenturedatedasofDecember6,2004,byandbetweentheCompanyandTheBankofNewYorkTrustCompany,N.A.asTrustee(andFormof3.0%ConvertibleSeniorSubordinatedNoteincludedasExhibitAtotheIndenture)(12)10.0*1999StockOptionPlan(32)10.1*2000Non-ExecutiveEmployeeStockOptionPlan(5)10.2*2001EmployeeStockPurchasePlan(11)10.3*2003StockOptionPlan(2)10.4*2004Long-TermEquityCompensationPlan(13)10.5*CrayCanadaInc.AmendedandRestatedKeyEmployeeStockOptionPlan(18)10.6*2006Long-TermEquityCompensationPlan(30)10.7*FormofOfficerNon-QualifiedStockOptionAgreement(19)10.8*FormofOfficerIncentiveStockOptionAgreement(19)10.9*FormofDirectorStockOptionAgreement(19)10.10*FormofDirectorStockOption,immediatevesting(19)10.11*FormofEmployeeRestrictedStockAgreement,currentform10.12*FormofDirectorRestrictedStockAgreement(1)10.13*2005ExecutiveBonusPlan(17)10.14*Cray2006BonusPlan(9)10.15*Cray2007CashIncentivePlan(8)10.16*LetterAgreementbetweentheCompanyandPeterJ.Ungaro,effectiveMarch7,2005(16)10.17*OfferLetterbetweentheCompanyandMargaretA.Williams,datedApril14,2005(23)10.18*OfferLetterbetweentheCompanyandBrianC.Henry,datedMay16,2005(24)10.19*FormofManagementContinuationAgreementbetweentheCompanyanditsExecutiveOfficersandcertainotherEmployees(10)10.20*ExecutiveSeverancePolicy,asamended(21)10.21*RetentionAgreementbetweentheCompanyandPeterJ.Ungaro,datedDecember20,2005(26)10.22*RetentionAgreementbetweentheCompanyandBrianC.Henry,datedDecember20,2005(26)10.23*RetentionAgreementbetweentheCompanyandMargaretA.Williams,datedDecember20,2005(26)10.24*Summarysheetsettingforthamendedcompensationarrangementsfornon-employeeDirectors(27)10.25LeaseAgreementbetweenMerrillPlace,LLCandtheCompany,datedNovember21,1997(6)10.26FourthAmendmenttotheLeasebetweenMerrillPlaceLLCandtheCompany,datedasofOctober31,2005(22)10.27FABIBuildingLeaseAgreementbetweenUnionSemiconductorTechnologyCorporationandtheCompany,datedJune30,2000(7)10.28AmendmentNo.1totheFABBuildingLeaseAgreementbetweenUnionSemiconductorTechnologyCorporationandtheCompany,datedasofAugust19,2002(3)10.29ConferenceCenterLeaseAgreementbetweenUnionSemiconductorTechnologyCorporationandtheCompany,datedJune30,2000(7)10.30AmendmentNo.1totheConferenceCenterLeaseAgreementbetweenUnionSemiconductorTechnologyCorporationandtheCompanydatedasofAugust19,2002(3)Form 10-K54ExhibitNumberDescription10.31MendotaHeightsOfficeLeaseAgreementbetweentheTeachers’RetirementSystemoftheStateofIllinoisandtheCompany,datedasofAugust10,2000(7)10.32FirstAmendmenttotheMendotaHeightsOfficeLeaseAgreementbetweentheTeachers’RetirementSystemoftheStateofIllinoisandtheCompany,datedasofJanuary17,2003(3)10.33SubleaseAgreementbetweenTrilliumDigitalSystemsCanada,Ltd.andOctigaBaySystemsCorporation,datedasofJanuary13,2003,withConsenttoSublettingbyandamong391102B.C,Ltd.andDominionConstructionandDevelopmentInc.,TrilliumDigitalSystemsCanada,Ltd.,OctigaBaySystemsCorporationandIntelCorporation,datedJanuary20,2003,andLeaseAgreementbetweenDominionConstructionCompanyInc.and391102B.C.Ltd.,TrilliumDigitalSystemsCanada,Ltd.andIntelCorporation,datedMarch5,2001(19)10.34TechnologyAgreementbetweenSiliconGraphics,Inc.andtheCompany,effectiveasofMarch31,2000(4)10.35ArrangementAgreement,datedasofFebruary25,2004,byandamongtheCompany,3084317NovaScotiaLimitedandOctigaBaySystemsCorporation(15)10.36PurchaseAgreement,datedDecember1,2004,byandbetweentheCompanyandBear,Stearns&Co.Inc.asInitialPurchaser(12)10.37SeniorSecuredCreditAgreementamongtheCompany,CrayFederalInc.andWellsFargoFoothill,Inc.,datedMay31,2005(20)10.38AmendmentNo.OnetotheSeniorSecuredCreditAgreementamongtheCompany,CrayFederalInc.andWellsFargoFoothill,Inc.,datedNovember9,2005(25)10.39AmendmentNumberTwotoSeniorSecuredCreditAgreement,datedasofMarch14,2006,amongWellsFargoFoothill,Inc.,CrayInc.andCrayFederalInc.(28)10.40AmendmentNumberThreetoSeniorSecuredCreditAgreement,datedasofJuly12,2006,amongWellsFargoFoothill,Inc.,CrayInc.andCrayFederalInc.(31)10.41CreditAgreement,datedasofDecember29,2006,betweenCrayInc.andWellsFargoBank,NationalAssociation(29)10.42FirstAmendment,datedJanuary31,2007,toCreditAgreementbetweenCrayInc.andWellsFargoBank,NationalAssociation21.1SubsidiariesoftheCompany23.1ConsentofPetersonSullivanPLLC,IndependentRegisteredPublicAccountingFirm23.2ConsentofDeloitte&ToucheLLP,IndependentRegisteredPublicAccountingFirm23.3PowerofAttorneyfordirectorsandofficers(includedonthesignaturepageofthisreport)31.1Rule13a-14(a)/15d-14(a)CertificationofMr.Ungaro,ChiefExecutiveOfficer31.2Rule13a-14(a)/15d-14(a)CertificationofMr.Henry,ChiefFinancialOfficer32.1Certificationpursuantto18U.S.C.Section1350bytheChiefExecutiveOfficerandtheChiefFinancialOfficer(1)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononJune8,2006.(2)IncorporatedbyreferencetotheCompany’sdefinitiveProxyStatementforthe2003AnnualMeeting,asfiledwiththeCommissiononMarch31,2003.(3)IncorporatedbyreferencetotheCompany’sAnnualReportonForm10-K,asfiledwiththeCommissionforthefiscalyearendedDecember31,2002.(4)IncorporatedbyreferencetotheCompany’sQuarterlyReportonForm10-Q,asfiledwiththeCommissiononMay15,2000.(5)IncorporatedbyreferencetotheCompany’sRegistrationStatementonFormS-8(SECNo.333-57970),asfiledwiththeCommissiononMarch30,2001.Form 10-K55(6)IncorporatedbyreferencetotheCompany’sAnnualReportonForm10-K,asfiledwiththeCommissionforthefiscalyearendedDecember31,1997.(7)IncorporatedbyreferencetotheCompany’sAnnualReportonForm10-K,asfiledwiththeCommissionforthefiscalyearendedDecember31,2000.(8)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononFebruary12,2007.(9)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononMay4,2006.(10)IncorporatedbyreferencetotheCompany’sQuarterlyReportonForm10-Q,asfiledwiththeCommissiononMay17,1999.(11)IncorporatedbyreferencetotheCompany’sRegistrationStatementonFormS-8(SECNo.333-70238),filedonSeptember26,2001.(12)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononDecember7,2004.(13)IncorporatedbyreferencetotheCompany’sdefinitiveProxyStatementforthe2004AnnualMeeting,asfiledwiththeCommissiononMarch24,2004.(14)IncorporatedbyreferencetotheRegistrationStatement,asfiledwiththeCommissiononMarch30,2001.(15)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononApril2,2004.(16)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononMarch8,2005.(17)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononMarch25,2005.(18)IncorporatedbyreferencetotheCompany’sRegistrationStatementonFormS-8(SECNo.333-114243),filedonApril6,2004.(19)IncorporatedbyreferencetotheCompany’sAnnualReportonForm10-K,asfiledwiththeCommissionforthefiscalyearendedDecember31,2004.(20)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononJune1,2005.(21)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononAugust10,2005.(22)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononNovember15,2005.(23)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononMay9,2005.(24)IncorporatedbyreferencetotheCompany’sQuarterlyReportonForm10-Q,asfiledwiththeCommissiononNovember9,2005.(25)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononNovember16,2005.(26)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononDecember22,2005.(27)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononFebruary21,2006.(28)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononMarch17,2006.(29)IncorporatedbyreferencetotheCompany’sCurrentReportonForm8-K,asfiledwiththeCommissiononJanuary4,2007.Form 10-K56(30)IncorporatedbyreferencetotheCompany’sdefinitiveProxyStatementforthe2006AnnualMeeting,asfiledwiththeCommissiononApril28,2006.(31)IncorporatedbyreferencetotheCompany’sQuarterlyReportonForm10-Q,asfiledwiththeCommissiononAugust9,2006.(32)IncorporatedbyreferencetotheCompany’sRegistrationStatementonFormS-8,RegistrationNo.333-57970,asfiledwiththeCommissiononMarch30,2001.*Managementcontractorcompensatoryplanorarrangement.Excludedfromthislistofexhibits,pursuanttoParagraph(b)(4)(iii)(a)ofItem601ofRegulationS-K,maybeoneormoreinstrumentsdefiningtherightsofholdersoflong-termdebtoftheCompany.TheCompanyherebyagreesthatitwill,uponrequestoftheSecuritiesandExchangeCommission,furnishtotheCommissionacopyofanysuchinstrument.57Form 10-K(This page intentionally left blank)CRAYINC.ANDSUBSIDIARIESCONSOLIDATEDBALANCESHEETS(Inthousands,exceptsharedata)December31,2005December31,2006ASSETSCurrentassets:Cashandcashequivalents........................................$46,026$115,328Restrictedcash................................................—25,000Accountsreceivable,net..........................................55,06444,790Inventory.....................................................67,71258,798Prepaidexpensesandothercurrentassets.............................2,9092,156Totalcurrentassets............................................171,711246,072Propertyandequipment,net.........................................31,29221,564Serviceinventory,net.............................................3,2854,292Goodwill.......................................................56,83957,138Deferredtaxasset................................................575722Intangibleassets,net..............................................1,1131,404Othernon-currentassets...........................................8,1906,311TOTALASSETS.............................................$273,005$337,503LIABILITIESANDSHAREHOLDERS’EQUITYCurrentliabilities:Accountspayable...............................................$14,911$22,450Accruedpayrollandrelatedexpenses................................12,14517,411Advanceresearchanddevelopmentpayments..........................1,53821,518Otheraccruedliabilities..........................................9,1645,121Deferredrevenue...............................................81,74943,248Totalcurrentliabilities.........................................119,507109,748Long-termdeferredrevenue.........................................5,2342,475Othernon-currentliabilities.........................................2,3173,906Convertiblenotespayable..........................................80,00080,000TOTALLIABILITIES.........................................207,058196,129CommitmentsandContingencies(Note12)Shareholders’equity:PreferredStock—Authorizedandundesignated,5,000,000shares;nosharesissuedoroutstanding..........................................——CommonStockandadditionalpaid-incapital,parvalue$.01pershare—Authorized,75,000,000shares;issuedandoutstanding,22,743,377and32,236,888shares,respectively...................................422,691507,356Exchangeableshares,noparvalue—Unlimitedsharesauthorized;19,710andnosharesoutstanding,respectively................................576—Deferredcompensation...........................................(2,811)—Accumulatedothercomprehensiveincome............................6,2586,855Accumulateddeficit.............................................(360,767)(372,837)TOTALSHAREHOLDERS’EQUITY..............................65,947141,374TOTALLIABILITIESANDSHAREHOLDERS’EQUITY..............$273,005$337,503SeeaccompanyingnotesF-1FinancialsCRAYINC.ANDSUBSIDIARIESCONSOLIDATEDSTATEMENTSOFOPERATIONS(Inthousands,exceptsharedata)200420052006YearsEndedDecember31,Revenue:Product...............................................$95,901$152,098$162,795Service...............................................49,94848,95358,222Totalrevenue.........................................145,849201,051221,017Operatingexpenses:Costofproductrevenue...................................104,196139,518124,728Costofservicerevenue...................................30,33829,03232,466Researchanddevelopment,net..............................53,26641,71129,042Salesandmarketing......................................34,94825,80821,977Generalandadministrative.................................19,45116,14518,785Restructuring,severanceandimpairment......................8,1829,7501,251In-processresearchanddevelopmentcharge....................43,400——Totaloperatingexpenses.................................293,781261,964228,249Lossfromoperations.......................................(147,932)(60,913)(7,232)Otherexpense,net.........................................(699)(1,421)(2,141)Interestincome(expense),net................................365(3,462)(2,095)Lossbeforeincometaxes....................................(148,266)(65,796)(11,468)Incometaxexpense(benefit).................................59,092(1,488)602Netloss................................................$(207,358)$(64,308)$(12,070)Basicanddilutednetlosspercommonshare.....................$(9.95)$(2.91)$(0.53)Basicanddilutedweightedaveragesharesoutstanding..............20,84722,12522,849SeeaccompanyingnotesF-2FinancialsCRAYINC.ANDSUBSIDIARIESCONSOLIDATEDSTATEMENTSOFSHAREHOLDERS’EQUITYANDCOMPREHENSIVEINCOME(LOSS)(Inthousands)NumberofSharesAmountNumberofSharesAmountDeferredCompensationAccumulatedOtherComprehensiveIncome(Loss)AccumulatedDeficitTotalComprehensiveIncome(Loss)CommonStockandAdditionalPaidInCapitalExchangeableSharesBALANCE,December31,2003..................18,203$312,646—$—$(105)$(807)$(89,101)$222,633CommonstockissuedinacquisitionofOctigaBay......1,84656,756————56,756$—ExchangeablesharesissuedinacquisitionofOctigaBay..——79024,207———24,207—DeferredcompensationrelatedtoacquisitionofOctigaBay............................451,19042111,185(14,599)——(2,224)—Exchangeablesharesconvertedintocommonshares.....1,06731,219(1,067)(31,219)—————Acquisition-relatedstock-basedcompensationexpense...————11,134——11,134—FairvalueofOctigaBayoptionsacquired...........—2,579—————2,579—IssuanceofsharesunderEmployeeStockPurchasePlan..1011,796—————1,796—Exerciseofstockoptions.....................2192,841—————2,841—IssuanceofsharesunderCompany401(k)Planmatch...23645—————645—Exerciseofwarrants,lessissuancecostsof$191.......3203,634—————3,634—Commonstockissuedforbonus.................13374—————374—Compensationexpenseonrestrictedstock...........————105——105—Compensationexpenseonmodificationofstockoptions..—196—————196—Compensationexpenseonstockoptionsissuedtocontractors............................—35—————35—Othercomprehensiveincome:Unrealizedlossonavailable-for-saleinvestments.....—————(33)—(33)(33)Currencytranslationadjustment...............————(755)5,400—4,6455,400Netloss..............................——————(207,358)(207,358)(207,358)BALANCE,December31,2004..................21,837413,9111444,173(4,220)4,560(296,459)121,965$(201,991)Exchangeablesharesconvertedintocommonshares.....1243,597(124)(3,597)————$—IssuanceofsharesunderEmployeeStockPurchasePlan..2001,211—————1,211—Exerciseofstockoptions.....................22138—————138—IssuanceofsharesunderCompany401(k)Planmatch...52770—————770—Warrantsissuedinconnectionwithfinancing.........—219—————219—Restrictedsharesissuedforcompensation...........4912,881——(2,881)————Amortizationofdeferredcompensation............————4,106——4,106—Reversalofdeferredcompensationforstockoptionsduetoemployeeterminations.....................—(116)——116————Commonsharesissuedinexchangeforleaseamendment............................1780—————80—Othercomprehensiveincome:Reclassificationadjustmentforavailable-for-salerealizedlossesincludedinnetloss............—————24—2424Currencytranslationadjustment...............————681,674—1,7421,674Netloss..............................——————(64,308)(64,308)(64,308)BALANCE,December31,2005..................22,743422,69120576(2,811)6,258(360,767)65,947$(62,610)Commonstockoffering,lessissuancecosts..........8,62581,250—————81,250$—Exchangeablesharesconvertedintocommonshares.....20576(20)(576)—————IssuanceofsharesunderEmployeeStockPurchasePlan..64532—————532—Exerciseofstockoptions.....................3822,625—————2,625—IssuanceofsharesunderCompany401(k)Planmatch...48394—————394—Restrictedsharesissuedforcompensation...........355——————ReclassificationofdeferredcompensationtoadditionalpaidincapitaluponadoptionofFAS123R........(2,811)——2,811————Amortizationofdeferredcompensation............—2,099————2,099—Othercomprehensiveincome:Currencytranslationadjustment...............————597—597597Netloss..............................——————(12,070)(12,070)(12,070)BALANCE,December31,2006..................32,237$507,356—$—$—$6,855$(372,837)$141,374$(11,473)SeeaccompanyingnotesF-3FinancialsCRAYINC.ANDSUBSIDIARIESCONSOLIDATEDSTATEMENTSOFCASHFLOWS(Inthousands)200420052006YearsEndedDecember31,Operatingactivities:Netloss.............................................................$(207,358)$(64,308)$(12,070)Adjustmentstoreconcilenetlosstonetcashusedinoperatingactivities:Depreciationandamortization.............................................17,17919,57816,181Share-basedcompensationexpense..........................................11,8444,1062,099In-processresearchanddevelopmentcharge....................................43,400——Inventorywrite-down...................................................8,5135,7511,644Impairmentofcoretechnologyintangibleasset..................................—4,912—Amortizationofissuancecosts,convertiblenotespayableandlineofcredit................—1,0081,644Deferredincometaxes..................................................59,188(2,260)(124)Other.............................................................—80—Cashprovidedby(usedin)changesinoperatingassetsandliabilities,netoftheeffectsoftheOctigaBayacquisition:Accountsreceivable....................................................15,471(21,623)10,305Inventory...........................................................(47,443)(10,628)2,410Prepaidexpensesandotherassets...........................................11,5553,908337Serviceinventory......................................................(58)141—Accountspayable.....................................................9,609(8,422)7,562Accruedpayrollandrelatedexpenses,otheraccruedliabilitiesandadvanceresearchanddevelopmentpayments................................................1,06183323,720Othernon-currentliabilities...............................................—47336Deferredrevenue......................................................24,38329,746(41,136)Netcashprovidedby(usedin)operatingactivities.................................(52,656)(36,705)12,608Investingactivities:Sales/maturitiesofshort-terminvestments......................................68,63544,437—Purchasesofshort-terminvestments.........................................(68,318)(10,161)—AcquisitionofOctigaBay,netofcashacquired..................................(6,270)——Proceedsfromsaleofinvestment...........................................——239(Increase)decreaseinrestrictedcash.........................................(11,437)11,437(25,000)Purchasesofpropertyandequipment.........................................(12,518)(3,982)(2,611)Netcashprovidedby(usedin)investingactivities..................................(29,908)41,731(27,372)Financingactivities:Saleofcommonstock,netofissuancecosts....................................——81,250Proceedsfromissuanceofcommonstockthroughemployeestockpurchaseplan............1,7961,211532Proceedsfromexerciseofoptions...........................................2,8411382,625Proceedsfromexerciseofwarrants..........................................3,634——Proceedsfromissuanceofconvertiblenotespayable...............................80,000——Convertiblenotespayableandlineofcreditissuancecosts...........................(3,376)(755)(375)Principalpaymentsoncapitalleases.........................................(742)(731)(123)Netcashprovidedby(usedin)financingactivities.................................84,153(137)83,909Effectofforeignexchangeratechangesoncashandcashequivalents.....................370(595)157Netincreaseincashandcashequivalents.......................................1,9594,29469,302CashandcashequivalentsBeginningofperiod....................................................39,77341,73246,026Endofperiod........................................................$41,732$46,026$115,328Supplementaldisclosureofcashflowinformation:Cashpaidforinterest...................................................$153$2,972$3,329Cashpaidforincometaxes...............................................590312279Non-cashinvestingandfinancingactivities:Inventorytransferstofixedassetsandserviceinventory.............................$11,281$8,703$4,860Sharesissuedinacquisition...............................................83,542——Warrantsissuedinconnectionwithlineofcreditarrangement........................—219—SeeaccompanyingnotesF-4FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTSNOTE1DESCRIPTIONOFBUSINESSCrayInc.(“Cray”orthe“Company”)designs,develops,manufactures,marketsandserviceshighperformancecomputersystems,commonlyknownassupercomputers.Thesesystemsprovidecapabilityandcapacityfarbeyondtypicalserver-basedcomputersystemsandaddresschallengingscientificandengineeringcomputingproblems.In2006,theCompanyincurredanetlossof$12.1millionbutgenerated$12.6millionincashfromoperatingactivities.Management’splansprojectthattheCompany’scurrentcashresourcesandcashtobegeneratedfromoperationsin2007willbeadequatetomeettheCompany’sliquidityneedsforatleastthenexttwelvemonths.Theseplansassumesales,shipment,acceptanceandsubsequentcollectionsfromseverallargecustomers,aswellascashreceiptsonnewbookings.NOTE2REVERSESTOCKSPLITOnJune6,2006,theCompany’sshareholdersapprovedanamendmenttotheCompany’sarticlesofincorporationtoincreasethenumberofauthorizedsharesofcommonstockfrom150millionto300millionandalsoapprovedaone-for-fourreversestocksplitoftheCompany’sauthorizedandoutstandingcommonstock.Theseconcurrentapprovalsresultedin75millionauthorizedsharesoftheCompany’scommonstockwithaparvalueof$0.01pershare.ThereversestocksplitwaseffectivewithrespecttoshareholdersofrecordattheopeningoftradingonJune8,2006,andtheCompany’scommonstockbegantradingasadjustedforthereversestocksplitonthatsameday.Asaresultofthereversestocksplit,eachfoursharesofcommonstockwerecombinedintooneshareofcommonstockandthetotalnumberofsharesoutstandingwasreducedfromapproximately92millionsharestoapproximately23millionshares.TheCompanyhasretroactivelyadjustedallshareandpershareinformationtoreflectthereversestocksplitintheconsolidatedfinancialstatementsandnotesthereto,aswellasthroughouttherestofthisForm10-KReportforallperiodspresented.NOTE3SUMMARYOFSIGNIFICANTACCOUNTINGPOLICIESAccountingPrinciplesTheconsolidatedfinancialstatementsandaccompanyingnotesarepreparedinaccordancewithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica.PrinciplesofConsolidationTheconsolidatedfinancialstatementsincludetheaccountsoftheCompanyanditswholly-ownedsubsidiaries.Intercompanybalancesandtransactionshavebeeneliminated.ReclassificationsCertainprioryearamountshavebeenreclassifiedtoconformwiththecurrentyearpresentation.Therehasbeennoimpactonpreviouslyreportednetincome(loss)orshareholders’equity.UseofEstimatesPreparationoffinancialstatementsinconformitywithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmericarequiresmanagementtomakeestimatesandassumptionsthataffecttheamountsreportedintheconsolidatedfinancialstatementsandaccompanyingnotes.Theseestimatesarebasedonmanagement’sbestknowledgeofcurrenteventsandactionstheCompanymayundertakeinthefuture.Estimatesareusedinaccountingfor,amongotheritems,fairvaluedeterminationusedinrevenuerecognition,percentageofcompletionaccounting,estimatesofproportionalperformanceonco-fundedengineeringcontracts,determinationofinventoryatthelowerofcostormarket,usefullivesfordepreciationandamortization,determinationoffuturecashflowsassociatedwithimpairmenttestingforgoodwillandlong-livedassets,determinationofthefairvalueofstockoptionsandF-5Financialsassessmentsoffairvalue,estimationofrestructuringcosts,calculationofdeferredincometaxassets,potentialincometaxassessmentsandothercontingencies.TheCompanybasesitsestimatesonhistoricalexperience,currentconditionsandonotherassumptionsthatitbelievestobereasonableunderthecircumstances.Actualresultscoulddifferfromthoseestimates.Cash,CashEquivalentsandRestrictedCashCashandcashequivalentsconsistofhighlyliquidfinancialinstrumentsthatarereadilyconvertibletocashandhaveoriginalmaturitiesofthreemonthsorlessatthetimeofacquisition.TheCompanymaintainscashandcashequivalentbalanceswithfinancialinstitutionsthatexceedfederallyinsuredlimits.TheCompanyhasnotexpe-riencedanylossesrelatedtothesebalances,andmanagementbelievesitscreditrisktobeminimal.TheCompanyhaspledgedcash,cashequivalentsandothersecuritiesvaluedat$25millionasrequiredbyitslineofcreditagreement,asdescribedinNote14—ConvertibleNotesPayableandLinesofCredit.ForeignCurrencyDerivativesFromtimetotimetheCompanymayutilizeforwardforeigncurrencyexchangecontractstoreducetheimpactofforeigncurrencyexchangeraterisks.ForwardcontractsarecashflowhedgesoftheCompany’sforeigncurrencyexposuresandarerecordedatthecontract’sfairvalue.Theeffectiveportionoftheforwardcontractisinitiallyreportedin“Accumulatedothercomprehensiveincome,”acomponentofshareholders’equity,andwhenthehedgedtransactionisrecorded,theamountisreclassifiedintoresultsofoperationsinthesameperiod.Anyineffectivenessisrecordedtooperationsinthecurrentperiod.TheCompanymeasureshedgeeffectivenessbycomparingchangesinfairvaluesoftheforwardcontractandexpectedcashflowsbasedonchangesinthespotpricesoftheunderlyingcurrencies.Cashflowsfromforwardcontractsaccountedforascashflowhedgesareclassifiedinthesamecategoryasthecashflowsfromtheitemsbeinghedged.ConcentrationofCreditRiskTheCompanycurrentlyderivesasignificantportionofitsrevenuefromsalesofproductsandservicestodifferentagenciesoftheU.S.governmentorcommercialcustomersprimarilyservingvariousagenciesoftheU.S.government.SeeNote17—SegmentInformationforadditionalinformation.Giventhetypeofcustomers,theCompanydoesnotbelieveitsaccountsreceivablerepresentsignificantcreditrisk.AccountsReceivableAccountsreceivablearestatedatprincipalamountsandareprimarilycomprisedofamountscontractuallyduefromcustomersforproductsandservicesandamountsduefromgovernmentreimbursedresearchanddevelopmentcontracts.TheCompanyprovidesanallowancefordoubtfulaccountsbasedonanevaluationofcustomeraccountbalancespastdueninetydaysfromthedateofinvoicing.Indeterminingwhethertorecordanallowanceforaspecificcustomer,theCompanyconsidersanumberoffactors,includingpriorpaymenthistoryandfinancialinformationforthecustomer.TheCompanyhadnopledgesnoranyrestrictionsonitsaccountsreceivablebalancesatDecember31,2006.FairValuesofFinancialInstrumentsTheCompanygenerallyhasthefollowingfinancialinstruments:cashandcashequivalents,accountsreceivable,accountspayable,accruedliabilitiesandconvertiblenotespayable.Thecarryingvalueofcashandcashequivalents,accountsreceivable,accountspayableandaccruedliabilitiesapproximatetheirfairvaluebasedontheshort-termnatureofthesefinancialinstruments.Thefairvalueofconvertiblenotespayableisbasedonquotedmarketprices.TheCompany’sconvertiblenotespayablearetradedinamarketwithlowliquidityandarethereforesubjecttopricevolatility.AsofDecember31,2006and2005,thefairvalueoftheseconvertiblenotespayablewasapproximately$77millionand$44million,respectively,comparedtotheircarryingvalueof$80million.F-6FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)InventoriesInventoriesarevaluedatcost(onafirst-in,first-outbasis)whichisnotinexcessofestimatedcurrentmarketprices.TheCompanyregularlyevaluatesthetechnologicalusefulnessandanticipatedfuturedemandforvariousinventorycomponentsandtheexpecteduseoftheinventory.Whenitisdeterminedthatthesecomponentsdonotfunctionasintended,orquantitiesonhandareinexcessofestimatedrequirements,thecostsassociatedwiththesecomponentsarechargedtoexpense.TheCompanyhadnopledgesnoranyrestrictionsonanyinventorybalancesatDecember31,2006.Inconnectionwithcertainofitssalesagreements,theCompanymayreceiveusedequipmentfromacustomer.ThisinventorygenerallywillberecordedatnovaluebasedontheexpectationthattheCompanywillnotbeabletoresellorotherwiseusetheequipment.IntheeventthattheCompanyhasaspecificcontractualplanforresaleatthedatetheinventoryisacquired,theinventoryisrecordedatitsestimatedfairvalue.PropertyandEquipment,netPropertyandequipmentarerecordedatcostlessaccumulateddepreciationandamortization.Depreciationiscalculatedonastraight-linebasisovertheestimatedusefullivesoftherelatedassets,rangingfrom18monthstosevenyearsforfurniture,fixturesandcomputerequipment,andeightto25yearsforbuildingsandlandimprovements.Equipmentundercapitalleaseisamortizedoverthelesseroftheleasetermoritsestimatedusefullife.Leaseholdimprovementsareamortizedoverthelesseroftheirestimatedusefullivesorthetermofthelease.Thecostofsoftwareobtainedorinventorytransferredforinternaluseiscapitalizedanddepreciatedovertheirestimatedusefullives,generallyfouryears.TheCompanyhadnopledgesnoranyrestrictionsonanyofitsnetpropertyandequipmentbalanceatDecember31,2006.InaccordancewithAmericanInstituteofCertifiedPublicAccountants(“AICPA”)StatementofPosition(“SOP”)98-1,AccountingfortheCostsofComputerSoftwareDevelopedorObtainedforInternalUse,theCompanymaycapitalizecertaincostsassociatedwiththeimplementationofsoftwaredevelopedforinternaluse.Costscapitalizedprimarilyconsistofemployeesalariesandbenefitsallocatedtotheimplementationproject.TheCompanycapitalizednosuchcostsin2006or2005.ServiceInventoryServiceinventoryisvaluedatthelowerofcostorestimatedmarketandrepresentsinventoryusedtosupportserviceandmaintenanceagreementswithcustomers.Asinventoryisutilized,replaceditemsarereturnedandareeitherrepairedorscrapped.Costsincurredtorepairinventorytoausablestatearechargedtoexpenseasincurred.Serviceinventoryisrecordedatcostandisamortizedovertheestimatedservicelifeoftherelatedproductplatform(generallyfouryears).TheCompanyhadnopledgesnoranyrestrictionsonanyserviceinventorybalancesatDecember31,2006.GoodwillandOtherIntangibleAssetsInaccordancewithStatementofFinancialAccountingStandards(“FAS”)No.142,GoodwillandOtherIntangibleAssets,theCompanytestsgoodwillforimpairmentonanannualbasisasofJanuary1,orifindicatorsofpotentialimpairmentexist,usingafair-valuebasedapproach.TheCompanycurrentlyhasoneoperatingsegmentandreportingunit.Assuch,theCompanyevaluatesimpairmentbasedoncertainexternalfactors,suchasitsmarketcapitalization.Noimpairmentofgoodwillhasbeenidentifiedduringanyoftheperiodspresented.TheCompanycapitalizescertainexternallegalcostsincurredforpatentfilings.TheCompanybeginsamortizationofthesecostsaseachpatentisawarded.Patentsareamortizedovertheirestimatedusefullives(generallyfiveyears).TheCompanyperformsperiodicreviewofitscapitalizedpatentcoststoensurethatthepatentshavecontinuingvaluetotheCompany.F-7FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)ImpairmentofLong-LivedAssetsInaccordancewithFASNo.144,AccountingfortheImpairmentorDisposalofLong-LivedAssets,managementtestslong-livedassetstobeheldandusedforrecoverabilitywhenevereventsorchangesincircumstancesindicatethattheircarryingamountmaynotberecoverable.Noimpairmentofintangibleassetswasrecordedduring2006.Aspartofthe2004OctigaBaySystemsCorporation(“OctigaBay”)acquisition,theCompanyassigned$6.7millionofvaluetocoretechnology.InDecember2005theCompanyannouncedplanstofurtherintegrateitstechnologyplatforms,andcombinetheCrayXD1andtheCrayXT3productsintoaunifiedproductoffering.Theexpectedundiscountedcashflowsfromtheproductusingthecoretechnologywerenotsufficienttorecoverthecarryingvalueoftheasset.TheCompanyperformedafairvalueassessmentsimilartotheoriginalvaluationanddeterminedtheassethadnocontinuingvalue.TheCompanywroteofftheunamortizedbalanceofitscoretechnologyintangibleassetof$4.9millionwhichisincludedin“Restructuring,SeveranceandImpairment”intheaccompanying2005ConsolidatedStatementsofOperations.Noimpairmentofintangibleassetswasrecordedduring2006or2004.RevenueRecognitionTheCompanyrecognizesrevenuewhenitisrealizedorrealizableandearned.InaccordancewiththeSecuritiesandExchangeCommissionStaffAccountingBulletin(“SAB”)No.104,RevenueRecognitioninFinancialStatements,theCompanyconsidersrevenuerealizedorrealizableandearnedwhenithaspersuasiveevidenceofanarrangement,theproducthasbeenshippedortheserviceshavebeenprovidedtothecustomer,thesalespriceisfixedordeterminable,nosignificantunfulfilledCompanyobligationsexist,andcollectibilityisreasonablyassured.TheCompanyrecordsrevenueinitsStatementsofOperationsnetofsales,use,valueaddedorcertainexcisetaxesimposedbygovernmentalauthoritiesonspecificsalestransactions.Inadditiontotheaforementionedgeneralpolicy,thefollowingarethespecificrevenuerecognitionpoliciesforeachmajorcategoryofrevenueandformultiple-elementarrangements.Products.TheCompanyrecognizesrevenuefromitsproductlinesasfollows:(cid:129)CrayX1/X1EandCrayXT3/XT4ProductLines:TheCompanyrecognizesrevenuefromproductsalesuponcustomeracceptanceofthesystem,whentherearenosignificantunfulfilledCompanyobligationsstipulatedbythecontractthataffectthecustomer’sfinalacceptance,thepriceisfixedordeterminableandcollectionisreasonablyassured.Acustomer-signednoticeofacceptanceorsimilardocumentisrequiredfromthecustomerpriortorevenuerecognition.(cid:129)CrayXD1ProductLine:TheCompanyrecognizesrevenuefromproductsalesofCrayXD1systemsuponshipmentto,ordeliveryto,thecustomer,dependinguponcontractterms,whentherearenosignificantunfulfilledCompanyobligationsstipulatedbythecontract,thepriceisfixedordeterminableandcollectionisreasonablyassured.Ifthereisacontractualrequirementforcustomeracceptance,revenueisrecognizeduponreceiptofthenoticeofacceptanceandwhentherearenounfulfilledobligations.RevenuefromcontractsthatrequiretheCompanytodesign,develop,manufactureormodifycomplexinformationtechnologysystemstoacustomer’sspecificationsisrecognizedusingthepercentageofcompletionmethodforlong-termdevelopmentprojectsunderAICPASOP81-1,AccountingforPerformanceofConstruction-TypeandCertainProduction-TypeContracts.Percentageofcompletionismeasuredbasedontheratioofcostsincurredtodatecomparedtothetotalestimatedcosts.Totalestimatedcostsarebasedonseveralfactors,includingestimatedlaborhourstocompletecertaintasksandtheestimatedcostofpurchasedcomponentsorservices.Estimatesmayneedtobeadjustedfromquartertoquarter,whichwouldimpactrevenueandmarginsonacumulativebasis.Totheextenttheestimateoftotalcoststocompletethecontractindicatesaloss,suchamountisrecognizedinfullintheperiodthatthedeterminationismade.In2004,theCompanyconcludedthatitsRedStormcontractwouldresultinanestimatedlossof$7.6million.Thisamountwaschargedtocostofproductrevenue.During2005,theCompanyincreasedtheestimateofthelossF-8FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)onthecontractby$7.7million(cumulativelossof$15.3million)duetoadditionalhardwaretobedeliveredtosatisfycontractualandperformanceissues.Thisamountwasalsochargedtocostofproductrevenue.AsofDecember31,2006and2005,thebalanceintheRedStormlosscontractaccrualwas$157,000and$5.7million,respectively,andisincludedin“OtherAccruedLiabilities”ontheaccompanyingConsolidatedBalanceSheets.Services.MaintenanceservicesareprovidedunderseparatemaintenancecontractswiththeCompany’scustomers.Thesecontractsgenerallyprovideformaintenanceservicesforoneyear,althoughsomeareformulti-yearperiods,oftenwithprepaymentsforthetermofthecontract.TheCompanyconsidersthemaintenanceperiodtocommenceuponinstallationandacceptanceoftheproduct,whichmayincludeawarrantyperiod.TheCompanyallocatesaportionofthesalespricetomaintenanceservicerevenuebasedonestimatesoffairvalue.Revenueforthemaintenanceofcomputersisrecognizedratablyoverthetermofthemaintenancecontract.Maintenancecontractsthatarepaidinadvancearerecordedasdeferredrevenue.TheCompanyconsidersfiscalfundingclausesascontingenciesfortherecognitionofrevenueuntilthefundingisvirtuallyassured.RevenuefromCrayTechnicalServicesisrecognizedastheservicesarerendered.Multiple-ElementArrangements.TheCompanycommonlyentersintotransactionsthatincludemultiple-elementarrangements,whichmayincludeanycombinationofhardware,maintenance,andotherservices.InaccordancewithEmergingIssuesTaskForceIssueNo.00-21,RevenueArrangementswithMultipleDeliverables,whensomeelementsaredeliveredpriortoothersinanarrangementandallofthefollowingcriteriaaremet,revenueforthedeliveredelementisrecognizedupondeliveryandacceptanceofsuchitem:(cid:129)Theelementcouldbesoldseparately;(cid:129)Thefairvalueoftheundeliveredelementisestablished;and(cid:129)Incaseswithanygeneralrightofreturn,theCompany’sperformancewithrespecttoanyundeliveredelementiswithintheCompany’scontrolandprobable.Ifallofthecriteriaarenotmet,revenueisdeferreduntildeliveryofthelastelementastheelementswouldnotbeconsideredaseparateunitofaccountingandrevenuewouldberecognizedasdescribedaboveundertheCompany’sproductlineorservicerevenuerecognitionpolicies.TheCompanyconsidersthemaintenanceperiodtocommenceuponinstallationandacceptanceoftheproduct,whichmayincludeawarrantyperiodandaccordinglyallocatesaportionofthesalespriceasaseparatedeliverablewhichisrecognizedasservicerevenueovertheentireserviceperiod.ForeignCurrencyTranslationThefunctionalcurrencyoftheCompany’sforeignsubsidiariesisthelocalcurrency.AssetsandliabilitiesofforeignsubsidiariesaretranslatedintoU.S.dollarsatyear-endexchangerates,andrevenueandexpensesaretranslatedataverageratesprevailingduringtheyear.Translationadjustmentsareincludedinaccumulatedothercomprehensiveincome(loss),aseparatecomponentofshareholders’equity.TransactiongainsandlossesarisingfromtransactionsdenominatedinacurrencyotherthanthefunctionalcurrencyoftheentityinvolvedareincludedintheConsolidatedStatementsofOperations.Aggregatetransactionlossesincludedinnetlossin2006,2005and2004were$1.8million,$1.4million,and$361,000,respectively.ResearchandDevelopmentResearchanddevelopmentcostsincludecostsincurredinthedevelopmentandproductionoftheCompany’shighperformancecomputingsystems,costsincurredtoenhanceandsupportexistingsoftwarefeaturesandexpensesrelatedtofutureproductdevelopment.Researchanddevelopmentcostsareexpensedasincurred,andmaybeoffsetbyco-fundingfromtheU.S.government.Amountstobereceivedunderco-fundingarrangementswiththeU.S.governmentarebasedoneithercontractualmilestonesorcostsincurred.Theseco-fundingmilestonepaymentsarerecognizedasanoffsettoF-9FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)researchanddevelopmentexpensesasperformanceisestimatedtobecompletedandismeasuredasmilestoneachievementsorascostsareincurred.AsofDecember31,2006and2005,theCompanyhadadvancepaymentliabilities(milestonesbilledinadvanceofamountsrecognized)underco-fundedresearchanddevelopmentarrangementsof$21.5millionand$1.5million,respectively.TheCompanydoesnotrecordareceivablefromtheU.S.governmentpriortocompletingtherequirementsnecessarytobillforamilestoneorcostreimbursement.FundingfromtheU.S.governmentissubjecttocertainbudgetrestrictionsandassuch,theremaybeperiodsinwhichresearchanddevelopmentcostsareexpensedasincurredforwhichnoreimbursementisrecorded,asmilestoneshavenotbeencompletedortheU.S.governmenthasnotfundedanagreement.TheCompanyclassifiesamountstobereceivedfromfundedresearchanddevelopmentprojectsaseitherrevenueorareductiontoresearchanddevelopmentexpense,basedonthespecificfactsandcircumstancesofthecontractualarrangement,consideringtotalcostsexpectedtobeincurredcomparedtototalexpectedfundingandthenatureoftheresearchanddevelopmentcontractualarrangement.Intheeventthataparticulararrangementisdeterminedtorepresentrevenue,thecorrespondingresearchanddevelopmentcostsareclassifiedascostofrevenue.IncomeTaxesTheCompanyaccountsforincometaxesunderFASNo.109,AccountingforIncomeTaxes(“FAS109”).Deferredtaxassetsandliabilitiesaredeterminedbasedontemporarydifferencesbetweenfinancialreportingandtaxbasesofassetsandliabilities,operatinglossandtaxcreditcarryforwards,andaremeasuredusingtheenactedtaxratesandlawsthatwillbeineffectwhenthedifferencesareexpectedtoberecoveredorsettled.Realizationofcertaindeferredtaxassetsisdependentupongeneratingsufficienttaxableincomeintheappropriatejurisdiction.TheCompanyrecordsavaluationallowancetoreducedeferredtaxassetstoamountsthataremorelikelythannottoberealized.Theinitialrecordingandanysubsequentchangestovaluationallowancesarebasedonanumberoffactors(positiveandnegativeevidence),asrequiredbyFAS109.TheCompanyconsidersitsactualhistoricalresultstohavestrongerweightthanothermoresubjectiveindicatorswhenconsideringwhethertoestablishorreduceavaluationallowance.Stock-BasedCompensationOnJanuary1,2006,theCompanyadoptedthefairvaluerecognitionprovisionsofFASNo.123(R),Share-BasedPayment,(“FAS123R”).PriortoJanuary1,2006,theCompanyaccountedforstock-basedpaymentsundertherecognitionandmeasurementprovisionsofAPBOpinionNo.25,AccountingforStockIssuedtoEmployees(“APB25”),andrelatedInterpretations,aspermittedbyFASNo.123,AccountingforStock-BasedCompensation(“FAS123”).InaccordancewithAPB25,nocompensationcostwasrequiredtoberecognizedforoptionsgrantedthathadanexercisepriceequaltothemarketvalueoftheunderlyingcommonstockonthedateofgrant.TheCompanyadoptedFAS123Rusingthemodified-prospectivetransitionmethod.Underthattransitionmethod,compensationcostrecognizedfortheyearendedDecember31,2006includes:(a)compensationcostforallshare-basedpaymentsgrantedpriorto,butnotyetvestedasofJanuary1,2006,basedonthegrant-datefairvalueestimatedinaccordancewiththeoriginalprovisionsofFAS123,and(b)compensationcostforallshare-basedpaymentsgrantedsubsequenttoJanuary1,2006,basedonthegrant-datefairvalueestimatedinaccordancewiththeprovisionsofFAS123R.Thefinancialresultsforthepriorperiodshavenotbeenrestated.TheCompanytypicallyissuesstockoptionswithafour-yearvestingperiod(definedbyFAS123Rastherequisiteserviceperiod),andnoperformanceorserviceconditions,otherthancontinuedemployment.TheCompanyamortizesstockcompensationcostratablyovertherequisiteserviceperiod.F-10FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)ThefairvalueofunvestedstockgrantsisbasedonthepriceofashareoftheCompany’scommonstockonthedateofgrant.Indeterminingthefairvalueofstockoptions,theCompanyusestheBlack-Scholesoptionpricingmodelthatemploysthefollowingkeyweightedaverageassumptions:200420052006Risk-freeinterestrate................................4.2%4.1%4.5%Expecteddividendyield..............................0%0%0%Volatility..........................................82%85%73%Expectedlife......................................6.9years4.6years4.0yearsWeightedaverageBlack-Scholesvalueofoptionsgranted.....$15.00$5.44$6.00Therisk-freeinterestrateisbasedontheU.S.Treasuryyieldcurveineffectatthetimeofgrant.TheCompanydoesnotanticipatedeclaringdividendsintheforeseeablefuture.Volatilityisbasedonhistoricaldata.FortheyearendedDecember31,2006,theexpectedtermofanoptionwasbasedontheassumptionthatoptionswillbeexercised,onaverage,abouttwoyearsaftervestingoccurs,whichapproximateshistoricalexercisepractices;formostoptions,25%vestafteroneyearwiththebalancevestingmonthlyoverthesubsequentthreeyears.FAS123RalsorequiresthattheCompanyrecognizecompensationexpenseforonlytheportionofoptionsorstockunitsthatareexpectedtovest.Therefore,managementappliesanestimatedforfeitureratethatisderivedfromhistoricalemployeeterminationdataandadjustedforexpectedfutureemployeeturnoverrates.TheestimatedforfeiturerateappliedfortheyearendedDecember31,2006is10%.Iftheactualnumberofforfeituresdiffersfromthoseestimatedbymanagement,additionaladjustmentstocompensationexpensemayberequiredinfutureperiods.TheCompany’sstockpricevolatility,optionlivesandexpectedforfeitureratesinvolvemanagement’sbestestimatesatthetimeofsuchdetermination,allofwhichimpactthefairvalueoftheoptioncalculatedundertheBlack-Scholesmethodologyand,ultimately,theexpensethatwillberecognizedoverthelifeoftheoption.TheCompanyalsohasanemployeestockpurchaseplan(“ESPP”)whichallowsemployeestopurchasesharesoftheCompany’scommonstockat95%oftheclosingmarketpriceonthefourthbusinessdayaftertheendofeachofferingperiod.TheESPPisdeemednon-compensatoryandthereforeisnotsubjecttotheprovisionsofFAS123R.For2006,theCompanyrecognized$123,000ofadditionalnon-cash,share-basedcompensationexpenseduetotheadoptionofFAS123R,whichincreasedthelossfromoperationsandnetlossbysuchamount.ThisexpenseincreasedtheCompany’snetlosspersharefortheyearendedDecember31,2006,by$.01,from$(0.52)to$(0.53).IfcompensationcostfortheCompany’sstockoptionplansanditsESPPhadbeendeterminedbasedonthefairvalueatthegrantdatesforawardsunderthoseplansinaccordancewithafairvaluebasedmethodofFAS123,theCompany’snetlossandnetlosspercommonsharefortheyearsendedDecember31,2005and2004wouldhavebeentheproformaamountsindicatedbelow(inthousands).Forpurposesofthisproformadisclosure,thevalueoftheoptionsisamortizedratablytoexpenseovertheoptions’vestingperiods.Becausetheestimatedvalueisdeterminedasofthedateofgrant,theactualvalueultimatelyrealizedbytheemployeemaybesignificantlydifferent.F-11FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)20042005Netloss,asreported..........................................$(207,358)$(64,308)Add:Stock-basedemployeecompensationincludedinreportednetloss,netofrelatedtaxeffects........................................11,8444,106Less:Amortizedstock-basedemployeecompensationexpensedeterminedunderfairvaluebasedmethodforallawards,netofrelatedtaxeffects.................................................(19,423)(30,524)Proformanetloss...........................................$(214,937)$(90,726)Amortizationofproformastock-basedemployeecompensationexpenseincreasedsignificantlyin2005duetotheactionstakentoacceleratevesting,asdescribedinNote15—Shareholders’Equity—StockOptionPlans.ProformabasicanddilutednetlosspercommonsharefortheyearsendedDecember31,2005and2004areasfollows:20042005Basicanddilutednetlosspercommonshare:Asreported..................................................$(9.95)$(2.91)Proforma...................................................$(10.31)$(4.10)ShippingandHandlingCostsCostsrelatedtoshippingandhandlingareincludedin“CostofProductRevenue”and“CostofServiceRevenue”ontheaccompanyingConsolidatedStatementsofOperations.AdvertisingCostsMarketingandsalesexpensesintheaccompanyingConsolidatedStatementsofOperationsincludeadvertisingexpensesof$871,000,$697,000,and$683,000in2006,2005and2004,respectively.TheCompanyincursadvertisingcostsforrepresentationatcertaintradeshows,promotionalevents,salesleadgeneration,aswellasdesignandprintingcostsforpromotionalmaterials.TheCompanyexpensesalladvertisingcostsasincurred.Earnings(Loss)PerShare(“EPS”)BasicEPSiscomputedbydividingnetincomeavailabletocommonshareholdersbytheweightedaveragenumberofcommonshares,includingexchangeablesharesbutexcludingunvestedrestrictedstock,outstandingduringtheperiod.DilutedEPSiscomputedbydividingnetincomeavailabletocommonshareholdersbytheweightedaveragenumberofcommonandpotentialcommonsharesoutstandingduringtheperiod,whichincludestheadditionaldilutionrelatedtoconversionofstockoptions,unvestedrestrictedstockandcommonstockpurchasewarrantsascomputedunderthetreasurystockmethodandthecommonsharesissuableuponconversionoftheoutstandingconvertiblenotes.FortheyearsendedDecember31,2006,2005and2004,outstandingstockoptions,unvestedrestrictedstock,warrants,andsharesissuableuponconversionoftheconvertiblenotesareantidilutivebecauseofnetlosses,andassuch,theireffecthasnotbeenincludedinthecalculationofdilutednetlosspershare.Potentiallydilutivesecuritiesof11.7million,12.1millionand9.1million,respectively,havebeenexcludedfromthedenominatorinthecomputationofdilutedEPSfortheyearsendedDecember31,2006,2005and2004,respectively,becausetheyareantidilutive.F-12FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)AccumulatedOtherComprehensiveIncomeAccumulatedothercomprehensiveincome,acomponentofshareholders’equity,consistedofthefollowingatDecember31(inthousands):200420052006Accumulatedunrealizedlossonavailable-for-saleinvestments.......$(24)$—$—Accumulatedcurrencytranslationadjustment....................4,5846,2586,855Accumulatedothercomprehensiveincome....................$4,560$6,258$6,855RecentAccountingPronouncementsInJune2006,theFinancialAccountingStandardsBoard(“FASB”)issuedInterpretationNo.48,AccountingforUncertaintyinIncomeTaxes,(“FIN48”).FIN48clarifiestheaccountingforuncertaintyinincometaxesandprescribesarecognitionthresholdandmeasurementattributeforthefinancialstatementrecognitionandmea-surementofataxpositiontakenorexpectedtobetakeninataxreturn.FIN48iseffectiveforfiscalyearsbeginningafterDecember15,2006.TheCompanydoesnotexpecttheadoptionofFIN48tobesignificantexcepttoprovideadditionaldisclosuresabouttaxuncertainties.InSeptember2006,theFASBissuedFASNo.157,FairValueMeasurements(“FAS157”).FAS157definesfairvalue,establishesaframeworkformeasuringfairvalueandexpandsdisclosuresaboutfairvaluemeasurementsbutdoesnotrequireanynewfairvaluemeasurements.FAS157iseffectiveforfinancialstatementsissuedforfiscalyearsbeginningafterNovember15,2007,andinterimperiodswithinthosefiscalyears.TheCompanydoesnotexpecttheadoptionofFAS157tohaveasignificantimpactonitsfinancialstatements.InSeptember2006,theFASBissuedFASNo.158,Employers’AccountingforDefinedBenefitPensionandOtherPostretirementPlans,(“FAS158”).FAS158requiresanemployertorecognizetheoverfundedorunder-fundedstatusofadefinedbenefitpostretirementplan(otherthanamultiemployerplan)asanassetorliabilityinitsbalancesheetandtorecognizechangesinthatfundedstatusintheyearinwhichthechangesoccurthroughcomprehensiveincome.TheCompanyadoptedFAS158asofDecember31,2006,andthisadoptiondidnothaveamaterialimpactonitsfinancialposition.InFebruary2007,theFASBissuedFASNo.159,TheFairValueOptionforFinancialAssetsandFinancialLiabilities,(“FAS159”).FAS159permitsentitiestochoosetomeasuremanyfinancialinstrumentsandcertainotheritemsatfairvalue.Theobjectiveistoimprovefinancialreportingbyprovidingentitieswiththeopportunitytomitigatevolatilityinreportedearningscausedbymeasuringrelatedassetsandliabilitiesdifferentlywithouthavingtoapplycomplexhedgeaccountingprovisions.FAS159iseffectiveforfinancialstatementsissuedforfiscalyearsbeginningafterNovember15,2007.TheCompanyhasnotyetdeterminedtheimpactofadoptingFAS159ontheCompany’sfinancialstatements.F-13FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)NOTE4ACCOUNTSRECEIVABLE,NETNetaccountsreceivableconsistedofthefollowingatDecember31(inthousands):20052006Tradeaccountsreceivable........................................$23,023$39,766Unbilledreceivables............................................12,3404,045Advancebillings...............................................19,8941,07855,25744,889Allowancefordoubtfulaccounts...................................(193)(99)Accountsreceivable,net.......................................$55,064$44,790UnbilledreceivablesrepresentamountswheretheCompanyhasrecognizedrevenueinadvanceofthecontractualbillingterms.Advancebillingsrepresentbillingsmadebasedoncontractualtermsforwhichnorevenuehasyetbeenrecognized.AsofDecember31,2006and2005,accountsreceivableincluded$34.7millionand$41.6million,respec-tively,duefromU.S.governmentagenciesandcustomersprimarilyservingtheU.S.government.Ofthisamount,$4.0millionand$12.0million,respectively,wereunbilled,baseduponcontractualbillingarrangementswiththesecustomers.NOTE5INVENTORYAsummaryofinventoryisasfollows(inthousands):20052006December31,Componentsandsubassemblies....................................$10,706$22,536Workinprocess...............................................8,31415,310Finishedgoods................................................48,69220,952$67,712$58,798AsofDecember31,2006and2005,$17.7millionand$48.7million,respectively,offinishedgoodsinventorywaslocatedatcustomersitespendingacceptance.AtDecember31,2006and2005,$16.4millionand$33.2million,respectively,wasrelatedtoasinglecustomerineachyear.Revenuefor2006,2005,and2004includes$256,000,$2.1million,and$498,000,respectively,fromthesaleofrefurbishedinventoryrecordedatazerocostbasis.In2005,theamountconsistedmainlyofthesaleofarefurbishedCrayT3Esupercomputer,oneoftheCompany’slegacysystems.During2006,theCompanywroteoff$1.6millionofinventory,primarilyrelatedtoinventoryontheCrayXT3productline.During2005,theCompanywroteoff$5.8millionofinventory,primarilyrelatedtotheCrayX1EandCrayXD1productlines.During2004,theCompanywroteoff$8.5millionofinventory,primarilyrelatedtotheCrayX1productline.F-14FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)NOTE6PROPERTYANDEQUIPMENT,NETAsummaryofpropertyandequipmentisasfollows(inthousands):20052006December31,Land......................................................$131$131Buildings...................................................9,6389,965Furnitureandequipment.......................................14,16114,753Computerequipment..........................................70,70473,825Leaseholdimprovements.......................................3,0463,06097,680101,734Accumulateddepreciationandamortization.........................(66,388)(80,170)Propertyandequipment,net.....................................$31,292$21,564Depreciationexpensefor2006,2005and2004was$16.1million,$17.9millionand$15.7million,respectively.NOTE7SERVICEINVENTORY,NETAsummaryofserviceinventoryisasfollows(inthousands):20052006December31,Serviceinventory.............................................$26,201$28,797Accumulateddepreciation.......................................(22,916)(24,505)Serviceinventory,net..........................................$3,285$4,292NOTE8GOODWILLANDINTANGIBLEASSETSThefollowingtableprovidesinformationaboutactivityingoodwillfortheyearsendedDecember31,2006and2005,respectively(inthousands):20052006Goodwill,atJanuary1..........................................$55,644$56,839Foreigncurrencytranslationadjustmentsandother......................1,195299Goodwill,atDecember31........................................$56,839$57,138InApril2004,theCompanycompletedtheacquisitionofOctigaBay,aprivately-helddevelopmentstagecompanylocatedinBurnaby,BritishColumbia,for$99.5millionandaccountedforthetransactionunderthepurchasemethodofaccounting.Goodwillofapproximately$39millionwasrecorded.Additionally,in-processresearchanddevelopmentof$43.4millionwasexpensedin2004.IntangibleassetsasofDecember31,2006and2005consistedofnetcapitalizedpatentcostsof$1.4millionand$1.1million,respectively.Amortizationexpensefor2006,2005and2004was$101,000,$1.6million,and$1.5million,respectively.AmortizationdecreasedsignificantlyfortheyearendedDecember31,2006asaresultoftheCompany’swriteoffofitscoretechnologyintangibleassetinDecember2005.F-15FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)NOTE9DEFERREDREVENUEDeferredrevenueconsistedofthefollowing(inthousands):20052006December31,Deferredproductrevenue........................................$58,593$26,993Deferredservicerevenue.........................................28,39018,730Totaldeferredrevenue.........................................86,98345,723Lesslong-termdeferredrevenue...................................(5,234)(2,475)Deferredrevenueincurrentliabilities.............................$81,749$43,248AtDecember31,2006and2005,deferredrevenueincluded$19.0millionand$43.5million,respectively,relatedtoasinglecustomerineachyear.NOTE10RESTRUCTURINGANDSEVERANCECHARGESDuring2006,theCompanyrecognizednetrestructuringchargesof$1.3million,whichisincludedin“Restructuring,SeveranceandImpairment”ontheaccompanyingConsolidatedStatementsofOperations,allofwhichoriginatedfromactionsarisingduring2005.Therewerenonewactionstakenduring2006.During2005,theCompanyrecognizedrestructuringchargesof$4.8million,whichisincludedin“Restruc-turing,SeveranceandImpairment”ontheaccompanyingConsolidatedStatementsofOperations,netofadjust-mentsforpreviouslyaccruedamounts.Theserestructuringchargesweretheresultoftwoactionstakenduring2005,oneofwhichwasaworldwidereductioninworkforcewhichwasannouncedonJune27,2005,andaffectedemployeesinoperations,salesandmarketing.TheotheractionwasaplanannouncedonDecember12,2005toreducenearly65full-timestaff,principallybasedintheCompany’sBurnaby,BritishColumbia,Canadafacility,baseduponCompanyplanstoincreaseresearchanddevelopmentefficiencies,lowercostsandintegratetechnologyplatforms,andmainlyaffectedemployeesinresearchanddevelopment.During2004,theCompanyrecognizedrestructuringcostsof$8.2millionin“Restructuring,SeveranceandImpairment”ontheaccompanyingConsolidatedStatementsofOperations,includinga$196,000compensationchargerelatedtothemodificationofstockoptionsforcertainindividualsaffectedbytherestructuring.The$196,000chargewasrecordeddirectlytocommonstock.Substantiallyalloftherestructuringcostsrepresentseveranceexpensesfor131terminatedemployees.ActivityrelatedtotheCompany’srestructuringliability,includedin“AccruedPayrollandRelatedExpenses”ontheaccompanyingConsolidatedBalanceSheets,duringtheyearsendedDecember31isasfollows(inthousands):200420052006Balance,January1.....................................$3,069$4,690$3,582Additionalrestructuringcharge............................8,0775,0921,284Payments............................................(6,420)(5,724)(3,849)Adjustmentstopreviouslyaccruedamounts...................(91)(255)(33)Foreigncurrencytranslationadjustment......................55(221)79Totalrestructuringandseveranceliability,December31..........4,6903,5821,063Lesslong-termrestructuringandseveranceliability.............—(362)—Currentrestructuringandseveranceliability...................$4,690$3,220$1,063F-16FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)NOTE11FOREIGNCURRENCYDERIVATIVEInordertoreducetheimpactofforeigncurrencyexchangerateriskrelatedtoasalescontractdenominatedinBritishpoundsterling,theCompanyenteredintoaforwardcontractonFebruary6,2006withanoriginalnotionalamountof£15milliontohedgeanticipatedcashreceiptsonthespecificsalescontract.DuringDecember2006,thefinalcashreceiptswerereceivedandthehedgecontractwassettled.TheamountreclassifiedfromOtherComprehensiveIncome(Loss)wasa$192,000reductiontorevenue.PriortoitsdesignationasaneffectivehedgeonJune30,2006,theCompanyrecordedlossesofapproximately$1.3millionin2006,whichareincludedin“Otherexpense”intheaccompanyingConsolidatedStatementofOperations.InJanuaryandFebruary2007,theCompanyenteredintoadditionalforwardcontractswithnotionalamountstotaling£37.8milliontohedgeanticipatedcashreceiptsonanotherspecificsalescontract.TheseforwardcontractsweredesignatedashedgesinFebruary2007.Thesehedgecontractsareexpectedtobesettledascashreceiptsarereceived,withthefinalcashreceiptsexpectedinlate2009.NOTE12COMMITMENTSANDCONTINGENCIESTheCompanyleasescertainpropertyandequipmentundercapitalleasespursuanttomasterequipmentleaseagreementsandhasnon-cancelableoperatingleasesforfacilities.Underthemasterequipmentleaseagreements,theCompanyhadfixedassetbalancesof$7.7millionand$7.5millionasofDecember31,2006and2005,respectively,netofaccumulatedamortizationof$6.7millionand$5.4million,respectively.TheCompanyhasrecordedrentexpenseunderleasesforbuildingsorofficespaceaccountedforasoperatingleasesin2006,2005and2004of$3.5million,$4.1millionand$4.2million,respectively.AsofDecember31,2006,theCompanyhadnocommitmentspast2012,exceptforprincipalandinterestdueonitsconvertiblenotespayabledescribedinNote14—ConvertibleNotesPayableandLinesofCredit.MinimumcontractualcommitmentsasofDecember31,2006,wereasfollows(inthousands):CapitalLeasesOperatingLeasesDevelopmentAgreements2007..............................................$32$3,215$12,9222008..............................................—2,576432009..............................................—793—2010..............................................—205—2011.............................................—205—Thereafter..........................................—22—Minimumcontractualcommitments.......................32$7,016$12,965Lessamountrepresentinginterest......................(1)Recordedcapitalleaseobligations........................$31Initsnormalcourseofoperations,theCompanyengagesindevelopmentarrangementsunderwhichithiresoutsideengineeringresourcestoaugmentitsexistinginternalstaffinordertocompleteresearchanddevelopmentprojects,orpartsthereof.FortheyearsendedDecember31,2006,2005and2004,theCompanyincurred$23.9million,$20.3millionand$16.8million,respectively,forsucharrangements.InOctober2005,theCompanyrenegotiatedoneofitsfacilityleasestoconsolidateitsfloorspaceinitsheadquartersinSeattle,Washington.TheCompanyissued17,500sharesofcommonstocktothelandlord,MerrillPlace,LLC,forreleasefromcertainofitsoperatingleaseobligations.TheCompanycharged$80,000,representingthefairvalueofthesharesissued,to“Restructuring,SeveranceandImpairment”ontheaccompanyingConsol-idatedStatementsofOperationsforthisissuanceandrelatedreleasefromfutureobligations.F-17FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)LitigationAsofDecember31,2006,theCompanyhadnomaterialpendinglitigation.In2005theCompanyandcertainofitscurrentandformerofficersanddirectorswerenamedasdefendantsinclassactionsfiledintheU.S.DistrictCourtfortheWesternDistrictofWashingtonallegingcertainfederalsecuritieslawsviolationsinconnectionwithcertainoftheCompany’spublicstatementsandfilings.TheCourtconsolidatedtheactions.OnSeptember8,2006,theCourtenteredjudgmentinfavorofthedefendantsdismissingtheconsolidatedactionwithprejudice.In2005twoderivativeactionswerefiled,andlaterconsolidated,inthesameCourtagainstcertainoftheCompany’scurrentandformerofficersanddirectors,assertingbreachoffiduciaryduty,abuseofcontrol,grossmismanagement,wasteofcorporateassetsandunjustenrichment.OnSeptember8,2006,theCourtenteredjudgmentinfavorofthedefendantsintheconsolidatedcase,dismissingwithprejudiceclaimsbasedonallegedinsidertradinganddismissingwithoutprejudicetheremainingclaims.InDecember2005,twoderivativeactionswerefiledintheSuperiorCourtoftheStateofWashingtonforKingCountyagainstcertainoftheCompany’scurrentandformerofficersanddirectors,andwerelaterconsolidated.Thestatecourtderivativeplaintiffassertedallegationssubstantiallysimilartothoseassertedinthedismissedfederalderivativeaction.OnJuly28,2006,theCompanyandthedefendantsfiledmotionstodismisstheamendedcomplaint.OnNovember1,2006,theSuperiorCourtapprovedplaintiff’sdismissalofthislitigationwithoutprejudice.OtherFromtimetotimetheCompanyissubjecttovariousotherlegalproceedingsthatariseintheordinarycourseofbusinessorarenotmaterialtotheCompany’sbusiness.Additionally,theCompanyissubjecttoincometaxesintheU.S.andseveralforeignjurisdictionsand,intheordinarycourseofbusiness,therearetransactionsandcalculationswheretheultimatetaxdeterminationisuncertain.AlthoughtheCompanycannotpredicttheoutcomesofthesematterswithcertainty,theCompany’smanagementdoesnotbelievethatthedispositionofthesematterswillhaveamaterialadverseeffectontheCompany’sfinancialposition,resultsofoperationsorcashflows.NOTE13INCOMETAXESUnderFAS109,AccountingforIncomeTaxes,incometaxesarerecognizedfortheamountoftaxespayableforthecurrentyearandfortheimpactofdeferredtaxassetsandliabilities,whichrepresentconsequencesofeventsthathavebeenrecognizeddifferentlyinthefinancialstatementsunderGAAPthanfortaxpurposes.AsofDecember31,2006,theCompanyhadfederalnetoperatinglosscarryforwardsofapproximately$290millionandgrossfederalresearchandexperimentationtaxcreditcarryforwardsofapproximately$12.6million.Thenetoperatinglosscarryforwards,ifnotutilized,willexpirefrom2010through2026,andresearchanddevelopmenttaxcreditswillexpirefrom2007through2026,ifnotutilized.Lossbeforeprovisionforincometaxesconsistsofthefollowing(inthousands):200420052006YearEndedDecember31,UnitedStates......................................$(92,654)$(63,304)$(10,550)International.......................................(55,612)(2,492)(918)Total............................................$(148,266)$(65,796)$(11,468)F-18FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)Theprovision(benefit)forincometaxesrelatedtooperationsconsistsofthefollowing(inthousands):200420052006YearEndedDecember31,Currentprovision:Federal.............................................$—$—$—State...............................................—128109Foreign.............................................581644617Totalcurrentprovision..................................581772726Deferredprovision(benefit):Federal.............................................61,906——State...............................................(3,466)——Foreign.............................................71(2,260)(124)Totaldeferredprovision(benefit)..........................58,511(2,260)(124)Totalprovision(benefit)forincometaxes......................$59,092$(1,488)$602ThefollowingtablereconcilesthefederalstatutoryincometaxratetotheCompany’seffectivetaxrate:200420052006Federalstatutoryincometaxrate................................(35.0)%(35.0)%(35.0)%Statetaxes,netoffederaleffect.................................(2.4)(3.1)(3.6)ForeignincometaxesatotherthanU.S.rates.......................(0.3)1.05.0In-processresearchanddevelopmentwrite-off.......................10.6——Permanentdifferences........................................3.91.58.2Foreigntaxcredit............................................(0.3)——Researchanddevelopmenttaxcredit..............................(1.0)(2.1)(7.6)Other.....................................................(0.1)(0.4)(4.5)Effectofchangeinvaluationallowanceondeferredtaxassets...........64.535.842.7Effectiveincometaxrate......................................39.9%(2.3)%5.2%F-19FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)Deferredincometaxesreflectthenettaxeffectsoftemporarydifferencesbetweenthetaxbasesofassetsandliabilitiesandthecorrespondingfinancialstatementamounts,operatingloss,andtaxcreditcarryforwards.SignificantcomponentsoftheCompany’sdeferredincometaxassetsandliabilitiesareasfollows(inthousands):20052006December31,AssetsCurrent:Inventory...............................................$2,840$2,610Accruedcompensation.....................................1,8764,292Deferredservicerevenue....................................684815Grosscurrentdeferredtaxassets..............................5,4007,717Valuationallowance.......................................(5,377)(7,717)Netcurrentdeferredtaxassets................................230Long-Term:Propertyandequipment.....................................709455Researchandexperimentation................................12,44712,587Netoperatinglosscarryforwards..............................115,110117,454Accruedrestructuringcharge.................................764240Other..................................................576518Grosslong-termdeferredtaxassets............................129,606131,254Valuationallowance.......................................(129,031)(130,532)Netlong-termdeferredtaxassets..............................575722Totalnetdeferredtaxassets..................................$598$722ThenetcurrentdeferredtaxassetsasofDecember31,2005of$23,000areincludedin“PrepaidExpensesandOtherCurrentAssets”ontheaccompanyingConsolidatedBalanceSheets.AsummaryofthechangestothevaluationallowanceondeferredtaxassetsfortheyearsendedDecember31,2006,2005and2004wasincreasesof$3.8million,$29.6millionand$96.7million,respectively.InSeptember2004,asaresultofsubstantiallossesduringtheyearandbasedonrevisedprojectionsindicatingcontinuedchallengingoperatingresults,theCompanyestablishedavaluationallowanceof$58.9million.During2003,theCompanyhadreduceditsvaluationallowanceby$58.0million.UndistributedearningsoftheCompany’sforeignsubsidiariesareconsideredtobepermanentlyreinvested;accordingly,noprovisionforU.S.federalandstateincometaxeshasbeenprovidedthereon.Uponrepatriationofthoseearnings,intheformofdividendsorotherwise,theCompanywouldbesubjecttobothU.S.incometaxes(subjecttoanadjustmentforforeigntaxcredits)andwithholdingtaxespayabletothevariousforeigncountries.DeterminationoftheamountofunrecognizeddeferredU.S.incometaxliabilityisnotpracticableduetothecomplexitiesassociatedwiththishypotheticalcalculation.NOTE14CONVERTIBLENOTESPAYABLEANDLINESOFCREDITInDecember2004theCompanyissued$80millionaggregateprincipalamountof3.0%ConvertibleSeniorSubordinatedNotesdue2024(“Notes”)inaprivateplacementpursuanttoRule144AundertheSecuritiesActof1933,asamended.TheseunsecuredNotesbearinterestatanannualrateof3.0%,payablesemiannuallyonJune1andDecember1ofeachyearthroughthematuritydateofDecember1,2024.F-20FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)TheNotesareconvertible,undercertaincircumstances,intotheCompany’scommonstockataninitialconversionrateof51.8001sharesofcommonstockper$1,000principalamountofNotes,whichisequivalenttoaninitialconversionpriceofapproximately$19.31pershareofcommonstock(subjecttoadjustmentincertainevents).UponconversionoftheNotes,inlieuofdeliveringcommonstock,theCompanymay,atitsdiscretion,delivercashoracombinationofcashandcommonstock.TheNotesaregeneralunsecuredseniorsubordinatedobligations,rankingjuniorinrightofpaymenttotheCompany’sexistingandfutureseniorindebtedness,equallyinrightofpaymentwiththeCompany’sexistingandfutureindebtednessorotherobligationsthatarenot,bytheirterms,eitherseniororsubordinatedtotheNotesandseniorinrightofpaymenttotheCompany’sfutureindebtednessthat,byitsterms,issubordinatedtotheNotes.Inaddition,theNotesareeffectivelysubordinatedtoanyoftheCompany’sexistingandfuturesecuredindebtednesstotheextentoftheassetssecuringsuchindebtednessandstructurallysubordinatedtotheclaimsofallcreditorsoftheCompany’ssubsidiaries.HoldersmayconverttheNotesduringaconversionperiodbeginningwiththemid-pointdateinafiscalquarterto,butnotincluding,themid-pointdate(or,ifthatdayisnotatradingday,thenthenexttradingday)intheimmediatelyfollowingfiscalquarter,ifoneachofatleast20tradingdaysintheperiodof30consecutivetradingdaysendingonthefirsttradingdayoftheconversionperiod,theclosingsalepriceoftheCompany’scommonstockexceeds120%oftheconversionpriceineffectonthat30thtradingdayofsuchperiod.The“mid-pointdates”forthefiscalquartersareFebruary15,May15,August15andNovember15.HoldersmayalsoconverttheNotesiftheCompanyhascalledtheNotesforredemptionor,duringprescribedperiods,upontheoccurrenceofspecifiedcorporatetransactionsorafundamentalchange,ineachcaseasdescribedintheindenturegoverningtheNotes.AsofDecember31,2006,2005and2004,noneoftheconditionsforconversionoftheNotesweresatisfied.TheCompanymay,atitsoption,redeemalloraportionoftheNotesforcashatanytimeonorafterDecember1,2007,andpriortoDecember1,2009,ataredemptionpriceof100%oftheprincipalamountoftheNotesplusaccruedandunpaidinterestplusamakewholepremiumof$150.00per$1,000principalamountofNotes,lesstheamountofanyinterestactuallypaidoraccruedandunpaidontheNotespriortotheredemptiondate,iftheclosingsalepriceoftheCompany’scommonstockexceeds150%oftheconversionpriceforatleast20tradingdaysinthe30-tradingdayperiodendingonthetradingdaypriortothedateofmailingoftheredemptionnotice.OnorafterDecember1,2009,theCompanymayredeemforcashalloraportionoftheNotesataredemptionpriceof100%oftheprincipalamountoftheNotesplusaccruedandunpaidinterest.HoldersmayrequiretheCompanytopurchaseallorapartoftheirNotesforcashatapurchasepriceof100%oftheprincipalamountoftheNotesplusaccruedandunpaidinterestonDecember1,2009,2014,and2019,orupontheoccurrenceofcertaineventsprovidedintheindenturegoverningtheNotes.InconnectionwiththeissuanceoftheNotes,theCompanyincurred$3.4millionofissuancecosts,whichprimarilyconsistedofinvestmentbankerfees,legalandotherprofessionalfees.Thesecostsarebeingamortizedusingtheeffectiveinterestmethodtointerestexpenseoverthefive-yearperiodfromDecember2004throughNovember2009.Atotalof$683,000and$676,000,respectively,wasamortizedintointerestexpenseduring2006and2005.Theunamortizedbalanceofthesecostswas$2.0millionand$2.7million,respectively,asofDecember31,2006and2005,andisincludedin“Othernon-currentassets”ontheaccompanyingConsolidatedBalanceSheets.LinesofCreditOnDecember29,2006,theCompanyenteredintoaCreditAgreementwithWellsFargoBank,N.A.,providingforalineofcreditforupto$25.0million.ThecreditlinereplacestheCompany’spreviouslineofcreditwithWellsFargoFoothill,Inc.enteredintoinMay2005.TheCreditAgreementprovidesforalineofcreditupto$25.0millionuntilDecember1,2008.TheCompanyisrequiredtomaintainapledgedcollateralaccountcontainingcash,cashequivalentsandothersecuritiesvaluedatnotlessthanthemaximumamountallowedunderthelineofcredit,currently$25.0million.TheCompanyreceivesallinterestandotherearningsonthecollateralaccountuntiltheF-21FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)BankotherwisenotifiestheaccountholderandtheCompany.Inaddition,theCompanyhascovenantstomaintainliquidassetswithanaggregatefairmarketvalueofnotlessthan$25.0million.TheCompanydesignated$25.0millionofitscashasrestrictedatDecember31,2006.TheCreditAgreementprovidessupportfortheCompany’sexistinglettersofcredit,thebalanceofwhichwas$190,000asofDecember31,2006.TheavailableborrowingbaseundertheCreditAgreementisreducedbytheamountofoutstandinglettersofcreditatthatdate.Therefore,theCompanywaseligibletouse$24.8millionofthelineofcreditasofDecember31,2006.OnMay31,2005,theCompanyenteredintoa$30.0million,two-yearrevolvinglineofcreditagreementwithWellsFargoFoothill,Inc.TheCompanycapitalized$1.3millioninfees,includingthefairvalueofafour-yearwarrantissuedtothelendertopurchase50,000sharesofitscommonstockwithanexercisepriceof$6.60pershare,whichwasexercisedonFebruary27,2007.ThatlineofcreditwascollateralizedbyalloftheCompany’sassetsandpledgesofthestockofitssubsidiaries.TheagreementwasreplacedinDecember2006andtheremainingunamortizedfeebalanceof$286,000waschargedtointerestexpenseontheaccompanyingConsolidatedStatementofOperations.NOTE15SHAREHOLDERS’EQUITYPreferredStock:TheCompanyhas5,000,000sharesofundesignatedpreferredstockauthorized,andnosharesofpreferredstockoutstanding.CommonStock:OnDecember19,2006,theCompanycompletedapublicofferingof8,625,000sharesofnewlyissuedcommonstockatapublicofferingpriceof$10.00pershare.TheCompanyreceivednetproceedsof$81.3millionfromtheoffering,afterunderwritingdiscountandsellingexpenses.TheCompanyexpectstousethenetproceedsforgeneralcorporatepurposes.In2004,theCompanyissued1,890,221sharesofitscommonstockand1,210,105exchangeablesharesinconnectionwiththeacquisitionofOctigaBay.ExchangeableShares:SharesofexchangeablestockwereissuedbyoneoftheCompany’sNovaScotiasubsidiariesinconnectionwiththeApril2004acquisitionofOctigaBay.NoexchangeableshareswereoutstandingasofDecember31,2006.ShareholderWarrants:AtDecember31,2006,theCompanyhadoutstandingandexercisablewarrantstopurchaseanaggregateof1,334,852sharesofcommonstock,asfollows:SharesofCommonStockExercisePriceperShareExpirationDateofWarrants50,000$6.60June3,20091,284,852$10.12June21,20091,334,852OnFebruary27,2007,thewarrantfor50,000sharesofcommonstockwasexercised,andtheCompanyissued25,194sharesinthenetexercisetransaction.RestrictedStock:During2006,theCompanyissuedanaggregateof354,993sharesofrestrictedstocktocertaindirectors,executivesandmanagers.TheCompanywillrecordapproximately$3.6millioninstockcompensationexpensefortheseissuancesratablyoverthevestingperiod,whichisgenerallytwoyearsfornon-employeedirectorsandfouryearsforofficersandemployeesoftheCompany.Inthefourthquarterof2005,theCompanyissuedanaggregateof491,250sharesofrestrictedstocktocertainexecutivesandmanagers.TheseshareswillbecomefullyvestedonJune30,2007.TheCompanyrecordedadeferredcompensationchargeof$2.9millionfortheissuanceoftheseshares,andwillrecognizecompensationexpenseratablyoverthe18-monthvestingperiod.AsofDecember31,2006,$2.1millionofexpensehasbeenrecordedfortheserestrictedstockissuances,andanaggregateof$4.4millionremainstobeexpensedovertherespectivevestingperiodsofthegrants.F-22FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)StockOptionPlans:AsofDecember31,2006,theCompanyhadfiveactivestockoptionplansthatprovidesharesavailableforoptiongrantstoemployees,directorsandothers.OptionsgrantedtoemployeesundertheCompany’soptionplansgenerallyvestoverfouryearsorasotherwisedeterminedbytheplanadministrator;however,optionsgrantedduring2005weregenerallygrantedwithfullvestingonorbeforeDecember31,2005,inordertoavoidadditionalexpenserelatedtotheoptionsundertheimplementationofFAS123Randtoenhanceshort-termretention.Optionstopurchasesharesexpirenolaterthantenyearsafterthedateofgrant.OnDecember20,2005,theCompanyannouncedastockoptionrepricingforcertainoutstandingoptionsasofthatdate,thepurposeofwhichwastoreducethenumberofnewoptionsneededforgrantatthesametime,sincetheCompanyhadalimitednumberofsharesavailableforsuchgrant.Atotalof318,565optionswithoriginalexercisepricesfrom$14.52to$34.12persharewererepricedtoanexercisepriceof$5.96pershare,allofwhichwerefullyvestedatthetimeofrepricing.PertherequirementsofFINNo.44,AccountingforCertainTransactionsInvolvingStockCompensation,thestockoptionmodificationresultedinvariablestockoptionaccountingfromthedateofrepricinguntiltheendoftheyear;however,becausetheclosingpriceoftheCompany’scommonstockonDecember31,2005,waslessthanthere-grantprice,nocompensationexpensewasrecorded.Twiceduring2005,theBoardofDirectorsapprovedtheaccelerationofthevestingofallunvestedoutstandingstockoptionspreviouslygrantedtoemployeesandexecutiveofficersundertheCompany’sstockoptionplanswhichexceededcertainexercisepricethresholds.InMarch2005thethresholdforacceleratedvestingwasalloptionswithapershareexercisepriceof$9.44orhigher(themarketpriceoftheCompany’scommonstockonthedateofthechange),whileinMay2005thethresholdwasalloptionswithapershareexercisepriceof$5.88orgreater(themarketpriceoftheCompany’scommonstockonthedateofthechange).Thisaccelerationresultedinoptionstoacquireapproximately1.2millionsharesoftheCompany’scommonstockbecomingimmediatelyexercisable.Optionsgrantedtoconsultantsandtonon-employeedirectorswerenotaccelerated.Allothertermsandconditionsapplicabletooutstandingstockoptiongrants,includingtheexercisepricesandnumbersofsharessubjecttotheacceleratedoptions,wereunchanged.Theaccelerationresultedinachargetoincomeofapprox-imately$1.1millionrelatedtothedeferredcompensationofpreviouslyunvestedoptionsgrantedaspartoftheOctigaBayacquisitioninApril2004.TheaccelerationeliminatedfuturecompensationexpensethattheCompanywouldhaverecognizedinitsConsolidatedStatementsofOperationswithrespecttotheseoptionsupontheadoptionofFAS123R,onJanuary1,2006.InconnectionwitharestructuringplanannouncedinJune2005,theCompanyamendedthestockoptiongrantsforcertainterminatedemployeestoextendtheexerciseperiodofvestedstockoptions,whichisnormallythreemonthsfromthedateoftermination.NocompensationexpensewasrecordedasthefairmarketvalueoftheCompany’sstock(theclosingmarketpriceoftheCompany’sstockonthedateofthechange)waslessthantherespectivestockoptionexerciseprices.F-23FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)AsummaryoftheCompany’sstockoptionactivityandrelatedinformationfollows:OptionsWeightedAverageExercisePriceRemainingContractualTermAggregateIntrinsicValueOutstandingatJanuary1,2004.............3,035,033$20.92Granted............................1,004,95818.36Exercised...........................(218,964)12.92Canceled...........................(249,929)21.64OutstandingatDecember31,2004..........3,571,09820.64Granted............................1,278,5678.56Exercised...........................(22,295)6.24Canceled...........................(327,225)16.60OutstandingatDecember31,2005(a)........4,500,14516.56Granted............................725,43010.44Exercised...........................(381,890)6.87Canceled...........................(976,270)23.25OutstandingatDecember31,2006..........3,867,41514.687.0years$7.2millionExercisableatDecember31,2006..........3,144,88715.646.4years$6.2millionAvailableforgrantatDecember31,2006.....2,319,928(a)TheweightedaverageexercisepriceofoutstandingoptionsatDecember31,2005includestheimpactofthe2005repricingof318,565options,asdescribedabove.Theaggregateintrinsicvalueinthetableaboverepresentsthetotalpretaxintrinsicvalueforall“in-the-mo-ney”options(i.e.,thedifferencebetweentheCompany’sclosingstockpriceonthelasttradingdayof2006andtheexerciseprice,multipliedbythenumberofshares)thatwouldhavebeenreceivedbytheoptionholdershadalloptionholdersexercisedtheiroptionsonDecember31,2006.Thisamountchanges,basedonthefairmarketvalueoftheCompany’sstock.Totalintrinsicvalueofoptionsexercisedwas$1.6millionfortheyearendedDecember31,2006.WeightedaveragefairvalueofoptionsgrantedduringtheyearendedDecember31,2006was$6.00pershare.AsummaryoftheCompany’sunvestedrestrictedstockgrantsandchangesduringtheyearsendedDecem-ber31isasfollows:SharesWeightedAverageGrantDateFairValueOutstandingatDecember31,2004.................—$—Grantedduring2005............................491,2505.87OutstandingatDecember31,2005.................491,2505.87Grantedduring2006............................354,99310.08OutstandingatDecember31,2006.................846,2437.63F-24FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)AsofDecember31,2006,theCompanyhad$8.7millionoftotalunrecognizedcompensationcostrelatedtounvestedstockoptionsandunvestedrestrictedstockgrants,whichisexpectedtoberecognizedoveraweightedaverageperiodof2.8years.OutstandingandexercisableoptionsbypricerangeasofDecember31,2006,areasfollows:RangeofExercisePricesperShareNumberOutstandingWeightedAverageRemainingLife(Years)WeightedAverageExercisePriceNumberExercisableWeightedAverageExercisePriceOutstandingOptionsExercisableOptions$0.00–$4.0087,1118.6$3.7787,111$3.77$4.01–$8.00789,1606.9$6.25780,863$6.24$8.01–$10.00292,9217.1$9.32270,046$9.38$10.01–$12.001,092,9088.5$10.67403,008$10.87$12.01–$14.00208,1817.7$13.70208,181$13.70$14.01–$16.00534,1456.6$15.15534,145$15.15$16.01–$32.00542,7434.8$24.99541,337$24.98$32.01–$54.75320,2465.9$39.37320,196$39.37$0.00–$54.753,867,4157.0$14.683,144,887$15.64Thefollowingtable(inthousands)setsforththeshare-basedcompensationcostresultingfromstockoptionsandunvestedstockgrantsrecordedintheCompany’sConsolidatedStatementsofOperationsfortheyearsendedDecember30,2006,2005and2004.The2006expenserepresentsexpenseasaresultoftheadoptionofFAS123R.The2005and2004expenserepresentsacquisition-related,share-basedcompensationexpensearisingfromtheacquisitionofOctigaBayin2004.200420052006Costofproductrevenue....................$—$—$60Costofservicerevenue....................——101Researchanddevelopment..................5,0683,444386Salesandmarketing.......................2,837579334Generalandadministrative..................3,229131,218Totalshare-basedcompensationexpense........$11,134$4,036$2,099EmployeeStockPurchasePlan:In2001,theCompanyestablishedanESPP,whichreceivedshareholderapprovalinMay2002.ThemaximumnumberofsharesoftheCompany’scommonstockthatemployeescouldacquireundertheESPPis1,000,000shares.EligibleemployeesarepermittedtoacquiresharesoftheCompany’scommonstockthroughpayrolldeductionsnotexceeding15%ofbasewages.ThepurchasepricepershareundertheESPPis95%oftheclosingmarketpriceonthefourthbusinessdayaftertheendofeachofferingperiod.AsofDecember31,2006and2005,526,710and462,533shares,respectively,hadbeenissuedundertheESPP.NOTE16BENEFITPLANS401(k)PlanTheCompanyhasaretirementplancoveringsubstantiallyallU.S.employeesthatprovidesforvoluntarysalarydeferralcontributionsonapre-taxbasisinaccordancewithSection401(k)oftheInternalRevenueCodeof1986,asamended.Priorto2005,theCompanymatched25%ofemployeecontributionseachcalendaryear,comprisedofa12.5%matchofemployeecontributionsincash45daysaftereachquarteranda12.5%matchdeterminedannuallybytheBoardofDirectorsandpayableincashorcommonstockoftheCompany.TheCompanyeliminateditsmatchingobligationasofJune30,2005.However,theCompanyreinstateditsmatchforF-25FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)2006at6.25%oftotalemployeecontributions,whichwassatisfiedin2007throughissuanceofcommonstock.TheCompany’s2006,2005and2004matchingcontributionexpenseswere$347,000,$795,000and$1.6million,respectively.PensionPlanTheCompany’sGermansubsidiarymaintainsadefinedbenefitplan.AtDecember31,2006and2005,theCompanyrecordedaliabilityof$1.9millionand$1.7million,respectively,whichapproximatestheexcessoftheprojectedbenefitobligationoverplanassetsof$671,000and$599,000,respectively.Planassetsareinvestedininsurancepoliciespayabletoemployees.Netpensionexpensewasnotmaterialforanyperiod.ContributionstotheplanarenotexpectedtobesignificanttothefinancialpositionoftheCompany.TheCompany’sadoptionofFAS158,effectiveDecember31,2006,didnothaveamaterialimpactonthefinancialpositionoftheCompany.NOTE17SEGMENTINFORMATIONFASNo.131,DisclosureaboutSegmentsofanEnterpriseandRelatedInformation(“FAS131”),establishesstandardsforreportinginformationaboutoperatingsegmentsandforrelateddisclosuresaboutproducts,servicesandgeographicareas.Operatingsegmentsareidentifiedascomponentsofanenterpriseaboutwhichseparatediscretefinancialinformationisavailableforevaluationbythechiefoperatingdecision-maker,ordecision-makinggroup,inmakingdecisionsregardingallocationofresourcesandassessingperformance.Cray’schiefdecision-maker,asdefinedunderFAS131,istheChiefExecutiveOfficer.During2006,2005and2004,Crayhadoneoperatingsegment.Productandservicerevenueandlong-livedassetsclassifiedbysignificantcountryareasfollows(inthousands):UnitedStatesAllOtherCountriesTotalFortheyearendedDecember31,2004:Productrevenue.....................................$86,067$9,834$95,901Servicerevenue.....................................$34,800$15,148$49,948FortheyearendedDecember31,2005:Productrevenue.....................................$104,274$47,824$152,098Servicerevenue.....................................$33,377$15,576$48,953Long-livedassets....................................$50,464$50,255$100,719FortheyearendedDecember31,2006:Productrevenue.....................................$76,370$86,425$162,795Servicerevenue.....................................$37,979$20,243$58,222Long-livedassets....................................$41,554$49,155$90,709Revenueattributedtoforeigncountriesarederivedfromsalestoexternalcustomers.RevenuederivedfromU.S.governmentagenciesorcommercialcustomersprimarilyservingtheU.S.government,andthereforeunderitscontrol,totaledapproximately$105.4million,$111.2millionand$107.8millionin2006,2005and2004,respectively.In2006,twocustomersaccountedforanaggregateofapproximately33%oftotalrevenue.In2005,onecustomercontributedapproximately18%oftotalrevenue;in2004,onecustomeraccountedforapproximately27%oftotalrevenue.In2006,revenueinKoreaaccountedfor20%oftotalrevenue,andrevenueintheUnitedF-26FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)Kingdomaccountedfor15%oftotalrevenue.Nosingleforeigncountryaccountedformorethan10%oftheCompany’srevenueineitheroftheotheryearspresented.Goodwillmakesupasignificantportionofthelong-livedassetbalancesoftheCompany’sforeignsubsid-iaries.AtDecember31,2006and2005,goodwillcomprised$45.4millionand$45.1million,respectively,or92%and90%,respectively,offoreignlong-livedassetbalances.NOTE18RESEARCHANDDEVELOPMENTThedetailsfortheCompany’snetresearchanddevelopmentcostsfortheyearsendedDecember31areasfollows(inthousands):200420052006December31,Grossresearchanddevelopmentexpenses..................$98,843$96,257$99,061Less:Amountsreimbursedorincludedincostofproductrevenue.........................................(45,577)(54,546)(70,019)Netresearchanddevelopmentexpenses...................$53,266$41,711$29,042NOTE19INTERESTINCOME(EXPENSE)Thedetailofinterestincome(expense)fortheyearsendedDecember31isasfollows(inthousands):200420052006Interestincome.........................................$666$741$2,525Interestexpense.........................................(301)(4,203)(4,620)Netinterestincome(expense)...............................$365$(3,462)$(2,095)InterestincomeisearnedbytheCompanyoncashandcashequivalentbalances,whichareinvestedinhighlyliquidmoneymarketfunds.Interestexpenseinboth2006and2005consistedof$2.4millionontheNotesineachyear,$1.6millionand$1.0million,respectively,ofamortizationofcapitalizedissuancecosts,and$390,000and$765,000,respectively,ofinterestandfeesonthelineofcreditwithWellsFargoFoothill,Inc.Amortizationoffeescapitalizedforthelineofcreditincreasedin2006astheCompanywroteoffallremainingcapitalizedcostswhenitchangedlinesofcredit,seeNote14—ConvertibleNotesPayableandLinesofCredit.NOTE20RESTATEMENTOFPREVIOUSLYISSUEDFINANCIALSTATEMENTSSubsequenttotheissuanceoftheDecember31,2004consolidatedfinancialstatements,theCompanydeterminedthatcertainresearchanddevelopmentcostswereincorrectlychargedtooneofitsproductdevelopmentcontractsin2004.Thecontractwasaccountedforunderthepercentageofcompletionmethodofaccounting.Theerrorresultedinrevenuebeingrecognizedprematurelyonthecontract.Accordingly,theaccompanying2004consolidatedfinancialstatementshavebeenrestatedfromtheamountspreviouslyreportedtocorrectthiserror.Additionally,theCompanyhasreclassifiedthecashflowimpactofchangesinrestrictedcashfromfinancingactivitiestoinvestingactivities.F-27FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)Asummaryofthesignificanteffectsoftherestatementisasfollows(inthousands,exceptpersharedata):AsPreviouslyReportedAsRestatedChangeConsolidatedStatementofOperationsYearEndedDecember31,2004:Productrevenue...................................$99,236$95,901$(3,335)Totalrevenue.....................................$149,184$145,849$(3,335)Costofproductrevenue.............................$107,264$104,196$(3,068)Researchanddevelopment(a)........................$50,198$53,266$3,068Netloss.........................................$(204,023)$(207,358)$(3,335)Basicanddilutednetlosspercommonshare.............$(9.79)$(9.95)$(0.16)Notes:(a)Previouslyreportedamountwasincreasedby$5,068toconformto2005financialstatementpresentation.AmountwasreclassifiedfromAcquisition-relatedCompensationExpense.F-28FinancialsCRAYINC.ANDSUBSIDIARIESNOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)REPORTOFINDEPENDENTREGISTEREDPUBLICACCOUNTINGFIRMTotheBoardofDirectorsandShareholdersofCrayInc.WehaveauditedtheaccompanyingconsolidatedbalancesheetsofCrayInc.andSubsidiariesasofDecem-ber31,2006and2005,andtherelatedconsolidatedstatementsofoperations,shareholders’equityandcompre-hensiveincome(loss),andcashflowsfortheyearsthenended.Theseconsolidatedfinancialstatementsaretheresponsibilityofthecompany’smanagement.Ourresponsibilityistoexpressanopiniononthesefinancialstatementsbasedonouraudits.WeconductedourauditsinaccordancewiththestandardsofthePublicCompanyAccountingOversightBoard(UnitedStates).Thosestandardsrequirethatweplanandperformtheaudittoobtainreasonableassuranceaboutwhetherthefinancialstatementsarefreeofmaterialmisstatement.Anauditincludesexamining,onatestbasis,evidencesupportingtheamountsanddisclosuresinthefinancialstatements.Anauditalsoincludesassessingtheaccountingprinciplesusedandsignificantestimatesmadebymanagement,aswellasevaluatingtheoverallfinancialstatementpresentation.Webelievethatourauditsprovideareasonablebasisforouropinion.Inouropinion,theconsolidatedfinancialstatementsreferredtoabovepresentfairly,inallmaterialrespects,thefinancialpositionofCrayInc.andSubsidiariesasofDecember31,2006and2005,andtheresultsoftheiroperationsandtheircashflowsfortheyearsthenendedinconformitywithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica.Ourauditswereconductedforthepurposeofforminganopiniononthe2006and2005basicconsolidatedfinancialstatementstakenasawhole.ThefinancialstatementschedulelistedintheindexatItem15(a)(2)ispresentedforpurposesofadditionalanalysisandisnotarequiredpartofthebasicconsolidatedfinancialstatements.Thisschedule,fortheyearsendedDecember31,2006and2005,hasbeensubjectedtotheauditingproceduresappliedintheauditsofthe2006and2005basicconsolidatedfinancialstatementsand,inouropinion,isfairlystatedinallmaterialrespectsinrelationtothe2006and2005basicconsolidatedfinancialstatementstakenasawhole.Wehavealsoaudited,inaccordancewiththestandardsofthePublicCompanyAccountingOversightBoard(UnitedStates),theeffectivenessofCrayInc.andSubsidiaries’internalcontroloverfinancialreportingasofDecember31,2006,basedoncriteriaestablishedinInternalControl—IntegratedFrameworkissuedbytheCommitteeofSponsoringOrganizationsoftheTreadwayCommission(COSO),andourreportdatedMarch5,2007,expressedanunqualifiedopiniononmanagement’sassessmentofinternalcontroloverfinancialreportingandanunqualifiedopinionontheeffectivenessofinternalcontroloverfinancialreporting.AsdiscussedinNote3totheconsolidatedfinancialstatements,Cray,Inc.andSubsidiariesadoptedStatementofFinancialAccountingStandardsNo.123(R),“Share-BasedPayment,”effectiveJanuary1,2006./s/PETERSONSULLIVANPLLCSeattle,WashingtonMarch5,2007F-29FinancialsREPORTOFINDEPENDENTREGISTEREDPUBLICACCOUNTINGFIRMTotheBoardofDirectorsandShareholdersofCrayInc.Seattle,WashingtonWehaveauditedtheaccompanyingconsolidatedbalancesheetofCrayInc.andsubsidiaries(the“Company”)asofDecember31,2004,andtherelatedconsolidatedstatementsofoperations,shareholders’equityandcomprehensiveincome(loss),andcashflowsfortheyearthenended.OurauditalsoincludedthefinancialstatementschedulefortheyearendedDecember31,2004,listedintheIndexatItem15.ThesefinancialstatementsandfinancialstatementschedulearetheresponsibilityoftheCompany’smanagement.Ourresponsibilityistoexpressanopiniononthefinancialstatementsandfinancialstatementschedulebasedonouraudit.WeconductedourauditinaccordancewiththestandardsofthePublicCompanyAccountingOversightBoard(UnitedStates).Thosestandardsrequirethatweplanandperformtheaudittoobtainreasonableassuranceaboutwhetherthefinancialstatementsarefreeofmaterialmisstatement.Anauditalsoincludesexamining,onatestbasis,evidencesupportingtheamountsanddisclosuresinthefinancialstatements,assessingtheaccountingprinciplesusedandsignificantestimatesmadebymanagement,aswellasevaluatingtheoverallfinancialstatementpresentation.Webelievethatourauditprovidesareasonablebasisforouropinion.Inouropinion,suchconsolidatedfinancialstatementspresentfairly,inallmaterialrespects,thefinancialpositionofCrayInc.andsubsidiariesatDecember31,2004,andtheresultsoftheiroperationsandtheircashflowsfortheyearthenended,inconformitywithaccountingprinciplesgenerallyacceptedintheUnitedStatesofAmerica.Also,inouropinion,suchfinancialstatementschedule,whenconsideredinrelationtothebasicconsolidatedfinancialstatementstakenasawhole,presentsfairlyinallmaterialrespectstheinformationsetforththerein.AsdiscussedinNote20,theaccompanyingfinancialstatementsasofandfortheyearendedDecember31,2004,havebeenrestated./s/DELOITTE&TOUCHELLPSeattle,WashingtonMarch31,2005(April20,2006astotheeffectsoftherestatementdiscussedinNote20)F-30FinancialsScheduleII—ValuationandQualifyingAccountsDecember31,2006DescriptionBalanceatBeginningofPeriodCharge/(Benefit)toExpenseDeductionsBalanceatEndofPeriodYearendedDecember31,2004:Allowancefordoubtfulaccounts..................$1,125$373$(59)(1)$1,439Warrantyaccrual..............................$655$—$(655)$—YearendedDecember31,2005:Allowancefordoubtfulaccounts..................$1,439$165$(1,411)(1)$193Warrantyaccrual..............................$—$—$—$—YearendedDecember31,2006:Allowancefordoubtfulaccounts..................$193$(17)$(77)(1)$99Warrantyaccrual..............................$—$—$—$—(1)Representsuncollectibleaccountswrittenoff,netofrecoveries.F-31Financials(This page intentionally left blank)(This page intentionally left blank)(This page intentionally left blank)InvestorInformationBOARDOFDIRECTORSStephenC.KielyChairman,CrayInc.Chairman,StratusTechnologiesInc.WilliamC.BlakeChiefExecutiveOfficerInteractiveSupercomputing,Inc.JohnB.Jones,Jr.PrivateInvestorFrankL.LedermanPrivateInvestorSallyG.NarodickPrivateInvestorDanielC.RegisManagingDirectorDigitalPartnersStephenC.RichardsPrivateInvestorPeterJ.UngaroPresidentandChiefExecutiveOfficerCrayInc.EXECUTIVEOFFICERSPeterJ.UngaroPresidentandChiefExecutiveOfficerBrianC.HenryExecutiveVicePresidentandChiefFinancialOfficerChristopherJehnVicePresidentKennethW.JohnsonSeniorVicePresident,GeneralCounselandCorporateSecretaryStevenL.ScottSeniorVicePresidentandChiefTechnologyOfficerJanC.SilvermanSeniorVicePresidentMargaretA.WilliamsSeniorVicePresidentSHAREHOLDERSERVICESMellonInvestorServices,LLC,ourtransferagentandregistrar,canhelpyouwithavarietyofshareholder-relatedservicesincluding:(cid:129)Changeofaddress(cid:129)Loststockcertificates(cid:129)Transferofstocktoanotherperson(cid:129)Additionaladministrativeservices(cid:129)AccountconsolidationMellonInvestorServices,LLCShareholderRelationsP.O.Box3315SouthHackensack,NJ07606or480WashingtonBoulevardJerseyCity,NJ07310-1900www.melloninvestor.com/isdTelephone:800-522-6645TDDforHearingImpaired:800-231-5469ForeignShareholders:201-680-6578TDDForeignShareholders:201-680-6610AVAILABLEINFORMATIONOurAnnualReportonForm10-K,ourotherSECreportsandfilings,ourCodeofBusinessConduct,CorporateGovernanceGuidelines,thechartersofourBoardcommitteesandothergovernancedocumentsandinformationareavailableonourwebsite,www.cray.com,under“Investors.”YoumayalsoobtainacopyofourForm10-KfiledwiththeSECandothercompanyinformation,withoutcharge,bywritingorcalling:CrayInc.InvestorRelations411FirstAvenueS.,Suite600Seattle,WA98104-2860Telephone:866-729-2729Shareholdersofrecordwhoreceivemorethanonecopyofthisannualreportcancontactourtransferagentandarrangetohavetheiraccountsconsolidated.ShareholderswhoownCraystockthroughabrokerageaccountcancontacttheirbrokertorequestconsolidationoftheiraccounts.CRAYANNUALMEETINGMAY16,2007—10:00A.M.CrayCafeteria1340MendotaHeightsRoadMendotaHeights,MN55120-1128CORPORATEHEADQUARTERSCrayInc.411FirstAvenueSouthSuite600Seattle,WA98104-2860206-701-2000206-701-2500faxOTHERPRINCIPALOFFICES1050LowaterRoadChippewaFalls,WI54729-00801340MendotaHeightsRoadMendotaHeights,MN55120-1128INTERNETE-Mailinfo@cray.comWebsitewww.cray.comLEGALCOUNSELStoelRivesLLPSeattle,WAINDEPENDENTPUBLICACCOUNTANTSPetersonSullivanPLLCSeattle,WASTOCKMARKETINFORMATIONCrayInc.commonstockistradedontheNasdaqGlobalMarketSystemunderthesymbolCRAY.EQUALOPPORTUNITYCrayisanequalopportunityemployer.Cray Inc.411 First Avenue S., Suite 600Seattle, WA 98104-2860 USA

Continue reading text version or see original annual report in PDF format above