Tarek Robbiati
Executive Vice President and Chief Financial Officer at Hewlett Packard Enterprise
Thank you very much, Antonio. Q1 '23 was, as Antonio said, a record quarter for HPE. As usual, I will reference slides from our earnings presentation to guide you through our performance. Antonio discussed key highlights for Q1 '23 on Slide 4. Let me discuss our Q1 performance details starting with Slide 5.
We are very pleased that the execution of our strategy has driven record quarterly results in terms of revenue, non-GAAP gross margin, non-GAAP operating margin, and non-GAAP EPS for first quarter of a financial year. These and other records I reference are primarily since we reset our strategy with our 2017 spin-off transactions. Notably, revenues grew year-over-year across all our business segments safe for Corporate in Q1 '23 as we benefited from improvements in the supply environment. Our supply chain execution is solid, we have very strong momentum thanks to our substantial order book, and our investments are bearing fruit, and we are gaining share in specific market segments. In short, our strategy is working and working really well.
Having said so, while we are optimistic about our fiscal year '23, we are also realistic. Overall, we have experienced above-trend demand through much of the past two years as attested by our growing order book over the fiscal year '20 to '22 period. And now, market demand has shifted from being steady across our portfolio to being uneven over the course of Q1 '23. More specifically, deal velocity for Compute has slowed as customers digest the investments of the past two years though demand for our Storage and HPC & AI solutions is holding and demand for our Edge solutions remains healthy. In that context, we are taking action to maintain our momentum for the second half of '23 and fiscal year '24. We intend to further our investments in software and services in all our business units including in our HPE GreenLake edge-to-cloud platform, HPC & AI, Storage, and Edge to extend our share gains across our segments all while retaining our cost discipline and productivity focus.
We delivered Q1 revenue of $7.8 billion, which equates to robust 12% year-over-year growth and 18% in constant currency despite our exit from Russia and Belarus in Q2 '22. We did not experience a typical seasonal decline between Q4 and Q1 thanks to excellent supply-chain execution on our large order book. Each of our segments, excluding only our Corporate segment grew revenue at least 8% in constant currency. This revenue performance was well above our prior guidance for Q1 of $7.2 billion to $7.6 billion and represented a record Q1 revenue level.
We benefited from improvements in the supply environment, particularly in our Compute segment. This allowed us to execute against our order book, which our customers greatly appreciated. The delivery times of our products and services across our portfolio are now almost back to pre-pandemic levels. Yet we continue to have more progress to make in supply-chain productivity as our order book entering Q2 '23 is more than twice normal level across our company. The combination of our large order book and improved supply environment gives us confidence that we can grow revenues well above the previously communicated guidance of 2% to 4% revenue growth in constant currency for fiscal year '23. More on that later. As a result, we also remain confident in the longer term 2% to 4% revenue CAGR outlook over the fiscal year '22 to fiscal year '25 period we provided at our 2022 Securities Analyst Meeting last October.
Our non-GAAP gross margin reached a Q1 record of 34.2%. This is up 30 basis points year-over-year and 110 basis points sequentially. Our margin structure has benefited from pricing actions we have taken over the course of the pandemic combined with the beginnings of declines in commodities and logistics costs. Over the long term, our margin structure will continue to benefit as we continue to shift our mix of business to higher-margin, software-intensive as-a-service offerings. Our non-GAAP operating margins reached a record high 11.8%. This is 80 basis points ahead of Q1 '22 and 30 basis points higher than Q4 '22. While strong revenue growth and gross margin performance are key drivers, this result would not have been possible without the strategic actions Antonio and I took in fiscal year '20 to reallocate resources and optimize our cost structure.
As mentioned during our last earnings call, Antonio and I remain determined to maintain our focus on productivity. Our top line and margin strength in Q1 translated to GAAP diluted net EPS of $0.38 and non-GAAP diluted net EPS of $0.63. Non-GAAP diluted net EPS easily exceeded our guidance range of $0.50 to $0.58 and was another company record. Our Q1 2023 free cash flow was negative $1.3 billion. We typically have seasonal outflows in our Q1. We will discuss cash flow in more detail in a moment, but having said that, we remain on track to generate between $1.9 billion and $2.1 billion in free cash flow in fiscal year '23. Finally, we are continuing to return substantial capital to our shareholders. We paid $156 million in dividend this quarter and repurchased $73 million in stock. We intend to buy back at least $500 million worth of shares in fiscal year '23 just like we did in fiscal year '22.
Turning on to our as-a-service business performance. We are very pleased to announce our ARR surpassed $1 billion in Q1 '23. This is an important milestone for our business that reflects that our as-a-service strategy is working. The supply chain challenges have slowed our ARR growth in prior quarters. The benefits of easing supply challenges are beginning to appear in our results as ARR growth in constant currency accelerated from 25% in Q4 '22 to 31% in Q1 '23. We expect further acceleration through fiscal year '23 as improving supply allows us to expedite delivery of as-a-service solutions to our customers. Our as-a-service order decline of 20% in Q1 is a function of a difficult compare to Q1 '22 in which orders grew 136% on strength from several large deals, including a large public cloud customer. We are comfortable with our robust pipeline of as-a-service business. We base this confidence on our 68% order growth in fiscal year '22, the number of deals currently pending acceptance, and our current view of the sales funnel. We, therefore, retain our three year ARR target of 35% to 45% CAGR from fiscal year '22 to fiscal year '25. Most importantly, we continue to make our as-a-service business more valuable with a growing mix of higher-margin software and services recurring revenue. In Q1 '23, our mix of software and services increased another 150 basis points year-over-year to 65% thanks to our cloud and SaaS offerings, particularly in edge and storage.
Let's now turn to our segment highlights on the next slide. I would like to remind you that all revenue growth rates on this slide are in constant currency. In the Intelligent Edge, we delivered a second consecutive record revenue quarter and surpassed the $1 billion revenue milestone for the first time. We grew our revenue 31% year-over-year. We are outgrowing our main competitors and are taking share with our combination of wireless LAN, enterprise switching, and SD-WAN solutions including in some of the largest enterprise customers. Customers are increasingly adopting our software-centric solutions such as our Edge service platform and automation suite.
Our operating margin of 21.9% was up 450 basis points annually and 860 basis points sequentially. We're benefiting from scale and our prior price increases have worked through our order book. We are very, very pleased that our Edge business has exceeded the Rule of 40 this quarter and feel very optimistic about the prospects of our Aruba business in fiscal year '23 and beyond given its substantial order book underpinned by a superior platform-based SaaS offerings. We retain confidence in our long-term target of mid-teens revenue growth and mid-20% operating margins.
In HPC & AI, revenue grew 37% year-over-year. We successfully closed the balance of the Frontier deal in Q1, which contributed to the strength of this business in Q1 '23. While this segment is also now benefiting from easing supply chain, the lumpiness and long lead times of this business means that operating margins will continue to fluctuate. As Antonio mentioned, we have been thinking strategically about and investing behind artificial intelligence for many years. This is true, both organically and inorganically. The emergence of large language models such as ChatGPT and BART and generative AI, some of which run on our systems has prompted many questions from our customer base. We believe AI-at-scale is a high growth market and that the building and refinement of AI models will require unique computational capabilities that our Cray supercomputers and HPI solutions are extremely well-positioned to enable. We intend to invest organically and inorganically as attested by our acquisition of Pachyderm to fully grasp this opportunity.
With regards to Storage, we are pleased to report 10% annual growth where we are bolstering our portfolio to grow market share. HPE Alletra remains one of our fastest-growing new products introductions ever, and grew well above triple digits in Q1. HPE Alletra contributed to double-digit growth in our own IP products, which is driving a mix shift to higher margin, software-intensive as-a-service revenue. We continue to invest in R&D for our own IP products in this business unit, and as a result, our Q1 operating margin of 12% is down 190 basis points year-over-year.
Compute revenues grew 19% year-over-year to $3.5 billion. The segment benefited from the multi-sourcing and demand steering initiatives we have discussed in prior calls as well as steadily improving supply availability. Our dynamic pricing strategy has helped us navigate a volatile supply climate while driving industry-leading gross margins. Our Compute operating margin of 17.6% exceeded our long-term outlook of 11% to 13% for the fifth consecutive quarter, which attests to our best-in-class performance. We do believe our Compute operating margins are peaking and should gradually return to our target range of 11% to 13%. While we are seeing commodities cost decreasing leading to increased competitive price pressure, we have for the first time three concurrent and differentiated platforms being sold in the market. Gen10, Gen10 Plus and Gen11, which would allow a gradual management of pricing and margins over time. In our Pointnext operational services business combined with storage services, orders declined mid-to-high single-digits and revenues were flat year-over-year, driven by uneven demand. As you know, this is a key component of recurring revenues and profit for each of our segments.
Finally, HPE Financial Services revenues rose 8% year-over-year and financing volume of $1.6 billion grew 21% in constant currency. Our operating margins fell 300 basis points year-over-year due to the higher interest rate climate that we will gradually offset over time through pricing. Time and time again, our HPE FS business has proven resilient in a downturn thanks to the quality of the underwriting of the book of business. Throughout the pandemic, I'd like to remind you, our annual loss ratio never exceeded 1%. Our loss ratio is back to pre-pandemic levels of approximately 50 basis points.
Slide 8 highlights our revenue and non-GAAP diluted net EPS performance. We are very pleased that the progress we're making against our edge-to-cloud strategy is evident in the financial results we have delivered on both the top and bottom lines. We have grown both our revenue and non-GAAP diluted net EPS to record or near-record levels in Q1 '23. This illustrates not only the commercial success of our products in the marketplace but also our ability to generate healthy margins. I am particularly pleased to see that our focus on supply chain execution has enabled the attainment of record revenues despite the substantial year-over-year headwind from foreign exchange rates that impacted revenue growth by 550 basis points in Q1 '23.
Slide 9 illustrates the progress we have made in our gross margin structure. Our Q1 '23 non-GAAP gross margin is up 30 basis points year-over-year. We generated $2.7 billion in gross profit in Q1 '23, which is yet another quarterly record. Our gross profit and margin are a testament to the success of our strategic pricing actions through the period of supply challenges in fiscal year '20 to fiscal year '22. It is also illustrative of the long-term favorable mix shift we are driving. Despite a strong Compute quarter, our revenue mix of Compute at 44% was flat year-over-year. This illustrates that we have a larger revenue base as our higher margin segments are growing rapidly and our as-a-service strategy is gaining momentum.
Slide 10 illustrates our non-GAAP operating margins progress, which reached 11.8% in Q1 '23. This is up 30 basis points sequentially and 80 basis points year-over-year. It is also a record quarterly non-GAAP operating margin for the company. Our very strong Q1 revenue performance and our resilient gross margins are the leading contributors to the operating margin expansion. Unlike many tech companies that have announced layoffs recently, we have strong momentum at HPE with the combination of our improved cost structure, substantial order book, and outstanding execution delivering profitable growth that is increasingly recurring at higher margins as our as-a-service transformation continues to unfold. Again, let me reiterate that Antonio and I are determined to maintain this focus on profitable growth and productivity for the future.
Let's now turn to discuss H3C. As you know, we have chosen to exercise our put options on our shares in H3C. We took this decision after carefully weighing the financial implications of remaining in the joint venture with a risk-reward profile of exercising the put. We are confident that we have made the decision that is in the best interest of our shareholders. HPE and our partner Unisplendour continue to have constructive discussions to reach agreement on the determination of the final purchase price of HPE shares in H3C and enter into a share purchase agreement. We will keep you updated. Please keep in mind that our decision to exercise the put is distinct from the commercial agreements with H3C. We intend to continue to do business in China through both our direct sales and through H3C, and we remain committed to serving our customers in China. I would like to remind you that we will continue to recognize the value of the dividends we received from H3C in our financials until the transaction is complete, and I'm happy to report H3C results remains healthy despite uncertainty in the Chinese economy.
Our first fiscal year from a cash flow perspective is typically a down quarter for cash flow. In Q1 '23, we had outflows of $800 million in cash flow from operations and $1.3 billion in free cash flow. Working capital was a use of cash due to timing of receipts, payments, and continued investments in inventory, which has driven our cash flow conversion cycle from a negative 14 days in Q4 to a positive 15 days in Q1 '23. More specifically, our accounts payable balance was reduced by $2.2 billion quarter-over-quarter, and was the main driver for negative operating cash flow and affected our cash flow conversion cycle. Also, we have made significant investment in HPE FS volumes to drive future growth in subsequent quarters. We expect to generate significant free cash flow in the remainder of fiscal year '23 and reiterate our guidance of $1.9 billion to $2.1 billion in free cash flow for the full year.
Now, let's turn to our outlook slide on Slide 13. As we have mentioned, demand for our products and services was more uneven in Q1 '23 across our business than it was in Q4 '22. Having said that, we also believe our portfolio differentiation will continue to drive market share gains and are entering Q2 '23 with a substantial order book relative to pre-pandemic levels. We had strong momentum in Q1 '23, and we are now turning our focus to invest in sustaining that momentum in the second half of '23 and fiscal year '24 in a context of continuous macroeconomic uncertainty. Let me reiterate that our guidance incorporates our current thinking on the macroeconomic picture, inflationary pressure, our exit from Russia and Belarus in '22, and foreign exchange risk. I would like to remind you that approximately 50% of our revenue is generated in foreign currencies. For Q2 '23, we expect revenues in the range of $7.1 billion to $7.5 billion. At the midpoint of the range, this represents a 9% year-over-year growth in reported dollars. We expect GAAP diluted net EPS of $0.27 and $0.35 and non-GAAP diluted net EPS of $0.44 to $0.52. This outlook assumes the current level of demand we have been experiencing remain unchanged, and that we continue to make progress on the delivery of our order book.
To sum it up, I am very pleased with our Q1 results and guidance for Q2. We also understand some of our end markets are likely to remain uneven in the near term. We had indicated at our last earnings announcements that our financial performance in fiscal year '23 is likely to be more weight -- more weighed to the first half of the year than is typical. Given the strong Q1 performance, momentum, and substantial order book we continue to have, we are lifting our full-year guidance accordingly. We are now targeting 5% to 7% revenue growth adjusted for currency, which is at the midpoint twice our prior revenue growth guidance, non-GAAP operating profit growth of 5% to 6%, GAAP-diluted net EPS of $1.40 to $1.48, non-GAAP diluted net EPS of $2.02 to $2.10, and free cash flow of $1.9 billion to $2.1 billion.
Specifically for I&E, we benefited in Q1 '23 from one-off foreign exchange gains that accounted for $0.02 to $0.03 per share. These are unlikely to repeat in the rest of the fiscal year. Given the high-interest rate environment is expected to remain unchanged, we expect I&E to be an expense of $20 million to $40 million on a full-year basis. This explains our fiscal year '23 EPS guidance range of $2.02 to $2.10, which incorporates $0.06 of the $0.09 beat in Q1 '23. In terms of capital returns, we will return approximately 60% of free cash flow to shareholders via dividends and repurchases. We are maintaining our dividend and expect to repurchase at least $500 million worth of shares in fiscal year '23.
So to conclude, our results speak for themselves and we continue to execute better than the competition. While many tech companies are playing defense with layoffs, we see fiscal year '23 as an opportunity to accelerate the execution of our strategy. Antonio and I look forward to continuing our execution momentum through fiscal year '23 and beyond.
Now with that, let's open it up for questions. Thank you.
