Tarek Robbiati
Executive Vice President and Chief Financial Officer at Hewlett Packard Enterprise
Thank you very much, Antonio. I will start with a summary of our financial results for the second quarter of fiscal year '23. As usual, I will reference slides from our earnings presentation to guide you through our performance. Antonio discussed key highlights for Q2 '23 on Slide 4.
Let me discuss our Q2 performance details, starting with Slide 5. I would characterize this quarter as solid overall despite the uneven demand indicators across our portfolio, particularly in Compute, with continued demand and outstanding performance in our Intelligent Edge business as a standout. We are very pleased that we are successfully driving further diversification of our business mix towards our higher-growth, higher-margin portfolio of Intelligent Edge, HPC & AI and HPE GreenLake solutions.
During the quarter, net revenues grew 56% year-over-year in Edge, 22% year-over-year in HPC & AI, and the HPE GreenLake ARR grew 38% year-over-year, all in constant currency. The pivot of our portfolio towards higher-growth, higher-margin markets is clearly visible in the expansion of gross margins and our strategy is working. While we remain confident about our fiscal year '23 and beyond, we are also realistic. Demand through much of the past two years has been above trend, as attested, by our growing order book over the fiscal year '20 to '22 period throughout our business, including Compute, which is very cyclical in nature. Demand shifted from fiscal year '22 and to uneven in Q1 and was even more uneven in Q2 across our portfolio. While Q2 revenue of $7 billion equates to a healthy 4% year-over-year growth and 9% year-over-year growth in constant currency, revenues were below our prior guidance range of $7.1 billion to $7.5 billion.
Deal velocity has slowed, particularly in North America in Compute and, to a lesser extent, in Storage. Deal cycles have elongated as customers, primarily our larger compute customers, digest their investments of the past two years. This trend has been particularly pronounced for compute in the manufacturing and financial services verticals in North America, in part as a result of loss of confidence in the banking sector. In addition, HPC & AI was affected by several customer acceptances that slipped out of Q2. Despite this, we see several promising indicators.
Demand in Q2 grew sequentially, led by HPC & AI and our Intelligent Edge business, Aruba. Aruba continues to grow revenues, both on a year-over-year and on a sequential basis. Overall demand in Compute in the mid-market is stable, including direct enterprise and the channel. Our overall order book at the start of Q3 remains elevated at more than 1.5 times normalized historical levels, and we expect the strong momentum in Intelligent Edge to continue. And finally, AI demand is very solid, as you heard from Antonio, and materializing in our pipeline and our order book with several very large deals. More on that later.
We also continue to take action to strengthen the portfolio mix shift inorganically across our businesses. We have closed the acquisitions of Axis Security and OpsRamp, and are already winning deals with these assets as part of a broader HPE. I am particularly proud that we have finalized an agreement with our partners at Unis for the sale of our 49% stake through the exercise of our put option for an amount of $3.5 billion. More on that later.
In recognition of the Compute weakness, we are adjusting our previously communicated guidance of 5% to 7% revenue growth to 4% to 6% in constant currency. Nevertheless, the combination of our order book, ongoing strength and momentum in Edge and HPC & AI gives us confidence that we will deliver solid FY '23 revenue growth and remain confident in the 2% to 4% revenue CAGR outlook over the FY '22 to FY '25 period that we provided at our 2022 Securities Analyst Meeting in October.
Our non-GAAP gross margin reached a high-water mark of 36.2%. This is up 200 basis points both year-over-year and sequentially. Our margin structure reflects the pivot of our business mix to higher-margin and software-intensive recurring revenue. Our Intelligent Edge business, Aruba, was 19% of total revenue in Q2, up 580 basis points year-over-year. And with Q2 sequential revenue growth in Aruba at 15%, we expect Aruba to represent a larger portion of the company's gross and operating profits by the end of fiscal year '23. As a result, our Q2 '23 non-GAAP operating margin reached 11.5%, this is 220 basis points ahead of Q2 '22, and down just 30 basis points from a record performance in Q1 '23.
In addition to the portfolio mix shift towards high-margin businesses, we remain focused on cost control and productivity. Antonio and I remain determined to maintain this focus and to grow revenues faster than OpEx over time. Our Q2 margin strength drove GAAP diluted net EPS to $0.32 and non-GAAP diluted net EPS to $0.52, at the high-end of our guidance range of $0.44 to $0.52. Q2 '23 free cash flow was positive $288 million, an improvement of nearly $500 million over Q2 '22 and $1.6 billion over Q1 '23. We will discuss cash flow in more details later. Having said that, we remain on track to generate between $1.9 billion and $2.1 billion in free cash flow this fiscal year. Finally, we are continuing to return substantial capital to our shareholders. We paid $155 million in dividends and repurchased $106 million in stock this quarter and are on track to buy back at least $500 million worth of shares in fiscal year '23. Our year-to-date total capital returns are $409 million, which reflects our confidence in future cash flow generation.
Moving to Slide 6. We are very pleased to announce our pivot to -- as-a-Service revenue continues to show strong momentum as ARR surpassed $1.1 billion in Q2 '23. The benefits of easing supply challenges are appearing in our results as ARR growth in constant currency accelerated from 25% in Q4 '22 to 31% in Q1 '23 and now 38% in Q2 '23. Our Edge and Storage SaaS offerings are the fastest growth components of our as-a-Service portfolio. Our as-a-Service order decline of 8% in Q2 '23 is a function of a tough compare to Q2 '22, in which orders grew 107% on strength of several large deals. We are comfortable with our robust pipeline, which includes very large enterprise AI wins we've recently closed and reiterate our three-year ARR target of a 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 Q2 '23, our mix of software and services increased another 220 basis points year-over-year to 66%, and we have attained a total TCV [Phonetic] well in excess of $10 billion.
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 grew our revenue 56% year-over-year and exceeded the Rule of 40 for a second consecutive quarter. Most importantly, we grew revenues 15% sequentially and delivered record revenues for a fourth consecutive quarter. We are outgrowing our main competitors and are taking share in some of the largest enterprise customers who are increasingly adopting our software-centric solutions such as EdgeConnect SD-WAN software and our Aruba Central management platform. We have now closed our acquisition of Axis Security, and are already generating SD-WAN and SASE wins in combination. Our acquisition of private 5G player, Athonet, is still pending but already contributing to our pipeline of business.
Our operating margin of 26.9% was up more than 1,400 basis points year-over-year and 500 basis points sequentially. We're benefiting from scale and a solid order book that continues to grow. And as a result, we are optimistic about the prospects of our Intelligent Edge business in fiscal year '23 and beyond. In HPC & AI, revenue grew 22% year-over-year. The emergence of large language models and generative AI has prompted many inquiries from our customer base during the past quarter, which are turning into pipeline and orders. In the past few months, we have multiple large enterprise AI wins totaling more than $800 million and counting, this includes large AI-as-a-Service deals under the GreenLake model. We believe building and operating large AI models requires unique computational capabilities, including silicon and software, that our great supercomputers and HPC & AI solutions are extremely well positioned to enable. We expect AI demand to drive healthy revenue growth in the future and intend to invest organically and inorganically to fully grasp this opportunity as our acquisitions of Determined AI and Pachyderm attest. The early stage of the AI market, tightness in certain key components and non-linked times in this business means that operating margins in the business unit will continue to fluctuate.
Storage revenue grew 2% year-over-year. HPE Alletra revenue grew triple digits in Q2 for the fourth consecutive quarter, lifting our total all-flash array growth to 20% year-over-year. HPE Alletra is driving a long-term mix shift to higher-margin, Software-intensive as-a-Service revenue. We will continue to invest in R&D for our own IP products in this business unit such as our new file as-a-Service and Alletra MP offerings. Our Q2 '23 operating margin of 7.9% is down 390 basis points year-over-year as we navigate uneven demand and migrate to our software-defined HPE Alletra, which includes a significant component of SaaS ratable revenue. Compute revenue was down 3% year-over-year to $2.8 billion and down 20% sequentially. The deal elongation and demand softness I discussed previously was most prevalent in the Compute business as our large customers, particularly in manufacturing and financial services in North America, digest the investments they have made in recent years.
Our Compute operating margin of 15.2% exceeded our long-term outlook of 11% to 13% for the sixth consecutive quarter, which attested the quality of our historical book of business. While we are seeing decreasing commodities cost leading to increased competitive price pressure, we are selling three differentiated platforms in the market, Gen10, Gen10 Plus and Gen11, which should allow a gradual management of margins over time.
In HPE Services, which is within our Compute, HPC & AI and Storage segments, and excluding HPE GreenLake, orders were down low-single digits, and revenues were flat year-over-year. HPE Financial Services revenues rose 7% year-over-year, and financing volume of $1.7 billion grew 17% in constant currency, driven by HPE GreenLake. Our operating margins were down 280 basis points year-over-year, reflecting rapid interest rate hikes and higher cost of funds that we will gradually offset over time through pricing. Time and time again, this business has proven resilient in a downturn, thanks to the quality of the underlying of the book of business. Throughout the pandemic, our annual loss ratio never exceeded 1%. Our Q2 loss ratio of 50 basis points was below full-year 2019 or pre-pandemic levels.
Slide 8 highlights our revenue and non-GAAP diluted net EPS performance. We are very pleased that the progress we are 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 again grown both our revenue and non-GAAP diluted net EPS in Q2 '23 year-over-year, despite our transition towards a recurring revenue model, an uneven spending environment and FX rates remaining a significant headwind that impacted revenue growth by 480 basis points in Q2 '23.
Slide 9 illustrates the progress we have made in our gross margin structure. Our Q2 '23 non-GAAP gross margin is up 200 basis points year-over-year. Our growing gross profit and margin are a testament to the success of the strategic pivot of our portfolio and the pricing actions we have taken. With 56% year-over-year growth in constant currency, our Intelligent Edge business was a standout and is now representing 19% of total sales in Q2 '23, up 580 basis points from a year ago.
Slide 10 illustrates our non-GAAP operating margin progress, which reached 11.5% in Q2 '23, this is up 220 basis points year-over-year, and it also represents a high watermark for non-GAAP operating profit margin for a Q2 in any year. Again, our portfolio mix shift, pricing strategies and productivity focus are the primary drivers of our operating margin expansion. The Intelligent Edge business not only represented 19% of revenue in the quarter, but did so with a record 26.9% operating margin.
Turning to the next slide. As you know, we have chosen to exercise our put options on our shares in H3C. We are pleased to have announced earlier that we and our partner, Unisplendour, have come to an agreement and signed a put share purchase agreement that values our 49% stake in H3C at $3.5 billion. The next step in the process is to obtain the necessary regulatory approvals and to complete certain conditions necessary for closing. We anticipate that the process to close will require a further six to 12 months to complete. However, this time line could be further extended pursuant to the terms of our agreement.
We intend to update our plans for the use of proceeds once the transaction closes. You can assume that we will use the same disciplined return-based framework for evaluating investments, capital returns and maintaining an investment-grade credit rating we have outlined in the past. As part of this framework, we may consider a range of allocation activities, including but not limited to, both organic and strategic investments, return of capital to shareholders, repayment and/or redemption of outstanding debt and general corporate purposes. We have also negotiated the terms of a new go-forward strategic sale agreement to be entered into with H3C that covers the commercial sales, service and reseller arrangements between the companies. We're firmly committed to serving our customers and to continuing to do business in China through both direct sales and our partner, H3C. Finally, as you see on this slide, we are continuing to benefit from H3C dividends in fiscal year '23, and we'll provide a more detailed update at SAM in October '23 as to our go-forward expectations in this area.
In Q2 '23, we are pleased to have generated a positive $889 million in cash flow from operations and $288 million in free cash flow. Our free cash flow improved by $1.6 billion sequentially from a seasonally low Q1 '23 and was also nearly $500 million above our Q2 '22 free cash flow. 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. Net income was the primary driver of our positive free cash flow. Working capital continued to be a use of cash in the quarter. The timing of receipts and payments plus continuing inventory investments have lifted our cash conversion cycle to a positive 24 days in Q2 '23. We expect to exit the year with a neutral cash conversion cycle. Also please remember, we have made significant CapEx investments in HPFS volumes to drive future revenue growth in subsequent quarters.
Now let's turn to our outlook on Slide 13. As we have mentioned, demand for our products and services was more uneven in Q2 '23 across our business than it was in Q1 '23. Macro uncertainty is affecting some of our end markets, yet customer investment is rising in other end markets such as Edge and HPC & AI. We believe our portfolio differentiation will continue to drive market share gains in key markets. We're also entering Q3 '23 still carrying a substantial order book relative to pre-pandemic levels. Let me reiterate that our guidance incorporates our current thinking on the macroeconomic picture, inflationary pressure and FX risk, which is -- which represented a 480 basis point headwind to revenue growth in Q2 '23. I would like to remind you that approximately 50% of our revenue is generated in foreign currencies.
We had indicated at our last earnings announcement that our financial performance in fiscal year '23 is likely to be more weighted to the first half of the year than is typical. We continue to view that as the proper lens for fiscal year '23. For Q3 '23, we expect revenues in the range of $6.7 billion to $7.2 billion. At the mid-point of the range, this represents revenues that are stable year-over-year and most importantly, flat sequentially in reported dollars. We expect GAAP diluted net EPS of $0.34 to $0.38 and non-GAAP diluted net EPS of $0.44 to $0.48. This outlook assumes the current levels of demand we have been experiencing remain relatively unchanged, that we continue to make progress on the delivery of our order book and no further deterioration from FX rates.
Given the weakness in Compute demand, we are adjusting our previously communicated fiscal year '23 guidance of 5% to 7% revenue growth to 4% to 6% in constant currency, and expect FX to be a 250 to 300 basis point revenue headwind. In parallel, we also expect our margin strengths from portfolio mix shift to deliver non-GAAP operating profit growth of 6% to 7%, which is up from our prior 5% to 6% view. We are lifting our GAAP diluted net EPS guidance from $1.40 to $1.48 to a new range of $1.42 to $1.50, and raising our non-GAAP diluted net EPS guidance from $2.02 to $2.10 to a new range of $2.06 to $2.14. We reiterate our guidance for free cash flow of $1.9 billion to $2.1 billion.
For I&E [Phonetic], we have benefited in the first half '23 from FX hedging costs lower than we originally forecasted. The combination of this plus other anticipated benefits in the second half of '23 now leads us to expect to I&E to be neutral on a full-year basis versus our prior expectation of a $20 million to $40 million. In terms of capital returns, we expect to return approximately 60% of free cash to shareholders via dividends and repurchases. And we are maintaining our dividend, and expect to repurchase at least $500 million worth of shares in fiscal year '23. So to conclude, we see the uneven end market demand in FY '23 as an opportunity for HPE to accelerate our portfolio pivot to faster growth, higher margin recurring revenues. 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.
