Marie Myers
Executive Vice President and Chief Financial Officer at Hewlett Packard Enterprise
Thank you, Antonio, and good afternoon, everyone. It's a pleasure to be here with all of you after my first full quarter as HPE's CFO. Over the past three months, I have become even more excited about our opportunities across AI, hybrid cloud, and networking. We remain in the very early days of AI, yet it is already driving strong interest, pipeline, orders, and revenue across our portfolio from servers, to storage, to services, to financing.
Our AI system revenue inflected positively in Q2. We are winning deals in the AI market now and are well-positioned for additional demand from enterprises and sovereigns in the future. Our differentiation includes decades of liquid cooling expertise, which we expect to become even more in demand with future iterations of chips, including NVIDIA's. In short, we see AI as a long-term driver of our financial results and as a pillar of our strategy to pursure higher-growth, higher-margin revenues.
We are very pleased that we have exceeded our expectations in Q2 across key metrics. We exceeded the midpoint of our revenue guidance by $400 million. Non-GAAP-diluted net EPS was above the high end of our range and free cash flow exceeded $600 million. Improving enterprise demand for traditional servers on top of the expected sharp ramp in AI servers drove the outperformance. Our AI orders are healthy. Intelligent Edge is set to grow sequentially beyond Q2, as expected, and AI emerged as a driver of our healthy HPE GreenLake momentum. We are seeing rapid growth in AI system revenue. Overall, I'm very pleased with our performance in Q2 and I'm excited about our continued progress through fiscal '24.
Let's take a closer look at the details of the quarter. Revenue grew 4% year-over-year and 7% quarter-over-quarter in constant currency to $7.2 billion. This exceeded the midpoint of our prior guidance by approximately $400 million. We have strong momentum in HPE GreenLake. The number of customers that have adopted HPE GreenLake rose 9% sequentially. ARR grew 39% year-over-year to above $1.5 billion in Q2. Storage and networking are typically the fastest growth elements of ARR and both retained robust growth rates. This quarter, AI was the fastest growth component of ARR.
Our software and services mix rose approximately 200 basis points year-over-year to 67%. ARR is the best indicator of our model transformation to our as-a-service offerings. This growth validates what our customers are telling us that HPE GreenLake is a key differentiator. We expect HPE GreenLake's value proposition to key customers, including enterprises and sovereigns, to sharpen with the advent of AI.
Our Q2 non-GAAP gross margin was 33.1%, which was down 310 basis points sequentially and year-over-year, driven by a mix shift from our higher-margin Intelligent Edge revenue to server revenue, plus an unfavorable mix within hybrid cloud. Our Q2 non-GAAP operating expenses fell 1.6% year-over-year despite our revenue growth of 4%. Our opex discipline partially offset lower non-GAAP gross margins and held the non-GAAP operating margin decline to 200 basis points sequentially and year-over-year to 9.5%. The opex discipline plus higher revenue drove GAAP-diluted net EPS of $0.24 and non-GAAP-diluted net EPS of $0.42. The latter exceeded the high end of the guidance range on strong revenue and cost discipline. And non-GAAP-diluted net earnings per share excludes $247 million in net costs, primarily from stock-based compensation expense, amortization of intangibles and acquisitions, and other related charges. We are managing the business with focus and discipline and evolving into a simpler, more agile company. We are also investing to capitalize on growth from the interrelated inflection points in AI, hybrid cloud, and networking, and to drive structurally higher profitability over time.
Let's turn to our segment results. Server revenues were $3.9 billion in the quarter. This was up 16% sequentially and up 18% year-over-year. Strength in both AI systems and traditional service drove the healthy revenue growth. Our cumulative AI system product and service orders since Q1 '23 rose approximately $600 million sequentially to $4.6 billion. I'm very pleased with our AI system product revenue more than doubled sequentially to over $900 million. This strong revenue growth allowed us to make progress against our backlog, which is now $3.1 billion.
Given the growing importance of our services business, we have updated our AI disclosures for this quarter to include services. Services is a small portion of our AI systems metrics at present, though we expect it to become more meaningful over time. Our differentiation with liquid cooling, software, HPE GreenLake, and increasingly services is resonating in the market. We have seen a threefold increase in our enterprise AI customer base in the past year.
Revenue from our traditional server business increased sequentially. We expect this trend to continue. Demand is improving as enterprises digest prior purchases and gain more comfort with the macro outlook. The structural mix shift to higher AUP Gen11 servers is ahead of our expectations and we are able to pass through rising input costs. We are encouraged that our Gen11 pipeline is starting to include AI inferencing activity and enterprise applications, and we see more evidence of adoption in the enterprise in Q2.
Our Q2 operating margin was 11%. This was down 40 basis points sequentially and was in line with the expectations we laid out last quarter for our operating margins near the lower-end of our long-term 11% to 13% range. While pricing remains aggressive in the server market, particularly in AI systems, we remain disciplined in cost and price as we pursue profitable growth. Hybrid cloud revenues of $1.3 billion were up 1% sequentially and down 9% year-over-year. We are already seeing some cross-selling benefits of integrating the majority of our HPE GreenLake offering into a single business unit. I mentioned a 39% growth in ARR this quarter.
Our traditional storage business was down year-over-year. The business is managing two long-term transitions at once. We talked about our migration to the more software-intensive Alletra platform. This is reducing current-period revenue growth, so locking in future recurring revenue. Storage ARR growth of over 50% year-over-year offers early confidence into the migration.
The second transition is from block storage to file storage driven by AI. While early, this is also on the right trajectory. Our new file offerings plus the sales force investment Antonio mentioned tripled our pipeline of file storage deals sequentially in Q2. Our operating margin was 0.8%, which was down 300 basis points sequentially and 110 basis points year-over-year. Reduced revenue scale and an unfavorable mix of third-party product and traditional storage was the largest driver of the sequential change.
Intelligent Edge revenues were $1.1 billion. Revenues fell 9% sequentially and 19% year-over-year. Backlog consumption created difficult compares with both prior periods. Our backlog is now at normal levels. The demand environment remains soft and large enterprises have yet to return to the market in force. However, we do see some green shoots that give us confidence that networking will transition to modest sequential growth beyond Q2 as we had expected. Our channel inventory remains within the normal range. Wi-Fi has grown sequentially for two consecutive quarters. Growth remained strong in software and services. Attach rates and renewals for Aruba Central, SASE, and our AIOps software remained strong. The Intelligent Edge portfolio of subscription revenue grew above 50% year-over-year.
The segment operating margin of 21.8% was down 760 basis points sequentially and 290 basis points year-over-year. As expected, the lower revenues, reduced mix of switching business and the less revenue from backlog were the primary drivers. As we indicated last quarter, we have reset our opex plan for the year to account for lower revenue and expect the Intelligent Edge operating margin to be back in the mid-20% range by Q4.
Our HPE financial service revenue was up 1% year-over-year and financing volume was $1.7 billion. Our operating margin of 9.3% was up 80 basis points sequentially and 40 basis points year-over-year. Our Q2 loss ratio remained steady below 0.5%. These results are what we have come to expect from this high-quality predictable business. However, underneath these steady results, FS is already adapting to drive AI growth across the business. Year-to-date, nearly $0.5 billion of our $3 billion in financing volume went to AI wins with both cloud and enterprise customers. This illustrates our prior point that AI is driving demand to every one of our businesses.
Turning now to cash flow and capital allocation. We generated $1.1 billion in cash flow from operations and $610 million in free cash flow this quarter. HPE typically consumes significant amounts of cash in the first half of the year and then generates cash in the second half. We are ahead of traditional free cash flow patterns thus far in fiscal '24, given higher-than-expected net income in Q2, prepayments for AI systems, and timing of working capital payments. Our cash conversion cycle was negative four days, which is a reduction of 28 days from Q2 '23. Our days of inventory and days payable were both higher to support our expected growth in AI system revenue in the second half. We returned $240 million in capital to shareholders in Q2, including $169 million in dividends and $45 million in share repurchases. Our year-to-date capital return is $386 million.
Let's turn now to our forward view. We expect a materially stronger second-half led by AI systems, traditional servers, and storage, networking, and HPE GreenLake. Let me recap the key drivers that factor into our expectations for Q3 and the full year. For server, we expect improving GPU supply for AI systems and improving demand for traditional servers to drive sequential revenue increases through fiscal year '24. While the rising AI systems mix is a gross margin headwind, we are balancing this with higher-margin services revenue, improving scale and cost discipline. We expect the segment operating margin to be approximately 11% for the fiscal year.
For hybrid cloud, we expect slight sequential revenue increases throughout the year. HPE GreenLake growth should continue and traditional storage should improve slightly. We expect operating margin to improve modestly to the mid-single-digit range through the year as HPE GreenLake deals mature, new products ramp, and our sales force optimization gathers momentum.
For Intelligent Edge, we anticipate slight sequential growth in Q3 and Q4, driven primarily by seasonal education spending rather than improving markets. We continue to expect our cost-reduction efforts to materialize in the second-half and our full-year operating margin to be in the mid-20% range.
With that context, let me now turn to our outlook. For Q3, we expect revenues in the range of $7.4 billion to $7.8 billion. We expect GAAP-diluted net EPS to be between $0.29 and $0.34 and non-GAAP-diluted net EPS between $0.43 and $0.48. For fiscal year '24, we now expect constant-currency revenue growth of 1% to 3%, which is up from our prior 0% to 2% range. We reiterate our non-GAAP operating profit growth guidance of 0% to 2%. We are reducing our GAAP-diluted net EPS guidance by $0.20 to $1.61 to $1.71 to incorporate the recent updates to our H3C proceeds. We are raising our non-GAAP-diluted net EPS guidance up $0.03 to $1.85 to $1.95. This incremental $0.03, or $0.06 annualized, reflects the contribution from the retained portion of our H3C stake. We are also increasingly comfortable with the high end of the non-GAAP-diluted net EPS range given our OI&E and operational improvement. We are excluding from our non-GAAP results the gain on sale from our H3C and CTG divestments.
This year's mix shift from networking to AI systems should weigh on our gross margins. We expect the fiscal '24 non-GAAP gross margin to be below our full-year expectation of 35% from our Analyst Day. To balance the mix shift, we are driving further simplicity and efficiency across the business. We are accelerating our generative AI capabilities such as implementing HPE-specific large language models and chatbots for our sales and service representatives.
As I mentioned last quarter, prudent cost management, simplified processes, and disciplined execution across cycles are key tenets of our long-term journey towards higher margins. These cost actions will be evident in financial results in the second-half of fiscal '24. We now expect fiscal year '24 opex to be down modestly from fiscal '23 opex. Our prior view was flat to down. This includes a sequential increase in Q3 for marketing before a sequentially lower Q4, which will serve us well heading into fiscal '25. We expect our fiscal '24 operating margin to be flattish year-over-year. We now expect OI&E to be less of a headwind this year. We anticipate a $150 million headwind versus our prior expectation of a $200 million to $250 million headwind given a onetime benefit in Q2 and the retained portion of our H3C stake. We expect the effect of currency to be immaterial.
Our strong first-half free cash flow increases our confidence that we will deliver at least $1.9 billion in fiscal year '24. We expect significantly stronger free cash flow in the second half of the year, led by higher earnings given our ramp in AI systems. This does not include the $2.1 billion that we expect to receive from Unisplendour this fiscal year as a result of our recently restructured agreements to sell our stake in H3C. We expect working capital to be neutral to free cash flow as we expect declines in inventory to balance declines in accounts payable.
We remain committed in the long term to our balanced capital allocation framework, including our target of returning 65% to 75% of free cash flow to shareholders. In the near term, we expect to continue share repurchases at a pace in line with Q2 as we prudently manage our balance sheet ahead of the anticipated receipt of the H3C proceeds and the Juniper transaction closing. The proposed Juniper deal remains on track to close in late 2024 or early '25 as planned. We remain committed to our dividend and to our investment-grade rating.
To conclude, our solid Q2 results illustrate how comprehensively AI is affecting our portfolio. We are capturing profitable growth opportunities in the AI market. We are excited for Discover and look forward to seeing many of you at our IR summit.
I'll open it up now for your questions.
