Marie Myers
Executive Vice President and Chief Financial Officer at Hewlett Packard Enterprise
Thank you, Antonio, and good afternoon. We are pleased with our performance this quarter and we did what we said we would do. We delivered strong top-line revenues, grew revenues sequentially in each segment, prudently managed costs, improved profitability sequentially, and delivered non-GAAP diluted net earnings per share that exceeded the high end of our guidance range. As Antonio said, we are pleased to have received the $2.1 billion in proceeds from the partial sale of the H3C equity position.
Today's results highlight our ability to deliver amidst a dynamic macro environment. While some customers remain cautious and prioritize mission critical projects, we are encouraged by the recovery and enterprise demand we are seeing in North America, followed by modest improvement across the other geographies. We remain excited about HPE's position across AI, hybrid cloud, and networking.
HPE is well-positioned for the AI opportunity. This quarter, our AI systems backlog increased and we grew AI systems revenues approximately 40% sequentially. We continue to win deals with both model builders and sovereigns and are well-positioned to address enterprise AI demand. In traditional service, we are seeing signs of a recovery as both demand and revenue increase sequentially. In hybrid cloud, we see an improvement in storage led by the strong demand for our HPE Alletra MP offering, and we continue to drive ARR growth. We are encouraged by the early and strong customer response to our Private Cloud AI offering that we announced at Discover, which we expect to drive AI adoption in the enterprise.
Lastly, results were solid in networking. Improving sequential demand in WLAN, data center networking and switching, along with continued growth in security and services keeps us optimistic heading into the fourth quarter.
We continue to make progress towards our strategic goals. Our recently announced acquisition of Morpheus Data that expands our hybrid cloud capabilities and our confidence in closing the Juniper acquisition by the end of calendar year 2024 or early calendar year 2025 are excellent examples. Overall, I am pleased with our performance in Q3 and look forward to carrying a momentum through the end of our fiscal year.
Now let me go through the details of the quarter. Revenue grew 10% year-over-year and 7% quarter-over-quarter in constant currency to $7.7 billion, near the high end of our guidance range for the quarter. Our as-a-service momentum continued this quarter, we grew ARR 39% in constant currency year-over-year to more than $1.7 billion led by AI through HPE GreenLake and networking and storage subscriptions. With enterprise AI customers, we are noticing a strong appetite for a consumption model, both to alleviate investment pressures as well as to retain flexibility to grow workflows though this is still early days.
We continue to lift HPE GreenLake's value proposition with an increasing mix of higher margin software and services revenue. This quarter, we expanded the software and services mix of ARR approximately 300 basis points year-over-year to 71%, due to the stronger sales of AI services tied to hardware sales and Aruba Central platform subscriptions.
Our non-GAAP gross margin was 31.8%, which was down 410 basis points year-over-year, driven by a lower mix of Intelligent Edge revenue and a higher mix of AI server revenue. The 130-basis point sequential decline was driven by the higher AI server revenue mix. We have balanced gross margin pressures by executing on strong cost controls and by maintaining pricing discipline in a competitive AI server market. Our non-GAAP operating expenses decreased approximately 7% year-over-year and 1% quarter-over-quarter despite a seasonal increase in marketing expenses associated with our annual Discover event.
Since joining as CFO, I have taken a rigorous, programmatic approach to streamlining our cost structure to drive operating expense improvements. And we expect to see the benefits of these actions in the second half of the year. This is already evident in our results as we drove a 50-basis point sequential improvement in our non-GAAP operating margin, offsetting pressures we saw at the gross margin line. Our non-GAAP operating margin was stable at 10%.
Profitability improvements and better than expected OI&E drove GAAP-diluted net EPS of $0.38 per share and our non-GAAP-diluted net EPS of $0.50 per share, both above the high end of our guidance ranges. Our non-GAAP-diluted net EPS excludes $149 million in net costs, primarily from stock-based compensation expense, amortization of intangibles and acquisition, and other related charges.
Now let's turn to the segment results, starting with servers. Strength in both AI systems and traditional servers drove healthy revenue growth and stable operating margins. Server revenues were $4.3 billion in the quarter, up 35% year-over-year and 11% sequentially. In traditional servers, we saw steady growth and are seeing signs of recovery. We saw strength in North America where our installed base is spending more, though EMEA and APJ customers continue to evaluate spend. Our Gen11 product continues to ramp ahead of expectations and now represents a growing proportion of total server revenue. And we have been able to manage an inflationary component environment through dynamic pricing and by leveraging strong supplier relationships.
In AI systems, demand remains strong, though large deals continue to be lumpy. AI systems product and services orders rose $1.6 billion sequentially, driving our cumulative orders since Q1 '23 to $6.2 billion. We are pleased with our current AI systems backlog, which has increased quarter-over-quarter to $3.4 billion. Demand remains healthy from the model builders. We are winning deals in this space and following a framework to manage risks and profits.
While still early days, we continue to see positive signs from enterprise customers. In fact, more than 80% of enterprises are experimenting with GenAI initiatives, which supports our view that the number of customers will continue to trend favourably. This quarter, our enterprise AI pipeline more than doubled sequentially. And sovereign AI is an adjacency for HPE, right beside our market leadership in supercomputing. We continue to see increasing demand from this set of customers who are embracing AI. Within model builders and sovereign AI, customers is a growing desire for liquid cooling. However, adoption relies on data center readiness. We view HPE's multi-decade design and manufacturing expertise, intellectual property, patent portfolio, and global reach and dedicated services as clear differentiators as the market moves in this direction.
Q3 was again a strong quarter for AI system revenue conversion. AI system revenues were $1.3 billion in the quarter, up approximately 40% from the prior quarter. We are pleased with the stability of our operating margins within our server business. Our Q3 server operating margin was 10.8%. This was up 70 basis points year-over-year, but down 20 basis points sequentially. AI systems make up a higher share of our total server revenue compared to one year ago, 10% in Q3 FY '23 versus 30% this quarter. This underscores our disciplined focus on profitability in a competitive AI server market. Our operating margin performance was in line with expectations. For the full year, we continue to expect our server margins to be at the low end of our target range of 11% to 13%. We will remain disciplined in cost and price as we pursue profitable growth.
Now moving to hybrid cloud. Both revenue and profitability improved quarter-over-quarter. Segment revenues of $1.3 billion were down 7% year-over-year, but up 4% sequentially. As we have previously discussed, we are managing both a sales model transition and product transition within the storage business. Our product model transition is to a more cloud-native software defined platform with HPE Alletra, which offers a unified storage architecture, comprehensive AI Ops, and cross-stack analytics and aligns to customer preferences for a hybrid cloud model. Translating this storage growth to revenues will take time because of the higher mix of ratable software and services which is deferred into future periods.
We continue to see strength for our Alletra MP offering with sequential improvement led by our continued business transformation efforts, particularly in go-to-market. We are seeing signs of improving demand for block storage and early traction in file, and we are closely monitoring the impacts of commodity costs on demand.
In our Private Cloud business, we are having constructive conversations with our customers to evaluate their virtualization strategy. At Discover, we announced efforts to develop our virtualization capabilities which will be available within our Private Cloud Business Edition solution. Lastly, customers are reacting positively to our recently announced Private Cloud AI offering in partnership with NVIDIA, which unifies AI skills, data, architecture and solutions into one fully managed platform and accelerates time to value for enterprises looking to begin their AI journeys. We are seeing traction in both customer demos and pipeline, and as of yesterday, our private cloud AI offering is globally available to order. Our hybrid cloud operating margin was 5.1%, down 30 basis points year-over-year, but up 430 basis points sequentially, predominantly due to better opex controls.
Moving to Intelligent Edge. Revenues were $1.1 billion, down 23% year-over-year on tough compares, but up 3% sequentially. Demand was steady quarter-over-quarter, backlog remains at normal levels, channel inventory remains healthy, and we believe that we have moved past the trough. On the order side, we are seeing a recovery that is in line with our industry peers. For the second consecutive quarter, we saw order improvements in each of our geographies, led by strength in North America, followed by modest growth at EMEA and APJ. By product, we saw sequential order improvements in data center networking and in campus. We grew both services and SASE orders mid- to high-single-digits year-over-year as customers remain excited about our Aruba Central platform that is part of our HPE GreenLake offering.
On the revenue side, we drove year-over-year strength in data center networking, SASE, and services, though saw declines in our campus and switching due to difficult annual compares. Our sequential revenue grew approximately 3%, consistent with our expectation that Q2 would be the trough. The segment operating margin of 22.4% was down 520 basis points year-over-year, driven by tough year-over-year revenue compares, offset slightly, but a better year-over-year gross margin rate. Better opex was the primary reason for our 60-basis point sequential improvement in operating margin. Our opex plan has put us on a path to achieve operating margins in the mid-20% range by Q4.
Now turning to financial services. Our HPE financial services revenue were $879 million, up 1% year-over-year, and financing volumes were $1.5 billion. Year-to-date, $800 million of $4.5 billion in financing volume went to AI wins with both cloud and enterprise customers, which illustrates that AI is driving demand across our portfolio. Operating margin of 9% was up 80 basis points year-over-year and down 30 basis points sequentially. Our portfolio remains healthy, and we continue to improve the investment-grade mix. Our Q3 loss ratio remained steady at below 0.5% and our return on equity is a solid 17.4%.
Turning now to cash flow and capital allocation. We generated $1.2 billion in cash flow from operations and $669 million in free cash flow. We are on track for $1.9 billion in free cash flow. We remain confident in our ongoing ability to generate strong free cash flow even as we pursue strategic buys given the rising component cost environment.
Our Q three cash conversion cycle was a positive four days, which is a reduction of 19 days from Q3 '23. Our days of inventory and days of payables were both higher on AI systems orders that outpaced revenue conversion and on our strategic purchases for our server business. We continue to believe working capital to be neutral to free cash flow as we expect declines in inventory led by strong AI system revenue conversion to balanced declines in accounts payable as we exit the year. We are pleased to have received the $2.1 billion in proceeds from the partial sale of the H3C equity position. We remain committed to our balanced capital allocation framework and are focused on managing our balance sheet and maintaining our dividend. We returned $221 million in capital to shareholders in Q3 and $607 million year-to-date.
Now let's turn to guidance. As Antonio mentioned, we are making steady progress on securing the necessary regulatory approvals required for our pending Juniper acquisition and look forward to closing by the end of calendar year '24 or early calendar year '25. For the fourth quarter, we expect revenues in the range of $8.1 billion to $8.4 billion, GAAP-diluted net EPS to be between $0.76 and $0.81, and our non-GAAP-diluted net EPS to be between $0.52 and $0.57. For revenue, we expect to see sequential growth similar to the last couple of quarters with revenue to remain indexed towards server. We continue to manage the business at the operating income level and therefore expect a sequential decline in operating expenses in order to deliver our EPS targets.
On a segment basis, we expect the following. For server, we expect to convert AI systems to revenue at a strong pace. As mentioned, the market remains competitive and large deals remain lumpy. We continue to be time to market for GPUs and are looking forward to shipping H200 chips for the AIST supercomputer in Q4. We also expect a continued demand in traditional servers driven by Gen11 adoption and higher units. We are maintaining our expectation of achieving the low end of our 11% to 13% operating margin range for the full year.
For hybrid cloud, we expect a slight revenue increase to close the year, though expect pressures from rising commodity costs, particularly in SSDs. ARR growth should continue as our storage business accelerates and shifts to subscription under HPE GreenLake. And we expect operating margins to continue to trend favorably to the mid-single-digit range.
For the Intelligent Edge business, we anticipate a slight sequential revenue increase for the fourth quarter on the recovery in campus and WLAN, as well as strength in data center networking. Benefits from our cost reduction efforts materialized in our third quarter results, and we expect a similar trend in the fourth quarter, supporting our outlook for a full-year operating margin in the mid-20% range.
For the full year, we are tracking towards the high end of our revenue guidance of 1% to 3% growth in constant currency. We expect to balance gross margin pressures from a higher mix of AI systems with continued operating discipline and expect to come in at the low end of our operating profit growth guidance of 0% to 2%. We now expect OI&E to be a $50 million to $100 million headwind versus our prior expectation of $150 million headwind. We have tightened our non-GAAP-diluted net EPS expectations for the full year to $1.92 to $1.97. For GAAP EPS, we are now seeing increased costs related to the Juniper transaction, with our expectations now at $1.68 to $1.73.
Lastly, we remain committed in the long term to our balanced capital allocation framework, our dividend, and to our investment-grade rating. In the near term, we expect to continue share repurchases at a pace in line with Q3 as we prudently manage our balance sheet ahead of the Juniper transaction closing.
To summarize, our Q3 results were strong and demonstrated good sequential revenue growth.
With that, I'll turn it over for Q&A.
