Jeremy Cox
Senior Vice President & Interim Chief Financial Officer at Hewlett Packard Enterprise
Thank you very much, Antonio. I'm honored to take on the responsibility of Interim CFO as we go through the process. I'll start with a summary of our financial results for the third quarter of FY 2023.
Antonio discussed key highlights on Slide 4. Let me begin with Slide 5, financial highlights. We're actively diversifying our business mix towards our higher-growth, higher-margin portfolio of Intelligent Edge, HPC & AI and HPE GreenLake solutions. This pivot is clearly visible in the 120 basis point year-over-year expansion of non-GAAP gross margins. We delivered a solid quarter within an IT market still under some pressure. Cycle times remain elongated and digestion of prior orders will continue to have some near-term impact. This has been particularly true in Compute and to a lesser extent, in Storage.
Despite these challenges, we delivered 3.5% year-over-year revenue growth in constant currency to $7 billion, which exceeded the midpoint of our Q3 revenue guidance. This figure included a modest amount of AI revenue. We do see several promising indicators that suggest stabilization. Antonio mentioned the sequential improvement in demand across our four product segments. We're starting to see indicators that our largest customers are returning to the market. Intelligent Edge continues to increase revenues rapidly, both on a year-over-year and sequential basis and robust AI demand is evident in our as-a-Service orders.
Our non-GAAP gross margin rose 120 basis points year-over-year to 35.9%. This is off just 30 basis points from our high watermark of 36.2% last quarter. Our margin structure reflects the pivot of our business mix to higher margin, software-intensive recurring revenue, such as Intelligent Edge. The edge mix was up 450 basis points year-over-year.
Our Q3 '23 non-GAAP operating margin reached 10.3%. This is down 120 basis points sequentially and 20 basis points year-over-year. Sequentially, the driver was largely return of Compute operating margins to just below long-term target range of 11% to 13% after six consecutive quarters above the range. We expect the impact of Compute operating margin cyclicality on HPE's operating margins to decline over time as our revenue mix shifts towards our higher growth, higher margin businesses.
Our Intelligent Edge business reached a record-high 29.7% operating margin. We remain focused on productivity and continue to expect revenue growth to outpace opex growth over time. Our solid Q3 revenue and margin performance led GAAP diluted net EPS to $0.35 and non-GAAP diluted net EPS to $0.49, which was up $0.01 year-over-year despite Compute cyclicality. It was also $0.01 above the high end of our Q3 guidance range of $0.44 to $0.48.
Our Q3 free cash flow was $955 million. We continue to return substantial capital to our shareholders, paying $154 million in dividends and repurchasing $187 million in stock this quarter. We have now returned $831 million in capital to shareholders this year.
Moving to Slide 6. Our as-a-Service revenue continues to show strong momentum. ARR reached $1.3 billion in Q3 '23. The benefits of as-a-Service deals we won in prior quarters are now appearing in our results, though the large AI-as-a-Service deals booked in Q3 have yet to reach revenues. Year-over-year ARR growth in constant currency has accelerated from 25% in Q4 '22 to 31%, 38% and now 48% in Q3 '23. The 48% growth is above our long-term 35% to 45% target and should be viewed as an indicator of our long-term momentum rather than as a new growth trajectory. The fastest growing components within ARR year-over-year are Storage and Edge.
We continue to lift HPE GreenLake's value proposition with an increasing mix of higher margin, recurring software and services revenue. Antonio mentioned that in Q3, our software and services mix rose to 68%, and should continue to increase. While this mix has traditionally tilted to services, software is now half of the total. In the future, we expect software growth to exceed services growth and for as-a-Service margins to rise over time.
To Slide 7. Our Q3 as-a-Service order growth was robust. We're pleased to have delivered 122% year-over-year order growth, which has raised our cumulative as-a-Service TCV to nearly $12 billion. The driving factor was AI demand. A significant percentage of our AI orders have come under the as-a-Service model and the strength this quarter should also provide confidence in our long-term 35% to 45% ARR growth outlook. Order growth will fluctuate given the volatility of large as-a-Service deals.
Now let's turn to our segment highlights on the next slide. And remember, all revenue growth rates on this slide are in constant currency. In Intelligent Edge, we grew revenues 53% year-over-year and 8% sequentially, delivering record revenues for a fifth consecutive quarter. Customers are increasingly adopting our software-centric solutions such as EdgeConnect SD-WAN software and our Aruba Central management platform.
We've expanded the access security and SASE funnel to six times since the acquisition. Our operating margin of 29.7% was up more than 1,300 basis points year-over-year and 280 basis points sequentially. We're benefiting from revenue scale and prior pricing actions, which are helping us build visibility into the durability of our mid-20% margin target over time. While we're making progress on our order book, we expect to carry an above-normal order book into FY '24.
In HPC & AI, revenue grew 3% year-over-year. Customer discussions on large language models and generative AI that began in Q1 turned to wins in Q2, and are now showing up as as-a-Service orders in Q3. AI, the predominant driver of our 122% year-over-year growth in as-a-Service dollars has also driven sequential growth in our corporate total order book, which I'll discuss in a moment.
We expect AI deals to provide gross margin rates above historical levels. We believe building and operating large AI models requires unique computational capabilities, including silicon and software that our HPE Cray supercomputers and HPC & AI solutions are extremely well-positioned to enable. As for operating margin, our Q3 performance was just below breakeven. The early stage of the AI market, tightness in certain key components and long lead times in this segment mean that operating margins in HPC & AI will continue to fluctuate. We'll discuss our outlook for revenue growth, investment and margin improvement at our Securities Analyst Meeting.
Storage fell 2% year-over-year, but rose 3% sequentially. HPE Alletra revenue grew triple-digits in Q3 for the fifth consecutive quarter. It is now one of our higher revenue products and thus growth rates may normalize. This product is shifting our mix within Storage to higher-margin, software-intensive revenue and is a key driver of our ARR growth. We'll continue to invest in R&D and our owned IP products in this business unit such as our new File-as-a-Service and HPE Alletra MP offerings. Q3 '23 operating margin of 10.7% is down 360 basis points year-over-year as we transition to HPE Alletra. HPE Alletra includes a meaningful component of ratable revenue, which pushes revenue recognition out into future periods.
Compute revenue was down 10% year-over-year to $2.6 billion and down 5% sequentially. Deal elongation challenges we've discussed previously were most prevalent in the Compute business as some customers digest prior investments. Declining AUPs from a record high in Q1 '23 was also a significant driver. But as previously noted, we did see sequential demand improvement. And after six quarters of above-planned operating margins in Compute, this quarter's 10.9% was a shade below our long-term margin target of 11% to 13%.
HPE Financial Services revenues rose 7% year-over-year and financing volume of $1.7 billion grew 6% in constant currency, driven by HPE GreenLake. Our operating margins were down 340 basis points year-over-year, reflecting rapid interest hikes and higher cost of funds that will gradually offset over time through pricing, as well as lower asset management margins as supply challenges ease. Time and time again, HPFS has proven resilient in a downturn; thanks to the quality underwriting of our book of business. Throughout the pandemic, our annual loss ratio never exceeded 1%, and our Q3 loss ratio of 0.48% was even lower than it was in the full-year 2019 pre-pandemic.
Slide 9 highlights our revenue and non-GAAP diluted net EPS performance. The progress we're making against our edge-to-cloud strategy is evident in the financial results we delivered on both the top and bottom lines. We've held our revenue steady this quarter and expanded non-GAAP diluted net EPS year-over-year despite an uneven spending environment, our transition towards a recurring revenue model and FX rates remaining a significant headwind. FX was a 280 basis point headwind to revenue growth in Q3.
On Slide 10, we've included a new depiction of our portfolio shift, which illustrates just how significant the Intelligent Edge business has become for HPE. Even three years ago, Intelligent Edge constituted just 10% of revenue, and this quarter, it represents 20%. Operating profit trajectory is even more dramatic. Edge contributed just over 10% of operating profit three years ago and is now 49% of total segment operating profit. We'll offer our forward-looking view at our Security Analyst Meeting.
Slide 11 illustrates the progress we've made on our gross margin structure. Our Q3 non-GAAP gross margin is up 120 basis points year-over-year despite FX headwinds. Our year-over-year non-GAAP gross profit and margin growth show the success of our strategic portfolio pivot and the pricing actions HPE has taken.
Slide 12 illustrates our non-GAAP operating margin, which was 10.3% in Q3. This is down 20 basis points year-over-year, also inclusive of FX headwinds and 120 basis points sequentially. While the primary driver of the sequential decline was the return of Compute operating margins to near our target range, we also made certain targeted investments in the quarter to further enable our pivot. Our deliberate portfolio mix shift, pricing strategies and productivity focus put us on track to increase operating margin in FY '23.
On Slide 13, as previously announced, we exercised the put option on our shares in H3C and signed a put share purchase agreement that values our 49% H3C stake at $3.5 billion. The next step in the process is to obtain the necessary regulatory approvals and to conclude certain conditions necessary for closing. We expect to conclude this process in the first half of calendar year 2024, although this timeline 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 returns-based framework for evaluating investments, capital returns and maintaining an investment-grade credit rating that we've outlined in the past. Finally, we continue to benefit from H3C dividends in FY '23. We'll offer update on our go-forward expectations for H3C dividend at SAM in October.
Now to Slide 14. We generated $1.5 billion in cash flow from operations and $955 million in free cash flow. Our Q3 free cash flow improved by approximately $670 million sequentially and nearly $370 million year-over-year. Similar to our Q4 '22 performance, we expect to generate significant free cash flow in the remainder of FY '23 and are reiterating our guidance of $1.9 billion to $2.1 billion in free cash flow in FY '23. The timing of receipts and payments plus inventory investments have held cash conversion cycle steady sequentially at 23 days. We expect to exit the year with a neutral cash conversion cycle.
Now let's turn to outlook on Slide 15. As we've mentioned, the broader IT market is still pressured. Macro uncertainty is affecting some of our end markets, yet customer investment is rising in others, such as Edge and HPC & AI. We believe our portfolio differentiation will continue to drive share gains in key markets. We are also entering Q4 with an order book that is more than two times pre-pandemic levels. Our order book has increased from more than 1.5 times pre-pandemic levels entering Q3, primarily on the strength of AI orders.
The assumptions in our guidance, which incorporate our current thinking on the macroeconomic picture, demand, inflationary pressure, supply and FX rates remain relatively unchanged. We've indicated throughout the fiscal year that our financial performance is likely to be weighted to the first half of the year. We continue to view this as the proper framework for FY '23.
For Q4, we expect revenues in the range of $7.2 billion to $7.5 billion. We expect GAAP diluted net EPS between $0.36 and $0.40 and non-GAAP diluted net EPS between $0.48 and $0.52. We're reiterating our prior fiscal year 2023 guidance of 4% to 6% revenue growth in constant currency. We expect FX to be a 300 basis point revenue headwind from our previously communicated 250 to 300 basis point headwind.
In parallel, we also reiterate our expectation that margin strength from our portfolio mix shift will deliver non-GAAP operating growth of 6% to 7%. We're reiterating our GAAP diluted net EPS guidance of between $1.42 and $1.46 due to tax rate differences and additional amortization of intangibles from our recent acquisitions.
We're raising our non-GAAP diluted net EPS guidance from between $2.06 to $2.14 to between $2.11 and $2.15. We reiterate our guidance for free cash flow of between $1.9 billion and $2.1 billion. For OI&E, we've benefited this year from higher interest income and FX hedging costs lower than we originally forecasted. The combination of these and other anticipated benefits in the second half of this fiscal year leads us to expect OI&E to be a positive $50 million to $70 million on a full-year basis. We had previously expected OI&E to be neutral for the full year. In terms of capital returns, we are maintaining our dividend and expect to return approximately 60% of free cash flow to shareholders via dividends and repurchases.
So, to conclude, the uneven end market demand thus far in FY '23 is an opportunity for HPE to showcase our differentiated portfolio led by HPE GreenLake Hybrid Cloud, Intelligent Edge and HPC & AI. And we'll continue to take the steps required to further accelerate the pivot of our product portfolio and our Company towards faster growth, higher margin recurring revenues. We look forward to updating you with HPE's outlook beyond FY '23 at our Securities Analyst Meeting in October.
Now, let's open it up for questions.
