Earnings Call Transcript - DELL Q3 2023

Operator, Operator

Good afternoon, ladies and gentlemen. Welcome to the Fiscal Year 2023 Third Quarter Financial Results Conference Call for Dell Technologies Incorporated. I would like to inform all participants that this call is being recorded at the request of Dell Technologies. This broadcast is the copyrighted property of Dell Technologies Incorporated. Any rebroadcast of this information in whole or in part without prior written permission of Dell Technologies is prohibited. Following prepared remarks, we will conduct a question-and-answer session. I would now like to turn the call over to Rob Williams, Head of Investor Relations. Mr. Williams, you may begin.

Rob Williams, Head of Investor Relations

Thanks everyone for joining us. With me today are Jeff Clarke, Chuck Whitten, Tom Sweet, and Tyler Johnson. Our earnings materials are available on our IR website and I encourage you to review our materials and presentation which includes additional content to complement our discussion this afternoon. Guidance will be covered on today’s call. During this call, unless otherwise indicated, all references to financial measures refer to non-GAAP financial measures, including non-GAAP revenue, gross margin, operating expenses, operating income, net income, and diluted earnings per share. A reconciliation of these measures to their most directly comparable GAAP measures can be found in our webdeck and our press release. Growth percentages refer to year-over-year change unless otherwise specified. Statements made during this call that relate to future results and events are forward-looking statements, based on current expectations. Actual results and events could differ materially from those projected due to a number of risks and uncertainties, which are discussed in our webdeck and our SEC filings. We assume no obligation to update our forward-looking statements. Now, I’ll turn it over to Chuck.

Chuck Whitten, Executive

Thanks Rob. We delivered very good results including strong ISG revenue with record profitability and good CSG profitability, despite the difficult demand environment that we highlighted in our last earnings call. The net of our disciplined execution was Q3 revenue of $24.7 billion, down 6% with record operating income of $2.4 billion and record diluted EPS of $2.30. ISG revenue was $9.6 billion, up 12% while CSG was $13.8 billion, down 17%. From a macro perspective, Q3 played out as we previewed last quarter, soft underlying PC demand and slowing infrastructure demand, though storage did hold up fairly well relative to servers with growth in multiple storage types including high end and PowerStore. Our Q3 performance underscores our strategic focus, the advantages of our model and our ability to deliver differentiated results in any market environment. Our unique sales model provides direct real-time feedback from customers of all sizes and across geographies and industries, which allows us to see the demand environment shift faster than the rest of the industry. And as the demand environment changed, we reacted quickly and decisively, which showed in our results. We took actions to reduce costs, decreasing our operating expense by 3% sequentially in Q2 and another 6% sequentially in Q3. We have now reduced quarterly operating expense by over $300 million since Q1. We reduced server backlog consistent with our Q2 commentary and delivered strong profitability as our model allowed us to access component cost deflation faster than the rest of the industry. And we stayed focused on relative performance in the most profitable segments of the market. Despite some expected distortions in the PC market given elevated competitor backlog, we continued to gain commercial PC unit share in Q3 and have now gained share in 35 of the last 39 quarters. In ISG, we expect to extend our industry-leading share positions in servers and storage when Q3 IDC results are announced in December. And we executed on all of the above without compromising our innovation agenda with 30 infrastructure launches in the last 13 weeks, including six new Dell APEX offerings in strategic areas like multicloud, edge, and subscription and as-a-service. We’re excited about the launch of Project Frontier, our initiative to deliver an edge operations software platform focused on unifying edge operations across infrastructure and applications for a broad set of industries. And earlier today, we announced the availability of PowerFlex, our flagship software defined storage solution, on AWS. With a cloud-first design point, PowerFlex on AWS is the first of Dell’s industry-leading storage offerings available in the public cloud as part of Project Alpine, our effort to bring our industry-leading storage software to public clouds to provide multicloud data mobility and simplify data management. It will enable customers to use Dell’s storage software capabilities and APIs wherever their data resides, without the need for purpose-built or specialized public cloud infrastructure. Our new Project Alpine related SaaS offerings will add to our growing portfolio of APEX solutions while enabling our customers to harness the power of multicloud. Stepping back, the near-term market remains challenged and uncertain. On one hand, we are seeing some customers delay IT purchases. Other customers continue to move ahead with Dell given the criticality of technology to their long-term competitiveness and a growing need to drive near-term productivity through IT. The world continues to digitally transform, data continues to grow exponentially, and customers continue to look to technology to drive their business forward, no matter the economic climate. As the market leader in commercial PCs and infrastructure, we are well positioned whether a customer is seeking to drive growth, productivity, and efficiencies, or a combination. We’re trusted advisors to our customers, and we have a business model that allows us to adjust quickly to meet their needs. So, we are very confident in our ability to adapt and deliver results despite the near-term uncertainty. Q3 was proof of our underlying advantages and ability to execute no matter the environment. As always, we’ll continue to focus on what we can control: taking care of our customers, driving differentiated relative performance, delivering against our innovation agenda, managing our cost position, maintaining pricing discipline, and building a unique and winning culture with our team. This is the playbook that has served us well across multiple cycles, and no matter the backdrop, we intend to accelerate our strategic position, as we did in Q3. Now I’ll turn it over to Tom for the financials.

Tom Sweet, CFO

Thanks Chuck. I’m pleased with our Q3 P&L performance despite the tougher near-term demand environment. As Chuck mentioned, we highlighted the softening environment and slowing ISG demand in our Q2 earnings conversation, and the third quarter generally played out as we expected, albeit with server demand velocity slowing a bit more than we anticipated. We continue to focus on executing our strategy to win in the consolidation and modernization of our core markets and we have executed well over the last few years and again in Q3. In ISG, we’ve grown our revenue for seven consecutive quarters and have grown our revenue at a 3% CAGR since fiscal year 20. We have been consistent structural share gainers in servers where we are number one, gaining 530 bps over the last 5 years in mainstream server revenue per IDC. In storage, we are bigger than the two and three combined, and with our refreshed storage portfolio, we have added to our number one position, gaining share over the last two quarters, and anticipate gaining share in both storage as well as servers again this quarter when IDC results come out in December. Our CSG business has grown at a 12% CAGR since fiscal year 20. As Chuck mentioned earlier, we have gained Commercial PC unit share in 35 of the last 39 quarters including Q3. Turning to our Q3 results. We delivered revenue of $24.7 billion, down 6% with strong ISG performance, particularly in servers. We reduced total backlog by $1.2 billion sequentially during the quarter with CSG backlog now in a more normal range and ISG backlog slightly elevated year-on-year, but substantially reduced from the beginning of the quarter. Profitability was strong in Q3. Gross margin was $5.9 billion, up 2% and 23.7% of revenue. Gross margin percentage was up 2 points, primarily due to a favorable mix shift to ISG and a decrease in our cost of goods sold due to certain components turning deflationary along with declining logistics costs. FX remained a headwind and impacted revenue by approximately 420 basis points. Q3 operating expense was $3.5 billion, down 8% and 14.1% of revenue as we slowed hiring and reduced discretionary costs given the current macro environment. As a result, operating income was a record $2.4 billion, up 22% and 9.6% of revenue. Our year-to-date tax rate decreased to 18.2%, primarily due to geographic mix of income. Q3 net income was $1.7 billion, up 30%, primarily driven by growth in operating income and a decline in interest expense due to our lower debt balances. Fully diluted earnings per share was a record $2.30, up 39% with diluted share count decreasing sequentially to 743 million shares as a result of share repurchases in Q3. Our recurring revenue is approximately $5.4 billion a quarter, up 11%. Our remaining performance obligations, or RPO, is approximately $39 billion, down Y/Y due to a decline in backlog partially offset by an increase in deferred revenue. Turning to our business units. In ISG, Q3 revenue was $9.6 billion, up 12% driven by a reduction in our server backlog, consistent with our Q2 call commentary. Servers and networking revenue was $5.2 billion, up 14% and Storage revenue was $4.4 billion, up 11%. As mentioned, we did see softening unit demand in servers somewhat offset by higher average selling prices given richer configurations driven by customers running more complex workloads. ISG operating income came in at a record $1.4 billion or 14.3% of revenue, which was up 390 basis points as we benefited from scale with lower operating expenses and pricing discipline. Our Client Solutions Group revenue was down 17% to $13.8 billion, primarily due to underlying softness in both Commercial and Consumer demand. Commercial revenue was $10.7 billion, down 13% and consumer revenue was $3 billion, down 29%. Average selling prices trended higher in both Commercial and Consumer as customers bought PCs with richer configurations. CSG operating income was $1.1 billion, down 7% primarily due to scaling, partially offset by stronger gross margin percentage and lower operating expenses. CSG operating income was 7.7% of revenue. Dell Financial Services originations were $2.3 billion, up 17% with strength across geographies and DFS ended the quarter with $13.8 billion in assets. We have historically seen stronger originations, and more recently an increasing interest in subscription models, as the macroeconomic environment slows. Turning to our cash flow and balance sheet. Our cash flow from operations was approximately $400 million in Q3 and is $3.9 billion on a trailing twelve month basis. Q3 cash flow was helped by profitability but offset by the sequential revenue decline in the P&L and a use in working capital. Within working capital, inventory was up sequentially as we strategically accelerated purchases of some key components as we continue to navigate through supply chain dynamics. Improving working capital efficiency and reducing inventory remains a priority. Our core debt balance is $16.2 billion and our core leverage ratio is 1.6x. We ended the quarter with $6.5 billion in cash and investments, down $600 million sequentially principally due to $800 million in capital returns. Turning to capital allocation. We repurchased 16.3 million shares of stock in Q3 for $609 million and paid $238 million in dividends. In addition to our $1 billion annual dividend, since the beginning of our current share repurchase program, we have bought back 70.3 million shares for $3.36 billion. Going forward, we will continue our balanced capital allocation approach, repurchasing shares programmatically to manage dilution while maintaining flexibility to be opportunistic. Turning to guidance, considering the demand environment, we expect Q4 revenue between $23 billion and $24 billion, down 16% at the midpoint, with ISG roughly flat. Similar to Q3, currency continues to be a headwind for us. We are expecting a roughly 500 basis-point impact to Q4 revenue. We continue to be focused on managing cost, however, we do expect to see a roughly $150 million OpEx increase sequentially given the extra week in our fiscal Q4. We expect our interest and other expense to be up $60 million sequentially driven by interest rate volatility and the impact on our derivatives portfolio. For our non-GAAP tax rate, you should assume 22% at the midpoint, which reflects a 19% plus or minus 100 basis points rate for the full year. We expect our diluted share count to be roughly 730 million to 735 million shares. Netting this out, we expect diluted EPS in the range of $1.50 to $1.80, down 4% at the midpoint. I recognize that many of you have questions about our view on fiscal year 24. It’s still early in our annual planning process. However, I’ll frame our current thinking. We expect ongoing global macroeconomic factors including slowing economic growth, inflation, rising interest rates, and currency pressure to weigh on our customers, and as a result, their IT spending intentions even as they continue to digitize their businesses. These dynamics are creating a broader range of financial outcomes for our upcoming fiscal year, particularly as we think about the second half of the year. With what we know today, it’s likely next year's revenue is below historical sequentials using our Q4 guidance as a starting point. In closing, we delivered strong third-quarter financial results. We have strong conviction in the growth of our TAM over the long-term even though some customers have paused purchases in the near-term. And we are committed to delivering our value creation framework with a revenue CAGR of 3% to 4%, a diluted EPS CAGR of 6% plus, and a net income to adjusted free cash flow conversion of 100% or better. Since fiscal year 20, our revenue has grown at an 8% CAGR, our diluted earnings per share has grown at nearly a 20% CAGR, and we have exceeded our net income to adjusted free cash flow target in each of the last three fiscal years. We have also committed to return 4% to 60% of our adjusted free cash flow to our shareholders over time and have returned $4.1 billion of capital to our shareholders over the last 12 months through share repurchase and dividends. We will continue to be disciplined in how we are managing the business and our financial posture in this complex macro environment, focusing on what we can control and helping our customers along their digital journey. Now, I’ll turn it back to Rob to begin Q&A.

Rob Williams, Head of Investor Relations

Thanks, Tom. Let’s get to Q&A. We ask that each participant ask one question to allow us to get to as many of you as possible. Let’s go to the first question.

Operator, Operator

We’ll take our first question from Krish Sankar with Cowen and Company.

Krish Sankar, Analyst

Yes. Hi. Thanks for taking my question. And Chuck, I’m just kind of curious; you mentioned how the IT spending is softening. What do you see across the ecosystem? Is it across all enterprises, the large and smaller ones? And within that, where do you think they’re focusing their budgets on right now? Is it more server storage or software? Just kind of curious, any thoughts you can give on the IT spending environment we’re seeing.

Chuck Whitten, Executive

Yes. Thanks, Krish. Let me give you a little bit of the texture that we’re seeing. But maybe let me start by just highlighting. Look, we executed very well in what was a very dynamic environment. As we’ve highlighted, our principal objective in this environment is to deliver relative performance and share gain. And in Q3, we did that across client server and storage, and we delivered very good profitability. So, while we’re not going to get into specific demand numbers today, let me offer some texture on the environment that we’re seeing. First, I would just say that the CSG demand environment remains challenged with, as you saw in our results, consumer weaker than commercial. We saw slowing server growth. As Tom highlighted in our prepared remarks, it was probably a little bit worse than we anticipated at the time of our Q2 earnings call. And so as we said, Q3 server revenue growth of 14% was aided by server backlog reduction and storage fared better. It’s ultimately not immune to the broader dynamics we’re seeing across customers, but we saw growth across multiple storage categories, including the high-end HCI and PowerStore. To your direct question about texture underpinning that, those dynamics were largely consistent across geographies; we’d say, verticals as well and customer size. There’s probably a couple of exceptions we would call out. One would be China, which had a much more pronounced weakness last quarter. And we would highlight the energy sector, the U.S. government sector, and then medium business generally globally as performing better relative to the rest of the business. And the customer feedback is very similar to what we described in Q2, very cautious and deliberate behavior in the face of what’s a lot of macroeconomic dynamics out there. So, we’re hearing reassessment of budgets, reprioritization of spending, and customers buying effectively for just their immediate needs. So net, I would say Q3 was a continuation of the trends that we called out during our Q2 earnings call.

Operator, Operator

We’ll take our next question from David Vogt with UBS. Please go ahead.

David Vogt, Analyst

Tom, can you elaborate on your earlier comments regarding the framework for 2024? Specifically, could you clarify how you view the historical sequential trends as we progress through the year? Are you suggesting that we should start with Q4 and follow a typical sequential pattern based on the last two to three years, perhaps making some adjustments due to the uncertainty? I'm just trying to get a clearer understanding since my line dropped briefly. Thank you.

Tom Sweet, CFO

David, I’m happy to elaborate on that. As we review the current environment, it’s still early in our planning for fiscal year ‘24. The overall landscape is complex, with many dynamics at play, including inflation, interest rates, currency fluctuations, global growth, supply chains, and geopolitical factors. There's a broad range of potential financial outcomes based on how these variables evolve. In particular, the second half of next year seems to carry significant complexity. Chuck noted that customers are currently showing some caution in their spending, which is quite clear. In light of this, we will concentrate on what we can control, focusing on supporting our customers and managing our profits effectively, being careful about spending and ensuring customer satisfaction. Importantly, we have been cautious with spending for several quarters, implementing hiring restraints and other cost control measures. While I won’t specify exactly what next year will look like since we are still navigating through our planning, we anticipate complexity and challenges ahead. If you take the midpoint of our guidance and compare it to historical trends, potentially adjusting down a bit, you might arrive at our current outlook, which will continue to be refined over the coming months. Additionally, for context, consider the revenue growth in the latter half of fiscal ‘23; the minus 6 we reported for Q3 and the midpoint of our Q4 guide reflecting minus 16 suggest a growth rate of minus 10 to minus 11, which is something to keep in mind as you evaluate the situation.

Operator, Operator

We’ll take our next question from Tim Long with Barclays. Please go ahead.

Tim Long, Analyst

I was hoping to dig a little deeper into CSG. Obviously, in the guide, that sounds like it’s a little bit more challenged of the market. I think you mentioned ASPs were up in the Q3. So can you talk a little bit about kind of where we are with channel inventory in commercial and consumer? What you see going on in the pricing and what impact that will have in margin? And maybe if you could just throw in what’s going on with your backlog. I’m sure it’s being worked down as well. It’s probably multiple parter there, but I think you get the gist. Thank you.

Chuck Whitten, Executive

Yes, Tim, there’s a lot to unpack here. I'll break it down, and we may have multiple perspectives on this. Clearly, we are facing a challenging PC market. As we move into Q4, our internal estimates remain at around 280 million to 290 million industry units. This indicates a mid double-digit decline in units year-over-year, marking the largest percentage drop in recent history since 2015. Currently, commercial demand is holding up better than consumer demand, consistent with long-term industry trends. Commercial PCs, excluding Chrome, are typically the more resilient segment of the market, along with premium consumer and gaming products, which are our primary focus. In this environment, channel inventories are elevated, and we are seeing increased promotional efforts to move units through distribution. Customers are waiting to purchase based on their immediate needs. Regarding pricing, it has stayed relatively stable across our businesses, although the PC market has become more competitive. Consumer pricing pressure emerged a couple of quarters ago and continues to be aggressive. Commercial pricing is also very competitive, especially with larger accounts as the quarter has progressed. From a supply chain perspective, we are now experiencing more standard lead times, and what we sell aligns closely with what we ship each quarter, reflecting the current dynamics in our Commercial Solutions Group.

Operator, Operator

We’ll take our next question from Samik Chatterjee with JP Morgan. Please go ahead.

Samik Chatterjee, Analyst

I guess if I can just talk about the sort of initial thoughts that you provided on fiscal ‘24 and understand some of the challenges and headwinds on the top line. But, maybe if you can talk about what you’re thinking in terms of the sustainability of the gross margin, particularly I’m assuming some of the mix impact carries over on ISG versus CSG. And you’ve had a couple of quarters of sequential decline in OpEx here. But, as you sort of look forward, how are you trying to align your cost structure to that sort of demand environment that you’re thinking of? And sort of what are the puts and takes when we think about the rest of the P&L in fiscal ‘24?

Tom Sweet, CFO

Yes. I don’t want to go through every line item, but we provided some initial thoughts to help you understand the potential P&L dynamics at the top line. I want to emphasize a couple of points. Regarding gross margin stability and our operating expenses, we will assess how the margin dynamics evolve. Currently, we expect component costs to decrease in the first half of next year based on what we know. However, the latter half of the year may see changes due to supply-demand imbalances. In a decreasing demand environment, there may be some pressure on average selling prices, which we anticipate will occur next year. Nonetheless, considering our product mix and market focus—whether related to configuration or attach rates in the client space, or the increased memory content in our servers—these factors should be beneficial. For operating expenses, we’ve implemented cost measures that demonstrate our capability to manage them effectively. We are focused on navigating this complex environment and adjusting our spending targets and cost structures accordingly. I am confident in our ability to do this. The improvements we’ve made are reflected in our P&L, and we will continue to address these challenges. It’s early to discuss the full P&L at this stage, but I wanted to provide some context regarding the top line as we see it now.

Operator, Operator

We’ll take our next question from Amit Daryanani with Evercore. Please go ahead.

Amit Daryanani, Analyst

I guess, I was really hoping you could talk a bit more about the ISG side and the performance this quarter. Is there a way to understand and look at ISG in aggregate or maybe even server and storage? How much of this growth is backlog versus end demand? And it sounds like the end demand was weak as one of the related slides goes 2 buckets up. And then Tom, I think you mentioned the OpEx headwind or the OpEx impact from the extra week in Q4. I could have missed this, but could you just tell us what the revenue benefit in Q4 as well from an extra week? Thank you.

Chuck Whitten, Executive

Yes, Amit, I can address the business aspect. I don't have much to add to our previous responses except to mention that we observed a slowdown in server growth. We had communicated this in Q2 and anticipated it for the current quarter. Unfortunately, the situation worsened throughout the quarter compared to our Q2 earnings call. Consequently, our server revenue growth of 14% was supported by a reduction in server backlog. We now consider the server backlog to be approximately at a normal level. The situation with storage is somewhat different; it performed better with growth seen across various storage categories such as high-end HCI and PowerStore. However, the storage backlog remains somewhat elevated compared to historical levels due to the larger scale of our business. While there are different dynamics between server and storage, it overall reflects a continuation of the trends we observed in Q2.

Tom Sweet, CFO

As it pertains to the fourth quarter, there is an additional week due to the nature of our fiscal year. Any effects on revenue and margin have already been included in our guidance. Clearly, the extra week can generate some additional transactional demand from our more transactional businesses. However, a significant portion of our business is also project and bid-based, which is not significantly affected by the extra week at the end of the quarter. Thus, our guidance incorporates all of these factors.

Operator, Operator

We’ll take our next question from Aaron Rakers with Wells Fargo. Please go ahead.

Aaron Rakers, Analyst

I want to go back a little bit to the margin profile and maybe understand the dynamics of deflationary component costs and how quickly you’re being able to capture that in your server business. I guess in the context of just thinking about the pressure on the model, how do we think about the sustainability of that operating margin given very strong performance this last quarter in terms of ISG in that context.

Tom Sweet, CFO

Hey Aaron, let me break that down for you a bit. As Chuck has already mentioned, we observed certain trends in the pricing environment. During our Q2 call, we noted that being in a deflationary environment for component costs generally helps our margins since we don't change pricing as rapidly as costs decrease. That's what we experienced this quarter. We saw lower input costs from both component and logistics expenses. We also adjusted prices due to foreign exchange and other factors in the environment. This combination, especially with the configuration and the amount of memory and storage we included in our servers, contributed to better-than-expected margins. While we can maintain this for now, we will eventually need to adjust pricing for some of these market commodities. However, that's just one part of the pricing structure, and factors like mix and configuration also play a role. Jeff, do you have anything to add?

Jeff Clarke, Executive

Maybe to add to that back to our model and inventory. We have a lower inventory model, one of the benefits of how we run the company since beginning. And it gave us availability to the lower cost component, I think, earlier than most. Our supply chain has executed well through this time. We had fewer mismatch sets. So, we were able to convert the demand shipments and the backlog shipments throughout the quarter. And as a result of that, we were able also to take advantage, as Tom said, lower freight rates, lower expedites, lower supplier premiums, and we’ve obviously benefited from that throughout the quarter.

Operator, Operator

We’ll take our next question from Sidney Ho with Deutsche Bank. Please go ahead.

Sidney Ho, Analyst

My question is on cash flow. So, I noticed your first three quarters of the year in aggregate, free cash flow was negative. And you talked about building some strategic inventory in the last quarter. How do you think about Q4, by definition, for the rest of the year? And as we think through next year, do you expect cash flow to exceed your net income? I guess I am asking how long do you think it would take working capital to get back to normalized levels. Thanks.

Tyler Johnson, Executive

This is Tyler. I’ll take that one. So look, I think maybe just to start, if you think about the last couple of years, right, cash has been really strong, right? So, we were seeing that build given that negative cash conversion cycle, and we obviously benefit from that. I think what we’re seeing now is the opposite of that, right? And there’s two things happening, and you talked about it, right? So, we’ve got the contraction in the P&L, which is impacting cash and then working capital. And our intent, obviously, is to drive those working capital balances down, but we also don’t want to miss opportunities and you saw us take advantage of that this quarter, which impacted cash. Now, as I’m thinking into Q4, and I’m thinking it next year and recognize we don’t provide guidance, I think you have to keep that in context that, one, Tom has talked about that there will be some pressure in the P&L, and that will impact cash. But at the same time, we do have opportunities in working capital, and it’s quite substantial, right? So, we’ll be focused on driving that down. And obviously, that’s something we know how to do, and we’ll be smart about it. But that’s how I’m thinking about it.

Tom Sweet, CFO

Yes. Tyler, traditionally we do generate cash, and the fourth quarter usually shows stronger performance for us. We need to navigate this current quarter, but I am confident in our long-term cash generation model. When we experience a decline in revenue and have negative working capital or cash conversion cycles, it leads to cash usage, which is what we're currently observing. However, the team is effectively managing the situation. We still have work to do regarding inventory, but I am satisfied with our progress in receivables, especially concerning aging, collections, and our management abilities. We are in a cycle that requires us to work through challenges, but I believe in the integrity of our long-term model.

Operator, Operator

We’ll take our next question from Erik Woodring with Morgan Stanley. Please go ahead.

Erik Woodring, Analyst

Could you provide more detail on the guidance for the fiscal fourth quarter and discuss the relationship between pricing and volume? Specifically, should we consider both as challenges, or did some of the higher configurations help balance the discounts you mentioned, allowing for pricing to still experience year-over-year growth? I’m looking for insights on pricing versus volume for the January quarter.

Tom Sweet, CFO

Yes. As we look at the guidance for 2023 to 2024 and 2023 to 2025, we anticipate that ISG will remain approximately flat at the midpoint of minus 16. This suggests that the client business or CSG is expected to experience negative growth, around mid-20 percent year-over-year. I won't delve into details regarding units versus average selling prices, but consider margin dynamics in Q4 for a moment. There are seasonal patterns that typically occur in our Q4. Firstly, this quarter generally sees stronger storage sales due to the annual corporate budget cycle, which positively impacts margin dynamics. However, the holiday season traditionally boosts consumer PC sales, which can shift the mix slightly and exert some downward pressure on margins. Additionally, we noted increased commercial PC discounting in Q3, especially in the last month of the quarter, and there are elevated inventory levels in the channel. Taking all these factors into account, we believe that margins will remain roughly flat from Q3 to Q4 on an aggregate level. Coupled with the operational expense dynamics we've discussed, this outlines the profit and loss outlook as we think about it.

Operator, Operator

We’ll take our next question from Steven Fox, Fox Advisors. Please go ahead.

Steven Fox, Analyst

I had a margin question also. I was just curious, when we look at sort of the big beat in gross margins this quarter, you mentioned a lot of different dynamics, including things that seem under your control a little bit, like configuration and content attach rates. So, how much were you able to manage the margins up versus just circumstance? And how much can we sort of think about Dell going forward in the tough environment, being able to manage the gross margins a little bit better? Thanks.

Chuck Whitten, Executive

Yes, let me start. The highlights from Q3 reflect both the strengths of our model and effective execution during the quarter. In Q3, we observed a higher ISG mix and a generally stable pricing dynamic. This pricing stability stemmed from richer configurations and a more favorable product mix on the PC side, along with increased attach rates that helped mitigate PC unit declines. On the server side, we experienced higher content rates, including memory, SSDs, and advanced GPUs, which helped counterbalance the unit pressure. Fundamentally, the real margin story revolves around Q3 being deflationary and our lower inventory model, which enables us to leverage component deflation more quickly than the industry. Coupled with our ability to promptly identify and respond to demand signals, we successfully reduced operating expenses by implementing prudent cost controls, as Tom described. These elements constituted the key factors influencing Q3, with much being within our control and other aspects highlighting the advantages of our model in the current environment.

Jeff Clarke, Executive

To add to that, another perspective on inventory is that we do not have excess inventory in the channel. We are not in a situation where we need to discount or promote our products, nor do we need to pursue volume aggressively. We have a deliberate strategy focused on high-priced consumers and commercial markets. Historically, this has provided us with an advantage, which we are witnessing today. Therefore, we do not have to engage in discounting or promotional activities to reduce excess inventory. Additionally, since we have lower inventory levels, as Chuck mentioned, we were able to benefit from decreased input and component costs throughout the quarter. I may not have been clear earlier, but it’s important to highlight again that logistics costs have decreased. As supply now exceeds demand, we can ship items by ocean without having to rush shipments as much, and we are not relying on expedited air freight as frequently. All these factors contribute to our input cost equation, positively impacting our bottom line and quarterly performance.

Operator, Operator

We’ll take our next question from Wamsi Mohan with Bank of America. Please go ahead.

Ruplu Bhattacharya, Analyst

It's Ruplu filling in for Wamsi today. Can you discuss the ongoing component shortage that is still impacting ISG? On the CSG side, did you miss any revenue opportunities due to not having all the necessary parts? Regarding ISG, you mentioned that backlog decreased this quarter. Can you estimate how far we are from normalizing that backlog? Will you receive any support on the server side, or is the backlog primarily an issue with storage right now? Thank you.

Jeff Clarke, Executive

Sure. Let me break down those multiple questions. When it comes to supply and shortages, in the CSG business, supply is ahead of demand for consumer PCs, commercial PCs, displays, and docs, with only a few minor exceptions. This allows us to adjust our freight networks effectively. We are in a strong position. Regarding servers, we previously discussed backlog and its reduction. In terms of supply hotspots, we are facing constraints primarily with power supplies, power ICs, and high-performance NICs. However, we navigated these challenges well, especially in Q3, allowing us to optimize server shipments. In storage, shortages are mainly in custom ASIC parts like FPGAs and CPLDs. We communicate lead times to our customers to manage expectations. Remarkably, I can now say that our PC product line is on standard lead time, which is a significant achievement considering the challenges posed by COVID-19. A large portion of our server product line is also on standard lead time, and we anticipate further improvements this quarter, including for storage. Currently, our backlog for PCs is normal, while we are close to normal for servers and have a slightly elevated backlog in storage. I believe that addresses all of your questions.

Operator, Operator

We’ll take our next question from Simon Leopold with Raymond James. Please go ahead.

Simon Leopold, Analyst

I wanted to see if you could maybe talk to the general idea of why storage would or would not be correlated to servers, in the sense that you’re seeing slowing demand in your server business, should that signal coming or threats to the storage business, or should we think of them as trending differently? And if so, why? Thank you.

Chuck Whitten, Executive

Yes. Look, Simon, I would say, look, we would never argue that storage is immune to the broader IT spending dynamics that are out there. What we would say is from where we sit right now, it’s held up better in our Q3. I think you’re right, historically, there’s been a correlation, but it tends to have less amplitude than, say, our commercial PC market or the server market. Clearly, right now, data is exploding. The world needs more storage. And so, when we flash forward to what’s implicit in our guidance, we’re anticipating a seasonally strong storage quarter in Q4. And so, I think while you’re right, historically, there’s been a correlation between our server and storage business, at least from where we sit right now, we’re still seeing strength in the storage market.

Jeff Clarke, Executive

We participate in the entire storage market, including primary storage, data protection, the cyber resilience sector, and hyper-converged infrastructure. This broad portfolio helps us navigate cyclical changes better than many others.

Operator, Operator

We’ll take our next question from Toni Sacconaghi with Bernstein. Please go ahead.

Toni Sacconaghi, Analyst

Thank you. I’m trying to understand how much worse you think demand might become in fiscal Q4. Typically, you see an increase of over 5% from Q3 to Q4, which would be around $1 billion. An extra week could contribute at least another 5%. I understand you have contractual business, but with an extra week, you should be able to fulfill those contracts, adding another 5%. That totals over $2 billion. Based on normal seasonality, you would expect an increase of over $2 billion, yet you are guiding towards a decrease of $1 billion. This raises a few questions. Does this suggest that you anticipate a further decline in demand? Are you expecting any backlog reduction? I recognize that it was $1.2 billion this quarter, but that does not account for the $3 billion difference when adjusted for the extra week. Are you forecasting any backlog reduction in Q4? Additionally, how much is the storage backlog in dollar terms compared to the server backlog entering Q3? Thank you.

Tom Sweet, CFO

Hey Toni, let me try and answer some of those questions anyway. As we look at Q4, it's clear that we project the business will continue to soften. This is evident as we expect PC revenue to experience mid-20s year-over-year negative growth. I anticipate that ISG will remain roughly flat compared to this quarter. The business is indeed softening, but we will manage through it as we always do. Regarding the 14th week, there is some additional transactional demand, but it is not significant. I haven't calculated your $3 billion or the 5% comment, but we believe that demand will soften. Our guidance for next year reflects this perspective. In terms of backlog, we do not forecast it in a specific way for the Street, but we acknowledge that backlog is now back in normal ranges, although storage is slightly elevated. If there is any opportunity, it may come from storage, but that will depend on the linearity of the quarter and how storage orders are received, which has always been a variable for us. This is our best assessment at this moment, and we will continue to manage the business closely because of it. Jeff or Chuck, do you have anything to add?

Jeff Clarke, Executive

I believe the issue is related to the PC segment. In the last Q3, we generated $16.6 billion in CSG revenue, whereas this Q3, it's down to $13 billion, which is likely where the problem lies.

Operator, Operator

We’ll take our next question from Shannon Cross with Credit Suisse. Please go ahead.

Shannon Cross, Analyst

Tom or Chuck, I’m not sure who mentioned it. I wanted to revisit a comment about the increasing interest in subscription models. Can you share more about which customer bases are showing interest? I understand they may have a slight dampening effect on revenue, but they do secure recurring revenue. Could you discuss what you’re hearing from customers? Thank you.

Chuck Whitten, Executive

Yes, thanks, Shannon. It’s Chuck. I’ll start. Our APEX business reached the $1 billion milestone in Q2 and continues to grow at a healthy rate while attracting new customers. We remain cautious about how we report progress, and we won’t be providing quarter-to-quarter updates. We can share metrics that are clearly linked to the P&L. However, I can tell you that there is still a strong interest in our subscription offers. We experienced triple-digit customer growth and healthy ARR growth this quarter. We are also continuing to invest in the portfolio and have introduced a series of new APEX offers since our last discussion in August. The interest seems to be widely spread, although it is mainly concentrated among larger medium-sized businesses globally. We are engaging in many conversations with customers as they navigate the current macro environment. However, this interest isn't substantial enough considering our $100 billion trailing 12-month business to elaborate much further. We are, nonetheless, seeing significant customer interest.

Jeff Clarke, Executive

I’m sorry, Shannon. I was going to add the new backup target service that we just announced. It’s a pretty exciting offer. What we’ve done around expanding our geographic capability, and our channel capability, and our customer managed option capability around ADSS, I think, is another extension that we can continue to grow on. And then the two as-a-service offers that we’ve extended one, the Red Hat offer that we announced back in September. And then secondly, the new one, which is the APEX high-performance computing service, I think, is another opportunity for us to grow. And I can tell you the pipeline is full of continued APEX offers.

Rob Williams, Head of Investor Relations

Thanks, Shannon. Hey Keith, we’ll take one last question, and then we’ll turn it back over to Chuck for closing comments.

Operator, Operator

Thank you. We’ll take our final question from Jim Suva with Citigroup. Please go ahead.

Jim Suva, Analyst

Thank you. And I actually only have one question and that’s on your inventories. While they were up and you talked about a deflationary environment for the need to secure some pretty key components, which is understandable, can you talk to us about when you think you’ll actually kind of renormalize inventory and working capital, or is it just better simply to hold more because with the deflationary environment, you just kind of have to wonder here, but I understand there’s shortages?

Tom Sweet, CFO

Yes. Hey Jim. It's my goal, and I believe it's the goal of the entire team, to reduce inventories. We built up stock over the past couple of years due to supply chain dynamics during the pandemic. In a deflationary environment, it's clear that we should maintain lower inventory levels. While I can't provide an exact timeline for how this will progress, I can say that, apart from the strategic purchases made this quarter, our inventory has decreased quite well. Those strategic buys made economic sense and were the rationale behind that decision. I anticipate that it will take a few more quarters to normalize inventory, and we will need to assess the appropriate level moving forward based on supply chain dynamics. There will be updates on this, but in the next several quarters, our focus is on reducing inventory from a working capital standpoint.

Chuck Whitten, Executive

Thanks for that, Jim. Before we end the call, I’m going to leave you with a few final thoughts on behalf of the team, and then we’ll wrap. Look, we delivered strong performance over the last few years, and we delivered again in Q3. As we discussed today, Q3 highlights the advantages of our model. We see changes in the market first, and we react and position the business to outperform. So, in Q3, we took appropriate cost action. We drove share gain. We delivered very good profitability. We drove our innovation agenda forward, and we delivered against our capital return commitments. And that’s what we mean when we say that we can deliver differentiated results in any market environment. We do expect the demand environment to be challenging in the near term. But the long-term trends remain very much in our favor. And importantly, we have a seasoned leadership team led by Michael, Jeff, and Tom, who have a strong track record of delivering across these challenging economic cycles. So, we’re going to stay focused on what we can control, and we remain committed to delivering differentiated results for our stakeholders as we did in Q3. So with that, we appreciate everybody joining us today, and look forward to seeing you soon.

Operator, Operator

Ladies and gentlemen, this concludes today’s conference call. We appreciate your participation. You may now disconnect at this time.