Earnings Call Transcript - DELL Q2 2024

Operator, Operator

Good afternoon, and welcome to the Fiscal Year 2024 Second Quarter Financial Results Conference Call for Dell Technologies Inc. I would like to inform all participants that this call is being recorded at the request of Dell Technologies. This broadcast is a copyrighted property of Dell Technologies Inc. Any rebroadcast of this information in whole or part without the prior written permission of Dell Technologies is prohibited. Following prepared remarks, we will conduct a question-and-answer session. I would like to turn the call over to Rob Williams, Head of Investor Relations. Mr. Williams, you may begin.

Robert Williams, Head of Investor Relations

Thanks, everyone, for joining us. With me today are Jeff Clarke, Yvonne McGill, 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 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 web deck and our press release. Growth percentages refer to year-over-year change unless otherwise specified. Given where we are in the macro cycle, we will be referencing sequential growth more frequently this quarter. 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 web deck and our SEC filings. We assume no obligation to update our forward-looking statements. Now I'll turn it over to Jeff.

Jeff Clarke, CEO

Thanks, Rob. Coming into the quarter, we were cautious given our Q1 results, but the demand environment improved at a faster rate than we anticipated, particularly as we moved into June and July. Operationally, we executed well with expense controls, pricing discipline, and lower input costs. We sharpened our focus on pricing this quarter, and we were selective on deals, particularly where share benefits would have been temporary. While revenue was down year-over-year, a better demand environment and strong execution enabled extraordinary Q2 results. Revenue was $22.9 billion, with operating income of $2 billion and diluted EPS of $1.74, well ahead of our initial expectations. We are encouraged by some of the signs we are seeing in the macro environment as we move into the second half. We saw better underlying demand in the U.S. market, and EMEA was better than anticipated. We also saw demand growth in government and SMB, and our transactional demand improved through the quarter. However, most of our largest global customers remain careful with their spending levels. From a solutions perspective, we saw significant strength in AI-enabled servers. PowerFlex and PowerStore demand grew within our storage portfolio. PowerFlex, our proprietary software-defined storage solution, has now grown eight consecutive quarters, with demand in Q2 more than doubling year-over-year. Workstation demand grew and was another bright spot that will continue to benefit from the rise of AI developers and data scientists fine-tuning Gen AI models locally before deploying them at scale. Commercial PC demand improved sequentially as we moved through the quarter, and S&P attach rates were strong, particularly in software. Our ASPs continue to expand across AI servers, traditional servers, and commercial PCs. Overall, we are pleased with the quarter given strong sequential growth of 10% and growing interest in orders in AI solutions. Artificial Intelligence is a strong tailwind for all things data and compute, as well as CSG when you think about the potential for workstations and eventually all PCs. AI is expanding the total addressable market for technology spending and is projected to grow at a 19% CAGR for the next couple of years to approximately $90 billion, including hardware and services. In Q2 alone, we saw unprecedented strength from our PowerEdge XE9680. It's the fastest ramping new solution in Dell history and builds on the success of other GPU-enabled servers we've been selling for years. The 9680 is a key element of our Dell Generative AI Solutions engineered to speed the deployment of a modular, secure, and scalable platform for generative AI in the enterprise. AI service increased to 20% of our servers order revenue in the first half of the year, and the 9680 was a big factor. Currently, we have approximately $2 billion of XE9680 orders in backlog, and our sales pipeline is substantially higher. Gen AI represents an inflection point driving fundamental change in the pace of innovation while improving customer expectations and enabling significant productivity gains and new ways to work. As the #1 infrastructure provider, we are clearly positioned to serve the market in a unique and differentiated way. We have the world's broadest Gen AI infrastructure portfolio that spans from the cloud to the client. Customers big and small are using their data and business context to train, fine-tune, and inference on Dell Infrastructure Solutions to incorporate advanced AI into their core business processes effectively and efficiently. We can help customers size, characterize, and build the Gen AI solutions that meet their performance, cost, and security requirements. Many of these new workloads will be on-prem or at the edge given the importance of latency, data security, and cost. In the near term, we are seeing organizations concentrate on four Gen AI use cases: customer operations, content creation and management, software development, and sales. Internally, we are doing the same to enhance how we build products, service our customers, and improve productivity and efficiency. As we think about the back half of the year, we are coming off a Q2 where we grew above normal seasonality and demonstrated the power of our model to generate cash in a sequential growth environment. You should expect us to focus on growing and extending our core business in areas with the most attractive profit pools. Deliver innovation for our customers, remain disciplined on our pricing, and focus on costs with multi-cloud edge and Gen AI as tailwinds. I like our hand and look forward to talking more about our views on technology trends, strategy, and innovation at our Securities Analyst Meeting in October. Now over to Yvonne for detailed Q2 financials.

Yvonne McGill, CFO

Thanks, Jeff. We're pleased with our Q2 execution and an improving demand environment. We delivered revenue of $22.9 billion, down 13% and up 10% on a sequential basis with strong gross margins and strong operating expense and net working capital management. Currency remained a headwind and impacted revenue growth by approximately 130 basis points. Gross margin was $5.5 billion and 24.1% of revenue. Our gross margin rate was up 270 basis points, driven by lower input costs and pricing discipline. We did see increased pricing pressure in Q2, but we're selective on deals depending on the customer and opportunity. As Jeff mentioned, we are focused on profitable opportunities rather than temporary share gains. You can expect us to continue focusing on the more profitable segments of the market and maintaining pricing discipline. Operating expense was $3.6 billion, down 4%, driven by lower discretionary spend in SG&A and was flat sequentially. Operating expense was 15.5% of revenue, and we will continue to actively manage our spend as we move through the second half. Operating income was $2 billion, up 1% and 8.6% of revenue, with the impact of the decline in revenue offset by an increase in gross margin rate and lower operating expense. Our quarterly tax rate was 20.4%. Net income was $1.3 billion, up 1%, primarily driven by higher operating income, and diluted EPS was $1.74, up 4% due to lower share count and higher net income. Our recurring revenue in the quarter was $5.6 billion, up 8%, and our remaining performance obligations, or RPO, was $39 billion, up 1% sequentially driven by deferred revenue. Deferred revenue was up primarily due to increases in software and hardware maintenance agreements. ISG revenue was $8.5 billion, down 11%, but up 11% sequentially on the back of improving server and storage demand. We delivered storage revenue of $4.2 billion with demand growth in PowerStore and PowerFlex. Service and networking revenue was $4.3 billion. We saw server ASPs continue to expand, and our AI server mix of server revenue demand continued to increase given the recent rise in customer interest in Generative AI Solutions. Both storage and service and networking revenue were up 11% sequentially. ISG operating income was $1 billion or 12.4% of revenue, up 140 basis points, driven by an increase in gross margin rate, offset by a decline in revenue. Turning to CSG. The calendar Q2 PC market was down 14% in units but is now showing signs of improvement, up 7% sequentially. Our fiscal Q2 CSG revenue was $12.9 billion, down 16%, primarily driven by a decline in units, partially offset by higher average selling prices. Revenue grew 8% sequentially, and commercial continues to fare better than consumer with commercial revenue growing sequentially to $10.2 billion. Consumer revenue was $2.4 billion. CSG profitability remained strong in Q2, with operating income of $1 billion or 7.5% of revenue, up 120 basis points, driven by an increase in gross margin rate and lower operating expense as we maintain pricing discipline and benefit from lower input costs. We remain focused on commercial and the high end of consumer, profitable relative performance, and executing our direct attach motion for services, software, peripherals, and financing. Customer interest remains high in financing and consumption models that provide both payment flexibility and predictability. Our Q2 Dell Financial Services originations were $2.3 billion, up 1%. DFS ending managed assets reached $14.7 billion, up 9%, while the overall DFS portfolio quality remains strong and credit losses near historically low levels. During the quarter, we continued to see APEX momentum, including a strong double-digit percentage increase in a number of new APEX customers that have subscribed to our as-a-service solutions with strength in our Data Center Utility and Flex On Demand offerings. Turning to our cash flow and balance sheet. Our cash flow from operations was $3.2 billion, primarily driven by working capital improvement, sequential growth, and profitability. Within working capital, we reduced inventory by $0.4 billion sequentially and continued strong collections performance with past due now at record low levels. With the work we've done on net working capital post-pandemic, our cash conversion cycle has now improved to negative 50 days in Q2, in line with pre-COVID levels. Cash and investments were up $0.7 billion sequentially driven by free cash flow generation offset by $1.1 billion of debt paydown and $0.5 billion in capital returns. In Q2, we repurchased 5.2 million shares of stock at an average price of $49.53 and paid a $0.37 per share dividend. Our core leverage improved to 1.6x exiting the quarter, and we ended Q2 with $9.9 billion in cash and investments, which gives us flexibility to increase our return of capital going forward. Since we implemented our current capital allocation framework six quarters ago, we have returned over 90% of our adjusted free cash flow in the form of share repurchase and dividends, and we continue to evaluate enhancements to our framework based on investor feedback. Turning to guidance. We're seeing signs of stability across a number of areas within our business, including small and medium businesses and government. But our largest corporate and global enterprise customers are still measured in their IT project investments and spending plans. Against that backdrop, we expect Q3 revenue to be in the range of $22.5 million and $23.5 billion, with a midpoint of $23 billion, flat sequentially. Currency continues to be a headwind, and we are expecting roughly a 40 basis point impact to Q3 revenue. We expect both CSG and ISG revenue to be roughly flat sequentially. Although we remain disciplined and focused on profitable share, we expect a more competitive pricing environment. Combined with more muted component cost deflation, we expect gross margin rates to be down 150 basis points sequentially. Our continued focus on cost controls will drive lower sequential operating expenses that will partially offset expected gross margin dilution. We expect our Q3 diluted share count to be between 733 million and 737 million shares and our diluted EPS to be $1.45 plus or minus $0.10. For the full year, we're raising our FY '24 revenue expectations to be in the range of $89.5 billion and $91.5 billion, down 12% at the midpoint. Given Q3 guidance, this implies sequential growth in Q4. We expect interest and other to be roughly flat year-over-year. For our tax rate, you should assume 22.5%, plus or minus 100 basis points. We are increasing our expectations for diluted earnings per share to $6.30, plus or minus $0.20. In closing, we have strong conviction in the growth of our total addressable market over the long term with AI, multi-cloud, and edge as tailwinds. We have generated $8.1 billion of cash flow from operations over the last 12 months, demonstrating our ability to drive efficiency in working capital during a more challenging demand environment, and our Q2 performance underscores the power of our model to generate cash when we return to sequential growth. We remain focused on executing our strategy, investing in innovation to expand our total addressable market and winning the consolidation of our core markets, including multi-cloud, edge, telco, and AI. Expect us to continue to be disciplined in how we manage the business, focusing on what we can control and delivering to our customers and our shareholders. We look forward to seeing you all at our Securities Analyst Meeting in October, where we'll provide updates on our strategy, long-term value creation framework, and capital allocation policy. Now I'll turn it back to Rob to begin Q&A.

Robert Williams, Head of Investor Relations

Thanks, Yvonne. 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 will take our first question from Shannon Cross with Credit Suisse.

Shannon Cross, Analyst

Jeff, could you elaborate on the AI opportunity? You've mentioned it previously, but I'd like to hear more about the four core use cases on a segment and geographic basis. Additionally, how should we assess the ASP potential for both servers and storage in relation to AI-oriented solutions? I'm curious whether you believe that AI will lead to a lasting increase in hardware spending rather than just a temporary shift.

Jeff Clarke, CEO

Shannon, let me address that. First of all, we believe AI represents a new set of workloads and additional capabilities that extend from PCs to data centers to the cloud. We see it as a significant growth opportunity in all of these areas due to the unique nature of these workloads. The way it's developed and utilized on PCs presents new possibilities for enhancing productivity. In enterprises, there's the concept of domain-specific, process-specific, or field-specific AI, where we utilize customer data to refine the model and implement it at the edge, whether in a smart factory, smart hospital, or transportation network. When considering the vertical applications of this technology and its practical implementation, it stretches out to the edge. AI is integrated where data is generated, allowing us to optimize computing resources based on the data being generated. This isn't limited by geography or business size; it's influenced by the type of application and the user's environment. This aspect is particularly exciting. We believe a one-size-fits-all approach doesn't apply here. Our AI solutions range from PCs to workstations to data center applications. The data center could consist of a single server operating inference at the edge, a small cluster for fine-tuning, or large foundational models used for cloud-scale training. Overall, this encapsulates the opportunity we see. We anticipate it will be incremental. While it's likely that some data center servers will be affected, we acknowledge that we're still in the early stages of understanding. The workloads and architectures will be inherently different, and we will develop specialized systems for AI and extensive parallel data processing, differing from how we've traditionally built data center applications.

Operator, Operator

We'll take our next question from David Vogt with UBS.

David Vogt, Analyst

Can we just stick on AI for a second and maybe dig into how you're thinking about your allocation or your ability to allocate to GPU capabilities, right? So obviously, it's a bit of a rush right now with some limited supply and some gating factors, and you talked about $2 billion of servers in your order book. Can you kind of just share with us how you see yourself competitively sitting into that queue? Are you seeing challenges in getting ample supply to sort of meet that order book? And how should we expect that order book to filter through revenue as supply becomes available?

Jeff Clarke, CEO

Sure, David. Maybe the easiest measure to determine our supply is that demand is way ahead of supply. If you order a product today, it's a 39-week lead time, which would be delivered the last week of May next year. So we are certainly asking for more parts and working to get more parts. It's what we do. I'm not the allocator; I'm the allocatee. We're advocating our position on our demand. Again, we are winning business signaled by the $2 billion in backlog today, with a significantly bigger pipeline. I was in discussions yesterday with two different customers about AI and two days earlier about AI. It's consistently coming into our business, and we are fielding opportunities, from cloud providers to enterprises beginning proof of concepts. We will continue to advocate for more supply, and I'm tracking at least 30 different accelerator chips in pipeline development coming. Many people that see the opportunity are also doing so with new technologies, some of which are exciting, like neuromorphic processors and other type of accelerators. There are various new technologies and algorithms that we'll be monitoring while supporting our businesses and assisting our customers.

Operator, Operator

We'll take our next question from Samik Chatterjee with JPMorgan. Samik, your line is open. If you could please check your mute button?

Samik Chatterjee, Analyst

Sorry about that. Congrats on the results. Just trying to square the guidance for ISG to be flat when you talked about seeing order improvement? Could you talk about what you saw in terms of linearity of orders during the quarter, both in servers and storage? While large enterprises might be still measured, you mentioned there are segments of the market or verticals that are spending, and it does look like you're seeing macro green shoots of improvement. Just trying to square how much of that flat guidance embeds pricing being the major driver versus demand. Help me square that, please.

Yvonne McGill, CFO

Let me go ahead and start on that, Samik. As we're looking into the third quarter, we have a lot of near-term dynamics that we are navigating through. We're confident about the go forward, but we're guiding to flat sequentially at $23 billion. We're expecting stability we've seen in the transactional business. I talked about small business, medium business, and government. But in ISG, which you're particularly asking about, we're expecting that to be overall flat sequentially with servers a bit better, really leaning in on the GPU mix, but not expecting that rate of decline to improve much on the rest of the server portfolio. In terms of storage, we've got normal seasonality that's usually down in the third quarter, and thus we're expecting a lower storage performance in that quarter. Now at CSG, we also have it flat, we have some mix dynamics in there with mixing more towards the holiday period. There will also be some TRU pressure from the external environment.

Jeff Clarke, CEO

Yes. I might add as a complement to what Yvonne just said about ISG, specifically storage; it is seasonally down from Q2 to Q3. With the weakness in our enterprise customers, we see the greatest concentration of high-end or high-priced band storage arrays, putting pressure on our P&L in Q3.

Operator, Operator

We'll take our next question from Toni Sacconaghi with Bernstein.

Toni Sacconaghi, Analyst

I just have a quick clarification and a question. I think you said your server backlog in revenue terms was 20% GPU or accelerator-based. I wanted to confirm that. Also, could you add what was the percentage of server revenues this quarter that was GPU-based and a year ago? Lastly, regarding operating margins, you're above your historical levels in PSG of 5% to 7%, and above ISG historically, maybe 11% to 12%. Is there anything structurally changing, or was this a unique quarter driven by strong sequential growth and cost control? Should we expect to revert back to normal levels next quarter, or is this related to AI or about how you're picking where to participate, making the margins we saw this quarter something we might continue to see?

Jeff Clarke, CEO

I'll take the first half of the question, Tony. I believe my remarks were that 20% of the first half orders in servers were AI-based servers, like the XE family, etc. If you were to compare it against a year ago, since the XE family of products did not exist, that's the vast majority of the backlog. It's a very large percentage on a year-over-year basis. I actually did calculate it, but it'd be a very big number, given most of the $2 billion backlog I noted is XE9680 based.

Yvonne McGill, CFO

I'll jump in on the profitability question. What we saw in Q1 and Q2 was a great example of our differentiated model with the ability to capture that deflationary environment and translate it through the P&L. We saw component deflation that was better than anticipated and stable TRUs, which let us deliver a higher margin rate. In Q3, we're expecting a few things: a more competitive environment as inventory levels normalize. We think more of our competitors will have broader access to lower component costs. We're also expecting deflation to continue, but at a more muted level than Q2. We performed well in Q2, but both CSG and ISG are expecting competitive pressure and mix dynamics, especially in ISG as we move into Q3 with less focus on seasonal storage performance.

Operator, Operator

We'll take our next question from Aaron Rakers with Wells Fargo.

Aaron Rakers, Analyst

Yes, thanks for the question and also on some of the results. I'm going to shift away from the AI narrative and maybe talk a little bit about the balance sheet side of the equation for Dell. I think in your prepared comments, you highlighted that you've now got, I think it was close to $9.9 billion of cash on the balance sheet. One of the things you mentioned was improving flexibility or increased flexibility on capital return side. How are you thinking about capital return relative to M&A? Could you provide some context of how much capacity, or put another way, how much operational cash do you think you necessarily need as we think about the excess cash you're carrying on the balance sheet on top of the free cash flow generation for the company?

Tyler Johnson, Chief Financial Officer

Yes, this is Tyler. Maybe I'll start, and Yvonne might step in. We've always talked about our minimum cash balances being somewhere around $4 billion to $5 billion. Now it doesn't necessarily mean I'm going to run at those levels. But clearly, we have excess cash. As you saw, it was a really strong cash quarter. If you look at the first half of the year at $5 billion of cash flow from operations, that's a record. Great job by the teams on working capital and something we've been extremely focused on. It’s great to see the progress that we made. As Yvonne mentioned during the opening remarks, this gives us more flexibility. As we look at share repurchase, we first look at dilution and then we think about opportunistic buys. I think this gives us more flexibility as we're working through that.

Operator, Operator

We'll take our next question from Erik Woodring with Morgan Stanley.

Erik Woodring, Analyst

Jeff, I hope to maybe spend some time on storage in the quarter, revenue down just 3% year-over-year. I imagine that was better than expected. Can you maybe walk us through what you're seeing in the storage market? Where do you think we are in the cycle? How much of the performance in Q2 was Dell specific versus the market? Is there any storage pull-through from AI servers that would be helpful?

Jeff Clarke, CEO

Sure. If you look at our performance, it was primarily driven by our strength in hyper-converged infrastructure, most notably, our PowerFlex, which is our proprietary software-defined storage solution. Its ability to independently scale compute and storage for high-performance applications has great momentum in the marketplace. I mentioned earlier that it has grown now for eight consecutive quarters, more than doubling in the quarter. This certainly was a highlight of the portfolio in storage. PowerStore, our mid-range offering, has grown for 12 consecutive quarters and remains a strength of the business, particularly given that our global enterprise customers are guarded in their buying. Sell to large corporates and midsized companies has certainly been where our midrange product is. I'm very optimistic. We're working to get tighter correlation that the AI compute side should be driving growth in unstructured storage and object storage. As massive amounts of data pass through, our highly scalable, high-performance unstructured systems exist in the market with PowerScale and ECS object storage. I'm optimistic there won't be a tight correlation just yet, but most sales are compute-centric with software-defined storage inside that compute. I hope that helped.

Operator, Operator

We'll take our next question from Amit Daryanani with Evercore.

Amit Daryanani, Analyst

Congrats on a nice set of numbers here. Maybe just going back to the AI server opportunity. I'm hoping you could talk about who the customers are that are buying this from Dell? Are they traditional enterprises, or are they hyperscale customers? Could you explain Dell's value proposition regarding GPU-enabled services? The concern might just be what's the durability of these revenues if they are coming from customers that are typically ODMs and are coming to you but can't get GPU allocations. Could you address the value prop and whether this is accretive or dilutive to your ISG margins?

Jeff Clarke, CEO

That must be four or five questions packed into that. Let me work my way through. We believe today that this AI opportunity is a big incremental opportunity that these new workloads demand a new type of architecture and technology. We think we've hit the sweet spot with the XE9680, for example. The XE9680 is interesting because we have worked closely with NVIDIA over three years to tune its performance. We believe it’s the highest performance, most dense AI server available today in a 6U package. Our power efficiency and air cooling at ambient temperature of 35 degrees Celsius, what we’ve done with iDRAC and the connectivity side with 10 PCI-E ports for high-performance clusters have made a purposely built AI server. When you think about services we announced at Dell Technologies World and subsequently, we have a broader range of services with Helix, helping enterprises deploy infrastructure, understanding where their data is, preparing data, and implementing the infrastructure with ease. We begin enabling training and tuning models, ultimately allowing inference to occur at the edge or within their data center. This package of services and capabilities is just starting to see sales. We have a broad range of customers, some concentrating on the density of AI as a service companies. Enterprises are early buyers in small volumes for proof of concepts. If you look at long-term attributes, we're expecting AI to be everywhere at the edge, in data centers, and the cloud while tracking data. In my mind, AI is likely to follow data, it will happen near smart factories and hospitals, where latency, security, and performance matter. It's likely to be a hybrid world with AI done both in the cloud and on-prem, which together illustrates a significant opportunity for us. We must continue building our portfolio of services, which is key to our hardware. We aim to align services with the application certification and the open-source community ensuring they run well on our XE server portfolio.

Operator, Operator

We'll take our next question from Wamsi Mohan with Bank of America.

Wamsi Mohan, Analyst

Your primary USB-C competitor noted a lower PC TAM in 2023, also against a backdrop of a more challenging component cost environment. Jeff, could you discuss trends in commercial and consumer through the rest of this year, especially from a PC TAM and margin perspective?

Jeff Clarke, CEO

Sure. Our view of the market hasn’t materially changed from our last call. We see the market is roughly 250 million units, down 15% compared to last year. After two consecutive years of decline, we expect it to slow in the second half against easier compares. That is reflected in the guidance for both Q3 and for the year. We see the rate of decline slowing, and we are optimistic about growth in the PC space for next year. Our forecast is low single digits, and if you told us, we’d say it’s probably in the 3% to 4% range for growth next year. What is interesting through this phase is the types of PCs that we’re selling tend to be at a higher ASP. Our ASP against the balance of the industry is roughly 2x. This is driven by commercial mix, the attach of our peripherals, software, and services leading to an ASP that drives twice the industry rate, and our products focus on the profitable profit pools. That’s not where all the units have been in the first half of the year; there have been a lot of units but in emerging markets and a lower-priced band consumer category, with which we’re not particularly strong. Next year, as we roll to the end of this year with the new version of Windows and CoPilot all of us are building AI-enabled PCs, we see AI at the edge being the killer app, which will drive high productivity. Every time we've seen new applications that drive productivity at the edge on the PC, the market rebounds.

Operator, Operator

We'll take our next question from Asiya Merchant with Citigroup.

Asiya Merchant, Analyst

Great. Thank you for the opportunity and great results. Jeff, in terms of the opportunity you guys discussed, when you think about your growth and market opportunity, how should we think about that in the face of AI? Should we expect that to edge higher given growing workloads and higher ASPs on the computer side? Should we expect a growth acceleration for calendar '24 coming off a down year in '23?

Jeff Clarke, CEO

We tend to think about these growth opportunities in areas where our model really extends and expands. If you view our leadership across PC, storage, compute, the scale, and our go-to-market presence, we can apply this model to new growth opportunities. We’ve pointed these out as telco, edge, and multi-cloud initiatives. There’s a fourth tailwind we’ve discussed today, which is AI. We consider this an incremental opportunity, though it is not wholly a new category that would cannibalize the data center. The workloads are different, the architecture and products that we build to serve that demand and need are also distinct. I find this pretty exciting. Given the backlog, we will be carrying AI backlog into next year. We won't have enough parts to clear the backlog, even with the 39-week lead time of today. This pitch is a significant opportunity for us, and we must build our services portfolio across the board, which we feel is key with our hardware.

Operator, Operator

We'll take our next question from Michael Ng with Goldman Sachs.

Michael Ng, Analyst

Thank you very much for the question. I just had on AI servers and ISG. It's encouraging to hear that server ASPs increased, the AI server mix increased, and we saw improving gross margins in ISG. Was that primarily storage mix, or are AI servers accretive to margins? Could you also discuss whether there are aspects around how GPUs are accounted for in AI servers? Is it on a consignment basis, or does it pass through normally? Lastly, I wanted to understand if the success of XE9680 will improve your revenue visibility next year, considering that backlog, and if we should think about seasonality differently for the next year?

Jeff Clarke, CEO

Regarding this, our improvement in the Q2 P&L was driven by sequential growth in both storage and servers. With a favorable cost environment, we saw margin expansion in both areas. From an ASP point of view, AI servers are significantly greater than general-purpose computers. They are dilutive in margin percentage but accretive in margin dollar basis. That’s how Yvonne and I look at the business. Since this is early innings, we are selling services around these products. Services for AI servers are often deferred on our balance sheet when we sell them, which provides opportunity for future service along the deployment of these products like Project Helix, which I've mentioned. That allows us to grow our presence in the AI hardware and service market. We estimate that market will grow 19% over the next few years to $90 billion.

Yvonne McGill, CFO

And we'll strengthen our balance sheet as that grows, so we're looking forward to this opportunity.

Operator, Operator

We'll take our next question from Simon Leopold with Raymond James.

Simon Leopold, Analyst

Great. I wanted to see if maybe you could discuss some of the dynamics related to the supply chain for your enterprise storage and how you’ve had some margin benefits from lower prices for NAND, solid-state memory. There are expectations that pricing will go up for memory next year. How do you think about the effects on both your revenue and margin in storage?

Jeff Clarke, CEO

As mentioned previously, we had a deflationary cost environment in Q2. Our view is that we'll continue to see some deflation in the second half, though the rate of deflation is slowing, benefitting our businesses from PCs to servers to storage. The material content in storage as a percentage of sales is actually the smallest in our businesses. As costs rise, we can generally pass those increases along over time based on our purchasing capability and the scale of it. We will be sensitive about pricing in relation to the competitive environment. We aim to avoid becoming uncompetitive by raising prices too soon, while still being able to absorb increases over time, safeguarding our interests. I expect a cost increase cycle in the future, but I’m unsure when that will occur. We maintain good reach and understanding in our supply base and will measure signals to push through into our prices as we monitor market conditions.

Operator, Operator

We'll take our next question from Steven Fox with Fox Advisors.

Steven Fox, Analyst

Just on the pricing discipline that you're exhibiting here. For the quarter, you had better-than-expected sales and as expected gross margins. Could you explain why that seems a little different than expected? When you think about pricing discipline for the rest of the fiscal year, where will we see it coming through the income statement?

Jeff Clarke, CEO

From a macro point of view, in terms of pricing in Q2 and the second half, it’s business as usual. When you see a slowing market alongside excess inventory, you tend to see pockets of aggressiveness in moving inventory to generate demand. We don't believe the market is very elastic, hence our discipline is really important. We are very focused on the profit pools. As mentioned, while enterprise-class customers are cautious, there are larger deals to be had, and they tend to attract significant profits. We expect consumer promos will be aggressive in the second half to maintain historical levels while also moving older product inventory. We're not exposed with excess inventory as we've maintained a lean inventory model. We will continue to pursue big deals as they arise. We will balance acquisition of new customers while ensuring we can expand our portfolio accordingly.

Yvonne McGill, CFO

I’d echo that with our continued focus on price discipline aimed at core profit pools in the market. We feel good about our approach. We will always make investments where we see a proper return but will remain balanced and disciplined.

Robert Williams, Head of Investor Relations

Cynthia, if we can take one more question and then turn it back over to Jeff for closing remarks.

Operator, Operator

We will now take our final question from Krish Sankar with TD Cowen.

Krish Sankar, Analyst

A quick one for Yvonne. Based on your full year revenue guide, your fiscal Q4 revenue should be up low single digits Q-over-Q. What’s driving the strength in Q4 relative to Q3? Is it driven by ISG or CSG seasonality? Any color there would be helpful.

Yvonne McGill, CFO

In the fourth quarter, we do see a seasonally strong storage performance, and we're expecting that again this year. So that's what's driving the differential in the fourth quarter.

Jeff Clarke, CEO

Well, perfect. Thank you, everyone. We executed well in Q2 and delivered extraordinary results. Our model is driven by a unique set of competitive advantages, starting from our position of strength with a broad portfolio, #1 positions, technology’s largest go-to-market engine, the industry's leading supply chain, and our world-class service organization. We remain focused on extending our leadership positions across PCs, compute, storage and applying our model to new opportunities. Michael, Yvonne and I will go into more detail about our strategy and other topics at our Securities Analyst Meeting on October 5. We hope to see you all there. Thank you.

Operator, Operator

This concludes today's conference call. We appreciate your participation. You may disconnect at this time.