Earnings Call Transcript - DELL Q3 2022

Operator, Operator

Good afternoon, and welcome to the Fiscal Year 2022 Third Quarter 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 the copyrighted property of Dell Technologies Inc. Any rebroadcast of this information in whole or part without prior written permission from Dell Technologies is prohibited. Following prepared remarks, we will have 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.

Rob Williams, Head of Investor Relations

Thanks, Jemaira, and thanks, everyone, for joining us. With me today are Jeff Clarke, Chuck Whitten, Tom Sweet, and Tyler Johnson. Our press release, financial tables, web deck, prepared remarks and additional materials are available on our IR website. The guidance section will be covered on today's call. During this call, unless we otherwise indicate, all references to financial measures refer to non-GAAP financial measures, including non-GAAP revenue, gross margin, operating expenses, operating income, net income, earnings per share, EBITDA, adjusted EBITDA, adjusted free cash flow as well as an estimated non-GAAP revenue, operating income and EPS from continuing operations. A reconciliation of these measures to their most directly comparable GAAP measures can be found in our web deck and press release. Also note that all growth percentages refer to year-over-year change unless otherwise specified. Certain items contained in our earnings materials are presented on a continuing operations basis, giving effect to the VMware spinoff. These amounts represent management's current estimate of continuing operations' financial results. Final amounts presented on a continuing operations basis will be provided in our Form 10-K for fiscal 2022 and subsequent Form 10-Q filings. Amounts are subject to change with no obligation to reconcile these estimates. Additionally, I'd like to remind you that all 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 SEC filings. We assume no obligation to update our forward-looking statements. Now, I'd like to turn it over to Chuck.

Chuck Whitten, COO

Thanks, Rob, and hi, everyone. Thanks for joining us today. We're three quarters into what will prove to be a historic year for Dell. As Michael said at our September Analyst Meeting, we're just beginning to write the next chapter of the Dell Technologies story. During that meeting and with industry analysts at our annual Dell Technologies Summit in October, we shared our view on the IT industry, our strategy going forward, and our view on long-term value creation. We'd emphasized four key points from those sessions. First, we are uniquely positioned in the data and multi-cloud era with durable advantages, market-leading positions, and the financial flexibility to drive sustained profitable growth. Second, our ISG and CSG core businesses are attractive. They sit in large markets estimated at $670 billion in TAM and are projected to grow in the low single digits over the next few years. We have ample headroom for growth, a track record of gaining share and are pursuing a differentiated strategy to consolidate and modernize our core business, including through our APEX-branded as-a-service solutions. In CSG, our differentiation comes from our unique direct sales motion and strategic channel program. Our focus on the most stable and premium parts of the PC market and our strong attach motion, which captures the value around the device as customers seek exceptional experiences and improved productivity by buying more software and peripherals. And for ISG, our leadership positions give us a unique ability to solve customer problems as data proliferates and infrastructure becomes more distributed, hybrid, and software-driven, where you're number one in x86 in mainstream server revenue, and we are also number one in all external storage categories with the most extensive and diverse storage portfolio in the industry. Our storage business addresses each segment of the market with a differentiated architecture optimized for workload needs. And of course, our alliance with VMware is unique in the industry. We've honed a first and best technical and commercial motion that enables faster time to market and differentiated jointly engineered solutions. The third point we'd highlight is the attractive new growth opportunities that surround our business, $650 billion in additional market opportunity growing at an 8% CAGR through 2024. These are markets where we have a unique right to win and are driving real innovation today, markets like telco and edge, to name just two examples. And lastly, we are firmly committed to creating shareholder value with an attractive long-term financial framework, balanced capital allocation strategy, and track record of delivering consistent results in any environment. Our year-to-date and Q3 financial results, along with our steady strategic progress, offer compelling proof of these points and our long-term strategy. Let's start with our core markets and execution. Demand for our solutions remains strong as global economic recovery and widespread digital transformation reset IT demand to higher levels. Against that backdrop and despite the difficult supply environment, we again delivered great performance in Q3, with strong growth in all three business units, all regions, and broad strength across our commercial PC, server, and notably, most of our storage portfolio. We gained share in servers, storage, and PCs, according to the latest reported IDC results. As we look forward, all signposts point to continued strong market demand, and we intend to continue winning in the consolidation and gaining share over the long term. Our strategy is not just to win in the consolidation but also to modernize our business, and our APEX-branded solutions are important to that future. Though it is still early days, we're pleased with our technical progress and the momentum across our family of as-a-service offerings, which will continue to expand going forward. For example, in October, we announced APEX Cloud Services with VMware Cloud, a terrific example of our first and best alliance with VMware. That solution gives organizations the ability to move workloads across multiple cloud environments and scale resources quickly with predictable pricing and transparent costs. Turning to our growth engines. As I said, edge and telecom are two perfect examples of the types of markets we are looking to disrupt, and we delivered a steady stream of innovation in these spaces in Q3. For the edge, we introduced VxRail satellite nodes and updates to our streaming data platform. For telecom, we introduced new bare metal orchestrator software, multiple reference architectures to accelerate ORAN and edge deployments and a new service offering called Respond and Restore for Telecom. We're encouraged by our ability to simultaneously deliver in our core while driving innovation in new growth markets. And we will continue to pursue adjacent growth to our market positions, customer relationships, and durable competitive advantages give us a unique right to solve customer problems in the data and multi-cloud era. Let me conclude with our commitment to long-term shareholder value. Since the September meeting, we have hit a few major milestones in our efforts to simplify our corporate structure and create financial flexibility to drive future growth. We completed the transaction to spin off VMware, and we closed the Boomi divestiture, each resulting in a more simplified corporate structure. In addition, we have returned to an investment-grade corporate rating, which opens up the opportunity for a more balanced capital allocation strategy. To sum up, we remain confident that our market positions, articulated strategy, durable competitive advantages, commitment to disciplined capital allocation, and importantly, our culture and track record of execution are great for customers and our team members and create an attractive near- and long-term opportunity for shareholders. Q3 was a great example of these winning elements coming together, and we're just getting started. With that, let me now turn it over to Jeff.

Jeff Clarke, Vice Chairman

Thanks, Chuck, and hello, everyone. I started off last quarter's call by saying in this incredibly unpredictable environment, we delivered our best second quarter ever. We now have delivered our best third quarter ever and we are on track for a historic year. The constant through all the change over the past 18 months is the unprecedented demand for technology. It is clear, technology is more essential today than ever before. We are clearly winning in the core, and this keeps us at the center of our customers' IT and digital agendas. Three quarters into our fiscal year, Dell Technologies has seen a record revenue of $79 billion, up 16%, along with record operating income of $8.4 billion, up 12%. For the third quarter, we delivered 21% of revenue growth as we saw broad-based growth across our business. Similar to last quarter, demand remains ahead of revenue growth as we continue to navigate industry-wide supply constraints driven primarily by integrated circuits. We shipped a record number of products globally in Q3 and have leveraged our strengths: a multi-decade operational excellence, product design flexibility, coupled with less complexity and our direct model with its high-quality demand signal and ability to shape demand. We are also delivering on our commitment to innovation. We launched a number of new offerings during the quarter. Out of our growing telecom business, we introduced bare metal orchestration software to give cloud service providers a flexible and cost-effective way to deploy and operate their open cloud-native network infrastructure. In storage, we announced network-attached storage software and hardware innovation for power scale, providing organizations with more flexible consumption, management, protection and cybersecurity capabilities. Additionally, we launched the industry's first end-to-end NVMe TCP SAN solution, featuring smart fabric storage software, which provides the intelligence for automated storage connectivity at scale. And in client, we are pairing Windows 11 with our Dell Optimizer built-in intelligence to deliver the most personalized productive computing experience on the world's most intelligent business PCs. We believe the introduction of Windows 11 will continue to drive demand in PCs. Lastly, as Chuck mentioned, our first and best partnership with VMware continued to demonstrate our joint ability to deliver differentiated offers with the announcement of APEX Cloud Services with VMware Cloud at VMworld. It's multi-cloud done right. Turning to our segment results. Our Infrastructure Solutions Group continues to see positive momentum as enterprise IT spending rebounded and our multiyear investments in the portfolio took hold. ISG delivered revenue growth of 5% to $8.4 billion, which was our third consecutive quarter of year-over-year growth. Customers across all regions are investing in IT infrastructure focused on multi-cloud solutions and accelerating digital transformation. This investment is driving very strong demand for compute and storage. Operating income was $892 million or 10.6% of revenue. Server and networking revenue was $4.5 billion, up 9%, our fourth consecutive quarter of growth. Both server and networking demand were exceptionally strong and ahead of revenue growth throughout the quarter. Our 15G server ramp accelerated over the quarter, and we continue to see positive momentum in high-value workloads. We are pleased with our storage performance in Q3, where we saw storage return to growth with revenue up 1% to $3.9 billion. Our overall storage demand was strong, driven by orders growth of 47% for hyperconverged infrastructure, 26% for data protection, and 18% for mid-range storage. Momentum in our mid-range storage business continues to be led by PowerStore, CRN's 2021 Innovator Award for mid-range storage where 23% of PowerStore customers renewed to Dell storage, and 28% were repeat buyers. PowerStore is the fastest-ramping storage product in our history. Dell continued to lead the transition to software-defined data center this quarter with customers leveraging the power of VxRail and PowerFlex as the foundation of their multi-cloud strategy. For example, Lowe's is bringing more power and resiliency to the edge, deploying VxRail to handle IT demands in each of its more than 2,200 home improvement and hardware stores in the United States and Canada, helping the Company deliver new capabilities and services that allow its employees to better serve customers during this holiday season and beyond. Turning to CSG, we had another record quarter, driven by the global economic recovery and the new distributed work environment requiring modern devices and advanced productivity solutions. CSG delivered revenue of $16.5 billion, which was up 35%, driven by strong demand across the board: commercial and consumer, notebooks and desktops and across all regions. Commercial revenue was a record at $12.3 billion in Q3, up an unprecedented 40%. We have reached record commercial revenue for each of the last three fiscal years and are on track for another strong year. Consumer revenue was a record at $4.3 billion, up 21% driven by strong growth in notebooks as well as premium and gaming desktops. Our team did a good job navigating the inflationary component cost and logistics environment, resulting in a record CSG operating income of $1.1 billion, up 14% and 6.9% of revenue. Our long-term focus on higher-value and stable segments of the client market is what helps drive our consistent results. Approximately 80% of the industry's revenue and nearly all of the industry's revenue growth has come from commercial PCs and premium consumer PCs, and that is where we are focused. We are driving profitable share gains over the long term, especially in commercial client, where we've gained nearly 400 basis points of share for calendar Q3 according to IDC. For total client, we gained more than 300 basis points of share in calendar Q3, outgrowing the next four PC vendors combined. In addition, we believe our leading share position in displays further expanded during calendar Q3 based on preliminary IDC data. We'll continue to leverage our strong attach motion to capture our share of the opportunity in the broader PC ecosystem. Our client business has delivered dependable and consistent growth throughout multiple cycles, and we believe trends will remain healthy, given businesses around the world are increasingly digitizing and utilizing technology to increase productivity and drive innovation. To close, we are focused on driving consistent growth in our core businesses, where we build customer trust and create insights that power innovation, and we are expanding into new growth businesses where we have a unique right to win. With our durable advantages like our broad customer reach, world-class supply chain, and modern services delivery network, I believe we are well positioned to win today and into the future. Now let me turn the call over to Tom.

Tom Sweet, CFO

Thanks, Jeff. The digital trends and real-time decision-making at the edge are tailwinds for our Infrastructure business, and we continue to see differentiated opportunities in how we target and execute within the PC space. These trends, along with our strategy and durable advantages, lead us to be optimistic about our long-term growth prospects. We continue to deliver strong results through any environment, and the third quarter was another example of this performance stability. We drove strong growth in revenue and delivered solid profitability growth despite some challenging dynamics. For the third quarter, we saw a record revenue of $28.4 billion, up 21%, driven by growth in all three business units, led by another record quarter for CSG and continued growth in ISG. I was pleased to see the improved demand growth in storage, although it did not all flow to the P&L, given timing and deferrals. Gross margin was $8.4 billion, up 8%, and was 29.6% of revenue. Gross margin as a percentage of revenue was 340 basis points lower, primarily due to a revenue mix shift to CSG along with an inflationary cost environment. As we told you on last quarter's call, component costs would be a headwind in Q3, particularly impacting our elevated units in backlog. We took various actions around pricing and configurations as we navigated through the quarter because of the higher cost. In general, as we've discussed in the past, we will realize a portion of the benefit of these price increases in the quarter in which we take the pricing actions as well as in future quarters. Operating expense was $5.5 billion, up 10% as we invest for long-term growth. And our variable costs such as sales compensation and bonus are running ahead of prior year levels, given our strong performance. As always, we will prudently manage our spending and expenses even as we continue to invest in the business. Operating income was a third quarter record at $2.9 billion, up 5% and 10.1% of revenue. A decline in interest expense due to our reduced debt balances and a decline in our effective tax rate contributed to the 18% growth of consolidated net income to $2 billion and 17% growth in diluted earnings per share to $2.37. Adjusted EBITDA was $3.4 billion, up 6% at 12% of revenue, and for the trailing 12 months, adjusted EBITDA was $13.8 billion, up 14%. Our recurring revenue is approximately $6 billion a quarter, up 13%. Our remaining performance obligations, or RPO, is approximately $47 billion, up 26% and includes deferred revenue plus committed contract value not included in deferred revenue. Excluding VMware, Dell's RPO is approximately $36 billion, up 32% and up 3% sequentially. The sequential growth was driven by an expanded ISG backlog. Dell Financial Service originations in Q3 were $2 billion, down 7%, given a number of customers who have opted to use cash to fund their technology purchases. DFS ended the quarter with $12.6 billion in total managed assets, flat year-over-year. Now turning to our balance sheet and capital structure, which excluding DFS debt, is now fully unsecured. Our cash flow continues to be strong and, as promised, we have repaid substantial debt and delevered the balance sheet. As of today, we have paid down approximately one-third of our debt balance from the end of the last fiscal year, and we have paid down $15.9 billion of core and margin loan debt. We are now solidly an investment-grade company, having received upgrades from all three of the major credit rating agencies. For the third quarter, cash flow from operations was $3.3 billion, up 9%, and excluding VMware, it was $2.2 billion. On a trailing 12-month basis, cash flow from operations was $13.1 billion, up 45%, and excluding VMware, it was $8.5 billion, up 76%. I'm happy with how we've managed our working capital although we did see higher inventory levels, given the supply chain dynamics and component availability. We expect inventory balances to come down as the supply chain situation improves over the next year. Cash and investments ended the quarter at $24.2 billion and approximately $11.5 billion up for Dell, excluding VMware. Finally, as of last Friday, November 19, we have repurchased approximately 2 million shares. Our intent is to continue buying shares going forward programmatically as we manage dilution and opportunistically return capital to shareholders. Before I talk to our outlook, I'd like to provide a view of our third-quarter financial results on a continuing operations basis, which is how prior periods will be recast beginning in the fourth quarter. As explained in Appendix C of our web deck, we currently estimate Q3 revenue from continuing operations was $26.5 billion, operating income was $2 billion and diluted earnings per share was $1.69. It's important to note that our continuing operations financials differ from the pro forma financials we released to date, particularly in the treatment of interest and other in a diluted share count. Please refer to Appendix C of our web deck for further details. Now to our outlook. The macroeconomic environment is healthy across multiple sectors, including IT. Our demand velocity reflects that businesses continue to prioritize their digital transformations to help meet customer needs and improve productivity. Semiconductor shortages, supply chain challenges, heightened logistics costs, as well as inflationary input costs are common themes across the economy. We'll leverage our durable competitive advantages to adapt and deliver consistent, predictable results over time. I'll provide more guidance this quarter than is typical to help facilitate our reporting transition to a post-VMware spin basis. As a reminder, our fourth-quarter financial results will include VMware reseller revenue. For Q4, on a continuing operations basis, we expect revenue in the range of $27 billion to $28 billion, which implies a 12% to 16% growth. We expect GAAP operating income between $1.65 billion and $1.75 billion and non-GAAP operating income between $2.25 billion and $2.35 billion, which is in line with historical trends. Operating income margin will be up sequentially given Q4 is a seasonally strong storage quarter. We expect a continued net inflationary environment and estimate a modest increase in OpEx as we invest alongside our strong top line growth. Below the operating income line, you should assume 17%, plus or minus 100 basis points, for the non-GAAP tax rate and diluted shares in the range of 810 million to 820 million. Additionally, we will benefit from lower interest expense, given the debt reduction we discussed. We expect diluted GAAP earnings per share between $0.97 and $1.16 and non-GAAP diluted earnings per share between $1.85 and $2.05. I'll provide guidance for fiscal '23 on our Q4 earnings call. However, I'd reiterate that we expect to see growth in both our CSG and ISG businesses. We expect revenue growth and EPS growth to be consistent with our long-range financial framework, which we discussed during our Analyst Meeting in September. In closing, a quick reminder. ESG remains an important focus for Dell Technologies, and we have a long legacy of engagement with investors. ESG marries our corporate purpose and commitment to value creation to help move societal and business progress forward together. You can find more details on Slide 19 of the web deck. As I look forward, I'm confident in our ability to deliver consistent and predictable financial performance across any economic or IT spending cycle. With our track record of strong operational and strategic execution and our durable competitive advantages, I'm optimistic about the long-term growth prospects for Dell. We are focused on executing our strategy to consolidate and modernize the core and build new growth businesses that enable the multi-cloud future, along with delivering an attractive long-term financial model of 3% to 4% revenue growth and 6% or better diluted earnings per share growth. With that, I'll turn it back to Rob to begin Q&A.

Rob Williams, Head of Investor Relations

Thanks, Tom. Let's move on to the Q&A session. Jamaria, could you please introduce the first question?

Operator, Operator

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

Toni Sacconaghi, Analyst

Yes, thank you for taking the question. I was wondering if you could comment a little bit on the dynamics for operating margins in ISG. They were down 90 basis points sequentially and 40 basis points year-over-year despite improving volumes. And whether you could comment on sort of order growth relative to revenue growth for both storage and for servers and networking? Thank you.

Tom Sweet, CFO

Toni, it's Tom. Let me explain our perspective and what we are observing. From an operating margin standpoint concerning ISG, we experienced a quarter-on-quarter decline of about 90 basis points, moving from 11.5 to 10.6. It's important to remember that last quarter we mentioned the increased component costs that would affect us in Q3. We anticipated an overall operating margin guidance of 1% to 2% sequentially, and we ultimately achieved 2% this quarter. We faced challenges with component costs, especially in the server segment, and as I noted last quarter, the backlog of units at the shipping point caused issues. Although we attempted to adjust prices for some of those units, we encountered some negative effects on those shipments, which was the main factor affecting operating margin in ISG. Regarding order growth, while we don’t typically discuss demand here, I can share that we observed strong demand growth in both servers and storage. I'm pleased with the momentum in those two areas, which is why I emphasized in the RPO that the backlog helped in the expansion, primarily in ISG. Overall, I am happy with the demand environment as we look ahead.

Operator, Operator

We'll take our next question from Katy Huberty with Morgan Stanley.

Katy Huberty, Analyst

Yes. Thank you. I wanted to follow up on ISG because Tom, as you said, you made notable comments about ISG backlog growing and also strong storage demand not necessarily converting to the P&L in the quarter. Can you just talk about the shape of demand linearity, why some of that revenue was pushed? And how you see it flowing through in the January quarter, particularly as it relates to whether we should expect an acceleration in storage revenue growth?

Tom Sweet, CFO

Yes. Katy, regarding storage demand, we've mentioned before that it tends to be more concentrated towards the end of the quarter, and we observed that trend again this quarter, possibly more than in previous quarters. Consequently, we were unable to convert that backlog into revenue. A significant portion of that order demand is revenue. That was clearly a challenge for us. Additionally, keep in mind that within my storage solutions, there is a significant amount of software and services tied to multi-year agreements, which typically leads to deferrals on the balance sheet. I consider this a positive aspect, as it eventually creates a future revenue stream. So, the main challenge we faced was that we built up backlog in storage due to the linearity, and we also deferred a considerable amount of revenue to the balance sheet, considering the service attach rate and the software components involved in the storage.

Chuck Whitten, COO

Maybe, Tom, to add a little bit to that. We're encouraged by storage orders growth because in the most strategic category, software-defined storage, we grew 47%, mid-range orders grew 18%, which is now the fourth consecutive quarter our mid-range business has grown. That's on top of taking share in the last third quarter in midrange in Q2. Data protection grew, unstructured data grew, and our entry-level orders grew as well in the storage business, so Katy, we remain encouraged by the orders growth. We have the conversion that Tom walked through that we have to continue to work on, but the demand environment in Q3, we're pleased with.

Tom Sweet, CFO

Yes. And Katy, I should answer, I guess, the second half of your question, which is around, as you think about what's the implication for Q4 revenue. Look, I think the reality is, as we highlighted in the talk track that we're continuing to face supply chain challenges. And so how much of server demand gets converted or backlog gets converted into shippable revenue is something that the teams are working every day. We have long-standing relationships with our supply chain. But it is a pretty dynamic environment, and semiconductors continue to be a challenge, particularly for NIC cards and cards for us. So I think that's going to be one of the things that we're going to have to work our way through as we go through the quarter in terms of how much headwind of supply chain gives us. Jeff, I don't know if you'd add anything to that.

Jeff Clarke, Vice Chairman

I think well said.

Operator, Operator

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

Wamsi Mohan, Analyst

Yes. Thank you. I know you typically don't give free cash flow guidance, but in the spirit of giving more color on guidance. Can you talk about the cash flow that you're expecting to generate from now here in fiscal 4Q? And how should we expect that to track relative to net income next year? You noted growth in both CSG and ISG next fiscal year with the long-term framework. Should we be thinking of applying that to free cash flow as well? Thank you.

Tyler Johnson, VP of Finance

Hey, Wamsi, it's Tyler. So like you said, we don't typically have guidance on Q4. But I would say, look, Q4 tends to be a strong cash flow quarter for us, and I'm expecting those same trends, so looking for a good cash flow quarter. As I look into next year, look, we've talked about the relationship between net income in excess of 100%, and I expect that to continue to hold.

Tom Sweet, CFO

Yes, and that's adjusted free cash flow.

Operator, Operator

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

Amit Daryanani, Analyst

Thanks for taking my question. I guess, maybe a question on the CSG side. Your ability to think accelerate CSG growth despite compares getting difficult is fairly impressive. So I'm wondering if you can just talk about what are some of the drivers that's driving this outperformance. And how should we think about the durability of the CSG growth as you go forward because you compare that, you get more difficult, I think, through the next few quarters now. And related to CSG, maybe the margin discussion you had on ISG, could you just talk about margin performance in CSG, better volumes than, I think, sequentially and year-over-year margins have slowed down?

Jeff Clarke, Vice Chairman

Okay, Wamsi, this is Jeff. That's a lot of questions in there, at least if I can work my way through them. What we're seeing and why we're encouraged about the demand environment that we've called out and you see it in our performance is our focus being in commercial PCs, premium consumer, gaming, and professional workstations, that's where the demand is. That's our strength. That's been our focus. And when we think about the trends that are underway, the do-from-anywhere, work-from-home, learn-from-home, buy-from-home, game-from-home, entertain-from-home, the change in the usage pattern of hybrid workers, what we think is now a reentry of workers back into the office, the addition of Windows 11 and the ability now to move to more mobile platforms and an aged installed base all set up for the demand environment we're seeing today, we believe, continues into next year. So we're encouraged by where the growth is in the marketplace. The areas that certainly have been challenged on the consumer side or the chrome side, we don't have great exposure to. We have exposure to where the growth is. Our execution and I think what is differentiating us today is the fact that we have a differentiated model. We're encountering the same supply chain challenges, the same integrated circuit semiconductor problems that Tom mentioned earlier that everybody else is. What's different is our Dell Direct model, our ability to really understand the pure demand signals from our customers and then equally translate that quickly into our supply base into the demand plan that we go build to. We're able to shape demand. We built an R&D engine that is really optimized to be able to be aligned to our direct way of selling. Translation, we have fewer SKUs, less complexity. We have a design methodology that has interchangeability and leverage and reuse. That gives us tremendous flexibility where components are and being able to do, for example, fast pen calls or pen-to-pen calls and changing out of components. If the Dell model, all the way from its demand engine to how we market to how we shape demand, put that demand signal into the supply chain, the product model that goes with it, and then a responsive supply chain that's pretty darn quick. I mean, what I like about our supply chain is we've digitized it over the years. We're now able to do scenario planning and simulations. That simulation allows us to make quicker decisions. In this time and day, quick decisions equal execution. And then you couple that with partnerships that we've built over the past three decades by the leaders that are currently in our organization that go multiple levels down, I think that's a distinguishing characteristic of our performance and our differentiated model today. Does that help?

Tom Sweet, CFO

Hey, Amit, I might add on your operating margin comment.

Rob Williams, Head of Investor Relations

Wamsi was on it.

Amit Daryanani, Analyst

Thank you for the reminder. You are correct. Year-over-year, CSG is down about 130 basis points on operating margin. The phenomenon I mentioned in server has also played out in client. Remember, we entered from Q2 into Q3 with the most significant cost increases we have ever experienced. As a result, with elevated backlogs, we faced challenges working through the backlog that was priced based on component cost frameworks that didn't fully reflect the cost increases coming in during the quarter. That was likely the main reason for the 130 basis points decline in our margin. There were also some mix dynamics involved. If you recall Q3 from a year ago, consumer demand was high, and chrome demand was very strong, which led to better profit margins than usual. Therefore, there were some profit margin mix dynamics that have lessened as we look ahead compared to a year ago.

Operator, Operator

We'll take our next question from Shannon Cross with Cross Research.

Shannon Cross, Analyst

Thank you very much. I wanted to ask about Project APEX. I realize it's pretty early, but I'm wondering if you can maybe give some more details on what you're hearing from customers, how we should think about growth in Project APEX then benefiting the $6 billion, I think, you're now running in terms of recurring revenue. If there's anything we should either not include as we think about growth there and then what runs through your recurring line, or just anything because I'm sure everybody is going to be starting to focus on some of these numbers going forward.

Chuck Whitten, COO

Thanks, Shannon. It's Chuck. I'm going to start on that and then we'll layer in. Look, as we've called out, our immediate focus in FY '22 has been centered on engaging customers and ensuring that our APEX offers are resonating in the marketplace and that we are making progress against our multiyear plans to broaden our APEX portfolio of offers. So while I won't quote specific numbers to your question on customer feedback, first and foremost, what I would say is interest in APEX continues to accelerate, and our pipeline continues to build across the family of offers. And the customer feedback has been good. They're drawn to the simplicity of engaging through our console, the flexibility to adjust based on their needs, and the value, obviously, of only paying for what they use. The second thing I would call out is we continue to make good progress in broadening the portfolio, as we called out in our remarks today. We were excited to announce the APEX Cloud Services with VMware Cloud, which is available next year. That's another great proof point of our joint engineering with VMware. So we feel like we're making good progress on APEX. From a financial impact, look, as you said, we're still in very early innings, and we'll provide much more detailed commentary and guidance when it's appropriate. But in the meantime, we're focused on customers and delivering against the technical road maps, as I said.

Operator, Operator

We'll take our next question from Rod Hall with Goldman Sachs.

Rod Hall, Analyst

Thank you for having me. I have one question and a follow-up. Tom, you mentioned that there was a very high backlog on CSG due to commercial orders last quarter. I'm curious if you made any progress in reducing that backlog this quarter or if it remains as high as before. Additionally, what is the current outlook for CSG, specifically regarding commercial order volume? How far ahead can you project into February? Thank you.

Tom Sweet, CFO

We made some progress on the high backlog in CSG as we navigated through the quarter, but it remains elevated, which poses challenges for us regarding component availability as we head into Q4. We also noted that the ISG backlog has further expanded. While I didn't specifically mention it, the CSG backlog decreased slightly but is still high. Regarding order visibility, it's difficult to predict, but overall, the market seems healthy. We are optimistic about the client space for the reasons Jeff highlighted earlier, which is reflected in the Q4 guidance I provided. Additionally, we're anticipating growth for next year in both CSG and ISG. Overall, we feel positive about the demand environment, although the supply chain will continue to present challenges, and it will be essential for us to navigate through that effectively.

Operator, Operator

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

Steven Fox, Analyst

Hi, good afternoon. I was just wondering off of all the comments around how you're managing through the current environment. If we think about the current quarter relative to seasonality and mix and then your ability to shape demand versus managed supply chain, can you give us a sense for how it's impacting sort of the implied margins and where you're getting better, where it's sort of status quo versus what you've done in the last couple of quarters?

Tom Sweet, CFO

Yes. Steve, maybe I'll start and then Chuck and Jeff can jump in as appropriate. I mean, look, we're shaping demand, quite frankly, to the component availability that we have, recognizing that within the CSG space, we're shaping demand towards those areas of focus for us, which is commercial, high-end, consumer, gaming, and the related peripheral environment around them. And so pricing is relatively benign or, I should say, stable in terms of the pricing environment. So it really comes down to can we get supply and ensure that we can deliver against our customer commitments there. And Jeff and team are doing a nice job every day of trying to fight their way through the component dynamics that are impacting us. So look, I feel good about our ability to shape demand, given the direct model, our ability to have the sales organization sell the configurations that we have. And in terms of how is that impacting profitability, I think that's a little bit harder to call. All I would tell you is that what we're trying to do is make sure we hit our customer commitments and that we're optimizing for our product, given the shortage in the industry that there is. So we are trying to make sure that our pricing is consistent with the conditions that exist.

Jeff Clarke, Vice Chairman

Yes, Tom, I would add that our ability to influence demand based on the supply available is well understood and performs effectively. We have set prices considering all known costs entering the system. We recently experienced our largest quarter-over-quarter cost increase. The unpredictable factor for us continues to be logistics, which presents a challenging cost environment right now. Inbound freight and our upcoming guided freight are impacted since we're shifting from less ocean freight to more air freight. Understanding these input costs is crucial for our pricing models, and this is a clear challenge we face in Q4. While we have a good grip on our component costs and availability, the main dynamic we need to navigate is the logistics costs and their variability.

Operator, Operator

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

Simon Leopold, Analyst

Thanks. Appreciate you taking the question. I imagine this may be a little bit tricky to answer, but I'm trying to get a better understanding of maybe a bridge for the gross margin in terms of the factors either sequentially or year-over-year, leading to the results when I think about the input costs, the product mix and your ability to move to higher ASPs. If we could maybe get some order of magnitude of what are the factors affecting your gross margin and how to think about that as we're modeling going forward, particularly in light of the VMware spin? Thank you.

Tom Sweet, CFO

Well, Simon, it's Tom. We typically don't provide comments on gross margin at the business unit level. However, at a top line level, it primarily comes down to how we view the mix as we move into Q4, which is generally a higher storage quarter for us. Therefore, we usually see gross margins improve from Q3 to Q4. There's a recognized seasonal pattern in storage as we transition into the next year. Regarding CSG, we're focusing on areas like commercial, gaming, and high-end consumer. Component costs will drive our decisions in that regard. We expect that in Q4, both component and logistics costs will be inflationary, and we've priced accordingly based on current knowledge. So, the dynamics of mix and input costs are critical factors to consider. It's important to monitor industry inflation and deflation trends, as while our response may not be dollar-for-dollar, it serves as a useful guide. I also missed discussing servers, but those will similarly depend on component cost dynamics. Additionally, keep the mix dynamics in mind; Q4 generally sees a higher ISG and higher storage volume. Consumer effects from the holiday season are also notable in Q4. Moving into Q1, we typically experience our seasonally softest quarter, followed by a ramp-up in Q2 with increased volume, after which the seasonal pattern repeats. This should provide you with a framework to think about the interplay between mix and input cost dynamics.

Operator, Operator

We'll take our next question from Jim Suva with Citigroup.

Jim Suva, Analyst

Thank you very much. It's well known a lot of component shortages are out there. Can you maybe help us get our arms around which ones are the most hardest to get now? Are they like power management integrated circuits? And what's the visibility that your suppliers are giving you for equilibrium for you to be able to catch up with demand? Thank you.

Jeff Clarke, Vice Chairman

Sure, Jim. This is Jeff. Integrated circuit semiconductors remain constrained and will continue to be constrained into next year. The trailing nodes are the most affected, particularly anything in an 8-inch network and the 12-inch 65-, 55-, and 40-nanometer networks, which are notably challenged. There are wafer shortages contributing to this situation. As I mentioned in our last two calls, the back end, including assembly and testing, was impacted by COVID. While there has been some improvement, it is still constrained. Additionally, there are various substrate shortages globally that continue to have an impact. Specifically, we monitor 27 different categories of integrated circuits within our portfolio. From codecs to audio amplifiers, USB Type-C controllers, MOSFETs, Power ICs, sensor ICs, TPM, microcontrollers, and driver ICs for our PC side; on the enterprise side, we see Power ICs, BMC, TPM, FPGAs, and MOSFETs. Power is indeed a key focus and we are facing the same shortages as others. However, our team is managing this situation effectively, mainly thanks to our long-standing partnerships. Our relationships with suppliers have been built over three decades, which aids us significantly in navigating these challenges and discussing long-term design prospects. I hope that answers your question.

Operator, Operator

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

Aaron Rakers, Analyst

Thanks for taking the question. And I won't ask about supply chain. What I wanted to ask about is just like as you guys have executed, it looks like nearly all of the $16 billion of debt reductions completed. Do we look into fiscal '23 and assume any incremental deleverage of the balance sheet? Or is the entirety of the capital return strategy focused on share repurchase at this point? And how do we think about, again, the bridge of free cash flow to adjusted free cash flow as we think about that targeted 40% to 60%?

Tom Sweet, CFO

Aaron, it's Tom, and I might have Tyler add some thoughts here as well. Regarding debt reduction as we progress through fiscal '23, I anticipate some continued debt reduction next year. We have already addressed a significant portion of the near-term maturities, but we remain focused on a core leverage ratio target of 1.5, while we are currently at 1.9. Therefore, some debt reduction is expected next year, although not to the same degree as in the past. I would like to remind you that, in terms of our capital allocation strategy, 40% to 60% of our adjusted free cash flow will be directed towards shareholder returns, including dividends—if approved by the Board next year—share buybacks, and investments in the business along with debt reduction. Tyler, would you like to address the free cash flow conversion question?

Tyler Johnson, VP of Finance

Yes. I mean, maybe Aaron, it's easier to take that one offline. I mean, the intent or purpose of that adjustment is to reflect the impact of DFS. There is a walk in the web deck, I believe, but happy to take that one offline.

Operator, Operator

We'll take our next question from Sidney Ho with Deutsche Bank.

Sidney Ho, Analyst

Great. Thanks for taking my question. I have a question on the VMware resale revenue. If I do my math right, the revenue would be somewhere around $1 billion, maybe a little bit over $1 billion a quarter. But if I do the same math for operating margin, it doesn't seem like that business is that profitable. First, is that the right conclusion? Second, how should we think about this profitability of this business going forward? And lastly, how do you plan on disclosing that revenue in the future? Thanks.

Tom Sweet, CFO

Sidney, it's Tom. To help you consider it, I would estimate Q4 VMware resale revenue to be around $1.3 billion. You're correct that, as we've previously discussed, the margin for that resale revenue is quite low. We're working on improving it, but currently, it has a long way to go to reach margins similar to those of distributors. For now, you should view it as not significantly affecting or contributing to our operating margin performance. This is likely the simplest way to understand it at this moment.

Rob Williams, Head of Investor Relations

Thanks for the question, Sidney. Let's take one more question, and we'll wrap it up.

Operator, Operator

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

David Vogt, Analyst

Thank you for including me. I have a long-term question. I understand you won't provide guidance for the next fiscal year, but when you discuss the strength of your order book in servers and storage, and the market share gains against a strong industry backdrop, I wonder about your outlook for next year in ISG. Are you being somewhat conservative regarding your longer-term model based on what you're seeing in the near term, and could this potentially lead to revenue growth next year in ISG that exceeds the 3% to 5% range, possibly aligning more with the higher end of that estimate?

Tom Sweet, CFO

Hey, David, I want to emphasize that we anticipate growth for the upcoming year. We expect our revenue to align with the long-term framework we've shared, and our profitability will also be within the established expectations. I don't want to elaborate further at this moment, but I can assure you that we will discuss more details regarding next year during the Q4 earnings call. So, I’ll leave it at that.

Rob Williams, Head of Investor Relations

Thanks, David. We appreciate the chance to discuss long-term plans. Thank you to everyone for joining us. Over the upcoming weeks, we will participate in several investor conferences, traveling on both the East and West Coast in early January. We look forward to engaging with the investor community at these events in the fourth quarter. Thank you for being with us.

Operator, Operator

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