Hewlett Packard Enterprise Co (HPE) Q2 2020 Earnings Call Transcript

Good afternoon, and welcome to the Second Quarter 2020 Hewlett Packard Enterprise Earnings Conference Call. My name is Eily, and I will be your conference moderator for today's call. At this time all participants will be in a listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference. As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Ms. Sonalee Parekh, Senior Vice President of Corporate Development and Investor Relations. Please proceed.

Thank you. And good afternoon, everyone. This is Sonalee Parekh, SVP of Corporate Development and Investor Relations for Hewlett Packard Enterprise. I would like to welcome you to our fiscal 2020 second quarter earnings conference call with Antonio Neri, HPE's President and Chief Executive Officer; and Tarek Robbiati, HPE's Executive Vice President and Chief Financial Officer. Before handing the call over to Antonio, let me remind you that this call is being webcast. A replay of the webcast will be made available shortly after the call for approximately one year. We posted the press release and the slide presentation accompanying today's earnings release on our HPE Investor Relations web page at investors.hpe.com. As always, elements of this presentation are forward-looking and are based on our best view of the world and our businesses as we see them today. For more detailed information, please see the disclaimers on the earnings materials relating to forward-looking statements that involve risks, uncertainties, and assumptions. For a discussion of some of these risks, uncertainties, and assumptions, please refer to HPE's filings with the SEC, including its most recent Form 10-K. HPE assumes no obligations and does not intend to update any such forward-looking statements. We also note that the financial information discussed on this call reflects estimates based on information available at this time and could differ materially from the amounts ultimately reported in HPE's quarterly report on Form 10-Q for the fiscal quarter ended April 30, 2020. Also, for financial information that has been expressed on a non-GAAP basis, we have provided reconciliations to the comparable GAAP information on our website. Please refer to the tables and slide presentation accompanying today's earnings release on our website for details. Throughout this conference call, all revenue growth rates, unless noted otherwise, are presented on a year-over-year basis and are adjusted to exclude the impact of currency. Finally, please note that after Antonio provides his high-level remarks, Tarek will be referencing the slides and our earnings presentation throughout his prepared remarks. As mentioned, the earnings presentation can be found posted to our website, and is also embedded within the webcast player for this earnings call. With that, let me turn it over to Antonio.

Thanks, Sonalee. Good afternoon, everyone. Thank you for joining us today. I hope everyone is safe and healthy. Our fiscal Q2 results represent a full quarter of operations during the COVID-19 crisis. This pandemic is unlike any other crisis we have faced. It has brought significant economic disruption. Businesses and communities are struggling, supply chain productivity continues to be significantly constrained, and the demand environment is uneven. The market for capabilities like remote connectivity and virtual desktop solutions is stronger than pre-crisis in certain segments, and we are well-positioned in those areas. But overall, customers are understandably cautious, given so much uncertainty. These dynamics had a significant impact on our financial performance this quarter, given economic lockdowns since February. Our overall Q2 revenue declined by 15% to $6 billion, which led to a 42% decline in our non-GAAP operating profit. This was a tough quarter by every measure, and I am, of course, disappointed in the results. However, I do not view our Q2 performance as a reflection of our capabilities nor of the opportunity ahead of us. Through this unsettling time, I have been really proud of our response that is aligned to our purpose of advancing the way people live and work. We consider it our responsibility to help the world navigate this pandemic. We have prioritized protecting the health and safety of our team members while also supporting our customers and partners as we weather the storm together. At the outset, we moved quickly to mobilize crisis management teams around the world. We took decisive steps to ensure our team members’ safety and well-being. We closed all of our sites and rapidly moved team members to work from home except for those performing mission-critical roles. We expanded team members’ benefits to cover COVID-19 testing and treatment, enhanced mental health support, and provided tools and resources to keep people connected and productive. We also responded with important initiatives to address key needs created by the pandemic. We made substantial donations through HPE's foundation and designated $2 billion in financing through HPE Financial Services to help customers and partners experiencing financial hardships. Our Aruba networking capabilities have been deployed in drive-up and virtual healthcare clinics and in schools that are facilitating distance learning. Our High-Performance Computing solutions are helping scientists and leading research institutions to speed up drug discovery with complex modeling and simulation, AI, and machine learning capabilities. We joined forces with the U.S. government and other high-tech companies to form the White House High-Performance Computing Consortium, giving COVID-19 researchers access to HPC resources. HPE also signed the Open COVID Pledge, granting free access to all our patented technologies for the purpose of diagnosing, preventing, and treating the virus. We have adapted to deliver much-needed capabilities and experiences to aid our customers’ transformations as they navigate this difficult time. Through an improved sales coverage model aligned to market segments, our Intelligent Edge business continued to outperform the market while expanding operating margins and demonstrated 12% year-over-year growth in North America. In addition, we gained traction in our HPE GreenLake business. We continued to see acceleration in this very profitable strategic business and are seeing large deals come in, underscoring a growing interest in our as-a-service offerings. Our annualized revenue run rate, or ARR, increased 17% to $520 million. While these are healthy signs of the needs that customers will continue to have coming out of the crisis, there continue to be significant supply constraints and delays in customer acceptance. This has impacted our ability to make deliveries to our customers. Across our portfolio, we exited Q2 with more than $1.5 billion in backlog in Compute, Storage, HPC, and mission-critical systems, as well as Aruba, which represents two times the historical backlog. Our team is doing everything we can to deliver on these customer orders. Tarek will take you through our Q2 results in more detail. But before he does that, I want to take the time to align the actions we will take to address the near-term uncertainty and ensure HPE is well-positioned to emerge stronger, more agile, and digitally enabled for a post-COVID-19 world. While the world is starting to envision what recovery might look like, we need to be prepared for different scenarios. We know there is not going back to what used to be; there is only preparing for and building what comes next. We need to adapt in order to keep our strategic momentum even as the world has changed dramatically. We have taken a deliberate set of actions to protect our financial foundation, become a more agile organization, and align our resources to critical core businesses in areas of growth that accelerate our edge-to-cloud platform-as-a-service strategy. We continue to analyze financial forecasts and customer trends to better understand when and how global economies will recover. In the meantime, we have taken some immediate steps to reduce operating expenses that will protect our financial profile. Effective July 1st, we will implement a short-term pay reduction for all team members where it is legally permitted through October 31, 2020. My executive team and I will take the highest percentage of reduction. Beyond us, the amount of reduction will vary by level. For team members who live in countries where pay reductions cannot be mandatory due to local laws and regulations, we are implementing unpaid leaves. In addition, we have implemented cost containment measures across the company, restricted external hiring through the end of our fiscal year, and put salary increases on hold. Our Board of Directors has voluntarily decided to forgo a percentage of its cash compensation for the remainder of fiscal year 2020 to demonstrate its commitment to Hewlett Packard Enterprise, as we focus on preserving liquidity and improving our position to deliver for our customers now and in the future. Alongside those short-term measures, today we are announcing a cost optimization and prioritization plan. This plan will help us focus our investments and realign our workforce to areas of growth that will accelerate our strategy. Some of the measures in the plan include continuing to streamline our product portfolio, implement new digital customer engagement models, and optimize our workplace site strategy and experiences. HPE expects the plan will be implemented through fiscal year 2022. As a result of the changes to the company's workforce, real estate model, and business process improvements, we estimate gross savings of at least $1 billion and annualized net run rate savings of at least $800 million by the end of fiscal year 2022. To achieve this level of cost savings, HPE estimates cash funding payments of between $1 billion to $1.3 billion over the next three years. Tarek will provide further details in his remarks. While we take steps to secure our financial foundation and strengthen our operations, we have simplified our operating model and aligned them to the financial segmentation we introduced early this year. Each of HPE's businesses is critical to our go-forward success. Each plays an important part in our mission. As our customers demand new and different products and services from us, we must deliver. I’m personally committed to helping each of our businesses leverage its existing strengths and evolve. Each of our business groups now reports directly to me. As part of the new organizational model, we created a GreenLake Cloud Services group to accelerate our service capabilities. We also added a new software team that will architect our software strategy and portfolio that powers our as-a-service platform. This new structure will provide fuller accountability and improve our execution and transformation. As the world emerges from the global pandemic, business continuity will depend on solutions that advance IT resiliency, empower remote workforces securely, extend connectivity, reinvigorate customer engagement, and enable business model evolution. This reality means digital transformation will be more critical than ever. This is why we must accelerate our strategy to deliver everything as-a-service, edge to cloud. We see data growth in the cloud, on and off premises, and increasingly at the edge, where we are uniquely positioned. Edge customers need persistent connectivity to bridge the digital and physical worlds. HPE Aruba Central is at the core of our edge strategy. It is the only cloud-native, simple-to-use, and secure platform that unifies network management for wired, wireless, and WAN networks, and soon 5G and edge computing. In Q2, the number of unique customers using Aruba Central increased to 65,000. Customers will also continue to need capabilities to harness the power of their data, wherever it lives, at the edge, across public and private clouds, in colocations, or in the traditional data center. We continue to believe the cloud is an experience, not a destination, and our as-a-service business models will expand the cloud experience everywhere for all apps and data. Earlier this month, we announced the general availability of HPE GreenLake Central, our advanced cloud-native platform that provides customers with a consistent cloud experience for all their applications and data through an online operations console that runs, manages, and optimizes their entire hybrid cloud estate. In Q2, we made HPE container platform generally available; our new cloud-native, software-defined stack is built using technologies from HPE’s acquisition of BlueData, Storage in MapR, and delivers greater flexibility and lower cost for Kubernetes deployment of cloud-native and non-cloud-native applications with persistent storage connectivity. Next month, at our first-ever Discover Virtual Experience, we will showcase how HPE will help organizations ensure seamless business continuity through new technology capabilities, greater business intelligence, and enhanced financial flexibility, joined by thousands of customers and partners who will discuss how we should think differently about transformation in the future, and will introduce new innovations to bring agility to customers’ apps and data everywhere. There is great promise in what we can accomplish when we increase the speed of innovation and continue to bring to market differentiated capabilities from edge to cloud. Our customers, partners, and communities need what HPE can provide. Our ability to execute our strategic pivot to offering our entire portfolio as-a-service by 2022, while we continue to re-architect and strengthen our core businesses, is critical. As we drive increased performance in our core businesses, we will be able to further align resources to new growth segments that will accelerate our strategy and pave the way to sustainable, profitable growth. One of our core beliefs at HPE is the power of 'Yes We Can.' I am confident in our ability to execute because I believe we have the right strategy, the right leadership team, and the right mindset to adapt and deliver in bold new ways. We are focused, and we are making the necessary trade-offs, so we can continue to invest in the future. We are undertaking this with a sense of urgency and conviction in our strategy. With that, let me turn it over to Tarek to review the quarter’s results. Tarek?

Thank you very much, Antonio. I hope you can all hear me and are all safe and well. I’ll start with a summary of our financial results for the second quarter of fiscal year 2020. As I've done before, I'll be referencing the slides from our earnings presentation to highlight our performance in the quarter. Please note, since last quarter, we're now reporting results according to our new segmentation. Antonio discussed some of the key highlights of this quarter on slide one. Now, let me discuss our financial performance, starting with slide two. Our Q2 results were heavily impacted by the global COVID-19 crisis. As Antonio mentioned, Q2 represented a full quarter of operating under COVID-19. Our revenues of $6 billion were down 15% year-over-year, primarily driven by supply chain disruption, which resulted in significantly higher levels of backlog, particularly in Compute, HPC, MCS, and Storage. We also saw uneven demand with customers pushing out business activity as they navigated through the current economic crisis and lockdown. At the edge, the market for capabilities like remote cloud connectivity and virtual desktop solutions was stronger than pre-crisis in certain segments, and we are well-positioned in those areas, offsetting the decline in campus switching that resulted from lower business activity. Despite the challenging backdrop, we managed to maintain relatively stable non-GAAP gross margins, which were down by 20 basis points year-over-year. Our non-GAAP operating profit, however, was down 42% year-over-year to 6.1% in operating margin terms, and our non-GAAP EPS of $0.22 was down 48% year-over-year. Our GAAP EPS was a loss of $0.64, primarily due to an $865 million non-cash goodwill impairment charge associated with legacy goodwill allocated to the HPC and MCS business segment, impacting GAAP net EPS by $0.67. This impairment was not driven by the Cray business, which continues to perform consistent with our expectations. Cash flow from operations this quarter was $100 million, impacted by reduced profitability and inventory build-up. Free cash flow was negative $402 million compared to a positive $402 million for the prior year period, which was impacted by higher financing volumes. Taking all the previous into account, we're taking decisive and prudent actions to manage our costs and expenses, further improve our liquidity, and focus on opportunities to emerge stronger in the post-COVID-19 world. Turning to slide 3, Antonio outlined some of the near-term cost takeout measures we're implementing, including reductions in pay across our workforce, unpaid leave in places where pay reductions are not legally permitted, and hiring restrictions. He also mentioned the actions we’re taking today to strengthen our financial profile in the medium and long term and accelerate our strategy. Today, we are announcing a cost optimization and prioritization plan to reflect the current revenue environment and position ourselves as a more resilient company ready to address the needs of our customers in a post-COVID-19 world. We remain confident that we have the right strategy and are taking the right actions to secure our financial foundation and support our path to sustainable, profitable growth. More specifically, our plan is designed to right-size our cost structure to the new normal, allocate resources in alignment with our new segmentation and growth areas, drive increased efficiencies through investments in digitization and automation, and finally, to accelerate our pivot to as-a-service to drive long-term sustainable, profitable growth. Overall, these new cost efficiencies will be captured from simplifying and evolving our product portfolio strategy and go-to-market, yielding cost savings from supply chain optimization, increased penetration of remote customer support, new initiatives to leverage digital marketing, and consolidating our real estate footprint. In terms of the timeline, we expect that the plan will be implemented through fiscal year 2022 and estimate that it will deliver annualized net run rate savings of at least $800 million by the end of fiscal year 2022. That being said, we expect to achieve the majority of the savings by the end of fiscal year 2021. In order to achieve this level of cost savings, we estimate cumulative cash funding payments of between $1 billion and $1.3 billion over the next three years. We'll now move to slide 4, which shows our performance in accordance with our new segmentation. Let me highlight a few key points. In the Intelligent Edge segment, we declined 2%. However, we saw over 12% year-over-year growth in North America, showing that the changes we made to our North America sales leadership and go-to-market segmentation are paying off, even amidst a challenging business environment while campus switching declined single digits due to increased emphasis on working from home. We grew the wireless LAN product business by 7% year-over-year due to high demand for our remote access solutions and Wi-Fi 6 certified access points with 35% year-over-year growth in North America. Furthermore, we expanded gross margins and also grew operating margins by 570 basis points year-over-year to 11%. The bottom line is that we gained share in both campus switching and wireless LAN markets while significantly improving profit margins. In Compute, revenue declined 19% this quarter, driven by lower conversion rates, even as order backlog grew to 2 times our average historical backlog and lower unit growth, which was negative double digits this quarter. Our ability to fulfill orders was impacted by component shortages, with supply chain logistics further disrupting our ability to fulfill demand due to the coronavirus pandemic. As the supply chain constraints alleviate, we expect to execute against our high backlog. In high-performance compute and mission-critical systems, revenue declined 18%, primarily as a result of delayed installation and customer acceptance on account of COVID-19. Similar to Compute, this resulted in an elevated backlog, but we expect to see a stronger uptick in revenues in the second half of the year, as we execute against the order book. Our HPC business has been actively involved in COVID-related research activity and is providing COVID-19 researchers worldwide with access to the world's most powerful HPC resources to advance the pace of scientific discovery in the fight against the virus. Furthermore, we announced the 2023 delivery of the world's fastest exascale supercomputer, El Capitan, for the United States Department of Energy at a record-breaking speed of 2 exaflops, 10 times faster than today's most powerful supercomputer. Most importantly, the Cray integration remains on track to deliver the FY20 revenue targets and triple-digit run rate synergies by fiscal year 2021. Within Storage, we declined 16% year-over-year due to higher backlog, similar to Compute, but had notable strength in big data, showing a growth of 61% year-over-year. Nimble Services revenues grew 20% year-over-year, with services intensity at record highs as customers add high-margin value-added services. For operational services across Compute, HPC, MCS, and Storage, revenue declined by less than 1% year-over-year, while orders were down 5% year-over-year, driven by the drop in Compute units. On the positive side, our services intensity, which is the ratio of attach revenue per hardware unit sold, continued to be strong with double-digit growth in Storage and HP, MCS services driven by Cray. This demonstrates that the underlying profitability of the units we sell and the attach rates continues to be robust. In advisory and professional services, revenue was down 8%, but we significantly improved operating margins by 6.2 points year-over-year due to our re-entry in select countries combined with an increase in remote delivery of projects from 65% to 90%, which helped to control costs and improve the chargeability levels of staff. Within HPE Financial Services, financing volume grew 10% year-over-year, despite the impact of COVID-19, and our net portfolio of assets was up 4% this quarter, with longer contract terms supporting GreenLake. We maintained a solid return on equity of approximately 15% again, this quarter. Our bad debt loss ratio this quarter was 0.5%, which is best in class in this industry. We will obviously continue to closely monitor the impairment losses as liquidity constraints could affect some of our customers’ ability to pay in upcoming quarters. We will tighten our underwriting guidelines as necessary to ensure we can manage through this crisis, and that any impairment losses remain within our level of comfort. Our Communications & Media Solutions business, which is included in our corporate investments segment, is a strategically important business for us, providing software and services capabilities to telecommunications service providers. CMS is showing improved momentum. We saw strong double-digit order growth with EMEA growing 45% and Japan growing 70% this quarter. Revenue gained momentum growing 2% sequentially. We also expanded operating margins by 170 basis points year-over-year this quarter. Furthermore, we recorded our first 5G core win with a Tier 1 carrier in the United States. This strategic win validates our 5G strategy with multi-vendor integration and true cloud-native telecom network solutions. Slide five shows our growing ARR profile I introduced at our securities analyst meeting in October 2019. I'm pleased to report that our Q2 '20 ARR came in at $520 million, reflecting 17% year-over-year growth and in line with our expectations. Our HPE Aruba Central SaaS platform continued to grow revenue at triple digits year-over-year this quarter. As we progress toward building our go-to-market as-a-service motion, we remain focused on offering a full suite of differentiated solutions that can be consumed as-a-service, reiterating our ARR growth guidance of 30% to 40% compounded annual growth rate from FY19 to FY22. Slide six highlights our EPS performance to date. Non-GAAP diluted net earnings per share was $0.22 in Q2 with headwinds from reduced operating leverage, suspension of our share buybacks, and lower but expected contribution from OI&E. Consistent with our guidance at SAM, we expect OI&E to be approximately negative $100 million for fiscal year '20. Turning to gross margin on slide 7. We delivered non-GAAP gross margin of 32% in Q2 of fiscal year '20, which was down 20 basis points year-over-year. Commodity costs were a tailwind to gross margin this quarter, even as the supply-demand volumes turned into a more inflationary commodities environment at the start of the quarter. Moving to slide 8. Non-GAAP operating margin was 6.1% in Q2 of fiscal year '20, and non-GAAP operating income was down 42% year-over-year. This clearly demonstrates the imperative to right-size our business to reflect the new revenue profile resulting from the COVID-19 impact. Turning to slide 9. Our cash flow from operations was $100 million, impacted by reduced profitability from the Compute and Storage businesses, which were heavily impacted this quarter, and higher than normal working capital. Free cash flow was a use of $402 million for the quarter, driven by year-over-year growth influenced by financing volumes. Higher than normal backlog and resulting inventory build-up triggered a reduction in our cash conversion cycle from minus 17 days in the prior quarter to minus 5 days this quarter. We expect our cash conversion cycle to improve through the rest of the year as we execute against the backlog and supply chain constraints alleviate, both of which will help us reduce our high inventory levels. Now, moving on to slide 10, I want to spend a moment on the strength of our balance sheet and investment-grade credit rating, which is a competitive advantage in this environment. As of our April 30th quarter-end, we had approximately $5.1 billion of cash and cash equivalents, having successfully raised $2.25 billion in senior notes in April 2020 at a low cost of capital. We also have an undrawn revolving credit facility of $4.75 billion at our disposal. In total, we have approximately $10 billion of liquidity. We remain committed to maintaining our investment-grade rating, which was reaffirmed by the rating agencies in April 2020. Bottom line, we have a strong cash position and ample credit available during these uncertain times to support and invest in our business. Let me recap our key takeaways for this quarter on slide 11. Before I do that, it's worth spending a couple of minutes on capital allocation. In Q2, we returned $305 million to shareholders in the form of share repurchases and dividends. We repurchased $151 million in shares and paid a cash dividend of $154 million. In April 2020, we decided to suspend share buybacks in light of the current environment where liquidity is of paramount importance. Subsequently, in April, we announced our regular dividend payment for Q3 ’20, payable in July. Finally, let me summarize the key takeaway for you this quarter. Our fiscal Q2 results represent a full quarter of operating under the COVID-19 crisis, and we’re heavily impacted by the crisis, both on the demand and supply side. As a result, we have enacted short-term actions and long-term cost optimization and prioritization plans to reflect the current revenue environment and position ourselves as a more resilient company in a post-COVID world. Our robust balance sheet, with approximately $10 billion of liquidity and investment-grade credit rating, gives us flexibility not only to weather the current storm but to continue to invest in key growth initiatives. We remain confident that we have the right strategy and are taking the right actions to secure our financial foundation and support our path to sustainable, profitable growth. Now, turning to outlook. Since the crisis began, we've been stress-testing our model and running scenarios based on various assumptions. Given the level of uncertainty around the duration of the crisis and the rate and shape of the recovery, there is a wide range of possible outcomes for the year. We have taken prudent and decisive steps with the latest being our cost optimization and prioritization plan, so that we are prepared for different outcomes. Due to the uncertainty and consistent with our April 6, 2020, 8-K filing, where we withdrew our fiscal year 2020 financial guidance, we will not be providing any third quarter or fiscal year 2020 guidance. Now with that, let me hand it over to Antonio and open it up for questions. Antonio?

Thank you, Tarek. I know Nancy is going to operate this. So, Nancy, why don’t we get started?

Our first question comes from Katy Huberty with Morgan Stanley.

Thank you. Good afternoon. The color on backlog is helpful, but I wonder whether you could also give some color on how orders trended through the fiscal second quarter, and what you've seen from an order perspective in the month of May. And then, just related to that, you specifically said that the HPC business and conversion rates would tick up in the second half, but you stopped short of giving a similar timeline for Compute and Storage. So, just any color as to when you think orders will begin to convert in those two segments as well.

Yes. Hi, Katy. Thanks for the question. The order intake or what I referred to as the order linearity was fairly steady. We normally plan a quarter in 13 weeks. The first week is the previous backlog from the previous quarter and then the following 12 weeks. Right? We plan the linearity early on, and I will say we hit or exceeded our order linearity intake every week of the quarter. These really came down to our ability to convert the order book into revenue. In the case of HPC, let me remind everyone that to convert that order into revenue, we have to build it, ship it, install it, and turn it on. Once the customer accepts that installation, which in many cases involves large installations with a number of clusters, only then can we recognize revenue. The impact on HPC was twofold: we were unable to go to customer sites because customers were locked down like we were, and we could not install and deliver and turn it on. The same challenge exists in Compute and Storage with supply chain constraints and capacity due to social distancing, and at the component level, we saw significant disruption. As a reminder, we ship pretty much three servers every minute. So, when that supply chain stops, it becomes pretty significant. Our priority one, two, and three continues to be clearing the backlog, and that's how I think about it. Throughout Q2, we made progress in the recovery. I’ll say China is pretty much back to normal, but they are also clearing their backlog. They first had to recover the labor and depend on sub-suppliers for the components—cables, connectors, transistors—you name it. For us, the majority backlog right now is in the bucket. Regional factories, for the vast majority, are all performing at capacity except for one or two, where the rules and regulations or shelter-in-place orders demand stringent social distancing on factory lines, but the factories are all up and running. So, I am optimistic about the weeks to come. I take this a week at a time. Obviously, we continue to focus on order intake. I cannot comment on May because, as you asked, we're in Q3 right now. But in Q2, the order linearity was steady. We expect not just HPC but also Compute and Storage to continue to make progress. That's why Q3 will be different from Q2.

Our next question comes from Wamsi Mohan with Bank of America Merrill Lynch.

Yes. Thank you. Antonio, you commented on rightsizing the cost structure to a new normal. A few years ago, HPE Next was supposed to be the last restructuring program. I know no one could have anticipated COVID-19. But is it your view that you will not get back to pre-COVID levels because of secular end-market challenges, or is there a different interpretation to that?

Yes. Thanks, Wamsi. Great question. Since you mentioned HPE Next, let me start with that. I was the architect of HPE Next in the 2017 year. We launched it in the fall of 2017. I would say HPE Next was a great success story, allowing us to re-architect the company in key areas — streamlining processes and simplifying go-to-market models. Remember, we moved from a worldwide geo to country, then to a more geo model, removing layers. It allowed us to reinvest back in innovation, which I announced with the investment of $4 billion at the edge. We're starting to see the results of that, despite challenges. Now, regarding your point, this is a crisis unlike any we have faced. In 2017, I said, listen, we don't envision another cost optimization plan. However, this is a cost optimization driven by the pandemic. I see an opportunity to speed up our pivot to offering everything as-a-service. It is unfortunate that we have this pandemic causing significant economic disruption and a huge impact on communities. From a business perspective, we are more confident than ever in our strategy. The demand for pervasive connectivity is strong; that's why access points are performing well for us. Our cloud experience is being deployed everywhere from edge to cloud, and the ability to consume as-a-service is critical. My focus is to right-size our cost structure to the new normal. We don't know exactly what that new normal is at this point; we don’t know what recovery looks like. It's about allocating resources in areas of growth we see for the future while learning efficiency from what we've learned in Q1. We extended the HPE Next, which is now part of this cost optimization and prioritization plan, and digitized everything. This, I believe, will have a significant structural impact on the way people work. My expectation is at least 50% of our employees will never return to an office. The office will look completely different, which means our offices will be more focused on innovation and collaboration instea. That resizing will require new experiences and investments. Bringing it all together, we see an opportunity to accelerate strategy and drive long-term sustainable, profitable growth.

Okay. Thanks, Antonio. The negative operating leverage on Compute was quite significant in the quarter. How much of that would you say was a supply-driven issue versus demand-driven issue? And how do you think investors should think about the trajectory of that, given that you also have the significant cost actions starting to kick in? Thank you.

Sure. It was definitely a supply chain-driven issue, although demand continued to be uneven, as we discussed before, particularly in Compute. The revenue shortfall was primarily all supply chain-driven. My earlier comments indicate that our linearity in order intake was steady. However, within that, we analyzed customer segments. Sales to cloud companies—more software companies delivering value through the cloud—were steady, while business was significantly disrupted in the SMB sector. The enterprise was also more steady, but the NVIDIA likely drove the shortfall. Let's remind ourselves that the Compute platform goes through its own innovation cycles, even though it's commoditized. As we plan for Gen10, remember we communicated earlier that two-thirds of those structural changes were permanent due to richer configurations. As we're heading towards what we call Gen10.5 and Gen11 within the next 18 months, we will see that innovation cycle again, where product density, memory, and storage will increase, which is good for us. However, our focus is to clear the backlog on both the Compute side and the HPC side. Finishing installations and clearing backlog is our main priority.

Our next question comes from Toni Sacconaghi with Bernstein.

I have two questions as well. First, it sounds like you're saying there was really a de minimis impact from coronavirus on demand, and this was largely supply chain-driven. If you have the supply and you kept backlog at normal levels, you would have done $700 million more in revenue in Q2. It sounds like if production is up and running, and if you can bring down your backlog to normal levels, such should boost Q3 revenues $700 million relative to normal seasonality. Am I thinking about that correctly? And how much progress do you think you can make on bringing your backlog down to normal levels over the course of Q3? And then, I have a follow-up.

Yes. Thanks, Toni. I hope all is well. Yes, you are thinking about this correctly. I will say there is definitely a majority that was supply chain. In the earlier comment I made regarding order intake, what happened in Q2 was primarily supply chain driven. There were pockets of uneven demand accentuated in the SMB space, which was significantly disrupted. The first half of the restructuring was supply-driven, as I mentioned previously. It is important to remember that while we saw some demand improvement in segments like VDI, big data storage, and cloud comparisons; limited our ability to fulfill orders. In Q2, our backlog was at $1.5 billion, and that's what I'm dedicated to focusing on. Yes, that's $700 million in revenues that we missed out on. I cannot provide specific forecasts for May as we are currently in Q3 but hope that activity will improve. We are indeed taking it week by week, and communication remains hopeful.

Okay, thank you for that. Maybe you could — is it unrealistic to think you could close backlog to normal levels? My second question is if you're really saying that this was largely the supply, not demand disruption, I'm still a little confused reconciling the new—sort of HPE Next too, because on your Q4 call, you were quite unequivocal there wouldn’t be another HPE Next. You felt you were in the right place on cost, you said last quarter you were doing a little more on cost, but it wasn’t structural, it wasn’t another HPE Next. Now, you are undertaking a significant multiyear structural change. A, that doesn't feel consistent with the statement that this was really a supply issue; and B, it makes me wonder—is your worry about your competitive position, or are you worried that the IT environment is going to be weaker for a while?

Yes. Thanks, Toni. Let me clarify, as I mentioned, what happened in Q2 was largely supply-driven. I cannot forecast demand entering future quarters; we base that on current order intake and broader economic indicators. Overall, I reiterate that the supply-chain issues predominantly impacted Q2. While there were pockets of growth despite the disruption—relating back to the order intake that remains steady in parts. The pandemic caused natural challenges; we are committed to cleaning the backlog and have a steady exploratory growth area, but I remain cautious. We have a structurally strong balance sheet and a strategy targeting profitable growth exiting the pandemic. Let's focus on each aspect. HPE Next was about reducing inefficiencies, which we succeeded in achieving. My remarks about HPE Next this past quarter were based around the need to provide nimbleness and reallocation of resources; hence, this optimization plan highlights that while we pursue new core area growth. We are optimistic due to continued investment in edge-computing differentiation—a plan that allows us to operate effectively and drive new solutions

Our next question comes from Shannon Cross with Cross Research.

Thank you very much for taking my questions. My first one is, I realize you're not giving guidance, but can you provide some parameters for us to consider thinking about OpEx, how much is variable, how material do you think the salary reductions will be relative to the overall base run-rate of OpEx? And, is there a significant amount of revenue that’s just sitting out there waiting to be recognized as soon as customers come back and can be trained and can accept? And I don't know, maybe something about backlog in terms of your confidence level that you're not going to lose those orders to competitors or that they are pretty firm orders? Just anything you can kind of give us to have some idea of how to think about was this the trough quarter for instance? Thank you.

Sure. Let me start, and then I'll ask Tarek to cover the first part of your question. Obviously, it goes back to Toni's question, the confidence to clear the backlog. We feel better about it than six weeks ago. But as I said earlier, we're taking it day by day and week by week. The progress is promising. In terms of size of revenue, I cannot give a precise figure right now, but I can say that HPC deals tend to be multimillion-dollar deals, with some reaching double-digit values and they are waiting to be deployed and installed globally. We have a fantastic services organization ready to execute as soon as customers allow access. I hope everyone appreciates that we’ve provided clear direction on backlog and what we are doing about it. I believe in our ability to secure it. For the first part, let me ask Tarek to discuss.

Thank you, Antonio. It's quite difficult to call the bottom or trough quarter, given the level of uncertainty that is currently visible. There's one thing we know: the uncertainty is high. Most economists we speak to believe in a U-shape recovery rather than a V-shape recovery. This informs the cost prioritization plan we've executed. In terms of costs, we are focused on achieving the majority of the $800 million net run rate savings by fiscal year ‘21, although this number will be visible by fiscal year ‘22. Our goal is to protect the financial profile while enhancing liquidity moving forward.

Our next question comes from Jeriel Ong from Deutsche Bank.

Thanks for letting me ask a question. I’d like to know more about GreenLake. While the business has grown year-over-year, why are you confident it will accelerate growth? Typically as businesses grow, it's challenging to maintain high growth rates. It seems like you're back-ending more of that growth to meet a 30% to 40% compound annual growth rate.

Sure. Thanks, Jeriel. We have a uniquely differentiated value proposition with HPE GreenLake. The introduction of HPE GreenLake Central, a true cloud-native platform where you can deploy the right mix from edge to cloud and consume as-a-service, provides us a strong competitive advantage. We've observed continuous growth in our pipeline and increased ability to convert that pipeline into larger, multi-year deals. Recently, we have seen multiple triple-digit deals being signed, which can substantially enhance our performance. Attached services round out these agreements—our operational service through the Pointnext division. I’m confident that GreenLake can realize its expected growth rate, as we've focused on solidifying our go-to-market as-a-service strategy with a differentiated suite of solutions available for consumption.

I appreciate that. Just one more question from me. It seems like the cash spend for the realignment will mostly occur in fiscal 2021. How should we assess whether that cost will be reflected in COGS or OpEx? Is there a significant difference?

By and large, we're leaving no stone unturned. The plan encompasses our entire business and will address efficiency improvements across the board. We'll make adjustments to real estate, workforce management, and collaboration. The goal is to ensure that we're adapting our strategy effectively to the current conditions, and this mix will impact both COGS and OpEx overall.

Thanks, Tarek. Next question, please. I know we're nearing the top of the hour and are five minutes over. Do we have any more questions on the line, operator?

Our next question comes from Simon Leopold with Raymond James.

Thanks for taking the question. To clarify, the revenue you just reported was primarily supply driven, and I thought it would be helpful to understand your customer verticals' structure. How much is federal government? How much is the SMB market? How much is Financial Services? I think even if we can’t predict, we have some sense of which verticals are healthier than others.

Sure. Thanks, Simon. The SMB has faced significant challenges, impacting economic indications and associated employment levels. The enterprise segments, like telco, remain steady. As we mentioned, Tarek spoke about our portfolio called Communications & Media Solutions. EMEA regions are growing, experiencing strong order growth. Overall, we've served large clients across industries diversely: telco represents a large portion of our revenue alongside financial services, which has been strong relative to retail's struggles. We need to look across a broad spectrum when assessing market health. In terms of growth and demand, we have a solid foundation to draw from, especially given the sector focus on cloud services and interconnectivity.

Our final question comes from Amit Daryanani with Evercore ISI.

Thanks. Hi! This is Irvin Liu dialing in for Amit. As I look at your cost optimization and prioritization plan that was announced today, that will result in $1 billion to $1.3 billion total cash payment through fiscal 2022. Now, is it fair to say that the cost savings plan will essentially push back the timing related to the achievement of your normalized free cash flow target of $2 billion by let's say another two to three years?

Yes. Thanks for the question. The most important aspect of our cost optimization and prioritization plan is to achieve those $800 million of net run rate savings and to retain them for as long as possible within our cost structure for enhanced margins. In Q2, if it were not for a legal settlement we had, we would have exceeded the $2 billion free cash flow mark. Effectively, what we evaluate is whether that new revenue base will be achieved back to pre-pandemic levels. Our focus remains on rightsizing the business for future success.

Thank you, Tarek. To recapitulate, last year we almost hit that $2 billion target while taking care of unique circumstances with our arbitration settlement. When we consider effective operating cash management, it leads us pivoting toward profitable growth in the long-term vision ahead. Our goal is to address the operational efficiency in a way that benefits all stakeholders, especially our clients. To wrap up, I just want to thank everyone for joining. These challenging times remind us of the paramount importance of technology in enabling transitions. Our pivots are geared towards enhancing delivery experiences for customers and partners alike. We are committed to relentless innovation. Thank you once again, and please continue to stay safe with your families. Until next time. Operator? You may disconnect.

Ladies and gentlemen, this concludes our call for today, and you may now disconnect. Thank you.