Earnings Call Transcript - HPE Q3 2020

Operator, Operator

Good afternoon, and welcome to the Third Quarter 2020 Hewlett Packard Enterprise Earnings Conference Call. My name is Cole, and I'll be your conference moderator for today's call. At this time, all participants will be in listen-only mode. We’ll 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, Corporate Development and Investor Relations.

Sonalee Parekh, SVP of Corporate Development and Investor Relations

Thank you, operator, and good afternoon. 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 third 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 webpage 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 obligation 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 July 31, 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-on-year basis and adjusted to exclude the impact of currency. Finally, please note that 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.

Antonio Neri, CEO

Thanks, Sonalee, and good afternoon, everyone. Thank you for joining us today, and I hope everyone is staying safe and healthy. Overall, I am pleased with our Q3 performance. We executed well to enable strong sequential growth across our businesses. We gained momentum in key areas of differentiation driven by customer demand aligned to our strategy, and we began to take decisive and prudent actions to strengthen our core financial foundation while we continue to align resources to critical areas of growth. COVID-19 has forced fundamental changes in businesses and communities. These changes have further validated our strategy. Navigating through the pandemic and planning for a post-COVID world has increased customer needs for other service offerings, secure connectivity, remote work capabilities and analytics to unlock insights from data. Our solutions are aligned to these needs, and we see a tremendous opportunity to help our customers transform and digitize their businesses as they continue to adapt and operate in our new world. Let me review a few highlights from the quarter. Total net revenue of $6.8 billion was up 14% quarter-over-quarter and non-GAAP operating profit was up 33% quarter-over-quarter. Compute, HPC & MCS, Storage, and Intelligent Edge business segments also grew sequentially. Moving forward, we expect continued gradual performance improvement. We made significant improvements in our supply chain execution, reducing our backlog by more than $500 million from our Q2 historical high exit levels, which contributed to our results. In our HPC business, COVID-related impacts continued to affect our customers' ability to accept delivery of our products. We expect to return to normalized level of backlog by the end of Q4 through continued improvements in both supply chain execution and customer acceptances. Our pivot to as-a-service continued its strong momentum in the quarter. Our annualized revenue run rate of $528 million grew 11% year-over-year. GreenLake services orders grew a record 82% year-over-year. We believe this is faster than the orders growth of public cloud vendors and it is a validation of our hyper strategy and competitive differentiation. We are focused on delivering one seamless cloud experience for all applications and data, no matter where they exist: at the edge, in a data center, in a colocation, or in a public cloud estate. While others are now publicly declaring plans to offer Everything-as-a-Service, we have been focused on this for several years and have made significant organic and inorganic investments to deliver a differentiated experience for our customers. Our Q3 free cash flow of $924 million was up $276 million year-over-year, driven by a record cash flow from operations as a result of our improved execution this quarter. Importantly, we also declared our Q4 dividend today. Dividends remain an important part of our capital allocation framework that consists of capital return to shareholders and strategic investments that together drive long-term shareholder value. Our customers are managing through the pandemic with even greater needs for the capabilities HP can uniquely provide. In June, we put our strategy in the spotlight at our Discover Virtual Experience event, where we introduced new breakthrough innovation on a global virtual stage. The new solutions we introduced support our position that cloud is an experience, not a destination, and they're already gaining traction with our customers. We launched our next-generation of HP GreenLake Cloud Services. These new cloud services span machine learning operations, container management, virtualization, Infrastructure-as-a-Service, data protection and Connectivity-as-a-Service. Now, our customers can access all of our HP GreenLake Cloud services via a soft service point-and-click catalog on our HP GreenLake Central Cloud Portal. Notably, in Q3, we signed several of our largest HPE GreenLake Cloud services deals in history, including LyondellBasell, one of the largest plastics, chemicals, and refining companies in the world who signed a $27 million HP GreenLake deal to drive their digital transformation and environmental efficiency. Underpinning our customers' cloud experience is the need for software. That is why we introduced our new HPE Ezmeral software portfolio. Our new portfolio includes a container platform that deploys Kubernetes at scale for a wide range of use cases on bare-metal and virtual machines. A data fabric that delivers enterprise-wide global access to data from edge-to-cloud with best-in-class reliability, security and performance, and a machine learning operations solution that increases speed and agility for machine learning ops by operationalizing end-to-end processes from pilot to production, as well as IT operations and automation to improve productivity and mitigate risk of service disruption. In addition, it enables our customers to control cost and compliance across their hybrid cloud estate through our managed cloud controls capabilities built into the portfolio. HPE Ezmeral can be consumed as a license or as a part of our HPE GreenLake Cloud Services offering. Just a few weeks ago, as a strong endorsement of our strategy and capabilities, we announced plans to partner with SAP to deliver the customer addition of SAP HANA Enterprise Cloud with HPE GreenLake Cloud Services. This new joint solution will help customers leverage our cloud capabilities while keeping their SAP workloads and data on-premises. At the same time, we continue to strengthen our core capabilities in Storage and Compute, which are essential resources to store and process customers' data. Every 60 seconds, we ship 46 terabytes of storage in four servers. Despite the challenging market that impacted our storage performance overall, in Q3, we saw sequential improvement of 4%, and importantly, we gained traction and grew in key areas of investment. Big Data storage, which is built on unique intellectual property from our MapR acquisition to enable real-time analytics for mission-critical Big Data workloads, grew revenues 31% year-over-year. Nimble distributed HCI, our new hyper-converged solution for business-critical applications and mixed workloads of scale grew revenue at 112% year-over-year. A great example of our organic innovation, HP Primera, our most intelligent storage platform, grew revenues 114% year-over-year. HP Primera gained 104 new logos this quarter, with nearly one-quarter of those being new to HP Storage. We saw strong sequential momentum with HPC in mission-critical systems that grew 10%, including a 10-year deal of $125 million with the University of Edinburgh in Scotland, who chose HPE to power the Edinburgh International Data Facility with our industry-leading HPC and AI solutions. Finally, we had a very solid quarter in Compute, with 29% quarter-over-quarter growth driven by the reduction in backlog and customer demand in VDI, or Virtual Desktop Infrastructure solutions. For example, Erasmus University Medical Center in the Netherlands wanted to upgrade its VDI environment for lifecycle management needs and to prepare for future waves of COVID-19. We introduced a complete composable hyper-converged infrastructure solution based on HPE Synergy along with HPE Primera to meet their needs. Our Intelligent Edge business performed in line with the market in Q3. We continue to see the edge as a significant opportunity over the long-term. The explosion of data devices and applications will drive demand for secure multi-protocol connectivity, analytics and cloud computing capabilities at the Edge, especially in the post-COVID world. We are now entering the edge of insights, driven by the amount of data we are generating and the utilization of new analytic tools, such as machine learning and artificial intelligence technologies. Customers are looking to power a new breed of applications and workloads that work in concert with the cloud but analyze and process data at the edge. To enable these new customer needs, we introduced the Aruba Edge services platform, or Aruba ESP, the industry's first AI-powered cloud platform designed to unify, automate and secure the edge. The Aruba ESP combines AIOps, Aruba Zero Trust security and a unified infrastructure with financial and consumption flexibility. We are seeing early customer adoption. Noble Hospitality, a luxury lifestyle brand, is standardizing on our Aruba Edge services platform as their edge cloud foundation for the hotel chain. The ability to generate actionable analytics where the data is created and deliver new on-property experiences for guests was critical to their decision. We also announced our plans to acquire SD-WAN leader Silver Peak. Silver Peak's advanced SD-WAN offerings strengthened our Aruba ESP and complement Aruba's existing work-from-home and branch office solutions to deliver one of the industry's most comprehensive portfolios designed to securely connect any edge to any cloud. This combination, which is expected to close in Q4 of this fiscal year, will allow enterprise customers to simplify their branch office and WAN deployments to empower remote workforces and enable cloud-native deployments and transform business operations without compromising quality or reliability. These are great examples of accelerating our strategy while maintaining a disciplined approach to capital allocation. Building on our 5G Core Stack launched in March, we introduced a new Telco Edge Orchestrator Solution for telecom operators. This new solution provides revenue opportunities for telecoms in the enterprise market with one-click deployment of applications at the edge of the new 5G networks. We are receiving positive feedback on our 5G offerings. For example, we announced an innovative technical demonstration of an automated virtual 5G network conducted with a French telecom operator, Orange, and telco infrastructure solutions provider Casa Systems. The demo highlights the expanding use cases and service agility needed to support 5G business applications, including location-based telemetry, IoT, edge computing and more that will require low latency. Our ability to innovate for our customers is made possible by strong financial management that strengthens our core financial foundation and allows us to align resources to the most critical areas. As we exited Q2, you will recall that we took a number of decisive and prudent actions to manage our business through the evolving impacts of COVID-19. This included several short-term initiatives to reduce operating expenses and drive efficiencies as well as the introduction of a long-term cost optimization and prioritization plan designed to accelerate sustainable profitable growth. We remain on track to deliver the annualized net run rate savings of at least $800 million by the end of fiscal year 2022, driven by optimizing our workplace site strategy, simplifying our product portfolio and introducing new digital customer engagement models. These efforts, backed by our diversified portfolio, robust balance sheet and investment-grade credit rating, will allow us to continue to invest in key growth areas. In closing, I am proud of our Q3 performance, and I am proud of our HPE team. Our team members have been steadfast partners for our customers through an unprecedented period. They have moved quickly to address rapidly evolving market conditions. They have innovated with our customers in mind. They have made personal sacrifices to invest in our company's future. They have passionately committed to help HPE play a role in shaping a more equitable and inclusive society. They have done all of this while managing the challenges of living through a global pandemic. Put simply, my HP colleagues have represented our values, culture and delivered on our purpose to advance the way people work. As a result of their efforts, HP is stronger and better able to serve our customers, partners and communities in a world that's forever changed. While we continue to navigate through the global pandemic and macro uncertainty, we are cautiously optimistic that we will see gradual quarter-over-quarter performance improvement going forward. This is why we are providing guidance for our fiscal year 2020 non-GAAP EPS, which Tarek will discuss. We look forward to seeing you virtually at our Security Analyst meeting on October 15, where we will provide more details about our long-term plans. With that, let me turn it over to Tarek to review the quarter's results.

Tarek Robbiati, CFO

Thank you very much, Antonio. I'll start with a summary of our financial results for the third quarter of fiscal year 2020. As usual, I'll be referencing the slides from our earnings presentation to highlight our performance in the quarter. Also, let me remind you that since the start of the fiscal year, we are reporting results according to our new segmentation. Antonio discussed the key highlights for this quarter on slide four. Now let me discuss our financial performance, starting with slide five. Q3 was characterized by strong execution, driving sequential growth. We delivered Q3 revenues of $6.8 billion, up 14% sequentially and down 4% from the prior year period. I am especially pleased to report that we have made significant progress in clearing our backlog by more than $500 million during the quarter. We expect a return to normalized backlog levels as we exit Q4 2020. As a result, we have grown non-GAAP gross profit by 8% sequentially to $2.1 billion in Q3. Non-GAAP gross margins were 30.4% this quarter, down 160 basis points sequentially, driven by a higher mix of Compute as we executed against our backlog from prior quarters. Normalizing for the effect of backlog, both our Compute and Storage business segments grew gross margin on a sequential basis. Our non-GAAP operating profit was up 33% sequentially, resulting in a 7.1% operating margin, and our non-GAAP EPS of $0.32 was up 45% sequentially. Our GAAP EPS was $0.01 as we accelerated our transformation program and incurred restructuring costs. Q3 cash flow from operations was approximately $1.5 billion, driven by strong operational execution. Free cash flow was $924 million, up $276 million from the prior year period, driven primarily by favorable working capital movements that I will detail later. Finally, we paid $154 million of dividends in the quarter and are declaring a Q4 dividend today of $0.12 per share payable October 7, 2020. Let's move to slide six, which shows our performance in the quarter by segment. Here are the highlights. In the Intelligent Edge segment, we grew revenues 3% quarter-over-quarter, in line with the market. While wireless LAN declined single digits sequentially, we grew the campus switching business 12% quarter-over-quarter. In North America, our largest geo, revenue grew 4% quarter-over-quarter, demonstrating our continued momentum. Operating margin in Q3 was 8.6%, down 240 basis points quarter-over-quarter, impacted primarily by higher logistics and duties costs in this current environment. In Compute, revenue grew 29% quarter-over-quarter as we executed against the backlog and improved our supply chain execution. Not only did units grow strong double digits sequentially, AUP grew 3% quarter-on-quarter as well. The increased operating leverage in this segment resulted in an operating profit margin of 8.5%, up 380 basis points quarter-over-quarter. In High Performance Compute & Mission Critical Systems, revenue grew 10% quarter-over-quarter, driven by strong performance in Edge Compute, HPC Apollo, and MCS, up sequentially 82%, 16%, and 2%, respectively. We expect to see sequential momentum next quarter driven by increased customer acceptance for HPC/MCS and Cray as we execute against the order book across the portfolio. Most importantly, Cray remains on track to deliver both on its FY 2020 revenue targets and triple-digit run rate synergies by the end of fiscal year 2021. Within Storage, we grew revenue 4% quarter-over-quarter, driven by strong operational execution across the segment portfolio of products and reduction of backlog to normalized levels. With respect to Pointnext operational services, which is included across our Compute, HPC/MCS, and Storage segments, total revenue was down 2%, while orders grew 1% on a sequential basis. Additionally, our services intensity, which is the ratio of attach revenue per hardware unit sold continued to be strong with solid double-digit growth on a sequential basis across all segments: Compute, Storage and HPC/MCS. This demonstrates that the underlying profitability of the units we sell and the attach rates continue to be robust. In Advisory & Professional Services, revenue was down 4% sequentially as COVID impacted consulting activity and the chargeability levels of our staff. This business is strategically important for us as it helps customers navigate through their digital transformation and also pull-through significant infrastructure and operational services orders. Within HPE Financial Services, financing volume was up 1% quarter-over-quarter despite the impact of COVID-19, and our net portfolio of assets was up 4% this quarter, driven primarily by FX movements. We maintained a solid return on equity of approximately 13% this quarter. Our bad debt loss ratio this quarter was 74 basis points, which was slightly higher than previous quarters but still best-in-class within this industry. I am particularly pleased by the collection performance in HPEFS, which attests to the quality of the book and the HPEFS franchise overall. I will come back to that later on. Our Communications and Media Solutions business that is included in our Corporate Investment segment is strategically important to us, providing software and services capabilities to telco service providers. Revenue was down 4% sequentially due to the first half slowdown in services bookings. However, due to our improved cost of delivery, we're able to expand operating margins by 30 basis points quarter-over-quarter. We continue to make good progress in our 5G core strategy that provides multi-vendor integration and true cloud-native telco network functions. Slide 7 shows our growing ARR profile, which I introduced at our Securities Analyst Meeting in October 2019. I am very pleased to report that our Q3 2020 ARR came in at $528 million, representing 11% year-over-year growth. GreenLake Service orders were up 82% year-over-year in constant currency, driven by outstanding performance in North America, which delivered 5x year-over-year growth. Our HPE Aruba Central SaaS platform continued to grow revenue strong double digits year-over-year as well. Based on strong customer demand, I am confident to reiterate our ARR growth guidance of 30% to 40% CAGR from fiscal year 2019 to fiscal year 2022. Slide 8 highlights our EPS performance to date. Non-GAAP diluted net earnings per share was $0.32 in Q3, up 45% sequentially from Q2 driven by improved operating leverage, cost control and lower OI&E expenses. We now expect fiscal year 2020 OI&E to be significantly less than our $100 million expense guidance provided at SAM 2019, driven by higher earnings from equity interest in HPC, and better cost of debt resulting from our balance sheet funding diversification strategy that I will elaborate further on. Turning to gross margin on slide 9. As I mentioned previously, non-GAAP gross profit was up 8% sequentially due to improved operating leverage. At 30.4% of revenues, our gross margin was down 160 basis points quarter-over-quarter driven by higher mix of Compute as we executed against our elevated backlog from the prior quarter. Most importantly, and normalizing for the effect of backlog, both Compute and Storage business segments grew gross margins on a sequential basis. Moving to slide 10. Non-GAAP operating margin was 7.1% in Q3 of fiscal year 2020 and non-GAAP operating income of $484 million was up 33% quarter-over-quarter. A combination of improved operating leverage and disciplined cost controls enabled us to improve profitability on a sequential basis. Last quarter, let me say this, we were proactive by announcing ahead of other industry players a cost optimization and prioritization plan that would deliver annualized net run rate savings of at least $800 million by the end of fiscal year 2022. We are making excellent progress there and are very much on track to emerge stronger in the post-COVID world. The actions we outlined as part of that plan to transform our core by optimizing our cost structure and aligning our resources through deep segmentation to key growth areas are now clearly starting to bear fruit. Turning to Slide 11. We generated cash flow from operations of approximately $1.5 billion. This is the highest level for the past 11 quarters, as we improved our operational execution. Free cash flow was $924 million for the quarter, driven by timing of working capital movements that resulted in favorability in Q3. Overall, we saw an improvement in our cash conversion cycle for minus five days in the prior quarter to minus 10 days this quarter. For Q4, we expect free cash flow to be sequentially lower, mainly due to two reasons: number one, working capital will be a use of cash; and number two, higher restructuring payments related to our core transformation plan we announced in Q2. As you recall, during the lockdown, we discussed our company exposure by industry vertical and company size and explained in detail that our business is highly resilient. As a proof point, I would like to highlight the performance of our credit collection teams in both our operating company and in HPEFS. Thanks to their contribution during the quarter, the level of our ARR that is current is at a record high of 99.5%, which attests to the strength of the HPE business and the quality of our franchise. Now moving on to Slide 12, I want to spend a moment to talk about the strength of our diversified balance sheet and liquidity position and provide some insight on the puts and takes on forthcoming adjustments to our cash and debt positions. As of our July 31 quarter end, we had approximately $8.5 billion of cash and cash equivalents, having successfully raised $1.75 billion in senior notes in July 2020 at a low cost of debt. Post the quarter end, we redeemed $3 billion of bonds maturing in October 2020. Together with an undrawn revolving credit facility of $4.75 billion at our disposal, we currently have approximately $10.3 billion of liquidity after the redemption of the notes maturing in October 2020. Additionally, we expect to pay $925 million cash when we complete the proposed acquisition of Silver Peak, which is expected to close in Q4 of fiscal year 2020. Adjusted for these known changes, our operating company's gross debt would be lower by $3 billion to approximately $4.4 billion, and our operating company's cash will also be lower by $3.9 billion to approximately $4 billion, resulting in an operating company's net debt of approximately $400 million. Separately, we have securitized some Financial Services-related debt through the ABS market in the U.S., and as of July 30 quarter end, we have approximately $2.1 billion in outstanding ABS issuances. The refinancing of higher-cost unsecured debt with ABS financing allows us to boost access to financing markets at cheaper cost of capital, which helps diversify our balance sheet and lower interest expense payments in the future. Finally, I would like to reiterate that we remain committed to maintaining our investment-grade credit rating, which was reaffirmed by the rating agencies in July 2020. Bottom line, we have a strong cash position and ample liquidity available to run our operations, continue to invest in our business and execute on our strategy. Now turning to outlook on slide 13. Given the progress made in our operations, we are now in a position to provide guidance on fiscal year 2020 EPS. We expect to finish fiscal year 2020 with non-GAAP diluted net earnings per share of $1.30 to $1.34, and we expect our fiscal year 2020 GAAP diluted net loss per share to be between $0.35 and $0.31. Let me recap our key takeaways for this quarter on slide 14. We delivered strong sequential improvement in top and bottom line and significantly improved operational and supply chain execution. We also accelerated our as-a-service pivot with very strong momentum in ARR and record GreenLake Services order growth. We're taking actions to strengthen our financial foundation and align resources to critical areas to transform our core and drive sustainable profitable growth. At this stage, given all of this, we expect gradual sequential performance improvement moving forward. In Q3, we paid $154 million in dividends to shareholders. We recognized that dividends are an important part of our capital allocation framework and returns to shareholders. Today, we are very pleased to declare a Q4 dividend of $0.12 per share payable on October 7, 2020. On a personal note, I’d like to echo Antonio's comments. We are both very proud of the way our company and team members quickly and decisively responded to the unprecedented challenges that the global COVID-19 pandemic has caused. As Antonio mentioned, we look forward to having you join us at our Virtual Securities Analyst Meeting on October 15, where we will provide an update on our strategy, financial outlook, and capital management policy. Now with that, let's open it up for questions. Thank you.

Antonio Neri, CEO

All right. Thank you, Tarek.

Operator, Operator

We will now begin the question-and-answer session. Our first question today will come from Shannon Cross with Cross Research. Please go ahead.

Shannon Cross, Analyst

Thank you very much. Antonio, can you talk a bit about what customers are telling you, maybe on a geographic basis or looking at your segments, about what they're looking to invest in? How they're feeling about IT budgets? Clearly, some of the other large-cap tech companies have come under pressure. So I'm curious as to sort of the sentiment that you're hearing from customers in the channel as they look to the next couple of quarters? And then I have a follow-up. Thank you.

Antonio Neri, CEO

Thank you, Shannon. I spend a significant amount of my time engaging with customers and partners, which provides me with valuable insights into the market. Currently, we are observing steady demand, although some areas are performing better than others. Overall, customers are focusing on strengthening their operations, making IT critical to their success, with IT resilience being more important than ever. Solutions that enhance security and facilitate digital processes are experiencing growth. Additionally, as customers manage large volumes of data, there is a pressing need for insights, leading to an increase in demand for AI and machine learning solutions. This trend has resulted in strong performance in our big data storage offerings, and we have seen high demand for our HP GreenLake Cloud Services related to machine learning operations. Moreover, the workforce is undergoing permanent changes, and remote connectivity has become essential. This is why I am particularly excited about our acquisition of Silver Peak, as it will enhance our ability to provide connectivity across various environments, including home offices, which I view as micro branches connecting to the cloud. Our approach is hybrid, encompassing multiple clouds, and there is also a significant demand for solutions that help preserve capital expenditures, which explains the momentum we are seeing with HP GreenLake Cloud Services as a true as-a-service offering. While we are currently in a transition period, enterprise demand remains steady, although small and medium-sized businesses are facing challenges. In terms of industry verticals, the financial sector appears solid, as does manufacturing. Education is increasingly important, and the public sector is demonstrating strength, supported by our distinctive portfolio of HPC and AI solutions, as well as our storage offerings. This is the general landscape we are observing at the moment. Regarding budgets, organizations are evaluating their revenues and profits, but I can say that enterprise demand, where we have the most presence, is relatively stable. This is what Tarek was referring to when he mentioned our diversified and resilient portfolio across both customer segments and solutions.

Shannon Cross, Analyst

Okay, that's helpful. And then maybe just looking at Compute, obviously, you had a benefit from the backlog. But underlying all of that, pricing, competition, component costs, I think you said that revenue was up even net of the backlog fulfillment. So, if you could just talk a bit about some of the underlying trends you're seeing there? Thank you.

Antonio Neri, CEO

The Compute business performed well, with a 29% increase sequentially and 1% year-over-year. We made great progress in reducing the backlog, and we are confident that we can return to historical levels by the end of Q4. We experienced double-digit growth in units sequentially, with a 3% increase in average unit price. In the first part of the year, commodity costs were inflationary, prompting us to take significant pricing actions, which contributed to the rise in our average unit prices, alongside structural changes in the product type. We shipped 46 terabytes of storage that integrates with the Compute systems and servers. Looking ahead, we will remain disciplined regarding pricing. Regarding commodity costs, especially DRAM, we are beginning to see declines, with trends moving downward. However, historically, when costs rise, prices escalate more quickly than they decrease, which takes longer. The next generation of the Compute platform is expected to feature richer configurations with more capabilities per gigabyte per unit. We are optimistic about our current position, but the competitive landscape in Compute remains intense. Demand is shifting across enterprise, public sector, and service provider segments.

Rod Hall, Analyst

Yes. Thanks for the question. I'll make them quick as you're done at the end of the hour here. I wanted to ask back on Compute. I think, Tarek, you had said AUPs are up 3% sequentially. Could you say what that is year-over-year on AUP for Compute? And then I'll just give you my follow-up now, so you don't have to come back to it. Could you just comment, maybe Antonio or Tarek, on visibility that you've got right now on demand, given your better commentary on demand than what we've heard from some other big enterprise players? Thanks.

Tarek Robbiati, CFO

Sure, Rod. Thanks for the question. So I'll say in Compute, units grew 36% quarter-on-quarter while AUP grew 3% quarter-on-quarter. I know you want the AUP on a year-over-year basis. I don't have that handy with me. I can follow-up and let you know what the answer is and the IR team will do that. And the second part of your question?

Antonio Neri, CEO

As I said, it depends by customer segment, depends by offer. Ultimately, what I see at this point in time has been steady. But the reality is that there are areas that are stronger and areas that are weaker. But I think it points to the diversification of our portfolio. We have a unique portfolio, and that's why we have a unique strategy to become the platform edge to cloud. I think, as I think about that, obviously, there are a lot of opportunities, particularly as we continue to pivot the company with more software and services-oriented type of offers. You can see even in Q3, some of the strength with big data Storage in our Primera, which is a software, essentially it’s a software offering based on InfoSight, up over 100%. These are the things that will continue to drive growth.

Rod Hall, Analyst

And our final question today will come from Amit Daryanani with Evercore. Please go ahead.

Amit Daryanani, Analyst

Thanks for squeezing me in, guys. I just have a question around your margin structure. Fairly impressive, I think, 100 basis points of margin uptick you guys saw sequentially. But when I kind of break it up, it looks like gross margins were down 170 basis points, and maybe more than made up for that in SG&A and R&D curtailment. So could you just maybe talk about first-half gross margin decline? Was that all mix, or were there other factors involved in it? That would be helpful. And then, the OpEx run rate you have today, is this a steady-state number we could think about as we go forward, or was there more one-off things that helped you curtail it? Thank you.

Tarek Robbiati, CFO

Thank you, Amit, for the question. Yes, your observation is right. The gross margin went down 160 basis points, as highlighted in our announcement, and we more than made that at the OP margin level, with the OP margin at 7.1%. So what's driving that at the gross margin level is purely the mix. We had more Compute revenue at lower margin; it's a mix issue. We did also articulate the fact that if you normalize for backlog, we did have an impact on gross margins, both in Compute and Storage our gross margins would be up. But also, what you can see at OP margin is the fact that we are starting to take cost out, and we are incurring restructuring costs as a result of this. I want to take the opportunity to remind everyone about our cost optimization and prioritization plan that we announced in Q2. We took proactive steps to strengthen our financial profile. I take a lot pride about this one, because we were present and we did it on time, being hit very hard in a full quarter of Q2 that was disrupted by COVID. We are on track with that program to generate net annualized run rate savings of at least $800 million by the end of fiscal year 2022 relative to the fiscal year 2019 exit level, and with most of those savings achieved at the end of fiscal year 2021. So that hopefully, should give you some comfort with respect to also the visibility point, and that's why we're saying, we expect gradual performance improvements going forward, knowing that we have taken actions with this core transformation program that is about prioritizing and reducing costs where we can find opportunities to do so.

Antonio Neri, CEO

Yes. I will say, just to wrap that up, I know that was the last question, there are significant opportunities. Remember that HPE Next was a very successful program for us and for our shareholders, and this is the next iteration. But most importantly, this is all about executing our strategy and aligning our resources to where we believe the growth is and continue to make this company even more efficient on a foundation of work we did the last three years. We are very, very confident about that and we have a disciplined and reliable track record while at the same time, we focus on innovation. Again, I will wrap up by saying I am very pleased with Q3. This was a quarter marked by strong execution and very strong sequential growth. While much of the uncertainty is still there in the market and the global pandemic is still with us, we are cautiously optimistic, and we will see quarter-over-quarter improvements going forward across our businesses. We are investing into the future, which is essential for us, but I'm very pleased with our execution in the Pivot-as-a-Service. You can see the momentum there. Hopefully, we will see you in October at the virtual event for the Security Analyst Meeting. Thank you for your time and I hope to talk to you soon.

Operator, Operator

And ladies and gentlemen, this concludes our call today. Thank you for attending and you may now disconnect your lines at this time.