Lenovo Group Ltd

HKEX:992

Earnings Call Transcript 2024-Q1

[Jenny Lai, Vice President of Investor Relations]

Good morning, good afternoon and good evening. Welcome to Lenovo's Investor Earnings Webcast. This is Jenny Lai, Vice President of Investor Relations at Lenovo. Thanks, everyone, for joining us. Before we start, let me introduce our management team joining the call today.

Mr. Yang Yuanqing, Lenovo's Chairman and CEO; Mr. Wong Wai Ming, Group CFO; Mr. Ken Wong, President of Solutions and Services Group; Mr. Kirk Skaugen, President of Infrastructure Solutions Group; Mr. Luca Rossi, President of Intelligent Devices Group. We will begin with earnings presentations. And shortly after that, we will open the call for questions. Now let me turn it over to Yang Yuanqing, please.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Hello, everyone, and thank you for joining us today. Last quarter, we achieved USD 12.9 billion in global revenue with net income of $191 million on our non-Hong Kong FRS basis. Despite a challenging market with unfavorable macroeconomic conditions, our service-led business achieved strong growth and sustained profitability. With the non-PC revenue mix further increasing by 4 points to 41% now continuously demonstrating the effectiveness of our efforts in building diversified growth engines.

As we predicted with the PC channel inventory digestion coming to an end, the trend of shipments and activations have become more consistent. Actually, the year-on-year decline of shipment was lower than PC activations for the first time in 6 quarters. But the AUR or average unit revenue of PC was under pressure due to declining component price and intensified competition and impacted our revenue.

The entire devices market is facing the similar challenge, including smartphone tablet businesses. Meanwhile, in the short term, the infrastructure market is challenged on multiple fronts, and that had downward pressure on our top line and bottom line as well.

In the next 2 to 3 quarters, we remain cautiously optimistic about the business recovery, and the economy stabilizes and improves and the component price bottoms out. The client device market is expected to recover and resume growth in the second half of the year. With USD 850 million cost savings that excluded more than committed, we will take more actions to keep our E/R ratio more resilient, and we are still committed to continuously improving our profitability.

Meanwhile, the booming of the intelligent technologies such as AI-generated content is propelling the wider adoption for AI accelerating digital and intelligent transformation across industries. For many years, Lenovo has been driving our transformation to become a full step intelligent solution provider, and we are well positioned to capture the significant growth opportunities ahead and strengthen the cycle.

Also unchanged is our commitment to doubling our investment in innovation in medium term. Over the next 3 years, we will invest an additional $1 billion to accelerate AI deployment for businesses around the world, focusing on AI devices, AI infrastructure and AI solutions. We will continue to empower our customers and the consumers in all works of life to grasp for the opportunities in the era of intelligent transformation. Now I will talk more about each of our businesses. Let's start with SSG, Solutions and Services Group.

Last quarter, SSG, again delivered a strong growth and higher profitability. While we protected the support services business as our core profit engine, we made significant progress in expanding our managed services and the project and solution services. The revenue of which has now grown to account for more than half of the SSG business, 4 points higher year-on-year.

Over the next 3 years, the trend of digital and intelligent transformation will continue to drive strong growth of global IT spending, especially in IT services. At the same time, overall demand for vertical solutions, including smart city, smart manufacturing, smart education and smart retail, is expected to see strong growth through 2026 as well. SSG also continued to scale with our hero offerings such as digital workplace solution, hybrid cloud and sustainability, and incubate these horizontal building blocks into vertical solutions to help our customers improve employee experience and productivity. Next our Infrastructure Solutions Group, or ISG. Last quarter, its overall revenue declined year-on-year for the first half in many quarters due to overall cloud service provider, computer server demand softness.

GPU constraint impacting full AI adoption and the industry is a slower-than-expected transition to the next-generation platform. But we achieved the hyper growth in storage, software, services and high-performance computing. In particular, storage achieved a triple-digit year-on-year growth and matters the fourth largest storage provider in the world. In AI hardware infrastructure business based on the latest IDC definition, we grew by triple digits and is the #3 in the world. Driven by AI-generated content breakthrough, the ICT infrastructure upgrade is accelerating even further.

We will continue to invest in developing AI-ready and AI-optimized infrastructure, such as AI Edge, AI Hybrid Cloud as well as server and storage that support AI-centric workloads. We will persist in differentiated competition, aiming to resume premium-to-market growth and sustainable profitability as soon as possible. And we remain focused on becoming the most trusted infrastructure partner for our customers in their digital and intelligent transformation. Our Intelligent Device Group, or IDG, is still under a lot of pressure last quarter. Despite all these challenges, we maintained our global #1 market share in PCs with inventory normalized to a healthy level.

Our smartphone business achieved a record Q1 activation in 10 years with our improved channel inventory, which will bring even more growth potential for the future. We further strengthened the premium and the 5G with the successful launch of Motorola razr. We also demonstrated great growth potential in smarter collaboration and smart home areas. We remain committed to investing in technology innovations to ride down industry trends and build long-term competitiveness. We are driving collaborations on building the next-generation AI devices such as AI PC, AI smartphone to deliver certain level of inferencing.

For our smartphone business, we will continue to execute on our 3-year growth plan, which has helped us achieve a premier growth in our traditional stronghold in North America and Latin America, and make solid progress expanding into EMEA and Asia Pacific. Meanwhile, we also expanded our smart devices for our more diversified portfolio and enriched software and services to build IDG ecosystem. Lastly, at the Lenovo, we believe a challenging business environment. Online makes innovation more important. AI and computing are our anchor technologies and the critical pillars of our Intelligent Transformation strategy.

We will continue the hard work and driving innovations. Here, I would like to take this opportunity to invite you to Lenovo Tech World, our annual flagship event in October where we will showcase our AI devices, AI infrastructure and AI solutions, all for individuals, enterprises and the vertical industries. Looking ahead, we will more effectively control expenses and mitigate risks so that we can deliver sustainable profitability improvement and continue to drive transformation and innovation to build our smarter future for all. Thank you. Now let me turn it over to our CFO, Wai Ming.

Wai Ming, please?

[Wai Ming Wong]

Thank you, Yuanqing. I will now take you through Lenovo's financial and operational performance for Q1 and fiscal year 2024. Next, slide please. Despite the persisting macroeconomic headwinds, the group accelerated service-led transformation with our SSG revenue up 18% year-on-year and our non-PC sales improved to 41% of the combined sales of its 3 business groups. Our progress in inventory reduction and strong balance sheet has posted agility to capture the future growth opportunities, including AI.

We are committed to returning to target profitability, doubling the net margin in the medium to long term remains the group's priority. The group's strong gross margin reached 17.5%, driven by the increasing contribution from the high-margin service business. The group was disciplined in streamlining its operating expense structure. Operating expense was reduced by 11% year-on-year, ahead of our committed $850 million run rate savings target. However, persistent headwinds remained in the quarter and impacted IDG and ISG resulting in a 24% decline in group revenue to $12.9 billion or down 22% in constant currency.

The magnitude of the revenue decline was healthier than expected, which led to a higher E/R ratio. The quarter saw a recent note in net profit margin on non-HKFRS standard. Group profit attributable to equity holders was $191 million, down 66% year-on-year. Global economy starts to stabilize, although challenges remain. The group will continue to focus on controlling expenses, enhancing product competitiveness and identifying new growth catalysts in order to expedite business recovery and expand profitability.

Next slide, please. We continue to optimize the efficiencies of group operations for greater responsiveness to challenges and long-term growth opportunities. Cash and cash equivalent balance reached $4.4 billion in June, up 15% year-on-year. For the seventh consecutive quarter, the group delivered a net cash with a balance of $454 million, 15% higher than a year ago. Inventory was reduced by nearly $3 billion or days of inventory reduced by 7 days in the quarter, attributable to accelerated adjustment in raw materials.

Base of accounts payable and receivable together improved 17 days. The group shortened is cash conversion cycle by 24 days to negative 11 days. All of this critical steps in ensuring a prudent capital management to support future growth and accelerate business transformation. Next slide, please. Successful service-led transformation position SSG to be a key beneficiary of the new IT era.

SSG delivered a year-on-year revenue growth of 18% to $1.7 billion, highest for any first fiscal quarter in SSG history. Operating margin of 21% demonstrated business resilience and robust profitability. Operating profit of $361 million was up 10% year-on-year. SSG continued to enrich its service portfolio across all 3 segments to meet evolving customer needs and to drive scale and profitability. Management services grew 54% year-on-year, capitalizing on strong demand for TruScale-as-a-service solutions, including first TruScale wins in Gulf countries in the quarter.

Revenue of Support Service increased 9% year-on-year, thanks to rising penetration rates that came with greater popularity of past services such as premium support and sustainability offerings. Project & Solutions Services revenue rose 9% year-on-year supported by strong demand for vertical solutions. Next slide, please. After outperforming the sector in growth for past 3 fiscal years based on server revenue, ISG was ultimately impacted by accelerated weakness in cloud server compute spending, combined with global GPU constraint impacting the AI server supply chain and a slower-than-expected transition to the next-generation platform. ISG reported Q1 revenue of $1.9 billion, down 8% year-on-year.

The segment operating performance turned into a loss of $60 million as a result of a smaller scale operations. Despite its service sales being impacted by these short-term sector-wide headwinds, ISG achieved multiple sales records across several product categories, showcasing its success in portfolio expansion. Storage revenue more than double year-on-year. Sales of Edge products and software increased by strong double digits in high-performance computing. ISG continued to rank as the top global player growing at 45% year-on-year in Q1.

In terms of server product, since cloud orders tend to be bulky in nature, its sales pattern can be more accurately assessed on a semiannual basis. ISG first half year run rate growth in calendar year 2023 is negative 4%, which is at a premium to sector growth. This product strategy plays an important role in enabling a broader adoption of AI by simplifying the deployment of AI solutions for businesses. The group has an AI-ready portfolio of smart devices and Edge to cloud infrastructure, and Lenovo and ISG will invest an additional $1 billion to further expand its portfolio to provide one-stop state-of-the-art AI enablement and solutions. Most recently, ISG new ThinkSystem model utilizes the most powerful universal GPU accelerator that deliver breakthrough performance for large language model inference and retraining and graphics and video applications, including AGPU support.

Another focus area is our investment in building an AI ecosystem. Lenovo AI innovators program is now delivering 150-plus turnkey solutions, helping businesses implement generated AI immersive metaverse simulations and cognitive decisions at scale. Next slide, please. Having navigated through the final phase of inventory digestion in the sector, the magnitude of IDG shipment decline was substantially moderated in Q1. The trends of PC shipment and activations are now more consistent.

Nevertheless, our actions to clear inventory across the sector led to more competitive pricing pressure. And as a result, IDG's revenue declined 28% year-on-year. The segment operating profit decreased by 39% to $650 million. IDG maintained its leadership position in global PC sector, the business made a great progress in seizing growth opportunities beyond PC products with non-PC sales making up 21% of IDG's revenue. Smartphone revenue declined at the beginning of the quarter but its activation rate would represent the actual customer demand, rose double digit year-on-year towards the end of the quarter.

Overall, the group's quarterly smartphone activation set a 10-year record for fiscal year first quarter to support demand recovery, and the trend is particularly strong across EMEA, Asia Pacific and North America. Smartphone premium mix achieved a record high of 18%, driven by successful recent launch. Next, slide please. Now let me shift gears and talk about R&D investments. As we continue to invest in innovation to foster diversified growth engines, R&D spending as a percentage of revenue rose to 3.5% from 3% last year.

AI has become a key enabler for many technologies and will unleash higher operating efficiency for us. More importantly, AI has created tremendous opportunities given the group's comprehensive and diversified exposure across devices, infrastructure and services. As mentioned earlier, we announced in June this year to invest an additional $1 billion over the next 3 years in AI. We have also extensively collaborated with many key partners to develop next-generation product road map and solution portfolios together. This strategic investment and collaboration will build our competitiveness in the long run.

Next slide, please. The group is consistently recognized for its ESG performance with numerous accolades, including the best employer for diversity award by Forbes. MSCI upgraded the company's ESG rating to AAA while EcoVadis acknowledge the group's excellence in sustainable procurement with an outstanding program leadership award. Lenovo has once again been named in the Gartner Supply Chain Top 25 for 2023, ranking 8th in the list of global companies with supply chain operations. The company has fully embraced digital transformation across its complex extensive supply chain network.

Additionally, Lenovo was highlighted in the Bloomberg Gender Equality Index for the fourth consecutive year.

Next slide, please. The trend of digitalization will unlock new opportunities in computing and AI solutions. AI is incredibly powerful, and we are leveraging our group's full capabilities to unlock the potential of AI. And these opportunities should benefit all business groups from infrastructure to services and devices. Looking ahead, SSGC promising prospect for digital transformation, and we'll continue to scale with next-generation offerings, including digital workplace, hybrid cloud and sustainability solutions while safeguarding its core business with high value-added support services.

Strengthening partnerships and channel tools are also key growth initiative for SSG to enhance its contribution to the group's success. ISG has built industry-leading full stack offerings and expanded to end-to-end infrastructure solutions that include hybrid cloud, HPC, data management, AI and Edge computing. AI provides new growth opportunities for ISG, and its unique ODM Plus business model addresses the growing demand for vertically integrated supply chains. The business will continue to diversify its customer base and drive new account acquisitions. The approach will achieve an optimal balance between general purpose and customized cloud offerings while ensuring an appropriate scale and efficient cost structure to drive revenue growth and profitability.

The global PC market is stabilizing and well positioned for year-on-year recovery in the later part of 2023. In addition, the increasing popularity of a digital life centered around PC will drive demand structurally higher than the pre-pandemic level. The commercial upgrade cycle and the premiumization trend will help IDG drive premium to market growth. IDG will continue to drive efficiency with its lean operations, maintain healthy cash generation and invest in non-PC areas, including fast-growing accessories and work collaboration solutions. It's smartphone business will focus on portfolio and regional expansion as well as differentiation to take advantage of accelerated 5G adoption.

Meanwhile, the group tries to reinforce its #1 position in the PC sector with leading profitability and accelerate innovation-led growth in non-PC and adjacent areas, including accessories. Our strong financial position provides us a solid foundation to proactively pursue growth opportunities ahead. Finally, as always, we remain committed to driving sustainable growth and profitability improvement for our shareholders. Thank you. We will now take your questions.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Wai Ming. Now we will open the line for questions, and this session will be in English only. Please be reminded to limit yourself to 2 questions at a time. Operator, please give us your instructions.

[Operator]

[Operator Instructions]

[Jenny Lai, Vice President of Investor Relations]

Thank you. Our first question is coming from Donnie Teng from Nomura. The first question is what would be the reasonable operating margin for IDG business? Would it be going back to the pre-COVID level?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes. So can Luca answer the question, please?

[Luca Rossi]

Yes, of course. And good morning, good afternoon to everyone. So look, in Q1, our IDG operating margin was 6.3%. Looking forward, we aim to maintain a superior operating margin than what was in pre-COVID. We think this could be driven by improved commercial and also premium mix and higher penetration rate -- range, sorry, of Attached services and also better design to cost, which is helped by our very strong R&D capabilities.

Also, higher ASP average price will contribute to a better operating scale paired with a tight expense management. Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Luca.

[Yang Yuanqing, Chairman and Chief Executive Officer]

So Luca, I don't know whether 6.3% is higher or lower than pre-COVID. I think at least is equal. From a profitability point of view, I don't think it's -- 6.3% is lower than pre-COVID. But definitely, we still have room to improve, for sure.

[Luca Rossi]

Yes. I think it's in the range of pre-COVID. And depending on the quarter, also the scale plays a very important factor. So -- but for sure, we aim to do better than pre-COVID. That's for sure.

[Jenny Lai, Vice President of Investor Relations]

Thank you, both. And we have the second question also coming from Nomura. Second question is on AI opportunities. Could you elaborate more on the progress of AI server projects by adopting NVIDIA's A/Edge GPU series? Are we going to have a project by using AMD solutions and AIGC?

What will be the incremental content goes? And what kind of new ICs or components would be aided or upgraded to?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes. So it was spread into 2 questions -- 2 answers. So probably Kirk will answer the first part.

[Kirk Skaugen]

So definitely -- thanks for the question. Lenovo is absolutely committed to deliver real user value on AI from the pocket to the cloud. As we discussed, we've now further invested USD 1 billion to accelerate this AI innovation and deployments. I think we're seeing tremendous demand. So let me share with you a few proof points on why we're excited about AI and the growth.

First, per IDC's latest report, our infrastructure AI business grew 139% year-on-year, and we've now grown over the past few years now to #3 in the world for AI infrastructure. And we've said that we now have over $2 billion in revenue from the ISG business on AI. We launched this AI innovators program, and we now have over 65 AI optimized platforms in the market. And to your question, we'll be launching additional products as we get through the fiscal year. We've had 45 ISV partners that are now delivering over 150 AI solutions into the market, and we have now over 100 active proof of concepts into the marketplace.

We also were public that we are the leading provider of Omniverse and OBX in the cloud, partnering with NVIDIA and with Microsoft. And we just recently announced a new product called the SR 675 with the new NVIDIA L40 SGPU. And where we're going to further extend our leadership with 8 GPU support for generative AI, for metaverse simulations and for other parts of AI.

And then lastly, yes, you're correct. We are partnering with Microsoft, NVIDIA, AMD, Intel and Qualcomm and planned out leading solutions across all these areas. So with that, we expect the AI market to be growing at, at least twice the market, we plan to extend our leadership position. Thank you.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Thank you, Kirk. So Luca, can you talk a little bit more on the AI PC?

[Luca Rossi]

Yes. So AI PC will be an inflection point for the entire PC industry. And we believe it will be driving a significant replacement cycle that is valued for commercial and consumer segments. Today, AI is already present in our devices with our own IP. But what we are talking now for the future AI PC is a new class of devices with a dedicated NPU that will allow a certain level of inferencing at the Edge.

There will be several innovations with great productivity features, security, privacy, improvements in battery life, improvements in some factor. And we think that we can be really -- we will be a great beneficiary of this AI PC trend, given the possibility for us to leverage our pocket to the cloud offering, including our Edge to cloud collaboration, multi-OS, multi-device R&D efforts that we have done now for a long time. Thank you.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Thank you, Luca.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Luca. Thank you, YY. For now, we have 2 cost ranges coming from Albert Hung with JPMorgan. Question one, could you elaborate details regarding to where Lenovo is going to invest in AI? Or does Lenovo see the addressable market to be in AI for data center and PC?

And question two, how quickly could Lenovo monetize this AI investments, i.e., its contribution to the total revenue? And what is going to be the growth rate in the next 2 to 3 years?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Okay. So thank you, Albert, for the question. So actually, AI is not new for Lenovo. So for years, we have been embracing AI from all aspects. So we have built our advantages in computing power from client to Edge to cloud and the network.

And as Kirk has said, we are investing a further USD 1 billion over the next 3 years in AI-driven innovation. No doubt a recent breakthrough in large language model or AIGC marks a major leap in development and application, although it's just 1 part of the narrative, but we believe is a catalyst and accelerate that will boost the adoption of AI so that it becomes relevant and real to the average person. But this is definite -- consistent with our 3 strategy. So more powerful infrastructure with GPUs, NPUs or heterogeneous computing and certainly a more powerful devices as Luca just introduced. This is because more inferencing will have under the device side in the future, whether it's for accessibility or privacy protection consideration.

So we are leveraging this way to drive our business groups addressing the real market beyond the hype and executing our strategy. So we will spend our money to make our devices more powerful -- more AI ready and optimized. So like Kirk and Luca just introduced AI PC, AI smartphone, AI server and storage, so are definitely our focus area. So actually, we'll probably -- we'll continue to embed this new AIGC technology into our smart vertical solutions to help our customer -- enterprise customer to improve their productivity as well. We are definitely collaborating with partners like Microsoft, Qualcomm, NVIDIA, Intel, AMD to build our next-generation product road map and the solution portfolio together.

So our partners value us not just because of our road to market capability, our design capability, but particularly our ability to develop across ecosystems. So Windows, Android and across the silicons, so x86 arm, et cetera, et cetera. So we definitely believe. So we are a leading company in providing the AI-ready, AI-optimized devices and infrastructure. Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you. And the next question -- 2 questions are coming from Mr. Howard Kao from Morgan Stanley. First question, can you talk about your PC inventory levels and how you view PC margins trending over the next couple of quarters? Also, how do you view the total PC 10 for 2023 and 2024?

And question number two, ISG, can you talk about the challenges you are seeing for the cloud? Any color on why the business went to losses again? Is it due to ASP pressure or mix change? And where do you think as you can go back to the profits?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Okay. So Luca, the first question is yours.

[Luca Rossi]

So our channel inventory level has now been corrected, and we are operating at a similar level of the channel inventory as the pre-COVID. We are comfortable with this level, and then we look cautiously optimistic in the second half to see shipment grow year-over-year, driven by our record activation share, normalized channel inventory, as I mentioned, and improving underlying demand and, of course, more favorable compared with the second half of last year. In regards of the PC market, we think it will end up at the low end of our guidance for this year, so around $250 million, $255 million. And then we expect a single-digit growth in 2024, helped also by the Windows 10 end of life from Microsoft, and then an accelerated growth in 2025 with a massive AI PC launch. In regards to the margin, despite the competition has intensified, we are working hard to maintain the same or better margin level, and that is driven by several actions, including mix, segment and product mix, procurement scale, our design to cost stability and also many product portfolio optimization programs that we have launched 1 and 2 years ago as well as strong operational expense discipline among other section that we are taking. Thank you.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes. So Kirk, second question for you.

[Kirk Skaugen]

Sure. So regarding the cloud and the dynamics we're seeing there, I think inherently, the cloud is a little lumpy because of the large customer base of the hyperscalers. We believe that if you look at calendar first half of the year, we actually executed at a double-digit premium to market. But if we look at this current quarter, I think we had some highlights and then some slowdown areas. As you saw, we grew our storage business more than 120% and crossed over to become the fourth largest storage vendor in the world and #1 in price bands 1 through 4.

So storage is doing extremely well for us. AI infrastructure, like I said, grew 139% year-to-year, but we are seeing GPU constraints. And in general, there is a move from server compute -- like general purpose compute over to AI workloads that's constrained by GPU. There is inventory consumption happening given the global macroeconomic environment. And we saw a slower-than-expected transition to the new DDR5 platforms based on the premiums on DDR5 and the overall value proposition of those.

So having said that, I think we are highly confident that as we go through our fiscal year, we're going to see an improvement from this quarter's results in the cloud and in enterprise SMB. As the world pivots more to AI and we have the 65-plus platforms launching into the market as well as our consistent expansion in storage, which obviously is well over 100% premium to market. Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Kirk. And the last question is from Mr. Kumar with Tech Insights. This is on smartphone. What are the key markets for Motorola smartphone business?

And what will be the key focus areas for the next 1 year? How was the foldable phone device performance?

[Yang Yuanqing, Chairman and Chief Executive Officer]

So Buniac is online?

[Luca Rossi]

No.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Not online. So Luca, yes.

[Luca Rossi]

So the key markets for Motorola are clearly Latin America, where we hold the strong #2 position with over 20% of market share. And the second strong hold is North America, where we are #3 and we continue to see opportunity to grow. Then in EMEA and AP, Asia Pacific, these are the geography where we are hyper growing when the last quarter, we had more than 20 points of premium to the market in each of these 2 geographies. Then what are the priority in the next year? I think we are putting a lot of focus on premium franchisees like our Edge and the razr franchisee, which represented close to 20% of our shipments and revenues in Q1 -- sorry, revenues in Q1.

And within this, you were asking on the foldable, and we are very happy with our razr launch. This is our fourth generation.

Just to give you an idea, in the first 120 days from the launch, we have shipped more than 3 times what we shipped for the 3 generations of the previous razr combined. We are receiving phenomenal feedback from the channel and end users. So giving us a lot of confidence on our strategy to balance the scale with also a presence in the premium segment, particularly in the innovative foldable segment. Thank you.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes. Regarding of our smartphone business, although last quarter declined as much as a PC, but I'm less worried about that. So as I said, my opening, actually, from an activation point of view, last quarter was the highest Q1 in 10 years. So this business is just consuming the channel inventory. So I think it should leave us more room to grow in the coming quarters.

[Jenny Lai, Vice President of Investor Relations]

Thank you, YY. Yes. And the next question is coming from Wes Chen from UBS. Could you comment on the outlook of enterprise server and general servers for 2024?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Kirk, yes?

[Kirk Skaugen]

I think if you look at our fiscal year and you look at the IDC reports, generally speaking, they're expecting a flat market. I think there'll be another quarter of inventory digestion by the large clouds and a pivot over to AI. And as we get into the second half of this year, we believe we'll have significantly improving results based on the portfolio and the demand we see. As I said earlier, we're seeing records across the business in general purpose and enterprise. So we've had 9 consecutive quarters of growth on our Edge server business with another double-digit growth quarter.

We had 45% growth in HPC, retaining our #1 position on the top 500 and #1 in the green 500. Server-based storage is growing, like I said, for us, well over 100 premium to market. And then our profit drivers underneath that, storage services and software are all growing at records this quarter as well. So it really is just a pause by the hyperscalers, I think, and that we see in the second half of the fiscal AI and overall demand coming back. Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Kirk. And the next question is coming from Ben with Technology Business Research. His question is TruScale best deals. Since the launch of [sync] phone, have you seen the material increase in terms of the number of TruScale best deals, including the smartphone? Overall, how would your TruScale does signs trending in the last couple of quarters?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes. So Kin, our SSG President, will answer the question.

[Kin Hang Wong]

Okay. Thank you, Ben, for your question. And good afternoon, good morning, everyone. So overall, we see -- we continue to see a strong demand from overall as a service, which cover from pocket to the cloud, right, starting from smartphone, PC, tablet, all the way to infrastructure. And this is also in line with the market data that we have seen from Gartner and IDC.

This is continued to be the sweet spot of the market in terms of growth. Now regarding some of the demand that we see in the market, right? Definitely, device-as-a-service continue to grow, and we see pockets of opportunity around high-performance computing and hybrid cloud even faster more demand coming from our customers. And especially about phone, right, when we look at the past few quarters, right, even -- especially when we look at our internal data and also to our interaction with the customer, the demand for phone in the business scenario is getting more, right? So as a result, right, our TruScale offering is exactly addressing the customer requirement because at the end of the day, the customer is looking for a one-stop solution spanning across all devices and infrastructure within the enterprises.

Thank you.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Thank you. Thank you, Kin. Next one.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Kin. Yes. The next question is coming from Mr. Desmond Lim from Eastspring. The company has been showing strong working capital management in the current quarter. Can you give some guidance on working capital trend going forward?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes. Wai Ming, our CFO, will answer the question.

[Wai Ming Wong]

Desmond, thank you for the question. We definitely put a lot of efforts in improving our working capital. And especially, if you look at our balance sheet, we at least get the inventory down by nearly $3 billion year-to-year as well as continue to improve. At that time, we'll continue. We will continue to improve how we actually manage our capital because one of the key priority for us is to keep the company very liquid so that we will generate more cash, I think, to invest in the growth area.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Wai Ming. And we have the net question coming from [Mr. Dodge] with [indiscernible]. On commercial PC recovery in end of 2023 and start of 2024, are you seeing any difference in demand strength between SMB and enterprise?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes. So Luca?

[Luca Rossi]

So we see our commercial relational segment at this point of time to be stronger than the SMB and also with a good outlook for the second half and the pipeline for 2024. SMB has been impacted in terms of the shipment also by the channel inventory correction. SMB is a business model where channel plays a bigger role than the pure commercial. So that is probably a significant difference that shows up in the performance so far year-to-date. We think SMB will return to grow as well, with the inventory, as I said, being normalized and the underlying demand stabilizing in the near term.

The demand in SMB, I would probably say that it's the one more impacted by the macroeconomic condition. So hopefully, we will also see a relaxation in 2024 of that macro to get more natural demand from SMB. So -- but commercial, at this point of time, we see stronger than SMB. Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Luca. And the next question is coming from [Dino Chen] from Grand Alliance Asset Management. Could you please share with me the level of both margin and operating margin of the AI server business compared with those of general server business, please? Thank you.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes, Kirk. Hey, Kirk?

[Kirk Skaugen]

I'll answer the question, sure. So I think we're trying to put AI into everything we do in this -- in the infrastructure space, from Edge server to storage to general purpose to cloud. So it's probably -- the answer is probably based on segment. I think in the Edge, we're seeing amazing new use cases with these over 150 solutions in these POCs where our Edge margins are likely improving because of the AI workloads that are getting put on them. We now have the densest Edge server in the world with more GPU support, and we're seeing proof of concepts that more than half of the global fast food chains, for example, because of that.

In the cloud, I think it's a very aggressive and fierce competitive market. But I would say in storage, our growth of 120% year-on-year is driven, again, because we're putting more and more AI into our storage business as well. And you can see that in the most recent announcement we've had. So I would say it's a mix in the cloud. It's very fierce competition and probably lower margin.

But in Edge, storage and general purpose, we'll be delivering real value to the customer that's helping us improve margins a bit. Thank you.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Thank you, Kirk.

[Jenny Lai, Vice President of Investor Relations]

Thank you. Yes, thank you, Kirk. This is going to be another question for Kirk as well. It's from [Mr. Fung] with TBR. He is asking, given ISG's strong storage business over the last year, how should we think about the growth potential over the medium term, specifically 1 to 3 years with regard to the ODM Plus contract ramp-up versus enterprise.

[Kirk Skaugen]

Yes. I think we're very excited about our storage growth that we've had. Again, in a market that's growing at low single digits, we're well over 100% -- year-on-year, we're 120% growth. So again, we crossed over to being #4 in the world overall and now #1 in price bands 1 through 4 in $25,000. So our growth is in the entry traditional NAS and SAN in the midrange, in software defined, in cloud, in high-performance computing.

So we're seeing records in our storage business essentially in almost every part of the world and every piece of our -- of the segments we participate in. Relative to the growth rates, I think we're challenging our segment managers to continue to grow at a premium to market in every piece of the business. So we will have new cloud storage designs, and we think we'll continue to grow at a significant premium marketing cloud. But we've also had new partnerships with partners like WECA, where we're seeing growth as well. So I would say all aspects of our storage business continue to be very exciting for the horizon.

Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you. And now we also have our last question from [Mr. Kuo] with Fullerton Fund Management. His question is on ISG as well, which recorded operating loss of USD 60 million. Is this related to investment in AI products or revenue bookings?

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes, Kirk.

[Kirk Skaugen]

Yes. We have to say we have confidence in our long-term strategy, and we think we'll continue over the long term to ramp our revenue at a significant premium to market while continuing to improve profitability. Again, if you look at the first half of the year calendar, we executed a premium to market. So I think this is a temporary issue as the cloud pivots to AI. They're consuming inventory of server compute and pivoting that to storage and AI use cases.

So as we get into the second half of the year, that will significantly improve. In the meantime, because of the lower-than-expected revenue, we're continuing to invest, for example, in AI and in storage to generate these 100-plus percent growth rates like we've shown in AI and storage, 50% growth in software, 45% growth in HPC, 9 consecutive quarters now double-digit growth in the Edge. So I think this is a temporary phenomenon, and we're confident in our long-term revenue and profit improvement strategy as we go towards the second half of this fiscal year. Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Kirk. And this is our last question for this webcast. And I would like to invite Yuanqing, YY, to give us a very short remark. Yuanqing, please.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Yes. So definitely, the -- in short term, so the macro economy is very challenging. So they impacted our last quarter performance. But for the remaining quarter of the fiscal year, so we are still cautiously optimistic. So we think the overall device market is stabilizing.

So we have finished the China inventory digestion. So from now on, so shipment will be consistent with the activation. So we are confident quarter-over-quarter. So we will see the improved performance no matter it's in the top line or in the bottom line. So to protect our bottom line, so we announced our $850 million cost-saving plan.

So we are -- so far, we have been above the track. But probably we will take even more actions to ensure our expense is consistent with the forecasted revenue so that we still can deliver the rather stable profitability to our shareholders. So definitely it's another opportunity. So we will invest more money in that space based on our client Edge cloud and network and intelligent architecture. So we think we will be a leading company, so in the AI-related devices, AI-related infrastructure under AI-related vertical solutions and the services.

So that's my summary for last quarter and the future. Thank you.

[Jenny Lai, Vice President of Investor Relations]

Thank you, Yuanqing. And we also want to thank you, everyone, for joining today's call. If you have any further questions, please feel free to contact the IR team directly. And the replay of this webcast will be available in the next couple of hours on our Investor Relations website. Thank you again for joining us. Bye, bye.

[Yang Yuanqing, Chairman and Chief Executive Officer]

Bye, bye.