HP Annual Report 2007 | Quarterlytics

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Annual Report 2007 Forward-looking Statements This document contains forward-looking statements that involve risks, uncertainties and assumptions. If such risks or uncertainties materialize or such assumptions prove incorrect, the results of HP and its consolidated subsidiaries could differ materially from those expressed or implied by such forward-looking statements and assumptions. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including but not limited to any statements of the plans, strategies and objectives of management for future operations; any statements concerning expected development, performance, market share or demand relating to HP’s products and services; any statements regarding anticipated operational and ﬁnancial results, including the execution of cost reduction programs; any statements including estimates regarding market size or growth; any statements regarding future economic conditions or performance; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing. Risks, uncertainties and assumptions include the execution and performance of contracts by HP and its customers, suppliers and partners; the achievement of expected results; expectations and assumptions relating to the execution and timing of cost reduction programs; and other risks that are described in HP’s ﬁlings with the Securities and Exchange Commission, including but not limited to HP’s Annual Report on Form 10 K for the ﬁscal year ended October 31, 2007, which is included as part of this document. HP assumes no obligation and does not intend to update these forward-looking statements. CEO Letter Dear Fellow Stockholders: If one word can best describe HP’s performance in ﬁscal 2007, it is growth. For the year, we added more than $12 billion of new revenue, grew non-GAAP operating proﬁt dollars 30 percent¹ and returned more than $12 billion to stockholders through share repurchases and dividends. We grew revenues across all of our each of our business segments and in regions. Overall, it was an impressive performance by HP’s employees and partners around the world. 1 CEO Letter Many factors contributed to that growth, but three stand out because of the major impact we expect them to have in the years ahead: the explosion of digital informa tion and content; the growing need for technology that enables people to create, store, share and print that content; and the rapidly growing demand for information technology (IT) in emerging markets around the world. Customers will need systems, software and services to create, store and analyze content; PCs and handheld devices to access and share it; and monitors, TVs and printers to view and print it. Many companies can do some of these things, but we believe that HP is the only company with the portfolio and partnerships to do them all. The volume of data today is growing faster than our ability to capture and use it. According to Forrester Research, the world’s data doubles approximately every three years ,² which is expected to lead to a more than sixfold increase in data between 2003 and 2010. It adds up to an enormous addressable market for HP—a $1.2 trillion global market . ³ Today HP has about 9 percent of this market, so we have a lot of room to grow. We are working hard to expand our market coverage and to proﬁtably increase our market share. Feeding the worldwide demand for information and rich digital content is the enormous expansion of search engines, blogs, social networks, e-mail, text messages and online video and images. To capitalize on these opportunities, we continue to align the company around an operating framework with three key elements: targeted growth, efﬁciency and capital strategy. To complicate matters, this content often lacks authenti cation and proper security, and it is increasingly global and mobile. Potentially hundreds of millions of new users in emerging markets are coming online—from small business owners in China to farmers in Brazil to consumers in Eastern Europe. At the same time, the expectations of consumers have changed. People want instantaneous access to content. They expect this accessibility regardless of what kind of device they are using or where they happen to be. And their tolerance for complexity is low. Opportunities Dealing with all this data—and rising consumer expec tations—is a huge and disruptive challenge for our customers and their IT environments and a major opportu nity for HP. It puts pressure on businesses to rebuild, retool and deploy a ﬂexible infrastructure so they can get the right information to the right people at the right time. 2 Targeted Growth HP’s businesses are targeting the most promising, high-growth markets and positioning themselves to take advantage of the explosion of digital content. In our Technology Solutions Group, we are helping customers manage and transform their IT environments. We had a particularly strong performance in blade servers during ﬁscal 2007. Our innovative c-Class blade systems helped drive year-over-year blade revenue growth of 67 percent, and we increased our industry-leading market share. In our Personal Systems Group, we continue to beneﬁt as demand shifts toward mobility, consumers and emerging markets. For example, our sales of notebook computers increased 47 percent during ﬁscal 2007. And our PC business in China nearly doubled, making it our third largest market for personal systems. FY07 Revenue by Segment • HP Financial Services and Other 2% • HP Software 2% HP Services 16% Imaging & Printing Group 27% Enterprise Storage & Servers 18% Personal Systems Group 35% t n e m g e S y b e u n e v e R 7 0 Y F 3 CEO Letter In our Imaging and Printing Group, we are extending our leadership in our core printing business while also taking advantage of new, high-growth opportunities in supplies, graphic arts and enterprise printing. We are expanding our sales coverage to accelerate growth in the enterprise business, which we expect to be a $121 billion market by 2010. In each of these businesses, we are using our scale to become even more competitive. We have more than double the scale of each of our printer competitors and all but one of our PC and server competitors. We are leveraging this scale to consolidate share and improve proﬁts while continuing to reinvest to maintain our technology leadership. We expect continued growth in developed countries but much higher growth in what are commonly known as the BRIC countries—Brazil, Russia, India and China—and in other emerging economies. Our revenue in the BRIC countries grew 33 percent in ﬁscal 2007 and now represents 8 percent of HP’s total revenue. Between acquisitions and organic growth, revenue in our software business nearly doubled in ﬁscal 2007— making HP the sixth largest software company in the world. Software is a critical differentiator for HP—not only in our standalone software business but in each of our businesses as well. Efﬁciency We have made great progress in reducing costs, which allows us to compete more aggressively and win in the market. But we have an opportunity to further improve our efﬁciency. We look at everything between revenue and non-GAAP operating proﬁt as a cost. From that perspective, HP had almost $95 billion in costs in ﬁscal 2007. That is too much. Even with all the work we have done, we must become more efﬁcient, further reduce costs and invest the savings to create more stockholder value. We assess our costs in three areas. As we reduce costs, we are shifting our investments to capitalize on these market opportunities. While it is important that we grow, it’s also important that we grow the right way with the right mix. For example, HP hired 1,000 sales professionals in ﬁscal 2007 to expand our coverage in key accounts and markets, and the company added more than 1,000 salespeople through acquisitions. The ﬁrst is corporate overhead, including IT, real estate and other corporate expenses. We are reducing our IT costs by consolidating and modernizing our data centers and operations. We also are becoming more efﬁcient in our use of real estate, which is a signiﬁcant expense for a company of HP’s size. During the next two years, we plan to reduce our number of sites worldwide by almost 25 percent. We also are investing in higher-margin categories such as software and services. We spent more than $6 billion across our businesses in ﬁscal 2007 to acquire 10 software, technology and service companies. We expect that each one will add signiﬁcant capabilities and technology to our portfolio, as well as new oppor tunities for growth. Second are our product costs. HP is the largest customer for most of our suppliers, and we are continually working with them to make sure we get the best terms, including the best price. Third are the costs owned by each of HP’s businesses. The businesses have detailed plans to reduce their costs, and we have launched new efforts to identify more savings. 4 We continue to align the company around an operating framework with three key elements: targeted growth, efﬁciency and capital strategy. 5 CEO Letter Capital Strategy We align our capital strategy with our operations to maximize stockholder value. The ﬁrst priority is to continue to invest in our businesses. We do that in two ways. One is to invest to grow, which shows up in research and development, demand generation and mergers and acquisitions. The other is to invest to save. We have made signiﬁcant investments in our IT and real estate infrastructure so we can reduce costs in the future. Our second priority is to return cash to stockholders, predominantly with share repurchases and to a lesser extent with dividends. Last year HP returned more than $12 billion to stockholders. We will continue to balance repurchase and dividend levels with other capital allocation priorities. Global Citizenship As HP has grown to become one of the world’s largest IT companies, our commitment to global citizenship has remained integral to our business strategy. It is an important part of our heritage and the values engrained in HP by Bill Hewlett and Dave Packard. Today, our citizenship efforts are built on a foundation of strong corporate accountability and governance, a commitment to environmental responsibility and active investment and involvement in the communities in which we do business. We are focused primarily on three global citizenship priorities: climate and energy, product reuse and recycling, and supply chain responsibility. HP is committed to reducing our own environmental impact as well as that of our customers, partners and suppliers. We launched our Design for Environment 6 program in 1992, and we have been investing in energy-efﬁciency programs for more than a decade. Innovations such as our Dynamic Smart Cooling and Thermal Logic technologies offer advanced, energy- efﬁcient solutions for customers. We expect these technologies to contribute to a 60 percent reduction in energy consumption in our new data centers. We also are expanding our use of renewable energy, including solar power for our San Diego facility and wind power for several of our facilities in Ireland. We believe we have reached a tipping point where the price and performance of IT are no longer compromised by being green; they are enhanced by it. Our goal is to reduce the combined energy consumption of our operations and products by 20 percent in 2010 compared to 2005 levels. During 2007, we met our goal of recycling 1 billion pounds of electronic products—including 500 million pounds between 2004 and 2007. We plan to recycle another 1 billion pounds of electronic products and print cartridges by the end of 2010. At the same time, we are working to ensure that our suppliers and vendors meet HP’s high standards for social and environmental responsibility. HP was the ﬁrst IT company to formally launch a supplier code of conduct. We continually work with our suppliers and with companies inside and outside the technology industry to raise standards for labor and human rights, health and safety, environmental responsibility and ethics. We do extensive onsite auditing to engage our suppliers, identify performance gaps and help them to build their capabilities to meet our expectations. We believe that HP has an unparalleled ability to drive simplicity, innovate and inﬂuence industry actions in a way that is good for customers, good for business and good for the planet. FY07 Revenue by Region EMEA 41% (up 15.7% Y/Y) Asia Paciﬁc 17% (up 18.2% Y/Y) Americas 42% (Canada/Latin America 9%, U.S. 33%) (up 10.3% Y/Y) i n o g e R y b e u n e v e R 7 0 Y F 7 CEO Letter We believe that HP has an unparalleled ability to drive simplicity, innovate and inﬂuence industry actions in a way that is good for customers, good for business and good for the planet. 8 Revenue s n o i l l i b n I $30 $29 $28 $27 $26 $25 $24 $23 $22 $21 $20 $19 1Q05 2Q05 3Q05 4Q05 1Q06 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 $21.5 $21.6 $20.8 $22.9 $22.7 $22.6 $21.9 $24.6 $25.1 $25.5 $25.4 $28.3 e u n e v e R 9 CEO Letter Conclusion We made solid progress in 2007—demonstrating that HP can cut costs and increase revenue at the same time. However, we are not complacent about our success, nor do we underestimate the strength of our competitors. We see signiﬁcant opportunities to take advantage of the explosion of digital content and address our $1.2 trillion market opportunity. We believe that we have a portfolio and a set of capabilities unmatched in the industry. We are investing in the right people and infrastructure, and we are continuing to leverage our scale and reduce our costs to improve our operating performance. Our goal is simple: to make HP the partner of choice for our customers, the investment of choice for our stock holders and the employer of choice for our employees. Executive Team Mark V. Hurd Chairman, Chief Executive Ofﬁcer and President R. Todd Bradley Executive Vice President, Personal Systems Group Jon E. Flaxman Executive Vice President and Chief Administrative Ofﬁcer Michael J. Holston Executive Vice President, General Counsel and Secretary Vyomesh I. Joshi Executive Vice President, Imaging and Printing Group Catherine A. Lesjak Executive Vice President and Chief Financial Ofﬁcer Ann M. Livermore Executive Vice President, Technology Solutions Group Randall D. Mott Executive Vice President and Chief Information Ofﬁcer Marcela Perez de Alonso Executive Vice President, Human Resources Thank you for your investment in HP. Shane V. Robison Executive Vice President and Chief Strategy and Technology Ofﬁcer Sincerely, Mark V. Hurd Chairman, Chief Executive Ofﬁcer and President ¹ Fiscal year 2007 non-GAAP operating proﬁt was $9.6 billion compared to $7.4 billion in ﬁscal year 2006. Fiscal year 2007 non-GAAP operating proﬁt of $9.6 billion equals GAAP operating proﬁt of $8.7 billion plus the sum of $783 million relating to charges associated with the amortization of purchased intangible assets, $190 million relating to in-process research and development charges and $387 million in restructuring charges less a $517 million net pension curtailment gain. Fiscal year 2006 non-GAAP operating proﬁt of $7.4 billion equals GAAP operating proﬁt of $6.6 billion plus the sum of $604 million relating to charges associated with the amortization of purchased intangible assets, $52 million relating to in-process research and development charges and $158 million in restructuring charges. HP’s management uses non- GAAP operating proﬁt to evaluate and forecast HP’ s performance before gains, losses or other charges that are considered by HP’s management to be outside of HP’s core business segment operating results. HP believes that presenting non-GAAP operating proﬁt in addition to GAAP operating proﬁt provides investors with greater transparency to the information used by HP’s management in its ﬁnancial and operational decision making. HP further believes that providing this additional non-GAAP information helps investors understand HP’s operating performance and evaluate the efﬁcacy of the methodology and information used by management to evaluate and measure such performance. This additional non-GAAP information is not intended to be considered in isolation or as a substitute for GAAP operating proﬁt. ² Forrester Research, “Data, Data Everywhere!”, Boris Evelson, July 23, 2007. ³ HP internal analysis. 10 Gross and Net Cash $20 $15 s n o i l l i b n I $10 $5 $0 Gross cash¹ Net cash² FY05 $13.9 $8.7 FY06 $16.4 $11.2 FY07 $11.6 $3.4 ¹ Includes cash and cash equivalents, short-term investments and certain liquid long-term investments. ² Net cash is deﬁned as gross cash less total debt. h s a C t e N d n a s s o r G 11 Members of the Board Lawrence T. Babbio, Jr. Director since 2002 at the Stanford University Graduate School of Business. Previously, Mr. Hyatt was the founder and Chief Executive Ofﬁcer of Hyatt Legal Mr. Babbio has served as a Senior Advisor to Warburg Pincus, a private Plans, Inc., a provider of employer-sponsored group legal plans. equity ﬁrm, since June 2007. Previously, Mr. Babbio served as Vice Chairman and President of Verizon Communications, Inc. (formerly Bell John R. Joyce Atlantic Corporation), a telecommunications company, from 2000 until his Director since 2007 retirement in April 2007. He was a director of Compaq Computer Mr. Joyce has served as a Managing Director at Silver Lake, a private Corporation from 1995 until HP’s acquisition of Compaq in May 2002. equity ﬁrm, since July 2005. Prior to joining Silver Lake, Mr. Joyce spent Sari M. Baldauf Director since 2006 30 years with IBM, a global technology ﬁrm, serving most recently as Senior Vice President and Group Executive of the IBM Global Services division from May 2004 until July 2005 and Chief Financial Ofﬁcer of Ms. Baldauf served as Executive Vice President and General Manager of IBM from 1999 until May 2004. Prior to that, Mr. Joyce served in a the Networks business group of Nokia Corporation, a communications variety of roles, including President, IBM Asia Paciﬁc, and Vice President company, from July 1998 until February 2005. She previously held various positions at Nokia since 1983. Ms. Baldauf also serves as a director of and Controller for IBM’s global operations. Mr. Joyce is a member of the Bertelsmann AG Supervisory Board and a director of Gartner, Inc., Avago SanomaWSOY, F-Secure Corporation, VIT Corporation, and CapMan Plc, Technologies Limited and Serena Software, Inc. and a s t he n on-executive c hairman o f t he S avonlinna O pera F estival a nd as a member of the Global Board of the International Youth Foundation. Robert L. Ryan Richard A. Hackborn Director since 1992 Director since 2004 Mr. Ryan served as Senior Vice President and Chief Financial Ofﬁcer of Medtronic, Inc., a medical technology company, from 1993 until his Mr. Hackborn has served as HP’s Lead Independent Director since retirement in May 2005. He also is a director of UnitedHealth Group September 2006. Previously, Mr. Hackborn served as HP’s Chairman from Incorporated, General Mills, Inc., The Black and Decker Corporation and January 2000 to September 2000. He was HP’s Vice President, Computer Citigroup, Inc. Products Organization from 1990 until his retirement in 1993 after a 33-year career with HP. John H. Hammergren Director since 2005 Lucille S. Salhany Director since 2002 Ms. Salhany has served as President and Chief Executive Ofﬁcer of JHMedia, a consulting company, since 1997. Since 2003, she has been a Mr. Hammergren has served as Chairman of McKesson Corporation, a partner and director of Echo Bridge Entertainment, an independent ﬁlm healthcare services and information technology company, since July 2002 distribution company. From 1999 to March 2002, she was President and and as President and Chief Executive Ofﬁcer of McKesson since April Chief Executive Ofﬁcer of LifeFX Networks, Inc., which ﬁled for federal 2001. From July 1999 to April 2001, Mr. Hammergren served as bankruptcy protection in May 2002. From 1994 to 1997, Ms. Salhany Co-President and Co-Chief Executive Ofﬁcer of McKesson. Mr. Hammergren was the Chief Executive Ofﬁcer and President of UPN (United Paramount is also a director of Nadro, S.A. de C.V. (Mexico) and Verispan LLC. Network), a broadcasting company. From 1993 to 1994, she was Mark V. Hurd Director since 2005 Chairman of Fox Broadcasting Company, a national television network, and from 1991 to 1993 she was Chairman of Twentieth Television, a division of Fox Broadcasting Company. Ms. Salhany was a director of Mr. Hurd has served as Chairman of HP since September 2006 and Compaq from 1997 until HP’s acquisition of Compaq in May 2002. as Chief Executive Ofﬁcer, President and a member of the board since Ms. Salhany also is a director of Ion Media Networks, Inc. April 2005. Prior to that, he served as Chief Executive Ofﬁcer of NCR Corporation, a technology company, from March 2003 to March 2005 G. Kennedy Thompson and as President from July 2001 to March 2005. From September 2002 Director since 2006 to March 2003, Mr. Hurd was the Chief Operating Ofﬁcer of NCR, and Mr. Thompson has served as Chairman of Wachovia Corporation, a from July 2000 until March 2003 he was Chief Operating Ofﬁcer of ﬁnancial services company, since February 2003 and as a director since NCR’s Teradata data-warehousing division. 1999. He has also served as Chief Executive Ofﬁcer of Wachovia since 2000 and as President since 1999. Mr. Thompson also is a director of Wachovia Preferred Funding Corp. Joel Z. Hyatt Director since 2007 Mr. Hyatt has served as the Chief Executive Ofﬁcer of Current Media, LLC, a cable and satellite television company, since September 2002. From September 1998 to June 2003, Mr. Hyatt was a Lecturer in Entrepreneurship 12 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ⌧ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended: October 31, 2007 Or (cid:134) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 1-4423 HEWLETT-PACKARD COMPANY (Exact name of registrant as specified in its charter) Delaware (State or other jurisdiction of incorporation or organization) 3000 Hanover Street, Palo Alto, California (Address of principal executive offices) 94-1081436 (I.R.S. employer identification no.) 94304 (Zip code) Registrant’s telephone number, including area code: (650) 857-1501 Securities registered pursuant to Section 12(b) of the Act: Title of each class Common stock, par value $0.01 per share Liquid Yield Option™ Notes due 2017 Name of each exchange on which registered New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes ⌧ No (cid:134) Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes (cid:134) No ⌧ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ⌧ No (cid:134) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (cid:134) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer ⌧ Accelerated filer (cid:134) Non-accelerated filer (cid:134) Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act) Yes (cid:134) No ⌧ The aggregate market value of the registrant’s common stock held by non-affiliates was $109,938,540,000 based on the last sale price of common stock on April 30, 2007. The number of shares of HP common stock outstanding as of November 30, 2007 was 2,573,868,626 shares. DOCUMENTS INCORPORATED BY REFERENCE DOCUMENT DESCRIPTION Portions of the Registrant’s notice of annual meeting of stockholders and proxy statement to be filed pursuant to Regulation 14A within 120 days after Registrant’s fiscal year end of October 31, 2007 are incorporated by reference into Part III of this Report. 10-K PART III Hewlett-Packard Company Form 10-K For the Fiscal Year Ended October 31, 2007 Table of Contents Page Item 1. Item 1A. Item 1B. Item 2. Item 3. Item 4. Item 5. Item 6. Item 7. Item 7A. Item 8. Item 9. Item 9A. Item 9B. Item 10. Item 11. Item 12. Item 13. Item 14. Item 15. PART I Business ........................................................................................................................................................ Risk Factors .................................................................................................................................................. Unresolved Staff Comments ......................................................................................................................... Properties ...................................................................................................................................................... Legal Proceedings......................................................................................................................................... Submission of Matters to a Vote of Security Holders................................................................................... PART II Market for Registrant’s Common Equity and Related Stockholder Matters ................................................ Selected Financial Data ................................................................................................................................ Management’s Discussion and Analysis of Financial Condition and Results of Operations........................ Quantitative and Qualitative Disclosures about Market Risk ....................................................................... Financial Statements and Supplementary Data............................................................................................. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures...................... Controls and Procedures ............................................................................................................................... Other Information ......................................................................................................................................... PART III Directors, Executive Officers and Corporate Governance of the Registrant ................................................ Executive Compensation .............................................................................................................................. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters ..... Certain Relationships and Related Transactions, and Director Independence..............................................152 Principal Accountant Fees and Services ....................................................................................................... PART IV Exhibits and Financial Statement Schedules ................................................................................................ 3 15 30 30 31 31 32 34 35 69 71 151 151 151 152 152 152 153 154 Forward-Looking Statements This Annual Report on Form 10-K, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7, contains forward-looking statements that involve risks, uncertainties and assumptions. If the risks or uncertainties ever materialize or the assumptions prove incorrect, the results of Hewlett-Packard Company and its consolidated subsidiaries (“HP”) may differ materially from those expressed or implied by such forward-looking statements and assumptions. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including but not limited to any projections of revenue, margins, expenses, tax provisions, earnings, cash flows, benefit obligations, share repurchases or other financial items; any statements of the plans, strategies and objectives of management for future operations, including the execution of cost reduction programs and restructuring plans; any statements concerning expected development, performance or market share relating to products or services; any statements regarding future economic conditions or performance; any statements regarding pending investigations, claims or disputes; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing. Risks, uncertainties and assumptions include macroeconomic and geopolitical trends and events; the execution and performance of contracts by HP and its customers, suppliers and partners; the challenge of managing asset levels, including inventory; the difficulty of aligning expense levels with revenue changes; assumptions related to pension and other post-retirement costs; expectations and assumptions relating to the execution and timing of cost reduction programs and restructuring plans; the outcome of pending legislation and accounting pronouncements; the resolution of pending investigations, claims and disputes; and other risks that are described herein, including but not limited to the items discussed in “Risk Factors” in Item 1A of this report, and that are otherwise described or updated from time to time in HP’s Securities and Exchange Commission reports. HP assumes no obligation and does not intend to update these forward-looking statements. ITEM 1. Business. PART I HP is a leading global provider of products, technologies, software, solutions and services to individual consumers, small- and medium-sized businesses (“SMBs”) and large enterprises, including in the public and education sectors. Our offerings span: • • • personal computing and other access devices, imaging and printing-related products and services, enterprise information technology infrastructure, including enterprise storage and server technology and software that optimizes business technology investments, and • multi-vendor customer services, including technology support and maintenance, consulting and integration and outsourcing services. HP was incorporated in 1947 under the laws of the State of California as the successor to a partnership founded in 1939 by William R. Hewlett and David Packard. Effective in May 1998, we changed our state of incorporation from California to Delaware. HP Products and Services; Segment Information During fiscal 2007, our operations were organized into seven business segments: Enterprise Storage and Servers (“ESS”), HP Services (“HPS”), HP Software, the Personal Systems Group (“PSG”), the Imaging and Printing Group (“IPG”), HP Financial Services (“HPFS”) and Corporate Investments. Given the solution sale approach across our enterprise offerings, and in order to capitalize on up-selling and cross-selling opportunities, ESS, HPS and HP Software are structured beneath a broader 3 Technology Solutions Group (“TSG”). While TSG is not a business segment, this aggregation provides a supplementary view of our business. In each of the past three fiscal years, industry standard servers, desktops, notebooks and printing supplies each accounted for more than 10% of our consolidated net revenue. A summary of our net revenue, earnings from operations and assets for our segments and business units is found in Note 18 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. A discussion of factors potentially affecting our operations is set forth in “Risk Factors” in Item 1A, which is incorporated herein by reference. Technology Solutions Group TSG provides servers, storage, software and information technology (“IT”) services that enable enterprise and midmarket business customers to better manage their current IT environments and transform IT into a business enabler. TSG products help accelerate growth, minimize risk and reduce costs to optimize the business outcomes of customers’ IT investments. Companies around the globe leverage HP’s infrastructure solutions to deploy next generation data centers and address business challenges ranging from compliance to business continuity. TSG’s modular IT systems and services are primarily standards-based and feature differentiated technologies in areas including power and cooling, unified management, security, virtualization and automation. Each of the three business segments within TSG is described in detail below. Enterprise Storage and Servers The server market continues to shift towards standards-based architectures as proprietary hardware and operating systems are replaced by industry standard server platforms that typically offer compelling price and performance advantages by leveraging standards-based operating systems and microprocessor designs. At the same time, critical business functions continue to demand scalability and reliability. By providing a broad portfolio of storage and server solutions, ESS aims to optimize the combined product solutions required by different customers and provide solutions for a wide range of operating environments, spanning both the enterprise and the SMB markets. ESS provides storage and server products in a number of categories. Industry Standard Servers. Industry standard servers include primarily entry-level and mid-range ProLiant servers, which run primarily Windows®,(1) Linux and Novell operating systems and leverage Intel Corporation (“Intel”) and Advanced Micro Devices (“AMD”) processors. The business spans a range of product lines that include pedestal-tower servers, density-optimized rack servers and HP’s BladeSystem family of server blades. In fiscal 2007, HP’s industry standard server business continued to lead the industry in terms of units shipped and factory revenue. HP also has a leadership position in server blades, the fastest-growing segment of the market. Business Critical Systems. Business Critical Systems include Itanium®(2)-based Integrity servers running on the HP-UX, Windows®, Linux and OpenVMS operating systems, including the high-end Superdome servers and fault-tolerant Integrity NonStop servers. Business Critical Systems also include the Reduced Instruction Set Computing (“RISC”)-based servers with the HP 9000 line running on the HP-UX operating system, HP AlphaServers running on both Tru64 UNIX®(3) and OpenVMS, and MIPs-based NonStop servers. (1) Windows® is a registered trademark of Microsoft Corporation. (2) Itanium® is a registered trademark of Intel Corporation. (3) UNIX® is a registered trademark of The Open Group. 4 Storage. HP’s StorageWorks offerings include entry-level, mid-range and high-end arrays, storage area networks, network attached storage, storage management software and virtualization technologies, as well as tape drives, tape libraries and optical archival storage. HP Services HPS provides a portfolio of multi-vendor IT services, including technology services, consulting and integration and outsourcing services. HPS also offers a variety of services tailored to particular industries such as communications, media and entertainment, manufacturing and distribution, financial services, health and life sciences and the public sector, including government services. HPS collaborates with the Enterprise Storage and Servers and HP Software groups, as well as with third-party system integrators and software and networking companies to bring solutions to HP customers. HPS also works with HP’s Imaging and Printing Group and Personal Systems Group to provide managed print services, end user workplace services, and mobile workforce productivity solutions to enterprise customers. Technology Services. HPS provides a range of technology services from standalone product support to high availability services for complex, global, networked, multi-vendor environments. This business also manages the delivery of product warranty support through its own service organization, as well as through authorized partners. Consulting and Integration. HPS provides consulting and integration services to architect, design and implement technology and industry-specific solutions for customers. Consulting and integration also provides cross-industry solutions in the areas of architecture and governance, infrastructure, applications and packaged applications, security, IT service management, information management and enterprise Microsoft solutions. Outsourcing Services. HPS offers a variety of IT management and outsourcing services that support customers’ infrastructure, applications, business processes, end user workplace, print environment and business continuity and recovery requirements. HP Software HP Software provides a suite of Business Technology Optimization (“BTO”) software solutions, including support, that allow customers to manage and automate their IT infrastructure, operations, applications, IT services and business processes under the OpenView brand. In addition, this segment delivers a suite of comprehensive, carrier-grade software platforms for developing and deploying next-generation voice, data and converged services to network and service providers under the HP OpenCall brand. We are focused on extending our enterprise systems management leadership position into application, service management and business process management market segments. During fiscal 2007, we completed the acquisitions of Mercury Interactive Corporation, Bristol Technologies, Inc., SPI Dynamics, Inc. and Opsware Inc., which added transaction monitoring, applications security testing and data center automation capabilities to the BTO portfolio. We expect to continue to make strategic acquisitions as well as undertake internal realignments as we deem appropriate. The portfolio of BTO solutions is designed to enable our customers to reduce their IT costs, and gain better insight to their business and IT operations. This helps our customers align IT resources with their business goals and automate data center operations and IT processes, enabling IT to deliver more value to the business. Personal Systems Group PSG is the leading provider of personal computers (“PCs”) in the world based on unit volume shipped and annual revenue. PSG provides commercial PCs, consumer PCs, workstations, handheld 5 computing devices, digital entertainment systems, calculators and other related accessories, software and services for the commercial and consumer markets. We group commercial desktops, commercial notebooks and workstations into commercial clients and consumer desktop and consumer notebooks into consumer clients when describing our performance in these markets. Like the broader PC market, PSG continues to experience a shift toward mobile products such as notebooks. Both commercial and consumer PCs are based predominately on the Windows® operating system and use Intel and AMD processors. Commercial PCs. PSG offers a variety of personal computers optimized for commercial uses, including enterprise and SMB customers, and for connectivity and manageability in networked environments. These commercial PCs include primarily the HP Compaq business desktops, business notebooks, and Tablet PCs. Consumer PCs. Consumer PCs include the HP Pavilion and Compaq Presario series of multi-media consumer desktops and notebooks, as well as HP Media Center and Voodoo Gaming PCs, which are targeted at the home user. Workstations. Workstations are individual computing products designed for users demanding enhanced performance, such as computer animation, engineering design and other programs requiring high-resolution graphics. HP provides workstations that run on UNIX®, Windows® and Linux-based operating systems. Handheld Computing. HP provides a series of HP iPAQ Pocket PC handheld computing devices that run on Windows® Mobile software. These products range from value devices such as music or Global Positioning System receivers to advanced devices with voice and data capability. Digital Entertainment. PSG’s digital entertainment products are targeted at the intersection of the personal computing and consumer electronics markets and span a range of products and product categories that allow customers to enjoy a broad range of digital entertainment experiences. PSG’s digital entertainment products include HD DVD and RW drives and DVD writers; plasma and LCD flat-panel televisions; and the HP Digital Entertainment Center, which allows consumers to access their music, movies, home videos and photos from a single device via remote control. Imaging and Printing Group IPG is the leading imaging and printing systems provider in the world for consumer and commercial printer hardware, printing supplies, printing media and scanning devices. IPG is also focused on imaging solutions in the commercial markets, from managed print services solutions to addressing new growth opportunities in commercial printing in areas such as industrial applications, outdoor signage, and the graphic arts business. When describing our performance in this segment, we group inkjet printer units and digital photography and entertainment products and services into consumer hardware, LaserJet printers and graphics and imaging products into commercial hardware and break out printer supplies separately. Inkjet Printers. Inkjet systems include desktop single function and inkjet all-in-one printers, including photo, productivity and business inkjet printers and scanners. Digital Photography and Entertainment. Digital imaging products and services include photo specialty printers, photo kiosks, digital cameras, accessories and online photo services through Snapfish. An important part of IPG’s strategy is to provide digital imaging solutions that rival traditional imaging for quality, cost and ease of use so that consumers can manage their digital imaging throughout the home and outside the home. On November 7, 2007, we announced that we were seeking an alternative business model for our HP-branded cameras. 6 LaserJet Printers. LaserJet systems include monochrome and color laser printers, printer-based multi-function devices and Total Print Management Solutions for enterprise customers. A key initiative in this area of IPG’s business has been and continues to be driving color printing penetration in the office. Graphics and Imaging. Graphics and Imaging products include large format (DesignJet) printers, Indigo and Scitex digital presses, digital publishing solutions and graphics printing solutions. A key initiative for IPG is to capture high-value pages by developing compelling solutions for the industrial, commercial printing and graphics segments. Printer Supplies. Printer supplies include LaserJet toner and inkjet cartridges and other printing-related media. These supplies include HP-branded Vivera and ColorSphere ink and HP Premium and Premium Plus photo papers, which are designed to work together as a system to produce faster prints with improved resistance to fading, increased print quality and better affordability. HP Financial Services HPFS supports and enhances HP’s global product and service solutions, providing a broad range of value-added financial life-cycle management services. HPFS enables our worldwide customers to acquire complete IT solutions, including hardware, software and services. The group offers leasing, financing, utility programs and asset recovery services, as well as financial asset management services for large global and enterprise customers. HPFS also provides an array of specialized financial services to SMBs and educational and governmental entities. HPFS offers innovative, customized and flexible alternatives to balance unique customer cash flow, technology obsolescence and capacity needs. Corporate Investments Corporate Investments is managed by the Office of Strategy and Technology and includes Hewlett-Packard Laboratories, also known as HP Labs, and certain business incubation projects. Revenue in this segment is attributable to the sale of certain network infrastructure products, including Ethernet switch products that enhance computing and enterprise solutions under the brand ProCurve Networking. Corporate Investments also derives revenue from licensing specific HP technology to third parties. Sales, Marketing and Distribution We manage our business and report our financial results based on the principal business segments described above. Our customers are organized by consumer and commercial customer groups, and distribution is organized by direct and channel. Within the channel, we have various types of partners that we utilize for various customer groups. The partners include: • • • • • retailers that sell our products to the public through their own physical or Internet stores; resellers that sell our products and services, frequently with their own value-added products or services, to targeted customer groups; distribution partners that supply our solutions to smaller resellers with which we do not have direct relationships; independent distributors that sell our products into geographies or customer segments in which we have little or no presence; original equipment manufacturers (“OEMs”) that integrate our products with their own hardware or software and sell the integrated products; 7 • • independent software vendors (“ISVs”) that provide their clients with specialized software products, frequently driving sales of additional non-HP products and services, and often assist us in selling our products and services to clients purchasing their products; and systems integrators that provide various levels and kinds of expertise in designing and implementing custom IT solutions and often partner with HPS to extend their expertise or influence the sale of our products and services. The mix of HP’s business by channel or direct sales differs substantially by business and region. We believe that customer buying patterns and different regional market conditions necessitate sales, marketing and distribution to be tailored accordingly. HP is focused on driving efficiencies and productivity gains in both the direct and indirect business. TSG manages enterprise and public sector customer relationships and also is charged with simplifying sales processes across our segments to improve speed and effectiveness of customer delivery. In this capacity, TSG manages our direct sales for both volume and value products including industry standard servers products, UNIX®, enterprise storage and software and pre-sales technical consultants, as well as our direct distribution activities for commercial products and go-to-market activities with systems integrators and ISVs. TSG also drives HP’s vertical sales and marketing approach in the communication, media and entertainment, financial services, manufacturing and distribution and public sector industries. PSG manages SMB customer relationships and commercial reseller channels, due largely to the significant volume of commercial PCs that HP sells through these channels. In addition to commercial channel relationships, the volume direct organization, which is charged with the management of direct sales for volume products, is hosted within PSG. IPG manages HP’s overall consumer-related sales and marketing activities, including our annual consumer product launch for the back-to-school and holiday seasons. IPG also manages consumer channel relationships with third-party retail locations for imaging and printing products, as well as other consumer products, including consumer PCs, which provides for a bundled sale opportunity between PCs and IPG products. In addition, IPG manages direct consumer sales online through HP Home & Home Office. Manufacturing and Materials We utilize a number of contract manufacturers (“CMs”) and original design manufacturers (“ODMs”) around the world to manufacture HP-designed products. The use of CMs and ODMs is intended to generate cost efficiencies and reduce time to market for certain HP-designed products. Third-party OEMs manufacture some products that we purchase and resell under the HP brand. In addition to our use of CMs and ODMs, we currently manufacture finished products from components and sub-assemblies that we acquire from a wide range of vendors. We utilize two primary methods of fulfilling demand for products: building products to order and configuring products to order. We employ building products to order capabilities to maximize manufacturing efficiencies by producing high volumes of basic product configurations. Configuring products to order permits configuration of units to the particular hardware and software customization requirements of certain customers. Our inventory management and distribution practices in both building products to order and configuring products to order seek to minimize inventory holding periods by taking delivery of the inventory and manufacturing immediately prior to the sale or distribution of products to our customers. We purchase materials, supplies and product subassemblies from a substantial number of vendors. For many of our products, we have existing alternate sources of supply, or such sources are readily available. However, we do rely on sole sources for laser printer engines, LaserJet supplies and parts for 8 products with short life cycles (although some of these sources have operations in multiple locations). We are dependent upon Intel as a supplier of processors and Microsoft for various software products. However, we believe that disruptions with these suppliers would result in industry-wide dislocations and therefore would not disproportionately disadvantage us relative to our competitors. We also have a valued relationship with AMD, and we have continued to see solid acceptance of AMD processors in the market during fiscal 2007. Like other participants in the high technology industry, we ordinarily acquire materials and components through a combination of blanket and scheduled purchase orders to support our requirements for periods averaging 90 to 120 days. From time to time, we experience significant price volatility and supply constraints of certain components that are not available from multiple sources. Frequently, we are able to obtain scarce components for somewhat higher prices on the open market, which may have an impact on gross margin but does not disrupt production. On occasion, we acquire component inventory in anticipation of supply constraints or enter into longer-term pricing commitments with vendors to improve the priority, price and availability of supply. See “Risk Factors—We depend on third-party suppliers, and our revenue and gross margin could suffer if we fail to manage supplier issues properly,” in Item 1A, which is incorporated herein by reference. International Our products and services are available worldwide. We believe this geographic diversity allows us to meet demand on a worldwide basis for both consumer and enterprise customers, draws on business and technical expertise from a worldwide workforce, provides stability to our operations, allows us to drive economies of scale, provides revenue streams to offset geographic economic trends and offers us an opportunity to access new markets for maturing products. In addition, we believe that future growth is dependent in part on our ability to develop products and sales models that target developing countries. In this regard, we believe that our broad geographic presence gives us a solid base upon which to build such future growth. A summary of our domestic and international net revenue and net property, plant and equipment is set forth in Note 18 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Approximately 67% of our overall net revenue in fiscal 2007 came from outside the United States. The substantial majority of our net revenue originating outside the United States was from customers other than foreign governments. For a discussion of risks attendant to HP’s foreign operations, see “Risk Factors—Due to the international nature of our business, political or economic changes or other factors could harm our future revenue, costs and expenses and financial condition,” in Item 1A, “Quantitative and Qualitative Disclosure about Market Risk” in Item 7A and Note 9 to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Research and Development We remain committed to innovation as a key element of HP’s culture. Our development efforts are focused on designing and developing products, services and solutions that anticipate customers’ changing needs and desires and emerging technological trends. Our efforts also are focused on identifying the areas where we believe we can make a unique contribution and the areas where partnering with other leading technology companies will leverage our cost structure and maximize our customers’ experiences. 9 HP Labs, together with the various research and development groups within the five principal business segments, are responsible for our research and development efforts. HP Labs is part of our Corporate Investments segment. Expenditures for research and development were $3.6 billion in each of fiscal years 2007 and 2006 and $3.5 billion in fiscal 2005. We anticipate that we will continue to have significant research and development expenditures in the future to provide a continuing flow of innovative, high-quality products and services to maintain and enhance our competitive position. For a discussion of risks attendant to our research and development activities, see “Risk Factors—If we cannot continue to develop, manufacture and market products and services that meet customer requirements for innovation and quality, our revenue and gross margin may suffer,” in Item 1A, which is incorporated herein by reference. Patents Our general policy has been to seek patent protection for those inventions and improvements likely to be incorporated into our products and services or where proprietary rights will improve our competitive position. At October 31, 2007, our worldwide patent portfolio included over 31,000 patents, which was slightly above the number of patents in our patent portfolio at the end of both fiscal 2006 and fiscal 2005. Patents generally have a term of twenty years from the time they are filed. As our patent portfolio has been built over time, the remaining terms on the individual patents vary. While we believe that our patents and applications are important for maintaining the competitive differentiation of our products and maximizing our return on research and development investments, no single patent is in itself essential to us as a whole or any of our principal business segments. In addition to developing our patents, we license intellectual property from third parties as we deem appropriate. We have also granted and continue to grant to others licenses under patents owned by us when we consider these arrangements to be in our interests. These license arrangements include a number of cross-licenses with third parties. For a discussion of risks attendant to intellectual property rights, see “Risk Factors—Our revenue, cost of sales, and expenses may suffer if we cannot continue to license or enforce the intellectual property rights on which our business depends or if third parties assert that we violate their intellectual property rights,” in Item 1A, which is incorporated herein by reference. Backlog We believe that backlog is not a meaningful indicator of future business prospects due to the large volume of products delivered from shelf or channel partner inventories, the shortening of product life cycles and the relative portion of net revenue related to our service and support businesses. Therefore, we believe that backlog information is not material to an understanding of our overall business. Seasonality General economic conditions have an impact on our business and financial results. From time to time, the markets in which we sell our products experience weak economic conditions that may negatively affect sales. We experience some seasonal trends in the sale of our products and services. For example, European sales often are weaker in the summer months and consumer sales often are stronger in the fourth calendar quarter. Demand during the spring and early summer months also may be adversely impacted by market anticipation of seasonal trends. See “Risk Factors—Our sales cycle makes planning and inventory management difficult and future financial results less predictable,” in Item 1A, which is incorporated herein by reference. 10 Competition We encounter aggressive competition in all areas of our business activity. We compete primarily on the basis of technology, performance, price, quality, reliability, brand, reputation, distribution, range of products and services, ease of use of our products, account relationships, customer training, service and support, security and availability of application software and our Internet infrastructure offerings. The markets for each of our business segments are characterized by vigorous competition among major corporations with long-established positions and a large number of new and rapidly growing firms. Product life cycles are short, and to remain competitive we must develop new products and services, periodically enhance our existing products and services and compete effectively on the basis of the factors listed above. In addition, we compete with many of our current and potential partners, including OEMs that design, manufacture and often market their products under their own brand names. Our successful management of these competitive partner relationships will continue to be critical to our future success. Moreover, we anticipate that we will have to continue to adjust prices on many of our products and services to stay competitive. On an overall basis we are among the largest U.S.-based companies offering our range of general purpose computers and personal information, imaging and printing products for industrial, scientific, business and consumer applications, and IT services. We are the leader or among the leaders in each of our principal business segments. The competitive environments in which each segment operates are described below: Enterprise Storage and Servers. The areas in which ESS operates are intensely competitive and are characterized by rapid and ongoing technological innovation and price reductions. Our competitors range from broad solutions providers such as International Business Machines Corporation (“IBM”) to more focused competitors such as EMC Corporation and Network Appliance, Inc. in storage, Dell, Inc. (“Dell”) in industry standard servers, and Sun Microsystems, Inc. in both industry standard and UNIX®-based servers. We believe that our important competitive advantages in this segment include the six technology components of our adaptive infrastructure initiatives: IT systems, power and cooling, security, management, virtualization and automation. We believe that our competitive advantages also include our global reach and our significant intellectual property portfolio and research and development capabilities, which will contribute to further enhancements of our product offerings and our ability to cross sell our portfolio and leverage scale advantages in everything from brand to procurement leverage. HP Services. HPS competes in IT support services, consulting and integration and outsourcing services. The IT support services and consulting and integration markets have been under significant pressure as our customers have reduced their IT budgets. However, this trend has benefited the outsourcing services business as customers look at reducing IT management costs to enable more strategic investments. Our competitors include IBM Global Services, systems integration firms such as Accenture Ltd., outsourcing firms such as Electronic Data Systems Corporation, and offshore companies. We also compete with other traditional hardware providers, such as Dell, which are increasingly offering services to support their products. Many of our competitors are able to offer a wide range of global services, and some of our competitors enjoy significant brand recognition. HPS teams with many companies to offer services, and those arrangements allow us to extend our reach and augment our capabilities. Our competitive advantages are evident in our deep technology expertise, which includes multi-vendor environments, virtualization and automation, our strong track record of collaboration with clients and partners, and the combination of our expertise in infrastructure management with skilled global resources in SAP, Oracle and Microsoft platforms. HP Software. Our software competitors include companies focused on providing software solutions for IT management, such as BMC Software Inc, CA Inc., and IBM Tivoli Software. 11 Personal Systems Group. The areas in which PSG operates are intensely competitive and are characterized by rapid price reductions and inventory depreciation. Our primary competitors for the branded personal computers are Dell, Acer Inc, Apple Inc., Lenovo Group Limited and Toshiba Corporation. In particular regions, we also experience competition from local companies and from generically-branded or “white box” manufacturers. Our competitive advantages include our broad product portfolio, our innovation and research and development capabilities, our brand and procurement leverage, our ability to cross sell our portfolio of offerings, our extensive service and support offerings and the availability of our broad-based distribution of products from retail and commercial channels to direct sales. Imaging and Printing Group. We are the leading imaging and printing systems provider in the world for printer hardware, printing supplies and scanning devices. We believe that our brand recognition, reputation for quality, breadth of product offerings and large customer base are important competitive advantages. However, the markets for printer hardware and associated supplies are highly competitive, especially with respect to pricing and the introduction of new products and features. IPG’s key competitors include Canon USA, Inc., Lexmark International, Inc., Xerox Corporation (“Xerox”), Seiko Epson Corporation, Samsung Electronics Co. Ltd. and Dell. In addition, independent suppliers offer refill and remanufactured alternatives for our supplies which, although generally offering lower print quality and reliability, may be offered at lower prices and put pressure on our supplies sales and margins. Other companies also have developed and marketed new compatible cartridges for HP’s laser and inkjet products, particularly in jurisdictions outside of the United States where adequate intellectual property protection may not exist. In recent years, we and our competitors have regularly lowered prices on printer hardware both to reach new customers and in response to the competitive environment. Important areas for future growth include digital photography in the home and outside the home, printer-based multi-function devices in the office space, digital presses in our imaging and graphics space and driving color printing expansion in the office. While we encounter competitors in some product categories whose current market share is greater than ours, such as Xerox in copiers and Heidelberger Druckmaschinen Aktiengesellschaft in publishing, we believe we will provide important new contributions in the home, the office and publishing environments by providing comprehensive solutions. HP Financial Services. In our financing business, our competitors are captive financing companies, mainly IBM Global Financing, as well as banks and financial institutions. We believe our competitive advantage in this business over banks and financial institutions is our ability to finance products, services and total solutions. For a discussion of risks attendant to these competitive factors, see “Risk Factors—The competitive pressures we face could harm our revenue, gross margin and prospects,” in Item 1A, which is incorporated herein by reference. Environment Some of our operations use substances regulated under various federal, state, local and international laws governing the environment, including laws governing the discharge of pollutants into the air and water, the management and disposal of hazardous substances and wastes and the cleanup of contaminated sites. Many of our products are subject to various federal, state, local and international laws governing chemical substances in products, including laws regulating the manufacture and distribution of chemical substances and laws restricting the presence of certain substances in electronics products. We could incur substantial costs, including cleanup costs, fines and civil or criminal sanctions, third-party damage or personal injury claims, if we were to violate or become liable under environmental laws or if our products become non-compliant with environmental laws. We also face increasing complexity in our product design and procurement operations as we adjust to new and future requirements relating to the materials composition of our products, including the restrictions on 12 lead, cadmium and certain other substances that apply to specified electronics products put on the market in the European Union (the “EU”) as of July 1, 2006 (Restriction of Hazardous Substances Directive) and similar legislation in China, the labeling provisions of which went into effect March 1, 2007. We also could face significant costs and liabilities in connection with product take-back legislation. The EU has enacted the Waste Electrical and Electronic Equipment Directive, which makes producers of electrical goods, including computers and printers, financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The deadline for the individual member states of the EU to enact the directive in their respective countries was August 13, 2004 (such legislation, together with the directive, the “WEEE Legislation”). Producers participating in the market became financially responsible for implementing their responsibilities under the WEEE Legislation beginning in August 2005. Implementation in certain EU member states was delayed into 2006 and 2007. Similar legislation has been or may be enacted in other jurisdictions, including in the United States, Canada, Mexico, China and Japan. It is our policy to apply strict standards for environmental protection to sites inside and outside the United States, even if we are not subject to regulations imposed by local governments. The liability for environmental remediation and other environmental costs is accrued when HP considers it probable and can reasonably estimate the costs. Environmental costs and accruals are presently not material to our operations or financial position, and we do not currently anticipate material capital expenditures for environmental control facilities. Executive Officers: Mark V. Hurd; age 50; Chairman, Chief Executive Officer and President Mr. Hurd has served as Chairman of HP since September 2006 and as Chief Executive Officer, President and a member of the Board since April 2005. Prior to that, he served as Chief Executive Officer of NCR Corporation, a technology company, from March 2003 to March 2005 and as President from July 2001 to March 2005. From September 2002 to March 2003, Mr. Hurd was the Chief Operating Officer of NCR, and from July 2000 until March 2003 he was Chief Operating Officer of NCR’s Teradata data-warehousing division. R. Todd Bradley; age 49; Executive Vice President, Personal Systems Group Mr. Bradley was elected Executive Vice President in June 2005. From October 2003 to June 2005, he served as the Chief Executive Officer of palmOne Inc., a mobile computing company. Mr. Bradley also served as President and Chief Operating Officer of palmOne from May 2002 until October 2003 and as Executive Vice President and Chief Operating Officer from June 2001 to May 2002. Charles N. Charnas; age 49; Vice President, Deputy General Counsel and Assistant Secretary Mr. Charnas was elected Assistant Secretary in 1999. He was appointed a Vice President and Deputy General Counsel in 2002. Since 1999, he has headed the Corporate, Securities and Mergers and Acquisitions Section of HP’s worldwide legal department. From September 2006 until February 2007, Mr. Charnas also served as Acting General Counsel of HP. Mr. Charnas is not an executive officer for purposes of Section 16 of the Securities Exchange Act of 1934. Jon E. Flaxman; age 50; Executive Vice President and Chief Administrative Officer Mr. Flaxman has served as Executive Vice President and Chief Administrative Officer of HP since March 2007. Mr. Flaxman served as Senior Vice President and Controller from 2002 until March 2007, and as Principal Accounting Officer from February 2005 until March 2007. 13 Michael J. Holston; age 45; Executive Vice President, General Counsel and Secretary Mr. Holston has served as Executive Vice President and General Counsel since February 2007 and as Secretary since March 2007. Prior to that, he was a partner in the litigation practice at Morgan, Lewis & Bockius LLP, where, among other clients, he supported HP as external counsel on a variety of litigation and regulatory matters for more than ten years. Vyomesh Joshi; age 53; Executive Vice President, Imaging and Printing Group Mr. Joshi was elected Executive Vice President in 2002 after serving as Vice President since January 2001. He became President of the Imaging and Printing Group in February 2001. Mr. Joshi also served as Chairman of Phogenix Imaging LLC, a joint venture between HP and Kodak, from 2000 until May 2003, when Phogenix was dissolved. Mr. Joshi also is a director of Yahoo! Inc. Catherine A. Lesjak; age 48; Executive Vice President and Chief Financial Officer Ms. Lesjak has served as Executive Vice President and Chief Financial Officer since January 2007. She served as Senior Vice President from 2003 until December 2006 and as Treasurer from 2003 until March 2007. From May 2002 to July 2003, she was Vice President of Finance for Enterprise Marketing and Solutions and Vice President of Finance for the Software Global Business Unit. Ann M. Livermore; age 49; Executive Vice President, Technology Solutions Group Ms. Livermore was elected Executive Vice President in 2002 after serving as Vice President since 1995. Since May 2004, she has led the Technology Solutions Group. In April 2001, she became President of HP Services. Ms. Livermore also is a director of United Parcel Service, Inc. John N. McMullen; age 49; Senior Vice President and Treasurer Mr. McMullen has served as Senior Vice President and Treasurer since March 2007. Previously, he served as Vice President of Finance for HP’s Imaging and Printing Group since May 2002. Randall D. Mott; age 51; Executive Vice President and Chief Information Officer Mr. Mott was elected Executive Vice President and Chief Information Officer in July 2005. From 2000 to June 2005, Mr. Mott was Senior Vice President and Chief Information Officer of Dell, Inc., a technology company. James T. Murrin; age 47; Senior Vice President, Controller and Principal Accounting Officer Mr. Murrin has served as Senior Vice President, Controller and Principal Accounting Officer since March 2007. Previously, he served as Vice President of Finance for the Technology Solutions Group since 2004. Prior to that, Mr. Murrin was Vice President of Finance for HP Services and held various other finance positions at HP since joining the company in 1989. Marcela Perez de Alonso; age 53; Executive Vice President, Human Resources Ms. Perez de Alonso was elected Executive Vice President, Human Resources in January 2004. From 1999 until she joined HP in January 2004, Ms. Perez de Alonso was Division Head of Citigroup North Latin America Consumer Bank, in charge of the retail business operations of Citigroup in Puerto Rico, Venezuela, Colombia, Peru, Panama, the Bahamas and the Dominican Republic and also in charge of deposit products for the international retail bank until 2002. 14 Shane V. Robison; age 54; Executive Vice President and Chief Strategy and Technology Officer Mr. Robison has served as Executive Vice President and Chief Strategy and Technology Officer since May 2002. He was elected Senior Vice President in 2002 in connection with the Compaq acquisition. Prior to joining HP, Mr. Robison served as Senior Vice President, Technology and Chief Technology Officer at Compaq from 2000 to May 2002. Employees We had approximately 172,000 employees worldwide as of October 31, 2007. Available Information and Exchange Certifications Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to reports filed or furnished pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available on our website at http://www.hp.com/investor/home, as soon as reasonably practicable after HP electronically files such reports with, or furnishes those reports to, the Securities and Exchange Commission. HP’s Corporate Governance Guidelines, Board of Directors committee charters (including the charters of the Audit Committee, HR and Compensation Committee, and Nominating and Governance Committee) and code of ethics entitled “Standards of Business Conduct” also are available at that same location on our website. Stockholders may request free copies of these documents from: Hewlett-Packard Company Attention: Investor Relations 3000 Hanover Street Palo Alto, CA 94304 (866) GET-HPQ1 or (866) 438-4771 http://www.hp.com/investor/informationrequest We submitted the certification of the CEO of HP required by Section 303A.12(a) of the New York Stock Exchange “NYSE” Listed Company Manual, relating to HP’s compliance with the NYSE’s corporate governance listing standards, to the NYSE on March 19, 2007 with no qualifications. We included the certifications of the CEO and the CFO of HP required by Section 302 of the Sarbanes-Oxley Act of 2002 and related rules, relating to the quality of HP’s public disclosure, in this Annual Report on Form 10-K as Exhibits 31.1 and 31.2. ITEM 1A. Risk Factors. Because of the following factors, as well as other variables affecting our operating results, past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods. The competitive pressures we face could harm our revenue, gross margin and prospects. We encounter aggressive competition from numerous and varied competitors in all areas of our business, and our competitors may target our key market segments. We compete primarily on the basis of technology, performance, price, quality, reliability, brand, reputation, distribution, range of products and services, ease of use of our products, account relationships, customer training, service and support, security, availability of application software, and Internet infrastructure offerings. If our products, services, support and cost structure do not enable us to compete successfully based on any of those criteria, our operations, results and prospects could be harmed. 15 Unlike many of our competitors, we have a portfolio of businesses and must allocate resources across these businesses while competing with companies that specialize in one or more of these product lines. As a result, we may invest less in certain areas of our businesses than our competitors do, and these competitors may have greater financial, technical and marketing resources available to them than our businesses that compete against them. Industry consolidation also may affect competition by creating larger, more homogeneous and potentially stronger competitors in the markets in which we compete, and our competitors also may affect our business by entering into exclusive arrangements with existing or potential customers or suppliers. We may have to continue to lower the prices of many of our products and services to stay competitive, while at the same time trying to maintain or improve revenue and gross margin. The markets in which we do business, particularly the personal computer and printing markets, are highly competitive, and we encounter aggressive price competition for all of our products and services from numerous companies globally. Over the past several years, price competition in the market for personal computers, printers and related products has been particularly intense as competitors have aggressively cut prices and lowered their product margins for these products. Our results of operations and financial condition may be adversely affected by these and other industry-wide pricing pressures. Because our business model is based on providing innovative and high quality products, we may spend a proportionately greater amount on research and development than some of our competitors. If we cannot proportionately decrease our cost structure on a timely basis in response to competitive price pressures, our gross margin and therefore our profitability could be adversely affected. In addition, if our pricing and other factors are not sufficiently competitive, or if there is an adverse reaction to our product decisions, we may lose market share in certain areas, which could adversely affect our revenue and prospects. Even if we are able to maintain or increase market share for a particular product, revenue could decline because the product is in a maturing industry. Revenue and margins also could decline due to increased competition from other types of products. For example, refill and remanufactured alternatives for some of HP’s LaserJet toner and inkjet cartridges compete with HP’s supplies business. In addition, other companies have developed and marketed new compatible cartridges for HP’s LaserJet and inkjet products, particularly in jurisdictions outside of the United States where adequate intellectual property protection may not exist. HP expects competitive refill and remanufacturing and cloned cartridge activity to continue to pressure margins in IPG, which in turn has a significant impact on HP margins and profitability overall. If we cannot continue to develop, manufacture and market products and services that meet customer requirements for innovation and quality, our revenue and gross margin may suffer. The process of developing new high technology products and services and enhancing existing products and services is complex, costly and uncertain, and any failure by us to anticipate customers’ changing needs and emerging technological trends accurately could significantly harm our market share and results of operations. We must make long-term investments, develop or obtain appropriate intellectual property and commit significant resources before knowing whether our predictions will accurately reflect customer demand for our products and services. After we develop a product, we must be able to manufacture appropriate volumes quickly and at low costs. To accomplish this, we must accurately forecast volumes, mixes of products and configurations that meet customer requirements, and we may not succeed at all or within a given product’s life cycle. Any delay in the development, production or marketing of a new product could result in our not being among the first to market, which could further harm our competitive position. In the course of conducting our business, we must adequately address quality issues associated with our products and services, including defects in our engineering, design and manufacturing processes, as 16 well as defects in third-party components included in our products. In order to address quality issues, we work extensively with our customers and suppliers and engage in product testing to determine the cause of the problem and to determine appropriate solutions. However, we may have limited ability to control quality issues, particularly with respect to faulty components manufactured by third parties. If we are unable to determine the cause, find an appropriate solution or offer a temporary fix (or “patch”), we may delay shipment to customers, which would delay revenue recognition and could adversely affect our revenue and reported results. Finding solutions to quality issues can be expensive and may result in additional warranty, replacement and other costs, adversely affecting our profits. If new or existing customers have difficulty operating our products, our operating margins could be adversely affected, and we could face possible claims if we fail to meet our customers’ expectations. In addition, quality issues can impair our relationships with new or existing customers and adversely affect our reputation, which could have a material adverse effect on our operating results. If we do not effectively manage our product and services transitions, our revenue may suffer. Many of the industries in which we compete are characterized by rapid technological advances in hardware performance and software features and functionality; frequent introduction of new products; short product life cycles; and continual improvement in product price characteristics relative to product performance. Among the risks associated with the introduction of new products and services are delays in development or manufacturing, variations in costs, delays in customer purchases or reductions in price of existing products in anticipation of new introductions, difficulty in predicting customer demand for the new offerings and effectively managing inventory levels so that they are in line with anticipated demand, risks associated with customer qualification and evaluation of new products and the risk that new products may have quality or other defects or may not be supported adequately by application software. If we do not make an effective transition from existing products and services to future offerings, our revenue may decline. Our revenue and gross margin also may suffer due to the timing of product or service introductions by our suppliers and competitors. This is especially challenging when a product has a short life cycle or a competitor introduces a new product just before our own product introduction. Furthermore, sales of our new products and services may replace sales, or result in discounting of some of our current offerings, offsetting the benefit of even a successful introduction. There also may be overlaps in the current products and services of HP and portfolios acquired through mergers and acquisitions that we must manage. In addition, it may be difficult to ensure performance of new customer contracts in accordance with our revenue, margin and cost estimates and to achieve operational efficiencies embedded in our estimates. Given the competitive nature of our industry, if any of these risks materializes, future demand for our products and services and our results of operations may suffer. Our revenue, cost of sales, and expenses may suffer if we cannot continue to license or enforce the intellectual property rights on which our business depends or if third parties assert that we violate their intellectual property rights. We rely upon patent, copyright, trademark and trade secret laws in the United States and similar laws in other countries, and agreements with our employees, customers, suppliers and other parties, to establish and maintain our intellectual property rights in technology and products used in our operations. However, any of our direct or indirect intellectual property rights could be challenged, invalidated or circumvented, or such intellectual property rights may not be sufficient to permit us to take advantage of current market trends or otherwise to provide competitive advantages, which could result in costly product redesign efforts, discontinuance of certain product offerings or other competitive harm. Further, the laws of certain countries do not protect our proprietary rights to the same extent as the laws of the United States. Therefore, in certain jurisdictions we may be unable to 17 protect our proprietary technology adequately against unauthorized third-party copying or use, which could adversely affect our competitive position. Because of the rapid pace of technological change in the information technology industry, much of our business and many of our products rely on key technologies developed or licensed by third parties. We may not be able to obtain or to continue to obtain licenses and technologies from these third parties at all or on reasonable terms, or such third parties may demand cross-licenses to our intellectual property. In addition, it is possible that as a consequence of a merger or acquisition transaction third parties may obtain licenses to some of our intellectual property rights or our business may be subject to certain restrictions that were not in place prior to the transaction. Consequently, we may lose a competitive advantage with respect to these intellectual property rights or we may be required to enter into costly arrangements in order to terminate or limit these rights. Third parties also may claim that we or customers indemnified by us are infringing upon their intellectual property rights. For example, in recent years, individuals and groups have begun purchasing intellectual property assets for the sole purpose of making claims of infringement and attempting to extract settlements from large companies such as HP. If we cannot or do not license the infringed technology at all or on reasonable terms or substitute similar technology from another source, our operations could suffer. Even if we believe that the claims are without merit, the claims can be time-consuming and costly to defend and divert management’s attention and resources away from our business. Claims of intellectual property infringement also might require us to redesign affected products, enter into costly settlement or license agreements or pay costly damage awards, or face a temporary or permanent injunction prohibiting us from marketing or selling certain of our products. Even if we have an agreement to indemnify us against such costs, the indemnifying party may be unable to uphold its contractual agreements to us. Finally, our results of operations and cash flows could be affected in certain periods and on an ongoing basis by the imposition, accrual and payment of copyright levies or similar fees. In certain countries (primarily in Europe), proceedings are ongoing against HP seeking to impose levies upon equipment (such as PCs, multifunction devices and printers) and alleging that the copyright owners are entitled to compensation because these devices enable reproducing copyrighted content. Other countries that do not yet have levies on these types of devices are expected to extend existing levy schemes, and countries that do not currently have levy schemes may decide to impose copyright levies on these types of devices. If imposed, the amount of copyright levies would depend on the types of products determined to be subject to the levy, the number of units of those products sold during the period covered by the levy and the per unit fee for each type of product, all of which may be affected by several factors, including the outcome of ongoing litigation involving HP and other industry participants and possible action by the legislative bodies in the applicable countries, but could be substantial. Consequently, the ultimate impact of these potential copyright levies or similar fees and the ability of HP to recover such amounts through increased prices, remains uncertain. Economic uncertainty could adversely affect our revenue, gross margin and expenses. Our revenue and gross margin depend significantly on general economic conditions and the demand for computing and imaging products and services in the markets in which we compete. Economic weakness and constrained IT spending has previously resulted, and may result in the future, in decreased revenue, gross margin, earnings or growth rates and problems with our ability to manage inventory levels and collect customer receivables. We could experience such economic weakness and reduced spending, particularly in our consumer and financial services businesses, due to increases in fuel and other energy costs, conditions in the residential real estate and mortgage markets, access to credit and other macroeconomic factors affecting spending behavior. In addition, customer financial difficulties have previously resulted, and could result in the future, in increases in bad debt write-offs and additions to reserves in our receivables portfolio, inability by our lessees to make required lease 18 payments and reduction in the value of leased equipment upon its return to us compared to the value estimated at lease inception. We also have experienced, and may experience in the future, gross margin declines in certain businesses, reflecting the effect of items such as competitive pricing pressures, inventory write-downs, charges associated with the cancellation of planned production line expansion, and increases in pension and post-retirement benefit expenses. Economic downturns also may lead to restructuring actions and associated expenses. Uncertainty about future economic conditions makes it difficult for us to forecast operating results and to make decisions about future investments. Delays or reductions in information technology spending could have a material adverse effect on demand for our products and services, and consequently our results of operations, prospects and stock price. Due to the international nature of our business, political or economic changes or other factors could harm our future revenue, costs and expenses and financial condition. Sales outside the United States make up approximately 67% of our net revenue. Our future revenue, gross margin, expenses and financial condition also could suffer due to a variety of international factors, including: • • • • ongoing instability or changes in a country’s or region’s economic or political conditions, including inflation, recession, interest rate fluctuations and actual or anticipated military or political conflicts; longer accounts receivable cycles and financial instability among customers; trade regulations and procedures and actions affecting production, pricing and marketing of products; local labor conditions and regulations; • managing a geographically dispersed workforce; • • • • • changes in the regulatory or legal environment; differing technology standards or customer requirements; import, export or other business licensing requirements or requirements relating to making foreign direct investments, which could affect our ability to obtain favorable terms for components or lead to penalties or restrictions; difficulties associated with repatriating cash generated or held abroad in a tax-efficient manner and changes in tax laws; and fluctuations in freight costs and disruptions in the transportation and shipping infrastructure at important geographic points of exit and entry for our products and shipments. The factors described above also could disrupt our product and component manufacturing and key suppliers located outside of the United States. For example, we rely on manufacturers in Taiwan for the production of notebook computers and other suppliers in Asia for product assembly and manufacture. As approximately 67% of our sales are from countries outside of the United States, other currencies, particularly the euro and the Japanese yen, can have an impact on HP’s results (expressed in U.S. dollars). Currency variations also contribute to variations in sales of products and services in impacted jurisdictions. In addition, currency variations can adversely affect margins on sales of our products in countries outside of the United States and margins on sales of products that include components obtained from suppliers located outside of the United States. We use a combination of forward contracts and options designated as cash flow hedges to protect against foreign currency exchange rate risks. Such hedging activities may be ineffective or may not offset more than a portion of 19 the adverse financial impact resulting from currency variations. Gains or losses associated with hedging activities also may impact our revenue and to a lesser extent our cost of sales and financial condition. In many foreign countries, particularly in those with developing economies, it is common to engage in business practices that are prohibited by laws and regulations applicable to us, such as the Foreign Corrupt Practices Act. Although we implement policies and procedures designed to facilitate compliance with these laws, our employees, contractors and agents, as well as those companies to which we outsource certain of our business operations, may take actions in violation of our policies. Any such violation, even if prohibited by our policies, could have a material adverse effect on our business. Terrorist acts, conflicts and wars may seriously harm our business and revenue, costs and expenses and financial condition and stock price. Terrorist acts, conflicts or wars (wherever located around the world) may cause damage or disruption to HP, our employees, facilities, partners, suppliers, distributors, resellers or customers. The potential for future attacks, the national and international responses to attacks or perceived threats to national security, and other actual or potential conflicts or wars, including the ongoing military operations in Iraq, have created many economic and political uncertainties. In addition, as a major multi-national company with headquarters and significant operations located in the United States, actions against or by the United States may impact our business or employees. Although it is impossible to predict the occurrences or consequences of any such events, they could result in a decrease in demand for our products, make it difficult or impossible to deliver products to our customers or to receive components from our suppliers, create delays and inefficiencies in our supply chain and result in the need to impose employee travel restrictions. We are predominantly uninsured for losses and interruptions caused by terrorist acts, conflicts and wars. Business disruptions could seriously harm our future revenue and financial condition and increase our costs and expenses. Our worldwide operations could be subject to earthquakes, power shortages, telecommunications failures, water shortages, tsunamis, floods, hurricanes, typhoons, fires, extreme weather conditions, medical epidemics and other natural or manmade disasters or business interruptions, for which we are predominantly self-insured. The occurrence of any of these business disruptions could seriously harm our revenue and financial condition and increase our costs and expenses. Our corporate headquarters, and a portion of our research and development activities, are located in California, and other critical business operations and some of our suppliers are located in California and Asia, near major earthquake faults. The ultimate impact on us, our significant suppliers and our general infrastructure of being located near major earthquake faults is unknown, but our revenue, profitability and financial condition could suffer in the event of a major earthquake or other natural disaster. In addition, some areas, including California and parts of the East Coast, Southwest and Midwest of the United States, have previously experienced, and may experience in the future, major power shortages and blackouts. These blackouts could cause disruptions to our operations or the operations of our suppliers, distributors and resellers, or customers. Moreover, the consolidation of all of our worldwide IT data centers into six centers located in the southern United States, when completed, could increase the impact on us of a natural disaster or other business disruption occurring in that geographic area. If we fail to manage the distribution of our products and services properly, our revenue, gross margin and profitability could suffer. We use a variety of different distribution methods to sell our products and services, including third-party resellers and distributors and both direct and indirect sales to both enterprise accounts and consumers. Successfully managing the interaction of our direct and indirect channel efforts to reach various potential customer segments for our products and services is a complex process. Moreover, since each distribution method has distinct risks and gross margins, our failure to implement the most 20 advantageous balance in the delivery model for our products and services could adversely affect our revenue and gross margins and therefore our profitability. Other distribution risks are described below. • Our financial results could be materially adversely affected due to channel conflicts or if the financial conditions of our channel partners were to weaken. Our future operating results may be adversely affected by any conflicts that might arise between our various sales channels, the loss or deterioration of any alliance or distribution arrangement or the loss of retail shelf space. Moreover, some of our wholesale and retail distributors may have insufficient financial resources and may not be able to withstand changes in business conditions, including economic weakness and industry consolidation. Many of our significant distributors operate on narrow product margins and have been negatively affected by business pressures. Considerable trade receivables that are not covered by collateral or credit insurance are outstanding with our distribution and retail channel partners. Revenue from indirect sales could suffer, and we could experience disruptions in distribution if our distributors’ financial conditions, abilities to borrow funds in the credit markets or operations weaken. • Our inventory management is complex as we continue to sell a significant mix of products through distributors. We must manage inventory effectively, particularly with respect to sales to distributors, which involves forecasting demand and pricing issues. Distributors may increase orders during periods of product shortages, cancel orders if their inventory is too high or delay orders in anticipation of new products. Distributors also may adjust their orders in response to the supply of our products and the products of our competitors and seasonal fluctuations in end-user demand. Our reliance upon indirect distribution methods may reduce visibility to demand and pricing issues, and therefore make forecasting more difficult. If we have excess or obsolete inventory, we may have to reduce our prices and write down inventory. Moreover, our use of indirect distribution channels may limit our willingness or ability to adjust prices quickly and otherwise to respond to pricing changes by competitors. We also may have limited ability to estimate future product rebate redemptions in order to price our products effectively. We depend on third-party suppliers, and our revenue and gross margin could suffer if we fail to manage suppliers properly. Our operations depend on our ability to anticipate our needs for components, products and services and our suppliers’ ability to deliver sufficient quantities of quality components, products and services at reasonable prices in time for us to meet critical schedules. Given the wide variety of systems, products and services that we offer, the large number of our suppliers and contract manufacturers that are dispersed across the globe, and the long lead times that are required to manufacture, assemble and deliver certain components and products, problems could arise in planning production and managing inventory levels that could seriously harm us. Other supplier problems that we could face include component shortages, excess supply, risks related to the terms of our contracts with suppliers, risks associated with contingent workers, and risks related to our relationships with single source suppliers, as described below. • Shortages. Occasionally we may experience a shortage of, or a delay in receiving, certain supplies as a result of strong demand, capacity constraints, supplier financial weaknesses, inability of suppliers to borrow funds in the credit markets, disputes with suppliers (some of which are also customers), other problems experienced by suppliers or problems faced during the transition to new suppliers. In particular, our PC business relies heavily upon Contract Manufacturers (“CMs”) and Original Design Manufacturers (“ODMs”) to manufacture its products and is 21 therefore dependent upon the continuing operations of those CMs and ODMs to fulfill demand for our PC products. HP represents a substantial portion of the business of some of these CMs and ODMs, and any changes to the nature or volume of business transacted by HP with a particular CM or ODM could adversely affect the operations and financial condition of the CM or ODM and lead to shortages or delays in receiving products from that CM or ODM. If shortages or delays persist, the price of these supplies may increase, we may be exposed to quality issues or the supplies may not be available at all. We may not be able to secure enough supplies at reasonable prices or of acceptable quality to build products or provide services in a timely manner in the quantities or according to the specifications needed. Accordingly, our revenue and gross margin could suffer as we could lose time-sensitive sales, incur additional freight costs or be unable to pass on price increases to our customers. If we cannot adequately address supply issues, we might have to reengineer some products or service offerings, resulting in further costs and delays. • Oversupply. In order to secure supplies for the provision of products or services, at times we may make advance payments to suppliers or enter into non-cancelable commitments with vendors. In addition, we may purchase supplies strategically in advance of demand to take advantage of favorable pricing or to address concerns about the availability of future supplies. If we fail to anticipate customer demand properly, a temporary oversupply could result in excess or obsolete components, which could adversely affect our gross margin. • Contractual terms. As a result of binding price or purchase commitments with vendors, we may be obligated to purchase supplies or services at prices that are higher than those available in the current market and be limited in our ability to respond to changing market conditions. In the event that we become committed to purchase supplies or services for prices in excess of the current market price, we may be at a disadvantage to competitors who have access to components or services at lower prices, and our gross margin could suffer. In addition, many of our competitors obtain products or components from the same CMs, ODMs and suppliers that we utilize. Our competitors may obtain better pricing and other terms and more favorable allocations of products and components during periods of limited supply, and our ability to engage in relationships with certain CMs, ODMs and suppliers could be limited. The practice employed by our PC business of purchasing product components and transferring those components to its CMs and ODMs may create large supplier receivables with the CMs and ODMs that, depending on the financial condition of the CMs and ODMs, may have a risk of uncollectibility. In addition, certain of our CMs, ODMs and suppliers may decide in the future to discontinue conducting business with us. Any of these actions by our competitors, CMs, ODMs or suppliers could adversely affect our future operating results and financial condition. • Contingent workers. We also rely on third-party suppliers for the provision of contingent workers, and our failure to manage our use of such workers effectively could adversely affect our results of operations. We have been exposed to various legal claims relating to the status of contingent workers in the past and could face similar claims in the future. We may be subject to shortages, oversupply or fixed contractual terms relating to contingent workers, as described above. Our ability to manage the size of, and costs associated with, the contingent workforce may be subject to additional constraints imposed by local laws. • Single source suppliers. Our use of single source suppliers for certain components could exacerbate our supplier issues. We obtain a significant number of components from single sources due to technology, availability, price, quality or other considerations. For example, we rely on Intel to provide us with a sufficient supply of processors for many of our PCs, workstations, handheld computing devices and servers, and some of those processors are customized for our products. New products that we introduce may utilize custom components obtained from only one source initially until we have evaluated whether there is a need for 22 additional suppliers. Replacing a single source supplier could delay production of some products as replacement suppliers initially may be subject to capacity constraints or other output limitations. For some components, such as customized components and some of the processors that we obtain from Intel, alternative sources may not exist or those alternative sources may be unable to produce the quantities of those components necessary to satisfy our production requirements. In addition, we sometimes purchase components from single source suppliers under short- term agreements that contain favorable pricing and other terms but that may be unilaterally modified or terminated by the supplier with limited notice and with little or no penalty. The performance of such single source suppliers under those agreements (and the renewal or extension of those agreements upon similar terms) may affect the quality, quantity and price of supplies to HP. The loss of a single source supplier, the deterioration of our relationship with a single source supplier, or any unilateral modification to the contractual terms under which we are supplied components by a single source supplier could adversely effect our revenue and gross margins. If we fail to comply with our customer contracts or government contracting regulations, our revenue could suffer. Our contracts with our customers may include unique and specialized performance requirements. In particular, our contracts with federal, state, provincial and local governmental customers are subject to various procurement regulations, contract provisions and other requirements relating to their formation, administration and performance. Any failure by us to comply with the specific provisions in our customer contracts or any violation of government contracting regulations could result in the imposition of various civil and criminal penalties, which may include termination of contracts, forfeiture of profits, suspension of payments and, in the case of our government contracts, fines and suspension from future government contracting. In addition, we are currently, and in the future may be, subject to qui tam litigation brought by private individuals on behalf of the government relating to our government contracts, which could include claims for up to treble damages. Further, any negative publicity related to our customer contracts or any proceedings surrounding them, regardless of its accuracy, may damage our business by affecting our ability to compete for new contracts. If our customer contracts are terminated, if we are suspended from government work, or if our ability to compete for new contracts is adversely affected, we could suffer a material reduction in expected revenue. The revenue and profitability of our operations have historically varied, which makes our future financial results less predictable. Our revenue, gross margin and profit vary among our products and services, customer groups and geographic markets and therefore will likely be different in future periods than our current results. Overall gross margins and profitability in any given period are dependent partially on the product, customer and geographic mix reflected in that period’s net revenue. In particular, IPG and certain of its business units such as printer supplies contribute significantly to our gross margin and profitability. Competition, lawsuits, investigations and other risks affecting IPG, therefore may have a significant impact on our overall gross margin and profitability. Certain segments, and ESS in particular, have a higher fixed cost structure and more variation in gross margins across their business units and product portfolios than others and may therefore experience significant operating profit volatility on a quarterly basis. In addition, newer geographic markets may be relatively less profitable due to investments associated with entering those markets and local pricing pressures, and we may have difficulty establishing and maintaining the operating infrastructure necessary to support the high growth rate associated with some of those markets. Market trends, competitive pressures, commoditization of products, seasonal rebates, increased component or shipping costs, regulatory impacts and other factors may result in reductions in revenue or pressure on gross margins of certain segments in a given period, which may necessitate adjustments to our operations. 23 We make estimates and assumptions in connection with the preparation of HP’s Consolidated Financial Statements, and any changes to those estimates and assumptions could have a material adverse effect on our results of operations. In connection with the preparation of HP’s Consolidated Financial Statements, we use certain estimates and assumptions based on historical experience and other factors. Our most critical accounting estimates are described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report. In addition, as discussed in Note 17 to the Consolidated Financial Statements, we make certain estimates under the provisions of SFAS No. 5 “Accounting for Contingencies,” including decisions related to provisions for legal proceedings and other contingencies. While we believe that these estimates and assumptions are reasonable under the circumstances, they are subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to have been incorrect, it could have a material adverse effect on our results of operations. Unanticipated changes in HP’s tax provisions or exposure to additional income tax liabilities could affect our profitability. We are subject to income taxes in the United States and numerous foreign jurisdictions. Our tax liabilities are affected by the amounts we charge for inventory, services, licenses, funding and other items in intercompany transactions. We are subject to ongoing tax audits in various jurisdictions. Tax authorities may disagree with our intercompany charges or other matters and assess additional taxes. We regularly assess the likely outcomes of these audits in order to determine the appropriateness of our tax provision. However, there can be no assurance that we will accurately predict the outcomes of these audits, and the actual outcomes of these audits could have a material impact on our net income or financial condition. In addition, our effective tax rate in the future could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in tax laws and the discovery of new information in the course of our tax return preparation process. In particular, the carrying value of deferred tax assets, which are predominantly in the United States, is dependent on our ability to generate future taxable income in the United States. Any of these changes could affect our profitability. Our sales cycle makes planning and inventory management difficult and future financial results less predictable. In some of our segments, our quarterly sales often have reflected a pattern in which a disproportionate percentage of each quarter’s total sales occur towards the end of such quarter. This uneven sales pattern makes prediction of revenue, earnings, cash flow from operations and working capital for each financial period difficult, increases the risk of unanticipated variations in quarterly results and financial condition and places pressure on our inventory management and logistics systems. If predicted demand is substantially greater than orders, there will be excess inventory. Alternatively, if orders substantially exceed predicted demand, we may not be able to fulfill all of the orders received in the last few weeks of each quarter. Other developments late in a quarter, such as a systems failure, component pricing movements, component shortages or global logistics disruptions, could adversely impact inventory levels and results of operations in a manner that is disproportionate to the number of days in the quarter affected. We experience some seasonal trends in the sale of our products that also may produce variations in quarterly results and financial condition. For example, sales to governments (particularly sales to the United States government) are often stronger in the third calendar quarter, consumer sales are often stronger in the fourth calendar quarter, and many customers whose fiscal and calendar years are the same spend their remaining capital budget authorizations in the fourth calendar quarter prior to new budget constraints in the first calendar quarter of the following year. European sales are often weaker during the summer months. Demand during the spring and early summer also may be adversely 24 impacted by market anticipation of seasonal trends. Moreover, to the extent that we introduce new products in anticipation of seasonal demand trends, our discounting of existing products may adversely affect our gross margin prior to or shortly after such product launches. Typically, our third fiscal quarter is our weakest and our fourth fiscal quarter is our strongest. Many of the factors that create and affect seasonal trends are beyond our control. Any failure by us to execute planned cost reductions successfully could result in total costs and expenses that are greater than expected. We have adopted restructuring and other cost reduction plans to bring operational expenses to appropriate levels for each of our businesses, while simultaneously implementing extensive new company-wide expense control programs. These initiatives include: • A workforce restructuring program and a related U.S. early retirement program announced in July 2005 that we expect to result in the elimination of approximately 14,985 positions by the end of fiscal 2008; • A multi-year plan announced in the third fiscal quarter of 2006 to reduce IT spending by consolidating HP’s 85 data centers worldwide into six larger centers located in three U.S. cities; • A multi-year program announced in the third fiscal quarter of 2006 to reduce real estate costs by consolidating several hundred HP real estate locations worldwide to fewer core sites; • Modifications to our defined benefit pension plan, our subsidized retiree medical program and our 401(k) plan announced in February 2007 pursuant to which affected employees will cease accruing pension benefits and will, instead, receive an increased 401(k) match effective January 1, 2008; and • A U.S. early retirement program announced in February 2007 under which 3,080 employees left the company as of May 31, 2007, all of whom have been or we expect will be replaced. Our ability to achieve the anticipated cost savings and other benefits from these initiatives within the expected time frame is subject to many estimates and assumptions, including estimates and assumptions regarding the cost of consolidating the data centers and real estate locations, the amount of accelerated depreciation or asset impairment to be incurred when we vacate facilities or cease using equipment before the end of their respective lease term or asset life, the savings associated with the benefit plan changes announced in February 2007, the costs associated with the replacement of employees who retired under the February 2007 early retirement program and the costs and timing of other activities in connection with these initiatives. These estimates and assumptions are subject to significant economic, competitive and other uncertainties, some of which are beyond our control. If these estimates and assumptions are incorrect, if we experience delays, or if other unforeseen events occur, our business and results of operations could be adversely affected. In order to be successful, we must attract, retain and motivate key employees, and failure to do so could seriously harm us. In order to be successful, we must attract, retain and motivate executives and other key employees, including those in managerial, technical, sales, marketing and IT support positions. Hiring and retaining qualified executives, engineers, skilled solutions providers in the IT support business and qualified sales representatives are critical to our future, and competition for experienced employees in the IT industry can be intense. The failure to hire executives and key employees or the loss of executives and key employees could have a significant impact on our operations. 25 Changes to our compensation and benefit programs could adversely affect our ability to attract and retain employees. We have historically used stock options and other forms of share-based payment awards as key components of our total rewards employee compensation program in order to align employees’ interests with the interests of our stockholders, encourage employee retention and provide competitive compensation and benefit packages. HP began recording charges to earnings for stock-based compensation expense in the first quarter of fiscal 2006 in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment.” As a result, we began to incur increased compensation costs associated with our stock-based compensation programs. Moreover, difficulties relating to obtaining stockholder approval of equity compensation plans could make it harder or more expensive for us to grant share-based payment awards to employees in the future. Like other companies, HP has reviewed its equity compensation strategy in light of the current regulatory and competitive environment and has reduced the total number of share-based payment awards granted to employees and the number of employees who receive share-based payment awards. Due to this change in our stock-based compensation strategy, combined with the pension and other benefit plan changes undertaken to reduce costs and our increasing reliance on variable pay, we may find it difficult to attract, retain and motivate employees, and any such difficulty could materially adversely affect our business. HP’s stock price has historically fluctuated and may continue to fluctuate, which may make future prices of HP’s stock difficult to predict. HP’s stock price, like that of other technology companies, can be volatile. Some of the factors that could affect our stock price are: • • • speculation in the press or investment community about, or actual changes in, our business, strategic position, market share, organizational structure, operations, financial condition, financial reporting and results, effectiveness of cost cutting efforts, value or liquidity of our investments, exposure to market volatility, prospects, business combination or investment transactions, or executive team; the announcement of new products, services, technological innovations or acquisitions by HP or its competitors; and quarterly increases or decreases in revenue, gross margin, earnings or cash flow from operations, changes in estimates by the investment community or guidance provided by HP, and variations between actual and estimated financial results. General or industry-specific market conditions or stock market performance or domestic or international macroeconomic and geopolitical factors unrelated to HP’s performance also may affect the price of HP common stock. For these reasons, investors should not rely on recent trends to predict future stock prices, financial condition, results of operations or cash flows. In addition, following periods of volatility in a company’s securities, securities class action litigation against a company is sometimes instituted. If instituted against HP, this type of litigation could result in substantial costs and the diversion of management time and resources. System security risks and systems integration issues could disrupt our internal operations or information technology services provided to customers, and any such disruption could harm our revenue, increase our expenses and harm our reputation and stock price. Experienced computer programmers and hackers may be able to penetrate our network security and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. In addition, computer programmers and hackers may be able to develop and deploy viruses, worms, and other malicious software programs that attack our products or otherwise exploit 26 any security vulnerabilities of our products. As a result, we could incur significant expenses in addressing problems created by security breaches of our network and any security vulnerabilities of our products. Moreover, we could lose existing or potential customers for information technology outsourcing services or other information technology solutions or incur significant expenses in connection with our customers’ system failures or any actual or perceived security vulnerabilities in our products. In addition, sophisticated hardware and operating system software and applications that we produce or procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate security problems, bugs, viruses, worms, malicious software programs and security vulnerabilities could be significant, and the efforts to address these problems could result in interruptions, delays, cessation of service and loss of existing or potential customers that may impede our sales, manufacturing, distribution or other critical functions. Portions of our IT infrastructure also may experience interruptions, delays or cessations of service or produce errors in connection with systems integration or migration work that takes place from time to time. We may not be successful in implementing new systems and transitioning data, including our current project to consolidate all of our worldwide IT data centers into six centers, which could cause business disruptions and be more expensive, time consuming, disruptive and resource-intensive. Such disruptions could adversely impact our ability to fulfill orders and interrupt other processes. Delayed sales, lower margins or lost customers resulting from these disruptions have adversely affected in the past, and in the future could adversely affect, our financial results, stock price and reputation. Any failure by us to manage, complete and integrate acquisitions, divestitures and other significant transactions successfully could harm our financial results, business and prospects and may result in financial results that are different than expected. As part of our business strategy, we frequently acquire complementary companies or businesses, divest non-core businesses or assets, enter into strategic alliances and joint ventures and make investments to further our business (collectively, “business combination and investment transactions”). In order to pursue this strategy successfully, we must identify suitable candidates for and successfully complete business combination and investment transactions, some of which may be large and complex, and manage post-closing issues such as the integration of acquired companies or employees. Integration and other risks associated with business combination and investment transactions can be more pronounced for larger and more complicated transactions or if multiple transactions are integrated simultaneously. If we fail to identify and complete successfully business combination and investment transactions that further our strategic objectives, we may be required to expend resources to develop products and technology internally, we may be at a competitive disadvantage or we may be adversely affected by negative market perceptions, any of which may have a material adverse effect on our revenue, gross margin and profitability. Integration issues are complex, time-consuming and expensive and, without proper planning and implementation, could significantly disrupt our business. The challenges involved in integration include: • • • combining product offerings and entering into new markets in which we are not experienced; convincing customers and distributors that the transaction will not diminish client service standards or business focus, preventing customers and distributors from deferring purchasing decisions or switching to other suppliers (which could result in our incurring additional obligations in order to address customer uncertainty), minimizing sales force attrition and coordinating sales, marketing and distribution efforts; consolidating and rationalizing corporate IT infrastructure, which may include multiple legacy systems from various acquisitions and integrating software code; 27 • minimizing the diversion of management attention from ongoing business concerns; • • • persuading employees that business cultures are compatible, maintaining employee morale and retaining key employees, engaging with employee works councils representing an acquired company’s non-U.S. employees, integrating employees into HP, correctly estimating employee benefit costs and implementing restructuring programs; coordinating and combining administrative, manufacturing, research and development and other operations, subsidiaries, facilities and relationships with third parties in accordance with local laws and other obligations while maintaining adequate standards, controls and procedures; achieving savings from supply chain integration; and • managing integration issues shortly after or pending the completion of other independent transactions. We evaluate and enter into significant business combination and investment transactions on an ongoing basis. We may not fully realize all of the anticipated benefits of any business combination and investment transaction, and the timeframe for achieving benefits of a business combination and investment transaction may depend partially upon the actions of employees, suppliers or other third parties. In addition, the pricing and other terms of our contracts for business combination and investment transactions require us to make estimates and assumptions at the time we enter into these contracts, and, during the course of our due diligence, we may not identify all of the factors necessary to estimate our costs accurately. Any increased or unexpected costs, unanticipated delays or failure to achieve contractual obligations could make these agreements less profitable or unprofitable. Managing business combination and investment transactions requires varying levels of management resources, which may divert our attention from other business operations. These business combination and investment transactions also have resulted and in the future may result in significant costs and expenses and charges to earnings, including those related to severance pay, early retirement costs, employee benefit costs, asset impairment charges, charges from the elimination of duplicative facilities and contracts, in-process research and development charges, inventory adjustments, assumed litigation and other liabilities, legal, accounting and financial advisory fees, and required payments to executive officers and key employees under retention plans. Moreover, HP has incurred and will incur additional depreciation and amortization expense over the useful lives of certain assets acquired in connection with business combination and investment transactions, and, to the extent that the value of goodwill or intangible assets with indefinite lives acquired in connection with a business combination and investment transaction becomes impaired, we may be required to incur additional material charges relating to the impairment of those assets. In order to complete an acquisition, we may issue common stock, potentially creating dilution for existing stockholders, or borrow, affecting our financial condition and potentially our credit ratings. Any prior or future downgrades in our credit rating associated with an acquisition could adversely affect our ability to borrow and result in more restrictive borrowing terms. In addition, HP’s effective tax rate on an ongoing basis is uncertain, and business combination and investment transactions could impact our effective tax rate. We also may experience risks relating to the challenges and costs of closing a business combination and investment transaction and the risk that an announced business combination and investment transaction may not close. As a result, any completed, pending or future transactions may contribute to financial results that differ from the investment community’s expectations in a given quarter. 28 We cannot predict the outcome of various regulatory inquiries and stockholder derivative action lawsuits arising out of the processes employed in the investigation into leaks of HP confidential information to members of the media, and we may be named in additional regulatory inquiries and stockholder litigation, all of which could result in significant legal and other expenses. The Attorney General of the State of California, the Committee on Energy and Commerce of the U.S. House of Representatives, the U.S. Attorney for the Northern District of California, the Division of Enforcement of the SEC and the U.S. Federal Communications Commission all have conducted inquiries or investigations relating to the processes employed in an investigation into leaks of HP confidential information to members of the media that concluded in May 2006. We have entered into an agreement with the California Attorney General to resolve civil claims relating to the leak investigation. Under the terms of the agreement, which includes an injunction, we have paid a total of $14.5 million and agreed to implement and maintain for five years a series of measures designed to ensure that HP’s corporate investigations are conducted in accordance with California law and the company’s high ethical standards. We also have consented to the entry of an order by the SEC ordering HP to cease and desist from committing or causing violations of the public reporting requirements of the Securities Exchange Act of 1934, as amended. If we fail to implement and maintain the measures required under the agreement with the California Attorney General or if we fail to comply with the SEC cease and desist order, we could be subject to civil or criminal penalties. Four stockholder derivative lawsuits also have been filed in California (all of which have been consolidated into a single lawsuit) and two in Delaware (both of which have been consolidated into a single lawsuit) purportedly on behalf of HP stockholders seeking to recover damages and to obtain specified injunctive relief stemming from the activities of the leak investigations. We may in the future also be subject to additional litigation or other proceedings arising in relation to these matters. The period of time necessary to resolve the stockholder lawsuits is uncertain, and the expense of defending and concluding such litigation may be significant. In addition, we may be obligated to indemnify (and advance legal expenses to) former or current directors, officers or employees in accordance with the terms of our certificate of incorporation, bylaws, other applicable agreements, and Delaware law. Unforeseen environmental costs could impact our future net earnings. We are subject to various federal, state, local and foreign laws and regulations concerning environmental protection, such as laws governing the conduct of our facilities and operations with respect to the discharge of pollutants into the air and water, the management and disposal of hazardous substances and wastes and the cleanup of contaminated sites. It is our policy to apply strict standards for environmental clean-up to sites outside the United States, even where we are not required to do so under applicable local laws and regulations. Many of our products are subject to various federal, state and international laws governing chemical substances, including laws regulating the manufacture and distribution of chemical substances and laws restricting the presence of certain substances in electronics products. We could incur substantial costs, including cleanup costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims, or our products could be enjoined from entering certain jurisdictions, if we were to violate or become liable under environmental laws or if our products become non-compliant with environmental laws. The ultimate costs under environmental laws and the timing of these costs are difficult to predict, and liability under some environmental laws relating to contaminated sites can be imposed retroactively and on a joint and several basis. We record a liability for environmental remediation and other environmental costs when we consider the costs to be probable and the amount of the costs can be reasonably estimated. We face increasing complexity in our product design and procurement operations as we adjust to new and future requirements relating to the materials composition of our products, including the restrictions on lead, cadmium and certain other substances that apply to specified electronics products put on the market in the European Union as of July 1, 2006 (Restriction of Hazardous Substances Directive) and 29 similar legislation in other countries including China, Japan and Korea. We also could face significant costs and liabilities in connection with product take-back legislation. The EU has enacted the Waste Electrical and Electronic Equipment Directive (the “WEEE Legislation”), which makes producers of electrical goods, including computers and printers, financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. Similar legislation has been or may be enacted in other jurisdictions, including in the United States, Canada, Mexico, China and Japan. We are continuing to evaluate the cumulative impact of, and are taking steps to comply with, the WEEE Legislation and similar legislation in other jurisdictions as individual countries issue their implementation legislation and guidance. Some anti-takeover provisions contained in our certificate of incorporation and bylaws, as well as provisions of Delaware law, could impair a takeover attempt. We have provisions in our certificate of incorporation and bylaws, each of which could have the effect of rendering more difficult or discouraging an acquisition of HP deemed undesirable by our Board of Directors. These include provisions: • • • • • • authorizing blank check preferred stock, which HP could issue with voting, liquidation, dividend and other rights superior to our common stock; limiting the liability of, and providing indemnification to, HP’s directors and officers; specifying that HP stockholders may take action only at a duly called annual or special meeting of stockholders and otherwise in accordance with our bylaws and limiting the ability of our stockholders to call special meetings; requiring advance notice of proposals by HP stockholders for business to be conducted at stockholder meetings and for nominations of candidates for election to our Board of Directors; requiring a vote by the holders of two-thirds of HP’s outstanding shares to amend certain bylaws relating to HP stockholder meetings, the Board of Directors and indemnification; and controlling the procedures for conduct of HP Board and stockholder meetings and election, appointment and removal of HP directors. These provisions, alone or together, could deter or delay hostile takeovers, proxy contests and changes in control or management of HP. As a Delaware corporation, HP also is subject to provisions of Delaware law, including Section 203 of the Delaware General Corporation Law, which prevents some stockholders from engaging in certain business combinations without approval of the holders of substantially all of HP’s outstanding common stock. Any provision of our certificate of incorporation or bylaws or Delaware law that has the effect of delaying or deterring a change in control of HP could limit the opportunity for our stockholders to receive a premium for their shares of HP common stock and also could affect the price that some investors are willing to pay for HP common stock. ITEM 1B. Unresolved Staff Comments. Not applicable. ITEM 2. Properties. As of October 31, 2007, we owned or leased a total of approximately 62 million square feet of space worldwide. We believe that our existing properties are in good condition and are suitable for the conduct of our business. 30 As of October 31, 2007, our sales and support operations occupied approximately 12 million square feet. We own 42% of the space used for sales and support activities and lease the remaining 58%. Our manufacturing plants, research and development facilities and warehouse and administrative facilities occupied approximately 50 million square feet. We own 57% of our manufacturing, research and development, warehouse and administrative space and lease the remaining 43%. Our plants are equipped with machinery, most of which we own and which, in part, we developed to meet the special requirements of our manufacturing processes. At the end of fiscal 2007, we were productively utilizing the majority of the space in our facilities, while executing our previously announced plans to consolidate our 85 data centers into six larger centers and to reduce our real estate costs and increase our productive utilization by consolidating several hundred real estate locations worldwide to fewer core sites over the next three years. As indicated above, we have seven business segments: ESS, HPS, HP Software, PSG, IPG, HPFS, and Corporate Investments. Because of the interrelation of these segments, a majority of these segments use substantially all of the properties at least in part, and we retain the flexibility to use each of the properties in whole or in part for each of the segments. Principal Executive Offices Our principal executive offices, including our global headquarters, are located at 3000 Hanover Street, Palo Alto, California, United States of America. Headquarters of Geographic Operations The locations of our headquarters of geographic operations at October 31, 2007 were as follows: Americas Houston, Texas Europe, Middle East, Africa Geneva, Switzerland Asia Pacific, including Japan Singapore Product Development and Manufacturing The locations of our major product development and manufacturing facilities and HP Labs at October 31, 2007 were as follows: Americas Cupertino, Fremont, Palo Alto, Roseville, San Diego and Woodland, California Fort Collins and Colorado Springs, Colorado Boise, Idaho Indianapolis, Indiana Andover and Marlboro, Massachusetts Nashua, New Hampshire Corvallis, Oregon Memphis, Tennessee Houston, Texas Sandston, Virginia Vancouver, Washington Aguadilla, Puerto Rico ITEM 3. Legal Proceedings. Europe, Middle East, Africa Hewlett-Packard Laboratories Palo Alto, California Beijing, China Bangalore, India Haifa, Israel Tokyo, Japan Bristol, United Kingdom Herrenberg, Germany Dublin, Ireland Rehovot and Netanya, Israel Amersfoort, The Netherlands Barcelona, Spain Erskine, United Kingdom Asia Pacific, including Japan Shanghai, China Bangalore, India Pantangar, India Akishima, Japan Singapore Information with respect to this item may be found in Note 17 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. ITEM 4. Submission of Matters to a Vote of Security Holders. Not applicable. 31 PART II ITEM 5. Market for the Registrant’s Common Equity and Related Stockholder Matters. Information regarding the market prices of HP common stock and the markets for that stock may be found in the “Quarterly Summary” in Item 8 and on the cover page of this Annual Report on Form 10-K, respectively, which are incorporated herein by reference. We have paid cash dividends each fiscal year since 1965. The current rate is $0.08 per share per quarter. As of November 30, 2007, there were approximately 142,000 stockholders of record. Additional information concerning dividends may be found in “Selected Financial Data” in Item 6 and in Item 8, which are incorporated herein by reference. Recent Sales of Unregistered Securities There were no unregistered sales of equity securities during fiscal 2007. Issuer Purchases of Equity Securities Period Month #1 (August 2007) ......................... Month #2 (September 2007).................... Month #3 (October 2007)........................ Total........................................ Total Number of Shares Purchased Average Price Paid per Share 24,543,000 12,945,679 4,600,000 42,088,679 $47.40 $49.49 $51.39 $48.48 Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet Be Purchased under the Plans or Programs 24,543,000 12,945,679 4,600,000 42,088,679 $3,591,773,284 $2,951,106,386 $2,714,725,466 HP repurchased shares in the fourth quarter of fiscal 2007 under an ongoing program to manage the dilution created by shares issued under employee stock plans as well as to repurchase shares opportunistically. This program, which does not have a specific expiration date, authorizes repurchases in the open market or in private transactions. All shares repurchased in the fourth quarter of fiscal 2007 were purchased in open market transactions. As of October 31, 2007, HP had remaining authorization of approximately $2.7 billion for future share repurchases under the $8.0 billion repurchase authorization approved by HP’s Board of Directors on March 15, 2007. On November 19, 2007, HP’s Board of Directors authorized an additional $8.0 billion for future repurchases of HP’s outstanding shares of common stock. 32 Stock Performance Graph and Cumulative Total Return The graph below shows the cumulative total stockholder return assuming the investment of $100 on the date specified (and the reinvestment of dividends thereafter) in each of HP common stock, the S&P 500 Index, and the S&P Information Technology Index.(1) The comparisons in the graph below are based upon historical data and are not indicative of, or intended to forecast, future performance of our common stock. Hewlett-Packard Company ........................................................ S&P 500..................................................................................... S&P Information Technology.................................................... 10/02 100.00 100.00 100.00 10/03 143.60 120.80 141.21 10/04 121.96 132.18 140.00 10/05 185.85 143.71 147.59 10/06 259.34 167.19 162.26 10/07 348.52 191.54 205.90 (1) The stock performance graph does not include HP’s peer group because peer group information is represented and included in the S&P Information Technology Index. 33 ITEM 6. Selected Financial Data. The information set forth below is not necessarily indicative of results of future operations and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the Consolidated Financial Statements and notes thereto included in Item 8, “Financial Statements and Supplementary Data,” of this Form 10-K, which are incorporated herein by reference, in order to understand further the factors that may affect the comparability of the financial data presented below. HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Selected Financial Data Net revenue.................................................................................... Earnings from operations(1)............................................................ Net earnings................................................................................... Net earnings per share Basic ........................................................................................... Diluted ........................................................................................ Cash dividends declared per share................................................. At year-end: 2007 $104,286 $8,719 $7,264 2006 For the fiscal years ended October 31, 2005 In millions, except per share amounts $79,905 $4,227 $3,497 $86,696 $3,473 $2,398 $91,658 $6,560 $6,198 2004 $2.76 $2.68 $0.32 $2.23 $2.18 $0.32 $0.83 $0.82 $0.32 $1.16 $1.15 $0.32 2003 $73,061 $2,896 $2,539 $0.83 $0.83 $0.32 Total assets.................................................................................. Long-term debt ........................................................................... $88,699 $4,997 $81,981 $2,490 $77,317 $3,392 $76,138 $4,623 $74,716 $6,494 (1) Earnings from operations include the following items: 2007 2006 2005 2004 2003 In millions 104 1,684 2 $622 $603 $604 48 536 114 158 52 37 — (199) — 54 — — $1,350 $970 $563 45 800 1 — 280 $2,213 $856 $1,689 $1,583 $604 $1,157 Amortization of purchased intangible assets ......................... Stock-based compensation expense....................................... Restructuring charges ............................................................ In-process research and development charges....................... Pension curtailments and pension settlements, net ................ Acquisition-related charges ................................................... Total charges before taxes ..................................................... Total charges, net of taxes ..................................................... $783 629 387 190 (517) — $1,472 $1,137 34 ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Consolidated Financial Statements and the related notes that appear elsewhere in this document. OVERVIEW We are a leading global provider of products, technologies, software, solutions and services to individual consumers, small- and medium-sized businesses (“SMBs”), and large enterprises, including in the public and education sectors. Our offerings span: • • • personal computing and other access devices; imaging and printing-related products and services; enterprise information technology infrastructure, including enterprise storage and server technology, and software that optimizes business technology investments; and • multi-vendor customer services, including technology support and maintenance, consulting and integration and outsourcing services. We have seven business segments: Enterprise Storage and Servers (“ESS”), HP Services (“HPS”), HP Software, the Personal Systems Group (“PSG”), the Imaging and Printing Group (“IPG”), HP Financial Services (“HPFS”), and Corporate Investments. ESS, HPS and HP Software are structured beneath a broader Technology Solutions Group (“TSG”). While TSG is not an operating segment, we sometimes provide financial data aggregating the segments within TSG in order to provide a supplementary view of our business. The operating framework in which we manage our businesses and guide our strategies is based on the disciplined management of three business levers: targeted growth, operational efficiency and capital strategy. Although we have made progress towards our goals in recent periods, there are still many areas in which we believe that we can improve. To implement this operating framework, we are focused on the following initiatives: • We are engaged in a process of examining every function and every business in the company in order to optimize efficiency and reduce cost; • We are in the process of consolidating 85 data centers worldwide into six state-of-the-art centers in three U.S. cities and consolidating several hundred real estate locations worldwide to fewer core sites in order to reduce our IT spending and real estate costs; • We are reinvesting a portion of the cost savings from these initiatives by expanding our sales force and aligning our resources in order to build our market share in emerging markets while expanding our coverage to drive growth in mature markets; • We are developing training programs for our sales forces designed to enhance our ability to provide solutions to our customers and build customer loyalty; • We are building and expanding our services organization to support our technology businesses and provide comprehensive solutions to our customers; • We are developing a global delivery structure to take advantage of regions where advanced technical expertise is available at lower costs; 35 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) • We are expanding our ethics and compliance programs and enhancing our corporate governance to ensure that all of our actions are consistent with HP’s values; and • We are repurchasing shares of our common stock under an ongoing program to manage the dilution created by shares issued under employee stock plans as well as to repurchase shares opportunistically. We continue to grow our business organically and through strategic acquisitions. During fiscal 2007, we acquired ten companies, among which the two largest were Mercury Interactive Corporation (“Mercury”) and Opsware Inc., and we expect to continue to make strategic acquisitions periodically in the future. In February 2007, we announced our decision to modify our U.S. defined benefit pension plan for the remaining number of U.S. employees still accruing benefits under the program. Effective January 1, 2008, these employees will cease accruing pension benefits and will, instead, receive an increased 401(k) match to 6 percent from 4 percent of eligible earnings. The final pension benefit amount will be calculated based on pay and service through December 31, 2007. In addition, future eligibility for the Pre-2003 HP Retiree Medical Program was limited to those employees who were within five years of satisfying the program’s eligibility criteria on June 30, 2007. These actions reduced our U.S. defined benefit and post- retirement plan obligations, and, as a result, we recorded a one-time curtailment gain of $542 million in fiscal 2007. In conjunction with this announcement, we provided eligible affected employees with the opportunity to participate in a 2007 U.S. Enhanced Early Retirement program (the “2007 EER”) and recorded a restructuring charge of $354 million during fiscal 2007. A total of 3,080 employees participated in the 2007 EER, including 595 persons who had been included in previous restructuring programs or who voluntarily left the company since November 30, 2006. All employees who participated in the 2007 EER left the company by May 31, 2007. For more information, see Notes 8 and 15 to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. In terms of how our execution has translated into financial performance, the following provides an overview of our key fiscal 2007 financial metrics: Net revenue.......................................... Year-over-year net revenue % increase ............................................ Earnings from operations..................... Earnings from operations as a % of net revenue........................................... Net earnings ......................................... Net earnings per share Basic .................................................... Diluted ................................................. HP Consolidated ESS HPS TSG HP Software Total PSG IPG HPFS $104,286 $18,769 $16,646 $2,325 $37,740 $36,409 $28,465 $2,336 In millions, except per share amounts 13.8% $8,719 8.4% $1,980 6.6% $1,829 78.7% 10.3% $4,156 $347 24.8% $1,939 6.3% 12.4% $155 $4,315 8.4% 10.5% 11.0% 14.9% 11.0% 5.3% 15.2% 6.6% $7,264 $2.76 $2.68 Cash and cash equivalents at October 31, 2007 totaled $11.3 billion, a decrease of $5.1 billion from the October 31, 2006 balance of $16.4 billion. The decrease for fiscal 2007 was related primarily to $10.9 billion paid to repurchase our common stock, $6.8 billion of net cash paid for business acquisitions and $2.5 billion net investments in property, plant and equipment, all of which were 36 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) partially offset by $9.6 billion in cash provided from operations, $3.1 billion in proceeds from the issuance of our common stock under employee stock plans and a $2.6 billion net increase in our debt and commercial paper. We intend the discussion of our financial condition and results of operations that follows to provide information that will assist in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. The discussion of results of operations at the consolidated level is followed by a more detailed discussion of results of operations by segment. For a further discussion of factors that could impact operating results, see the section entitled “Risk Factors” in Item 1A, which is incorporated herein by reference. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General The Consolidated Financial Statements of HP are prepared in accordance with U.S. generally accepted accounting principles, which require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, net revenue and expenses, and the disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Senior management has discussed the development, selection and disclosure of these estimates with the Audit Committee of HP’s Board of Directors. Management believes that the accounting estimates employed and the resulting balances are reasonable; however, actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably likely to occur could materially impact the financial statements. Management believes the following critical accounting policies reflect the significant estimates and assumptions used in the preparation of the Consolidated Financial Statements. Revenue Recognition We enter into contracts to sell our products and services, and, while the majority of our sales agreements contain standard terms and conditions, there are agreements that contain multiple elements or non-standard terms and conditions. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and, if so, how the price should be allocated among the elements and when to recognize revenue for each element. We recognize revenue for delivered elements only when the delivered elements have standalone value, fair values of undelivered elements are known, uncertainties regarding customer acceptance are resolved and there are no customer-negotiated refund or return rights affecting the revenue recognized for delivered elements. Changes in the allocation of the sales price 37 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) between elements might impact the timing of revenue recognition but would not change the total revenue recognized on the contract. We recognize revenue as work progresses on certain fixed-price contracts, such as consulting arrangements. Using a proportional performance method, we estimate the total expected labor costs in order to determine the amount of revenue earned to date. We follow this basis because reasonably dependable estimates of the labor costs applicable to various stages of a contract can be made. Total contract profit is subject to revisions throughout the life of the contract. We record changes in revenue as a result of revisions to cost estimates to income in the period in which the facts that give rise to the revision become known. We record estimated reductions to revenue for customer and distributor programs and incentive offerings, including price protection, promotions, other volume-based incentives and expected returns. Future market conditions and product transitions may require us to take actions to increase customer incentive offerings, possibly resulting in an incremental reduction of revenue at the time the incentive is offered. Additionally, certain incentive programs require us to estimate, based on historical experience, the number of customers who will actually redeem the incentive. Restructuring We have engaged, and may continue to engage, in restructuring actions, which require management to utilize significant estimates related to expenses for severance and other employee separation costs, realizable values of assets made redundant or obsolete, lease cancellation and other exit costs. If the actual amounts differ from our estimates, the amount of the restructuring charges could be materially impacted. For a full description of our restructuring actions, refer to our discussions of restructuring in the Results of Operations section and Note 8 to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Stock-Based Compensation Expense Effective November 1, 2005, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method, and therefore have not restated prior periods’ results. Under this method, we recognize stock-based compensation expense for all share-based payment awards granted after November 1, 2005 and granted prior to but not yet vested as of November 1, 2005, in accordance with SFAS 123R. Under the fair value recognition provisions of SFAS 123R, we recognize stock-based compensation expense net of an estimated forfeiture rate and recognize compensation cost for only those shares expected to vest on a straight-line basis over the requisite service period of the award. Prior to SFAS 123R adoption, we accounted for share-based payment awards under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and, accordingly, generally recognized compensation expense only when we granted options with a discounted exercise price. Determining the appropriate fair value model and calculating the fair value of share-based payment awards require subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. Management determined that implied volatility calculated based on actively traded options on HP common stock is a better indicator of expected volatility and future stock price trends than historical volatility. Therefore, expected volatility in fiscal years 2007, 2006 and 2005 was based on a market-based implied volatility. The assumptions used in calculating the fair value of 38 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from what we have recorded in the current period. See Note 2 to the Consolidated Financial Statements in Item 8 for a further discussion on stock-based compensation. Taxes on Earnings We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the actual results reflected in our income tax returns filed during the subsequent year. We record adjustments based on filed returns when we have identified and finalized them, which is generally in the third and fourth quarters of the subsequent year for U.S. federal and state provisions, respectively. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year in which we expect the differences to reverse. We record a valuation allowance to reduce the deferred tax assets to the amount that we are more likely than not to realize. We have considered future market growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies in determining the need for a valuation allowance. In the event we were to determine that we would not be able to realize all or part of our net deferred tax assets in the future, we would increase the valuation allowance and make a corresponding charge to earnings in the period in which we make such determination. Likewise, if we later determine that we are more likely than not to realize the net deferred tax assets, we would reverse the applicable portion of the previously provided valuation allowance. In order for us to realize our deferred tax assets we must be able to generate sufficient taxable income in the tax jurisdictions in which the deferred tax assets are located. Our effective tax rate includes the impact of certain undistributed foreign earnings for which we have not provided U.S. taxes because we plan to reinvest such earnings indefinitely outside the United States. We plan foreign earnings remittance amounts based on projected cash flow needs as well as the working capital and long-term investment requirements of our foreign subsidiaries and our domestic operations. Based on these assumptions, we estimate the amount we will distribute to the United States and provide the U.S. federal taxes due on these amounts. Further, as a result of certain employment actions and capital investments HP has undertaken, income from manufacturing activities in certain countries is subject to reduced tax rates, and in some cases is wholly exempt from taxes, for fiscal years through 2019. Material changes in our estimates of cash, working capital and long-term investment requirements in the various jurisdictions in which we do business could impact our effective tax rate. We are subject to income taxes in the United States and over sixty foreign countries, and we are subject to routine corporate income tax audits in many of these jurisdictions. We believe that our tax return positions are fully supported, but tax authorities are likely to challenge certain positions, which may not be fully sustained. However, our income tax expense includes amounts intended to satisfy income tax assessments that result from these challenges. Determining the income tax expense for these potential assessments and recording the related assets and liabilities requires significant management judgments and estimates. We evaluate our income tax contingencies in accordance with SFAS No. 5, 39 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) “Accounting for Contingencies.” We believe that our reserve for income tax liabilities, including related interest, is adequate in relation to the potential for additional tax assessments. The amounts ultimately paid upon resolution of audits could be materially different from the amounts previously included in our income tax expense and therefore could have a material impact on our tax provision, net income and cash flows. Our reserve for income tax liabilities is attributable primarily to uncertainties concerning the tax treatment of our international operations, including the allocation of income among different jurisdictions, and related interest. We review our reserves quarterly, and we may adjust such reserves because of proposed assessments by tax authorities, changes in facts and circumstances, issuance of new regulations or new case law, previously unavailable information obtained during the course of an examination, negotiations between tax authorities of different countries concerning our transfer prices, execution of Advanced Pricing Agreements, resolution with respect to individual audit issues, the resolution of entire audits, or the expiration of statutes of limitations. Material adjustments are most likely to occur in the fiscal years in which major ongoing audits, such as audits by the Internal Revenue Service (“IRS”), are closed. In addition, our tax contingency reserve includes certain amounts for potential tax assessments for pre-acquisition tax years of acquired companies which, if released, will impact the carrying value of goodwill attributable to the acquired company. Allowance for Doubtful Accounts We determine our allowance for doubtful accounts using a combination of factors to ensure that we have not overstated our trade and financing receivables balances due to uncollectibility. We maintain an allowance for doubtful accounts for all customers based on a variety of factors, including the length of time receivables are past due, trends in overall weighted-average risk rating of the total portfolio, macroeconomic conditions, significant one-time events, historical experience and the use of third-party credit risk models that generate quantitative measures of default probabilities based on market factors, and the financial condition of customers. Also, we record specific provisions for individual accounts when we become aware of a customer’s inability to meet its financial obligations to us, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position. If circumstances related to customers change, we would further adjust our estimates of the recoverability of receivables either upward or downward. The annual provision for doubtful accounts has averaged approximately 0.01% of net revenue over the last three fiscal years. Using our third-party credit risk model at October 31, 2007, a 50-basis-point deterioration in the weighted-average default probabilities of our significant customers would have resulted in an approximately $84 million increase to our trade allowance at the end of fiscal year 2007. Inventory We state our inventory at the lower of cost or market. We make adjustments to reduce the cost of inventory to its net realizable value, if required, at the product group level for estimated excess, obsolescence or impaired balances. Factors influencing these adjustments include changes in demand, rapid technological changes, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Revisions to these adjustments would be required if these factors differ from our estimates. Valuation of Goodwill and Indefinite-Lived Purchased Intangible Assets We review goodwill and purchased intangible assets with indefinite lives for impairment annually and whenever events or changes in circumstances indicate the carrying value of an asset may not be 40 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) recoverable in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” The provisions of SFAS No. 142 require that we perform a two-step impairment test on goodwill. In the first step, we compare the fair value of each reporting unit to its carrying value. Our reporting units are consistent with the reportable segments identified in Note 18 to the Consolidated Financial Statements in Item 8. We determine the fair value of our reporting units based on a weighting of income and market approaches. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. Under the market approach, we estimate the fair value based on market multiples of revenue or earnings for comparable companies. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then we must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then we record an impairment loss equal to the difference. SFAS No. 142 also requires that the fair value of the purchased intangible assets with indefinite lives be estimated and compared to the carrying value. We estimate the fair value of these intangible assets using an income approach. We recognize an impairment loss when the estimated fair value of the intangible asset is less than the carrying value. Determining the fair value of a reporting unit or an indefinite-lived purchased intangible asset is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, assumed royalty rates, future economic and market conditions and determination of appropriate market comparables. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. In addition, we make certain judgments and assumptions in allocating shared assets and liabilities to determine the carrying values for each of our reporting units. Our annual goodwill impairment analysis, which we performed during the fourth quarter of fiscal 2007, did not result in an impairment charge. The excess of fair value over carrying value for each of HP’s reporting units as of August 1, 2007, the annual testing date, ranged from approximately $520 million to approximately $46 billion. In order to evaluate the sensitivity of the fair value calculations on the goodwill impairment test, we applied a hypothetical 10% decrease to the fair values of each reporting unit. This hypothetical 10% decrease would result in excess fair value over carrying value ranging from approximately $360 million to approximately $41 billion for each of HP’s reporting units. Warranty Provision We provide for the estimated cost of product warranties at the time we recognize revenue. We evaluate our warranty obligations on a product group basis. Our standard product warranty terms generally include post-sales support and repairs or replacement of a product at no additional charge for a specified period of time. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, we base our estimated warranty obligation upon warranty terms, ongoing product failure rates, repair costs, product call rates, average cost per call, and current period product shipments. If actual product failure rates, repair rates, service delivery costs or post- sales support costs differ from our estimates, we would be required to make revisions to the estimated warranty liability. Warranty terms generally range from 41 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) 90 days to three years parts and labor, depending upon the product. Over the last three fiscal years, the annual warranty provision has averaged approximately 3.4% of annual net product revenue, while actual annual warranty costs have averaged approximately 3.2% of annual net product revenue. Retirement Benefits Our pension and other post-retirement benefit costs and obligations are dependent on various assumptions. Our major assumptions relate primarily to discount rates, salary growth, long-term return on plan assets and medical cost trend rates. We base the discount rate assumption on current investment yields of high quality fixed income investments during the retirement benefits maturity period. The salary growth assumptions reflect our long-term actual experience and future and near-term outlook. Long-term return on plan assets is determined based on historical portfolio results and management’s expectation of the future economic environment, as well as target asset allocations. In the beginning of fiscal 2008, we implemented a liability-driven investment strategy for the U.S. defined benefit pension plan, which will be frozen by December 31, 2007 and is currently overfunded. As part of the strategy, we have transitioned our equity allocation to predominantly fixed income assets. The expected return on the plan assets, used in calculating the net benefit cost, has been reduced from 8.3% to 6.3% for fiscal 2008 to reflect the changes in our asset allocation policy. Our medical cost trend assumptions are developed based on historical cost data, the near-term outlook and an assessment of likely long-term trends. Actual results that differ from our assumptions are accumulated and are amortized generally over the estimated future working life of the plan participants. Our major assumptions vary by plan and the weighted-average rates used are set forth in Note 15 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Each assumption has different sensitivity characteristics, and, in general, changes, if any, have moved in the same direction over the last several years. For fiscal 2007, changes in the weighted-average rates would have had the following impact on our net periodic benefit cost: • A decrease of 25 basis points in the long-term rate of return would have increased our net benefit cost by approximately $33 million; • A decrease of 25 basis points in the discount rate would have increased our net benefit cost by approximately $51 million; and • An increase of 25 basis points in the future compensation rate would have increased our net benefit cost by approximately $21 million. RECENT ACCOUNTING PRONOUNCEMENTS In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes by prescribing the recognition threshold a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by us in the first quarter of fiscal 2008. The cumulative effects of applying FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. Additionally, in May 2007, the FASB published FASB Staff Position No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”). 42 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) FSP FIN 48-1 is an amendment to FIN 48. It clarifies how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is effective upon the initial adoption of FIN 48, and therefore will be adopted by us in the first quarter of fiscal 2008. While we are still evaluating the impact of adoption of FIN 48 and FSP FIN 48-1 on our consolidated financial statements, we estimate that the adoption of FIN 48 and FSP FIN 48-1 will result in a net increase to retained earnings in the range of $500 million to $900 million. This estimate is subject to revision as management completes its analysis. In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and is required to be adopted by us in the first quarter of fiscal 2009. We are currently evaluating the effect that the adoption of SFAS 157 will have on our consolidated results of operations and financial condition and are not yet in a position to determine such effects. In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—An Amendment of FASB No. 87, 88, 106 and 132(R)” (“SFAS 158”). SFAS 158 requires that the funded status of defined benefit postretirement plans be recognized on the company’s balance sheet and changes in the funded status be reflected in comprehensive income, effective for fiscal years ending after December 15, 2006, which we adopted during fiscal 2007. See Note 15 to the Consolidated Financial Statements in Item 8 for the effect of applying this provision on the consolidated financial statements. SFAS 158 also requires companies to measure the funded status of the plan as of the date of their fiscal year end, effective for fiscal years ending after December 15, 2008. We expect to adopt the measurement provisions of SFAS 158 effective October 31, 2009. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 expands the use of fair value accounting but does not affect existing standards that require assets or liabilities to be carried at fair value. Under SFAS 159, a company may elect to use fair value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees and issued debt. Other eligible items include firm commitments for financial instruments that otherwise would not be recognized at inception and non-cash warranty obligations where a warrantor is permitted to pay a third party to provide the warranty goods or services. If the use of fair value is elected, any upfront costs and fees related to the item must be recognized in earnings and cannotbe deferred, such as debt issuance costs. The fair value election is irrevocable and generally made on an instrument-by-instrument basis, even if a company has similar instruments that it elects not to measure based on fair value. At the adoption date, unrealized gains and losses on existing items for which fair value has been elected are reported as a cumulative adjustment to beginning retained earnings. Subsequent to the adoption of SFAS 159, changes in fair value are recognized in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by us in the first quarter of fiscal 2009. We currently are determining whether fair value accounting is appropriate for any of our eligible items and cannot 43 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) estimate the impact, if any, that SFAS 159 will have on our consolidated results of operations and financial condition. In June 2007, the FASB also ratified EITF 07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities” (“EITF 07-3”). EITF 07-3 requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. EITF 07-3 is effective, on a prospective basis, for fiscal years beginning after December 15, 2007 and will be adopted by us in the first quarter of fiscal 2009. We do not expect the adoption of EITF 07-3 to have a material effect on our consolidated results of operations and financial condition. In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141R is effective as of the beginning of an entity’s fiscal year that begins after December 15, 2008, and will be adopted by us in the first quarter of fiscal 2010. We are currently evaluating the potential impact, if any, of the adoption of SFAS 141R on our consolidated results of operations and financial condition. In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective as of the beginning of an entity’s fiscal year that begins after December 15, 2008, and will be adopted by us in the first quarter of fiscal 2010. We are currently evaluating the potential impact, if any, of the adoption of SFAS 160 on our consolidated results of operations and financial condition. In addition to the SFAS 158 adoption mentioned above, we adopted the following accounting standards in fiscal 2007, none of which had a material effect on our consolidated results of operations during such period or financial condition at the end of such period: • • SFAS No. 154, “Accounting for Changes and Error Corrections”; Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”; • EITF 05-5, “Accounting for Early Retirement or Postemployment Programs with Specific Features (Such as Terms Specified in Altersteilzeit Early Retirement Arrangements)”; and • EITF 06-9, “Reporting a Change in (or the Elimination of) a Previously Existing Difference between the Fiscal Year End of a Parent Company and That of a Consolidated Entity or between the Reporting Period of an Investor and That of an Equity Method Investee.” 44 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) RESULTS OF OPERATIONS Results of operations in dollars and as a percentage of net revenue were as follows for the following fiscal years ended October 31: Net revenue............................................................................. Cost of sales(1)......................................................................... Gross profit ............................................................................. Research and development ..................................................... Selling, general and administrative......................................... Amortization of purchased intangible assets .......................... In-process research and development charges ........................ Restructuring charges ............................................................. Pension curtailments and pension settlements, net ................. Earnings from operations........................................................ Interest and other, net ............................................................. Gains (losses) on investments................................................. Earnings before taxes.............................................................. Provision for taxes .................................................................. Net earnings............................................................................ (1) Cost of products, cost of services and financing interest. 2007 2006(2) In millions $104,286 100.0% $91,658 100.0% 69,427 75.7% 22,231 24.3% 3.9% 3,591 11,266 12.3% 0.7% — 0.2% — 7.2% 0.6% — 7.8% 1.0% 6.8% 78,887 25,399 3,611 12,226 783 190 387 (517) 8,719 444 14 9,177 1,913 $7,264 75.6% 24.4% 3.5% 11.7% 0.7% 0.2% 0.4% (0.5)% 8.4% 0.4% — 8.8% 1.8% 7.0% 604 52 158 — 6,560 606 25 7,191 993 $6,198 2005(2) $86,696 100.0% 76.6% 23.4% 4.0% 13.0% 0.7% — 1.9% (0.2)% 4.0% 0.1% — 4.1% 1.3% 2.8% 66,440 20,256 3,490 11,184 622 2 1,684 (199) 3,473 83 (13) 3,543 1,145 $2,398 (2) Certain reclassifications have been made to prior year amounts in order to conform to the current year presentation. 45 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Net Revenue The components of weighted-average net revenue growth as compared to prior-year periods were as follows for the following fiscal years ended October 31: 2007 2006 Percentage points Personal Systems Group ..................................................................................................................... Imaging and Printing Group ............................................................................................................... Enterprise Storage and Servers ........................................................................................................... HP Software........................................................................................................................................ HP Services......................................................................................................................................... HP Financial Services......................................................................................................................... Corporate Investments/Other.............................................................................................................. Total HP.............................................................................................................................................. 7.9 1.8 1.6 1.1 1.1 0.3 — 13.8 2.8 1.9 0.7 0.3 0.1 (0.1) — 5.7 In fiscal 2007, HP net revenue increased approximately 14% from the prior year period (10% on a constant currency basis). The favorable currency impact for fiscal 2007 was due primarily to the movement of the dollar against the euro. U.S. net revenue was $34.8 billion for fiscal 2007, an increase of 8% from the prior year, while international net revenue increased 17% to $69.5 billion. PSG had double-digit net revenue growth across all regions as a result of overall unit volume increases of 28%. The unit volume increases resulted from strong growth in notebooks with significant improvements in emerging markets. The impact of these increases was partially offset by declines in average selling prices (“ASPs”) in commercial and consumer clients of 5% and 1%, respectively. IPG net revenue growth in fiscal 2007 was due mainly to increased unit volumes of printer supplies resulting from the continued expansion of printer hardware placements and the strong performance of supplies for color-related products. ESS net revenue growth during fiscal 2007 was the result primarily of strong blade revenue and unit growth in our industry standard servers business, increased option attach rates in our ProLiant server line, continued strong performance in mid-range EVA products, growth in commercial storage area networks and revenue increases from our Integrity servers. The ESS growth was partially moderated by the revenue declines in our tape business, high-end arrays and our PA-RISC and Alpha server product lines during fiscal 2007. The net revenue growth in HP Software during fiscal 2007 was due primarily to growth in our OpenView business as a result of the Mercury acquisition and increases in revenue from license and support contracts. HPS net revenue during fiscal 2007 increased due primarily to favorable currency impacts, revenue increases in outsourcing services driven by existing accounts growth and new business, and revenue increases in consulting and integration associated with acquisitions made in fiscal 2007. The HPFS net revenue increase during fiscal 2007 was due primarily to operating lease growth and higher end-of-lease activity. In fiscal 2006, HP net revenue increased approximately 6% from the prior year period (7% on a constant currency basis). The unfavorable currency impact for fiscal 2006 was due primarily to the movement of the dollar against the euro and the yen. U.S. net revenue was $32.2 billion for fiscal 2006, an increase of 6% from the prior year, while international net revenue increased 6% to $59.4 billion. PSG net revenue increased across all regions as a result of a 15% volume increase. The volume increase resulted from strong growth in consumer and commercial markets and significant improvement in emerging markets, which was partially offset by 6% and 7% declines in ASPs in consumer and 46 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) commercial clients, respectively. IPG net revenue growth in fiscal 2006 was due mainly to increased shipment volumes of printer supplies resulting from the continued expansion of printer hardware placements and the strong performance of color-related products. ESS net revenue growth was the result primarily of strong unit growth in our industry standard servers business, blade revenue growth, increased option attach rates in our ProLiant server line, continued strong performance in mid-range EVA products within our Storage business and revenue increases from our Integrity servers. The ESS growth was moderated by revenue declines in our tape business and PA-RISC and Alpha Server product lines. The net revenue growth in HP Software for fiscal 2006 was due primarily to growth in our OpenView business as a result of the Peregrine acquisition and an increase in support and service contracts. HPS net revenue increased in fiscal 2006 due primarily to revenue increases in management services driven by new business and existing account growth, which were offset by declines in the technology services business resulting from competitive pricing pressures and changes in the mix of platforms being serviced. The HPFS net revenue decline in fiscal 2006 was due primarily to lower used equipment sales. Stock-Based Compensation Expense See Note 2 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Gross Margin The weighted-average components of the change in gross margin as compared to prior-year periods were as follows for the following fiscal years ended October 31: 2006 2007 Percentage points HP Software.......................................................................................................................................... HP Services........................................................................................................................................... Enterprise Storage and Servers ............................................................................................................. HP Financial Services........................................................................................................................... Personal Systems Group ....................................................................................................................... Imaging and Printing Group ................................................................................................................. Corporate Investments/Other................................................................................................................ Total HP................................................................................................................................................ 0.6 0.1 (0.1) (0.1) (0.2) (0.2) — 0.1 0.2 0.2 0.4 (0.1) 0.1 0.2 (0.1) 0.9 Total company gross margin increased slightly in fiscal 2007 from fiscal 2006. The improvement in HP Software gross margin in fiscal 2007 was due primarily to a favorable change in revenue mix driven by the inclusion of revenue from Mercury licenses and support, which typically have a higher gross margin than the other offerings within the segment. HPS gross margin increased during fiscal 2007 from fiscal 2006 due primarily to continued focus on cost structure improvements from delivery efficiencies and cost controls. This gross margin increase was partially offset by the impact from the continued competitive pricing environment. During fiscal 2007, ESS contributed unfavorably to our total company’s weighted-average change in gross margin while the ESS gross margin remained stable. This stability was due primarily to improved cost management, which was offset by an ongoing mix shift to lower-margin Integrity products within business critical systems and a continued mix shift towards industry standard servers. HPFS gross margin decline during fiscal 2007 was caused primarily by increased bad debt expenses and lower bad debt recoveries, as well as lower margins on leases and 47 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) used equipment sales. During fiscal 2007, PSG contributed unfavorably to our total company’s weighted-average change in gross margin as a result of higher growth than the other segments. However, PSG gross margin increased primarily as a result of component cost declines and improvements in supply chain costs per unit, which were partially offset by ASP declines. During fiscal 2007, IPG gross margin decreased due primarily to unfavorable hardware margins, increased costs associated with new product introductions and a change in product mix. Total company gross margin increased in fiscal 2006 as compared to fiscal 2005. The improvement in ESS gross margin in fiscal 2006 was due primarily to a favorable unit mix, improved discount management, and lower component costs. HPS gross margin increase was driven mainly by the continued focus on cost structure improvement from delivery efficiencies and cost controls, the impact of which was partially offset by the continued competitive environment in the solutions and services business and higher fiscal 2006 bonus accruals. For IPG, gross margin increased in fiscal 2006 due primarily to improved supplies margins and a favorable portfolio mix shift from hardware to supplies, which were partially offset by unfavorable consumer hardware margins. The improvement in HP Software gross margin in fiscal 2006 was due primarily to an increase in revenue and more effective management of the support and services costs for OpenView and OpenCall. The gross margin improvement in PSG resulted primarily from reduced warranty expense and supply chain costs as a percentage of revenue and component cost declines. HPFS gross margin was impacted unfavorably in fiscal 2006 due primarily to competitor pricing pressures, a higher mix of lower margin operating lease assets and lower recoveries for bad debts, which were partially offset by lower credit losses in fiscal 2006. Operating Expenses Research and Development Total research and development (“R&D”) expense increased in fiscal 2007 due primarily to additional R&D expense as a result of the Mercury acquisition in the first quarter of fiscal 2007. As a percentage of net revenue, each of our major segments experienced a year-over-year decrease in R&D expense in fiscal 2007. Total R&D expense increased in fiscal 2006 due primarily to higher bonus accruals and stock-based compensation expense, the impact of which was partially offset by expense controls and cost savings from restructuring actions. As a percentage of net revenue, each of our major segments experienced a year-over-year decrease in R&D expense in fiscal 2006. Selling, General and Administrative Total SG&A expense increased during fiscal 2007 due primarily to additional expense as a result of the acquisition of Mercury in the first quarter of fiscal 2007, unfavorable currency impacts related to the movement of the dollar against the euro and additional investments in our sales forces. As a percentage of net revenue, the ESS, HPS, PSG and IPG segments experienced a year-over-year decrease in SG&A expense during fiscal 2007, while HP Software experienced a year-over- year increase in SG&A expense. Total SG&A expense increased slightly during fiscal 2006 as higher bonus accruals and stock-based compensation expenses as well as increased marketing spending were offset in part by savings from expense controls and restructuring actions and favorable currency impacts due to movement of the 48 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) dollar against the euro and the yen. As a percentage of net revenue, each of our segments experienced a year-over-year decrease or no change in fiscal 2006. Amortization of Purchased Intangible Assets The increase in amortization expense in fiscal 2007 as compared to fiscal 2006 was due primarily to amortization expense related to the acquisition of Mercury in the first quarter of fiscal 2007. This increase was partially offset by a decrease in amortization expense related to certain intangible assets associated with prior acquisitions, including the Compaq Computer Corporation (“Compaq”) acquisition, that had reached the end of their amortization period. The decrease in amortization expense in fiscal 2006 as compared to fiscal 2005 was due primarily to a decrease in amortization expense related to certain intangible assets associated with prior acquisitions including the Compaq acquisition that had reached the end of their amortization period, which decrease was partially offset by an increase in amortization expense related primarily to the acquisitions of Scitex Vision Ltd. (“Scitex”), Peregrine Systems, Inc. (“Peregrine”), and OuterBay Technologies, Inc. (“OuterBay”) in fiscal year 2006. For more information on our amortization of purchased intangibles assets, see Note 7 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. In-Process Research and Development Charges We record in-process research and development (“IPR&D”) charges in connection with acquisitions accounted for as business combinations, as more fully described in Note 6 to the Consolidated Financial Statements in Item 8. In fiscal 2007, 2006 and 2005 we recorded IPR&D charges of $190 million, $52 million, and $2 million, respectively, related to acquisitions during those years. The increase in IPR&D in fiscal 2007 was due primarily to our acquisition of Mercury in the first quarter of fiscal 2007. Restructuring Charges Restructuring charges for fiscal 2007 were $387 million, which included $354 million of expenses related to severance and other benefit costs associated with those employees who elected to participate in the 2007 EER and a net charge of $33 million relating to adjustments to our fiscal 2005, 2003, 2002 and 2001 restructuring programs. Restructuring charges in fiscal year 2006 were $158 million. This included a net charge of $233 million related to true- ups of severance and other related restructuring charges for all restructuring plans, a $6 million termination benefits expense and a $3 million settlement and curtailment loss from our non-U.S. pension plans related to the fiscal 2005 restructuring plan, which was approved by our Board of Directors in the fourth quarter of fiscal 2005. These charges were partially offset by a $46 million settlement gain from the U.S. pension plans, a $24 million curtailment gain from the U.S. retiree medical program and a $14 million adjustment to reduce our non-cash stock-based compensation expense, all related to our fiscal 2005 restructuring plan approved in the fourth quarter of fiscal 2005. Restructuring charges in fiscal 2005 were $1.7 billion, which included a $1.6 billion charge for the fiscal 2005 restructuring plan approved in the fourth quarter of fiscal 2005. The fiscal 2005 restructuring plan was designed to simplify our structure, reduce costs and place greater focus on our customers. We initially estimated that 15,300 positions would be eliminated in the fiscal 2005 restructuring plan. 49 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Subsequent to the initial estimate, we reduced the number of total positions to be eliminated to 14,985. We had substantially completed eliminating these positions as of October 31, 2007. The remaining charge for fiscal 2005 of $109 million was related to severance and related costs associated with the termination of approximately 1,450 employees in connection with a restructuring plan approved by our management in the third quarter of fiscal 2005. All employees under this restructuring plan were terminated as of October 31, 2005. We paid all of the costs associated with the fiscal 2005 third quarter restructuring plan as of January 31, 2007. For more information on our restructuring charges, see Note 8 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Workforce Rebalancing As part of our ongoing business operations, we incur workforce rebalancing charges for severance and related costs within certain business segments. Workforce rebalancing activities are considered part of normal operations as we continue to optimize our cost structure and are included in our business segment results. We expect to incur additional workforce rebalancing costs in the future. Pension Curtailments and Pension Settlements, Net In fiscal 2007, we recognized a net gain on pension curtailments and settlements of $517 million, relating primarily to a $542 million curtailment gain associated with a modification to our U.S. defined benefit pension plan and post-retirement benefit plan. This curtailment gain was offset partially by net settlement losses related to our other pension plan design changes. In conjunction with management’s plan to restructure certain of our operations, we modified our U.S. retirement programs to align them more closely to industry practice. Effective January 1, 2006, we ceased pension accruals and eliminated eligibility for the subsidized retiree medical program for employees who did not meet defined criteria based on age and years of service. As a result, we recognized a curtailment gain of $199 million in fiscal 2005 stemming from the elimination of future benefit accruals for the affected employee group. For more information on our plan design changes, see Note 15 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Interest and Other, Net Interest and other, net decreased by $162 million in fiscal 2007 from fiscal 2006. The decrease was due primarily to higher interest expense resulting from higher average debt balances. Interest and other, net increased by $523 million in fiscal 2006 from fiscal 2005. The increase in fiscal 2006 resulted primarily from higher net interest income over the prior year related to higher short-term interest rates in fiscal 2006, net gains from sales of certain real estate properties, and lower interest expense due to our lower average debt balances. The increase in fiscal 2006 also was attributable to a net $106 million of dispute settlement charge and its related interest charge recorded in fiscal 2005. In fiscal 2005, we reached a legal settlement of $141 million in our patent infringement case with Intergraph Hardware Technologies Company (“Intergraph”) and recorded a charge of $116 million related to a cross-license agreement with Intergraph for products shipped in prior years. Partially offsetting this amount was a $10 million recovery from an individual related to a prior period settlement with the Government of Canada. 50 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Gains (Losses) on Investments Net gains on investment in fiscal 2007 and fiscal 2006 resulted primarily from gains on the sale of equity investments, which were offset in part by impairment charges on our investment portfolio. Net losses in fiscal 2005 resulted primarily from impairment charges on equity investments in our publicly-traded and privately-held investment portfolios. Partially offsetting these losses were gains attributable to the sale of investments. Provision for Taxes Our effective tax rates were 20.8%, 13.8%, and 32.3% in fiscal 2007, 2006 and 2005, respectively. The increase in the overall tax rate in fiscal 2007 from fiscal 2006 was related in part to favorable income tax adjustments of $599 million recorded in fiscal 2006, which included net favorable tax adjustments of $565 million to income tax accruals as a result of the settlement of IRS examinations of our U.S. income tax returns for fiscal years 1993 to 1998. The reductions to the net income tax accruals for these years related primarily to the resolution of issues with respect to Puerto Rico manufacturing tax incentives and export tax incentives, and other issues involving our non-U.S. operations. In addition, the decrease in the overall tax rate in 2006 from fiscal 2005 was attributable in part to $697 million of income tax expense related to items unique to fiscal 2005. The tax expense was the result primarily of $792 million associated with the repatriation of $14.5 billion under the American Jobs Creation Act of 2004 (“Jobs Act”) and $76 million related to additional distributions received from foreign subsidiaries. These tax expenses were offset in part by tax benefits of $177 million resulting from agreements with the IRS and other governmental authorities. The Jobs Act, enacted on October 22, 2004, provided for a temporary 85% dividend received deduction on certain foreign earnings repatriated during a one-year period. The deduction resulted in an approximate 5.25% federal tax rate on the repatriated earnings. For a full reconciliation of our effective tax rate to the U.S. federal statutory rate of 35% and further explanation of our provision for taxes, see Note 13 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Segment Information A description of the products and services, as well as financial data, for each segment can be found in Note 18 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. We have realigned segment financial data for the fiscal years ended October 31, 2006 and 2005 to reflect changes in HP’s organizational structure that occurred at the beginning of the first quarter of fiscal 2007. We describe these changes more fully in Note 18 to the Consolidated Financial Statements in Item 8. We have presented the business segments in this Annual Report on Form 10-K based on our management organizational structure as of October 31, 2007 and the distinct nature of various businesses. Future changes to this organizational structure may result in changes to the reportable segments disclosed. The discussions below include the results of each of our segments. Technology Solutions Group ESS, HPS and HP Software are structured beneath a broader Technology Solutions Group (“TSG”). We describe the results of the business segments of TSG in more detail below. 51 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Enterprise Storage and Servers Net revenue........................................................................................................................... Earnings from operations...................................................................................................... Earnings from operations as a % of net revenue................................................................... 2005 2007 For the fiscal years ended October 31 2006 In millions $17,308 $1,446 8.4% $18,769 $1,980 10.5% $16,717 $800 4.8% The components of weighted-average net revenue growth as compared to prior-year periods by business unit were as follows for the following fiscal years ended October 31: Industry standard servers ...................................................................................................... Storage .................................................................................................................................. Business critical systems ...................................................................................................... Total ESS.............................................................................................................................. 2007 2006 Percentage points 8.0 0.9 (0.5) 8.4 3.5 0.9 (0.9) 3.5 On a constant currency basis, ESS net revenue increased 5% in fiscal 2007 from fiscal 2006. The favorable currency impact in fiscal 2007 was due primarily to the movement of the dollar against the euro. Industry standard servers revenue grew 14% in fiscal 2007 compared to fiscal 2006 as a result of strong growth in blade revenue and units, as well as increased option attach rates in the ProLiant server line. Storage net revenue increased 4% in fiscal 2007 compared to fiscal 2006, with the increase driven primarily by mid-range EVA products and commercial products within the storage area networks offerings, as well as improved revenue growth in storage software. This increase was partially moderated by the revenue declines in our tape business and high-end arrays. Business critical systems net revenue decreased 3% in fiscal 2007 compared to fiscal 2006. The decrease was due primarily to revenue declines in the PA-RISC product line and the planned phase out of our Alpha server product line. The declines were partially offset by strong net revenue growth in our Integrity servers, which represented 64% of the business critical systems revenue mix in fiscal 2007, up from 37% in fiscal 2006. We expect revenue mix from Integrity servers to continue to grow as customers migrate from PA-RISC and Alpha products. In fiscal 2007, ESS earnings from operations as a percentage of net revenue increased by 2.1 percentage points compared to fiscal 2006, due primarily to a decrease in operating expenses as a percentage of net revenue. Gross margin remained stable in fiscal 2007 compared to fiscal 2006 due primarily to improved cost management. The improved cost management was offset by an ongoing mix shift to lower-margin integrity products within business critical systems and a continued mix shift towards industry standard servers. The decrease in operating expense as a percentage of net revenue in fiscal 2007 was due primarily to cost structure improvements. On a constant currency basis, ESS net revenue increased 5% in fiscal 2006 from fiscal 2005. The unfavorable currency impact for fiscal 2006 was due primarily to the movement of the dollar against the euro and the yen. The net revenue growth in industry standard servers of 6% in fiscal 2006 compared to fiscal 2005 was driven by strong unit growth and the growth in blade revenue as well as increased option attach rates in the ProLiant server line. Storage net revenue increased 4% in fiscal 2006 compared to fiscal 2005 due to continued strong performance in mid-range EVA products within 52 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) the storage area networks offerings while the tape business decline moderated the overall storage growth. Business critical systems net revenue decreased 4% in fiscal 2006 compared to fiscal 2005. This decrease was due primarily to revenue declines in the PA-RISC product line and to the planned phase out of our Alpha server product line. The declines were partially offset by net revenue growth in our Integrity servers which posted strong net revenue growth, reaching 37% of the business critical systems revenue mix in fiscal 2006 up from 20% in the prior fiscal year. Revenue mix from Integrity servers continued to grow as customers migrated from PA-RISC and Alpha products. Integrity server revenue in fiscal 2006 also included revenue from Montecito-based Integrity servers that were first shipped in the fourth quarter of fiscal 2006. NonStop server net revenue decreased 2% in fiscal 2006 from the prior year due primarily to the revenue decrease on the discontinued product line, which was partially offset by NonStop Integrity product revenue growth. In fiscal 2006, ESS earnings from operations as a percentage of net revenue increased by 3.6 percentage points compared to fiscal 2005, due primarily to an increase in gross margin combined with a decrease in operating expenses as a percentage of net revenue. The improvement in gross margin was due primarily to a favorable unit mix, improved discount management, and lower component costs. The increase was partially offset by a continued mix shift towards industry standard servers within the segment and the ongoing mix shift to lower-margin Integrity products within business critical systems. The decrease in operating expense as a percentage of net revenue in fiscal 2006 was due primarily to efficient expense management. HP Services Net revenue........................................................................................................................... Earnings from operations...................................................................................................... Earnings from operations as a % of net revenue................................................................... 2007 For the fiscal years ended October 31 2006 In millions $15,617 $1,507 9.6% $16,646 $1,829 11.0% $15,536 $1,151 7.4% 2005 The components of weighted-average net revenue growth as compared to prior-year periods by business unit were as follows for the following fiscal years ended October 31: Technology services .............................................................................................................2 Outsourcing services ‘(1) ........................................................................................................ Consulting and integration.................................................................................................... Total HPS ............................................................................................................................. 2007 2006 Percentage points .1 ( 2.8 1.7 6.6 1.6) 1.8 0.3 0.5 ‘(1) Reflects the name change from managed services to outsourcing services effective in fiscal 2007. On a constant currency basis, HPS net revenue increased 3% in fiscal 2007 from fiscal 2006. In fiscal 2007, the favorable currency impact was due primarily to the movement of the dollar against the euro. Net revenue in technology services increased 4% in fiscal 2007 from the prior year due primarily to favorable currency impacts, growth in the IT solution support services and extended warranty revenue, the impact of which was partially offset by competitive pricing pressures and revenue erosion from installed base contracts. Net revenue in outsourcing services increased 10% in fiscal 2007 from the prior year. The increase was driven mainly by favorable currency impacts, existing account growth and 53 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) new business, which were partially offset by installed base revenue erosion and pricing pressures. Net revenue in consulting and integration increased 9% in fiscal 2007 from the prior year due mainly to acquisitions made in fiscal 2007 and favorable currency impacts. HPS earnings from operations as a percentage of net revenue in fiscal 2007 increased by 1.4 percentage points. The operating margin increase was the result of an increase in gross margin and a decrease in operating expenses as a percentage of net revenue. The gross margin increase in fiscal 2007 was due primarily to the continued focus on cost structure improvements generated by delivery efficiencies and cost controls, the impact of which was partially offset by the impact from the continued competitive pricing environment. In fiscal 2007, continued efficiency improvements in our operating expense structure contributed to the decline in operating expenses as a percentage of net revenue compared to the prior year. Technology services operating margin in fiscal 2007 continued to benefit from improved delivery efficiencies and cost controls, the impact of which was offset in part by the impact of the ongoing portfolio mix shift from higher margin proprietary support to lower margin areas such as IT solution services. Outsourcing services operating margin increased in fiscal 2007 due primarily to improved delivery efficiencies and reduced operating expenses partially offset by contractual pricing pressure. Consulting and integration operating margin decreased in fiscal 2007 due mainly to increased customer project losses and acquisition related costs, the impact of which was partially offset by more efficient utilization of our consultants and operating expense improvement. On a constant currency basis, HPS net revenue increased 2% in fiscal 2006 from fiscal 2005. In fiscal 2006, the unfavorable currency impact was due primarily to the movement of the dollar against the euro and the yen. Net revenue in technology services decreased 3% in fiscal 2006 from the prior year due primarily to declines related to competitive pricing pressures and changes in the mix of platforms being serviced. In fiscal 2006, the 7% growth in outsourcing services net revenue from the prior year was driven mainly by new business and existing account growth, with continued focus on making more strategic portfolio decisions to improve profitability. Net revenue in consulting and integration increased 2% in fiscal 2006 from the prior year due primarily to improved performance in Asia Pacific and Europe, Middle East and Africa. HPS earnings from operations as a percentage of net revenue in fiscal 2006 increased by 2.2 percentage points. The operating margin increase was the result of a combination of an increase in gross margin and a decrease in operating expenses as a percentage of net revenue. The gross margin increase in HPS was due primarily to the continued focus on cost structure improvement from delivery efficiencies and cost controls, the impact of which was partially offset by the continued competitive environment in solutions and services business and higher fiscal 2006 bonus accruals. In fiscal 2006, improved efficiencies in our operating expense structure contributed to the decline in operating expenses as a percentage of net revenue compared to fiscal year 2005 despite the impact of higher bonus accruals in fiscal 2006. Technology services operating margin in fiscal 2006 continued to benefit from improved delivery efficiencies and cost controls as well as portfolio decisions made to improve profitability, all of which benefit was offset in part by the impact of the ongoing portfolio mix shift from higher margin proprietary support to lower margin areas such as solution services. Outsourcing services operating margin increased in fiscal 2006 due to delivery efficiencies, reduced operating expenses and more strategic portfolio decisions made to improve profitability. Consulting and integration operating margin improved in fiscal 2006 due to more efficient utilization of our consultants and reduced operating expenses. 54 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) HP Software Net revenue........................................................................................................................... Earnings (loss) from operations ............................................................................................ Earnings (loss) from operations as a % of net revenue ......................................................... 2007 For the fiscal years ended October 31 2006 In millions $1,301 $85 6.5% $2,325 $347 14.9% $1,061 $(49) (4.6)% 2005 On a constant currency basis, HP Software revenue increased 74% in fiscal 2007 as compared to fiscal 2006. The favorable currency impact was due primarily to the movement of the dollar against the euro. Excluding the results of Mercury, HP Software’s revenue grew 5% in fiscal 2007. Net revenue associated with the acquisition of Mercury was included in the results of OpenView, which increased 121% in fiscal 2007 and 15% in the same respective period without Mercury. OpenView net revenue growth also was the result of increases in revenue from license and support contracts. Net revenue for OpenCall, our telecommunications solutions product line, decreased 16% in fiscal 2007. The decrease in OpenCall net revenue was due primarily to a platform shift that resulted in a transfer of the hardware revenue to ESS. The operating margin improvement of 8.4 percentage points in fiscal 2007 as compared to fiscal 2006 was the result primarily of an increase in gross margin and to a lesser degree a decrease in operating expense as a percentage of net revenue. In fiscal 2007, the improvement in gross margin was a result of a favorable change in revenue mix driven by the inclusion of revenue from Mercury licenses and support, which typically have a higher gross margin than the other offerings in the segment, and to a lesser degree by more effective management of the support costs for OpenView and OpenCall. Operating expense as a percentage of net revenue in fiscal 2007 decreased due primarily to cost controls and synergy savings from the Mercury acquisition. In fiscal 2006, Software net revenue increased 23% (8% excluding the impact of acquisitions and 24% on a constant currency basis) from fiscal 2005. The unfavorable currency impact was due primarily to the movement of the dollar against the euro and the yen for fiscal 2006. Peregrine, which HP acquired in December 2005, represented 14.7 percentage points of HP Software’s net revenue growth for fiscal 2006. Net revenue associated with the Peregrine acquisition is included in the results of OpenView, our management solutions software product line, which represented 20 percentage points of growth on a weighted-average net revenue basis for fiscal 2006. OpenCall contributed the remaining 3 percentage points of the weighted-average net revenue increase for fiscal 2006. OpenView net revenue growth was the result of acquisitions and increases in support and services contracts. OpenCall net revenue growth was the result of increased product sales and licenses as well as larger contracts. The operating margin improvement of 11.1 percentage points for fiscal 2006 from fiscal 2005 was the result primarily of a decrease in operating expense as a percentage of net revenue and an increase in gross margin. The decrease in operating expense as a percentage of net revenue was attributable to growth in field selling costs, research and development and marketing expenses attributable to cost management efforts that was slower than revenue growth. These cost reductions were partially offset by high integration costs associated with the acquisition of Peregrine as well as higher bonus accruals. The improvement in gross margin was driven by an increase in revenue, more effective management of the support and services costs for OpenView and OpenCall and from improved margins of our OpenCall product line resulting from a favorable product mix shift towards higher margin products. 55 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Personal Systems Group Net revenue........................................................................................................................... Earnings from operations...................................................................................................... Earnings from operations as a % of net revenue................................................................... 2005 2007 For the fiscal years ended October 31 2006 In millions $29,166 $1,152 3.9% $36,409 $1,939 5.3% $26,741 $657 2.5% The components of weighted-average net revenue growth as compared to prior-year periods by business unit were as follows for the following fiscal years ended October 31: 2006 2007 Percentage points Notebook PCs ............................................................................................................................................. Desktop PCs ............................................................................................................................................... Workstations............................................................................................................................................... Handhelds ................................................................................................................................................... Other ........................................................................................................................................................... Total PSG ................................................................................................................................................... 19.3 4.2 1.2 (0.4) 0.5 24.8 8.4 0.8 0.6 (0.8) 0.1 9.1 On a constant currency basis, PSG’s net revenue increased 21% in fiscal 2007 from fiscal 2006. The favorable currency impact was due primarily to the movement of the dollar against the euro. Unit volumes increased by 28% in fiscal 2007, driving double-digit net revenue growth across all regions. The unit volume increase was the result of strong growth in notebooks, with significant improvements in emerging markets. In fiscal 2007, net revenue for notebook PCs increased 47% while net revenue for desktop PCs increased 8% from the prior-year period. In fiscal 2007, net revenue for consumer clients increased 39%, while net revenue for commercial clients increased 16% from the prior-year period. The net revenue increase in Other PSG in fiscal 2007 was related primarily to improvements in extended warranty sales. The revenue increase was partially offset by decreases in handhelds revenue due to declines in the Personal Digital Assistant (“PDA”) product market, which were partially offset by our new converged device and travel companion products. In fiscal 2007, the positive revenue impact from the PSG unit volume increase compared to fiscal 2006 was also moderated by a 5% decline in commercial client ASPs and a 1% decline in consumer client ASPs. ASPs declined from the prior year was a result of price erosion related to component cost reductions, the impact of which was partially offset by increased notebook mix and monitor attach rates. PSG earnings from operations as a percentage of net revenue increased by 1.4 percentage points in fiscal 2007 from fiscal 2006 as a result of decreases in operating expenses as a percentage of net revenue coupled with an increase in gross margin. The increased gross margin was primarily a result of component cost declines and improvements in supply chain costs per unit, the impact of which was partially offset by ASP declines. The operating expense decline as a percentage of net revenue in fiscal 2007 was the result primarily of the increased net revenue and continued efforts to improve our cost structure through efficiency measures. 56 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) On a constant currency basis, PSG’s net revenue increased 10% in fiscal 2006. The unfavorable currency impact was due primarily to the movement of the dollar against the euro and the yen. In fiscal 2006, net revenue increased across all regions and each business unit with the exception of handhelds, due primarily to an overall volume increase of 15%. The volume increase in fiscal 2006 was the result of strong growth in the consumer and commercial markets, with significant improvement in emerging markets. Net revenue for notebook PCs increased 23% while net revenue for desktop PCs increased slightly in fiscal 2006 from the prior year. Net revenue for consumer clients and commercial clients increased 19% and 4%, respectively, from the prior year. The revenue increases in consumer and commercial clients were partially offset by a decrease in handhelds revenue due to a decline in the PDA product market coupled with our product transition to converged devices. The PSG volume increase in fiscal 2006 was moderated by a decline of 6% in consumer client ASPs and 7% in commercial client ASPs. The ASP declines were due to pricing decisions resulting from lower component costs as well as competitive pricing pressures, the impact of which was partially offset by a strong monitor attach rate in commercial desktops PCs. PSG earnings from operations as a percentage of net revenue increased by 1.4 percentage points in fiscal 2006 from fiscal 2005 as a result of gross margin improvement and a decrease in operating expenses as a percentage of revenue. The gross margin improvement was due primarily to reduced supply chain costs and warranty expense as a percentage of net revenue, combined with component cost declines. The operating expense decline as a percentage of net revenue was the result primarily of the increased net revenue and continued efforts on improving cost structure through efficiency measures. Operating expenses decreased slightly in fiscal 2006 due primarily to savings from our expense controls, which savings were partially offset by higher bonus accruals in fiscal 2006. Imaging and Printing Group Net revenue............................................................................................................................. Earnings from operations...................................................................................................... Earnings from operations as a % of net revenue................................................................... 2007 For the fiscal years ended October 31 2006 In millions $26,786 $3,978 14.9% $28,465 $4,315 15.2% $25,155 $3,413 13.6% 2005 The components of weighted-average net revenue growth as compared to prior-year periods by business unit were as follows for the following fiscal years ended October 31: Supplies .............................................................................................................................................................. Commercial hardware......................................................................................................................................... Consumer hardware ............................................................................................................................................ Total IPG ............................................................................................................................................................ 2006 2007 Percentage points 5.4 1.4 (0.3) 6.5 5.2 1.0 0.1 6.3 On a constant currency basis, net revenue increased 4% in fiscal 2007 from fiscal 2006. The favorable currency impact was due primarily to the movement of the dollar against the euro in fiscal 2007. The growth in printer supplies net revenue in fiscal 2007 from fiscal 2006 reflected higher unit volumes of supplies as a result of the continued expansion of printer hardware placements and the strong performance of supplies for color-related products. The growth in commercial hardware net 57 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) revenue in fiscal 2007 was attributable mainly to unit volume growth in multifunction printers and revenue from our digital press and large format printing products. The slight increase in consumer hardware net revenue in fiscal 2007 was attributable to increased unit volumes, improved average revenue per unit performance and a mix shift from single function products to All-in-Ones, the impact of which was partially offset by the continued shift in demand to lower priced products and strategic pricing decisions. IPG earnings from operations as a percentage of net revenue increased by 0.3 percentage points in fiscal 2007 from fiscal 2006, driven by a decrease in operating expenses as a percentage of net revenue that was partially offset by a decrease in gross margin. Gross margin decreased due primarily to unfavorable hardware margins, increased costs associated with new product introductions and a change in product mix. Operating expenses as a percentage of net revenue decreased due primarily to higher prior-year research and development expenses associated with product introduction costs, coupled with higher revenue and more effective spending controls. On a constant currency basis, net revenue increased 7% in fiscal 2006 from fiscal 2005. The unfavorable currency impact was due primarily to the movement of the dollar against the euro and the yen in fiscal 2006. In fiscal 2006, the growth in printer supplies net revenue reflected higher unit volumes as a result of the continued expansion of printer hardware placements and the strong performance of color-related products. The growth in commercial hardware net revenue in fiscal 2006 was attributable mainly to unit volume growth in color laser printers and multifunction printers and, to a lesser extent, revenue from our large format printing products with the acquisition of Scitex in November 2005. Commercial and consumer hardware revenue was unfavorably impacted by the continued shift in demand to lower-priced products and strategic pricing decisions, which caused average revenue per unit to decline. IPG earnings from operations as a percentage of net revenue increased 1.3 percentage points in fiscal 2006 from fiscal 2005, which was the result primarily of an increase in gross margin and a decrease in operating expense as a percentage of net revenue. The gross margin increase was due primarily to improved margins for supplies due to product mix and a favorable portfolio mix shift from hardware to supplies, the impact of which was partially offset by unfavorable consumer hardware margins. Operating expense as a percentage of net revenue for fiscal 2006 declined, due mainly to realized savings from our cost structure initiatives coupled with increased revenue and partially offset by higher bonus accruals. HP Financial Services Net revenue.......................................................................................................................... Earnings from operations..................................................................................................... Earnings from operations as a % of net revenue.................................................................. 2007 For the fiscal years ended October 31 2006 In millions $2,078 $147 7.1% $2,336 $155 6.6% $2,102 $213 10.1% 2005 HPFS net revenue increased by 12% in fiscal 2007 from fiscal 2006. The net revenue increase was due primarily to operating lease growth and higher end-of-lease activity. The financing lease growth and increased used equipment sales, to a lesser extent, also contributed to the revenue growth. HPFS earnings from operations as a percentage of net revenue decreased by 0.5 percentage point in fiscal 2007 from fiscal 2006 due primarily to a decrease in gross margin, which was partially offset by 58 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) a decrease in operating expense as a percentage of net revenue. The gross margin decrease was driven primarily by increased bad debt expenses and lower bad debt recoveries, as well as lower margins on leases and used equipment sales. The decline in operating expenses as a percentage of net revenue was due to continued cost controls. HPFS net revenue decreased by 1% in fiscal 2006 from fiscal 2005. The net revenue decrease was due primarily to lower used equipment sales and other end-of-lease revenue, which were largely offset by a higher mix of leases classified as operating leases. In fiscal 2006, the 3.0 percentage point decrease in earnings from operations as a percentage of net revenue consisted of a decrease in gross margin, which was partially offset by a decrease in operating expense as a percentage of net revenue. The gross margin decline was due primarily to competitor pricing pressures, a higher mix of lower margin operating lease assets and lower recoveries for bad debts, the impact of which was partially offset by lower credit losses. The decrease in operating expenses as a percentage of net revenue was the result of cost savings achieved through continued cost controls. Financing Originations Total financing originations................................................................................................ 2007 For the fiscal years ended October 31 2006 In millions $3,994 $4,441 2005 $4,136 New financing originations, which represent the amounts of financing provided to customers for equipment and related software and services, and include intercompany activity, increased 11% in fiscal 2007 from fiscal 2006. The increase reflects higher financing associated with HP product sales resulting from improved integration and engagement with HP’s sales efforts and a favorable currency impact. Financing originations decreased 3% in fiscal 2006 from fiscal 2005 with the decrease reflecting lower financing associated with HP product sales. Portfolio Assets and Ratios HPFS maintains a strategy to generate a competitive return on equity by effectively leveraging its portfolio against the risks associated with interest rates and credit. The HPFS business model is asset-intensive and uses certain internal metrics to measure its performance against other financial services companies, including a segment balance sheet that is derived from our internal management reporting system. The accounting policies used to derive these amounts are substantially the same as those used by the consolidated company. However, certain intercompany loans and accounts that are reflected in the segment balances are eliminated in our Consolidated Financial Statements. 59 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) The portfolio assets and ratios derived from the segment balance sheet for HPFS were as follows for the following fiscal years ended October 31: Portfolio assets ‘(1) ......................................................................................................................................... Allowance for doubtful accounts .................................................................................................................. Operating lease equipment reserve ............................................................................................................... Total reserves................................................................................................................................................ Net portfolio assets ....................................................................................................................................... Reserve coverage .......................................................................................................................................... Debt to equity ratio ‘(2)................................................................................................................................... 2007 2006 In millions $8,415 84 49 133 $8,282 1.6% 6.0x $7,345 80 42 122 $7,223 1.7% 6.0x ‘(1) Portfolio assets include gross financing receivables of approximately $5.4 billion at October 31, 2007 and $4.9 billion at October 31, 2006 and net equipment under operating leases of $1.8 billion at October 31, 2007 and $1.5 billion at October 31, 2006, as disclosed in Note 10 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Portfolio assets also include capitalized profit on intercompany equipment transactions of approximately $500 million at October 31, 2007 and $400 million at October 31, 2006, and intercompany leases of approximately $700 million at October 31, 2007 and $500 million at October 31, 2006, both of which are eliminated in consolidation. ‘(2) HPFS debt consists of intercompany equity that is treated as debt for segment reporting purposes, intercompany debt and debt issued directly by HPFS. Portfolio assets at October 31, 2007 increased 15% from October 31, 2006. The increase resulted from a favorable currency impact and a high level of financing originations in fiscal 2007. The overall percentage of portfolio assets reserved decreased due primarily to the write-off of assets covered by specific reserves. HPFS funds its operations mainly through a combination of intercompany debt and equity. Corporate Investments Net revenue.............................................................................................................................. Loss from operations ............................................................................................................... Loss from operations as a % of net revenue ............................................................................ 2005 2007 For the fiscal years ended October 31 2006 In millions $566 $(151) $523 $(174) (26.7)% (33.3)% $762 $(57) (7.5)% The majority of the net revenue in Corporate Investments relates to network infrastructure products sold under the brand “ProCurve Networking.” In fiscal 2007, revenue from network infrastructure products increased 33% compared to the same period in fiscal 2006 as new product introductions continued to drive increased sales of enterprise class gigabit Ethernet switch products. Corporate Investments’ loss from operations in fiscal 2007 was due primarily to expenses associated with corporate development, global alliances and HP Labs that are carried in the segment. 60 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) The year-over-year decrease in operating losses was driven primarily by higher earnings from operations generated by network infrastructure products. In fiscal 2006, the majority of the net revenue in Corporate Investments related to network infrastructure products, which grew 8% from fiscal 2005 as a result of increased sales of gigabit Ethernet switch products. Corporate Investments’ loss from operations in fiscal 2006 decreased compared to fiscal 2005 due primarily to lower operating expenses related to global alliances and HP Labs and higher gross profits from network infrastructure products. The decrease in operating expenses was due primarily to savings resulting from restructuring actions and lower program spending. Expenses related to global alliances and HP Labs contributed to the majority of the loss from operations. LIQUIDITY AND CAPITAL RESOURCES Our cash balances are held in numerous locations throughout the world, including substantial amounts held outside of the United States. Most of the amounts held outside of the United States could be repatriated to the United States but under current law would be subject to United States federal income taxes, less applicable foreign tax credits. Repatriation of some foreign balances is restricted by local laws. We have provided for the United States federal tax liability on these amounts for financial statement purposes, except for foreign earnings that are considered indefinitely reinvested outside of the United States. Repatriation could result in additional United States federal income tax payments in future years. Our intent is that most of the non-U.S. cash balances would remain outside of the United States and we would meet United States liquidity needs through ongoing cash flows, external borrowings, or both. We utilize a variety of tax planning and financing strategies in an effort to ensure that our worldwide cash or debt is available in the locations in which it is needed. FINANCIAL CONDITION (Sources and Uses of Cash) Our total cash and cash equivalents declined approximately 31% to $11.3 billion at October 31, 2007 from $16.4 billion at October 31, 2006 due primarily to increased spending for repurchases of our common stock and investment spending on acquisitions, which spending was partially offset by positive operating cash flows and increased borrowings. The net $14.7 billion used for investing and financing activities during fiscal 2007 included $10.9 billion for share repurchases, $6.8 billion for cash payments in connection with acquisitions and $2.5 billion for net investments in property, plant and equipment. Partially offsetting these cash expenditures were $3.1 billion of proceeds relating to the issuance of stock under employee stock plans and a $2.6 billion net increase in our debt and commercial paper from increased borrowings. Our cash position remains strong, and we believe our cash balances are sufficient to cover cash outlays expected in fiscal 2008 associated with additional stock repurchases, acquisitions, company bonus payments, and other operating cash requirements. 2005 2007 For the fiscal years ended October 31 2006 In millions $11,353 (2,787) (6,077) $2,489 $9,615 (9,123) (5,599) $(5,107) $8,028 (1,757) (5,023) $1,248 Net cash provided by operating activities ......................................................................... Net cash used in investing activities ................................................................................. Net cash used in financing activities................................................................................. Net (decrease) increase in cash and cash equivalents ....................................................... 61 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Key Performance Metrics Days of sales outstanding in accounts receivable .................................................................................... Days of supply in inventory..................................................................................................................... Days of purchases outstanding in accounts payable ................................................................................ Cash conversion cycle ............................................................................................................................. October 31 2006 40 38 (59) 19 2007 43 34 (50) 27 2005 39 35 (52) 22 Days of sales outstanding in accounts receivable (“DSO”) measures the average number of days our receivables are outstanding. DSO is calculated by dividing accounts receivable, net of allowance for doubtful accounts, by a 90-day average net revenue. Days of supply in inventory (“DOS”) measures the average number of days from procurement to sale of our product. DOS is calculated by dividing inventory by a 90-day average cost of goods sold. Days of purchases outstanding in accounts payable (“DPO”) measures the average number of days our accounts payable balances are outstanding. DPO is calculated by dividing accounts payable by a 90-day average cost of goods sold. Our working capital requirements depend upon our effective management of the cash conversion cycle, which represents effectively the number of days that elapse from the day we pay for the purchase of raw materials to the collection of cash from our customers. The cash conversion cycle is the sum of DSO and DOS less DPO. The increase in DSO was due primarily to selectively extending payment terms and reducing cash discount rates for early payments for certain customers. The decrease in DOS was due primarily to more efficient inventory management and higher cost of goods sold during the fourth quarter as a result of increased revenues. The decrease in DPO was due primarily to purchasing linearity and reduced payment terms and cash discounts from our major contract manufacturers. These changes contributed to the increase in our current year cash conversion cycle compared to the prior year. 2007 Compared to 2006 Operating Activities Net cash provided by operating activities decreased by $1.7 billion during fiscal 2007 from fiscal 2006. The decrease was due primarily to an increase in accounts receivable, a decrease in accounts payable and higher payments for bonuses earned in fiscal 2006 and paid in the first quarter of fiscal 2007. The decease in our cash flow from operations was partially offset by higher earnings in fiscal 2007. Investing Activities Net cash used in investing activities increased by $6.3 billion in fiscal 2007 from fiscal 2006, due primarily to higher cash payments made in connection with acquisitions. 62 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Financing Activities Net cash used in financing activities decreased by $0.5 billion during fiscal 2007 from fiscal 2006. The decrease was due primarily to higher net issuance of commercial paper and debt, the impact of which was partially offset by increased repurchases of our common stock. Common Stock Repurchases We repurchase shares of our common stock under an ongoing program to manage the dilution created by shares issued under employee benefit plans as well as to repurchase shares opportunistically. This program authorizes repurchases in the open market or in private transactions. In fiscal 2007, we completed share repurchases of approximately 209 million shares. Repurchases of approximately 210 million shares were settled for $9.1 billion, which included approximately 1 million shares repurchased in transactions that were executed in fiscal 2006 but settled in fiscal 2007. In fiscal 2006, we completed share repurchases of approximately 188 million shares. Repurchases of approximately 190 million shares were settled for $6.1 billion in fiscal 2006, including 2 million shares repurchased in transactions that were executed in fiscal 2005 but settled in fiscal 2006. In addition to the above transactions, we entered into an Accelerated Share Repurchase program (the “ASR Program”) with a third-party investment bank during the second quarter of fiscal 2007. Pursuant to the terms of the ASR Program, we purchased 40 million shares of our common stock from the investment bank for $1.8 billion (the “Purchase Price”) on March 30, 2007 (the “Purchase Date”). We decreased our shares outstanding and reduced the outstanding shares used to calculate the weighted-average common shares outstanding for both basic and diluted EPS on the Purchase Date. The shares delivered to us included shares that the investment bank borrowed from third parties. The investment bank purchased an equivalent number of shares in the open market to cover its position with respect to the borrowed shares during a contractually specified averaging period that began on the Purchase Date and ended on June 6, 2007. At the end of the averaging period, the investment bank’s total purchase cost based on the volume weighted-average purchase price of our shares during the averaging period was approximately $90 million less than the Purchase Price. Accordingly, we had the option to receive either additional shares of our common stock or a cash payment in the amount of the difference from the investment bank. In June 2007, we received approximately 2 million additional shares purchased by the investment bank in the open market with a value approximately equal to that amount. We reduced our shares outstanding upon receipt of those shares. Also, we entered into a prepaid variable share purchase program (“PVSPP”) with a third-party investment bank during the first quarter of 2006 and prepaid $1.7 billion in exchange for the right to receive a variable number of shares of our common stock weekly over a one-year period beginning in the second quarter of fiscal 2006 and ending during the second quarter of fiscal 2007. We completed all repurchases under the PVSPP on March 9, 2007. As of that date, we had cumulatively received a total of 53 million shares. We retired all shares repurchased and no longer deem those shares outstanding. We intend to continue to repurchase shares as a means to manage dilution from the issuance of shares under employee benefit plans and to purchase shares opportunistically. On March 15, 2007, our Board of Directors authorized an additional $8.0 billion for future share repurchases. As of October 31, 2007, we had remaining authorization of approximately $2.7 billion for future share repurchases. On November 19, 2007, our Board of Directors authorized an additional $8.0 billion for future share repurchases. For more information on our share repurchases, see Item 5 and Note 14 to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. 63 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) 2006 Compared to 2005 Operating Activities Net cash provided by operating activities increased by $3.3 billion during fiscal 2006. The increase in our cash flow from operations was due primarily to higher earnings and lower payments for pension and taxes, with the increase partially offset by higher payments for restructuring costs. Investing Activities Net cash used in investing activities increased by $1.0 billion during fiscal 2006 due primarily to higher capital expenditures for property, plant and equipment, lower net proceeds from maturities and sales of investments and higher amounts of cash paid for acquisitions. Financing Activities Net cash used in financing activities increased by $1.1 billion during fiscal 2006 from fiscal 2005. The increase was due primarily to a $2.5 billion increase in repurchases of common stock and a $1.7 billion prepayment for common stock to be repurchased in future periods. These expenditures were partially offset by a $1.6 billion net increase to financing activities resulting from higher borrowings and lower debt payments and $1.4 billion increased proceeds from the issuance of common stock related to our employee stock plans due mainly to increased exercises of employee stock options as a result of higher market prices for our common stock during fiscal 2006. Common Stock Repurchases In fiscal 2006, we completed share repurchases of approximately 188 million shares. Repurchases of approximately 190 million shares were settled for $6.1 billion, which included 2 million shares repurchased in transactions that were executed in fiscal 2005 but settled in fiscal 2006, as compared to approximately 150 million shares repurchased, of which 148 million shares were settled for $3.5 billion in fiscal 2005. In addition to the shares we repurchased, we received approximately 34 million shares for an aggregate price of $1.1 billion under PVSPP as described above. Under the PVSPP, we prepaid $1.7 billion in the first quarter of fiscal 2006 in exchange for the right to receive a variable number of shares of our common stock weekly over a one-year period beginning in the second quarter of fiscal 2006 and ending during the second quarter of fiscal 2007. We recorded the payment as a prepaid stock repurchase in the stockholders’ equity section of our Consolidated Balance Sheet and included the payment in the cash flows from financing activities in the Consolidated Statement of Cash Flows. In connection with this program, the investment bank purchased shares of our common stock in the open market over time. The prepaid funds were expended ratably over the term of the program. During fiscal 2006, our Board of Directors authorized an additional $10.0 billion for future repurchases of our outstanding shares of common stock. As of October 31, 2006, we had remaining authorization of approximately $5.6 billion for future share repurchases. LIQUIDITY As previously discussed, we use cash generated by operations as our primary source of liquidity; we believe that internally generated cash flows are sufficient to support business operations, capital expenditures and the payment of stockholder dividends, in addition to a level of discretionary 64 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) investments and share repurchases. We are able to supplement this near-term liquidity, if necessary, with broad access to capital markets and credit line facilities made available by various foreign and domestic financial institutions. We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), share repurchase activities, and the overall cost of capital. Outstanding debt increased to $8.2 billion as of October 31, 2007 as compared to $5.2 billion at October 31, 2006, bearing weighted-average interest rates of 5.2% and 5.1%, respectively. Short-term borrowings increased to $3.2 billion at October 31, 2007 from $2.7 billion at October 31, 2006. The increase in short-term borrowings was due primarily to the net issuance of approximately $1.9 billion of our commercial paper and notes payable and the reclassification from long-term to short-term debt, including $500 million U.S. Dollar Global Notes that will mature in March 2008 and $50 million Series A Medium-Term Notes that matured and we repaid in December 2007. The increase was offset partially by our repayment of $1.0 billion Global Notes in December 2006 and $1.0 billion Global Notes in July 2007. During fiscal 2007, we issued $32 billion and repaid $30 billion of commercial paper. As of October 31, 2007, we had $5 million in total borrowings collateralized by certain financing receivable assets. The majority of our outstanding debt relates to HPFS. We issue debt in order to finance HPFS and as needed for other purposes. HPFS has a business model that is asset-intensive in nature and therefore we fund HPFS more by debt than we fund our other business segments. At October 31, 2007, HPFS had approximately $8.3 billion in net portfolio assets, which included short- and long-term financing receivables and operating lease assets. We have the following resources available to obtain short-term or long-term financings, if we need additional liquidity: 2002 Shelf Registration Statement Debt, U.S. global securities and up to $1,500 of Series B Medium-Term Notes........................................................................... Euro Medium-Term Notes........................................................................ Uncommitted lines of credit ..................................................................... Commercial paper programs U.S. ........................................................................................................ Euro........................................................................................................ Original amount available At October 31, 2007 Used In millions Available $3,000 3,000 2,455 6,000 500 $14,955 $2,000 $1,000 — 645(1) 1,821 244 $4,710 3,000 1,810 4,179 256 $10,245 (1) Approximately $151 million of this amount was recorded as debt as of October 31, 2007; the remaining amount was used to satisfy business operational requirements. In addition to the financing resources listed above, we had additional borrowing activities as described below. In November 2006, in connection with the Mercury acquisition, we assumed notes issued by Mercury with a face value of $300 million, maturing on July 1, 2007 and bearing interest at a rate of 65 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) 4.75% per annum (the “Mercury Notes”). As of July 31, 2007, we had repurchased or repaid at maturity all of the Mercury Notes. In May 2006, we filed a shelf registration statement (the “2006 Shelf Registration Statement”) with the Securities and Exchange Commission (the “SEC”) to enable us to offer and sell from time to time, in one or more offerings, debt securities, common stock, preferred stock, depositary shares and warrants. On May 23, 2006, we issued $1.0 billion in floating rate global notes due May 22, 2009 under the 2006 Shelf Registration Statement that we redeemed in June 2007. On February 22, 2007, we issued an additional $2.0 billion of global notes under the 2006 Shelf Registration Statement. The global notes included $600 million of notes due March 2012 with a floating interest rate equal to the three-month USD LIBOR plus 0.11% per annum, $900 million of notes due March 2012 with a fixed interest rate of 5.25% per annum and $500 million of notes due March 2017 with a fixed interest rate of 5.40% per annum. We issued the $600 million notes at par and the $900 million notes and $500 million notes at discounts to par at 99.938% and 99.694%, respectively. We used the net proceeds from these note offerings for general corporate purposes, including funding the repurchase of the Mercury Notes as described above and repaying short-term commercial paper. On June 12, 2007, we issued an additional $2.0 billion of global notes under the 2006 Shelf Registration Statement. The global notes included $1.0 billion of notes due June 2009 with a floating interest rate equal to the three-month USD LIBOR plus 0.01% per annum, and $1.0 billion of notes due June 2010 with a floating interest rate equal to the three-month USD LIBOR plus 0.06% per annum. We issued these global notes at par. We used the net proceeds from these offerings for general corporate purposes, including the redemption of the floating rate global notes due May 22, 2009 as described above in June 2007 and the repayment of short-term commercial paper. On December 17, 2007, we repaid $50 million Series A Medium-Term Notes due December 2007 at maturity. We have a $3.0 billion U.S. credit facility expiring in May 2012. This credit facility is a senior unsecured committed borrowing arrangement that we put in place primarily to support our U.S. commercial paper program. Our ability to have a U.S. commercial paper outstanding balance that exceeds the $3.0 billion committed credit facility is subject to a number of factors, including liquidity conditions and business performance. Our credit risk is evaluated by three independent rating agencies based upon publicly available information as well as information obtained in our ongoing discussions with them. Standard & Poor’s Ratings Services, Moody’s Investors Service and Fitch Ratings currently rate our senior unsecured long-term debt A, A2 and A+ and our short-term debt A-1, Prime-1 and F1, respectively. We do not have any rating downgrade triggers that would accelerate the maturity of a material amount of our debt. However, a downgrade in our credit rating would increase the cost of borrowings under our credit facilities. Also, a downgrade in our credit rating could limit our ability to issue commercial paper under our current programs. If this occurs, we would seek alternative sources of funding, including through drawdowns under our credit facility or the issuance of notes under our existing shelf registration statements and our Euro Medium-Term Note Programme. We have revolving trade receivables-based facilities permitting us to sell certain trade receivables to third parties on a non-recourse basis. The aggregate maximum capacity under these programs was approximately $525 million as of October 31, 2007. We sold approximately $2.2 billion of trade 66 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) receivables during fiscal 2007. As of October 31, 2007, we had approximately $117 million available under these programs. Contractual Obligations The impact that we expect our contractual obligations as of October 31, 2007 to have on our liquidity and cash flow in future periods is as follows: Long-term debt, including capital lease obligations ‘(1)........... Operating lease obligations..................................................... Purchase obligations(2) ............................................................ Total........................................................................................ Payments Due by Period Total $5,827 2,193 2,029 $10,049 Less than 1 Year $683 595 1,826 $3,104 1-3 Years In millions $2,059 761 164 $2,984 3-5 Years More than 5 Years $2,012 409 24 $2,445 $1,073 428 15 $1,516 ‘(1) Amounts represent the expected cash payments of our long-term debt and do not include any fair value adjustments or discounts. Included in our long-term debt are approximately $48 million of capital lease obligations that are secured by certain equipment. ‘(2) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. These purchase obligations are related principally to inventory and other items. Funding Commitments During fiscal 2007, we made approximately $133 million of contributions to non-U.S. pension plans, paid $16 million to cover benefit payments to U.S. non-qualified plan participants, and paid $58 million to cover benefit claims under post- retirement benefit plans. In addition, we used $108 million of cash to fund the distribution and subsequent transfer of accrued pension benefits from the U.S. Excess Benefit Plan to the U.S. Executive Deferred Compensation Plan for the terminated vested plan participants. In fiscal 2008, we expect to contribute approximately $145 million to our pension plans and approximately $15 million to cover benefit payments to U.S. non-qualified plan participants. We also expect to pay approximately $80 million to cover benefit claims for our post-retirement benefit plans in fiscal 2008. Our funding policy is to contribute cash to our pension plans so that we meet at least the minimum contribution requirements, as established by local government and funding and taxing authorities. We expect to use contributions made to the post-retirement benefit plans primarily for the payment of retiree health claims incurred during the fiscal year. In conjunction with our February 2007 announcement to modify our U.S. defined benefit pension plan and our Pre-2003 Retiree Medical Program, we offered eligible affected employees an option to participate in the 2007 EER. We funded the cash expenditures associated with the 2007 EER primarily by using available U.S. pension plan assets. We made no incremental pension contributions to the pension plan stemming from the 2007 EER. 67 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) We have implemented bonus programs that are designed to reward our employees upon achievement of annual performance objectives. We calculate bonuses based on a formula, with targets that are set at the beginning of each fiscal year. Our Board of Directors approves both the formula and the targets. In fiscal 2007, we outperformed against our targets, which will result in a significant bonus payout during the first quarter of fiscal 2008 and a corresponding reduction of cash flow from operations in that quarter. We accrued and expensed this bonus, as it was earned, throughout fiscal 2007. As a result of our approved restructuring plans, we expect future cash expenditures of $173 million, which we recorded on our Consolidated Balance Sheet at October 31, 2007. We expect to make cash payments of approximately $123 million in fiscal 2008 and the majority of the remaining $50 million through 2014. Pending and Subsequent Acquisitions For pending acquisitions, see Note 6 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Off-Balance Sheet Arrangements As part of our ongoing business, we do not participate in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of October 31, 2007, we are not involved in any material unconsolidated SPEs. Indemnifications In the ordinary course of business, we enter into contractual arrangements under which we may agree to indemnify the third-party to such arrangement from any losses incurred relating to the services they perform on behalf of us or for losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to past performance. Such indemnification obligations may not be subject to maximum loss clauses. Historically, payments we have made related to these indemnifications have been immaterial. 68 ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. In the normal course of business, we are exposed to foreign currency exchange rate, interest rate and equity price risks that could impact our financial position and results of operations. Our risk management strategy with respect to these three market risks may include the use of derivative financial instruments. We use derivative contracts only to manage existing underlying exposures of HP. Accordingly, we do not use derivative contracts for speculative purposes. Our risks, risk management strategy and a sensitivity analysis estimating the effects of changes in fair values for each of these exposures are outlined below. Actual gains and losses in the future may differ materially from the sensitivity analyses based on changes in the timing and amount of interest rate, foreign currency exchange rate and equity price movements and our actual exposures and hedges. Foreign currency exchange rate risk We are exposed to foreign currency exchange rate risk inherent in our sales commitments, anticipated sales, anticipated purchases and assets, liabilities and debt denominated in currencies other than the U.S. dollar. We transact business in approximately 40 currencies worldwide, of which the most significant to our operations for fiscal 2007 were the euro, the Japanese yen and the British pound. For most currencies, we are a net receiver of the foreign currency and therefore benefit from a weaker U.S. dollar and are adversely affected by a stronger U.S. dollar relative to the foreign currency. Even where we are a net receiver, a weaker U.S. dollar may adversely affect certain expense figures taken alone. We use a combination of forward contracts and options designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in our forecasted net revenue and, to a lesser extent, cost of sales denominated in currencies other than the U.S. dollar. In addition, when debt is denominated in a foreign currency, we may use swaps to exchange the foreign currency principal and interest obligations for U.S. dollar-denominated amounts to manage the exposure to changes in foreign currency exchange rates. We also use other derivatives not designated as hedging instruments under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” consisting primarily of forward contracts to hedge foreign currency balance sheet exposures. We recognize the gains and losses on foreign currency forward contracts in the same period as the remeasurement losses and gains of the related foreign currency-denominated exposures. Alternatively, we may choose not to hedge the foreign currency risk associated with our foreign currency exposures if such exposure acts as a natural foreign currency hedge for other offsetting amounts denominated in the same currency or the currency is difficult or too expensive to hedge. We have performed sensitivity analyses as of October 31, 2007 and 2006, using a modeling technique that measures the change in the fair values arising from a hypothetical 10% adverse movement in the levels of foreign currency exchange rates relative to the U.S. dollar, with all other variables held constant. The analyses cover all of our foreign currency contracts offset by the underlying exposures. The foreign currency exchange rates we used were based on market rates in effect at October 31, 2007 and 2006. The sensitivity analyses indicated that a hypothetical 10% adverse movement in foreign currency exchange rates would result in a foreign exchange loss of $104 million at both October 31, 2007 and October 31, 2006. Interest rate risk We also are exposed to interest rate risk related to our debt and investment portfolios and financing receivables. We issue long-term debt in either U.S. dollars or foreign currencies based on market conditions at the time of financing. We then typically use interest rate and/or currency swaps to modify the market risk exposures in connection with the debt to achieve primarily U.S. dollar LIBOR-based floating interest expense. The swap transactions generally involve the exchange of fixed for 69 floating interest payments. However, we may choose not to swap fixed for floating interest payments or may terminate a previously executed swap if we believe a larger proportion of fixed-rate debt would be beneficial. In order to hedge the fair value of certain fixed-rate investments, we may enter into interest rate swaps that convert fixed interest returns into variable interest returns. We may use cash flow hedges to hedge the variability of LIBOR-based interest income received on certain variable-rate investments. We may also enter into interest rate swaps that convert variable rate interest returns into fixed-rate interest returns. We have performed sensitivity analyses as of October 31, 2007 and 2006, using a modeling technique that measures the change in the fair values arising from a hypothetical 10% adverse movement in the levels of interest rates across the entire yield curve, with all other variables held constant. The analyses cover our debt, investment instruments, financing receivables and interest rate swaps. The analyses use actual maturities for the debt, investments and interest rate swaps and approximate maturities for financing receivables. The discount rates we used were based on the market interest rates in effect at October 31, 2007 and 2006. The sensitivity analyses indicated that a hypothetical 10% adverse movement in interest rates would result in a loss in the fair values of our debt and investment instruments and financing receivables, net of interest rate swap positions, of $17 million at October 31, 2007 and $19 million at October 31, 2006. Equity price risk We are also exposed to equity price risk inherent in our portfolio of publicly-traded equity securities, which had an estimated fair value of $9 million at October 31, 2007 and $36 million at October 31, 2006. We monitor our equity investments for impairment on a periodic basis. In the event that the carrying value of the equity investment exceeds its fair value, and we determine the decline in value to be other than temporary, we reduce the carrying value to its current fair value. Generally, we do not attempt to reduce or eliminate our market exposure on these equity securities. However, we may use derivative transactions to hedge certain positions from time to time. We do not purchase our equity securities with the intent to use them for speculative purposes. A hypothetical 30% adverse change in the stock prices of our publicly-traded equity securities would result in a loss in the fair values of our marketable equity securities of $3 million at October 31, 2007 and $11 million at October 31, 2006. The aggregate cost of privately-held companies and other investments was $533 million at October 31, 2007 and $362 million at October 31, 2006. 70 ITEM 8. Financial Statements and Supplementary Data. Table of Contents Reports of Independent Registered Public Accounting Firm.............................................................................................. Management’s Report on Internal Control Over Financial Reporting................................................................................ Consolidated Statements of Earnings ................................................................................................................................. Consolidated Balance Sheets .............................................................................................................................................. Consolidated Statements of Cash Flows............................................................................................................................. Consolidated Statements of Stockholders’ Equity.............................................................................................................. Notes to Consolidated Financial Statements....................................................................................................................... Note 1: Summary of Significant Accounting Policies ..................................................................................................... Note 2: Stock-Based Compensation ................................................................................................................................ Note 3: Net Earnings Per Share ....................................................................................................................................... Note 4: Balance Sheet Details.......................................................................................................................................... Note 5: Supplemental Cash Flow Information................................................................................................................. Note 6: Acquisitions ........................................................................................................................................................ Note 7: Goodwill and Purchased Intangible Assets ......................................................................................................... Note 8: Restructuring Charges......................................................................................................................................... Note 9: Financial Instruments .......................................................................................................................................... Note 10: Financing Receivables and Operating Leases ................................................................................................... Note 11: Guarantees......................................................................................................................................................... Note 12: Borrowings........................................................................................................................................................ Note 13: Taxes on Earnings ............................................................................................................................................. Note 14: Stockholders’ Equity......................................................................................................................................... Note 15: Retirement and Post-Retirement Benefit Plans ................................................................................................. Note 16: Commitments .................................................................................................................................................... Note 17: Litigation and Contingencies ............................................................................................................................ Note 18: Segment Information......................................................................................................................................... Quarterly Summary.......................................................................................................................................................... 72 74 75 76 77 78 79 79 88 95 96 98 98 101 103 105 110 111 112 115 120 122 132 133 142 150 71 Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of Hewlett-Packard Company We have audited the accompanying consolidated balance sheets of Hewlett-Packard Company and subsidiaries as of October 31, 2007 and 2006, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the three years in the period ended October 31, 2007. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hewlett-Packard Company and subsidiaries at October 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended October 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Hewlett-Packard Company’s internal control over financial reporting as of October 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated December 14, 2007 expressed an unqualified opinion thereon. As discussed in Note 1 to the consolidated financial statements, in fiscal year 2007, Hewlett-Packard Company changed its method of accounting for defined benefit postretirement plans in accordance with the guidance provided in Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—An Amendment of FASB No. 87, 88, 106 and 132(R)” and, in fiscal year 2006, changed its method of accounting for stock-based compensation in accordance with guidance provided in Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”. /s/ ERNST & YOUNG LLP San Jose, California December 14, 2007 72 Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of Hewlett-Packard Company We have audited Hewlett-Packard Company’s internal control over financial reporting as of October 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Hewlett-Packard Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Hewlett-Packard Company maintained, in all material respects, effective internal control over financial reporting as of October 31, 2007 based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheets of Hewlett-Packard Company and subsidiaries as of October 31, 2007 and 2006, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the three years in the period ended October 31, 2007 and our report dated December 14, 2007 expressed an unqualified opinion thereon. /s/ERNST & YOUNG LLP San Jose, California December 14, 2007 73 Management’s Report on Internal Control Over Financial Reporting HP’s management is responsible for establishing and maintaining adequate internal control over financial reporting for HP. HP’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. HP’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of HP; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of HP are being made only in accordance with authorizations of management and directors of HP; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of HP’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. HP’s management assessed the effectiveness of HP’s internal control over financial reporting as of October 31, 2007, utilizing the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on the assessment by HP’s management, we determined that HP’s internal control over financial reporting was effective as of October 31, 2007. The effectiveness of HP’s internal control over financial reporting as of October 31, 2007 has been audited by Ernst & Young LLP, HP’s independent registered public accounting firm, as stated in their report which appears on page 73 of this Annual Report on Form 10-K. /s/ MARK V. HURD Mark V. Hurd Chairman, Chief Executive Officer and President December 14, 2007 /s/ CATHERINE A. LESJAK Catherine A. Lesjak Executive Vice President and Chief Financial Officer December 14, 2007 74 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Consolidated Statements of Earnings For the fiscal years ended October 31 2006 In millions, except per share amounts 2007 2005 Net revenue: Products ........................................................................................................................... Services............................................................................................................................ Financing income............................................................................................................. Total net revenue........................................................................................................... $84,229 19,699 358 104,286 $73,557 17,773 328 91,658 $68,945 17,380 371 86,696 Costs and expenses: Cost of products ............................................................................................................... Cost of services................................................................................................................ Financing interest............................................................................................................. Research and development .............................................................................................. Selling, general and administrative.................................................................................. Amortization of purchased intangible assets.................................................................... In-process research and development charges ................................................................. Restructuring charges....................................................................................................... Pension curtailments and pension settlements, net .......................................................... Total operating expenses............................................................................................... Earnings from operations.................................................................................................... Interest and other, net .........................................................................................................444 606 Gains (losses) on investments............................................................................................. Earnings before taxes.......................................................................................................... Provision for taxes .............................................................................................................. Net earnings........................................................................................................................ Net earnings per share: Basic ................................................................................................................................ Diluted ............................................................................................................................. Weighted-average shares used to compute net earnings per share: Basic ................................................................................................................................ Diluted ............................................................................................................................. 63,435 15,163 289 3,611 12,226 783 190 387 (517) 95,567 8,719 14 9,177 1,913 $7,264 $2.76 $2.68 2,630 2,716 55,248 13,930 249 3,591 11,266 604 52 158 — 85,098 6,560 25 7,191 993 $6,198 $2.23 $2.18 2,782 2,852 52,550 13,674 216 3,490 11,184 622 2 1,684 (199) 83,223 3,473 83 (13) 3,543 1,145 $2,398 $0.83 $0.82 2,879 2,909 The accompanying notes are an integral part of these Consolidated Financial Statements. 75 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Consolidated Balance Sheets Current assets: ASSETS Cash and cash equivalents .................................................................................................................... Short-term investments ......................................................................................................................... Accounts receivable .............................................................................................................................. Financing receivables............................................................................................................................ Inventory............................................................................................................................................... Other current assets............................................................................................................................... Total current assets............................................................................................................................. Property, plant and equipment ................................................................................................................. Long-term financing receivables and other assets ................................................................................... Goodwill .................................................................................................................................................. Purchased intangible assets...................................................................................................................... Total assets .............................................................................................................................................. Current liabilities: LIABILITIES AND STOCKHOLDERS’ EQUITY Notes payable and short-term borrowings ............................................................................................ Accounts payable.................................................................................................................................. Employee compensation and benefits................................................................................................... Taxes on earnings ................................................................................................................................. Deferred revenue................................................................................................................................... Accrued restructuring............................................................................................................................ Other accrued liabilities ........................................................................................................................ Total current liabilities ....................................................................................................................... Long-term debt ........................................................................................................................................ Other liabilities ........................................................................................................................................ Commitments and contingencies Stockholders’ equity: Preferred stock, $0.01 par value (300 shares authorized; none issued)................................................. Common stock, $0.01 par value (9,600 shares authorized; 2,580 and 2,732 shares issued and outstanding, respectively) .................................................................................................................. Additional paid-in capital ..................................................................................................................... Prepaid stock repurchase....................................................................................................................... Retained earnings.................................................................................................................................. Accumulated other comprehensive income .......................................................................................... Total stockholders’ equity.................................................................................................................. Total liabilities and stockholders’ equity ................................................................................................. October 31 2006 2007 In millions, except par value $11,293 152 13,420 2,507 8,033 11,997 47,402 7,798 7,647 21,773 4,079 $88,699 $3,186 11,787 3,465 1,891 5,025 123 13,783 39,260 4,997 5,916 $16,400 22 10,873 2,440 7,750 10,779 48,264 6,863 6,649 16,853 3,352 $81,981 $2,705 12,102 3,148 1,905 4,309 547 11,134 35,850 2,490 5,497 — 26 — 27 16,381 — 21,560 559 38,526 $88,699 17,966 (596) 20,729 18 38,144 $81,981 The accompanying notes are an integral part of these Consolidated Financial Statements. 76 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Consolidated Statements of Cash Flows 2007 For the fiscal years ended October 31 2006 In millions 2005 Cash flows from operating activities: Net earnings .................................................................................................................................. Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization.................................................................................................. Stock-based compensation expense.......................................................................................... Provision (benefit) for doubtful accounts — accounts and financing receivables................... Provision for inventory ............................................................................................................. Restructuring charges................................................................................................................ Pension curtailments and pension settlements, net................................................................... In-process research and development charges.......................................................................... Deferred taxes on earnings........................................................................................................ Excess tax benefit from stock-based compensation ................................................................. (Gains) losses on investments................................................................................................... Other, net................................................................................................................................... Changes in assets and liabilities: Accounts and financing receivables...................................................................................... Inventory................................................................................................................................ Accounts payable................................................................................................................... Taxes on earnings .................................................................................................................. Restructuring ......................................................................................................................... Other assets and liabilities..................................................................................................... Net cash provided by operating activities ......................................................................... Cash flows from investing activities: Investment in property, plant and equipment............................................................................... Proceeds from sale of property, plant and equipment.................................................................. Purchases of available-for-sale securities and other investments ................................................ Maturities and sales of available-for-sale securities and other investments ................................ Payments made in connection with business acquisitions, net .................................................... Net cash used in investing activities.................................................................................. Cash flows from financing activities: Issuance (repayment) of commercial paper and notes payable, net............................................. Issuance of debt ............................................................................................................................ Payment of debt ............................................................................................................................ Issuance of common stock under employee stock plans.............................................................. Repurchase of common stock....................................................................................................... Prepayment of common stock repurchase.................................................................................... Excess tax benefit from stock-based compensation..................................................................... Dividends ...................................................................................................................................... Net cash used in financing activities ................................................................................. (Decrease) increase in cash and cash equivalents............................................................................ Cash and cash equivalents at beginning of period........................................................................... Cash and cash equivalents at end of period ..................................................................................... $7,264 $6,198 $2,398 2,705 629 47 362 387 (517) 190 415 (481) (14) (86) (2,808) (633) (346) 502 (606) 2,605 9,615 (3,040) 568 (283) 425 (6,793) (9,123) 1,863 4,106 (3,419) 3,103 (10,887) — 481 (846) (5,599) (5,107) 16,400 $11,293 2,353 536 4 267 158 — 52 693 (251) (25) 18 (882) (1,109) 1,879 (513) (810) 2,785 11,353 (2,536) 556 (46) 94 (855) (2,787) (55) 1,121 (1,259) 2,538 (6,057) (1,722) 251 (894) (6,077) 2,489 13,911 $16,400 2,344 104 (22) 398 1,684 (199) 2 (162) — 13 (82) 666 (208) 846 748 (247) (255) 8,028 (1,995) 542 (1,729) 2,066 (641) (1,757) (1) 84 (1,827) 1,161 (3,514) — — (926) (5,023) 1,248 12,663 $13,911 The accompanying notes are an integral part of these Consolidated Financial Statements. 77 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Consolidated Statements of Stockholders’ Equity Common Stock Number of Shares Par Value Additional Paid-in Capital Prepaid stock repurchase Retained Earnings Accumulated Other Comprehensive (Loss) income Total In millions, except number of shares in thousands Balance October 31, 2004 ....................................... Net earnings......................................................... Net unrealized loss on available-for-sale securities...................................................... Net unrealized gains on cash flow hedges ...... Minimum pension liability .............................. Cumulative translation adjustment.................. Comprehensive income ....................................... Issuance of common stock in connection with employee stock plans and other....................... Repurchases of common stock ............................ Tax benefit from employee stock plans .............. Dividends............................................................. Balance October 31, 2005 ....................................... Net earnings......................................................... Net unrealized loss on available-for-sale securities...................................................... Minimum pension liability .............................. Cumulative translation adjustment.................. Comprehensive income ....................................... Issuance of common stock in connection with employee stock plans and other....................... Prepaid stock repurchase ..................................... Repurchases of common stock ............................ Tax benefit from employee stock plans .............. Dividends............................................................. Stock-based compensation expense under SFAS 123R ................................................................ Balance October 31, 2006 ....................................... Net earnings......................................................... Net unrealized loss on available-for-sale securities...................................................... Net unrealized loss on cash flow hedges......... Minimum pension liability .............................. Cumulative translation adjustment.................. Comprehensive income ....................................... Issuance of common stock in connection with employee stock plans and other....................... Repurchases of common stock ............................ Tax benefit from employee stock plans .............. Dividends............................................................. Stock-based compensation expense under SFAS 123R ................................................................ Adjustment to accumulated other comprehensive income upon adoption of SFAS 158......................................................... Balance October 31, 2007 ....................................... 2,910,760 $29 $22,129 $— 76,884 (150,448) (1) 1,452 (3,121) 30 2,837,196 $28 $20,490 $— 117,720 (222,882) 1 (2) 2,487 (5,903) 356 536 (1,722) 1,126 2,732,034 $27 $17,966 $(596) $15,649 2,398 (442) (926) $16,679 6,198 (1,254) (894) $20,729 7,264 116,661 (268,981) 1 (2) 3,134 (5,878) 530 629 596 (5,587) (846) $(243) (1) 69 171 (17) $(21) (6) (9) 54 $18 (12) (18) (3) 106 $37,564 2,398 (1) 69 171 (17) 2,620 1,452 (3,564) 30 (926) $37,176 6,198 (6) (9) 54 6,237 2,488 (1,722) (6,033) 356 (894) 536 $38,144 7,264 (12) (18) (3) 106 7,337 3,135 (10,871) 530 (846) 629 2,579,714 $26 $16,381 $— $21,560 $559 $38,526 468 468 The accompanying notes are an integral part of these Consolidated Financial Statements. 78 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements Note 1: Summary of Significant Accounting Policies Principles of Consolidation The Consolidated Financial Statements include the accounts of Hewlett-Packard Company, its wholly-owned subsidiaries and its controlled majority-owned subsidiaries (collectively, “HP”). HP accounts for equity investments in companies over which HP has the ability to exercise significant influence, but does not hold a controlling interest, under the equity method, and HP records its proportionate share of income or losses in interest and other, net in the Consolidated Statements of Earnings. HP has eliminated all significant intercompany accounts and transactions. Reclassifications and Segment Reorganization HP has made certain organizational realignments in order to more closely align its financial reporting with its business structure. These realignments are immaterial in size and reflect primarily revenue shifts among business units within the same business segment. None of the changes impacts HP’s previously reported consolidated net revenue, earnings from operations, net earnings or net earnings per share. HP has revised the presentation of its Consolidated Statements of Earnings and Consolidated Statements of Cash Flows for the fiscal years ended October 31, 2006 and 2005 to provide improved visibility and comparability with the current year presentation. This change does not affect previously reported results of operations for any period presented, or previously reported subtotals within the Consolidated Statements of Cash Flows. Use of Estimates The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in HP’s Consolidated Financial Statements and accompanying notes. Actual results could differ materially from those estimates. Revenue Recognition Net revenue is derived primarily from the sale of products and services. The following revenue recognition policies define the manner in which HP accounts for sales transactions. HP recognizes revenue when persuasive evidence of a sales arrangement exists, delivery has occurred or services are rendered, the sales price or fee is fixed or determinable and collectibility is reasonably assured. Additionally when HP recognizes revenue on sales to channel partners, including resellers, distributors or value-added solution providers we do so when the channel partners have economic substance apart from HP and we have completed our obligations related to the sale. When a sales arrangement contains multiple elements, such as hardware and software products, licenses and/or services, HP allocates revenue to each element based on its relative fair value, or for software, based on vendor specific objective evidence (“VSOE”) of fair value. In the absence of fair value for a delivered element, HP first allocates revenue to the fair value of the undelivered elements and the residual revenue to the delivered elements. Where the fair value for an undelivered element cannot be determined, HP defers revenue for the delivered elements until the undelivered elements are delivered or the fair value is determinable for the remaining undelivered elements. HP limits the 79 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) amount of revenue recognition for delivered elements to the amount that is not contingent on the future delivery of products or services or subject to customer-specified return or refund privileges. Products Hardware Under HP’s standard terms and conditions of sale, HP transfers title and risk of loss to the customer at the time product is delivered to the customer and revenue is recognized accordingly, unless customer acceptance is uncertain or significant obligations remain. HP reduces revenue for estimated customer returns, price protection, rebates and other programs offered under sales agreements established by HP with its distributors and resellers. HP records revenue from the sale of equipment under sales-type leases as product revenue at the inception of the lease. HP accrues the estimated cost of post-sale obligations, including basic product warranties, based on historical experience at the time HP recognizes revenue. Software In accordance with the specific guidance of the American Institute of Certified Public Accountants Statement of Position 97-2, “Software Revenue Recognition” where applicable, the company recognizes revenue from perpetual software licenses at the inception of the license term assuming all revenue recognition criteria have been met. Term based software license revenue is recognized on a subscription basis over the term of the license entitlement. HP uses the residual method to allocate revenue to software licenses at the inception of the license term when VSOE of fair value for all undelivered elements exists, such as post-contract support, and all other revenue recognition criteria have been satisfied. Revenue generated from maintenance and unspecified upgrades or updates on a when-and-if-available basis is recognized over the period such items are delivered. Services HP recognizes revenue from fixed-price support or maintenance contracts, including extended warranty contracts and software post-customer support contracts, ratably over the contract period and recognizes the costs associated with these contracts as incurred. For time and material contracts, HP recognizes revenue and costs as services are rendered. HP recognizes revenue from fixed-price consulting arrangements over the contract period on a proportional performance basis, as determined by the relationship of actual labor costs incurred to date to the estimated total contract labor costs, with estimates regularly revised during the life of the contract. While HP uses the proportional performance basis as its basic accounting policy, the company uses the completed performance method if reasonable and reliable cost estimates for a project cannot be made. For outsourcing contracts, HP recognizes revenue ratably over the contractual service period for fixed price contracts and on the output or consumption basis for all other outsourcing contracts. HP recognizes costs associated with outsourcing contracts as incurred, unless such costs relate to the transition phase of the outsourcing contract, in which case HP generally amortizes those costs over the contractual service period. HP recognizes revenue from operating leases on a straight-line basis as service revenue over the rental period. In addition, under the provisions of Emerging Issues Task Force No. 00-21, “Revenue Arrangements with Multiple Deliverables,” if the revenue for a delivered item is not recognized 80 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) because it is not separable from the outsourcing arrangement, then HP also defers the cost of the delivered item. HP recognizes both the revenue and associated cost for the delivered item ratably over the remaining contractual service period. HP recognizes losses on consulting and outsourcing arrangements in the period that the contractual loss becomes probable and estimable. HP records amounts invoiced to customers in excess of revenue recognized as deferred revenue until the revenue recognition criteria are met. HP records revenue that is earned and recognized in excess of amounts invoiced on fixed-price contracts as trade receivables. Financing Income Sales-type and direct-financing leases produce financing income, which HP recognizes at consistent rates of return over the lease term. Shipping and Handling HP includes costs related to shipping and handling in cost of sales for all periods presented. Advertising HP expenses advertising costs as incurred or when the advertising is first run. Such costs totaled approximately $1.1 billion in each of fiscal 2007, fiscal 2006 and fiscal 2005. Taxes on Earnings HP recognizes deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year the differences are expected to reverse. HP records a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. Cash and Cash Equivalents HP classifies investments as cash equivalents if the original maturity of an investment is three months or less. Cash and cash equivalents consists primarily of highly liquid investments in time deposits held in major banks and commercial paper. As of October 31, 2007 and 2006, the carrying value of cash and cash equivalents approximates fair value due to the short period of time to maturity. Interest income was approximately $598 million in fiscal 2007, $623 million in fiscal 2006 and $424 million in fiscal 2005. Allowance for Doubtful Accounts HP establishes an allowance for doubtful accounts to ensure trade and financing receivables are not overstated due to uncollectibility. HP maintains bad debt reserves based on a variety of factors, including the length of time receivables are past due, trends in overall weighted-average risk rating of the total portfolio, macroeconomic conditions, significant one-time events, historical experience and the use of third-party credit risk models that generate quantitative measures of default probabilities based on market factors and the financial condition of customers. HP records a specific reserve for individual accounts when HP becomes aware of a customer’s inability to meet its financial obligations, such as in the case of bankruptcy filings or deterioration in the customer’s operating results or financial position. 81 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) If circumstances related to customers change, HP would further adjust estimates of the recoverability of receivables. Inventory HP values inventory at the lower of cost or market, with cost computed on a first-in, first-out basis. Fixed Assets HP states property, plant and equipment at cost less accumulated depreciation. HP capitalizes additions and improvements. HP expenses maintenance and repairs as incurred. HP provides depreciation using straight-line or accelerated methods over the estimated useful lives of the assets. Estimated useful lives are 5 to 40 years for buildings and improvements and 3 to 15 years for machinery and equipment. HP depreciates leasehold improvements over the life of the lease or the asset, whichever is shorter. HP depreciates equipment held for lease over the initial term of the lease to the equipment’s estimated residual value. HP capitalizes certain internal and external costs incurred to acquire or create internal use software, principally related to software coding, designing system interfaces and installation and testing of the software. HP amortizes capitalized costs using the straight-line method over the estimated useful lives of the software, generally from three to five years. Goodwill and Indefinite-Lived Purchased Intangible Assets Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), prohibits the amortization of goodwill and purchased intangible assets with indefinite useful lives. HP reviews goodwill and purchased intangible assets with indefinite lives for impairment annually at the beginning of its fourth fiscal quarter and whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable in accordance with SFAS 142. For goodwill, HP performs a two-step impairment test. In the first step, HP compares the fair value of each reporting unit to its carrying value. HP determines the fair value of its reporting units based on a weighting of income and market approaches. Under the income approach, HP calculates the fair value of a reporting unit based on the present value of estimated future cash flows. Under the market approach, HP estimates the fair value based on market multiples of revenue or earnings for comparable companies. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not impaired and no further testing is performed. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then HP must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, HP records an impairment loss equal to the difference. SFAS 142 also requires that the fair value of the indefinite-lived purchased intangible assets be estimated and compared to the carrying value. HP estimates the fair value of these intangible assets using an income approach. HP recognizes an impairment loss when the estimated fair value of the indefinite-lived purchased intangible assets is less than the carrying value. 82 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) Long-Lived Assets Including Finite-Lived Purchased Intangible Assets HP amortizes purchased intangible assets with finite lives using the straight-line method over the estimated economic lives of the assets, ranging from one to ten years. HP evaluates long-lived assets, such as property, plant and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” HP assesses the fair value of the assets based on the undiscounted future cash flow the assets are expected to generate and recognizes an impairment loss when estimated undiscounted future cash flow expected to result from the use of the asset plus net proceeds expected from disposition of the asset, if any, are less than the carrying value of the asset. When HP identifies an impairment, HP reduces the carrying amount of the asset to its estimated fair value based on a discounted cash flow approach or, when available and appropriate, to comparable market values. Derivative Financial Instruments HP uses derivative financial instruments, primarily forwards, swaps, and options, to hedge certain foreign currency and interest rate exposures. HP also may use other derivative instruments not designated as hedges such as forwards used to hedge foreign currency balance sheet exposures. HP does not use derivative financial instruments for speculative purposes. See Note 9 for a full description of HP’s derivative financial instrument activities and related accounting policies, which is incorporated herein by reference. Investments HP’s investments consist principally of time deposits, commercial paper, corporate debt, other debt securities, and equity securities of publicly-traded and privately-held companies. HP classifies investments with maturities of less than one year as short-term investments. HP classifies its investments in debt securities and its equity investments in public companies as available-for-sale securities and carries them at fair value. HP determines fair values for investments in public companies using quoted market prices. HP records the unrealized gains and losses on available-for-sale securities, net of taxes, in accumulated other comprehensive income (loss). HP carries equity investments in privately-held companies at the lower of cost or fair value. HP may estimate fair values for investments in privately-held companies based upon one or more of the following: pricing models using historical and forecasted financial information and current market rates; liquidation values; the values of recent rounds of financing; and quoted market prices of comparable public companies. Losses on Investments HP monitors its investment portfolio for impairment on a periodic basis. In the event that the carrying value of an investment exceeds its fair value and the decline in value is determined to be other than temporary, HP records an impairment charge and establishes a new cost basis for the investment at its current fair value. In order to determine whether a decline in value is other than temporary, HP evaluates, among other factors: the duration and extent to which the fair value has been less than the 83 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) carrying value; the financial condition of and business outlook for the company or financial institution, including key operational and cash flow metrics, current market conditions and future trends in the issuer’s industry; the company’s relative competitive position within the industry; and HP’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. HP determined the declines in value of certain investments to be other than temporary. Accordingly, HP recorded impairments of approximately $28 million in fiscal 2007, $8 million in fiscal 2006 and $43 million in fiscal 2005. HP includes these impairments in gains (losses) on investments in the Consolidated Statements of Earnings. Depending on market conditions, HP may record additional impairments on its investment portfolio in the future. Concentrations of Credit Risk Financial instruments that potentially subject HP to significant concentrations of credit risk consist principally of cash and cash equivalents, investments, accounts receivable from trade customers and from contract manufacturers, financing receivables and derivatives. HP maintains cash and cash equivalents, short and long-term investments, derivatives and certain other financial instruments with various financial institutions. These financial institutions are located in many different geographical regions and HP’s policy is designed to limit exposure with any one institution. As part of its cash and risk management processes, HP performs periodic evaluations of the relative credit standing of the financial institutions. HP has not sustained material credit losses from instruments held at financial institutions. HP utilizes forward contracts and other derivative contracts to protect against the effects of foreign currency fluctuations. Such contracts involve the risk of non-performance by the counterparty, which could result in a material loss. HP sells a significant portion of its products through third-party distributors and resellers and, as a result, maintains individually significant receivable balances with these parties. If the financial condition or operations of these distributors and resellers deteriorate substantially, HP’s operating results could be adversely affected. The ten largest distributor and reseller receivable balances collectively, which were concentrated primarily in North America, represented approximately 23% of gross accounts receivable at October 31, 2007 and 21% at October 31, 2006. No single customer accounts for more than 10% of accounts receivable. Credit risk with respect to other accounts receivable and financing receivables is generally diversified due to the large number of entities comprising HP’s customer base and their dispersion across many different industries and geographical regions. HP performs ongoing credit evaluations of the financial condition of its third-party distributors, resellers and other customers and requires collateral, such as letters of credit and bank guarantees, in certain circumstances. To ensure a receivable balance is not overstated due to uncollectibility, an allowance for doubtful accounts is maintained as required under U.S. generally accepted accounting principles. The past due or delinquency status of a receivable is based on the contractual payment terms of the receivable. The need to write off a receivable balance depends on the age, size and a determination of collectibility of the receivable. HP generally has experienced longer accounts receivable collection cycles in its emerging markets, in particular Asia Pacific and Latin America, compared to its United States and European markets. In the event that accounts receivable collection cycles in emerging markets significantly deteriorate or one or more of HP’s larger resellers in these regions fail, HP’s operating results could be adversely affected. 84 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) Other Concentration HP obtains a significant number of components from single source suppliers due to technology, availability, price, quality or other considerations. The loss of a single source supplier, the deterioration of its relationship with a single source supplier, or any unilateral modification to the contractual terms under which HP is supplied components by a single source supplier could adversely effect HP’s revenue and gross margins. Stock-Based Compensation Effective November 1, 2005, HP adopted the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method and therefore has not restated results for prior periods. Under this transition method, stock-based compensation expense in fiscal 2006 included stock-based compensation expense for all share-based payment awards granted prior to, but not yet vested as of November 1, 2005, based on the grant-date fair value estimated in accordance with the original provision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Stock-based compensation expense for all share-based payment awards granted after November 1, 2005 is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. HP recognizes these compensation costs on a straight-line basis over the requisite service period of the award, which is generally the option vesting term of four years. Prior to the adoption of SFAS 123R, HP recognized stock-based compensation expense in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). In March 2005, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”) regarding the SEC’s interpretation of SFAS 123R and the valuation of share-based payments for public companies. HP has applied the provisions of SAB 107 in its adoption of SFAS 123R. In November 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards” (“FSP 123R- 3”). HP has elected to adopt the alternative transition method provided in the FSP 123R-3 for calculating the tax effects of stock-based compensation pursuant to SFAS 123R. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123R. See Note 2 to the Consolidated Financial Statements for a further discussion on stock-based compensation. Foreign Currency Transactions HP uses the U.S. dollar predominately as its functional currency. Assets and liabilities denominated in non-U.S. dollars are remeasured into U.S. dollars at current exchange rates for monetary assets and liabilities, and historical exchange rates for nonmonetary assets and liabilities. Net revenue, cost of sales and expenses are remeasured at average exchange rates in effect during each period, except for those net revenue, cost of sales and expenses related to the previously noted balance sheet amounts, which HP remeasures at historical exchange rates. HP includes gains or losses from foreign currency remeasurement in net earnings. Certain foreign subsidiaries designate the local 85 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) currency as their functional currency, and HP records the translation of their assets and liabilities into U.S. dollars at the balance sheet dates as translation adjustments and includes them as a component of accumulated other comprehensive income (loss). Retirement and Post-Retirement Plans HP has various defined benefit, other contributory and noncontributory retirement and post-retirement plans. HP generally amortizes unrecognized actuarial gains and losses on a straight-line basis over the remaining estimated service life of participants. The measurement date for all plans is September 30 for fiscal 2007 and fiscal 2006. See Note 15 for a full description of these plans and the accounting and funding policies, which is incorporated herein by reference. Recent Pronouncements In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes by prescribing the recognition threshold a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by HP in the first quarter of fiscal 2008. The cumulative effects of applying FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. Additionally, in May 2007, the FASB published FASB Staff Position No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”). FSP FIN 48-1 is an amendment to FIN 48. It clarifies how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is effective upon the initial adoption of FIN 48, and therefore will be adopted by HP in the first quarter of fiscal 2008. While HP is still evaluating the impact of adoption of FIN 48 and FSP FIN 48-1 on its consolidated financial statements, it is estimated that the adoption of FIN 48 and FSP FIN 48-1 will result in a net increase to retained earnings in the range of $500 million to $900 million. This estimate is subject to revision as management completes its analysis. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and is required to be adopted by HP in the first quarter of fiscal 2009. HP is currently evaluating the effect that the adoption of SFAS 157 will have on its consolidated results of operations and financial condition and is not yet in a position to determine such effects. In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—An Amendment of FASB No. 87, 88, 106 and 132(R)” (“SFAS 158”). SFAS 158 requires that the funded status of defined benefit postretirement plans be recognized on the company’s balance sheet and changes in the funded status be reflected in 86 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) comprehensive income, effective for fiscal years ending after December 15, 2006, which HP adopted during fiscal 2007. See Note 15 for the effect of applying this provision on the consolidated financial statements. SFAS 158 also requires companies to measure the funded status of the plan as of the date of their fiscal year end, effective for fiscal years ending after December 15, 2008. HP expects to adopt the measurement provisions of SFAS 158 effective October 31, 2009. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 expands the use of fair value accounting but does not affect existing standards that require assets or liabilities to be carried at fair value. Under SFAS 159, a company may elect to use fair value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees and issued debt. Other eligible items include firm commitments for financial instruments that otherwise would not be recognized at inception and non-cash warranty obligations where a warrantor is permitted to pay a third party to provide the warranty goods or services. If the use of fair value is elected, any upfront costs and fees related to the item must be recognized in earnings and cannot be deferred, such as debt issuance costs. The fair value election is irrevocable and generally made on an instrument-by-instrument basis, even if a company has similar instruments that it elects not to measure based on fair value. At the adoption date, unrealized gains and losses on existing items for which fair value has been elected are reported as a cumulative adjustment to beginning retained earnings. Subsequent to the adoption of SFAS 159, changes in fair value are recognized in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by HP in the first quarter of fiscal 2009. HP currently is determining whether fair value accounting is appropriate for any of its eligible items and cannot estimate the impact, if any, that SFAS 159 will have on its consolidated results of operations and financial condition. In June 2007, the FASB also ratified EITF 07-3, “Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities” (“EITF 07-3”). EITF 07-3 requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. EITF 07-3 is effective, on a prospective basis, for fiscal years beginning after December 15, 2007 and will be adopted by HP in the first quarter of fiscal 2009. HP does not expect the adoption of EITF 07-3 to have a material effect on HP’s consolidated results of operations and financial condition. In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008, and will be adopted by HP in the first quarter of fiscal 2010. HP is currently evaluating the potential impact, if any, of the adoption of SFAS 141R on its consolidated results of operations and financial condition. In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by 87 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 1: Summary of Significant Accounting Policies (Continued) parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008, and will be adopted by HP in the first quarter of fiscal 2010. HP is currently evaluating the potential impact, if any, of the adoption of SFAS 160 on its consolidated results of operations and financial condition. In addition to the SFAS 158 adoption mentioned above, HP adopted the following accounting standards in fiscal 2007, none of which had a material effect on HP’s consolidated results of operations during such period or financial condition at the end of such period: • • SFAS No. 154, “Accounting for Changes and Error Corrections”; Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”; • EITF 05-5, “Accounting for Early Retirement or Postemployment Programs with Specific Features (Such as Terms Specified in Altersteilzeit Early Retirement Arrangements)”; and • EITF 06-9, “Reporting a Change in (or the Elimination of) a Previously Existing Difference between the Fiscal Year End of a Parent Company and That of a Consolidated Entity or between the Reporting Period of an Investor and That of an Equity Method Investee.” Note 2: Stock-Based Compensation At October 31, 2007, HP has the stock-based employee compensation plans described below. The total compensation expense before taxes related to these plans was $629 million and $536 million for fiscal 2007 and 2006, respectively. Prior to November 1, 2005, HP accounted for those plans under the recognition and measurement provisions of APB 25. Accordingly, HP generally recognized stock-based compensation expense only when it granted options with a discounted exercise price. Any resulting compensation expense was recognized ratably over the associated service period, which was generally the option vesting term. Prior to November 1, 2005, HP also provided pro forma disclosure amounts in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS 148”), as if the fair value method defined by SFAS 123 had been applied to its stock-based compensation. Effective November 1, 2005, HP adopted the fair value recognition provisions of SFAS 123R, using the modified prospective transition method and therefore has not restated prior periods’ results. Under this transition method, stock-based compensation expense in fiscal 2006 included compensation expense for all share-based payment awards granted prior to, but not yet vested as of, November 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123. Stock-based compensation expense for all share-based payment awards granted after November 1, 2005 is based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. HP recognizes these compensation costs net of an estimated forfeiture rate and recognizes the compensation costs for only those shares expected to vest on a straight-line basis over the requisite service period of the award, which is generally the option vesting term of four years. HP estimated the 88 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 2: Stock-Based Compensation (Continued) forfeiture rates in fiscal 2007 and 2006 based on its historical experience for fiscal grant years where the majority of the vesting terms have been satisfied. As a result of adopting SFAS 123R, earnings before income taxes and net earnings in fiscal 2007 were lower by $494 million and $353 million, respectively, than if we had continued to account for stock-based compensation under APB 25. The unfavorable impact on both basic and diluted earnings per share in fiscal 2007 was $0.13 per share. Earnings before income taxes and net earnings in fiscal 2006 were lower by $448 million and $318 million, respectively, as a result of adopting SFAS 123R. The unfavorable impact on both basic and diluted earnings per share in fiscal 2006 was $0.11 per share. In addition, prior to the adoption of SFAS 123R, HP presented the tax benefit of stock option exercises as operating cash flows. Upon the adoption of SFAS 123R, the tax benefit resulting from tax deductions in excess of the tax benefit related to compensation cost recognized for those options is classified as financing cash flows. The pro forma table below reflects net earnings and basic and diluted net earnings per share for the following fiscal year ended October 31, 2005, if HP had applied the fair value recognition provisions of SFAS 123: Net earnings, as reported .................................................................................................................................. Add: stock-based compensation included in reported net earnings, net of related tax effects.......................... Less: stock-based compensation expense determined under the fair-value based method for all awards, net of related tax effects.......................................................................................................................................... Pro forma net earnings...................................................................................................................................... Basic net earnings per share: As reported..................................................................................................................................................... Pro forma ....................................................................................................................................................... Diluted net earnings per share: As reported..................................................................................................................................................... Pro forma ....................................................................................................................................................... Employee Stock Purchase Plan 2005 In millions, except per share amounts $2,398 144 (621) $1,921 $0.83 $0.67 $0.82 $0.66 HP sponsors the Hewlett-Packard Company 2000 Employee Stock Purchase Plan, also known as the Share Ownership Plan (the “ESPP”), pursuant to which eligible employees may contribute up to 10% of base compensation, subject to certain income limits, to purchase shares of HP’s common stock. Prior to November 1, 2005, employees were able to purchase stock semi-annually at a price equal to 85% of the fair market value at certain plan-defined dates. As of November 1, 2005, HP changed the ESPP so that employees will purchase stock semi-annually at a price equal to 85% of the fair market value on the purchase date. Since the price of the shares is now determined at the purchase date and there is no longer a look-back period, HP recognizes the expense based on the 15% discount at 89 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 2: Stock-Based Compensation (Continued) purchase. In fiscal 2007, ESPP compensation expense was $56 million, net of taxes. At October 31, 2007, approximately 161,000 employees were eligible to participate and approximately 51,000 employees were participants in the ESPP. In fiscal 2006, ESPP compensation expense was $53 million, net of taxes. At October 31, 2006, approximately 147,000 employees were eligible to participate and approximately 53,000 employees were participants in the ESPP. In fiscal 2007, participants purchased approximately 8,744,000 shares of HP common stock at a weighted-average price of $39 per share. In fiscal 2006, participants purchased approximately 11,076,000 shares of HP common stock at a weighted-average price of $30 per share. In fiscal 2005, participants purchased approximately 20,673,000 shares of HP common stock at a weighted-average price of $17 per share. Incentive Compensation Plans HP stock option plans include principal plans adopted in 2004, 2000, 1995 and 1990 (“principal option plans”), as well as various stock option plans assumed through acquisitions under which stock options are outstanding. All regular employees meeting certain employment qualifications were eligible to receive stock options in fiscal 2007. There were approximately 99,000 employees holding options under one or more of the option plans as of October 31, 2007. Options granted under the principal option plans are generally non-qualified stock options, but the principal option plans permit some options granted to qualify as “incentive stock options” under the U.S. Internal Revenue Code. The exercise price of a stock option is equal to the fair market value of HP’s common stock on the option grant date (as determined by the average of the highest and lowest reported sale prices of HP’s common stock on that date). The contractual term of options granted since fiscal 2003 was generally eight years, while the contractual term of options granted prior to fiscal 2003 was generally ten years. Under the principal option plans, HP may choose, in certain cases, to establish a discounted exercise price at no less than 75% of fair market value on the grant date. HP has not granted any discounted options since fiscal 2003. Under the principal option plans, HP granted certain employees cash, restricted stock awards, or both. Restricted stock awards are nonvested stock awards that may include grants of restricted stock or grants of restricted stock units. Cash and restricted stock awards are independent of option grants and are generally subject to forfeiture if employment terminates prior to the release of the restrictions. Such awards generally vest one to three years from the date of grant. During that period, ownership of the shares cannot be transferred. Restricted stock has the same cash dividend and voting rights as other common stock and is considered to be currently issued and outstanding. Restricted stock units have dividend equivalent rights equal to the cash dividend paid on restricted stock. Restricted stock units do not have the voting rights of common stock, and the shares underlying the restricted stock units are not considered issued and outstanding. HP expenses the cost of the restricted stock awards, which HP has determined to be the fair market value of the shares at the date of grant, ratably over the period during which the restrictions lapse. In fiscal 2007, HP granted 1,469,000 shares of restricted stock with a weighted-average grant date fair value of $43. In fiscal 2006, HP granted 1,492,000 shares of restricted stock with a weighted-average grant date fair value of $32. In fiscal 2005, HP granted 6,773,000 shares of restricted stock with a weighted-average grant date fair value of $21. HP had 4,763,000 shares of restricted stock outstanding at October 31, 2007, 5,492,000 shares of restricted stock outstanding at October 31, 2006 and 7,099,000 shares of restricted stock outstanding at October 31, 2005. In fiscal 2007, HP granted 151,000 shares of restricted stock units with a 90 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 2: Stock-Based Compensation (Continued) weighted-average grant date fair value of $45. In fiscal 2006, HP granted 33,000 shares of restricted stock units with a weighted-average grant date fair value of $30. In fiscal 2005, HP granted 1,820,000 shares of restricted stock units with a weighted-average grant date fair value of $21. HP had restricted stock units covering approximately 935,000 shares outstanding at October 31, 2007, 873,000 shares outstanding at October 31, 2006 and 1,780,000 shares outstanding at October 31, 2005. In light of new accounting guidance under SFAS 123R, beginning in the second quarter of fiscal 2005 HP reevaluated its assumptions used in estimating the fair value of employee options granted. As part of this assessment, management determined that implied volatility calculated based on actively traded options on HP common stock is a better indicator of expected volatility and future stock price trends than historical volatility. Therefore, expected volatility in fiscal 2007, 2006 and 2005 was based on a market-based implied volatility. As part of its SFAS 123R adoption, HP also examined its historical pattern of option exercises in an effort to determine if there were any discernable activity patterns based on certain employee populations. From this analysis, HP identified three employee populations. HP used the Black-Scholes option pricing model to value the options for each of the employee populations. The table below presents the weighted-average expected life in months of the combined three identified employee populations. The expected life computation is based on historical exercise patterns and post-vesting termination behavior within each of the three populations identified. The risk-free interest rate for periods within the contractual life of the award is based on the U.S. Treasury yield curve in effect at the time of grant. The fair value of share-based payment awards was estimated using the Black-Scholes option pricing model with the following assumptions and weighted-average fair values: 2005 $5.63 Stock Options(1) 2006 $9.38 ESPP 2005 2007 $13.01 $6.01 4.68% 4.35% 3.93% 2.66% 1.5% 1.6% 0.8% 30% 28% 28% 6 54 59 1.0% 29% 57 Weighted-average fair value of grants .............................................................................. Risk-free interest rate........................................................................................................ Dividend yield .................................................................................................................. Expected volatility ............................................................................................................ Expected life in months .................................................................................................... (1) The fair value calculation was based on stock options granted during the period. 91 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 2: Stock-Based Compensation (Continued) Option activity under the principal option plans as of October 31 during each fiscal year were as follows: Outstanding at beginning of year........... Granted and assumed through acquisitions ...................................... Exercised................................................ Forfeited/cancelled/expired ................... Outstanding at end of year..................... Vested and expected to vest at end of year................................................... Exercisable at end of year...................... Shares In thousands 445,740 45,562 (106,302) (17,661) 367,339 361,496 265,366 2007 Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term In years Aggregate Intrinsic Value In millions $31 $40 $26 $43 $33 $33 $33 4.2 4.2 3.4 Shares In thousands 531,233 52,271 (100,986) (36,778) 445,740 437,109 $7,375 $7,256 $5,298 316,341 2006 Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term In years Aggregate Intrinsic Value In millions $30 $31 $22 $40 $31 $31 $33 4.7 4.6 4.0 $4,861 $4,742 $3,081 The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between HP’s closing stock price on the last trading day of fiscal 2007 and fiscal 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on October 31, 2007 and 2006. This amount changes based on the fair market value of HP’s stock. Total intrinsic value of options exercised in fiscal 2007 and 2006 was $2.0 billion and $1.2 billion, respectively. Total fair value of options vested and expensed in fiscal 2007 and 2006 was $297 million and $265 million, respectively, net of taxes. Option activity was as follows for the fiscal year ended October 31, 2005: Outstanding at beginning of year...................................................................................................... Granted ............................................................................................................................................. Assumed through acquisitions .......................................................................................................... Exercised .......................................................................................................................................... Forfeited or cancelled ....................................................................................................................... Outstanding at end of year ................................................................................................................ Exercisable at end of year................................................................................................................. Weighted- Average Exercise Price $30 $22 $1 $17 $35 $30 $33 Shares In thousands 549,868 63,635 558 (46,628) (36,200) 531,233 386,303 92 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 2: Stock-Based Compensation (Continued) Information about options outstanding was as follows at October 31, 2007: Range of Exercise Prices $0-$9.99........................................................... $10-$19.99..................................................... $20-$29.99..................................................... $30-$39.99..................................................... $40-$49.99..................................................... $50-$59.99..................................................... $60 and over .................................................. Options Outstanding Options Exercisable Weighted- Average Remaining Contractual Life in Years Shares Outstanding Weighted- Average Exercise Price Shares Exercisable Weighted- Average Exercise Price 678 40,902 134,093 85,074 71,619 21,759 13,214 367,339 Shares in thousands $5 $16 $23 $33 $45 $57 $71 $34 6.0 3.8 4.5 4.6 4.3 2.7 1.7 4.2 357 40,145 95,882 51,330 43,405 21,033 13,214 265,366 $6 $16 $23 $34 $46 $57 $71 $33 As of October 31, 2007, $771 million of total unrecognized compensation cost related to stock options is expected to be recognized over a weighted-average of 2.11 years. As of October 31, 2006, $677 million of total unrecognized compensation cost related to stock options was expected to be recognized over a weighted-average period of 2.30 years. Cash received from option exercises and purchases under the ESPP in fiscal 2007 was $3.1 billion. The actual tax benefit realized for the tax deduction from option exercises of the share-based payment awards in fiscal 2007 totaled $675 million. Cash received from option exercises and purchases under the ESPP in fiscal 2006 was $2.5 billion. The actual tax benefit realized for the tax deduction from option exercises of the share-based payment awards in fiscal 2006 totaled $420 million. Nonvested restricted stock awards as of October 31, 2007 and 2006 were as follows: Nonvested at October 31, 2005................................................................................................ Granted .................................................................................................................................... Vested ...................................................................................................................................... Forfeited................................................................................................................................... Nonvested at October 31, 2006................................................................................................ Granted .................................................................................................................................... Vested ...................................................................................................................................... Forfeited................................................................................................................................... Nonvested at October 31, 2007................................................................................................ Shares In thousands 8,869 1,525 (2,521) (1,508) 6,365 1,620 (1,284) (1,003) 5,698 Weighted- Average Grant Date Fair Value $21 $32 $21 $21 $24 $44 $25 $24 $29 93 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 2: Stock-Based Compensation (Continued) As of October 31, 2007, there was $83 million of unrecognized stock-based compensation expense related to nonvested restricted stock awards. That cost is expected to be recognized over a weighted-average period of 1.02 years. As of October 31, 2006, there was $90 million of unrecognized stock-based compensation expense related to nonvested restricted stock awards. That cost is expected to be recognized over a weighted-average period of 1.46 years. HP recorded $84 million, $58 million and $144 million of stock-based compensation expense, net of taxes, relating to options assumed through acquisitions and restricted stock awards in fiscal 2007, 2006, and 2005 respectively. HP allocated stock-based compensation expense related to the ESPP and the principal option plans under SFAS 123R as follows for each of the fiscal years: 2007 2006 In millions Cost of sales.................................................................................................................................................. Research and development ........................................................................................................................... Selling, general and administrative............................................................................................................... Stock-based compensation expense before income taxes ............................................................................. Income tax benefit ........................................................................................................................................ Total stock-based compensation expense after income taxes ....................................................................... $161 74 394 629 (182) $447 $144 70 322 536 (160) $376 Total stock-based compensation expense before taxes in fiscal 2007 excludes a $14 million credit adjustment in restructuring charges associated with the fiscal 2005 restructuring plan and a $29 million restructuring charge for accelerating the vesting of options held by those employees who elected to participate in the 2007 EER. In fiscal 2005, as part of its fiscal 2005 restructuring plans, HP accelerated the vesting on options held by terminated employees and included a one-year post- termination exercise period on the options. This modification resulted in compensation expense of $107 million that HP included in the restructuring charges. In fiscal 2006, an adjustment of $14 million was recorded as a reduction to the $107 million in restructuring charges to reflect actual stock-based compensation expense related to employees who left the company. Stock-based compensation expense recognized under incentive compensation plans was approximately $644 million in fiscal 2007 (including the $14 million credit adjustment in restructuring charges and a $29 million charge for accelerating the vesting of options held by those employees who elected to participate in the 2007 EER, both referred to above) $522 million in fiscal 2006 (including the $14 million credit in restructuring charges referred to above), and $211 million in fiscal 2005 (including the $107 million in restructuring charges referred to above). Shares Reserved Shares available for future grant under the ESPP and stock-based compensation plans were 181,704,000 at October 31, 2007, including 45,312,000 shares under the assumed Compaq plans; 217,556,000 at October 31, 2006, including 39,151,000 shares under the assumed Compaq plans; and 260,669,000 at October 31, 2005, including 32,449,000 shares under the assumed Compaq plans. 94 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 2: Stock-Based Compensation (Continued) HP had 549,045,000 shares of common stock reserved at October 31, 2007, 664,267,000 shares of common stock reserved at October 31, 2006, and 794,750,000 shares of common stock reserved at October 31, 2005 for future issuance under all stock-related benefit plans. Additionally, HP had 21,494,000 shares of common stock reserved at each of October 31, 2007, October 31, 2006 and October 31, 2005 for future issuances related to conversion of its outstanding zero- coupon subordinated notes. Note 3: Net Earnings Per Share HP calculates basic earnings per share (“EPS”) using net earnings and the weighted-average number of shares outstanding during the reporting period. Diluted EPS includes the effect from potential issuance of common stock, such as stock issuable pursuant to the exercise of stock options and the assumed conversion of convertible notes. The reconciliation of the numerators and denominators of the basic and diluted EPS calculations was as follows for the following fiscal years ended October 31: Numerator: 2007 2005 2006 In millions, except per share amounts Net earnings ....................................................................................................................................... $7,264 $6,198 $2,398 — Adjustment for interest expense on zero-coupon subordinated convertible notes, net of taxes......... Net earnings, adjusted........................................................................................................................ $7,271 $6,205 $2,398 7 7 Denominator: Weighted-average shares used to compute basic EPS ....................................................................... 2,630 2,782 Effect of dilutive securities: 62 Dilution from employee stock plans .................................................................................................. 8 Zero-coupon subordinated convertible notes ..................................................................................... Dilutive potential common shares...................................................................................................... 70 Weighted-average shares used to compute diluted EPS .................................................................... 2,716 2,852 78 8 86 2,879 30 — 30 2,909 Net earnings per share: Basic .................................................................................................................................................. $2.76 $2.23 Diluted ............................................................................................................................................... $2.68 $2.18 $0.83 $0.82 HP excludes options with exercise prices that are greater than the average market price from the calculation of diluted EPS because their effect would be anti-dilutive. In fiscal 2007, 2006 and 2005, HP excluded 60 million shares, 130 million shares and 255 million shares, respectively, from its diluted EPS calculation. Also, as a result of adopting SFAS 123R on November 1, 2005, HP excluded from the calculation of diluted EPS options to purchase an additional 33 million shares and 48 million shares in fiscal 2007 and fiscal 2006, respectively, whose combined exercise price, unamortized fair value and excess tax benefits were greater in each of those periods than the average market price for HP’s common stock, as their effect would be anti-dilutive. In addition, HP excluded approximately 8 million 95 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 3: Net Earnings Per Share (Continued) shares of HP stock issuable upon the assumed conversion of zero-coupon subordinated notes from the calculation of diluted EPS in fiscal 2005 because the effect was anti-dilutive. Note 4: Balance Sheet Details Balance sheet details were as follows for the following fiscal years ended October 31: Accounts and Financing Receivables Accounts receivable................................................................................................................................. Allowance for doubtful accounts ............................................................................................................. Financing receivables .............................................................................................................................. Allowance for doubtful accounts ............................................................................................................. 2007 2006 In millions $13,646 (226) $13,420 $2,547 (40) $2,507 $11,093 (220) $10,873 $2,480 (40) $2,440 HP has revolving trade receivables-based facilities permitting it to sell certain trade receivables to third parties on a non- recourse basis. The aggregate maximum capacity under these programs was approximately $525 million as of October 31, 2007. HP sold approximately $2.2 billion of trade receivables during fiscal 2007. As of October 31, 2007, HP had approximately $117 million available under these programs. Inventory Finished goods .............................................................................................................................................. Purchased parts and fabricated assemblies ................................................................................................... Other Current Assets Deferred tax assets—short-term ................................................................................................................... Tax, supplier and other receivables .............................................................................................................. Prepaid and other current assets.................................................................................................................... 2007 2006 In millions $5,404 2,629 $8,033 $5,424 2,326 $7,750 2007 2006 In millions $4,609 5,655 1,733 $4,144 5,242 1,393 $11,997 $10,779 96 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 4: Balance Sheet Details (Continued) Property, Plant and Equipment Land .......................................................................................................................................................... Buildings and leasehold improvements .................................................................................................... Machinery and equipment ........................................................................................................................ Accumulated depreciation ........................................................................................................................ 2007 2006 In millions $464 6,044 9,903 16,411 (8,613) $7,798 $534 5,771 8,719 15,024 (8,161) $6,863 Depreciation expense was approximately $1.9 billion in fiscal 2007 and $1.7 billion in both fiscal 2006 and fiscal 2005. Long-Term Financing Receivables and Other Assets Financing receivables ............................................................................................................................... Deferred tax assets—long-term ................................................................................................................ Other ......................................................................................................................................................... Other Accrued Liabilities Other accrued taxes.................................................................................................................................. Warranty .................................................................................................................................................. Sales and marketing programs ................................................................................................................. Other ........................................................................................................................................................ Other Liabilities Pension, post-retirement, and post-employment liabilities ......................................................................... Long-term deferred revenue ....................................................................................................................... Other long-term liabilities........................................................................................................................... 2007 2006 In millions $2,778 961 3,908 $7,647 $2,340 1,475 2,834 $6,649 2007 2006 In millions $2,965 1,762 2,930 6,126 $13,783 $2,366 1,585 2,394 4,789 $11,134 2007 2006 In millions $1,495 2,459 1,962 $5,916 $2,099 1,750 1,648 $5,497 97 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 4: Balance Sheet Details (Continued) Long-term deferred revenue represents service and product deferred revenue to be recognized after one year from the balance sheet date. Deferred revenue represents amounts received or billed in advance for fixed-price support or maintenance contracts, software customer support contracts, outsourcing services start-up or transition work, consulting and integration projects, product sales and leasing income. The fixed-price support or maintenance contracts include stand-alone product support packages, routine maintenance service contracts, upgrades or extensions to standard product warranty, as well as high availability services for complex, global, networked, multi-vendor environments. HP defers these service amounts at the time HP bills the customer, and HP then recognizes the amounts ratably over the contract life or as HP renders the services. Note 5: Supplemental Cash Flow Information Supplemental cash flow information was as follows for the following fiscal years ended October 31: Cash paid for income taxes, net ............................................................................................................... $956 Cash paid for interest ............................................................................................................................... $489 Non-cash investing and financing activities: 2007 2006 In millions $637 $299 2005 $884 $447 Issuance of common stock and options assumed in business acquisitions............................................ Purchase of assets under financing arrangement................................................................................... Purchase of assets under capital leases ................................................................................................. $41 $57 $— $19 $13 $12 $— $— $— Note 6: Acquisitions HP has recorded all acquisitions using the purchase method of accounting and, accordingly, included the results of operations in HP’s consolidated results as of the date of each acquisition. HP allocates the purchase price of its acquisitions to the tangible assets, liabilities and intangible assets acquired, including in-process research & development (“IPR&D”) charges, based on their estimated fair values. The excess purchase price over those fair values is recorded as goodwill. The fair value assigned to assets acquired is based on valuations using management’s estimates and assumptions. HP does not expect goodwill recorded on a majority of these acquisitions to be deductible for tax purposes. HP has not presented pro forma results of operations because these acquisitions are not material to HP’s consolidated results of operations on either an individual or an aggregate basis. Mercury Acquisition On November 2, 2006, HP completed its tender offer for Mercury Interactive Corporation (“Mercury”), a leading IT management software and services company, and acquired approximately 96% of Mercury common shares for cash consideration of $52 per share. On November 6, 2006, HP acquired the remaining outstanding common shares, and Mercury became a wholly owned subsidiary of HP. This acquisition combines Mercury’s application management, application delivery and IT governance capabilities with HP’s broad portfolio of management solutions. The aggregate purchase price of approximately $4.9 billion consisted of cash paid for outstanding stock, vested in-the- money stock options and direct transaction costs. In addition, the purchase price 98 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 6: Acquisitions (Continued) also included the estimated fair value of earned unvested stock options and out-of-the-money vested stock options assumed by HP. Based on valuations prepared using estimates and assumptions provided by management, the purchase price allocation as of the date of acquisition has been allocated as follows: Cash and short-term investments ............................................................................................................................. Other tangible assets ................................................................................................................................................ Notes payable .......................................................................................................................................................... Other liabilities assumed.......................................................................................................................................... Total net assets...................................................................................................................................................... Amortizable intangible assets .................................................................................................................................. Goodwill .................................................................................................................................................................. IPR&D ..................................................................................................................................................................... Total purchase price................................................................................................................................................. In millions $830 541 (303) (954) 114 1,079 3,480 181 $4,854 Note 8 contains information related to the cost of restructuring programs for Mercury employees, which was also included as part of other liabilities assumed. HP has included Mercury in the OpenView business within the HP Software segment. Goodwill, which represents the excess of the purchase price over the net tangible and intangible assets acquired, is not deductible for tax purposes. The amortizable intangible assets are being amortized over their estimated useful lives as follows: Technology .................................................................................................................................... Customer relationships .................................................................................................................. Maintenance contracts ................................................................................................................... Trademarks .................................................................................................................................... Total amortizable intangible assets................................................................................................ Opsware Acquisition In millions $592 243 239 5 $1,079 Weighted- average useful life 4.2 years 7.0 years 6.8 years 6.0 years 5.4 years On September 17, 2007, HP completed its tender offer for Opsware Inc. (“Opsware”), a leader in data center automation, and acquired more than 90% of Opsware’s common shares for cash consideration of $14.25 per share. On September 21, 2007, HP acquired all remaining outstanding Opsware shares and Opsware became a wholly owned subsidiary of HP which will be included in the HP Software segment. The aggregate purchase price of approximately $1.7 billion consisted of cash paid for outstanding stock, vested in-the- money stock options and direct transaction costs. In addition, the purchase price also included the estimated fair value of earned unvested stock options and out-of-the-money vested stock options assumed by HP. In connection with this acquisition, HP recorded approximately 99 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 6: Acquisitions (Continued) $1.3 billion of goodwill and $249 million of amortizable intangible assets. HP is amortizing the purchased intangibles on a straight-line basis over their estimated lives ranging from five to six years. HP did not record any IPR&D in connection with the Opsware acquisition. Other Acquisitions in fiscal 2007 HP also completed eight other acquisitions during fiscal 2007. Total consideration for these acquisitions was approximately $1.0 billion, which included direct transaction costs, the estimated fair value of earned unvested stock options and certain liabilities recorded in connection with these acquisitions. The largest of these transactions was the acquisition of Neoware, Inc., which HP expects to further its leadership in personal computing by accelerating HP’s thin client portfolio. HP recorded approximately $700 million of goodwill and $182 million of purchased intangibles in connection with these other acquisitions. HP also recorded approximately $9 million of IPR&D related to these acquisitions in fiscal 2007. Projects that qualify for treatment as IPR&D have not yet reached technological feasibility and have no alternative use. HP has included the results of operations of these transactions prospectively from the respective date of the transaction. Pending and Subsequent Acquisitions In November 2007, HP agreed to acquire EYP Mission Critical Facilities Inc., a consulting company specializing in strategic technology planning, design and operations support for large-scale data centers. The transaction is subject to certain closing conditions and is expected to be completed during HP’s first quarter of fiscal 2008. Upon completion, the business is expected to be fully integrated into HP Services. In November 2007, HP completed the acquisition of MacDermid ColorSpan Inc., a privately held manufacturer of wide- format digital inkjet printers. The business is being integrated into HP’s Imaging and Printing Group. In November 2007, HP completed the acquisition of Atos Origin Middle East Group, one of the Middle East’s leading systems integrators. The business is being integrated into HP Services. In December 2007, HP agreed to acquire NUR Macroprinters Ltd., a maker of industrial wide-format digital inkjet printers. This transaction is subject to certain closing conditions and is expected to be completed during HP’s second quarter of fiscal 2008. Upon completion, the business is expected to be fully integrated into HP’s Imaging and Printing Group. Acquisitions in fiscal 2006 Peregrine On December 19, 2005, HP acquired the outstanding shares of Peregrine Systems, Inc. (“Peregrine”) in a cash merger for $26.08 per share. The purchase price was approximately $538 million, consisting of $442 million of cash paid, which includes direct transaction costs, as well as the assumption of certain liabilities in connection with the transaction. The acquisition of Peregrine added key asset and service management components to the HP OpenView portfolio, a distributed management software suite for business operations and IT. In connection with this acquisition, HP 100 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 6: Acquisitions (Continued) recorded approximately $342 million of goodwill and $162 million of amortizable intangible assets. HP also expensed $34 million for IPR&D. HP is amortizing the purchased intangibles, principally customer relationships and developed technology, on a straight-line basis over their estimated useful lives ranging from five to six years. Other Acquisitions in fiscal 2006 HP also completed seven other acquisitions during fiscal 2006. Total consideration for these acquisitions and the buyout of a minority interest was approximately $473 million, which included direct transaction costs. The largest of these transactions was the acquisition of substantially all of the assets of Scitex Vision Ltd (“Scitex”). The Scitex asset acquisition expanded HP’s leadership in printing into the industrial wide-format market. HP recorded approximately $193 million of goodwill and $205 million of purchased intangibles in connection with these other acquisitions. HP also recorded approximately $18 million of IPR&D related to these acquisitions in fiscal 2006. In addition, HP paid approximately $17 million for the balance of the outstanding shares of Digital Globalsoft Limited, a consolidated subsidiary of HP (“DGS”), and as a result increased HP’s ownership from 98.5% to 100%. This subsidiary has enhanced HP’s capability in IT services, including expertise in life cycle services such as migration, technical and application services. HP has included the results of operations of these transactions prospectively from the respective date of the transaction. HP has not presented the pro forma results of operations of the acquired businesses because the results are not material to HP’s results of operations on either an individual or an aggregate basis. Note 7: Goodwill and Purchased Intangible Assets Goodwill Goodwill allocated to HP’s business segments as of October 31, 2007 and 2006 and changes in the carrying amount of goodwill during the fiscal year ended October 31, 2007 are as follows: HP Services Enterprise Storage and Servers HP Software Balance at October 31, 2006............... Goodwill acquired during the period .. Goodwill adjustments ......................... Balance at October 31, 2007............... $6,339 93 (211) $6,221 $5,091 173 (188) $5,076 $1,098 4,868 (45) $5,921 Personal Systems Group In millions $2,322 290 (89) $2,523 Imaging and Printing Group $1,853 71 (37) $1,887 HP Financial Services Total $150 — (5) $145 $16,853 5,495 (575) $21,773 The goodwill adjustments relate primarily to the reversal of income tax reserves of Compaq Computer Corporation (“Compaq”), which HP acquired in 2002, for pre-acquisition tax years. These tax years have been audited and agreed upon with the Internal Revenue Service and the statute of 101 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 7: Goodwill and Purchased Intangible Assets (Continued) limitations for them has expired. Accordingly, the reserves have been reclassified as a reduction of goodwill. Based on the results of its annual impairment tests, HP determined that no impairment of goodwill existed as of August 1, 2007 or August 1, 2006. However, future goodwill impairment tests could result in a charge to earnings. HP will continue to evaluate goodwill on an annual basis as of the beginning of its fourth fiscal quarter and whenever events and changes in circumstances indicate that there may be a potential impairment. Purchased Intangible Assets HP’s purchased intangible assets associated with completed acquisitions for each of the following fiscal years ended October 31 are composed of: Customer contracts, customer lists and distribution agreements................................ Developed and core technology and patents.... Product trademarks .......................................... Total amortizable purchased intangible assets. Compaq trade name ......................................... Total purchased intangible assets..................... Gross $3,239 2,768 115 6,122 1,422 $7,544 2007 Accumulated Amortization Net Gross In millions 2006 Accumulated Amortization Net $(1,679) (1,694) (92) (3,465) $1,560 1,074 23 2,657 — 1,422 $4,079 $(3,465) $2,586 1,923 103 4,612 1,422 $6,034 $(1,293) (1,307) (82) (2,682) $1,293 616 21 1,930 — 1,422 $3,352 $(2,682) Amortization expense related to finite-lived purchased intangible assets was approximately $783 million in fiscal 2007, $604 million in fiscal 2006 and $622 million in fiscal 2005. Based on the results of its annual impairment tests, HP determined that no impairment of the Compaq trade name existed as of August 1, 2007 or August 1, 2006. However, future impairment tests could result in a charge to earnings. HP will continue to evaluate the purchased intangible asset with an indefinite life on an annual basis as of the beginning of its fourth fiscal quarter and whenever events and changes in circumstances indicate that there may be a potential impairment. The finite-lived purchased intangible assets consist of customer contracts, customer lists and distribution agreements, which have weighted-average useful lives of approximately eight years, and developed and core technology, patents and product trademarks, which have weighted-average useful lives of approximately six years. 102 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 7: Goodwill and Purchased Intangible Assets (Continued) Estimated future amortization expense related to finite-lived purchased intangible assets at October 31, 2007 was as follows: Fiscal year: 2008 ...................................................................................................................................................................... 2009 ...................................................................................................................................................................... 2010 ...................................................................................................................................................................... 2011 ...................................................................................................................................................................... 2012 ...................................................................................................................................................................... Thereafter.............................................................................................................................................................. Total...................................................................................................................................................................... In millions 779 $ 692 585 337 166 98 $ 2,657 Note 8: Restructuring Charges Fiscal 2007 U.S. Enhanced Early Retirement Program In the second quarter of fiscal 2007, HP announced that it was offering eligible employees an option to participate in the 2007 EER. The 2007 EER was open to employees who satisfied defined eligibility criteria based on combined age and years of service as well as to otherwise eligible employees who had been included in previous restructuring programs or who voluntarily left the company since November 30, 2006. A total of 3,080 employees participated in the 2007 EER, including 595 persons who had been included in previous restructuring programs or who had voluntarily left the company since November 30, 2006. All participating employees left the company by May 31, 2007. HP recorded a net restructuring charge of $354 million in fiscal 2007 in connection with the 2007 EER. This charge reflected $367 million of severance and benefits cost for the participating employees, $29 million of stock-based compensation expense for accelerating the vesting of options held by participating employees and $2 million of outplacement costs. These charges were partially offset by a $28 million settlement gain from HP’s U.S. pension plan and a $16 million curtailment gain from its U.S. post-retirement benefit plans. The net restructuring charge of $354 million for the 2007 EER program was subsequently offset by a $542 million curtailment gain that HP recognized in fiscal 2007, resulting from changes in the U.S. defined benefit pension and post- retirement plans that HP also announced in the second quarter of 2007. HP funded the cash expenditures associated with the 2007 EER primarily by using available U.S. pension plan assets. For more information, see Note 15, which is incorporated herein by reference. Fiscal 2007 Mercury Plan In connection with the acquisition of Mercury, HP’s management approved and initiated plans to restructure the operations of Mercury to eliminate certain duplicative activities, reduce the cost structure and better align product and operating expenses with existing general economic conditions. During fiscal 2007, HP recorded $45 million in severance-related costs associated with the initial estimate of the elimination of approximately 370 positions primarily in the United States and in Europe. HP eliminated substantially all of these positions and paid the majority of the related severance payments in fiscal 2007. 103 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 8: Restructuring Charges (Continued) During fiscal 2007, HP also recorded a total cost of $13 million related to exiting duplicative leased facilities. HP expects to pay the costs for exiting the facilities through 2014. All Mercury restructuring costs are reflected in the purchase price of Mercury in accordance with EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” These costs are subject to change based on the actual costs incurred. Changes to these estimates could increase or decrease the amount of the purchase price allocated to goodwill. Fiscal 2005 Restructuring Plans In the fourth quarter of fiscal 2005, HP’s Board of Directors approved a restructuring plan designed to simplify HP’s structure, reduce costs and place greater focus on its customers. At that time, HP estimated that it would eliminate 15,300 positions in connection with the restructuring plan. Subsequent to the initial estimate, HP reduced the number of total positions to 14,985. As of October 31, 2007, HP had substantially completed eliminating these positions. The initial charge for these actions totaled $1.6 billion. During fiscal 2007, HP recognized a net $46 million reduction recorded in the first quarter of fiscal 2007, which included severance adjustments for employees whose positions HP eliminated but who found other positions within HP, a $14 million non-cash stock-based compensation expense adjustment, and a $9 million curtailment gain relating to the HP subsidized U.S. retiree medical program. This net reduction was offset by $46 million of higher employee severance and other benefit charges than originally estimated. HP had paid the majority of the costs related to severance and other employee benefits as of October 31, 2007 and expects to pay out the remaining costs associated primarily with tax payments for early retirees through fiscal 2018. In the third quarter of fiscal 2005, HP’s management approved a restructuring plan and HP recorded restructuring charges of $109 million related to severance and related costs associated with the termination of approximately 1,450 employees, all of whom left HP as of October 31, 2005. HP paid all of the costs associated with the restructuring plan as of January 31, 2007. Fiscal 2003, 2002 and 2001 Restructuring Plans The 2003, 2002 and 2001 restructuring plans are substantially complete, although HP records minor revisions to previous estimates as necessary. In fiscal 2007, HP recorded an adjustment of $33 million in additional restructuring charges relating primarily to facility lease obligations. As of October 31, 2007, the aggregate $69 million outstanding restructuring liability with respect to these plans relates primarily to facility lease obligations. HP expects to pay the majority of these obligations over the lives of the related obligations, which extend to the end of fiscal 2010. Workforce Rebalancing As part of our ongoing business operations, HP incurs workforce rebalancing charges for severance and related costs within certain business segments. Workforce rebalancing activities are considered part of normal operations as HP continues to optimize our cost structure. Workforce rebalancing costs are included in HP’s business segment results, and HP expects to incur additional workforce rebalancing costs in the future. 104 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 8: Restructuring Charges (Continued) Summary of Restructuring Plans The activity in the accrued restructuring balances related to all of the plans described above was as follows for fiscal 2007: Balance, October 31, 2006 Fiscal year 2007 charges (reversals) Goodwill adjustments Cash payments Non-cash settlements and other adjustments In millions $354 $(2) $(352) $45 13 $58 $— (10) $48 $(30) (7) $(37) $(484) (83) $(606) $2 1 $3 $43 12 $(294) $521 117 $638 $— 33 $387 As of October 31, 2007 Total costs and adjustments to date Total expected costs and adjustments Balance, October 31, 2007 $— $17 7 $24 $80 69 $173 $354 $354 $45 13 $58 $1,780 4,145 $6,337 $45 13 $58 $1,780 4,145 $6,337 Fiscal 2007 U.S. Enhanced Early Retirement Program Employee severance and other benefits charges ................................ Fiscal 2007 Mercury Plan: Employee severance and other benefits charges ................................ Infrastructure ........................................ Total employee severance and other benefits charges ................................ Fiscal 2005 plan ....................................... Fiscal 2003, 2002 and 2001 plans ........... Total restructuring plans........................... At October 31, 2007 and October 31, 2006, HP included the long-term portion of the restructuring liability of $50 million and $91 million, respectively, in Other Liabilities in the accompanying Consolidated Balance Sheets. Note 9: Financial Instruments Investments in Debt and Equity Securities Investments in available-for-sale debt and equity securities at fair value were as follows for the following fiscal years ended October 31: 2007 Gross Unrealized Gains Gross Unrealized Losses Cost Estimated Fair Value Cost In millions 2006 Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value Available-for-Sale Securities Debt securities: Time deposits..................................... $141 Commercial paper.............................. 104 11 Corporate debt.................................... 27 Other debt securities .......................... Total debt securities .............................. 283 3 Equity securities in public companies... $286 $— — — — — 6 $6 $— — — (2) (2) — $(2) $141 $2 104 — 20 11 21 25 43 281 9 13 $290 $56 $— — — — — 23 $23 $— — — (1) (1) — $(1) $2 — 20 20 42 36 $78 105 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 9: Financial Instruments (Continued) Time deposits consist of certificate of deposits with maturity dates greater than three months. Commercial paper investments include asset-backed commercial paper. Corporate debt consists primarily of loans to the other companies that are guaranteed by standby letters of credit issued by third-party banks. Other debt securities consist primarily of fixed-interest securities invested for early retirement purposes. Equity securities in public companies are primarily common stock. HP estimated the fair values based on quoted market prices or pricing models using current market rates. These estimated fair values may not be representative of actual values that could have been realized as of year-end or that will be realized in the future. The gross unrealized losses as of October 31, 2007 were associated with other debt securities with a fair value of $20 million that had been in a continuous loss position for 12 months or longer. The gross unrealized losses were due primarily to changes in interest rates. Because HP has the intent and ability to retain the investment for a period of time sufficient to allow for the anticipated recovery in fair value, HP does not consider those investments to be other-than- temporarily impaired as of October 31, 2007. The gross unrealized losses as of October 31, 2006 were associated with other debt securities with a fair value of $18 million and had been in a continuous loss position for fewer than 12 months. Contractual maturities of available-for-sale debt securities were as follows at October 31, 2007: Available-for-Sale Securities Cost Estimated Fair Value In millions Due in less than one year ......................................................................................................................... $152 131 Due in 1-5 years....................................................................................................................................... $283 $152 129 $281 Proceeds from sales or maturities of available-for-sale and other securities were $425 million in fiscal 2007, $91 million in fiscal 2006 and $2.1 billion in fiscal 2005. The gross realized gains totaled $42 million in fiscal 2007. The gross realized gains and losses totaled $35 million and $2 million, respectively, in fiscal 2006. The gross realized gains and losses totaled $31 million and $1 million, respectively, in fiscal 2005. The specific identification method is used to account for gains and losses on available-for-sale securities. 106 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 9: Financial Instruments (Continued) A summary of the carrying values and balance sheet classification of all investments in debt and equity securities was as follows for the following fiscal years ended October 31: Available-for-sale debt securities ......................................................................................................................... Short-term investments ...................................................................................................................................... Available-for-sale debt securities ......................................................................................................................... Available-for-sale equity securities ...................................................................................................................... Equity securities in privately-held companies and other investments .................................................................. Included in long-term financing receivables and other assets............................................................................... Total investments.................................................................................................................................................. 2007 2006 In millions $152 152 129 9 533 671 $823 $22 22 20 36 362 418 $440 Equity securities in privately-held companies include cost basis and equity method investments. Other investments consist primarily of marketable trading securities held to generate returns that HP expects to offset changes in certain liabilities related to deferred compensation arrangements. HP includes gains or losses from changes in fair value of these securities, offset by losses or gains on the related liabilities, in interest and other, net, in HP’s Consolidated Statements of Earnings. The gains or losses associated with these securities are not material for both fiscal years 2007 and 2006. Derivative Financial Instruments HP is a global company that is exposed to foreign currency exchange rate fluctuations and interest rate changes in the normal course of its business. As part of its risk management strategy, HP uses derivative instruments, primarily forward contracts, swaps and options, to hedge certain foreign currency and interest rate exposures. HP’s objective is to offset gains and losses resulting from these exposures with losses and gains on the derivative contracts used to hedge them, thereby reducing volatility of earnings or protecting fair values of assets and liabilities. HP does not use derivative contracts for speculative purposes. HP applies hedge accounting based upon the criteria established by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), whereby HP designates its derivatives as fair value hedges, cash flow hedges or hedges of the foreign currency exposure of a net investment in a foreign operation (“net investment hedges”). HP recognizes all derivatives in the Consolidated Balance Sheets at fair value and reports them in other current assets, long-term financing receivables and other assets, other accrued liabilities, and other liabilities. HP classifies cash flows from the derivative programs as cash flows from operating activities in the Consolidated Statement of Cash Flows. Fair Value Hedges HP may enter into fair value hedges to reduce the exposure of its debt portfolio to both interest rate risk and foreign currency exchange rate risk. HP issues long-term debt in either U.S. dollars or foreign currencies based on market conditions at the time of financing. HP may then use interest rate or cross currency swaps to modify the market risk exposures in connection with the debt to achieve primarily U.S. dollar LIBOR-based floating interest expense and to manage exposure to changes in foreign currency exchange rates. The swap transactions generally involve the exchange of fixed for 107 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 9: Financial Instruments (Continued) floating interest payments, and, when the underlying debt is denominated in a foreign currency, exchange of the foreign currency principal and interest obligations for U.S. dollar-denominated amounts. Alternatively, HP may choose not to swap fixed for floating interest payments or may terminate a previously executed swap if it believes a larger proportion of fixed- rate debt would be beneficial. HP may choose not to hedge the foreign currency risk associated with its foreign currency denominated debt if this debt acts as a natural hedge for foreign currency assets denominated in the same currency. When investing in fixed rate instruments, HP may enter into interest rate swaps that convert the fixed interest returns into variable interest returns and would classify these swaps as fair value hedges. For derivative instruments that are designated and qualify as fair value hedges, HP recognizes the gain or loss on the derivative instrument, as well as the offsetting loss or gain on the hedged item in interest and other, net, in the Consolidated Statements of Earnings in the current period. When HP terminates an interest rate swap before maturity, the resulting gain or loss from the termination is amortized over the remaining life of the underlying hedged item. Cash Flow Hedges HP may use cash flow hedges to hedge the variability of LIBOR-based interest income HP receives on certain variable- rate investments. HP may enter into interest rate swaps that convert variable rate interest returns into fixed-rate interest returns. For interest rate swaps that HP designates and that qualify as cash flow hedges, HP records changes in the fair values in accumulated other comprehensive income as a separate component of stockholders’ equity and subsequently reclassifies such changes into earnings in the period during which the hedged transaction is recognized in earnings. HP uses a combination of forward contracts and options designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in its forecasted net revenue and, to a lesser extent, cost of sales denominated in currencies other than the U.S. dollar. HP’s foreign currency cash flow hedges mature generally within six months. However, certain leasing revenue-related forward contracts extend for the duration of the lease term, which can be up to five years. For derivative instruments that are designated and qualify as cash flow hedges, HP initially records the effective portions of the gain or loss on the derivative instrument in accumulated other comprehensive loss as a separate component of stockholders’ equity and subsequently reclassifies these amounts into earnings in the period during which the hedged transaction is recognized in earnings. HP reports the effective portion of cash flow hedges in the same financial statement line item as the changes in value of the hedged item. As of October 31, 2007, amounts related to derivatives qualifying as cash flow hedges amounted to an accumulated other comprehensive loss of $64 million, net of taxes, of which $63 million HP expects to reclassify to earnings in the next 12 months along with the earnings effects of the related forecasted transactions. In addition, during fiscal 2007 and 2006 HP did not discontinue any cash flow hedges for which it was probable that a forecasted transaction would not occur. Net Investment Hedges HP uses forward contracts designated as net investment hedges to hedge net investments in certain foreign subsidiaries whose functional currency is the local currency. For derivative instruments that are designated as net investment hedges, HP records the effective portion of the gain or loss on the derivative instrument together with changes in the hedged items in cumulative translation adjustment as a separate component of stockholders’ equity. Cumulative translation adjustment decreased as result of 108 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 9: Financial Instruments (Continued) an unrecognized net loss on net investment hedges of $109 million and $31 million for the fiscal years ended October 31, 2007 and 2006, respectively. Other Derivatives Other derivatives not designated as hedging instruments under SFAS 133 consist primarily of forward contracts HP uses to hedge foreign currency balance sheet exposures. For derivative instruments not designated as hedging instruments under SFAS 133, HP recognizes changes in the fair values in earnings in the period of change. HP recognizes the gains or losses on foreign currency forward contracts used to hedge balance sheet exposures in interest and other, net in the same period as the remeasurement gain and loss of the related foreign currency denominated assets and liabilities. Interest and other, net, included net foreign currency exchange gains of approximately $86 million in fiscal 2007, gains of approximately $54 million in fiscal 2006, and gains of approximately $70 million in fiscal 2005. Hedge Effectiveness For interest rate swaps designated as fair value hedges, HP measures effectiveness by offsetting the change in fair value of the hedged debt and investments with the change in fair value of the derivative. For interest rate swaps designated as cash flow hedges, HP measures effectiveness by offsetting the change in the variable portion of the interest rate swaps with the changes in expected interest income received due to the fluctuations in the LIBOR based interest rate. For foreign currency option and forward contracts designated as cash flow or net investment hedges, HP measures effectiveness by comparing the cumulative change in the hedge contract with the cumulative change in the hedged item, both of which are based on forward rates. HP recognizes any ineffective portion of the hedge, as well as amounts not included in the assessment of effectiveness, in the Consolidated Statements of Earnings. As of October 31, 2007, the portion of hedging instruments’ gains or losses excluded from the assessment of effectiveness was not material for fair value, cash flow or net investment hedges. Hedge ineffectiveness for fair value, cash flow and net investment hedges was not material in the fiscal years ended October 31, 2007, 2006 and 2005. HP estimates the fair values of derivatives based on quoted market prices or pricing models using current market rates and records all derivatives on the balance sheet at fair value. The gross notional 109 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 9: Financial Instruments (Continued) and fair market value of derivative financial instruments and the respective SFAS 133 classification on the Consolidated Balance Sheets were as follows for the following fiscal years ended October 31: Gross Notional $2,450 9,657 1,002 17,854 $30,963 Other Current Assets $— 73 5 86 $164 2007 Long-term Financing Receivables and Other Assets Other Accrued Liabilities Other Liabilities Total In millions $21 — — 7 $28 2006 $— (183) (78) (377) $(638) $21 $— — (110) (100) (371) $(560) (27) (87) $(114) Long-term Financing Receivables and Other Assets Other Current Assets Other Accrued Liabilities Other Liabilities $1 33 1 25 $60 In millions $2 — 1 13 $16 $(1) (97) (8) (135) $(241) $(3) — (7) (28) $(38) Gross Notional $2,550 8,768 844 10,482 $22,644 Total $(1) (64) (13) (125) $(203) Fair value hedges ............................................ Cash flow hedges............................................ Net investment hedges .................................... Other derivatives............................................. Total................................................................ Fair value hedges ............................................ Cash flow hedges............................................ Net investment hedges .................................... Other derivatives............................................. Total................................................................ Fair Value of Other Financial Instruments For certain of HP’s financial instruments, including cash and cash equivalents, short-term investments, accounts receivable, financing receivables, notes payable and short-term borrowings, accounts payable and other accrued liabilities, the carrying amounts approximate fair value due to their short maturities. The estimated fair value of HP’s short- and long- term debt was approximately $8.1 billion at October 31, 2007, compared to a carrying value of $8.2 billion at that date. The estimated fair value of the debt is based primarily on quoted market prices, as well as borrowing rates currently available to HP for bank loans with similar terms and maturities. Note 10: Financing Receivables and Operating Leases Financing receivables represent sales-type and direct-financing leases resulting from the marketing of HP’s and third-party products. These receivables typically have terms from two to five years and are usually collateralized by a security interest in the underlying assets. Financing receivables also include billed receivables from operating leases. The components of net financing receivables, which are 110 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 10: Financing Receivables and Operating Leases (Continued) included in financing receivables and long-term financing receivables and other assets, were as follows for the following fiscal years ended October 31: 2007 2006 In millions Minimum lease payments receivable................................................................................................... Allowance for doubtful accounts ......................................................................................................... Unguaranteed residual value................................................................................................................ Unearned income ................................................................................................................................. Financing receivables, net.................................................................................................................... Less current portion ............................................................................................................................. Amounts due after one year, net .......................................................................................................... $5,568 (84) 291 (490) 5,285 (2,507) $2,778 $5,010 (80) 289 (439) 4,780 (2,440) $2,340 As of October 31, 2007, scheduled maturities of HP’s minimum lease payments receivable were as follows for the following fiscal years ended October 31: Scheduled maturities of minimum lease payments receivable.... $2,706 $1,485 $759 $334 $168 $116 $5,568 2008 2009 2010 2012 2011 In millions Thereafter Total Equipment leased to customers under operating leases was $2.4 billion at October 31, 2007 and $2.1 billion at October 31, 2006 and is included in machinery and equipment. Accumulated depreciation on equipment under lease was $0.6 billion at both October 31, 2007 and October 31, 2006. As of October 31, 2007, minimum future rentals on non- cancelable operating leases related to leased equipment were as follows for the following fiscal years ended October 31: Minimum future rentals on non-cancelable operating leases...... $882 $430 $196 2008 2009 2010 Note 11: Guarantees Indemnifications 2011 2012 In millions $31 $85 Thereafter Total $25 $1,649 In the ordinary course of business, HP enters into contractual arrangements under which HP may agree to indemnify the third party to such arrangement from any losses incurred relating to the services they perform on behalf of HP or for losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to past performance. Such indemnification obligations may not be subject to maximum loss clauses. Historically, payments made related to these indemnifications have been immaterial. Warranty HP provides for the estimated cost of product warranties at the time it recognizes revenue. HP engages in extensive product quality programs and processes, including actively monitoring and 111 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 11: Guarantees (Continued) evaluating the quality of its component suppliers; however, product warranty terms offered to customers, ongoing product failure rates, material usage and service delivery costs incurred in correcting a product failure, as well as specific product class failures outside of HP’s baseline experience, affect the estimated warranty obligation. If actual product failure rates, material usage or service delivery costs differ from estimates, revisions to the estimated warranty liability would be required. The changes in HP’s aggregate product warranty liabilities were as follows for the following fiscal years ended October 31: Product warranty liability at beginning of year ................................................ Accruals for warranties issued.......................................................................... Adjustments related to pre-existing warranties (including changes in estimates).......................................................................................................... Settlements made (in cash or in kind)............................................................... Product warranty liability at end of year .......................................................... 2007 2006 In millions $2,248 2,712 (108) $2,172 2,467 (45) (2,476) $2,376 (2,346) $2,248 Note 12: Borrowings Notes Payable and Short-Term Borrowings Notes payable and short-term borrowings, including the current portion of long-term debt, were as follows for the following fiscal years ended October 31: Current portion of long-term debt............................................. Commercial paper..................................................................... Notes payable to banks, lines of credit and other...................... 2007 2006 Amount Outstanding Weighted- Average Interest Rate Amount Outstanding Weighted- Average Interest Rate $675 2,065 446 $3,186 In millions 4.0% 5.0% 5.2% $2,081 190 434 $2,705 5.7% 3.3% 4.6% Notes payable to banks, lines of credit and other includes deposits associated with HP’s banking-related activities of approximately $391 million and $393 million at October 31, 2007 and 2006, respectively. 112 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 12: Borrowings (Continued) Long-Term Debt Long-term debt was as follows for the following fiscal years ended October 31: U.S. Dollar Global Notes $1,000 issued December 2001 at 5.75%, matured and paid December 2006 ....................................... $1,000 issued June 2002 at 5.5%, matured and paid July 2007 ............................................................ $500 issued June 2002 at 6.5%, due July 2012..................................................................................... $500 issued March 2003 at 3.625%, due March 2008 .......................................................................... $1,000 issued May 2006 at floating interest rate, due May 2009 and redeemed June 2007 ................. $600 issued February 2007 at floating interest rate, due March 2012 .................................................. $900 issued February 2007 at 5.25%, due March 2012 ........................................................................ $500 issued February 2007 at 5.4%, due March 2017 .......................................................................... $1,000 issued June 2007 at floating interest rate, due June 2009.......................................................... $1,000 issued June 2007 at floating interest rate, due June 2010.......................................................... Series A Medium-Term Notes $50 issued December 2002 at 4.25%, due December 2007 .................................................................. Other $505, U.S. dollar zero-coupon subordinated convertible notes, issued in October and November 1997 at an imputed rate of 3.13%, due 2017 (“LYONs”) .................................................................. Other, including capital lease obligations, at 3.75%-15%, due 2006-2029........................................... Fair value adjustment related to SFAS No. 133....................................................................................... Less current portion ................................................................................................................................. 2007 2006 In millions $— — 499 500 — 600 900 499 1,000— 1,000 4,998 50 50 371 263 634 (10) (675) $4,997 $1,000 999 498 499 1,000 — — — — 3,996 50 50 360 228 588 (63) (2,081) $2,490 HP may redeem some or all of the Global Notes and the Series A Medium-Term Notes (collectively, the “Notes”), as set forth in the above table, at any time at the redemption prices described in the prospectus supplements relating thereto. The Notes are senior unsecured debt. In May 2006, HP filed a shelf registration statement (the “2006 Shelf Registration Statement”) with the Securities and Exchange Commission (the “SEC”) to enable HP to offer and sell, from time to time, in one or more offerings, debt securities, common stock, preferred stock, depositary shares and warrants. On May 23, 2006, HP issued $1.0 billion in floating rate global notes due May 22, 2009 under the 2006 Shelf Registration Statement. The notes bear interest at a floating rate equal to the three-month USD LIBOR plus 0.125% per annum. HP used a portion of the proceeds it received to repay its 5.25% Euro Medium-Term Notes due July 2006 at maturity and the remainder of the net proceeds for general corporate purposes. 113 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 12: Borrowings (Continued) On February 22, 2007, HP issued an additional $2.0 billion of global notes under the 2006 Shelf Registration Statement. The global notes included $600 million of notes due March 2012 with a floating interest rate equal to the three-month USD LIBOR plus 0.11% per annum, $900 million of notes due March 2012 with a fixed interest rate of 5.25% per annum, and $500 million of notes due March 2017 with a fixed interest rate of 5.40% per annum. HP issued the $600 million notes at par, and HP issued the $900 million notes and $500 million notes at discounts to par at 99.938% and 99.694%, respectively. HP used the net proceeds from this offering for general corporate purposes, including funding the repurchase of the notes it assumed in connection with the Mercury acquisition as described in detail below and repaying short-term commercial paper. On June 12, 2007, HP issued an additional $2.0 billion of global notes under the 2006 Shelf Registration Statement. The global notes included $1.0 billion of notes due June 2009 with a floating interest rate equal to the three-month USD LIBOR plus 0.01% per annum, and $1.0 billion of notes due June 2010 with a floating interest rate equal to the three-month USD LIBOR plus 0.06% per annum. HP issued these global notes at par. HP used the net proceeds from these offerings for general corporate purposes, including the redemption of the floating rate global notes due May 22, 2009 in June 2007 and the repayment of short-term commercial paper. HP registered the sale of up to $3.0 billion of debt or global securities, common stock, preferred stock, depositary shares and warrants under a shelf registration statement in March 2002 (the “2002 Shelf Registration Statement”). In December 2002, HP filed a supplement to the 2002 Shelf Registration Statement, which allows HP to offer from time to time up to $1.5 billion of Medium-Term Notes, Series B, due nine months or more from the date of issuance (the “Series B Medium-Term Note Program”). As of October 31, 2007, HP has not issued Medium-Term Notes pursuant to the Series B Medium-Term Note Program. HP registered the sale of up to $3.0 billion of Medium-Term Notes under its Euro Medium-Term Note Programme filed with the Luxembourg Stock Exchange. HP can denominate these notes in any currency, including the euro. HP has not and will not register these notes in the United States. In July 2006, HP repaid the previously issued 750 million euro notes at maturity under this programme. The LYONs are convertible by the holders at an adjusted rate of 15.09 shares of HP common stock for each $1,000 face value of the LYONs, payable in either cash or common stock at HP’s election. In December 2000, the HP Board of Directors authorized a repurchase program for the LYONs that allowed HP to repurchase the LYONs from time to time at varying prices. The last repurchase under this program occurred in fiscal 2002. In November 2006, in connection with the Mercury acquisition, HP assumed notes issued by Mercury (the “Mercury Notes”) with a face value of $300 million, maturing on July 1, 2007 and bearing interest at a rate of 4.75% per annum. As of July 31, 2007, HP had repurchased or repaid at maturity all of the outstanding Mercury Notes. HP has a U.S. commercial paper program with a $6.0 billion capacity. Its subsidiaries are authorized to issue up to an additional $1.0 billion of commercial paper, of which $500 million of capacity is currently available to be used by Hewlett-Packard International Bank PLC, a wholly-owned subsidiary of HP, for its Euro Commercial Paper/Certificate of Deposit Programme. HP has a $3.0 billion five-year credit facility. Commitment fees, interest rates and other terms of borrowing under the credit facility vary, based on HP’s external credit ratings. The credit facility is a 114 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 12: Borrowings (Continued) senior unsecured committed borrowing arrangement primarily to support the issuance of U.S. commercial paper. No amounts are outstanding under the credit facility. HP also maintains uncommitted lines of credit from a number of financial institutions that are available through various foreign subsidiaries. The amount available for use as of October 31, 2007 was approximately $1.8 billion. Included in Other, including capital lease obligations, are borrowings that are collateralized by certain financing receivable assets. As of October 31, 2007, the carrying value of the assets approximated the carrying value of the borrowings of $5 million. At October 31, 2007, HP had up to approximately $10 billion of available borrowing resources under the 2002 Shelf Registration Statement and other programs. HP also may issue additional debt securities, common stock, preferred stock, depositary shares and warrants under the 2006 Shelf Registration Statement. Aggregate future maturities of long-term debt at face value (excluding the fair value adjustment related to SFAS 133 of $10 million and discount on debt issuance of $145 million) were as follows at October 31, 2007: Aggregate future maturities of debt outstanding including capital lease obligations ......................... $683 $1,037 $1,022 $5 $2,007 $1,073 $5,827 2008 2009 2010 2011 2012 Thereafter Total In millions Interest expense on borrowings was $531 million in fiscal 2007, $336 million in fiscal 2006, and $334 million in fiscal 2005. Note 13: Taxes on Earnings The domestic and foreign components of earnings (losses) were as follows for the following fiscal years ended October 31: U.S................................................................................................................................. $3,577 $1,645 $(1,406) 4,949 Non-U.S. ....................................................................................................................... $5,600 5,546 $3,543 $9,177 $7,191 2007 2006 In millions 2005 115 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 13: Taxes on Earnings (Continued) The provision for (benefit from) taxes on earnings was as follows for the following fiscal years ended October 31: 2007 2006 In millions 2005 U.S. federal taxes: Current ...................................................................................................................................... Deferred .................................................................................................................................... $211 657 $(443) 524 Non-U.S. taxes: Current ...................................................................................................................................... Deferred .................................................................................................................................... 1,281 (125) State taxes: Current ...................................................................................................................................... Deferred .................................................................................................................................... 34 (145) $1,913 755 173 (11) (5) $993 $687 (139) 598 (19) 21 (3) $1,145 The significant components of deferred tax assets and deferred tax liabilities were as follows for the following fiscal years ended October 31: 2007 2006 Deferred Tax Assets Deferred Tax Liabilities Deferred Tax Assets Deferred Tax Liabilities Loss carryforwards ........................................................................ Credit carryforwards...................................................................... Unremitted earnings of foreign subsidiaries .................................. Inventory valuation........................................................................ Intercompany transactions—profit in inventory ............................ Intercompany transactions—excluding inventory ......................... Fixed assets.................................................................................... Warranty ........................................................................................ Employee and retiree benefits........................................................ Accounts receivable allowance...................................................... Capitalized research and development........................................... Purchased intangible assets............................................................ Restructuring ................................................................................. Equity investments......................................................................... Deferred revenue ........................................................................... Other .............................................................................................. Gross deferred tax assets and liabilities ......................................... Valuation allowance ...................................................................... Total deferred tax assets and liabilities .......................................... $1,573 1,999 — 173 506 1,850 295 709 1,014 190 1,538 48 75 61 748 1,134 11,913 (1,543) $10,370 In millions $— — 4,018 11 — — 7 — 543 2 — 627 — — — 112 5,320 — $5,320 $558 2,247 — 135 519 1,471 362 670 1,545 152 1,880 58 182 54 592 896 11,321 (840) $10,481 $— — 4,111 74 — — 5 — 553 — — 445 — — — 103 5,291 — $5,291 116 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 13: Taxes on Earnings (Continued) The breakdown between current and long-term deferred tax assets and deferred tax liabilities was as follows for the following fiscal years ended October 31: 2007 2006 In millions Current deferred tax assets............................................................................................................................ Current deferred tax liabilities ...................................................................................................................... Long-term deferred tax assets....................................................................................................................... Long-term deferred tax liabilities ................................................................................................................. Total deferred tax assets net of deferred tax liabilities ................................................................................. $4,609 (123) 961 (397) $5,050 $4,144 (138) 1,475 (291) $5,190 At October 31, 2007, HP had a deferred tax asset of $1.6 billion related to loss carryforwards, of which $1.2 billion relates to foreign net operating losses. HP has provided a valuation allowance of $1.1 billion on those foreign net operating loss carryforwards that HP does not expect to utilize. The remaining $377 million deferred tax asset relates to $970 million and $805 million of federal and state net operating losses, respectively, including losses from acquired companies. HP has provided $178 million in valuation allowance for such losses, which begin to expire in fiscal 2010. Of the total tax credit carryforwards of $2.0 billion, HP had foreign tax credit carryforwards of $1.1 billion, of which $29 million will expire in fiscal 2012 and the remainder of which will begin to expire in fiscal 2015. HP had alternative minimum tax credit carryforwards of $86 million, which do not expire, and research and development credit carryforwards of $387 million, which will begin to expire in fiscal 2019. HP also had tax credit carryforwards of $436 million in various states and foreign countries, on which HP has provided a valuation allowance of $263 million. These credits begin to expire in fiscal 2009. Gross deferred tax assets at October 31, 2007 and 2006 were reduced by valuation allowances of $1.5 billion and $840 million, respectively. Total valuation allowances increased by $703 million. This valuation allowance increase was composed of a $787 million net increase attributable to foreign net operating losses not previously recorded as deferred tax assets, a $96 million increase attributable to non-U.S. tax credits, and a $20 million increase attributable to federal net operating loss carryovers. These increases were partially offset by an $86 million decrease in the valuation allowances on unrealized domestic capital losses, and a $114 million decrease in the valuation allowances for state tax credits and net operating losses. Of the $1.5 billion in valuation allowances at October 31, 2007, $140 million was related to deferred tax assets for acquired companies that existed at the time of acquisition. In the future, if HP determines that the realization of these deferred tax assets is more likely than not, the reversal of the related valuation allowance will reduce goodwill instead of the provision for taxes. Of the total tax benefits resulting from the exercise of employee stock options and other employee stock programs, the amounts recorded to stockholders’ equity were approximately $530 million in fiscal 2007, $356 million in fiscal 2006 and $30 million in fiscal 2005. 117 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 13: Taxes on Earnings (Continued) The differences between the U.S. federal statutory income tax rate and HP’s effective tax rate were as follows for the following fiscal years ended October 31: U.S. federal statutory income tax rate ....................................................... State income taxes, net of federal tax benefit ............................................ Lower rates in other jurisdictions, net ....................................................... Jobs Act Repatriation, including state taxes .............................................. Research and development credit .............................................................. Valuation allowance .................................................................................. U.S. federal tax audit settlement................................................................ Other, net................................................................................................... 2005 2007 2006 35.0% 35.0% 35.0% (3.0) (0.1) (23.6) (11.9) 22.4 — (0.2) (0.2) 3.4 (1.0) — (7.9) (1.7) (0.1) 20.8% 13.8% 32.3% 0.5 (13.2) — (0.6) (1.7) — 0.8 In fiscal 2007, HP recorded $80 million of net income tax benefit related to items unique to the year. This is attributable to a $154 million valuation allowance release attributable to state tax credits and $60 million benefit from foreign net operating losses, offset by $96 million net increase to various tax reserves, a net tax charge of $18 million for the adjustment to estimated fiscal 2006 tax accruals upon filing the 2006 U.S. federal and state income tax returns, and a net tax charge of $20 million for other items. In fiscal 2006, HP recorded $599 million of net income tax benefit related to items unique to the year. This included net favorable tax adjustments of $565 million to income tax accruals as a result of the settlement of the Internal Revenue Service (“IRS”) examinations of HP’s U.S. income tax returns for fiscal years 1993 to 1998. The reductions to the net income tax accruals for these years related primarily to the resolution of issues with respect to Puerto Rico manufacturing tax incentives and export tax incentives, and other issues involving our non-U.S. operations. In December 2006, the Tax Relief and Health Care Act of 2006 was signed into law, which includes a retroactive reinstatement of the research and development credit. The retroactive amount was recorded in HP’s financial statements in the first quarter of fiscal 2007. The amount did not have a material impact on HP’s consolidated results of operations and financial condition. In fiscal 2005, HP recorded $697 million of net income tax expense related to items unique to the year. The tax expense was the result primarily of $792 million associated with the repatriation of $14.5 billion under the Jobs Act and $76 million related to additional distributions received from foreign subsidiaries. These tax expenses were offset in part by tax benefits of $177 million resulting from agreements with the IRS and other governmental authorities, which were reflected in “Lower rates in other jurisdictions, net” and “Other, net.” As a result of certain employment actions and capital investments HP has undertaken, income from manufacturing activities of subsidiaries in certain countries is subject to reduced tax rates, and in some cases is wholly exempt from taxes through 2019. The gross income tax benefits attributable to the tax status of these subsidiaries were estimated to be $1.2 billion ($0.43 per diluted share) in fiscal year 2007, $876 million ($0.31 per diluted share) in fiscal year 2006, and $1.1 billion ($0.36 per diluted share) in fiscal year 2005. The gross income tax benefits were offset partially by accruals of U.S. income taxes on undistributed earnings. 118 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 13: Taxes on Earnings (Continued) The IRS has completed its examination of the income tax returns of HP for all years through fiscal 1998. HP’s 1993 through 1998 years were settled with the IRS’s Appeals Division and the settlements were approved by the Joint Committee on Taxation in 2006. These tax years remain open for net operating loss and foreign tax credit carrybacks from subsequent years if the IRS’s audits of those years approve such carrybacks. On June 28, 2007, HP received a Notice of Deficiency from the IRS for its fiscal 1999 and 2000 tax years. The Notice of Deficiency asserted that HP owes additional tax of $13 million for these two years. At the same time, HP received a Revenue Agent’s Report (“RAR”) from IRS for its fiscal 2001 tax year that proposed no change in HP’s tax liability for that year. In addition to the proposed deficiencies for fiscal 1999 and 2000, the IRS’s adjustments, if sustained, would reduce tax refund claims HP has filed for foreign tax credit and net operating loss carrybacks to earlier fiscal years and reduce the tax benefits of carryforwards to subsequent years, by approximately $361 million. HP plans to contest certain of the adjustments proposed in the Notice of Deficiency and the RAR. Towards this end, HP filed a Petition with the United States Tax Court on September 25, 2007. HP believes that it has provided adequate reserves for any tax deficiencies or reductions in refund claims that could result from the IRS actions. As of October 31, 2007, the IRS was in the process of concluding its examination of HP’s income tax returns for years 2002 and 2003. The IRS began an audit of HP’s 2004 and 2005 income tax returns in 2007. In addition, HP is subject to numerous ongoing audits by state and foreign tax authorities. HP believes that adequate accruals have been provided for all HP open tax years. All Compaq tax years through the merger date with HP, May 3, 2002, have been audited and agreed with the IRS. During fiscal 2007 substantially all of the remaining tax accruals for Compaq were reclassified as a reduction of goodwill upon closing of the statute of limitations. HP has not provided for U.S. federal income and foreign withholding taxes on $7.7 billion of undistributed earnings from non-U.S. operations as of October 31, 2007 because HP intends to reinvest such earnings indefinitely outside of the United States. If HP were to distribute these earnings, foreign tax credits may become available under current law to reduce the resulting U.S. income tax liability. Determination of the amount of unrecognized deferred tax liability related to these earnings is not practicable. HP will remit non-indefinitely reinvested earnings of its non-US subsidiaries where excess cash has accumulated and it determines that it is advantageous for business operations, tax or cash reasons. American Jobs Creation Act of 2004—Repatriation of Foreign Earnings The American Jobs Creation Act of 2004 (“the Jobs Act”), enacted on October 22, 2004, provided for a temporary 85% dividends received deduction on certain foreign earnings repatriated during a one-year period. The deduction resulted in an approximate 5.25% federal tax rate on the repatriated earnings. During the third quarter of fiscal 2005, HP’s CEO and Board of Directors approved a domestic reinvestment plan as required by the Jobs Act to repatriate $14.5 billion in foreign earnings in fiscal 2005. HP recorded tax expense in fiscal 2005 of $792 million related to this $14.5 billion dividend under the Jobs Act. The additional tax expense consists of federal taxes of $744 million, state taxes, net of 119 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 13: Taxes on Earnings (Continued) federal benefits, of $73 million, and a net tax benefit of $25 million related to an adjustment of deferred tax liabilities on both repatriated and unrepatriated foreign earnings. Note 14: Stockholders’ Equity Dividends The stockholders of HP common stock are entitled to receive dividends when and as declared by HP’s Board of Directors. Dividends are paid quarterly. Dividends were $0.32 per common share in each of fiscal 2007, 2006 and 2005. Stock Repurchase Program HP’s share repurchase program authorizes both open market and private repurchase transactions. In fiscal 2007, HP completed share repurchases of approximately 209 million shares. Repurchases of approximately 210 million shares were settled for $9.1 billion, which included approximately 1 million shares repurchased in transactions that were executed in fiscal 2006 but settled in fiscal 2007. In fiscal 2006, HP completed share repurchases of approximately 188 million shares. Repurchases of approximately 190 million shares were settled for $6.1 billion, which included 2 million shares repurchased in transactions that were executed in fiscal 2005 but settled in fiscal 2006. In fiscal 2005, HP completed share repurchases of approximately 150 million shares, of which approximately 148 million shares were settled for $3.5 billion. Shares repurchased and settled in fiscal 2007 and fiscal 2006 were all open market repurchases. Shares repurchased and settled in fiscal 2005 included open market repurchases of 37 million shares for $1.0 billion and 111 million shares for $2.5 billion from the David and Lucile Packard Foundation. In addition to the above transactions, HP entered into an Accelerated Share Repurchase (the “ASR Program”) with a third-party investment bank during the second quarter of fiscal 2007. Pursuant to the terms of the ASR Program, HP purchased 40 million shares of its common stock from the investment bank for $1.8 billion (the “Purchase Price”) on March 30, 2007 (the “Purchase Date”). HP decreased its shares outstanding and reduced the outstanding shares used to calculate the weighted-average common shares outstanding for both basic and diluted EPS on the Purchase Date. The shares delivered to HP included shares that the investment bank borrowed from third parties. The investment bank purchased an equivalent number of shares in the open market to cover its position with respect to the borrowed shares during a contractually specified averaging period that began on the Purchase Date and ended on June 6, 2007. At the end of the averaging period, the investment bank’s total purchase cost based on the volume weighted-average purchase price of HP shares during the averaging period was approximately $90 million less than the Purchase Price. Accordingly, HP had the option to either receive additional shares of HP’s common stock or a cash payment in the amount of the difference from the investment bank. In June 2007, HP received approximately 2 million additional shares purchased by the investment bank in the open market with a value approximately equal to that amount. HP reduced its shares outstanding upon receipt of those shares. Also, HP entered into a prepaid variable share purchase program (“PVSPP”) with a third-party investment bank during the first quarter of 2006 and prepaid approximately $1.7 billion in exchange for the right to receive a variable number of shares of its common stock weekly over a one-year period beginning in the second quarter of fiscal 2006 and ending during the second quarter of fiscal 2007. Under the PVSPP, the prices at which HP purchased the shares were subject to a minimum and 120 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 14: Stockholders’ Equity (Continued) maximum price that was determined in advance of any repurchases being completed under the program, thereby effectively hedging HP’s repurchase price. The minimum and maximum number of shares HP could receive under the program was 52 million shares and 70 million shares, respectively. The exact number of shares to be repurchased was based upon the volume weighted-average market price of HP’s shares during each weekly settlement period, subject to the minimum and maximum price as well as regulatory limitations on the number of shares HP was permitted to repurchase. HP decreased its shares outstanding each settlement period as shares were physically received. HP completed all repurchases under the PVSPP on March 9, 2007. As of that date, HP had cumulatively received a total of 53 million shares. HP retired all shares repurchased and no longer deems those shares outstanding. HP’s Board of Directors authorized an additional $8.0 billion, $10.0 billion and $4.0 billion for future share repurchases in fiscal 2007, 2006 and 2005, respectively. As of October 31, 2007, HP had remaining authorization of $2.7 billion for future share repurchases. On November 19, 2007, HP’s Board of Directors authorized an additional $8.0 billion for future share repurchases. Comprehensive Income The changes in the components of other comprehensive income, net of taxes, were as follows for the following fiscal years ended October 31: 2006 In millions Net earnings..................................................................................................................................... $7,264 $6,198 Net change in unrealized gains on available-for-sale securities: 2007 2005 $2,398 Change in net unrealized gains, net of taxes of $2 in 2007, $3 in 2006 and of $6 in 2005........... Net unrealized gains reclassified into earnings, net of taxes of $7 in 2007, $9 in 2006 and $6 in 2005 ........................................................................................................................................... 2 (14) 7 (13) 9 (10) (12) (6) (1) Net change in unrealized losses on cash flow hedges: Change in net unrealized losses, net of tax benefit of $37 in 2007, $24 in 2006 and $16 in (63) (41) (28) 2005 ........................................................................................................................................... Net unrealized losses reclassified into earnings, net of tax benefit of $26 in 2007, $24 in 2006 45 41 97 and $56 in 2005.......................................................................................................................... Net change in cumulative translation adjustment, net of tax benefit of $37 in 2007, $40 in 2006 and $8 in 2005 ................................................................................................................................. Net change in additional minimum pension liability, net of tax benefit of $1 in 2007, tax benefit of $1 in 2006 and taxes of $89 in 2005............................................................................................ Comprehensive income.................................................................................................................... $7,337 $6,237 (3) (9) (18) 106 — 54 69 (17) 171 $2,620 121 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 14: Stockholders’ Equity (Continued) The components of accumulated other comprehensive income, net of taxes, were as follows for the following fiscal years ended October 31: In millions $4 Net unrealized gains on available-for-sale securities...................................................................... (64) Net unrealized losses on cash flow hedges ..................................................................................... Cumulative translation adjustment ................................................................................................. 173 Additional minimum pension liability............................................................................................ — Unrealized components of defined benefit pension plan ................................................................ 446 Accumulated other comprehensive income .................................................................................... $559 $16 (46) 67 (19) — $18 2007 2006 Note 15: Retirement and Post-Retirement Benefit Plans Plan Design Changes In fiscal 2007, HP modified its U.S. defined benefit pension plan for the remaining number of U.S. employees still accruing benefits under the program. Effective January 1, 2008, these employees will cease accruing pension benefits, and HP will calculate the final pension benefit amount based on pay and service through December 31, 2007. In addition, HP limited future eligibility for the Pre-2003 HP Retiree Medical Program to those employees who were within five years of satisfying the program’s retirement criteria on June 30, 2007. These actions resulted in reductions to the U.S. defined benefit and post-retirement plan obligations. As a result, HP recognized one-time curtailment gains of $541 million for the U.S. defined benefit pension plan and $1 million for the post-retirement benefit plan. As part of this announcement, HP offered an option for eligible affected employees to participate in the 2007 EER. A total of 3,080 employees participated in the 2007 EER. HP recognized a special termination benefit expense of $307 million in fiscal 2007, which reflects aggregate additional lump-sum benefits that HP expects to pay to those individuals participating in the 2007 EER. HP will distribute this amount from the plan assets. Also, HP recognized a special termination benefit expense of $60 million for the HP retiree medical plans for those employees participating in the 2007 EER. This expense amount reflects the additional medical coverage that HP expects to provide to those employees participating in the 2007 EER. The total $367 million expense for the 2007 EER was included in the restructuring charge of fiscal 2007. HP will fund the cash expenditures associated with the 2007 EER primarily by using available U.S. pension plan assets. Eligible employees whose pension accruals will cease effective December 31, 2007 will benefit from an increased company 401(k) match opportunity from 4 percent to 6 percent of eligible earnings effective January 1, 2008. In fiscal 2007, HP also recognized a net settlement loss of $8 million for its U.S. pension plans, including a settlement loss of $36 million, which was partially offset by a settlement gain of $28 million for its U.S. pension plans. The settlement loss of $36 million related to the distributions and the subsequent transfer of accrued pension benefits from the U.S. Excess Benefit Plan to the U.S. Executive Deferred Compensation Plan for the terminated vested plan participants. The distributions and the transfer of this pension obligation represented a reduction in the projected benefit obligation and exceeded the sum of service and interest cost for this plan. As a result, HP recognized a portion of the unrecognized loss, re-measured as of January 31, 2007, in the second quarter of fiscal 2007. The settlement gain of $28 million primarily resulted from the distribution of lump-sum benefit payments 122 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) made to pension plan participants who left HP under the 2007 EER. These lump sum benefit payments, which were paid out to participants during the October 1, 2006 to September 30, 2007 measurement period, represent a reduction in the projected benefit obligation. As a result, a portion of the unrecognized gain was recognized in fiscal 2007. The gain was recorded in accordance with SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” which requires that a settlement event be recorded once prescribed payment thresholds have been reached. HP recorded this $28 million as a reduction to the restructuring charge recorded in connection with the 2007 EER. In fiscal 2007, HP recognized a net curtailment gain of $26 million for its U.S. post-retirement benefit plans. The gain included $16 million and $9 million, resulting from the reduction in the eligible plan population stemming from the 2007 EER and the restructuring plans implemented in fiscal 2005, respectively. HP reported these gains as reductions to the restructuring charge. HP also recorded a one-time curtailment gain of $1 million for its post-retirement benefit plans as a result of the modification of its Pre-2003 HP Retiree Medical Program in fiscal 2007 as described above in detail. In fiscal 2007 HP recognized net curtailment gains of $13 million in connection with its non-U.S. defined benefit plans. These gains reflected a plan design change in Mexico and Canada of $11 million where HP ceased pension accruals for current employees who did not meet defined criteria based on age and years of service and a $2 million gain related to the fiscal 2005 restructuring programs recorded as a reduction to the restructuring charges in fiscal 2007. Also in fiscal 2007, HP recognized a restructuring settlement expense of $4 million. The settlement expense reflected primarily the distribution of lump-sum benefit payments in Mexico and Canada, thereby resulting in a portion of the unrecognized loss being recorded as expense once the settlement recognition thresholds had been reached. In addition, HP incurred a $4 million restructuring special termination benefit expense associated with the early retirement of employees in the U.K. and Ireland. Defined Benefit Plans HP sponsors a number of defined benefit pension plans worldwide, of which the most significant are in the United States. The HP Retirement Plan (the “Retirement Plan”) is a defined benefit pension plan for U.S. employees hired on or before December 31, 2002. Benefits under the Retirement Plan generally are based on pay and years of service, except for eligible pre-acquisition Compaq employees, who do not receive credit for years of service prior to January 1, 2003. Effective December 31, 2005, participants whose combination of age plus years of service is less than 62 ceased accruing benefits under the Retirement Plan. Effective January 1, 2008, the remaining number of U.S. employees still accruing benefits under the program will cease accruing pension benefits. For U.S employees hired or rehired on or after January 1, 2003, HP sponsors the Hewlett-Packard Company Cash Account Pension Plan (the “Cash Account Pension Plan”), under which benefits accrue pursuant to a cash accumulation account formula based upon a percentage of pay plus interest. Effective November 30, 2005, HP merged the Cash Account Pension Plan into the Retirement Plan; the merged plan is treated as one plan for certain legal and financial purposes, including funding requirements. The merger has no impact on the separate benefit structures of the plans. Effective December 31, 2005, the Cash Account Pension Plan was closed to new participants, and participants whose combination of age plus years of service is less than 62 will cease accruing benefits. 123 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) HP reduces the benefit payable to a U.S. employee under the Retirement Plan for service before 1993, if any, by any amounts due to the employee under HP’s frozen defined contribution Deferred Profit-Sharing Plan (“the DPSP”). HP closed the DPSP to new participants in 1993. The DPSP plan obligations are equal to the plan assets and are recognized as an offset to the Retirement Plan when HP calculates its defined benefit pension cost and obligations. The fair value of plan assets and projected benefit obligations for the U.S. defined benefit plans combined with the DPSP as of the September 30 measurement date is as follows for the following fiscal years ended October 31: U.S. defined benefit plans............................................................................. DPSP............................................................................................................. Total.............................................................................................................. Post-Retirement Benefit Plans 2007 2006 Projected Benefit Obligation Plan Assets Projected Benefit Obligation In millions $3,982 1,029 $5,011 $4,325 1,095 $5,420 $4,688 1,095 $5,783 Plan Assets $4,258 1,029 $5,287 Through fiscal 2005, substantially all of HP’s U.S. employees at December 31, 2002 could become eligible for partially subsidized retiree medical benefits and retiree life insurance benefits under the Pre-2003 HP Retiree Medical Program (the “Pre-2003 Program”) and certain other retiree medical programs. Plan participants in the Pre-2003 Program make contributions based on their choice of medical option and length of service. U.S. employees hired or rehired on or after January 1, 2003 may be eligible to participate in a post-retirement medical plan, the HP Retiree Medical Program but must bear the full cost of their participation. Effective January 1, 2006, employees whose combination of age and years of service is less than 62 no longer will be eligible for the subsidized Pre-2003 Program, but instead will be eligible for the HP Retiree Medical Program. Employees no longer eligible for the Pre-2003 Program, as well as employees hired on or after January 1, 2003, are eligible for certain credits under the HP Retirement Medical Savings Account Plan (“RMSA Plan”) upon attaining age 45. Upon retirement, former employees may use credits under the RMSA Plan for the reimbursement of certain eligible medical expenses, including premiums required for participation in the HP Retiree Medical Program. Also, HP limited future eligibility for the pre-2003 HP Retiree Medical Program to those employees who were within five years of satisfying the program’s retirement criteria on June 30, 2007. Defined Contribution Plans HP offers various defined contribution plans for U.S. and non-U.S. employees. Total defined contribution expense was $481 million in fiscal 2007, $430 million in fiscal 2006 and $422 million in fiscal 2005. U.S. employees are automatically enrolled in the Hewlett-Packard Company 401(k) Plan (the “HP 401(k) Plan”) when they meet eligibility requirements, unless they decline participation. During fiscal 2007, HP matched employee contributions to the HP 401(k) Plan with cash contributions up to a maximum of 6% of eligible compensation. Effective January 1, 2008, all U.S. employees will be eligible for a 6% HP matching contribution. 124 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) Effective January 31, 2004, HP designated the HP Stock Fund, an investment option under the HP 401(k) Plan, as an Employee Stock Ownership Plan and, as a result, participants in the HP Stock Fund may receive dividends in cash or may reinvest such dividends into the HP Stock Fund. HP paid approximately $9 million, $10 million and $12 million in dividends for the HP common shares held by the HP Stock Fund in fiscal 2007, 2006 and 2005, respectively. HP records the dividends as a reduction of retained earnings in the Consolidated Statements of Stockholders’ Equity. The HP Stock Fund held approximately $28 million shares of HP common stock at October 31, 2007. Implementation of SFAS 158 SFAS 158 requires that the funded status of defined benefit postretirement plans be recognized on the company’s balance sheet and changes in the funded status be reflected in comprehensive income, effective for fiscal years ending after December 15, 2006, which HP adopted effective October 31, 2007. SFAS 158 also requires companies to measure the funded status of the plan as of the date of their fiscal year-end, effective for fiscal years ending after December 15, 2008. HP expects to adopt the measurement provisions of SFAS 158 effective October 31, 2009. The following table summarizes the financial impact stemming from the initial adoption of SFAS 158: Before application of SFAS 158 Adjustments In millions After application of SFAS 158 Other long-term assets (including pension assets).................... Deferred tax assets, long-term .................................................. Total assets ............................................................................... Pension, post-retirement, and post-employment liabilities ................................................................................... Deferred tax liabilities, long-term............................................. Total liabilities.......................................................................... Accumulated other comprehensive income .............................. Total stockholders’ equity ........................................................ $3,431 $1,040 $88,301 $1,739 $223 $50,243 $91 $38,058 $477 $(79) $398 $(244) $174 $(70) $468 $468 $3,908 $961 $88,699 $1,495 $397 $50,173 $559 $38,526 The following table summarizes the pre-tax net experience (gain) / loss and prior service cost / (benefit) recognized in accumulated other comprehensive income for the company’s defined benefit and postretirement benefit plans as of October 31, 2007. U.S. Defined Benefit Plans Non-U.S. Defined Benefit Plans In millions Post-Retirement Benefit Plans Net experience (gain) loss ................................. Prior service cost (benefit)................................. Total recognized in accumulated other comprehensive (income) loss ............................ $(450) (1) $(451) $104 (96) $8 $214 (462) $(248) 125 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) The following table summarizes the experience (gain) / loss and prior service cost / (benefit) that will be amortized from accumulated other comprehensive income and recognized as components of net periodic benefit cost / (credit) during the next fiscal year. U.S. Defined Benefit Plans Net experience (gain) loss ...................................................... Prior service cost (benefit)...................................................... Total recognized in accumulated other comprehensive (gain) loss...................................................................................... $(36) — $(36) Pension and Post-Retirement Benefit Expense Non-U.S. Defined Benefit Plans In millions $2 (8) $(6) Post-Retirement Benefit Plans $19 (56) $(37) HP’s net pension and post-retirement benefit costs were as follows for the following fiscal years ended October 31: Service cost............................................ Interest cost............................................ Expected return on plan assets............... Amortization and deferrals: Actuarial (gain) / loss.......................... Prior service cost (benefit) .................. Net periodic benefit cost ........................ Curtailment (gain) / loss...................... Settlement loss / (gain)........................ Special termination benefits................ Net benefit (gain) / cost ......................... 2007 $130 260 (355) (13) — 22 (541) 8 307 $(204) U.S. Defined Benefit Plans 2006 2005 2007 Non-U.S. Defined Benefit Plans 2006 In millions 2005 Post-Retirement Benefit Plans 2006 2007 2005 $177 276 (361) $338 275 (290) 38 (14) 2 1 79 363 — (199) — 352 $516 (46) — $33 $261 366 (579) 87 (7) 128 (13) 4 4 $123 $299 325 (495) 136 (3) 262 1 2 12 $277 $236 304 (412) 104 (1) 231 — 1 3 $235 $31 77 (38) 26 (54) 42 (26) — 60 $76 $32 84 (34) $63 98 (32) 35 39 (18) (55) 146 66 — (24) — — — 55 $201 $42 The weighted average assumptions used to calculate net benefit cost were as follows for the following fiscal years ended October 31: Discount rate................................................................. Average increase in compensation levels ..................... Expected long-term return on assets ............................. U.S. Defined Benefit Plans 2006 Non-U.S. Defined Benefit Plans 2005 2006 2007 5.9% 5.9% 5.7% 4.4% 4.2% 4.9% 5.8% 5.8% 5.6% 4.0% 4.0% 4.0% 3.3% 3.7% 3.7% — — 8.3% 8.3% 8.3% 6.7% 6.7% 6.7% 8.3% 8.3% 8.3% Post-Retirement Benefit Plans 2006 2007 2005 2007 2005 — As a result of the restructuring plans implemented in fiscal 2007, HP re-measured its U.S. defined benefit plan and post- retirement benefit plan obligations. The 2007 discount rates outlined in the table 126 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) above are those rates used by HP in conducting each of the respective plan re-measurements and reflect the weighted-average rate across all measurement periods. The medical cost and related assumptions used to calculate the net post-retirement benefit cost for the following fiscal years ended October 31 were as follows: 2005 Current medical cost trend rate ................................................................................................................ 8.5% 9.5% 10.5% Ultimate medical cost trend rate .............................................................................................................. 5.5% 5.5% 5.5% 2010 Year the medical cost rate reaches ultimate trend rate............................................................................. 2010 2010 2006 2007 A 1.0 percentage point increase in the medical cost trend rate would have increased the fiscal 2007 service and interest components of the post-retirement benefit costs by $1.8 million, while a 1.0 percentage point decrease would have resulted in a decrease of $2.2 million in the same period. 127 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) Funded Status The funded status of the defined benefit and post-retirement benefit plans was as follows for the following fiscal years ended October 31: U.S. Defined Benefit Plans Non-U.S. Defined Benefit Plans Post-Retirement Benefit Plans 2007 2006 2007 2006 2007 2006 Change in fair value of plan assets: Fair value—beginning of year ........................................... Acquisition/addition/deletion of plans ............................... Actual return on plan assets ............................................... Employer contributions...................................................... Participants’ contributions ................................................. Benefits paid ...................................................................... Settlements......................................................................... Currency impact................................................................. Fair value—end of year ..................................................... Change in benefit obligation: Projected benefit obligation—beginning of year ............... Acquisition/addition/deletion of plans ............................... Service cost........................................................................ Interest cost........................................................................ Participants’ contributions ................................................. Actuarial (gain) / loss......................................................... Benefits paid ...................................................................... Plan amendments ............................................................... Curtailment ........................................................................ Settlement .......................................................................... Special termination benefits............................................... Currency impact................................................................. Projected benefit obligation—end of year ............................ Plan assets greater (less) than benefit obligation .................. Unrecognized net experience (gain) loss .............................. Unrecognized prior service cost (benefit) related to plan amendments ....................................................................... Net prepaid (accrued) amount recognized ............................ Contributions after measurement date .................................. Net amount recognized ......................................................... Accumulated benefit obligation............................................ $4,325 $4,775 ———39 — 482 51 — (42) (941) — 4,325 667 124 — (299) (559) — 4,258 $4,688 $5,296 ———70 8 177 276 — (86) (42) (2) 10 (941) — — 4,688 (363) (142) 3 130 260 — 136 (299) — (681) (559) 307 — 3,982 276 — — In millions $8,367 $7,152 $448 669 145 88 (235) (62) 844 9,816 671 244 50 (199) (25) 435 8,367 68 56 42 (125) — — 489 $8,089 $7,566 $1,367 261 366 88 (811) (235) — (39) (62) 4 765 8,426 1,390 299 325 50 (393) (199) (48) (13) (25) 12 445 8,089 278 — 1,078 (92) — 31 77 42 (74) (125) (91) 21 — 60 7 1,323 (834) — — $426 — 43 67 37 (125) — — 448 $1,496 (34) 32 84 37 (151) (125) — 26 — — 2 1,367 (919) 346 (480) 276 — $276 $3,963 (502) — $(502) $4,066 1,390 13 $1,403 $7,677 1,264 25 $1,289 $7,264 (834) 6 $(828) (1,053) 4 $(1,049) 128 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) After the adoption of SFAS 158, the net amount recognized for HP’s defined benefit and post-retirement benefit plans in HP’s Consolidated Balance Sheet as of October 31, 2007 was as follows: Non-current assets ......................................................................... Current liability.............................................................................. Non-current liability ...................................................................... Net amount recognized .................................................................. $407 (15) (116) $276 In millions $1,751 (18) (330) $1,403 $— (70) (758) $(828) U.S. Defined Benefit Plans Non-U.S. Defined Benefit Plans Post-Retirement Benefit Plans The net amount recognized for HP’s defined benefit and post-retirement benefit plans was as follows for the fiscal year ended October 31, 2006(1): U.S. Defined Benefit Plans Non-U.S. Defined Benefit Plans In millions Post-Retirement Benefit Plans Prepaid benefit costs .................................................................... Pension, post-retirement and post-employment liabilities ........... Intangible asset............................................................................. Accumulated other comprehensive loss ....................................... Contribution after measurement date ........................................... Net amount recognized ................................................................ $— (502) — — — $(502) $1,527 (297) 4 30 25 $1,289 $— (1,053) — — 4 $(1,049) (1) Due to the adoption of SFAS 158, which was implemented at October 31, 2007, year-to-year comparability is not practical. The weighted average assumptions used to calculate the benefit obligation as of the September 30 measurement date were as follows: Discount rate....................................................................................................... Average increase in compensation levels ........................................................... Current medical cost trend rate ........................................................................... Ultimate medical cost trend rate ......................................................................... Year the rate reaches ultimate trend rate............................................................. U.S. Defined Benefit Plans Post-Retirement Benefit Plans Non-U.S. Defined Benefit Plans 2006 2007 2006 2007 2006 2007 6.2% 5.8% 5.1% 4.4% 6.2% 5.8% — 4.0% 4.0% 3.4% 3.3% — — — 7.5% 8.5% — — — 5.5% 5.5% 2010 — — — 2010 — — — — A 1.0 percentage point increase in the medical cost trend rate would have increased the total post-retirement benefit obligation reported at October 31, 2007 by $30 million, while a 1.0 percentage point decrease would have resulted in a decrease of $36 million. 129 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) Defined benefit plans with projected benefit obligations exceeding the fair value of plan assets were as follows: Aggregate fair value of plan assets ..................................................................................... Aggregate projected benefit obligation............................................................................... — $131 In millions $4,325 $422 $4,688 $776 $1,984 $2,411 Defined benefit plans with accumulated benefit obligations exceeding the fair value of plan assets were as follows: U.S. Defined Benefit Plans 2006 2007 Non-U.S. Defined Benefit Plans 2006 2007 U.S. Defined Benefit Plans 2006 2007 Non-U.S. Defined Benefit Plans 2006 2007 In millions Aggregate fair value of plan assets .............................................................................................. — — $116 $360 Aggregate accumulated benefit obligation .................................................................................. $124 $146 $350 $586 Plan Asset Allocations HP’s weighted-average target and asset allocations at the September 30 measurement date were as follows: U. S. Defined Benefit Plans Non-U.S. Defined Benefit Plans Post-Retirement Benefit Plans Asset Category Public equity securities .............. Private equity securities ............. Real estate and other.................. Equity-related investments ........ Public debt securities ................. Cash ........................................... Total........................................ Investment Policy 2007 Target Allocation Plan Assets Plan Assets 2007 Target Allocation 2007 2006 62.5% 70.5% 5.8% 3.4% 0.6% 0.3% 70% 68.9% 74.2% 28% 28.0% 25.8% — 2% 3.1% 100% 100% 100% 2006 2007 62.1% 63.5% — — 2.6% 6.5% 67% 68.6% 66.1% 33% 30.9% 33.4% 0.5% 100% 100.0% 100.0% — 0.5% 2007 Target Allocation Plan Assets 2007 2006 64.3% 66.8% 8.6% 11.5% 0.9% 0.7% 76% 76.7% 76.1% 21% 20.5% 23.9% 2.8% — 3% 100% 100.0% 100.0% HP’s investment strategy for worldwide plan assets is to seek a competitive rate of return relative to an appropriate level of risk. The majority of the plans’ investment managers employ active investment management strategies with the goal of outperforming the broad markets in which they invest. Risk management practices include diversification across asset classes and investment styles and periodic rebalancing toward asset allocation targets. A number of the plans’ investment managers are 130 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) authorized to utilize derivatives for investment purposes, and HP occasionally utilizes derivatives to effect asset allocation changes or to hedge certain investment exposures. The target asset allocation selected for each plan reflects a risk/return profile HP feels is appropriate relative to each plan’s liability structure and return goals. HP regularly conducts periodic asset-liability studies for U.S. plan assets in order to model various potential asset allocations in comparison to each plan’s forecasted liabilities and liquidity needs. HP invests a portion of the U.S. defined benefit plan assets and post-retirement benefit plan assets in private market securities such as venture capital funds, private debt and private equity to provide diversification and higher expected returns. Outside the United States, local regulations require different approaches to target asset allocations, resulting in a higher percentage allocation in fixed income securities. For each country outside the U.S., the local pension board decides on the target allocation after consideration of local regulations. HP’s corporate office acts in a governance role in periodically reviewing investment strategy and providing a recommended list of investment managers for each country plan. Basis for Expected Long-Term Rate of Return on Plan Assets The expected long-term rate of return on assets for each U.S. plan reflects the expected returns for each major asset class in which the plan invests, the weight of each asset class in the target mix, the correlations among asset classes and their expected volatilities. Expected asset class returns reflect the current yield on U.S. government bonds and risk premiums for each asset class. Because HP’s investment policy is to employ primarily active investment managers who seek to outperform the broader market, the asset class expected returns are adjusted to reflect the expected additional returns net of fees. In the beginning of fiscal 2008, HP implemented a liability-driven investment strategy for the U.S. defined benefit pension plan, which will be frozen by December 31, 2007 and is currently overfunded. As part of the strategy, HP has transitioned its equity allocation to predominantly fixed income assets. The expected return on the plan assets, used in calculating the net benefit cost, has been reduced from 8.3% to 6.3% for fiscal 2008 to reflect the changes in its asset allocation policy. The approach used to arrive at the expected rate of return on assets for the non-U.S. plans reflects the asset allocation policy of each plan to the expected country real returns for equity and fixed income investments. On an annual basis, HP gathers empirical data from the local country subsidiaries to determine expected long-term rates of return for equity and fixed income securities. HP then weights these expected real rates of return based on country specific allocation mixes adjusted for inflation. Future Contributions and Funding Policy In fiscal 2008, HP expects to contribute approximately $145 million to its pension plans and approximately $15 million to cover benefit payments to U.S. non-qualified plan participants. HP expects to pay approximately $80 million to cover benefit claims for HP’s post-retirement benefit plans. HP’s funding policy is to contribute cash to its pension plans so that it meets at least the minimum contribution requirements, as established by local government and funding and taxing authorities. In August 2006, the Pension Protection Act of 2006 (the “Act”) was enacted into law. The Act did not have any significant effect on HP’s current funding strategy for its U.S. pension plan. 131 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 15: Retirement and Post-Retirement Benefit Plans (Continued) Estimated Future Benefits Payable HP estimates that the future benefits payable for the retirement and post-retirement plans in place were as follows at October 31, 2007: U.S. Defined Benefit Plans Non-U.S. Defined Benefit Plans In millions Post-Retirement Benefit Plans(1) Fiscal year ending October 31 2008 .................................................... 2009 .................................................... 2010 .................................................... 2011 .................................................... 2012 .................................................... Next five fiscal years to October 31, $365 $269 $289 $316 $353 $204 $215 $228 $253 $272 2017................................................... $1,623 $1,809 $123 $115 $118 $121 $112 $584 (1) The estimated future benefits payable for the post-retirement plans are reflected net of the expected Medicare Part D subsidy. Note 16: Commitments HP leases certain real and personal property under non-cancelable operating leases. Certain leases require HP to pay property taxes, insurance and routine maintenance and include escalation clauses. Rent expense was approximately $767 million in fiscal 2007, $744 million in fiscal 2006 and $770 million in fiscal 2005. Sublease rental income was approximately $44 million in fiscal 2007, $47 million in fiscal 2006 and $43 million in fiscal 2005. Future annual minimum lease payments and sublease rental income commitments at October 31, 2007 were as follows: Minimum lease payments ...................................................................... Less: Sublease rental income ................................................................. 2008 2009 $595 (56) $539 $441 (57) $384 2010 2012 2011 In millions $320 $233 $176 (57) (34) (40) $263 $193 $142 Thereafter $428 (74) $354 At October 31, 2007, HP had unconditional purchase obligations of approximately $2.0 billion. These unconditional purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on HP and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. These unconditional purchase obligations are related principally to inventory and other items. Future unconditional purchase obligations at October 31, 2007 were as follows: Unconditional purchase obligations................................................... $1,826 $100 In millions $64 $12 $12 $15 2008 2009 2010 2011 2012 Thereafter 132 Note 17: Litigation and Contingencies HP is involved in lawsuits, claims, investigations and proceedings, including those identified below, consisting of intellectual property, commercial, securities, employment, employee benefits and environmental matters, which arise in the ordinary course of business. In accordance with SFAS No. 5, “Accounting for Contingencies”, HP records a provision for a liability when management believes that it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. HP believes it has adequate provisions for any such matters. HP reviews these provisions at least quarterly and adjusts these provisions to reflect the impact of negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular case. Based on its experience, HP believes that any damage amounts claimed in the specific matters discussed below are not a meaningful indicator of HP’s potential liability. Litigation is inherently unpredictable. However, HP believes that it has valid defenses with respect to legal matters pending against it. Nevertheless, it is possible that cash flows or results of operations could be materially affected in any particular period by the unfavorable resolution of one or more of these contingencies, or because of the diversion of management’s attention and the creation of significant expenses. Litigation, Proceedings and Investigations Copyright levies. As described below, proceedings are ongoing against HP in certain European Union (“EU”) member countries, including litigation in Germany, seeking to impose levies upon equipment (such as multifunction devices (“MFDs”) and printers) and alleging that these devices enable producing private copies of copyrighted materials. The total levies due, if imposed, would be based upon the number of products sold and the per-product amounts of the levies, which vary. Some EU member countries that do not yet have levies on digital devices are expected to implement similar legislation to enable them to extend existing levy schemes, while some other EU member countries are expected to limit the scope of levy schemes and applicability in the digital hardware environment. HP, other companies and various industry associations are opposing the extension of levies to the digital environment and advocating compensation to rights holders through digital rights management systems. VerwertungsGesellschaft Wort (“VG Wort”), a collection agency representing certain copyright holders, instituted non- binding arbitration proceedings against HP in June 2001 in Germany before the arbitration board of the Patent and Trademark Office. The proceedings relate to whether and to what extent copyright levies for photocopiers should be imposed in accordance with copyright laws implemented in Germany on MFDs that allegedly enable the production of copies by private persons. Following unsuccessful arbitration, VG Wort filed a lawsuit against HP in May 2004 in the Stuttgart Civil Court in Stuttgart, Germany seeking levies on MFDs sold from 1997 to 2001. On December 22, 2004, the court held that HP is liable for payments regarding MFDs sold in Germany, and ordered HP to pay VG Wort an amount equal to 5% of the outstanding levies claimed plus interest on MFDs sold in Germany up to December 2001. VG Wort appealed this decision. On July 6, 2005, the Stuttgart Court of Appeals ordered HP to pay VG Wort levies based on the published tariffs for photocopiers in Germany (which range from EUR 38.35 to EUR 613.56 per unit) plus interest on MFDs sold in Germany up to December 2001. HP has appealed the Stuttgart Court of Appeals’ decision to the Bundesgerichtshof (the German Federal Supreme Court). An oral hearing has been set for January 30, 2008. On September 26, 2005, VG Wort filed an additional lawsuit against HP in the Stuttgart Civil Court in Stuttgart, Germany seeking levies on MFDs sold in Germany between 1997 and 2001, as well 133 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) as for products sold from 2002 onwards. On July 26, 2007, the court issued a decision following the ruling of the Stuttgart Court of Appeals with respect to the initial VG Wort lawsuit as described above. HP has appealed the decision. The Appeal Court has stayed the proceedings pending the German Federal Supreme Court judgment in the initial VG Wort lawsuit seeking levies on MFDs described above. In July 2004, VG Wort filed a separate lawsuit against HP in the Stuttgart Civil Court seeking levies on printers. On December 22, 2004, the court held that HP is liable for payments regarding all printers using ASCII code sold in Germany but did not determine the amount payable per unit. HP appealed this decision in January 2005 to the Higher Regional Court of Baden Wuerttemberg. On May 11, 2005, the Higher Regional Court issued a decision confirming that levies are due. On June 6, 2005, HP filed an appeal to the German Federal Supreme Court in Karlsruhe. On December 6, 2007 the German Federal Supreme Court issued a judgment that printers are not subject to levies under the existing law. The court has not yet issued a written decision, and VG Wort has indicated that it is considering a claim to the German Federal Constitutional Court. In September 2003, VG Wort filed a lawsuit against Fujitsu Siemens Computer GmbH (“FSC”) in Munich State Court seeking levies on PCs. This is an industry test case in Germany, and HP has agreed not to object to the delay if VG Wort sues HP for such levies on PCs following a final decision against FSC. On December 23, 2004, the Munich State Court held that PCs are subject to a levy and that FSC must pay 12 euros plus compound interest for each PC sold in Germany since March 2001. FSC appealed this decision in January 2005 to the Higher Regional Court of Bavaria. On December 15, 2005, the Higher Regional Court affirmed the Munich State Court decision. FSC filed an appeal with the German Federal Supreme Court in February 2006. On December 29, 2005, ZPU, a joint association of various German collection societies, instituted non-binding arbitration proceedings against HP before the arbitration board of the Patent and Trademark Office demanding reporting of every PC sold by HP in Germany from January 2002 through December 2005 and seeking a levy of 18.42 euros plus tax for each PC sold during that period. HP filed a notice of defense in connection with these proceedings in February 2006, and an arbitration hearing was held in December 2006. On August 3, 2007, the arbitration board issued a ruling proposing a levy of 15 euros plus tax for each PC sold during that period. HP has rejected the ruling of the arbitration board, and the arbitration proceedings have concluded. ZPU has indicated it will pursue the claim through the regular courts. Based on industry opposition to the extension of levies to digital products, HP’s assessments of the merits of various proceedings and HP’s estimates of the units impacted and levies, HP has accrued amounts that it believes are adequate to address the matters described above. However, the ultimate resolution of these matters and the associated financial impact on HP, including the number of units impacted, the amount of levies imposed and the ability of HP to recover such amounts through increased prices, remains uncertain. Alvis v. HP is a defective product consumer class action filed in the District Court of Jefferson County, Texas in April 2001. In February 2000, a similar suit captioned LaPray v. Compaq was filed in the District Court of Jefferson County, Texas. The basic allegation is that HP and Compaq sold computers containing floppy disk controllers that fail to alert the user to certain floppy disk controller errors. That failure is alleged to result in data loss or data corruption. The complaints in Alvis and LaPray seek injunctive relief, declaratory relief, unspecified damages and attorneys’ fees. In July 2001, a 134 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) nationwide class was certified in the LaPray case, which the Beaumont Court of Appeals affirmed in June 2002. The Texas Supreme Court reversed the certification and remanded to the trial court in May 2004. On March 29, 2005, the Alvis trial court certified a Texas-wide class action for injunctive relief only, which HP appealed on April 15, 2005. HP’s appeal in the Alvis case is still pending. On June 4, 2003, each of Barrett v. HP and Grider v. Compaq was filed in the District Court of Cleveland County, Oklahoma, with factual allegations similar to those in Alvis and LaPray. The complaints in Barrett and Grider seek, among other things, specific performance, declaratory relief, unspecified damages and attorneys’ fees. On December 22, 2003, the District Court entered an order staying the Barrett case until the conclusion of Alvis. On September 23, 2005, the District Court granted the Grider plaintiffs’ motion to certify a nationwide class action which the Oklahoma Court of Civil Appeals affirmed on October 13, 2006. On November 5, 2006, HP filed a Petition for Writ of Certiorari with the Oklahoma Supreme Court seeking reversal of the lower courts’ decisions. That petition was denied on March 26, 2007. The Grider case is scheduled for trial in April of 2008. On November 5, 2004, Batiste v. HP (formerly Scott v. HP), and on January 27, 2005, Schultz v. HP (formerly Jurado v. HP), were filed in state court in San Joaquin County, California, with factual allegations similar to those in LaPray and Alvis, seeking certification of a California-only class, injunctive relief, unspecified damages (including punitive damages), restitution, costs, and attorneys’ fees. On November 27, 2006, the trial court granted plaintiff’s motion for class certification and certified the Schultz case as a California-only class. On March 26, 2007, HP filed a Petition for Writ of Mandate with the California Supreme Court; that petition was summarily denied on May 9, 2007. On December 11, 2007, the court in the Grider v. Compaq and Barrett v. HP cases preliminarily approved a settlement under which the Grider, Barrett, Alvis, LaPray, Schultz and Batiste class actions will be dismissed with prejudice. Under the proposed settlement, eligible class members will each have the right to obtain a redemption certificate for use in purchasing a PC through HP’s website; a USB flash drive as long as the class member meets certain requirements; and a software patch designed to address the alleged defect at issue in the lawsuits. In addition, class counsel and the class representatives will be paid attorneys’ fees and expenses and stipends in an amount that is yet to be finally approved by the court. As of October 31, 2007, HP had established adequate reserves to cover the costs associated with the settlement, including the anticipated attorneys’ fees and expenses and stipends. The court has scheduled a hearing for April 29, 2008 to determine whether to grant final approval of the settlement. In addition, the Civil Division of the Department of Justice, the General Services Administration Office of Inspector General and other Federal agencies are conducting an investigation of allegations that HP and Compaq made, or caused to be made, false claims for payment to the United States for computers known by HP and Compaq to contain defective parts or otherwise to perform in a defective manner relating to the same alleged floppy disk controller errors. HP’s agreement with the Department of Justice to extend the statute of limitations on its investigation expired on December 6, 2006. HP is cooperating fully with this investigation. Barbara’s Sales, et al. v. Intel Corporation, Hewlett-Packard Company, et al. and Neubauer, et al. v. Compaq Computer Corporation are separate lawsuits filed on June 3, 2002 in the Circuit Court, Third Judicial District, Madison County, Illinois, alleging that HP and Compaq (along with Intel) misled the public by suppressing and concealing the alleged material fact that systems that use the Intel Pentium 4 processor are less powerful and slower than systems using the Intel Pentium III processor and processors made by a competitor of Intel. The plaintiffs seek unspecified damages, restitution, attorneys’ fees and costs, and certification of a nationwide class. The trial court in the HP action certified an Illinois class as to Intel but denied a nationwide class. Both parties appealed the trial 135 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) court’s decision. On July 25, 2006, the Fifth District Appellate Court ruled that the trial court erred in applying Illinois law in deciding to certify the Illinois class and to deny certification of the nationwide class and directed the trial court to reconsider those decisions applying California law instead. On August 28, 2006, Intel appealed the Fifth District’s decision to the Illinois Supreme Court. On November 29, 2007, the Illinois Supreme Court reversed certification of the nationwide class, held that no statewide class could be certified under Illinois law, and remanded the case back to the trial court. Skold, et al. v. Intel Corporation and Hewlett-Packard Company is a lawsuit to which HP was joined on June 14, 2004 that was initially filed in state court in Alameda County, California, based upon factual allegations similar to those in the Illinois cases. The plaintiffs in the Skold matter also seek unspecified damages, restitution, attorneys’ fees and costs, and certification of a nationwide class. The Skold case has since been transferred to state court in Santa Clara County, California. Feder v. HP (formerly Tyler v. HP) is a lawsuit filed in the United States District Court for the Northern District of California on June 16, 2005 asserting breach of express and implied warranty, unjust enrichment, violation of the Consumers Legal Remedies Act and deceptive advertising and unfair business practices in violation of California’s Unfair Competition Law. Among other things, plaintiffs alleged that HP employed a “smart chip” in certain inkjet printing products in order to register ink depletion prematurely and to render the cartridge unusable through a built-in expiration date that is hidden, not documented in marketing materials to consumers, or both. Plaintiffs also contend that consumers received false ink depletion warnings and that the smart chip limits the ability of consumers to use the cartridge to its full capacity or to choose competitive products. On September 6, 2005, a lawsuit captioned Ciolino v. HP was filed in the United States District Court for the Northern District of California. The allegations in the Ciolino case are substantively identical to those in Feder, and the two cases have been formally consolidated in a single proceeding in the District Court for the Northern District of California under the caption In re HP Inkjet Printer Litigation. In addition, on January 17, 2007, an additional lawsuit captioned Blennis v. HP was filed in the United States District Court for the Northern District of California with allegations substantially the same as those consolidated in In re Inkjet Printer Litigation. The plaintiffs seek class certification, restitution, damages (including enhanced damages), injunctive relief, interest, costs, and attorneys’ fees. Three related lawsuits filed in California state court, Tyler v. HP (filed in Santa Clara County on February 17, 2005), Obi v. HP (filed in Los Angeles County on February 17, 2005), and Weingart v. HP (filed in Los Angeles County on March 18, 2005), have been dismissed without prejudice by the plaintiffs. In addition, two related lawsuits filed in federal court, namely Grabell v. HP (filed in the District of New Jersey on March 18, 2005) and Just v. HP (filed in the Eastern District of New York on April 20, 2005), have been dismissed without prejudice by the plaintiffs. Substantially similar allegations have been made against HP and its subsidiary, Hewlett-Packard (Canada) Co., in four Canadian class actions, one commenced in British Columbia in February 2006, two commenced in Quebec in April 2006 and May 2006, respectively, and one commenced in Ontario in June 2006, all seeking class certification, restitution, declaratory relief, injunctive relief and unspecified statutory, compensatory and punitive damages. Schorsch v. HP is a consumer class action filed against HP on October 28, 2003 in Illinois state court alleging that HP has included an electrically erasable programmable read only memory (EEPROM) chip in certain of its LaserJet printers that prematurely advises the user that the drum kit needs replacing in violation of Illinois state law. The plaintiffs subsequently filed an amended complaint seeking to expand the class from purchasers of drum kits to purchasers of all HP printer consumables 136 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) that contain EEPROM chips. The most current amended complaint seeks certification of an Illinois-only class and seeks unspecified damages, attorneys’ fees and costs. On June 6, 2007, a separate consumer class action lawsuit captioned Baggett v. HP was filed in the United States District Court for the Central District of California containing similar allegations that HP employs a technology in its LaserJet color printers whereby the printing process shuts down prematurely, preventing customers from using the toner that is stranded in the cartridge. The plaintiffs allege that HP fails to disclose to consumers that they will be unable to utilize the toner remaining in the cartridge after the printer shuts down. The complaint seeks certification of a nationwide class of purchasers of all HP LaserJet color printers and seeks unspecified damages, restitution, disgorgement, injunctive relief, attorneys’ fees and costs. Rich v. HP is a consumer class action filed against HP on May 22, 2006 in the United States District Court for the Northern District of California. The suit alleges that HP designed its color inkjet printers to unnecessarily use color ink in addition to black ink when printing black and white images and text. The plaintiffs seek injunctive and monetary relief on behalf of a nationwide class. The Court has granted HP’s motion to dismiss several of the plaintiffs’ claims, and HP answered the remaining claims in February 2007. On December 27, 2001, Cornell University and the Cornell Research Foundation, Inc. filed a complaint, amended on September 6, 2002, against HP in United States District Court for the Northern District of New York alleging that HP’s PA- RISC 8000 family of microprocessors, and servers and workstations incorporating those processors, infringe a patent assigned to Cornell Research Foundation, Inc. that describes a way of executing microprocessor instructions. The complaint seeks declaratory and injunctive relief and unspecified damages. On March 26, 2004, the district court issued a ruling interpreting the disputed claim terms in the patent at issue. HP filed five motions for summary judgment on September 29, 2006. The district court ruled on those motions September 24, 2007, eliminating certain patent claims but otherwise allowing the case to proceed to trial. The patent at issue in this litigation, United States Patent No. 4,807,115, expired on February 21, 2006. Therefore, the plaintiffs are no longer entitled to seek injunctive relief against HP. No trial date has been set. Digwamaje et al. v. Bank of America et al. is a purported class action lawsuit that names HP and numerous other multinational corporations as defendants. It was filed on September 27, 2002 in United States District Court for the Southern District of New York on behalf of current and former South African citizens and their survivors who suffered violence and oppression under the apartheid regime. The lawsuit alleges that HP and other companies helped perpetuate, profited from, and otherwise aided and abetted the apartheid regime during the period from 1948-1994 by selling products and services to agencies of the South African government. Claims are based on the Alien Tort Claims Act, the Torture Victims Protection Act, the Racketeer Influenced and Corrupt Organizations Act and state law. The complaint seeks, among other things, an accounting, the creation of a historic commission, compensatory damages in excess of $200 billion, punitive damages in excess of $200 billion, costs and attorneys’ fees. On November 29, 2004, the District Court dismissed with prejudice the plaintiffs’ complaint. On October 12, 2007, the United States Court of Appeals for the Second Circuit affirmed in part and reversed in part the District Court’s decision. The Second Circuit affirmed the dismissal of the plaintiffs’ claims under the Torture Victims Protection Act, but reversed the District Court’s dismissal of the plaintiffs’ Alien Tort Claims Act claims, finding that it was possible for the plaintiffs to state such 137 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) a claim. The Second Circuit, therefore, remanded the case to the District Court to permit the plaintiffs to attempt to plead the allegations needed to state a claim under the Alien Tort Claims Act. CSIRO Patent Litigation. Microsoft Corporation, Hewlett-Packard Company, et al. v. Commonwealth Scientific and Industrial Research Organisation of Australia is an action filed by HP and two other plaintiffs on May 9, 2005 in the District Court for the Northern District of California seeking a declaratory judgment against Commonwealth Scientific and Industrial Research Organisation of Australia (“CSIRO”) that HP’s products employing the IEEE 802.11a and 8.02.11g wireless protocol standards do not infringe CSIRO’s US patent no. 5,487,069 relating to wireless transmission of data at frequencies in excess of 10GHz. On September 22, 2005, CSIRO filed an answer and counterclaims alleging that all HP products which employ those wireless protocol standards infringe the CSIRO patent and seeking damages, including enhanced damages and attorneys fees and costs, and an injunction against sales of infringing products. On December 12, 2006, CSIRO successfully moved to have the case transferred to the District Court of the Eastern District of Texas, a court that has granted CSIRO’s motions for summary judgment on the issues of validity and patent infringement and a permanent injunction in favor of CSIRO in a patent infringement action brought by CSIRO against a third party vendor of wireless networking products based on the same patent. On June 15, 2007, CSIRO filed an amended answer and counterclaims adding the allegation that all HP products which employ the draft IEEE 802.11n wireless protocol infringe the CSIRO patent. Trial is scheduled for April 2009. Polaroid Corp. v. HP is a lawsuit filed against HP by Polaroid Corporation on December 2006 in the United States District Court for the District of Delaware. The lawsuit involves a single U.S. patent that will expire in April 2008. Polaroid alleges that certain HP products containing “Digital Flash” or “Adaptive Lighting” technology infringe Polaroid’s U.S. Patent No. 4,829,381 relating to a system and method for continuously enhancing electronic images by varying the contrast in different portions of the image. Polaroid seeks monetary relief. A trial is scheduled for December 2008. Tandberg Data Corporation v. HP: In January 2006, Exabyte Corporation, which has since been acquired by Tandberg Data Corporation, sued HP in the United States District Court for the District of Colorado. The plaintiff alleges that a particular HP tape drive infringes a patent that describes an apparatus and method for recovering data from a distorted tape by rewinding and replaying the tape at a slower speed. The complaint seeks injunctive relief and unspecified damages. In June 2006, HP asserted counterclaims against the plaintiff and is now asserting two HP patents relating to tape drive technology. HP seeks injunctive relief and unspecified damages for the plaintiff’s alleged infringement. A claim construction hearing is scheduled for January 2008, and a trial is scheduled for September 2008. Convolve, Inc. and Massachusetts Institute of Technology v. Compaq Computer Corporation and Seagate Technology, Inc. In July 2000, Compaq and Seagate were sued in the United States District court for the Southern District of New York by MIT and a small technology company named Convolve. Convolve accused Compaq and Seagate of misappropriating certain confidential information and infringing certain patents in Seagate’s development of certain disk drive products and Compaq’s development of a user interface. MIT and Convolve are owners of one of the patents at issue. With respect to one of the patents, the accused feature is contained within the Seagate drive procured by Compaq, not in Compaq’s own designs or products; therefore, Seagate is taking the lead in defending against Convolve’s claims. The second patent relates to a user interface that HP has removed from its 138 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) products. Seagate has agreed to indemnify HP with respect to one patent; HP has requested but not received indemnification from Seagate with respect to the second. Pre-trial discovery is ongoing. A claim construction hearing was held on March 30- 31, 2004; the court issued its ruling on August 10, 2005. No trial date has been set. The United States of America, ex rel. Norman Rille and Neal Roberts v. Hewlett-Packard Company, et al. In 2004, two private individuals filed a civil “qui tam” complaint under the False Claims Act in the United States District Court for the Eastern District of Arkansas containing generalized allegations that HP and several other companies participated in an industry-wide practice of using partnership and alliance programs to make improper payments and cause the submission of false claims in connection with contracts to provide products and services to the federal government. On April 12, 2007, the U.S. Department of Justice intervened in the qui tam action and filed a complaint against HP (and several other companies in separate actions) on behalf of the United States containing allegations that HP violated the False Claims Act and the Anti- Kickback Act of 1986 by providing millions of dollars in kickbacks to its alliance partners, including “influencer fees” and “new business opportunity rebates.” The U.S. complaint further alleges that HP violated the False Claims Act and the Anti- Kickback Act, breached its federal government contracts, induced the federal government to make payments to HP to which HP was not entitled to receive under those contracts, and was unjustly enriched by expressly or impliedly making false statements, records or certifications to the federal government that it complied with and would continue to comply with the Anti-Kickback Act and by submitting claims to the government that allegedly were inflated because they included the amounts of the influencer fees and new business opportunity rebates. The U.S. complaint seeks treble damages plus civil penalties in connection with the alleged violations of the False Claims Act, double damages plus civil penalties in connection with the alleged violations of the Anti-Kickback Act and disgorgement of profits earned in connection with the breach of contract and unjust enrichment claims. Leak Investigation Proceedings. As described below, HP is or has been the subject of various governmental inquiries concerning the processes employed in an investigation into leaks of HP confidential information to members of the media that concluded in May 2006: • In August 2006, HP was informally contacted by the Attorney General of the State of California requesting information concerning the processes employed in the leak investigation. On December 7, 2006, HP announced that it has entered into an agreement with the California Attorney General to resolve civil claims arising from the leak investigation, including a claim made by the California Attorney General in a Santa Clara County Superior Court action filed on December 7, 2006 that HP committed unfair business practices under California law in connection with the leak investigation. As a result of this agreement, which includes an injunction, the California Attorney General will not pursue civil claims against HP or its current and former directors, officers and employees. Under the terms of the agreement, HP paid a total of $14.5 million and agreed to implement and maintain for five years a series of measures designed to ensure that HP’s corporate investigations are conducted in accordance with California law and the company’s high ethical standards. Of the $14.5 million, $13.5 million has been used to create a Privacy and Piracy Fund to assist California prosecutors in investigating and prosecuting consumer privacy and information piracy violations, $650,000 was used to pay statutory damages and $350,000 reimbursed the California Attorney General’s office for its investigation costs. There was no finding of liability against HP as part of the settlement. 139 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) • Beginning in September 2006, HP has received requests from the Committee on Energy and Commerce of the U.S. House of Representatives (the “Committee”) for records and information concerning the leak investigation, securities transactions by HP officers and directors, including an August 25, 2006 securities transaction by Mark Hurd, HP’s Chairman and Chief Executive Officer, and related matters. HP has responded to those requests. In addition, Mr. Hurd voluntarily gave testimony before the Committee regarding the leak investigation on September 28, 2006. • In September 2006, HP was informally contacted by the U.S. Attorney for the Northern District of California requesting similar information concerning the processes employed in the leak investigation. HP is responding to that request. • Beginning in September 2006, HP has received requests from the Division of Enforcement of the Securities and Exchange Commission for records and information and interviews with current and former HP directors and officers relating to the leak investigation, the resignation of Thomas J. Perkins from HP’s Board of Directors, HP’s May 22, 2006 and September 6, 2006 filings with the SEC on Form 8-K, stock repurchases by HP and securities transactions by its officers and directors that occurred between May 1 and October 1, 2006, and HP’s policies, practices and approval of securities transactions. In May 2007, HP consented to the entry of an order by the SEC ordering HP to cease and desist from committing or causing violations of the public reporting requirements of the Securities Exchange Act of 1934, as amended. HP has been advised by the staff of the Division of Enforcement that the staff has completed its investigation and does not intend to recommend that any other SEC enforcement action be brought in connection with these matters. • In September 2006, HP received a request from the U.S. Federal Communications Commission for records and information relating to the processes employed in the leak investigation. HP has responded to that request. HP is continuing to cooperate fully with all ongoing inquiries and investigations. In addition, four stockholder derivative lawsuits have been filed in California purportedly on behalf of HP stockholders seeking to recover damages for alleged breach of fiduciary duty and to require HP to improve its corporate governance and internal control procedures as a result of the activities of the leak investigation: Staehr v. Dunn, et al. was filed in Santa Clara County Superior Court on September 18, 2006; Worsham v. Dunn, et al. was filed in Santa Clara County Superior Court on September 14, 2006; Tansey v. Dunn, et al. was filed in Santa Clara County Superior Court on September 20, 2006; and Hall v. Dunn, et al. was filed in Santa Clara County Superior Court on September 25, 2006. On October 19, 2006, the Santa Clara County Superior Court consolidated the four California cases under the caption In re Hewlett-Packard Company Derivative Litigation. The consolidated complaint filed on November 19, 2006 also seeks to recover damages in connection with sales of HP stock alleged to have been made by certain current and former HP officers and directors while in possession of material non-public information. Two additional stockholder derivative lawsuits, Pifko v. Babbio, et al., filed on September 19, 2006, and Gross v. Babbio, et al., filed on November 21, 2006, were filed in Chancery Court, County of New Castle, Delaware, both of which seek to recover damages for alleged breaches of fiduciary duty and to obtain an order instructing the defendants to refrain from further breaches of fiduciary duty and to implement corrective measures that will prevent future occurrences of the alleged breaches of fiduciary duty. On January 24, 2007, the Delaware court 140 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) consolidated the two cases under the caption In re Hewlett-Packard Company Derivative Litigation and subsequently stayed the proceedings, as the parties have reached a tentative settlement. The HP Board of Directors has appointed a Special Litigation Committee consisting of independent Board members authorized to investigate, review and evaluate the facts and circumstances asserted in these derivative matters and to determine how HP should proceed in these matters. On December 14, 2007, HP and the plaintiffs in the California and Delaware derivative actions entered into an agreement to settle those lawsuits, which agreement is subject to the approval of the California and Delaware courts before it becomes final. Under the terms of the proposed settlement, HP has agreed to continue certain corporate governance changes until December 31, 2012 and to pay the plaintiffs’ attorneys’ fees. Mercury Interactive Corporation Proceedings. In November 2006, HP completed its acquisition of Mercury Interactive Corporation (“Mercury”). Upon completion of the acquisition, HP assumed oversight for all litigation and regulatory matters pending or subsequently commenced against Mercury. The following Mercury-related litigation and regulatory inquiries currently are pending: • Prior to the announcement of the acquisition, and beginning on or about August 19, 2005, four securities class action lawsuits were filed against Mercury and certain of its officers and directors on behalf of purchasers of Mercury’s stock from October 2003 to November 2005: Archdiocese of Milwaukee Supporting Fund, Inc. v. Mercury Interactive, et al, Johnson v. Mercury Interactive, et al., Munao v. Mercury Interactive, et al., and Public Employees’ Retirement System of Mississippi v. Mercury Interactive, et al. These class action lawsuits were consolidated in the United States District Court for the Northern District of California as In re Mercury Interactive Corporation Securities Litigation. The consolidated complaint filed on September 8, 2006 alleges that, during the putative class period of October 17, 2000 through November 1, 2005, the defendants made false or misleading public statements regarding Mercury’s business and operations in violation of Section 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder and seeks unspecified monetary damages and other relief. On July 30, 2007, the court granted the defendants’ motion to dismiss the consolidated complaint with leave to amend. On October 15, 2007, HP and counsel for the plaintiffs reached an agreement in principle to settle the consolidated class action lawsuit. The agreement, if finalized and approved by the court, provides for HP to pay an aggregate of $117.5 million to administer the settlement, to compensate the class, and to pay attorneys’ fees. • On February 26, 2007, HP received a request from the Permanent Subcommittee on Investigations of the U.S. Senate Committee on Homeland Security and Governmental Affairs for information relating to Mercury’s past executive compensation and stock option granting policies and procedures, including information about the practice of backdating the grant date of options that allegedly occurred before HP acquired Mercury. HP has responded to the Subcommittee’s request and intends to cooperate with the inquiry. European Commission OEM Investigation. In May 2002, the European Commission of the EU publicly stated that it was considering conducting an investigation into original equipment manufacturer (“OEM”) activities concerning the sales of printers and supplies to consumers within the EU. The European Commission contacted HP requesting information on the printing systems businesses. HP has cooperated fully in response to the initial inquiry and intends to cooperate fully with respect to subsequent requests for information. 141 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 17: Litigation and Contingencies (Continued) Environmental HP is party to, or otherwise involved in, proceedings brought by U.S. or state environmental agencies under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), known as “Superfund,” or state laws similar to CERCLA. HP is also conducting environmental investigations or remediations at several current or former operating sites pursuant to administrative orders or consent agreements with state environmental agencies. It is our policy to apply strict standards for environmental clean-up to sites outside the United States, even where we are not required to do so under applicable local laws and regulations. The European Union (“EU”) adopted the Waste Electrical and Electronic Equipment Directive in January 2003. The directive makes producers of electrical goods, including computers and printers, financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. The deadline for the individual member states of the EU to enact legislation implementing the directive in their respective countries was August 13, 2004 (such legislation, together with the directive, the “WEEE Legislation”). The EU member states were obliged to make producers participating in the market financially responsible for implementing these responsibilities under the WEEE Legislation beginning in August 2005. Implementation in certain of the member states has been delayed into 2007. Similar legislation has been or may be enacted in other jurisdictions, including in the United States, Canada, Mexico, China and Japan. HP is continuing to evaluate the impact of and take steps to comply with the WEEE Legislation and similar legislation in other jurisdictions as individual countries issue their implementation legislation and guidance. The liability for environmental remediation and other environmental costs is accrued when it is considered probable and the costs can be reasonably estimated. We have accrued amounts in conjunction with the foregoing environmental issues that we believe was adequate as of October 31, 2007. These accruals were not material to our operations or financial position and we do not currently anticipate material capital expenditures for environmental control facilities. Note 18: Segment Information Description of Segments HP is a leading global provider of products, technologies, software, solutions and services to individual consumers, small and medium sized businesses (“SMBs”), and large enterprises including the public and education sectors. HP’s offerings span personal computing and other access devices; imaging and printing-related products and services; enterprise information technology (“IT”) infrastructure, including enterprise storage and server technology; software that optimizes business technology investments; and multi-vendor customer services, including technology support and maintenance, consulting and integration and outsourcing services. HP and its operations are organized into seven business segments: Enterprise Storage and Servers (“ESS”), HP Services (“HPS”), HP Software, the Personal Systems Group (“PSG”), the Imaging and Printing Group (“IPG”), HP Financial Services (“HPFS”), and Corporate Investments. HP’s organizational structure is based on a number of factors that management 142 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 18: Segment Information (Continued) uses to evaluate, view and run its business operations, which include, but are not limited to, customer base, homogeneity of products and technology. The business segments disclosed in the accompanying Consolidated Financial Statements are based on this organizational structure and information reviewed by HP’s management to evaluate the business segment results. ESS, HPS and HP Software are structured beneath a broader Technology Solutions Group (“TSG”). In order to provide a supplementary view of HP’s business, aggregated financial data for TSG is presented herein. HP has reclassified segment operating results for fiscal 2006 and fiscal 2005 to conform to certain fiscal 2007 organizational realignments. These realignments are immaterial in size and reflect primarily revenue shifts among business units within the same business segment. None of the changes impacts HP’s previously reported consolidated net revenue, earnings from operations, net earnings or net earnings per share. Future changes to this organizational structure may result in changes to the business segments disclosed. A description of the types of products and services provided by each business segment follows. Technology Solutions Group. Each of the business segments within TSG is described in detail below. • Enterprise Storage and Servers provides storage and server products. The various server offerings range from entry-level servers to high-end scalable servers, including Superdome servers. Industry standard servers include primarily entry-level and mid-range ProLiant servers, which run primarily Windows®(1), Linux and Novell operating systems and leverage Intel Corporation (“Intel”) and Advanced Micro Devices (“AMD”) processors. The business spans a range of product lines, including pedestal-tower servers, density-optimized rack servers and HP’s BladeSystem family of server blades. Business critical systems include Itanium®(2)-based Integrity servers running on HP-UX, Windows®, Linux and OpenVMS operating systems, including the high-end Superdome servers and fault-tolerant Integrity NonStop servers. Business critical systems also include the Reduced Instruction Set Computing (“RISC”)-based servers with the HP 9000 line running on the HP-UX operating system, HP AlphaServers running on both Tru64 UNIX®(3) and OpenVMS, and MIPs-based NonStop servers. HP’s StorageWorks offerings include entry-level, mid-range and high-end arrays, storage area networks (“SANs”), network attached storage (“NAS”), storage management software, and virtualization technologies, as well as tape drives, tape libraries and optical archival storage. • HP Services provides a portfolio of multi-vendor IT services including technology services, consulting and integration and outsourcing services. HPS also offers a variety of services tailored to particular industries such as communications, media and entertainment, manufacturing and distribution, financial services, health and life sciences and the public sector, including government services. HPS collaborates with the Enterprise Storage and Servers and HP Software, as well as with third-party system integrators and software and networking companies to bring solutions to HP customers. HPS also works with HP’s Imaging and Printing Group and Personal Systems Group to provide managed print services, end user workplace services, and mobile workforce productivity solutions to enterprise customers. Technology Services provides a range of services, including standalone product support and high availability services for complex, global, networked and multi-vendor environments. Technology Services also manages the delivery of product warranty support through its own service organization, as well as through (1) Windows® is a registered trademark of Microsoft Corporation. (2) Itanium® is a registered trademark of Intel Corporation. (3) UNIX® is a registered trademark of The Open Group. 143 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 18: Segment Information (Continued) authorized partners. Consulting and Integration provides services to architect, design and implement technology and industry-specific solutions for customers. Consulting and Integration also provides cross-industry solutions in the areas of architecture and governance, infrastructure, applications and packaged applications, security, IT service management, information management and enterprise Microsoft solutions. Outsourcing Services offers a variety of IT management and outsourcing services that support customers’ infrastructure, applications, business processes, end user workplace, print environment and business continuity and recovery requirements. • HP Software has OpenView and OpenCall businesses. OpenView, including Mercury’s product lines, provides a suite of Business Technology Optimization (“BTO”) software for automating key processes across critical IT functions, including strategy, applications, and operations. HP BTO software solutions help customers drive business results for a wide range of functional IT initiatives, including demand and portfolio management, service oriented architecture transformation, software quality management, business service management, IT service management, and IT infrastructure library. Under the OpenCall brand, HP Software also delivers a suite of solutions and platforms that enables service providers to develop and deploy next generation multimedia services including voice, data and video. HP’s other business segments are described below. • Personal Systems Group provides commercial PCs, consumer PCs, workstations, handheld computing devices, digital entertainment systems, calculators and other related accessories, software and services for the commercial and consumer markets. Commercial PCs are optimized for commercial uses, including enterprise and SMB customers, and for connectivity and manageability in networked environments. Commercial PCs include the HP Compaq business desktops, business notebooks and Tablet PCs. Consumer PCs are targeted at the home user and include the HP Pavilion and Compaq Presario series of multi-media consumer desktops and notebooks, as well as HP Media Center and Voodoo Gaming PCs. Workstations are individual computing products designed for users demanding enhanced performance, such as computer animation, engineering design and other programs requiring high-resolution graphics. Workstations run on UNIX®, Windows® and Linux-based operating systems. Handheld computing devices include a series of HP iPAQ handheld computing devices, ranging from Pocket PCs and navigation devices to smartphones and data devices, that run on Windows® Mobile software, and include software and support. Handheld computing also offers software and support that provide security and manageability of mobile devices. Digital entertainment products include plasma and LCD flat-panel televisions, HD DVD and RW drives, DVD writers, and the HP Digital Entertainment Center. • Imaging and Printing Group provides consumer and commercial printer hardware, printing supplies, printing media and scanning devices. IPG is also focused on imaging solutions in the commercial markets, from managed print services solutions to addressing new growth opportunities in commercial printing in areas such as industrial applications, outdoor signage, and the graphic arts business. Inkjet systems include desktop single function and inkjet all-in-one printers, including photo, productivity and business inkjet printers and scanners. Digital imaging products and services include photo specialty printers, photo kiosks, digital cameras, accessories and online photo services through Snapfish. LaserJet systems include monochrome and color 144 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 18: Segment Information (Continued) laser printers, printer-based MFDs and Total Print Management Solutions for enterprise customers. Graphics and Imaging products include large format (DesignJet) printers, Indigo and Scitex digital presses, digital publishing solutions and graphics printing solutions. Printer supplies include LaserJet toner and inkjet printer cartridges and other printing-related media such as HP-branded Vivera and ColorSphere ink and HP Premium and Premium Plus photo papers. • HP Financial Services supports and enhances HP’s global product and services solutions, providing a broad range of value-added financial life-cycle management services. HPFS enables HP’s worldwide customers to acquire complete IT solutions, including hardware, software and services. HPFS offers leasing, financing, utility programs, and asset recovery services, as well as financial asset management services, for large global and enterprise customers. HPFS also provides an array of specialized financial services to SMBs and educational and governmental entities. HPFS offers innovative, customized and flexible alternatives to balance unique customer cash flow, technology obsolescence and capacity needs. • Corporate Investments is managed by the Office of Strategy and Technology and includes HP Labs and certain business incubation projects. Revenue in this segment is attributable to the sale of certain network infrastructure products, including Ethernet switch products that enhance computing and enterprise solutions under the brand “ProCurve Networking,” as well as the licensing of specific HP technology to third parties. Segment Data HP derives the results of the business segments directly from its internal management reporting system. The accounting policies HP uses to derive business segment results are substantially the same as those the consolidated company uses. Management measures the performance of each business segment based on several metrics, including earnings from operations. Management uses these results, in part, to evaluate the performance of, and to assign resources to, each of the business segments. HP does not allocate to its business segments certain operating expenses, which it manages separately at the corporate level. These unallocated costs include primarily amortization of purchased intangible assets, stock-based compensation expense related to HP-granted employee stock options and the employee stock purchase plan, certain acquisition-related charges and charges for purchased IPR&D, as well as certain corporate governance costs. HP does not allocate to its business segments restructuring charges and any associated adjustments related to restructuring actions. 145 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 18: Segment Information (Continued) Selected operating results information for each business segment was as follows for the following fiscal years ended October 31: Total Net Revenue 2006 2007 2005 In millions Earnings (Loss) from Operations 2006 2007 2005 Enterprise Storage and Servers ....................................... HP Services..................................................................... HP Software.................................................................... Technology Solutions Group .......................................... Personal Systems Group ................................................. Imaging and Printing Group ........................................... HP Financial Services..................................................... Corporate Investments .................................................... Segment total .................................................................. $18,769 16,646 2,325 37,740 36,409 28,465 2,336 762 $105,712 $17,308 15,617 1,301 34,226 29,166 26,786 2,078 566 $92,822 $16,717 15,536 1,061 33,314 26,741 25,155 2,102 523 $87,835 $1,980 1,829 347 4,156 1,939 4,315 155 (57) $10,508 $1,446 1,507 85 3,038 1,152 3,978 147 (151) $8,164 $800 1,151 (49) 1,902 657 3,413 213 (174) $6,011 The reconciliation of segment operating results information to HP consolidated totals was as follows for the following fiscal years ended October 31: Net revenue: Segment total ...................................................................................................................... Elimination of intersegment net revenue and other ............................................................ Total HP consolidated net revenue ..................................................................................... 2007 2006 In millions 2005 $105,712 (1,426) $104,286 $92,822 (1,164) $91,658 $87,835 (1,139) $86,696 Earnings before taxes: Total segment earnings from operations............................................................................. Corporate and unallocated costs and eliminations .............................................................. Unallocated costs related to certain stock-based compensation expense............................ Amortization of purchased intangible assets ...................................................................... In-process research and development charges .................................................................... Restructuring charges ......................................................................................................... Pension curtailments and settlements, net........................................................................... Interest and other, net .........................................................................................................444 606 Gains (losses) on investments............................................................................................. Total HP consolidated earnings before taxes...................................................................... $10,508 (439) (507) (783) (190) (387) 517 14 $9,177 $8,164 (331) (459) (604) (52) (158) — 25 $7,191 $6,011 (429) — (622) (2) (1,684) 199 83 (13) $3,543 HP allocates its assets to its business segments based on the primary segments benefiting from the assets. Corporate and unallocated assets are composed primarily of cash and cash equivalents. As described above, fiscal 2007 segment asset information is stated based on the fiscal 2007 organizational 146 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 18: Segment Information (Continued) structure. Total assets by segment as well as for TSG and the reconciliation of segment assets to HP consolidated total assets were as follows at October 31: Enterprise Storage and Servers ............................................................................................. HP Services........................................................................................................................... HP Software.......................................................................................................................... Technology Solutions Group ............................................................................................. Personal Systems Group ....................................................................................................... Imaging and Printing Group ................................................................................................. HP Financial Services........................................................................................................... Corporate Investments .......................................................................................................... Corporate and unallocated assets .......................................................................................... Total HP consolidated assets ................................................................................................ 2007 $13,518 17,232 8,366 $39,116 14,153 14,573 9,001 297 11,559 $88,699 2006 In millions $13,647 15,712 1,909 $31,268 12,237 13,889 7,927 305 16,355 $81,981 2005 $13,591 15,381 1,408 $30,380 11,277 13,523 7,856 297 13,984 $77,317 Major Customers No single customer represented 10% or more of HP’s total net revenue in any fiscal year presented. Geographic Information Net revenue, classified by the major geographic areas in which HP operates, was as follows for the following fiscal years ended October 31: Net revenue: U.S......................................................................................................... Non-U.S................................................................................................. Total HP consolidated net revenue........................................................ 2007 2006 In millions 2005 $34,814 69,472 $104,286 $32,244 59,414 $91,658 $30,548 56,148 $86,696 Net revenue by geographic area is based upon the sales location that predominately represents the customer location. Other than the United States, no single country represented more than 10% of HP’s total consolidated net revenue in any period presented. HP reports revenue net of sales taxes, use taxes and value-added taxes directly imposed by governmental authorities on HP’s revenue producing transactions with its customers. At October 31, 2007, no single country other than the United States had 10% or more of HP’s total consolidated net assets. At October 31, 2006, Belgium and the Netherlands each represented 10% or more of HP’s total consolidated net assets in addition to the United States. At October 31, 2005, no single country other than the United States had 10% or more of HP’s total consolidated net assets. No single country other than the United States had more than 10% of HP’s total consolidated net property, plant and equipment in any period presented. HP’s long-lived assets other than goodwill and 147 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 18: Segment Information (Continued) purchased intangible assets, which HP does not allocate to specific geographic locations as it is impracticable for HP to do so, are composed principally of net property, plant and equipment. Net property, plant and equipment, classified by major geographic areas in which HP operates, was as follows for the following fiscal years ended October 31: Net property, plant and equipment: U.S.................................................................................................................. Non-U.S.......................................................................................................... Total HP consolidated net property, plant and equipment.............................. 2007 2006 In millions 2005 $4,321 3,477 $7,798 $3,710 3,153 $6,863 $3,427 3,024 $6,451 148 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) Note 18: Segment Information (Continued) Net revenue by segment and business unit The following table provides net revenue by segment and business unit for the following fiscal years ended October 31: Net revenue(1): Industry standard servers............................................................................................................................................................... Business critical systems ............................................................................................................................................................... Storage ........................................................................................................................................................................................... Enterprise Storage and Servers.......................................................................................................................................................... Technology services ...................................................................................................................................................................... Outsourcing services(2) .................................................................................................................................................................. Consulting and integration ............................................................................................................................................................ HP Services........................................................................................................................................................................................ OpenView...................................................................................................................................................................................... OpenCall & other........................................................................................................................................................................... HP Software....................................................................................................................................................................................... Technology Solutions Group............................................................................................................................................................. Notebooks...................................................................................................................................................................................... Desktops ........................................................................................................................................................................................ Workstations.................................................................................................................................................................................. Handhelds ...................................................................................................................................................................................... Other .............................................................................................................................................................................................. Personal Systems Group.................................................................................................................................................................... Commercial hardware ................................................................................................................................................................... Consumer hardware....................................................................................................................................................................... Supplies ......................................................................................................................................................................................... Other .............................................................................................................................................................................................. Imaging and Printing Group .............................................................................................................................................................. HP Financial Services........................................................................................................................................................................ Corporate Investments ....................................................................................................................................................................... Total segments............................................................................................................................................................................... Eliminations of inter-segment net revenue and other........................................................................................................................ Total HP consolidated net revenue................................................................................................................................................ 2007 2006 In millions 2005 $11,380 3,564 3,825 18,769 8,678 4,821 3,147 16,646 1,988 337 2,325 37,740 17,642 15,850 1,721 490 706 36,409 7,181 4,442 16,788 54 28,465 2,336 762 105,712 (1,426) $104,286 $9,982 3,656 3,670 17,308 8,348 4,382 2,887 15,617 899 402 1,301 34,226 12,000 14,613 1,368 620 565 29,166 6,899 4,427 15,402 58 26,786 2,078 566 92,822 (1,164) $91,658 $9,389 3,812 3,516 16,717 8,599 4,097 2,840 15,536 691 370 1,061 33,314 9,763 14,406 1,195 836 541 26,741 6,558 4,497 14,045 55 25,155 2,102 523 87,835 (1,139) $86,696 (1) Certain fiscal 2007 organizational realignments have been reflected retroactively to provide improved visibility and comparability. For fiscal year 2006, the realignments primarily resulted in revenue movement within business units within the ESS and HPS segments. There was no impact to total segment revenue. (2) Reflects the name change from Managed Services to Outsourcing Services effective in fiscal 2007. 149 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Quarterly Summary (Unaudited) 2007 Net revenue........................................................................................................................................... Cost of sales(1)....................................................................................................................................... Research and development ................................................................................................................... Selling, general and administrative ...................................................................................................... Amortization of purchased intangible assets........................................................................................ In-process research and development charges ..................................................................................... Restructuring......................................................................................................................................... Pension curtailments and pension settlements, net............................................................................... Total costs and expenses....................................................................................................................... Earnings from operations...................................................................................................................... Interest and other, net ........................................................................................................................... Gains (losses) on investments............................................................................................................... Earnings before taxes............................................................................................................................ Provision for taxes ................................................................................................................................ Net earnings .......................................................................................................................................... Net earnings per share:(2) Basic ................................................................................................................................................. Diluted .............................................................................................................................................. Cash dividends paid per share .............................................................................................................. Range of per share closing stock prices on the New York Stock Exchange Low ................................................................................................................................................... High .................................................................................................................................................. 2006 Net revenue........................................................................................................................................... Cost of sales(1)....................................................................................................................................... Research and development ................................................................................................................... Selling, general and administrative ...................................................................................................... Amortization of purchased intangible assets........................................................................................ In-process research and development charges ..................................................................................... Restructuring......................................................................................................................................... Total costs and expenses....................................................................................................................... Earnings from operations...................................................................................................................... Interest and other, net ........................................................................................................................... (Losses) gains on investments .............................................................................................................. Earnings before taxes............................................................................................................................ Provision for (benefit from) taxes ........................................................................................................ Net earnings .......................................................................................................................................... Net earnings per share:(2) Basic ................................................................................................................................................. Diluted .............................................................................................................................................. Cash dividends paid per share .............................................................................................................. Range of per share closing stock prices on the New York Stock Exchange and Nasdaq Stock Market: Low ................................................................................................................................................... High .................................................................................................................................................. (1) Cost of products, cost of services and financing interest. Three-month periods ended January 31 April 30 July 31 October 31 In millions, except per share amounts $25,082 19,136 877 2,908 201 167 (41) (9) 23,239 1,843 111 10 1,964 417 $1,547 $0.57 $0.55 $0.08 $38.22 $43.53 $22,659 17,392 871 2,692 147 50 15 21,167 1,492 38 (2) 1,528 301 $1,227 $0.43 $0.42 $0.08 $28.12 $32.24 $25,534 19,283 903 3,044 212 19 453 (508) 23,406 2,128 87 13 2,228 453 $1,775 $0.67 $0.65 $0.08 $38.67 $43.13 $22,554 16,970 930 2,858 151 2 (14) 20,897 1,657 157 6 1,820 (79) $1,899 $0.68 $0.66 $0.08 $25,377 19,164 917 3,002 183 — (5) — 23,261 2,116 165 5 2,286 508 $1,778 $0.68 $0.66 $0.08 $42.83 $48.54 $21,890 16,472 920 2,830 153 — 5 20,380 1,510 221 7 1,738 363 $1,375 $0.50 $0.48 $0.08 $28,293 21,304 914 3,272 187 4 (20) — 25,661 2,632 81 (14) 2,699 535 $2,164 $0.84 $0.81 $0.08 $46.01 $52.87 $24,555 18,593 870 2,886 153 — 152 22,654 1,901 190 14 2,105 408 $1,697 $0.62 $0.60 $0.08 $30.27 $34.36 $29.79 $33.87 $31.67 $39.87 (2) EPS for each quarter is computed using the weighted-average number of shares outstanding during that quarter, while EPS for the fiscal year is computed using the weighted-average number of shares outstanding during the year. Thus, the sum of the EPS for each of the four quarters may not equal the EPS for the fiscal year. 150 ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. ITEM 9A. Controls and Procedures. Controls and Procedures Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to HP, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to HP’s management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. See Management’s Report on Internal Control over Financial Reporting in Item 8, which is incorporated herein by reference. ITEM 9B. Other Information. Not applicable. 151 PART III ITEM 10. Directors, Executive Officers and Corporate Governance of the Registrant. The names of the executive officers of HP and their ages, titles and biographies as of the date hereof are incorporated by reference from Part I, Item 1, above. The following information is included in HP’s Notice of Annual Meeting of Stockholders and Proxy Statement to be filed within 120 days after HP’s fiscal year end of October 31, 2007 (the “Proxy Statement”) and is incorporated herein by reference: • • • • Information regarding directors of HP who are standing for reelection and any persons nominated to become directors of HP is set forth under “Election of Directors.” Information regarding HP’s Audit Committee and designated “audit committee financial experts” is set forth under “Corporate Governance Principles and Board Matters—Board Structure and Committee Composition—Audit Committee.” Information on HP’s code of business conduct and ethics for directors, officers and employees, also known as the “Standards of Business Conduct,” and on HP’s Corporate Governance Guidelines is set forth under “Corporate Governance Principles and Board Matters.” Information regarding Section 16(a) beneficial ownership reporting compliance is set forth under “Section 16(a) Beneficial Ownership Reporting Compliance.” ITEM 11. Executive Compensation. The following information is included in the Proxy Statement and is incorporated herein by reference: • • Information regarding HP’s compensation of its named executive officers is set forth under “Executive Compensation.” Information regarding HP’s compensation of its directors is set forth under “Director Compensation and Stock Ownership Guidelines.” • The report of HP’s HR and Compensation Committee is set forth under “HR and Compensation Committee Report on Executive Compensation.” ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. The following information is included in the Proxy Statement and is incorporated herein by reference: • • Information regarding security ownership of certain beneficial owners, directors and executive officers is set forth under “Common Stock Ownership of Certain Beneficial Owners and Management.” Information regarding HP’s equity compensation plans, including both stockholder approved plans and non- stockholder approved plans, is set forth in the section entitled “Equity Compensation Plan Information.” ITEM 13. Certain Relationships and Related Transactions, and Director Independence. The following information is included in the Proxy Statement and is incorporated herein by reference: 152 • • Information regarding transactions with related persons is set forth under “Related Person Transaction Policy and Procedures.” Information regarding director independence is set forth under “Corporate Governance Principles and Board Matters—Board Independence.” ITEM 14. Principal Accountant Fees and Services. Information regarding principal auditor fees and services is set forth under “Principal Accountant Fees and Services” in the Proxy Statement, which information is incorporated herein by reference. 153 PART IV ITEM 15. Exhibits and Financial Statement Schedules. (a) The following documents are filed as part of this report: 1. All Financial Statements: The following financial statements are filed as part of this report under Item 8—”Financial Statements and Supplementary Data.” Reports of Independent Registered Public Accounting Firm ....................................................... 72 Management’s Report on Internal Control Over Financial Reporting.......................................... 74 Consolidated Statements of Earnings ........................................................................................... 75 Consolidated Balance Sheets........................................................................................................ 76 Consolidated Statements of Cash Flows....................................................................................... 77 Consolidated Statements of Stockholders’ Equity........................................................................ 78 Notes to Consolidated Financial Statements................................................................................. 79 Quarterly Summary ...................................................................................................................... 150 2. Financial Statement Schedules: Schedule II—Valuation and Qualifying Accounts for the three fiscal years ended October 31, 2007. All other schedules are omitted as the required information is inapplicable or the information is presented in the Consolidated Financial Statements and notes thereto in Item 8 above. 3. Exhibits: A list of exhibits filed or furnished with this report on Form 10-K (or incorporated by reference to exhibits previously filed or furnished by HP) is provided in the Exhibit Index on page 158 of this report. HP will furnish copies of exhibits for a reasonable fee (covering the expense of furnishing copies) upon request. Stockholders may request exhibits copies by contacting: Hewlett-Packard Company Attn: Investor Relations 3000 Hanover Street Palo Alto, CA 94304 (866) GET-HPQ1 or (866) 438-4771 154 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES Valuation and Qualifying Accounts Schedule II For the fiscal years ended October 31 2006 In millions 2007 2005 Allowance for doubtful accounts—accounts receivable: Balance, beginning of period ................................................................................................ Amount acquired through acquisition................................................................................... Addition of bad debt provision ............................................................................................. Deductions, net of recoveries................................................................................................ Balance, end of period .......................................................................................................... Allowance for doubtful accounts—financing receivables: Balance, beginning of period ................................................................................................ Additions (reversal) to allowance ......................................................................................... Deductions, net of recoveries................................................................................................ Balance, end of period .......................................................................................................... $220 3 32 (29) $226 $80 15 (11) $84 $227 4 37 (48) $220 $111 (33) 2 $80 $286 — 17 (76) $227 $213 (39) (63) $111 155 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: December 18, 2007 HEWLETT-PACKARD COMPANY By: /s/ CHARLES N. CHARNAS Charles N. Charnas Vice President, Deputy General Counsel and Assistant Secretary POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Charles N. Charnas and Catherine A. Lesjak, or either of them, his or her attorneys-in-fact, for such person in any and all capacities, to sign any amendments to this report and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that either of said attorneys-in-fact, or substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature /s/ MARK V. HURD Mark V. Hurd Title(s) Chairman, Chief Executive Officer and President (Principal Executive Officer) /s/ CATHERINE A. LESJAK Catherine A. Lesjak Executive Vice President and Chief Financial Officer (Principal Financial Officer) /s/ JAMES T. MURRIN James T. Murrin Senior Vice President and Controller (Principal Accounting Officer) /s/ LAWRENCE T. BABBIO, JR. Lawrence T. Babbio, Jr. /s/ SARI M. BALDAUF Sari M. Baldauf /s/ RICHARD A. HACKBORN Richard A. Hackborn /s/ JOHN H. HAMMERGREN John H. Hammergren Director Director Director Director Date December 18, 2007 December 18, 2007 December 18, 2007 December 18, 2007 December 18, 2007 December 18, 2007 December 18, 2007 156 Signature Title(s) Date /s/ JOEL Z. HYATT Joel Z. Hyatt /s/ JOHN R. JOYCE John R. Joyce /s/ ROBERT L. RYAN Robert L. Ryan /s/ LUCILLE S. SALHANY Lucille S. Salhany /s/ G. KENNEDY THOMPSON G. Kennedy Thompson Director Director Director Director Director December 18, 2007 December 18, 2007 December 18, 2007 December 18, 2007 December 18, 2007 157 HEWLETT-PACKARD COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibit Number 2 None. Exhibit Description Form File No. Incorporated by Reference Exhibit(s) Filing Date 3(a) Registrant’s Certificate of 10-Q 001-04423 3(a) June 12, 1998 Incorporation. 3(b) Registrant’s Amendment to the 10-Q 001-04423 3(b) March 16, 2001 Certificate of Incorporation. 3(c) Registrant’s Amended and Restated 8-K 001-04423 99.1 November 19, 2007 By-Laws effective November 15, 2007. 4(a) Indenture dated as of October 14, 1997 among Registrant and Chase Trust Company of California regarding Liquid Yield Option Notes due 2017. S-3 333-44113 4.2 January 12, 1998 4(b) Supplemental Indenture dated as of 10-Q 001-04423 4(b) September 12, 2000 March 16, 2000 to Indenture dated as of October 14, 1997 among Registrant and Chase Trust Company of California regarding Liquid Yield Option Notes due 2017. 4(c) Second Supplemental Indenture to 10-Q 001-04423 4(c) September 10, 2004 Indenture dated as of October 14, 1997 among Registrant and J.P. Morgan Trust Company (as successor to Chase Trust Company of California) regarding Liquid Yield Option Notes due 2017. 4(d) Form of Senior Indenture. S-3 333-30786 4.1 March 17, 2000 4(e) Form of Registrant’s Fixed Rate Note 8-K 001-04423 4.1, 4.2 and 4.4 May 24, 2001 and Floating Rate Note and related Officers’ Certificate. 4(f) Form of Registrant’s 6.50% Global Note due July 1, 2012, and form of related Officers’ Certificate. 4(g) Form of Registrant’s Fixed Rate Note and form of Floating Rate Note. 8-K 001-04423 4.2 and 4.3 June 27, 2002 8-K 001-04423 4.1 and 4.2 December 11, 2002 4(h) Form of Registrant’s 3.625% Global 8-K 001-04423 4.1 and 4.2 March 14, 2003 Note due March 15, 2008, and related Officers’ Certificate. 4(i) Indenture, dated as of June 1, 2000, S-3 333-134327 4.9 June 7, 2006 between the Registrant and J.P. Morgan Trust Company, National Association (formerly Chase Manhattan Bank), as Trustee. 158 Exhibit Number Exhibit Description Form File No. Incorporated by Reference Exhibit(s) 4.1, 4.2 and 4.3 001-04423 Filing Date February 28, 2007 4(j) Form of Registrant’s Floating Rate Global Note due March 1, 2012, form of 5.25% Global Note due March 1, 2012 and form of 5.40% Global Note due March 1, 2017. 8-K 4(k) Form of Registrant’s Floating Rate Global Note 10-Q 001-04423 4(l) September 7, 2007 due June 15, 2009 and Floating Rate Global Note due June 15, 2010. 4(l) Specimen certificate for the Registrant’s common 8-A/A 001-04423 4.1 June 23, 2006 stock. 9 None. 10(a) Registrant’s 2004 Stock Incentive Plan.* S-8 333-114253 4.1 April 7, 2004 10(b) Registrant’s 2000 Stock Plan, amended and 10-K 001-04423 10(a) January 21, 2003 restated effective November 21, 2002.* 10(c) Registrant’s 1997 Director Stock Plan, amended and restated effective November 1, 2005.* 10(d) Registrant’s 1995 Incentive Stock Plan, amended and restated effective November 21, 2002.* 10(e) Registrant’s 1990 Incentive Stock Plan, amended and restated effective November 21, 2002.* 10(f) Compaq Computer Corporation 2001 Stock Option Plan, amended and restated effective November 21, 2002.* 10(g) Compaq Computer Corporation 1998 Stock Option Plan, amended and restated effective November 21, 2002.* 8-K 001-04423 99.4 November 23, 2005 10-K 001-04423 10(c) January 21, 2003 10-K 001-04423 10(d) January 21, 2003 10-K 001-04423 10(f) January 21, 2003 10-K 001-04423 10(g) January 21, 2003 10(h) Compaq Computer Corporation 1995 Equity 10-K 001-04423 10(h) January 21, 2003 Incentive Plan, amended and restated effective November 21, 2002.* 10(i) Compaq Computer Corporation 1989 Equity 10-K 001-04423 10(i) January 21, 2003 Incentive Plan, amended and restated effective November 21, 2002.* 10(j) Compaq Computer Corporation 1985 S-3 333-86378 10.5 April 18, 2002 Nonqualified Stock Option Plan for Non-Employee Directors.* 10(k) Amendment of Compaq Computer Corporation S-3 333-86378 10.11 April 18, 2002 Non-Qualified Stock Option Plan for Non-Employee Directors, effective September 3, 2001.* 10(l) Compaq Computer Corporation 1998 Former S-3 333-86378 10.9 April 18, 2002 Nonemployee Replacement Option Plan.* 159 Exhibit Number Exhibit Description Form File No. Incorporated by Reference Exhibit(s) Filing Date 10(m) Registrant’s Excess Benefit Retirement Plan, amended and restated as of January 1, 2006.* 8-K 001-04423 10.2 September 21, 2006 10(n) Hewlett-Packard Company Cash 8-K 001-04423 99.3 November 23, 2005 Account Restoration Plan, amended and restated as of January 1, 2005.* 10(o) Registrant’s 2005 Pay-for-Results 8-K 001-04423 99.5 November 23, 2005 Plan.* 10(p) Registrant’s 2005 Executive Deferred Compensation Plan, as amended and restated effective October 1, 2006.* 8-K 001-04423 10.1 September 21, 2006 10(q) First Amendment to the Registrant’s 10-Q 001-04423 10(q) June 8, 2007 2005 Executive Deferred Compensation Plan, as amended and restated effective October 1, 2006.* 10(r) Employment Agreement, dated 8-K 001-04423 99.1 March 30, 2005 March 29, 2005, between Registrant and Mark V. Hurd.* 10(s) Employment Agreement, dated June 9, 2005, between Registrant and R. Todd Bradley.* 10-Q 001-04423 10(x) September 8, 2005 10(t) Employment Agreement, dated July 11, 10-Q 001-04423 10(y) September 8, 2005 2005, between Registrant and Randall D. Mott.* 10(u) Registrant’s Amended and Restated Severance Plan for Executive Officers.* 8-K 001-04423 99.1 July 27, 2005 10(v) Form letter to participants in the 10-Q 001-04423 10(w) March 10, 2006 Registrant’s Pay-for-Results Plan for fiscal year 2006.* 10(w) Registrant’s Executive Severance 10-Q 001-04423 10(u)(u) June 13, 2002 Agreement.* 10(x) Registrant’s Executive Officers Severance Agreement.* 10(y) Form letter regarding severance offset for restricted stock and restricted units.* 10(z) Form of Indemnity Agreement between Compaq Computer Corporation and its executive officers.* 10-Q 001-04423 10(v)(v) June 13, 2002 8-K 001-04423 10.2 March 22, 2005 10-Q 001-04423 10(x)(x) June 13, 2002 160 Exhibit Number Exhibit Description Form File No. Incorporated by Reference Exhibit(s) 10(a)(a) Filing Date 10(a)(a) Form of Stock Option Agreement for Registrant’s 10-Q 001-04423 June 8, 2007 2004 Stock Incentive Plan, Registrant’s 2000 Stock Plan, as amended, Registrant’s 1995 Incentive Stock Plan, as amended, the Compaq Computer Corporation 2001 Stock Option Plan, as amended, the Compaq Computer Corporation 1998 Stock Option Plan, as amended, the Compaq Computer Corporation 1995 Equity Incentive Plan, as amended and the Compaq Computer Corporation 1989 Equity Incentive Plan, as amended.* 10(b)(b) Form of Restricted Stock Agreement for Registrant’s 2004 Stock Incentive Plan, Registrant’s 2000 Stock Plan, as amended, and Registrant’s 1995 Incentive Stock Plan, as amended.* 10-Q 001-04423 10(b)(b) June 8, 2007 10(c)(c) Form of Restricted Stock Unit Agreement for 10-Q 001-04423 10(c)(c) June 8, 2007 Registrant’s 2004 Stock Incentive Plan.* 10(d)(d) Form of Stock Option Agreement for Registrant’s 1990 Incentive Stock Plan, as amended.* 10(e)(e) Form of Common Stock Payment Agreement and Option Agreement for Registrant’s 1997 Director Stock Plan, as amended.* 10-K 001-04423 10(e) January 27, 2000 10-Q 001-04423 10(j)(j) March 11, 2005 10(f)(f) Form of Restricted Stock Grant Notice for the 10-Q 001-04423 10(w)(w) June 13, 2002 Compaq Computer Corporation 1989 Equity Incentive Plan.* 10(g)(g) Forms of Stock Option Notice for the Compaq 10-K 001-04423 10(r)(r) January 14, 2005 Computer Corporation Non-Qualified Stock Option Plan for Non-Employee Directors, as amended.* 10(h)(h) Form of Long-Term Performance Cash Award 10-K 001-04423 10(t)(t) January 14, 2005 Agreement for Registrant’s 2004 Stock Incentive Plan and Registrant’s 2000 Stock Plan, as amended.* 10(i)(i) Amendment One to the Long-Term Performance Cash Award Agreement for the 2004 Program.* 10(j)(j) Form of Long-Term Performance Cash Award Agreement for the 2005 Program.* 10-Q 001-04423 10(q)(q) September 8, 2005 10-Q 001-04423 10(r)(r) September 8, 2005 10(k)(k) Form of Long-Term Performance Cash Award 10-Q 001-04423 10(o)(o) March 10, 2006 Agreement.* 161 Exhibit Number Exhibit Description Form File No. Incorporated by Reference Exhibit(s) Filing Date 10(l)(l) Second Amendment to the Registrant’s 2005 Executive Deferred Compensation Plan, as amended and restated effective October 1, 2006.*‡ 11 None. 12 Statement of Computation of Ratio of Earnings to Fixed Charges.‡ 13-14 None. 16 None. 18 None. 21 Subsidiaries of the registrant as of October 31, 2007.‡ 22 None. 23 Consent of Independent Registered Public Accounting Firm.‡ 24 Power of Attorney (included on the signature page). 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.‡ 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act of 1934, as amended.‡ 32 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.† * ‡ † Indicates management contract or compensatory plan, contract or arrangement. Filed herewith. Furnished herewith. The registrant agrees to furnish to the Commission supplementally upon request a copy of (1) any instrument with respect to long-term debt not filed herewith as to which the total amount of securities authorized thereunder does not exceed 10 percent of the total assets of the registrant and its subsidiaries on a consolidated basis and (2) any omitted schedules to any material plan of acquisition, disposition or reorganization set forth above. 162 Exhibit 31.1 I, Mark V. Hurd, certify that: 1. I have reviewed this Annual Report on Form 10-K of Hewlett-Packard Company; CERTIFICATION 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: December 14, 2007 /s/ MARK V. HURD Mark V. Hurd Chairman, Chief Executive Officer and President (Principal Executive Officer) Exhibit 31.2 I, Catherine A. Lesjak, certify that: 1. I have reviewed this Annual Report on Form 10-K of Hewlett-Packard Company; CERTIFICATION 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures, and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. Date: December 14, 2007 /s/ CATHERINE A. LESJAK Catherine A. Lesjak, Executive Vice President and Chief Financial Officer (Principal Financial Officer) Exhibit 32 CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, Mark V. Hurd, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report on Form 10-K of Hewlett-Packard Company for the fiscal year ended October 31, 2007 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Annual Report on Form 10-K fairly presents, in all material respects, the financial condition and results of operations of Hewlett-Packard Company. December 14, 2007 By: /s/ MARK V. HURD Mark V. Hurd Chairman, Chief Executive Officer and President I, Catherine A. Lesjak, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report on Form 10-K of Hewlett-Packard Company for the fiscal year ended October 31, 2007 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Annual Report on Form 10-K fairly presents, in all material respects, the financial condition and results of operations of Hewlett-Packard Company. December 14, 2007 By: /s/ CATHERINE A. LESJAK Catherine A. Lesjak Executive Vice President and Chief Financial Officer A signed original of this written statement required by Section 906 has been provided to Hewlett-Packard Company and will be retained by Hewlett-Packard Company and furnished to the Securities and Exchange Commission or its staff upon request. For more information on HP’s non-ﬁnancial performance, read our Global Citizenship Report at www.hp.com/go/report. paper. © 2008 Hewlett Packard Development Company, LP. The information contained herein is subject to change without notice. The only warranties Printed on recycled for HP products and services are set forth in the express warranty statements accompanying such products and services. Nothing herein should be construed as constituting an additional warrant. HP shall not be liable for technical or editorial errors or omissions contained herein. 4AA0-7010ENW

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