2005 Annual Report Dear Fellow Stockholders, HP underwent significant change in its fiscal year 2005. We appointed a number of new senior executives. We streamlined our operating structure. We began taking steps to reduce our workforce. We made several acquisitions. And we introduced many new products and services. It is a tribute to HP’s people that, even amid this activity, our business performed increasingly well. We achieved solid revenue growth, good cost control and improved margins in key areas. As a result, we saw healthy stock price appreciation and were able to pay our employees their first significant bonus in several years. To provide context for some of the decisions we made in the past year, let me share some observations from my first 60 days as CEO. In a relatively short time, many different groups came forward and offered their input: investors, customers, partners, employees, financial and industry analysts. It was a mixed picture. In recent years, investors in HP have been confronted with inconsistent results. As a consequence, our stock performance has been volatile and occasionally disappointing. Our portfolio of businesses has yet to prove its full value — not due to issues with the strategy, but rather due to the execution of the strategy. Revenue by Segment FY05 Customers and partners told us they like HP and want to see us win. They told us the company has great technology and talented people, but we were difficult to do business with and too complex. From an employee perspective, morale was mixed. Although the company had been through a turbulent period, it was encouraging to find many of our people have a strong desire to improve perceptions of the company and to fight and win in the marketplace. Operationally, HP was a highly matrixed organization. We had a front-end sales group that shared decisions with the product generation organizations. In a few cases, there were nine layers of management between the CEO and a customer. And some business divisions had less than 30 percent of their budgets directly under their control because of the way costs were allocated. When this kind of organizational design is applied to a company of HP’s scale, it represents the underpinnings of slow decision-making and confusion in terms of accountability. Revenue (1) While the technology HP produces is impressive, there was far more of it inside the company than expected — Combines the results of HP for the twelve months ended October 31, even more than customers were telling me about. We clearly need to do a much better job of communicating 2002 and the historical quarterly results of Compaq Computer all the great technology we’re working on inside HP. Corporation for the six-month period ended March 31, 2002 and for the period May 3, 2002 (the acquisition Financially, the company’s revenue growth for fiscal 2005 was impressive, increasing $6.8 billion. However, date) to October 31, 2002. this growth was driven by lower-end products, which resulted in gross margin erosion. Our cost structure was not competitive, leaving significant room for improvement around spending discipline. Operating framework To address these challenges, we put in place an operating framework with three interdependent levers: efficiency, growth and our capital strategy. We want to be in markets that will scale and grow. We want to be as cost competitive as possible. And we want to use our resources to help us save money and fuel growth simultaneously. Efficiency Some would say that being a ”blend” company with a number of different business models reduces our focus and ability to achieve best-in-class cost structures. We actually see it as a competitive advantage. The real opportunity is to build cost structures that best align to our most competitive businesses. In this way, the other businesses can gain competitive advantage and benefit from HP’s scale along several dimensions — pricing, operating expenses and cost of goods sold, among others. In June, the 10 millionth HP ProLiant server rolled off HP’s assembly lines. HP’s LightScribe technology offers a simple, innovative way to burn labels on CDs/DVDs. HP has shipped more than 385 million printers since introducing its first model in 1984. There was already a good deal of benchmarking and analytic work going on inside the company prior to my arrival — which helped us to accelerate our recent cost decisions. In July, we made some tough decisions to get HP on the right track for long-term success. We announced workforce reduction and enhanced early retirement programs involving approximately 15,300 employees worldwide — many of whom came out of shared service functions such as IT, human resources and finance. These were not easy decisions to make, but we tried to execute them with the utmost integrity and respect for those affected. We made changes to the U.S. retirement programs effective January 1, 2006. These included modifications to the U.S. defined benefits plan that froze pension benefits and reduced medical program benefits for current employees who did not meet defined criteria based on age and years of service. To streamline HP’s operating model, we dissolved the Customer Solutions Group. This commercial sales function was folded directly into the business groups to provide each with greater accountability, tighter links to its customer segment, better line of sight into operations and greater control over its operating profit. Cash Flow from Operations The objective was to create a simpler, nimbler HP with fewer matrices, clearer accountability and greater (1) Free cash flow is cash flow from oper- financial flexibility. ations minus net capital expenditures. Over the years, HP built a complicated IT architecture that carries unacceptable costs. We see opportunity to improve this function by investing in the simplification of this environment. Building a single, integrated view of our data will help us better understand our business and markets and enable us to more efficiently tailor our offerings directly to customers. Our intention is to engineer HP IT to be the world’s best showcase for the company’s technology. It is also an example of how we can invest money to save money and, at the same time, build a capability in the business that allows us to scale, grow and compete in the marketplace. Growth The best way to steer a company toward growth is to look out four or five years at the big market trends evolving, and then work backward to identify opportunities. We see three developments that present significant opportunity for HP. Next-generation data center architecture. In the enterprise market, we will see the emergence of a 24 x7 Stock Repurchase & Dividends automated, lights-out data center. Moving labor around the world in pursuit of lower wages is not the long-term answer for lowering costs. This next-generation data center architecture will be about lowering the fundamental unit cost of computing, while increasing computing power and data capacity. It will be utility-based in the sense that businesses will pay only for what they use. To achieve this, there will be continued movement toward a lower cost, industry-standard, distributed computing environment and a shift away from mainframe computing. We’ll see increases in virtualization of processing and storage and the ability to dial up capacity whenever and wherever it is needed. This environment will need to be highly secure, highly automated and remotely accessed and managed. This is also the architecture for an Adaptive Enterprise and, in developing this, we foresee continued investments in areas such as blades, storage, Linux, management software, virtualization and automation — technologies and services critical for creating this next-generation data center architecture. Always-ready, always-on mobile computing. People will become increasingly mobile — and we see this trend accelerating. The convergence of voice and data services is inevitable. People will be able to receive e-mail via voicemail or receive voicemail via e-mail. The ability to have a mobile office and personalized services delivered to individuals no matter where they are will become a reality. Bandwidth will increase and so will HP powers the majority of the world’s exchange, ATM and credit- card transactions. The company also uses its technology to empower people in underserved communities around the world to accelerate economic development. the capacity for consuming rich content. Driving this evolution requires not just advanced devices, but also infrastructure, services and solid go-to-market partnerships — all strong HP assets. Additionally, the requirement for security will heavily leverage the next-generation data center architecture. Ubiquitous printing and imaging. We don’t just think about the market for printers. We think about the market for printing. Consumer printing is very important to HP, but we also see significant opportunity across the entire digital printing arena. In the consumer market, we have invested both in the United States and abroad in web-based digital photo-printing services. Color use is increasing, and the multifunction printer and copier markets are converging in the office and small and medium-size business markets. In addition, with the emergence of digital high-end commercial printing technology, we will see an increase in do-it-yourself marketing collateral, both inside companies and through small commercial printing companies that can operate more efficiently and effectively with this technology. With HP’s Indigo and Scitex Vision acquisitions, the opportunity to compete and grow in this broader market is significant. And all of these markets have after-market supplies revenues that we intend to capture. Go-to-market model. We believe that all three of these industry trends play to HP’s strengths and, in many cases, we will be driving them.