Hewlett-Packard (HPQ)

Enterprise Storage and Servers

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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 2009, 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, OpenVMS and NonStop 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. During 2009, we continued to transition all business critical systems platforms to Itanium-based 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.

        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.

Enterprise Storage and Servers

        The components of the weighted net revenue change as compared to prior-year periods by business unit were as follows for the following fiscal years ended October 31:

        ESS net revenue decreased 20.8% (16.0% when adjusted for currency) in fiscal 2009 from fiscal 2008. The revenue decline was due primarily to the economic slowdown and overall weak demand environment. ISS net revenue declined 20% in fiscal 2009 as compared to fiscal 2008 due to declines in unit volume. ISS average unit prices declined in fiscal 2009 while improving in the second half of fiscal 2009 as a result of a new product ramp up. Total ESS blades revenue declined by 8% in fiscal 2009 as compared to fiscal 2008. Business critical systems net revenue decreased 27% in fiscal 2009 compared to fiscal 2008 driven by a decline in Integrity server revenue due to weaker market conditions and by the planned phase-out of the PA-RISC and Alpha Server product lines. Storage net revenue declined 17% in fiscal 2009 compared to fiscal 2008 due to a decline in disk and tape products as a result of a

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Table of Contents

HEWLETT-PACKARD COMPANY AND SUBSIDIARIES

Management's Discussion and Analysis of
Financial Condition and Results of Operations (Continued)

weaker demand environment, the effects of which were partially offset by revenue resulting from the acquisition of Lefthand Networks, which was completed in the first quarter of fiscal 2009.

        In fiscal 2009, ESS earnings from operations as a percentage of net revenue decreased by 3.4 percentage points compared to fiscal 2008, due primarily to a decline in gross margin. Gross margin in fiscal 2009 decreased due primarily to competitive pricing across each of the segment business units and product mix shifts. Operating expense as a percentage of net revenue in fiscal 2009 was generally consistent with the fiscal 2008.

        ESS net revenue increased 4.1% (decreased 0.5% when adjusted for currency) in fiscal 2008 from fiscal 2007. Storage net revenue increased 13% in fiscal 2008 compared to fiscal 2007, with strong performance in mid-range EVA, entry MSA, tape media and storage software. Industry standard servers net revenue grew 2% in fiscal 2008 compared to fiscal 2007 as a result of growth in blade revenue and unit volumes. Revenue growth in the industry standard servers business was partially offset by the decline in average unit prices driven by market movement to low-end product lines and component cost declines. Business critical systems net revenue growth was flat in fiscal 2008 compared to fiscal 2007. Integrity servers net revenue grew 22% in fiscal 2008 and represents 79% of the business critical systems revenue mix, up from 64% in fiscal 2007. The increase was offset by revenue declines in the PA-RISC product line and the planned phase-out of our Alpha Server product line. Integrity servers revenue in fiscal 2008 also included revenue from Montvale-based Integrity servers.

        In fiscal 2008, ESS earnings from operations as a percentage of net revenue increased by 1.8 percentage points compared to fiscal 2007, due primarily to a decrease in operating expenses as a percentage of net revenue. Gross margin increased slightly in fiscal 2008 compared to fiscal 2007 due primarily to cost management and improved attach rates in industry standard servers, the effect of which was mostly offset by competitive pricing in storage and industry standard servers and a mix shift to entry level integrity servers. The decrease in operating expense as a percentage of net revenue in fiscal 2008 was due primarily to continued cost structure improvements.

Enterprise Storage and Servers

        The components of the weighted net revenue decline as compared to the prior-year periods by business unit were as follows:

        ESS net revenue decreased 27.7% (21.0% when adjusted for currency) and 22.9% (17.7% when adjusted for currency) for the second quarter and first six months of fiscal 2009, respectively, as compared to the same periods in fiscal 2008. The revenue declines were due primarily to the economic slowdown and overall weak demand environment. Industry standard servers ("ISS") net revenue declined 29% and 26% for the second quarter and first six months of fiscal 2009, respectively, as compared to the same periods of fiscal 2008 with declines in both unit volume and average unit prices. Total ESS blades revenue declined by 12% and 4% for the second quarter and first six months of fiscal 2009, respectively, when compared to the prior-year periods. Business critical systems net revenue decreased 29% and 23% for the second quarter and first six months of fiscal 2009, respectively, compared to the prior-year periods driven by the planned phase-out of the PA-RISC and Alpha Server product lines and a decline in Integrity server revenue due to weaker market conditions. Storage net revenue declined 22% and 14% for the second quarter and first six months of fiscal 2009, respectively, compared to the prior-year periods, due to a decline in disk and tape products as a result of a weaker demand environment, the effects of which were partially offset by revenue resulting from the acquisition of Lefthand Networks.

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        ESS earnings from operations as a percentage of net revenue for the second quarter and first six months of fiscal 2009 decreased by 6.5 and 5.0 percentage points, respectively, compared to the same periods in fiscal 2008, due to decreases in gross margin. Gross margin decreased due primarily to unfavorable currency impacts in all the business units, product mix shifts and competitive pricing. Gross margin was also unfavorably impacted by a patent litigation settlement, which occurred in the second quarter of fiscal 2009. Operating expense as a percentage of net revenue in the second quarter and first six months of fiscal 2009 remained flat when compared to the same periods in fiscal 2008.

Enterprise Storage and Servers

        The components of weighted net revenue growth as compared to the prior-year period by business unit were as follows:

        ESS net revenue decreased 18.1% (14.4% when adjusted for currency) in the first quarter of fiscal 2009 as compared to the same period of fiscal 2008 due to the economic slowdown and overall declines in business IT spending. Industry standard servers ("ISS") net revenue declined 22%, with declines in both volume and average unit prices in the first quarter of fiscal 2009 as compared to the same period of fiscal 2008. The ISS blades business, however, continued to outperform overall ISS performance. Total ESS blades revenue increased by 4% for the first quarter of fiscal 2009 when compared to the prior-year period. Business critical systems net revenue decreased 17% for the first quarter of fiscal 2009 compared to the prior-year period, impacted by the planned phase-out of the PA-RISC and Alpha Server product lines and a decline in integrity server revenue resulting from a decrease in customer capital purchases. Storage net revenue decreased 7% in the first quarter of fiscal 2009 compared to the prior-year period due to declines in tape, media, commercial automation and EVA revenue, the effect of which was partially offset by the revenue resulting from the acquisition of Lefthand Networks.

        In the first quarter of fiscal 2009, ESS earnings from operations as a percentage of net revenue decreased by 3.7 percentage points compared to the same period in fiscal 2008, due to a decrease in gross margin that was partially offset by a decrease in operating expenses as a percentage of net revenue. Gross margin decreased due primarily to competitive pricing, business mix shifts, and unfavorable currency impacts in all the business units, as well as product mix shift to entry level products in business critical systems. The decrease in operating expense as a percentage of net revenue was due to continued cost structure improvements including lower compensation expense.

Enterprise Storage and Servers

        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:

        ESS net revenue increased 4.1% (decreased 0.5% when adjusted for currency) in fiscal 2008 from fiscal 2007. Storage net revenue increased 13% in fiscal 2008 compared to fiscal 2007, with strong

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Table of Contents

HEWLETT-PACKARD COMPANY AND SUBSIDIARIES

Management's Discussion and Analysis of
Financial Condition and Results of Operations (Continued)

performance in mid-range EVA, entry MSA, tape media and storage software. Industry standard servers net revenue grew 2% in fiscal 2008 compared to fiscal 2007 as a result of growth in blade revenue and unit volumes. Revenue growth in the industry standard servers business was partially offset by the decline in average unit prices driven by market movement to low-end product lines and component cost declines. Business critical systems net revenue growth was flat in fiscal 2008 compared to fiscal 2007. Integrity servers net revenue grew 22% in fiscal 2008 and represents 79% of the business critical systems revenue mix, up from 64% in fiscal 2007. The increase was offset by revenue declines in the PA-RISC product line and the planned phase-out of our Alpha Server product line. The contribution of Integrity server revenue to the business critical systems revenue mix is currently within the range expected in future periods. Integrity servers revenue in fiscal 2008 also included revenue from Montvale-based Integrity servers.

        In fiscal 2008, ESS earnings from operations as a percentage of net revenue increased by 1.8 percentage points compared to fiscal 2007, due primarily to a decrease in operating expenses as a percentage of net revenue. Gross margin increased slightly in fiscal 2008 compared to fiscal 2007 due primarily to cost management and improved attach rates in industry standard servers, the effect of which was mostly offset by competitive pricing in storage and industry standard servers and a mix shift to entry level integrity servers. The decrease in operating expense as a percentage of net revenue in fiscal 2008 was due primarily to continued cost structure improvements.

        ESS net revenue increased 8.3% (4.8% when adjusted for currency) in fiscal 2007 from fiscal 2006. 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 2.5 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.

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Table of Contents

HEWLETT-PACKARD COMPANY AND SUBSIDIARIES

Management's Discussion and Analysis of
Financial Condition and Results of Operations (Continued)

Enterprise Storage and Servers

        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:

        ESS
net revenue increased 4.1% (decreased 0.5% when adjusted for currency) in fiscal 2008 from fiscal 2007. Storage net revenue increased 13% in
fiscal 2008 compared to fiscal 2007, with strong

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HEWLETT-PACKARD COMPANY AND SUBSIDIARIES

Management's Discussion and Analysis of

Financial Condition and Results of Operations (Continued)

performance
in mid-range EVA, entry MSA, tape media and storage software. Industry standard servers net revenue grew 2% in fiscal 2008 compared to fiscal 2007 as a result of
growth in blade revenue and unit volumes. Revenue growth in the industry standard servers business was partially offset by the decline in average unit prices driven by market movement to
low-end product lines and component cost declines. Business critical systems net revenue growth was flat in fiscal 2008 compared to fiscal 2007. Integrity servers net revenue
grew 22% in fiscal 2008 and represents 79% of the business critical systems revenue mix, up from 64% in fiscal 2007. The increase was offset by revenue declines in the
PA-RISC product line and the planned phase-out of our Alpha Server product line. The contribution of Integrity server revenue to the business critical systems revenue
mix is currently within the range expected in future periods. Integrity servers revenue in fiscal 2008 also included revenue from Montvale-based Integrity servers.

        In
fiscal 2008, ESS earnings from operations as a percentage of net revenue increased by 1.8 percentage points compared to fiscal 2007, due primarily to a decrease
in operating expenses as a percentage of net revenue. Gross margin increased slightly in fiscal 2008 compared to fiscal 2007 due primarily to cost management and improved attach rates in
industry standard servers, the effect of which was mostly offset by competitive pricing in storage and industry standard servers and a mix shift to entry level integrity servers. The decrease in
operating expense as a percentage of net revenue in fiscal 2008 was due primarily to continued cost structure improvements.

        ESS
net revenue increased 8.3% (4.8% when adjusted for currency) in fiscal 2007 from fiscal 2006. 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 2.5 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.

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HEWLETT-PACKARD COMPANY AND SUBSIDIARIES

Management's Discussion and Analysis of

Financial Condition and Results of Operations (Continued)

Enterprise Storage and Servers

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        The components of weighted-average net revenue growth as compared to the prior-year periods by business unit were as follows:

        ESS net revenue increased 5.0% (decreased 0.3% when adjusted for currency) and increased 6.0% (increased 0.3% when adjusted for currency) for the third quarter and first nine months of fiscal 2008, respectively, as compared to the same periods in fiscal 2007. Industry standard servers net revenue increased by 2% and 4% for the third quarter and first nine months of fiscal 2008, respectively, compared to the prior-year periods. Blade servers continued to be the key driver of growth. Strong revenue growth in the industry standard servers business was tempered by erosion of average unit prices driven by market movement to the low-end product lines and by competition. Storage net revenue increased 16% and 14% for the third quarter and first nine months of fiscal 2008, respectively, compared to the prior-year periods, with strong performance in mid-range EVA and entry MSA products within the Storage Area Networks, in media within the tape business, in storage blades and in storage software. Business critical systems net revenue increased 2% and 3% for the third quarter and first nine months of fiscal 2008, respectively, as compared to the same periods in the prior year. The increases for both periods were due primarily to strong net revenue growth in our Integrity servers, which grew 18% and 30% for the third quarter and the first nine months of fiscal 2008, respectively. Integrity servers revenue represented 78% of the business critical systems revenue mix in the third quarter of fiscal 2008 and 77% in the first nine months of fiscal 2008, up from 67% and 61%, respectively, in the same periods in the prior year. The increases were partially offset by revenue declines in the PA-RISC product line and the planned phase-out of our Alpha Server product line. The contribution of Integrity server revenue to the business critical systems revenue mix is currently within the range expected in future periods. Integrity servers revenue in the first nine months of fiscal 2008 also included revenue from Montvale-based Integrity servers, which were first shipped in the first quarter of fiscal 2008.

        ESS earnings from operations as a percentage of net revenue for the third quarter and first nine months of fiscal 2008 increased by 0.3 and 2.7 percentage points, respectively, compared to the prior-year periods, due to decreases in operating expenses as a percentage of net revenue. Gross margin in the third quarter of fiscal 2008 decreased primarily due to discounting and pricing, partially offset by improved cost management. The increase in gross margin in the first nine months of fiscal 2008 was driven primarily by improved cost management, improved higher-margin attach rates and lower component costs in industry standard servers, the effect of which was partially offset by ongoing mix shift to lower-margin Integrity products within business critical systems. The decreases in operating expenses as a percentage of net revenue for the third quarter and first nine months of fiscal 2008 were due primarily to continued cost structure improvements.

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