##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 ****
 FORM 10-Q
 ****
 þ
    
    Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 For the quarterly period ended December 2, 2006.
 o
    
    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 0-10078
 HEI, Inc.
 (Exact name of Registrant as Specified in Its Charter)
 Minnesota
    
    41-0944876(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)PO Box 5000, 1495 Steiger Lake Lane, Victoria, MN
    
    55386(Address of principal executive offices)
    
    (Zip Code)
 (952) 443-2500
 þ o
  o o þ
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TABLE OF CONTENTS
  PagePart I  Financial Information (Unaudited)Item 1. Financial StatementsConsolidated Balance Sheets
    
    
    3Consolidated Statements of Operations
    
    
    4Consolidated Statements of Cash Flow
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    19Item 4. Controls and Procedures
    
    
    20Part II  Other InformationItem 5. Other Information
    
    
    20Item 6. Exhibits
    
    
    21Signature
    
    
    22Waiver and AmendmentWaiver and AmendmentWaiverSection 302 Certification of CEO and CFOSection 906 Certification of CEO and CFO
  2




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PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 HEI, Inc.
 
 Consolidated Balance Sheets
 December 2 ,
    
    
    September 2,2006
    
    
    2006(Unaudited)
    
    
    (Audited)(In thousandsexcept per share and share data)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    2,191
    
    
    $
    674Accounts receivable, net of allowance for doubtful accounts
of $124
    
    
    7,946
    
    
    
    9,205Inventories
    
    
    7,245
    
    
    
    7,000Deferred income taxes
    
    
    830
    
    
    
    830Other current assets
    
    
    274
    
    
    
    316Total current assets
    
    
    18,486
    
    
    
    18,025Property and equipment:Land
    
    
    216
    
    
    
    216Building and improvements
    
    
    4,374
    
    
    
    4,374Fixtures and equipment
    
    
    24,467
    
    
    
    24,406Accumulated depreciation
    
    
    (21,837
    )
    
    
    (21,279
    )Net property and equipment
    
    
    7,220
    
    
    
    7,717Security deposit
    
    
    550
    
    
    
    550Other long-term assets
    
    
    547
    
    
    
    580Total assets
    
    $
    26,803
    
    
    $
    26,872LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Line of credit
    
    $
    1,500
    
    
    $
    5,948Related party note payable
    
    
    5,000
    
    
    
    Current maturities of long-term debt
    
    
    1,024
    
    
    
    1,038Accounts payable
    
    
    4,393
    
    
    
    3,735Accrued liabilities
    
    
    3,295
    
    
    
    2,772Total current liabilities
    
    
    15,212
    
    
    
    13,493Deferred income taxes
    
    
    830
    
    
    
    830Other long-term liabilities, less current maturities
    
    
    942
    
    
    
    961Long-term debt, less current maturities
    
    
    2,590
    
    
    
    2,824Total other long-term liabilities, less current maturities
    
    
    4,362
    
    
    
    4,615Total liabilities
    
    
    19,574
    
    
    
    18,108Commitments and contingencies
Shareholders equity:Undesignated stock; 5,000,000 shares authorized; none issued
    
    
    
    
    
    
    Convertible preferred stock, $.05 par; 167,000 shares authorized; 32,000 shares issued and
outstanding at both December 2, 2006 and September 2, 2006; liquidation preference at $26 per
share (total liquidation preference $832,000) at both December 2, 2006 and September 2, 2006
    
    
    2
    
    
    
    2Common stock, $.05 par; 20,000,000 shares authorized; 9,545,000 shares issued and 9,504,000
shares outstanding at both December 2, 2006 and September 2, 2006
    
    
    475
    
    
    
    475Paid-in capital
    
    
    27,637
    
    
    
    27,581Accumulated deficit
    
    
    (20,834
    )
    
    
    (19,226
    )Notes receivable-related parties-officers and former directors
    
    
    (51
    )
    
    
    (68
    )Total shareholders equity
    
    
    7,229
    
    
    
    8,764Total liabilities and shareholders equity
    
    $
    26,803
    
    
    $
    26,872
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HEI, Inc.
 
 Consolidated Statements of Operations (Unaudited)
 Three Months EndedDecember 2, 2006
    
    
    November 26, 2005(In thousandsExcept per share and share data)Net sales
    
    $
    12,945
    
    
    $
    13,787Cost of sales
    
    
    11,497
    
    
    
    11,063Gross profit
    
    
    1,448
    
    
    
    2,724Operating expenses:Selling, general and administrative
    
    
    1,948
    
    
    
    2,163Research, development and engineering
    
    
    755
    
    
    
    1,093Total operating expenses
    
    
    2,703
    
    
    
    3,256Operating loss
    
    
    (1,255
    )
    
    
    (532
    )Other income (expenses):Interest expense, net
    
    
    (360
    )
    
    
    (127
    )Other income (expense), net
    
    
    7
    
    
    
    29Net loss
    
    $
    (1,608
    )
    
    $
    (630
    )Net loss per common share:Basic
    
    $
    (0.17
    )
    
    $
    (0.07
    )Diluted
    
    $
    (0.17
    )
    
    $
    (0.07
    )Weighted average common shares outstanding:Basic
    
    
    9,505,000
    
    
    
    9,400,000Diluted
    
    
    9,505,000
    
    
    
    9,400,000
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HEI, Inc.
 
 Consolidated Statements of Cash Flows (Unaudited)
 Three Months EndedDecember 2, 2006
    
    
    November 26, 2005(In thousands)Cash flow from operating activities:Net loss
    
    $
    (1,608
    )
    
    $
    (630
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    592
    
    
    
    585Stock based compensation expense
    
    
    56
    
    
    
    116Changes in operating assets and liabilities:Accounts receivable
    
    
    1,259
    
    
    
    1,051Inventories
    
    
    (245
    )
    
    
    247Other current assets
    
    
    42
    
    
    
    406Accounts payable
    
    
    658
    
    
    
    (665
    )Accrued liabilities and other long-term liabilities
    
    
    504
    
    
    
    (360
    )Net cash flow provided by operating activities
    
    
    1,258
    
    
    
    750Cash flow from investing activities:Additions to property and equipment
    
    
    (62
    )
    
    
    (58
    )Refund of security deposit
    
    
    
    
    
    
    1,350Net cash flow provided by (used in) investing activities
    
    
    (62
    )
    
    
    1,292Cash flow from financing activities:Officer note repayment
    
    
    17
    
    
    
    Repayment of long-term debt
    
    
    (248
    )
    
    
    (147
    )Proceeds from note payable  related party
    
    
    5,000
    
    
    
    Net repayments on line of credit
    
    
    (4,448
    )
    
    
    (1,420
    )Net cash flow provided by (used in) financing activities
    
    
    321
    
    
    
    (1,567
    )Net increase in cash and cash equivalents
    
    
    1,517
    
    
    
    475Cash and cash equivalents, beginning of period
    
    
    674
    
    
    
    351Cash and cash equivalents, end of period
    
    $
    2,191
    
    
    $
    826Supplemental disclosures of cash flow information:Interest paid
    
    $
    325
    
    
    $
    143Capital lease obligations related to equipment acquisitions
    
    $
    
    
    
    $
    121Issuance of common stock to landlord recorded as long-term asset
    
    $
    
    
    
    $
    336
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##### Table of Contents



HEI, Inc.
 
 Notes to Unaudited Consolidated Financial Statements
 (1) Basis of Financial Statement Presentation
     Summary of Significant Accounting Policies
 Revenue Recognition.
  Inventories.
 Property and Equipment.
  6




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Use of Estimates.
 Income Taxes.
 New Accounting Pronouncements.
   (2) Liquidity
   7




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
    
    Expanding our sales efforts to existing customers and to find new customers for our
products. We plan to accomplish this through the restructuring of our sales staff in
Boulder and Victoria and by adding an additional sales person to support our flexible
substrate business in Tempe.
    
    Focusing on gross margin improvements at all segments. We will accomplish this by
focusing on our costs and looking at all areas for improvements including material
costs, labor costs and overhead structures.
    
    Structuring our staffing to work within our current sales levels for all of our
general and administrative costs and engineering costs, and to reorganize the staff as
necessary to position the Company for growth.
    
    Pursuing additional sublease tenants for the excess space in our Boulder facility
while allowing for adequate room for expansion in that the AMO segment. This will help
to offset a portion of the operating costs and lease costs of that facility.
    
    Refinancing our debt to improve cash flow.
    
    Reduction in inventories by reviewing buying procedures and reducing any excess on
hand inventory while maintaining the required inventories to meet customer demand.
These initiatives are targeted to reduce inventories by $1 million by the end of Fiscal
2007.
  8




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(3) Stock Based Compensation
  Stock Options
   Restricted Stock
   (4) Other Financial Statement Data
  9




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December 2,
    
    
    September 2,2006
    
    
    2006Inventories:Purchased parts
    
    $
    4,867
    
    
    $
    4,735Work in process
    
    
    811
    
    
    
    671Finished goods
    
    
    1,567
    
    
    
    1,594$
    7,245
    
    
    $
    7,000Accrued liabilities:Employee related costs (1)
    
    $
    1,900
    
    
    $
    1,346Accrued lease expenses
    
    
    652
    
    
    
    588Accrued taxes
    
    
    328
    
    
    
    396Accrued audit, professional, board, public reporting and interest
    
    
    219
    
    
    
    120Current maturities of Other long-term liabilities
    
    
    79
    
    
    
    79Other accrued liabilities
    
    
    119
    
    
    
    243$
    3,295
    
    
    $
    2,772Other long-term liabilities:Remaining lease obligation, less estimated sublease
Proceeds
    
    $
    503
    
    
    $
    513Unfavorable operating lease, net
    
    
    518
    
    
    
    527Total
    
    
    1,021
    
    
    
    1,040Less current maturities
    
    
    79
    
    
    
    79Total other long-term liabilities
    
    $
    942
    
    
    $
    961
 
 (1)
    
    This total includes Accrued Severance Related Expenses. During the first quarter of
2007, the Company reduced its workforce in an effort to lower its operating expenses. The
Company recorded $348,000 in expense for these staff reductions of which $145,000 related to the
resignation of the former CEO. At December 2, 2006, the remaining balance of the Accrued Severance
Related Expenses was $168,000 and will be paid prior to the end of Fiscal 2007. 10




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(5) Long-Term Debt
  December 2,
    
    
    September 2,2006
    
    
    2006(In thousands)Commerce Bank mortgage payable in
monthly installments of principal and
interest of $9 based on a twenty-year
amortization with a final payment of
approximately $1,050 due in November 2009;
collateralized by our Victoria facility
    
    $
    1,116
    
    
    $
    1,122Commerce Financial Group, Inc. equipment
loan payable in fixed monthly principal and
interest installments of $28 through
September 2007; collateralized by our
Victoria facility and equipment located at
our Tempe facility
    
    
    284
    
    
    
    361Capital lease obligation; payable in
installments of $1 through February 2009;
collateralized with certain equipment
    
    
    17
    
    
    
    18Commercial loans payable in fixed monthly
installments of $1 through May 2009;
collateralized with certain machinery and
equipment
    
    
    16
    
    
    
    17Capital lease obligations; payable in fixed
monthly installments of $16 through July
2008; collateralized with certain machinery
and equipment
    
    
    257
    
    
    
    292Capital lease obligations; payable in fixed
monthly installments of $4 through September
2008; collateralized with certain machinery
and equipment
    
    
    78
    
    
    
    87Capital lease obligations; payable in fixed
monthly installments of $1 through November
2008; collateralized with certain machinery
and equipment
    
    
    15
    
    
    
    17Capital lease obligations; payable in fixed
monthly installments of $4 through January
2009; collateralized with certain machinery
and equipment
    
    
    81
    
    
    
    89Capital lease obligations; payable in fixed
monthly installments of $9 with a final
payment of approximately $70 due in February
2009; collateralized with certain machinery
and equipment
    
    
    250
    
    
    
    268Capital lease obligations; payable in fixed
monthly installments of $2 through March
2009; collateralized with certain machinery
and equipment
    
    
    42
    
    
    
    46Capital lease obligations; payable in fixed
monthly installments of $2 with a final
payment of approximately $10 due in April
2009; collateralized with certain machinery
and equipment
    
    
    45
    
    
    
    48Capital lease obligations; payable in fixed
monthly installments of $10 with a final
payment of approximately $72 due in June
2009; collateralized with certain machinery
and equipment
    
    
    306
    
    
    
    325Capital lease obligations; payable in fixed
monthly installments of $2 through May
2009; collateralized with certain machinery
and equipment
    
    
    48
    
    
    
    52Capital lease obligations; payable in fixed
monthly installments of $3 with a final
payment of approximately $18 due in June
2009; collateralized with certain machinery
and equipment
    
    
    98
    
    
    
    105Capital lease obligations; payable in fixed
monthly installments of $22 with a final
payment of approximately $141 due in
November 2009; collateralized with certain
machinery and equipment
    
    
    733
    
    
    
    775Capital lease obligations; payable in fixed
monthly installments of $6 with a final
payment of approximately $43 due in February
2010; collateralized with certain machinery
and equipment
    
    
    228
    
    
    
    240Total
    
    
    3,614
    
    
    
    3,862Less current maturities
    
    
    1,024
    
    
    
    1,038Total long-term debt
    
    $
    2,590
    
    
    $
    2,824
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(6) Line of Credit
  12




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(7) Related Party Note Payable
    (8) Deferred Taxes
  (9) Net Loss per Share Computation
  Three Months EndedDecember 2, 2006
    
    November 26, 2005Basic and Diluted:Net loss
    
    $
    (1,608,000
    )
    
    $
    (630,000
    )Net loss per share
    
    $
    (0.17
    )
    
    $
    (0.07
    )Weighted average number of common shares outstanding
    
    
    9,505,000
    
    
    
    9,400,000
  (10) Major Customers
  13




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(11) Geographic Data (In Thousands)
  Three Months EndedDecember 2, 2006
    
    
    November 26, 2005Dollars
    
    
    % of Sales
    
    
    Dollars
    
    
    % of SalesUnited States
    
    $
    10,311
    
    
    
    80
    %
    
    $
    9,908
    
    
    
    72
    %Canada / Mexico
    
    $
    107
    
    
    
    1
    %
    
    $
    654
    
    
    
    5
    %Europe
    
    $
    1,081
    
    
    
    8
    %
    
    $
    1,621
    
    
    
    12
    %Asia-Pacific
    
    $
    1,438
    
    
    
    11
    %
    
    $
    1,598
    
    
    
    11
    %South America
    
    $
    8
    
    
    
    0
    %
    
    $
    6
    
    
    
    0
    %Total
    
    $
    12,945
    
    
    
    
    
    
    $
    13,787
 (12) Segments (In Thousands)
     Three Months Ended December 2, 2006Corporate
    
    Microelectronics
    
    Advanced MedicalOperations
    
    Operations
    
    Operations
    
    TotalNet sales
    
    $
    
    
    
    $
    8,458
    
    
    $
    4,487
    
    
    $
    12,945Gross profit
    
    
    
    
    
    
    1,189
    
    
    
    259
    
    
    
    1,448Operating expense
    
    
    1,313
    
    
    
    1,190
    
    
    
    200
    
    
    
    2,703Operating income (loss)
    
    
    (1,313
    )
    
    
    (1
    )
    
    
    59
    
    
    
    (1,255
    )Total assets
    
    
    
    
    
    
    20,971
    
    
    
    5,832
    
    
    
    26,803Depreciation and amortization
    
    
    
    
    
    
    566
    
    
    
    26
    
    
    
    592Capital expenditures
    
    
    
    
    
    
    15
    
    
    
    47
    
    
    
    62
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Three Months Ended November 26, 2005Corporate
    
    Microelectronics
    
    Advanced MedicalOperations
    
    Operations
    
    Operations
    
    TotalNet sales
    
    $
    
    
    
    $
    8,920
    
    
    $
    4,867
    
    
    $
    13,787Gross profit
    
    
    
    
    
    
    1,981
    
    
    
    743
    
    
    
    2,724Operating expense
    
    
    2,144
    
    
    
    863
    
    
    
    249
    
    
    
    3,256Operating income (loss)
    
    
    (2,144
    )
    
    
    1,118
    
    
    
    494
    
    
    
    (532
    )Total assets
    
    
    
    
    
    
    18,111
    
    
    
    6,917
    
    
    
    25,028Depreciation and amortization
    
    
    
    
    
    
    482
    
    
    
    103
    
    
    
    585Capital expenditures
    
    
    
    
    
    
    50
    
    
    
    8
    
    
    
    58
 (13) Commitments and Contingencies
    (14) Notes Receivable-Related Parties-Officers and Former Directors
  
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 FORWARD-LOOKING STATEMENTS
 Some of the information included in this Quarterly Report on Form 10-Q contains forward-looking
statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform
Act of 1995 that involve substantial risks and uncertainties. You can identify these statements by
forward-looking words such as may, will, expect, anticipate, believe, intend,
estimate, continue, and similar words. You should read statements that contain these words
carefully for the following reasons: such statements discuss our future expectations, such
statements contain projections of future earnings or financial condition and such statements state
other forward-looking information. Although it is important to communicate our expectations, there
may be events in the future that we are not accurately able to predict or over which we have no
control. The Risk Factors included in Item 1A of our Annual Report on Form 10-K for the fiscal year
ended September 2, 2006 provide examples of such risks, uncertainties and events that may cause
actual results to differ materially from our expectations and the forward-looking statements.
Readers are cautioned not to place undue reliance on forward-looking statements, as we undertake no
obligation to update these forward-looking statements to reflect ensuing events or circumstances,
or subsequent actual results.
 This Quarterly Report of Form 10-Q should be read in conjunction with our Annual Report on Form
10-K for the fiscal year ended September 2, 2006.
 Overview
  15




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Results of Operations
 Three Months Ended December 2, 2006 and November 26, 2005:
 Net Sales
    Gross Profit
   Operating Expenses
 Selling, general and administrative expenses
 16




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Research, development, and engineering expenses
  Interest Expense, Net
  Income Taxes
  FINANCIAL CONDITION AND LIQUIDITY
      17




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
    
    Expanding our sales efforts to existing customers and to find new customers for our
products. We will accomplish this through the restructuring of our sales staff in Boulder
and Victoria and we have added an additional sales person to support our flexible substrate
business in Tempe.
    
    Focusing on gross margin improvements at all segments. We plan to accomplish this by
focusing on our costs and looking at all areas for improvements including material costs,
labor costs and overhead structures.
    
    Structuring our staffing to work within our current sales levels for all of our general
and administrative costs and engineering costs, and to reorganize the staff as necessary to
position the Company for growth.
    
    Pursuing additional sublease tenants for the excess space in our Boulder facility while
allowing for adequate room for expansion in that the AMO segment. This will help to offset a
portion of the operating costs and lease costs of that facility.
    
    Refinancing our debt to improve cash flow. To that end, in November 2006, the Company
paid off the Credit Agreement with Beacon Bank and replaced the funding through a $5,000,000
one-year term secured loan from Thomas F. Leahy, the Companys Chairman of the Board. The
new term loan was undertaken to provide the Company with the opportunity to establish a
relationship with a new asset-based lender during Fiscal 2007. This transaction allowed the
Company to have direct access again to the collection of its accounts receivables, which
should reduce the days outstanding and improve cash flow from collections. In addition, the
loan provided additional future working capital of approximately $1.8 million after the
Credit Agreement was repaid and current working capital was funded.
    
    Reduction in inventories by reviewing buying procedures and reducing any excess on hand
inventory while maintaining the required inventories to meet customer demand. These
initiatives are targeted to reduce inventories by $1 million by the end of Fiscal 2007.
     18




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CRITICAL ACCOUNTING POLICIES
  Revenue recognition, sales returns and warranty
    
 Item 3. Qualitative and Quantitative Disclosures About Market Risk
 Market Risk
  Interest Rate Risk
   19




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Item 4. Controls and Procedures
      
 PART II  OTHER INFORMATION
 
 Item 5. Other Information
 20




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Item 6. Exhibits
 a) Exhibits
 10.1
    
    Waiver and Amendment dated as of January 12, 2007 by and between HEI,
Inc., a Minnesota corporation, and Commerce Bank, a Minnesota banking
corporation.10.2
    
    Waiver and Amendment dated as of January 12, 2007 by and between HEI,
Inc., a Minnesota corporation, and Commerce Financial Group, Inc., a
Minnesota corporation.10.3
    
    Waiver dated as of January 12, 2007 by and between HEI, Inc., a
Minnesota corporation, and Commerce Leasing Corporation, a division
of Commerce Financial Group, Inc., a Minnesota corporation.31.1
    
    Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 21




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SIGNATURES
  HEI, Inc.Date: January 12, 2007
    /s/ Mark B. ThomasMark B. ThomasChief Executive Officer and Chief Financial Officer 22