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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 May
29, 2004.
 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. 
  Minnesota
    
    41-0944876(State or other jurisdiction
    
    (I.R.S. Employer Identification No.)of incorporation or organization)1495 Steiger Lake Lane, Victoria, Minnesota
    
    55386(Address of principal executive offices)
    
    (Zip Code)
 (952) 443-2500 
 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 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 þ No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes o No þ As of July 12, 2004, 8,356,805 Common Shares, par value $.05 per share, were
outstanding.




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##### Table of Contents



Table of Contents
    
    HEI, Inc.
 Part I  Financial Information (unaudited)Item 1. Financial StatementsConsolidated Balance Sheets
    
    
    
    
    
    
    3Consolidated Statements of Operations
    
    
    
    
    
    
    4Consolidated Statements of Cash Flows
    
    
    
    
    
    
    5Notes to Consolidated Financial Statements
    
    
    
    
    
    
    6-15Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    
    
    
    
    16-21Item 3. Quantitative and Qualitative Disclosures About
Market Risk
    
    
    
    
    
    
    22Item 4. Controls and Procedures
    
    
    
    
    
    
    23Part II  Other InformationItem 1. Legal Proceedings
    
    
    
    
    
    
    24Item 6. Exhibits and Reports on Form 8-K
    
    
    
    
    
    
    25Signature
    
    
    
    
    
    
    26Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
 2




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##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements 
 HEI, Inc.
Consolidated Balance Sheets (Unaudited)(In thousands) May 29, 2004
    
    August 31, 2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    336
    
    
    $
    806Restricted cash
    
    
    562
    
    
    
    Accounts receivable, net
    
    
    7,058
    
    
    
    6,314Inventories
    
    
    6,924
    
    
    
    6,864Other current assets
    
    
    454
    
    
    
    403Total current assets
    
    
    15,334
    
    
    
    14,387Property and equipment:Land
    
    
    216
    
    
    
    216Building and improvements
    
    
    4,316
    
    
    
    4,316Fixtures and equipment
    
    
    21,521
    
    
    
    21,137Accumulated depreciation
    
    
    (17,789
    )
    
    
    (15,769
    )Net property and equipment
    
    
    8,264
    
    
    
    9,900Developed technology, net
    
    
    216
    
    
    
    341Security deposits
    
    
    1,580
    
    
    
    1,580Other long-term assets
    
    
    473
    
    
    
    295Total assets
    
    $
    25,867
    
    
    $
    26,503Liabilities and Shareholders EquityCurrent liabilities:Line of credit
    
    $
    784
    
    
    $
    490Current maturities of long-term debt
    
    
    367
    
    
    
    397Accounts payable
    
    
    6,338
    
    
    
    3,951Accrued liabilities
    
    
    3,472
    
    
    
    3,798Total current liabilities
    
    
    10,961
    
    
    
    8,636Other long-term liabilities, less current maturities:Other long-term liabilities
    
    
    1,443
    
    
    
    2,121Long-term debt
    
    
    1,912
    
    
    
    2,555Total other long-term liabilities, less current maturities
    
    
    3,355
    
    
    
    4,676Total liabilities
    
    
    14,316
    
    
    
    13,312Shareholders equity:Undesignated stock; 4,000 shares authorized; none issued
    
    
    
    
    
    
    Common stock, $.05 par; 11,000 shares authorized;
8,357 and 7,046 shares issued and outstanding
    
    
    418
    
    
    
    352Paid-in capital
    
    
    22,426
    
    
    
    18,951Accumulated deficit
    
    
    (10,694
    )
    
    
    (5,443
    )Notes receivable
    
    
    (599
    )
    
    
    (669
    )Total shareholders equity
    
    
    11,551
    
    
    
    13,191Total liabilities and shareholders equity
    
    $
    25,867
    
    
    $
    26,503
 See accompanying notes to unaudited consolidated financial statements. 3




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HEI, Inc.
Consolidated Statements of Operations (Unaudited)(In thousands, except per share amounts) Three Months Ended
    
    Nine Months EndedMay 29, 2004
    
    May 31, 2003
    
    May 29, 2004
    
    May 31, 2003Net sales
    
    $
    11,131
    
    
    $
    12,517
    
    
    $
    32,042
    
    
    $
    26,151Cost of sales
    
    
    9,980
    
    
    
    10,027
    
    
    
    29,376
    
    
    
    22,202Gross profit
    
    
    1,151
    
    
    
    2,490
    
    
    
    2,666
    
    
    
    3,949Operating expenses:Selling, general and administrative
    
    
    1,999
    
    
    
    2,178
    
    
    
    5,817
    
    
    
    5,047Research, development and engineering
    
    
    737
    
    
    
    749
    
    
    
    2,316
    
    
    
    1,837Costs related to investigation
    
    
    94
    
    
    
    
    
    
    
    851
    
    
    
    Operating loss
    
    
    (1,679
    )
    
    
    (437
    )
    
    
    (6,318
    )
    
    
    (2,935
    )Other income (expenses):Former officer note write off
    
    
    
    
    
    
    (681
    )
    
    
    
    
    
    
    (681
    )Bank fees
    
    
    
    
    
    
    (165
    )
    
    
    
    
    
    
    (181
    )Interest expense
    
    
    (60
    )
    
    
    (105
    )
    
    
    (227
    )
    
    
    (224
    )Gain on prepayment of promissory note
    
    
    
    
    
    
    
    
    
    
    472
    
    
    
    Litigation recovery
    
    
    687
    
    
    
    
    
    
    
    799
    
    
    
    Other income, net
    
    
    23
    
    
    
    75
    
    
    
    23
    
    
    
    198Loss before income taxes
    
    
    (1,029
    )
    
    
    (1,313
    )
    
    
    (5,251
    )
    
    
    (3,823
    )Income tax benefit
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    21Net loss
    
    $
    (1,029
    )
    
    $
    (1,311
    )
    
    $
    (5,251
    )
    
    $
    (3,802
    )Net loss per common share:Basic
    
    $
    (0.12
    )
    
    $
    (0.19
    )
    
    $
    (0.70
    )
    
    $
    (0.59
    )Diluted
    
    $
    (0.12
    )
    
    $
    (0.19
    )
    
    $
    (0.70
    )
    
    $
    (0.59
    )Weighted average common shares outstanding:Basic
    
    
    8,310
    
    
    
    7,029
    
    
    
    7,533
    
    
    
    6,488Diluted
    
    
    8,310
    
    
    
    7,029
    
    
    
    7,533
    
    
    
    6,488
 See accompanying notes to unaudited consolidated financial statements. 4




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HEI, Inc.
Consolidated Statements of Cash Flows (Unaudited) (In thousands) Nine Months EndedMay 29, 2004
    
    May 31, 2003Cash flow from operating activities:Net loss
    
    $
    (5,251
    )
    
    $
    (3,802
    )Depreciation and amortization
    
    
    2,054
    
    
    
    2,256Accounts receivable allowance
    
    
    (20
    )
    
    
    Notes receivable allowance
    
    
    
    
    
    
    587Loss on disposal of property and equipment
    
    
    18
    
    
    
    Gain on prepayment of promissory note
    
    
    (472
    )
    
    
    Changes in operating assets and liabilities:Restricted cash related to deferred litigation recovery
    
    
    (562
    )
    
    
    Accounts receivable
    
    
    (724
    )
    
    
    (2,503
    )Inventories
    
    
    (60
    )
    
    
    619Other current assets
    
    
    (46
    )
    
    
    83Other assets
    
    
    (22
    )
    
    
    64Accounts payable
    
    
    2,387
    
    
    
    2,517Accrued liabilities
    
    
    (943
    )
    
    
    (152
    )Net cash used in operating activities
    
    
    (3,641
    )
    
    
    (331
    )Cash flow from investing activities:Additions to property and equipment
    
    
    (520
    )
    
    
    (224
    )Proceeds from sale of assets
    
    
    17
    
    
    
    Additions to patents
    
    
    (64
    )
    
    
    (89
    )AMO acquisition costs paid
    
    
    
    
    
    
    (1,198
    )Cash acquired from CMED
    
    
    
    
    
    
    1,215Sale of technology
    
    
    323
    
    
    
    Net cash used in investing activities
    
    
    (244
    )
    
    
    (296
    )Cash flow from financing activities:Proceeds from issuance of stock, net
    
    
    3,374
    
    
    
    54Officer note repayment
    
    
    70
    
    
    
    Proceeds from long-term debt, net
    
    
    2,200
    
    
    
    204Promissory note payable
    
    
    
    
    
    
    2,600Repayment of long-term debt
    
    
    (2,523
    )
    
    
    (3,895
    )Deferred financing costs
    
    
    
    
    
    
    (92
    )Net repayments on line of credit
    
    
    294
    
    
    
    (1,589
    )Restricted cash
    
    
    
    
    
    
    1,000Net cash provided by (used in) financing activities
    
    
    3,415
    
    
    
    (1,718
    )Net decrease in cash and cash equivalents
    
    
    (470
    )
    
    
    (2,345
    )Cash and cash equivalents, beginning of period
    
    
    806
    
    
    
    2,372Cash and cash equivalents, end of period
    
    $
    336
    
    
    $
    27Supplemental disclosures of cash flow information:Interest paid
    
    $
    210
    
    
    $
    224Income taxes received
    
    
    
    
    
    
    (21
    )
 See accompanying notes to unaudited consolidated financial statements. 5




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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share and per share amounts) (1) Basis of Financial Statement Presentation The accompanying unaudited interim consolidated financial statements have been
prepared by HEI, Inc. pursuant to the rules and regulations of the Securities
and Exchange Commission (SEC). These financial statements contain all normal
recurring adjustments, which are, in our opinion, necessary for a fair
presentation of our financial position, results of operations and cash flows in
accordance with accounting principles generally accepted in the United States
of America (GAAP). Certain information and footnote disclosures normally included in financial
statements prepared in accordance with GAAP have been condensed or omitted. We
believe, however, that the disclosures are adequate to make the information
presented not misleading. The August 31, 2003 balance sheet data was derived
from audited financial statements but does not include all disclosures required
by GAAP. These unaudited interim consolidated financial statements should be
read in conjunction with the consolidated financial statements and accompanying
notes included in our Annual Report on Form 10-K for our fiscal year ended
August 31, 2003. Interim results of operations for the three- and nine-month
periods ended May 29, 2004, may not necessarily be indicative of the results to
be expected for the full year. The unaudited interim consolidated financial statements include the operations
and certain assets and liabilities of Colorado MEDtech, Inc.s (CMED)
Colorado Operations (a business unit of CMED or our Advanced Medical Operations
(AMO) since its acquisition by the Company on January 24, 2003. The
accompanying unaudited interim consolidated financial statements have been
prepared on the basis of assumptions discussed in Note 6 to our unaudited
consolidated financial statements, including an allocation of the consideration
paid for the assets and liabilities of AMO based on valuations of their fair
values. The unaudited interim consolidated financial statements include our accounts
and the accounts of our wholly owned subsidiary. All significant intercompany
transactions and balances have been eliminated in consolidation. Our quarterly periods end on the Saturday closest to the end of each quarter of
our fiscal year ending August 31. (2) Liquidity The accompanying unaudited consolidated financial statements have been prepared
assuming that we will continue as a going concern, which contemplates the
realization of assets and the satisfaction of liabilities in the normal course
of business. We incurred net losses of $1,029 and $5,251 for the three-month
and nine-month periods ended May 29, 2004, and $4,629 for the year ended August
31, 2003. A number of factors have contributed to the losses we have sustained
during Fiscal 2004 including operational issues we have encountered in our
microelectronics facilities and reduced order activity at our AMO facility. We have historically financed our operations through the public and private
sale of debt and equity securities, bank borrowings under lines of credit and
term debt, operating equipment leases and cash generated by operations. During
our fiscal year ended August 31, 2003 (Fiscal 2003), and the first
nine-months of our fiscal year ending August 31, 2004 (Fiscal 2004), we
undertook a number of activities to improve our capital structure to lower our
average interest rate and have less restrictions. We replaced our revolving
line of credit with LaSalle Business Credit, LLC, with an accounts receivable
backed credit agreement with Beacon Bank that does not have restrictive
covenants. On October 29, 2003, we completed the funding of two separate loans in the
aggregate amount of $2,350 under new Term Credit Facilities with Commerce Bank,
a Minnesota state banking corporation, and its affiliate, Commerce Financial
Group, Inc,. a Minnesota corporation. The first note, with Commerce Bank in
the amount of $1,200, is secured by our Victoria, Minnesota facility. The
second note, with Commerce Financial Group, Inc. in the amount of $1,150, is
secured by our Victoria, Minnesota facility and equipment located at our Tempe,
Arizona facility. These loans provided us with the necessary resources to
prepay the Subordinated Promissory Note (as defined below) held by 6




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Whitebox
Hedged High Yield Partners (See Note 7). The terms of these new loans have an
average interest rate of 7.75%, as compared to 12.00% for the retired debt. On February 13, 2004, we sold 1,180,000 shares of our Common Stock together
with five-year warrants to purchase up to 354,000 shares of our Common Stock at
an exercise price of $3.72 per share in a private placement to a group of 18
institutional and accredited investors. We received gross proceeds of $3,540,
excluding transaction costs of $301, for the shares and warrants sold, which
will be used to increase working capital and for future capital expenditures.
We paid a 6% underwriting discount in connection with the sale and the
placement agent, ThinkEquity Partners, LLC, also received warrants to purchase
up to 70,800 shares of our Common Stock at an exercise price of $3.72 per share
as additional compensation for the private placement. As a result of the equity raised, we have demanded repayment of our deposit of
$1,430 that the landlord, Eastside Properties, LLC (Eastside), of our Boulder
facility now holds on our behalf. On June 1, 2004, we signed a purchase
agreement for the Boulder facility calling for the transfer of ownership of our
AMO facility from Eastside to Titan Real Estate Investment Group, Inc.
(Titan). As a part of the consideration related to this agreement, the
Company and Eastside signed a standstill agreement for payment of the leasehold
deposit to the Company. The sale to Titan is scheduled to close approximately
in August 2004 and is subject to various closing conditions, including
completion of normal due diligence. Upon completion of this transaction, Titan
would become our new landlord, which would potentially result in substantially
lower rental and operating costs for the Boulder facility. As discussed in Note 10, we continue to pursue collection efforts against the
judgments received from the courts against Anthony J. Fant our former Chairman
of the Board, Chief Executive Officer and President, and a current director.
As of May 29, 2004, we have collected approximately $1,375 against judgments of
approximately $2,255. This includes $562 of restricted cash at May 29, 2004
that we expect to become unrestricted during the quarter ended August 31, 2004.
In June 2004, we obtained $481 through a garnishment of assets previously held
by Mr. Fant which will be recorded as income in the first quarter of Fiscal
2005. Ongoing efforts are being made to monetize other Fant assets that are
expected to add to liquidity. At May 29, 2004, our sources of liquidity consisted of $898 of cash, cash
equivalents and restricted cash and our revolving credit line agreement, which
pursuant to an extension granted in June 2004, expires on January 1, 2005, and
is extended for successive six-month periods subject to prior lender approval.
The revolving credit line agreement allows for borrowings of up to $3,000,
subject to availability based on accounts receivable. There was $784
outstanding and $2,216 available on the revolving line at May 29, 2004. In the
event the revolving credit line agreement is not extended beyond the January 1,
2005 expiration date, management may be required to take certain measures to
meet our short-term liquidity needs. These potential measures include pursuing
other financing or asset based lending arrangements, which may not have as
attractive of terms as our current lending arrangement. If we were unable to
find a suitable lending arrangement, management will need to take measures to
reduce expenditures to meet liquidity demands. This includes, but not limited
to, reductions in research and development spending and headcounts. If we are
unable to repay the bank through other capital resources or operating cash
flows, we may be required to renegotiate supply contracts and other
arrangements with third parties, which may impact our ability to procure
inventory, meet customer demands and comply with other contractual
arrangements. Our liquidity is affected by many factors, some of which are based on the
normal ongoing operations and profitability of our business, and the most
significant of which include the timing of the collection of receivables, and
the level of inventories and capital expenditures. In the event cash flows are
not sufficient to fund operations at the present level, management believes
certain measures can be taken to reduce the expenditure levels including, but
not limited to, reduction of spending for research and development and
headcount reductions. We have also been impacted by operational issues we have
encountered in our microelectronics facilities. While the remediation of these
operational issues is ongoing, we have observed improvements in both quantity
and quality of customer deliveries. Management believes that, as a result of the financial restructuring actions it
has taken to reduce cash expenditures, the continuing efforts to increase
revenues from continuing customers and to generate new customers in various
industry sectors, and the replacement and subsequent extension of the revolving and
term credit facilities, it will meet its short and
long-term debt obligations and operation requirements for at least the next
twelve months. 7




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(3) Stock Based Compensation We apply the intrinsic-value method prescribed in Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees, to account
for the issuance of stock incentives to employees and directors. No
compensation expense related to employees and directors stock incentives has
been recognized in the financial statements, as all options granted under stock
incentive plans had an exercise price equal to the market value of the
underlying common stock on the date of grant. Had we applied the fair value
recognition provisions of Financial Accounting Standards Board (FASB)
Statement No. 123, Accounting for Stock-Based Compensation, to stock based
employee compensation, our net loss per share would have increased to the pro
forma amounts indicated below: Three Months Ended
    
    Nine Months EndedMay 29, 2004
    
    May 31, 2003
    
    May 29, 2004
    
    May 31, 2003Net loss as reported
    
    $
    (1,029
    )
    
    $
    (1,311
    )
    
    $
    (5,251
    )
    
    $
    (3,802
    )Add: Stock-based employee compensation
included in reported net income, net of related
tax effects
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards
    
    
    (461
    )
    
    
    (349
    )
    
    
    (1,368
    )
    
    
    (1,419
    )Net loss pro forma
    
    $
    (1,490
    )
    
    $
    (1,660
    )
    
    $
    (6,619
    )
    
    $
    (5,221
    )Basic and diluted net loss per share as reported
    
    $
    (0.12
    )
    
    $
    (0.19
    )
    
    $
    (0.70
    )
    
    $
    (0.59
    )Stock-based compensation income (expense)
    
    
    (0.06
    )
    
    
    (0.05
    )
    
    
    (0.18
    )
    
    
    (0.22
    )Basic and diluted net loss per share pro forma
    
    $
    (0.18
    )
    
    $
    (0.24
    )
    
    $
    (0.88
    )
    
    $
    (0.81
    )
 There were 17,500 and 364,500 options granted under our stock option plans
during the three-months and nine-months ended May 29, 2004. 8




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(4) Other Financial Statement Data The following provides additional information concerning selected consolidated
balance sheet accounts at May 29, 2004 and August 31, 2003: May 29,
    
    August 31,2004
    
    2003Accounts Receivable, net:Trade accounts receivable
    
    $
    7,130
    
    
    $
    6,406Less: allowance for doubtful accounts
    
    
    (72
    )
    
    
    (92
    )$
    7,058
    
    
    $
    6,314Inventories:Purchased parts
    
    $
    4,573
    
    
    $
    4,297Work in process
    
    
    929
    
    
    
    958Finished goods
    
    
    1,422
    
    
    
    1,609$
    6,924
    
    
    $
    6,864Accrued Liabilities:Employee related costs
    
    $
    984
    
    
    $
    1,085Contractual manufacturing obligations
    
    
    208
    
    
    
    498Customer deposits
    
    
    296
    
    
    
    371Current maturities of long-term liabilities
    
    
    741
    
    
    
    741Interest
    
    
    
    
    
    
    156Warranty reserve
    
    
    163
    
    
    
    122Deferred litigation recovery
    
    
    562
    
    
    
    Other accrued liabilities
    
    
    518
    
    
    
    825$
    3,472
    
    
    $
    3,798Other long-term liabilities:Remaining lease obligation, less estimated sublease proceeds
    
    $
    1,627
    
    
    $
    2,183Unfavorable operating lease, net
    
    
    557
    
    
    
    610Other non-current liabilities
    
    
    
    
    
    
    69Total
    
    $
    2,184
    
    
    $
    2,862Less current maturities
    
    
    741
    
    
    
    741Total other long-term liabilities
    
    $
    1,443
    
    
    $
    2,121
 (5) Warranty Obligations Sales of our products are subject to limited warranty guarantees that typically
extend for a period of twelve months from the date of manufacture. Warranty
terms are included in customer contracts under which we are obligated to repair
or replace any components or assemblies deemed defective due to workmanship or
materials. We do, however, reserve the right to reject warranty claims where
we determine that failure is due to normal wear, customer modifications,
improper maintenance, or misuse. Warranty provisions are based on estimated
returns and warranty expenses applied to current period revenue and historical
warranty incidence over the preceding twelve-month period. Both the experience
and the warranty liability are evaluated on an ongoing basis for adequacy.
Warranty provisions and claims for the first nine months of Fiscal 2004 and
Fiscal 2003 were as follows: 9




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Warranty
    
    WarrantyBeginning Balance
    
    Provisions
    
    Claims
    
    Ending BalanceFiscal 2004
    
    $
    122
    
    
    $
    128
    
    
    $
    87
    
    
    $
    163Fiscal 2003
    
    $
    200
    
    
    $
    376
    
    
    $
    160
    
    
    $
    416
 (6) Acquisition On January 24, 2003, we acquired certain assets and assumed certain liabilities
of CMEDs Colorado operations (a business unit of CMED or our AMO) in a
business combination accounted for as a purchase. In exchange for certain
assets of our AMO, we issued 1,000,000 shares of our Common Stock, and assumed
approximately $1,364 of liabilities related to our AMO, as well as an operating
lease and other contractual commitments. Our consolidated financial statements
include the results of our AMO since January 24, 2003. Our purposes for
acquiring our AMO were to immediately gain access to the more stable medical
sector, to consolidate marketing and sales efforts, and to expand our resources
to become more full service or one stop shop to our customers and target
markets. The design, development and manufacturing capabilities for medical
devices at our AMO, coupled with our microelectronic design, development and
manufacturing, improves our offerings to the market to retain and gain
customers. During the second quarter ended February 28, 2004, we finalized our purchase
price allocation for this acquisition. Since our Annual Report of Form 10-K
for the fiscal year ended August 31, 2003, we have increased the balance for
our developed technologies by $323 related to technology sold to MKS
Instruments and we increased other reserves by $160 related to legal costs.
The net of these adjustments resulted in a reduction of property and equipment
of $163. Below is a table of the acquisition consideration, purchase price
allocation and annual amortization of the intangible assets acquired in the
acquisition of our AMO: AmountPurchase price allocation:Cash
    
    $
    1,215Accounts receivable
    
    
    300Inventories
    
    
    3,418Property and equipment
    
    
    1,348Prepaids, deposits and other assets
    
    
    1,690Developed technology
    
    
    738Customer deposits and other reserves
    
    
    (1,504
    )Operating lease reserves
    
    
    (3,110
    )Transaction costs
    
    
    (1,495
    )$
    2,600
 The intangible asset value for the developed technology of our AMO was
determined utilizing discounted cash flow analyses. The discounted cash flow
analysis was based on three to five-year cash flow projections. The expected
future cash flows attributable to developed technology was discounted to
present value at discount rates ranging from 23% to 40%, taking into account
risks related to the characteristics and applications of the developed
technology, our anticipated courses of business activities, historical
financial market rates of return, and assessments of the stage of the
technologys life cycle. The developed technology had reached technological
feasibility and therefore was capitalized. Amortization expense for developed technology for the three-months and
nine-months ended May 29, 2004, was $29 and $88, respectively. Amortization
expense is estimated to be $120 in Fiscal 2004, $124 in our fiscal year ending
August 31, 2005, $57 in our fiscal year ending August 31, 2006, and $4
thereafter. 10




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##### Table of Contents



The purchase allocation includes an accrual of $730 related to an
unfavorable operating lease, $2,380 for future estimated lease payments and a
$760 accrual to fulfill estimated contractual manufacturing obligations. The
$2,380 accrued for estimated lease payments consists of $5,910 for future lease
obligations less estimated sublease payments of $3,530 on 50,000 square feet of
unoccupied space for which we are in the process of reviewing alternative uses
since we do not intend to occupy. We have entered into an agency agreement
with Julien J. Studley, Inc., a national commercial real estate services firm.
Julien J. Studley is assisting us in reducing our occupancy costs at this
facility by sub-leasing the 50,000 square foot addition, performing tenant
representation with our landlord, and assisting us in exploring other options
related to our future use of the Boulder facility. At May 29, 2004, the
carrying value of long-lived assets had been reduced by a net of $3,914 by the
allocation of negative goodwill. On October 31, 2003, we entered into an agreement with MKS Instruments, Inc.
(the MKS Agreement), wherein MKS Instruments, Inc. purchased our solid state
radio frequency power amplifier technology. This technology focused on Tesla
1.5 magnetic resonance imaging (MRI) applications but could be scaled for use
in other MRI equipment. The value of the transaction was $423. The first two
milestone payments totaling $323 were paid by wire transfer on October 31,
2003. The remaining $100 will be recognized in revenue and due upon our
completion of engineering or expiration of time as set forth in the MKS
Agreement. The engineering development services were completed on
May 31, 2004.
The MKS Agreement contains a non-compete clause restricting us from developing
and selling competing solid state amplifiers in the MRI market for a period of
two years. This non-compete clause does not restrict us from fulfilling our
traditional role as a contract manufacturer of third party solid state MRI
amplifiers. On November 17, 2003, we entered into a Settlement Agreement and Mutual Release
(the BD Settlement Agreement) with Becton Dickinson (BD), pursuant to
which, among other things, we agreed to pay to BD the sum of $400. Such amount
will be paid in five installments of $80, of which the initial three were paid
on November 17, 2003, February 20, 2004, and April 30, 2004 and the remainder
of which will be paid on July 31, 2004, and September 30, 2004, respectively.
Except for cash flow, the BD Settlement Agreement did not impact our results of
operations as we had established a full reserve in the purchase accounting
adjustments for this matter. Our dispute was based on certain equipment that
was shipped to BD prior to the acquisition of AMO that did not meet the
customers acceptance criteria. Our results for the three-months and nine-months ended May 29, 2004, and the
three-month period ended May 31, 2003, include our AMO for the entire periods.
The following table presents our unaudited pro forma consolidated results of
operations for the nine-months ended May 31, 2003, as if the
acquisition of our AMO took place on September 1, 2002. Nine MonthsMay 31, 2003Net sales
    
    $
    42,421Net loss
    
    
    (6,714
    )Net loss per share
    
    $
    (0.34
    )
 As our AMO had a June 30 fiscal year-end and we have an August 31 fiscal
year-end, the pro forma information reflects the combination of different
periods for us and our AMO. The 2003 pro forma information includes unaudited
results of operations for the nine-month period ended May 31, 2003, for us and
unaudited results of operations for the nine-month period ended December 31,
2002, for our AMO. The unaudited pro forma amounts have been derived by applying pro forma
adjustments to the historical consolidated financial information of us and our
AMO. The unaudited pro-forma results are for comparative purposes only and do
not necessarily reflect the results that would have been recorded had the
acquisition occurred at the beginning of the period presented or the results
which might occur in the future. 11




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##### Table of Contents



(7) Long-Term Debt Our long-term debt consists of the following: May 29, 2004
    
    August 31, 2003Subordinated promissory note, due September 30, 2004
    
    $
    
    
    
    $
    2,740Commercial loans payable in fixed monthly principal installments of
$12 through May 2004 and July 2005; secured with certain
machinery and equipment.
    
    
    120
    
    
    
    212Commerce Bank mortgage payable in monthly installments of
principal and interest based on a twenty-year
amortization with a final payment of approximately $980
due in November 2009; secured by our Victoria facility.
    
    
    1,180
    
    
    
    Commerce Financial Group, Inc. equipment loan payable in
fixed monthly principal and interest installments of $28 through
September 2007; secured by our Victoria facility and equipment
equipment located at our Tempe facility.
    
    
    979
    
    
    
    Total
    
    
    2,279
    
    
    
    2,952Less current maturities
    
    
    367
    
    
    
    397Total long-term debt
    
    $
    1,912
    
    
    $
    2,555
 During Fiscal 2003, and the first six-months of Fiscal 2004, we undertook a
number of activities to restructure our term-debt. The following is a summary
of the history of our debt and those restructuring transactions. We originally issued Industrial Development Revenue Bonds (IDRBs) in April
1996 in connection with the construction of a new addition to our manufacturing
facility in Victoria, Minnesota, and for the purchase of production equipment.
On March 14, 2003, an aggregate of approximately $1,735 of debt proceeds from
the Subordinated Promissory Note issued by us to CMED, in the principal amount
of $2,600 (the Subordinated Promissory Note), in connection with the
acquisition of our AMO were used to fund the repayment of principal and
interest on the IDRBs. We also used $845 of the proceeds from the Subordinated
Promissory Note to retire our capital expenditure notes with LaSalle Business
Credit, LLC. The Subordinated Promissory Note was funded by CMED at the time of our AMO
acquisition in January 2003. On May 8, 2003 the Subordinated Promissory Note
was sold by CMED to Whitebox Hedged High Yield Partners (Whitebox) and
continued with the same terms as the original agreement with CMED until August
15, 2003. To encourage early repayment, the terms of the Subordinated
Promissory Note were modified on May 16, 2003, and subsequently modified again
on September 12, 2003. On October 15, 2003, we prepaid the Subordinated
Promissory Note for a discount on the principal amount outstanding of $360. We
paid the accrued interest, totaling $167, with 47,700 unregistered shares of
our Common Stock valued at $3.50 per share. The 47,700 shares of Common Stock
were issued to Whitebox on December 8, 2003. Interest from September 15, 2003
through October 15, 2003, was forgiven in connection with such prepayment. As
a result of the prepayment of the Subordinated Promissory Note, we recognized a
gain on the early extinguishment of the Subordinated Promissory Note totaling
$472 (included in other income (expense)) during the first quarter of Fiscal
2004. The funds to prepay the Subordinated Promissory Note were obtained from two
separate loans in the aggregate amount of $2,350 under new Term Credit
Facilities with Commerce Bank, a Minnesota state banking association, and, its
affiliate, Commerce Financial Group, Inc., a Minnesota corporation. The first
note, with Commerce Bank in the amount of $1,200, is secured by our Victoria,
Minnesota facility. The term of the first note is six years with an interest
rate at 6.50% per annum for the first three years. Thereafter the interest
rate will be adjusted to the then Three Year Treasury Base Rate (as defined)
plus 3.00%; provided, however, that in no event shall the interest rate be less
than the Prime Rate plus 1.0% per annum. Monthly payments of principal and
interest will be based on a twenty-year amortization with a final payment of 12




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##### Table of Contents



approximately $980 due on November 1, 2009. The second note, with Commerce
Financial Group, Inc. in the amount of $1,150, was executed on October 28,
2003. The second note is secured by our Victoria facility and equipment
located at our Tempe facility. The term of the second note is four years, with
an interest rate
of 8.975% per year through September 27, 2007. Monthly payments of principal
and interest in the amount of $28 will be paid over a forty-eight month period
that began on October 28, 2003. (8) Deferred Taxes Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. The significant
components of our deferred tax assets and liabilities consist of timing
differences related to allowance for doubtful accounts, depreciation, reserves
for excess and obsolete inventory, accrued warranty reserves, and the future
benefit associated with Federal and state net operating loss carryforwards. A
valuation allowance has been set at approximately $7,364 and $5,405, at May 29,
2004, and August 31, 2003, respectively, because of uncertainties related to
the ability to utilize certain Federal and state net loss carryforwards as
determined in accordance with GAAP. The valuation allowance is based on
estimates of taxable income by jurisdiction and the period over which our
deferred tax assets are recoverable. (9) Net Loss per Share Computation The components of net loss per basic and diluted share are as follows: Three Months Ended
    
    Nine Months EndedMay 29, 2004
    
    May 31, 2003
    
    May 29, 2004
    
    May 31, 2003Basic:Net loss
    
    $
    (1,029
    )
    
    $
    (1,311
    )
    
    $
    (5,251
    )
    
    $
    (3,802
    )Net loss per share
    
    $
    (0.12
    )
    
    $
    (0.19
    )
    
    $
    (0.70
    )
    
    $
    (0.59
    )Weighted average number of common shares outstanding
    
    
    8,310
    
    
    
    7,029
    
    
    
    7,533
    
    
    
    6,488Diluted:Net loss
    
    $
    (1,029
    )
    
    $
    (1,311
    )
    
    $
    (5,251
    )
    
    $
    (3,802
    )Net loss per share
    
    $
    (0.12
    )
    
    $
    (0.19
    )
    
    $
    (0.70
    )
    
    $
    (0.59
    )Weighted average number of common shares outstanding
    
    
    8,310
    
    
    
    7,029
    
    
    
    7,533
    
    
    
    6,488Assumed conversion of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Weighted average common and assumed conversion shares
    
    
    8,310
    
    
    
    7,029
    
    
    
    7,533
    
    
    
    6,488
 An aggregate of 1,810,650 and 1,515,425 shares of our Common Stock under stock
options and warrants outstanding as of May 29, 2004 and May 31, 2003 have been
excluded from the calculation of diluted net loss per common share as they are
antidilutive for each three-and nine-month period then ended. (10) Notes Receivable and Transactions with Former CEO Notes Receivable  Officers and Directors During April 2001, we recorded notes receivable of $1,266 from certain officers
and directors in connection with the exercise of stock options. These notes
were amended in July 2002. These notes provide for full recourse to the
individuals, bear interest at prime (with the exception of one individual whose
note bears interest at prime plus 1/2 per annum) and have a term of five years
with interest only payments to be made for 13




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##### Table of Contents



the first two years (on November 2,
2002 and April 2, 2003) and with annual principal and interest installments to
be paid thereafter through April 2, 2006. These notes receivable are
classified as a reduction to shareholders equity on the consolidated balance
sheet. As of May 29, 2004, the interest due to us under these notes receivable
was $14, and is payable April 2, 2005. In the first and second quarters of
Fiscal 2004, Steve E. Tondera, our former Chief Financial Officer, paid $46
against our note receivable from him, which constitute payment in full of that
note. In the third quarter of Fiscal 2004, Donald R. Reynolds, our former
President, paid $24 of principal against our note receivables from him. Edwin
W. Finch, III, our former director, missed a payment of $93 in principal and
interest under his note, which was due on April 2, 2004, and Mack V. Traynor,
III, our current Chief Executive Officer and President, made a payment of $14
in interest under his note, but missed a payment of $101 in principal under his
note. We are in negotiations with Messrs. Finch and Traynor regarding the
payment of the notes. As of May 29, 2004, the outstanding principal due to us
under these notes receivable was $1,186, $587 of which is reserved due to its
uncollectible nature as it relates to our judgment against Mr. Anthony J. Fant,
our former Chairman of the Board, Chief Executive Officer and President and a
current director. Anthony J. Fant Litigation On June 30, 2003, we commenced litigation against Mr. Fant, in the State of
Minnesota, Hennepin County District Court, Fourth Judicial District. The
complaint alleged breach of contract, conversion, breach of fiduciary duty,
unjust enrichment and corporate waste resulting from, among other things, Mr.
Fants default on his note receivable and other loans and certain other
matters. On August 12, 2003, we obtained a judgment against Mr. Fant on the
breach of contract count in the amount of approximately $606. On November 24,
2003, the Court granted an additional judgment to us against Mr. Fant in the
amount of approximately $993 on the basis of our conversion, breach of
fiduciary duty, unjust enrichment and corporate waste claims. On March 29,
2004, we obtained a third judgment against Mr. Fant relating to our claims for
damages for conversion, breach of fiduciary duty, and our legal and special
investigation costs in the amount of approximately $656. As of May 29, 2004,
the total combined judgment against Mr. Fant was approximately $2,255. We have obtained, through garnishments, in excess of approximately $112 from
Mr. Fants accounts that was recognized as a recovery in the second quarter of
Fiscal 2004. We have also caused to be sold Common Stock previously held by
Mr. Fant, $634 of the proceeds from that sale reduced judgments against Mr.
Fant. We obtained approximately $49 from other garnishments that were
recognized as a recovery in the third quarter of Fiscal 2004. In May 2004, we
we caused to be sold additional Common Stock previously held by Mr. Fant, $472
of the proceeds from that sale reduced judgments against Mr. Fant. This
judgment recovery will be recorded as income in the fourth quarter of Fiscal
2004. In June 2004, we obtained $481 through a garnishment of assets
previously held by Mr. Fant which will be recorded as income in the first
quarter of Fiscal 2005. As of July 2, 2004, we have collected $1,748, which
partially reduces our total judgment against Mr. Fant. We continue to seek to
collect on our remaining judgment amount in Minnesota and other states where it
is believed that Mr. Fant may have non-exempt and unencumbered assets. There
is no assurance that we will be able to collect the full amounts of our
judgments against Mr. Fant. Total Judgments
    
    
    
    
    
    $
    2,255Recoveries Recognized in:Garnishments
    
    
    112Second Quarter, FY2004
    
    
    
    
    
    
    112Sale of Stock
    
    
    634Garnishments
    
    
    8Third Quarter, FY2004
    
    
    
    
    
    
    642Sale of Stock
    
    
    472Garnishments
    
    
    41Expected for Fourth Quarter, FY2004
    
    
    
    
    
    
    513Garnishments
    
    
    481Expected for First Quarter, FY2005
    
    
    
    
    
    
    481Total Recoveries
    
    
    
    
    
    $
    1,748
 14




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##### Table of Contents



(11) Major Customers The table below sets forth the approximate percentage of net sales to major
customers that represented over 10% of our net sales at May 29, 2004, and May
31, 2003, respectively. Three Months Ended
    
    Nine Months EndedMay 29, 2004
    
    May 31, 2003
    
    May 29, 2004
    
    May 31, 2003GE Medical Systems
    
    
    14
    %
    
    
    20
    %
    
    
    15
    %
    
    
    14
    %Ethicon
    
    
    10
    %
    
    
    10
    %
    
    
    12
    %
    
    
    7
    %Siemens, Inc.
    
    
    8
    %
    
    
    10
    %
    
    
    9
    %
    
    
    14
    %Sonic Innovations, Inc.
    
    
    1
    %
    
    
    15
    %
    
    
    3
    %
    
    
    19
    %Total
    
    
    33
    %
    
    
    55
    %
    
    
    39
    %
    
    
    54
    %
 Accounts receivable from these customers represented 24% and 31%, respectively,
of the total accounts receivable at May 29, 2004, and August 31, 2003,
respectively. 15




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results
of Operations
(in thousands, except share and per share amounts) Overview We provide a comprehensive range of engineering, product design, automation and
test, manufacturing, distribution, and fulfillment services and solutions to
our customers in the hearing, medical device, medical equipment,
communications, computing and industrial equipment industries. We provide
these services and solutions on a global basis through integrated facilities in
North America. These services and solutions support our customers products
from initial product development and design through manufacturing to worldwide
distribution and aftermarket support. We leverage our various technology
platforms and internal manufacturing capacity to provide bundled solutions to
the markets served. Our current focus is on managing costs and integration of
our business operating units. The following discussion highlights the significant factors affecting changes
in our results of operations and financial condition. This review should be
read in conjunction with the Consolidated Financial Statements, Notes to
Consolidated Financial Statements and the Managements Discussion and Analysis
of Financial Condition and Results of Operations included in our Annual Report
on Form 10-K for the fiscal year ended August 31, 2003. Results of Operations
Three and Nine Months Ended May 29, 2004 and May 31, 2003: Although sales increased during the third quarter of Fiscal 2004 compared to
the previous two quarters of Fiscal 2004, the results were lower than expected
due to our inability to deliver product on a timely basis. These lower results
are the direct result of the operational issues we have encountered in our
microelectronics facilities since the beginning of this fiscal year. Selected Operating Results The following table indicates the dollars and percentages of total revenues
represented by the selected items in our unaudited consolidated statements of
operations: Three Months Ended
    
    Nine Months EndedMay 29, 2004
    
    May 31, 2003
    
    May 29, 2004
    
    May 31, 2003Net sales
    
    $
    11,131
    
    
    
    100
    %
    
    $
    12,517
    
    
    
    100
    %
    
    $
    32,042
    
    
    
    100
    %
    
    $
    26,151
    
    
    
    100
    %Cost of sales
    
    
    9,980
    
    
    
    90
    %
    
    
    10,027
    
    
    
    80
    %
    
    
    29,376
    
    
    
    92
    %
    
    
    22,202
    
    
    
    85
    %Gross profit
    
    
    1,151
    
    
    
    10
    %
    
    
    2,490
    
    
    
    20
    %
    
    
    2,666
    
    
    
    8
    %
    
    
    3,949
    
    
    
    15
    %Operating expenses
    
    
    2,830
    
    
    
    25
    %
    
    
    2,927
    
    
    
    23
    %
    
    
    8,984
    
    
    
    28
    %
    
    
    6,884
    
    
    
    26
    %Operating loss
    
    
    (1,679
    )
    
    
    (15
    %)
    
    
    (437
    )
    
    
    (3
    %)
    
    
    (6,318
    )
    
    
    (20
    %)
    
    
    (2,935
    )
    
    
    (11
    %)Other income (expense)
    
    
    650
    
    
    
    6
    %
    
    
    (876
    )
    
    
    (7
    %)
    
    
    1,067
    
    
    
    3
    %
    
    
    (888
    )
    
    
    (4
    %)Loss before income taxes
    
    
    (1,029
    )
    
    
    (9
    %)
    
    
    (1,313
    )
    
    
    (10
    %)
    
    
    (5,251
    )
    
    
    (17
    %)
    
    
    (3,823
    )
    
    
    (15
    %)Income tax benefit
    
    
    
    
    
    
    0
    %
    
    
    2
    
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    21
    
    
    
    0
    %Net loss
    
    $
    (1,029
    )
    
    
    (9
    %)
    
    $
    (1,311
    )
    
    
    (10
    %)
    
    $
    (5,251
    )
    
    
    (17
    %)
    
    $
    (3,802
    )
    
    
    (15
    %)
 16




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##### Table of Contents



Net Sales Net sales for the three-months ended May 29, 2004 were $11,131, a decrease of
$1,386 or 11%, from the comparable quarter last year. Net sales for the
nine-months ended May 29, 2004 were $32,042, an increase of $5,891 or 23%. The
three-month decrease in net sales is attributable primarily to a decreased
demand and lower pricing for our AMO imaging products. The nine-month increase
is mainly related to having a full nine months of sales for AMO in Fiscal 2004
compared to four months of sales in Fiscal 2003. AMO was acquired in January
2003. AMO generated the net sales of $5,054 and $15,526 during the three and
nine months ended May 29, 2004, respectively, compared to net sales of $6,240
and $9,049 during the three and four months ended May 31, 2003, respectively. Because sales are generally tied to the customers projected sales and
production of the related product, our sales are subject to uncontrollable
fluctuations. To the extent that sales to any one customer represent a
significant portion of sales, any change in the sales levels to that customer
can have a significant impact on total sales. In addition, production from one
customer may conclude while production for a new customer may not have begun or
is not yet at full volume. We have significant customer concentration with 32%
and 36% of net sales in the three and nine months ended May 29, 2004 being
generated by three customers. At May 29, 2004, our backlog for future orders was approximately $18,639,
compared to approximately $18,645 at August 31, 2003. Our backlog is not
necessarily a firm commitment from our customers and can change, in some cases
materially, beyond our control. Net sales by market for the three and nine months ended May 29, 2004 and May
31, 2003, respectively, are as follows: Three Months Ended
    
    Nine Months EndedMay 29, 2004
    
    May 31, 2003
    
    May 29, 2004
    
    May 31, 2003Medical/Hearing
    
    $
    9,159
    
    
    $
    10,538
    
    
    $
    26,954
    
    
    $
    21,225RFID
    
    
    841
    
    
    
    821
    
    
    
    2,482
    
    
    
    2,084Communications
    
    
    839
    
    
    
    729
    
    
    
    1,807
    
    
    
    1,643Other
    
    
    292
    
    
    
    429
    
    
    
    799
    
    
    
    1,199Total Net Sales
    
    $
    11,131
    
    
    $
    12,517
    
    
    $
    32,042
    
    
    $
    26,151
 Net sales analysis by market follows: Sales to medical/hearing customers represented 82% and 84% of total net sales
for the three and nine months ended May 29, 2004, respectively, as compared to
84% and 81% for the three and nine months ended May 31, 2003, respectively.
The decrease of $1,379 for the three months of Fiscal 2004 compared to the same
period in Fiscal 2003 is primarily the result of a decrease in AMO sales due to
decreased demand and lower pricing for our imaging products. The increase of
$5,729 for the first nine months of Fiscal 2004 compared to the same period in
Fiscal 2003 is primarily the result of the addition of our AMO. AMO
contributed medical revenues of $5,054 and $15,526 for the three and nine
months ended May 29, 2004, respectively, compared to $6,240 and $9,049 for the
three and nine months ended May 31, 2003, respectively. The offsetting
decrease in sales for the nine months ended May 29, 2004 is a result of Sonic
Innovations, Inc. moving a program offshore, and Siemens, Inc. increasing their
internal manufacturing capabilities. Net sales to the RFID (radio frequency identification device) products market
represented 7%-8% of our total net sales. RFID sales increased $20 and $398
for the three and nine months ended Fiscal 2004, respectively, as compared to
the same periods last year. New products have been developed and capabilities
have been expanded to improve revenue; however, the actual level of long-term
market acceptance of these initiatives is currently unknown. 17




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##### Table of Contents



Net sales to the communications
products market represented 6%-8% of total net
sales. Communications revenues increased $110 and $164 for the three and nine
months of Fiscal 2004, respectively, compared to the same periods of Fiscal
2003. We are experiencing increased activity in this market with the improving
broadband segment with numerous low volume purchase orders. Net sales to the Industrial products market represented 2%-5% of our total net
sales. Industrial sales have decreased $137 and $400 for the three and nine
months ended Fiscal 2004, respectively, compared to the same periods in Fiscal
2003. The overall industrial products market remains depressed. Gross Profit Gross profit was $1,151 (10% of net sales) and $2,666 (8%) for the three and
nine months ended May 29, 2004, respectively, compared to $2,490 (20%) and
$3,949 (15%) for the three and nine months ended May 31, 2003, respectively.
Our gross margins are heavily impacted by fluctuations in net sales, due to the
fixed nature of many of our manufacturing costs. In addition, the start up of
eleven new significant customer programs and the start up of one internal
program between our Victoria and Boulder facilities had an impact on our
margins due to the operational difficulties experienced since the beginning of
the current fiscal year. Operating Expenses Selling, general and administrative expenses Selling, general and administrative expenses were $1,999 (18% of net sales) and
$5,817 (18%) for the three and nine months ended May 29, 2004, respectively,
compared to $2,178 (17%) and $5,047 (19%) for the comparable periods last year.
The increase for the nine months ended May 29, 2004, compared to the nine
months ended May 31, 2003 is primarily related to our AMO business acquired in
January 2003, which has incurred $1,991 of selling, general and administrative
expenses in 2004 compared to $345 in 2003. Without regard to our acquisition
of AMO, selling, general and administrative expenses declined in total and as a
percentage of net sales in the first three and six months ended May 29, 2004,
respectively. These decreases are mainly the result of decreased depreciation
costs related to computer software and equipment becoming fully depreciated
during Fiscal 2003. Partially offsetting this decrease was an increase in
legal fees in the second and third quarter of Fiscal 2004 related primarily to
our negotiations with our Boulder landlord. Research, development, and engineering expenses Research, development, and engineering expenses were $737 (7% of net sales) and
$2,316 (7%) for the three and nine months ended May 29, 2004, respectively,
compared to $749 (6%) and $1,837 (7%) for the comparable periods last year.
The increase in these expenses is primarily a result of the addition of our AMO
in January 2003, which contributed $450 and $1,233 in research, development,
and engineering expenses during the three and nine months ended May 29, 2004,
respectively, compared to $228 and $363 for the comparable periods last year.
The remaining decrease of these expenses is a result of our continued efforts
to right-size the business. Costs related to investigation During the three and nine months ended May 29, 2004, we directly, and on behalf
of the Special Committee of our Board of Directors, incurred outside legal and
accounting costs of $94 and $851 in connection with our litigation against, and
other issues involving, Anthony J. Fant, our former Chairman of the Board,
Chief Executive Officer and President. See Note 10 to our unaudited
consolidated financial statements. The Special Committee completed its
investigation into such issues on December 14, 2003. We continue to incur
costs related to our collection efforts against the judgments received from the
courts against Mr. Fant. Other Income (Expense), net For the three months ended May 29, 2004, the net other income consists
primarily of a $687 judgment recovery related to Mr. Fant. For the nine months
ended May 29, 2004, the net other income consists primarily of $799 in judgment
recoveries related to Mr. Fant and a gain of $472 recognized in connection with
the prepayment of the Subordinated Promissory Note. 18




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Income Taxes We established a valuation allowance of approximately $7,364 and $5,405 at May
29, 2004 and August 31, 2003, respectively, to fully reserve the deferred tax
assets because of uncertainties related to our ability to
utilize certain federal and state loss carryforwards as measured by GAAP. This
allowance is based on estimates of taxable income by jurisdiction during the
period over which its deferred tax assets are recoverable. The economic
benefits of our net operating loss carryforwards to future years will continue
until expired. At May 29, 2004, we had Federal net operating loss
carryforwards expiring at various dates ranging from 2013 through 2023. FINANCIAL CONDITION AND LIQUIDITY Our net cash flow used in operating activities was $3,641 for the nine-months
ended May 29, 2004, as compared to $331 in the same prior-year period. For the
nine-months ended May 29, 2004, the increase in cash flow used by operating
activities resulted from a number of items. In addition to the increase in
operating loss of $1,449, we recognized a non cash gain of $472 for the
prepayment of our Subordinated Promissory Note. Partially offsetting this,
accounts receivable generated cash usage of $724 in Fiscal 2004 compared to a
cash usage of $2,503 in Fiscal 2003 due to improved terms with certain large
customers. Accounts receivable average days outstanding were 53 days at May 29, 2004,
compared to 46 days at August 31, 2003. Inventory turns were 5.8 for the
nine-months ended May 29, 2004, compared to 5.0 for the same period a year ago.
The increase in average days outstanding is due to several large customers with
balances exceeding 60 days. Net cash flow used by investing activities was $244 for the nine-months ended
May 29, 2004, as compared to $296 for the nine-months ended May 31, 2003.
Property and equipment additions were $520 for the first nine-months of Fiscal
2004. We intend to purchase property and equipment on an as needed basis only
for the remainder of Fiscal 2004. Our net cash flow of $3,415 provided by financing activities during the
nine-months ended May 29, 2004, relates primarily to $3,540 in proceeds from
the issuance of stock net of issuance costs of $301. On February 13, 2004, we
sold 1,180,000 shares of our Common Stock together with five-year warrants to
purchase up to 354,000 shares of our Common Stock at an exercise price of $3.72
per share in a private placement to a group of 18 institutional and accredited
investors. We received gross proceeds of $3,540, excluding transaction costs
of $301, for the shares and warrants sold, which will be used to increase
working capital and for future capital expenditures. The shares and warrants
were sold in reliance on the exemption afforded under Rule 506 of Regulation D
promulgated under the Securities Act of 1933, as amended. We paid a 6%
underwriting discount in connection with the sale and the placement agent,
ThinkEquity Partners, LLC, also received warrants to purchase up to 70,800
shares of our Common Stock at an exercise price of $3.72 per share as
additional compensation for the private placement. In addition we had net
borrowing of $294 on the line of credit. The result of these activities was a decrease in cash by $470 during the
nine-months ended May 29, 2004, compared to a decrease of $2,345 during the
nine-months ended May 31, 2003. Our unrestricted cash balance was $336 as of
May 29, 2004. Our revolving credit line agreement allows for borrowings of up to $3,000,
subject to availability based on accounts receivable. There was $784
outstanding and $2,216 available on the revolving line at May 29, 2004. In the
event the revolving credit line agreement is not extended beyond the January 1,
2005 expiration date, management may be required to take certain measures to
meet our short-term liquidity needs. These potential measures include pursuing
other financing or asset based lending arrangements, which may not have as
attractive of terms as our current lending arrangement. If we were unable to
find a suitable lending arrangement, management will need to take measures to
reduce expenditures to meet liquidity demands. This includes, but not limited
to, reductions in research and development spending and headcounts. If we are
unable to repay the bank through other capital resources or operating cash
flows, we may be required to renegotiate supply contracts and other
arrangements with third parties, which may impact our ability to procure
inventory, meet customer demands and comply with other contractual
arrangements. As a result of the equity raised as described above, we have demanded repayment
of our deposit of $1,430 that the landlord, Eastside Properties, LLC
(Eastside), of our Boulder facility now holds on our behalf. On June 1,
2004, we signed a purchase agreement for the Boulder facility calling for the
transfer of ownership of our AMO facility from Eastside to Titan Real Estate
Investment Group, Inc. (Titan). As a part of the consideration related to
this agreement, the Company and Eastside signed a standstill agreement for
payment of the leasehold deposit to the Company. The sale to Titan is
scheduled to close approximately in August 2004 and is subject to various
closing conditions, 19




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including completion of normal due
diligence. Upon completion of this transaction, Titan would become our new landlord, which
would potentially result in substantially lower rental and operating costs
estimated at $500 per year for the Boulder facility. Our liquidity is affected by many factors, some of which are based on the
normal ongoing operations and profitability of our business, and the most
significant of which include the timing of the collection of receivables, and
the level of inventories and capital expenditures. In the event cash flows are
not sufficient to
fund operations at the present level, management believes certain measures can
be taken to reduce the expenditure levels including, but not limited to,
reduction of spending for research and development, and headcount reductions.
We have also been impacted by operational issues we have encountered in our
microelectronics facilities. While the remediation of these operational issues
is ongoing, we have observed improvements in both quantity and quality of
customer deliveries. Management believes that, as a result of the financial restructuring actions it
has taken to reduce cash expenditures, the continuing efforts to increase
revenues from continuing customers and to generate new customers in various
industry sectors, and the replacement and subsequent extension of its revolving and
term credit facilities, it will meet its short and
long-term debt obligations and operation requirements for at least the next
twelve months. CRITICAL ACCOUNTING POLICIES The accompanying consolidated financial statements are based on the selection
and application of accounting principles generally accepted in the United
States (GAAP), which require estimates and assumptions about future events
that may affect the amounts reported in these financial statements and the
accompanying notes. Future events and their effects cannot be determined with
absolute certainty. Therefore, the determination of estimates requires the
exercise of judgment. Actual results could differ from those estimates, and
any such differences may be material to the financial statements. We believe
that the following accounting policy as well as the policies included in our
Annual Report on Form 10-K for our fiscal year ended August 31, 2003, may
involve a higher degree of judgment and complexity in their application and
represent the critical accounting policies used in the preparation of our
financial statements. If different assumptions or conditions were to prevail,
the results could be materially different from reported results. Purchase Accounting The accompanying statements reflect the allocation of the purchase price of our
AMO  see Note 6 to our unaudited consolidated financial statements. This
allocation includes an accrual of $730 related to an unfavorable operating
lease, $2,380 for future estimated lease payments and a $760 accrual to fulfill
estimated contractual manufacturing obligations. The $2,380 accrued for
estimated lease payments consists of $5,910 for future lease obligations less
estimated sublease payments of $3,530 on 50,000 square feet of unoccupied space
for which we are in the process of reviewing alternative uses. We have entered
into an agency agreement with Julien J. Studley, Inc., a national commercial
real estate services firm. Julien J. Studley is assisting us in reducing our
occupancy costs at this facility by sub-leasing the 50,000 square foot
addition, performing tenant representation with our landlord, and assisting us
in exploring other options related to our future use of the Boulder facility.
In our opinion, all adjustments necessary to present fairly such financial
statements have been made based on the terms and structure of the acquisition
of our AMO. During the second quarter ended February 28, 2004, we finalized our purchase
price allocation for this transaction. Since our Annual Report of Form 10-K
for the fiscal year ended August 31, 2003, we have adjusted our developed
technologies by $323 related to technology sold to MKS Instruments and we
adjusted other reserves by $160 related to legal costs. The net of these
adjustments resulted in a reduction of property and equipment of $163. RECENT ACCOUNTING PRONOUNCEMENTS In November 2002, Emerging Issues Task Force (EITF) finalized its consensus
on EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, which
provides guidance on the timing of revenue recognition for sales undertaking to
deliver more that one product or service. We were required to adopt EITF Issue
00-21 on transactions occurring after September 1, 2003. 20




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In evaluating EITF 00-21, generally customer orders are manufactured and
delivered without installation or special acceptance protocols. We provide
development services and fulfill service contracts for the maintenance of
equipment sold by AMO. Maintenance service revenues are currently
insignificant to our consolidated financial statements. Occasionally, we may
have special acceptance protocols or may have revenues that are contingent upon
the completion of certain milestones. We may establish one or more contractual
relationships with one customer that involve multiple deliverables including
development, manufacturing and service. Each of these deliverables is
considered a separable element and sufficient
evidence of fair value of these elements exists to allow separate revenue
recognition for these units of accounting. For manufacturing or assembly
orders, revenue is recognized upon shipment, less the greater of the fair value
associated with installation or the amount of revenue that is deemed contingent
upon these elements, which is deferred until customer acceptance or the
underlying contingency has been fulfilled and relieved. In addition, service
revenues are deferred based on the fair value of the services to be provided.
Development contracts are discrete projects that generally do not involve
multiple deliverables. Revenue for our development contracts is recorded using
either the percentage of completion or completed contract methods. Where a
development agreement includes multiple deliverables, we will continue to
recognize revenue using either the percentage of completion or completed
contract methods as long as the other contractual elements qualify for separate
accounting. Otherwise, the entire arrangement may be accounted for as one
arrangement with revenue recognized upon the delivery of all elements. The adoption of EITF 00-21 did not have a material effect on our financial
statements since revenue associated with these projects in Fiscal 2004 were
immaterial. 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 7 of our Annual
Report on Form 10-K for the fiscal year ended August 31, 2003 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. 21




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Item 3. Qualitative and Quantitative Disclosures About Market Risk
(In thousands, except share and per share amounts) Market Risk We do not have material exposure to market risk from fluctuations in foreign
currency exchange rates because all sales are denominated in U.S. dollars. Interest Rate Risk We are exposed to a floating interest rate risk from our Term Credit Facilities
with Commerce Bank, a Minnesota state banking association, and, its affiliate,
Commerce Financial Group, Inc., a Minnesota corporation. We obtained two
separate loans in the aggregate amount of $2,350. The first note, with
Commerce Bank, in the amount of $1,200, is secured by our Victoria, Minnesota
facility. The term of the first note is six years with an interest rate at
6.50% per annum for the first three years. Thereafter the interest rate will
be adjusted to the then Three Year Treasury Base Rate (as defined) plus 3.00%;
provided, however, that in no event shall the interest rate be less than the
Prime Rate plus 1.0% per annum. Monthly payments of principal and interest
will be based on a twenty-year amortization with a final payment of
approximately $980 due on November 1, 2009. The second note, with Commerce
Financial Group, Inc., in the amount of $1,150 was executed on October 28,
2003. The second note is secured by our Victoria facility and equipment
located at our Tempe facility. The term of the second note is four years, with
an interest rate of 8.975% per year through September 27, 2007. Monthly
payments of principal and interest in the amount of $28 will be paid over a
forty-eight month period that began on October 28, 2003. A change in interest
rates is not expected to have a material adverse effect on our near-term
financial condition or results of operation as the first note has a fixed rate
for its first three years and the second note has a fixed rate for its term. 22




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Item 4. Controls and Procedures Our management, including the Chief Executive Officer and President and Chief
Financial Officer, have conducted an evaluation of the effectiveness of
disclosure controls and procedures (as such term is defined in Rules 13a-15(e)
and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the
Exchange Act)) as of the end of the period covered by this report. Based on
such evaluation, our Chief Executive Officer and President and Chief Financial
Officer have concluded that, as of the end of such period, our disclosure
controls and procedures are effective. Notwithstanding the foregoing, there can be no assurances that our disclosure
controls and procedures will detect or uncover all failure of persons with the
Company and its consolidated subsidiaries to report material information
otherwise required to be set forth in the reports that we file with the
Securities and Exchange Commission. 23




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PART II  OTHER INFORMATION 
 Item 1. Legal Proceedings Anthony J. Fant Litigation On June 30, 2003, we commenced litigation against Mr. Fant, in the State of
Minnesota, Hennepin County District Court, Fourth Judicial District. The
complaint alleged breach of contract, conversion, breach of fiduciary duty,
unjust enrichment and corporate waste resulting from, among other things, Mr.
Fants default on his note receivable and other loans and certain other
matters. On August 12, 2003, we obtained a judgment against Mr. Fant on the
breach of contract count in the amount of approximately $606. On November 24,
2003, the Court granted an additional judgment to us against Mr. Fant in the
amount of approximately $993 on the basis of our conversion, breach of
fiduciary duty, unjust enrichment and corporate waste claims. On March 29,
2004, we obtained a third judgment against Mr. Fant relating to our claims for
damages for conversion, breach of fiduciary duty, and our legal and special
investigation costs in the amount of approximately $656. As of May 29, 2004,
the total combined judgment against Mr. Fant was approximately $2,255. We have obtained, through garnishments, in excess of approximately $112 from
Mr. Fants accounts that was recognized as a recovery in the second quarter of
Fiscal 2004. We have also caused to be sold Common Stock
previously held by Mr. Fant $634 of the proceeds from that sale reduced judgments against Mr. Fant.
We obtained approximately $49 from other garnishments that were recognized as a
recovery in the third quarter of Fiscal 2004. In May 2004, we caused to be sold Common Stock previously held by Mr. Fant $472
of the proceeds from that sale reduced judgments against Mr. Fant. This judgment recovery will be recorded as
income in the fourth quarter of Fiscal 2004. In June 2004, we obtained $481
through a garnishment of assets previously held by Mr. Fant which will be
recorded as income in the first quarter of Fiscal 2005. As of July 2, 2004, we
have collected $1,748, which partially reduces our total judgment against Mr.
Fant. We continue to seek to collect on our remaining judgment amount in
Minnesota and other states where it is believed that Mr. Fant may have
non-exempt and unencumbered assets. There is no assurance that we will be able
to collect the full amounts of our judgments against Mr. Fant. Total Judgments
    
    
    
    
    
    $
    2,255Recoveries Recognized in:Garnishments
    
    
    112Second Quarter, FY2004
    
    
    
    
    
    
    112Sale of Stock
    
    
    634Garnishments
    
    
    8Third Quarter, FY2004
    
    
    
    
    
    
    642Sale of Stock
    
    
    472Garnishments
    
    
    41Expected for Fourth Quarter, FY2004
    
    
    
    
    
    
    513Garnishments
    
    
    481Expected for First Quarter, FY2005
    
    
    
    
    
    
    481Total Recoveries
    
    
    
    
    
    $
    1,748
 24




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Item 6. Exhibits and Reports on Form 8-K  a)
    
    Exhibits  2.1
    
    Form of Registration Rights Agreement, dated as of May 7, 2004, among
HEI, Inc. and the Purchasers of an aggregate of 631,524 shares of
HEI, Inc.(1)3.1
    
    Certificate of Designation of Common Stock of HEI, Inc.(2)31.1
    
    Certification of Chief Executive Officer and President pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 203 of
the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer and President pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.   (1)
    
    Incorporated by reference to Exhibit 10.1 to the Registration Statement
on Form S-3 of HEI, Inc. filed with the Securities and Exchange Commission
on May 28, 2004(2)
    
    Incorporated hereby by reference to Exhibit 3.2 to the Registration
Statement of Form S-3 of HEI, Inc. filed with the Securities and Exchange
Commission on May 28, 2004  b)
    
    Reports on Form 8-K The following reports on Form 8-K were filed during the third quarter of Fiscal
2004: On April 7, 2004, we filed a Current Report on Form 8-K announcing under Item 5
 Other Events, that we had obtained an additional judgment against Anthony J.
Fant in the amount of approximately $656. On April 8, 2004, we filed a Current Report on Form 8-K announcing under Item 5
 Other Events, that we had issued a press release announcing our quarterly
conference call for the second quarter of fiscal year 2004. On April 13, 2004, we filed a Current Report on Form 8-K announcing under Item
5  Other Events, that we had issued a press release announcing our second
quarter results. On April 14, 2004, we filed a Current Report on Form 8-K announcing under Item
9  Regulation FD Disclosure, that during the quarterly conference call, we
provided certain guidance which had not been previously disclosed. On May 11, 2004, we filed a Current Report on Form 8-K announcing under Item 5
 Other Events, that we had issued a press release announcing we are not an
owner of Google warrants. 25




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SIGNATURES Pursuant to the requirements 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 HEI, Inc.Date:      July 13, 2004
    /s/ Douglas J. NesbitDouglas J. NesbitChief Financial Officer 26




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Exhibit Index  31.1
    
    Certification of Chief Executive Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002. 27