##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 ****
 FORM 10-Q
 ****
 [X]
    
    Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended
February 28, 2004.[  ]
    
    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 [X] No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X] As
of April 12, 2004, 8,273,491 Common Shares, par value $.05 per share, were
outstanding.




---



Table of Contents
    
    HEI, Inc.Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
  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 2.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    24Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    24-25Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    25-26Signature
    
    
    
    
    27
 2




---



##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements HEI, Inc. 
 Consolidated Balance Sheets (Unaudited)
 (In thousands)
 February 28, 2004
    
    August 31, 2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    1,611
    
    
    $
    806Restricted cash
    
    
    679
    
    
    
    Accounts receivable, net
    
    
    5,781
    
    
    
    6,314Inventories
    
    
    6,328
    
    
    
    6,864Other current assets
    
    
    445
    
    
    
    403Total current assets
    
    
    14,844
    
    
    
    14,387Property and equipment:Land
    
    
    216
    
    
    
    216Building and improvements
    
    
    4,316
    
    
    
    4,316Fixtures and equipment
    
    
    21,244
    
    
    
    21,137Accumulated depreciation
    
    
    (17,054
    )
    
    
    (15,769
    )Net property and equipment
    
    
    8,722
    
    
    
    9,900Developed technology, net
    
    
    246
    
    
    
    341Security deposits
    
    
    1,580
    
    
    
    1,580Other long-term assets
    
    
    479
    
    
    
    295Total assets
    
    $
    25,871
    
    
    $
    26,503Liabilities and Shareholders EquityCurrent liabilities:Line of credit
    
    $
    
    
    
    $
    490Current maturities of long-term debt
    
    
    368
    
    
    
    397Accounts payable
    
    
    5,174
    
    
    
    3,951Accrued liabilities
    
    
    4,195
    
    
    
    3,798Total current liabilities
    
    
    9,737
    
    
    
    8,636Other long-term liabilities, less current
maturities:Other long-term liabilities
    
    
    1,714
    
    
    
    2,121Long-term debt
    
    
    1,999
    
    
    
    2,555Total other long-term liabilities, less
current maturities
    
    
    3,713
    
    
    
    4,676Total liabilities
    
    
    13,450
    
    
    
    13,312Shareholders equity:Undesignated stock; 5,000 shares
authorized; none issued
    
    
    
    
    
    
    Common stock, $.05 par; 10,000 shares
authorized;
8,273 and 7,046 shares issued
and outstanding
    
    
    414
    
    
    
    352Paid-in capital
    
    
    22,295
    
    
    
    18,951Accumulated deficit
    
    
    (9,665
    )
    
    
    (5,443
    )Notes receivable
    
    
    (623
    )
    
    
    (669
    )Total shareholders equity
    
    
    12,421
    
    
    
    13,191Total liabilities and shareholders equity
    
    $
    25,871
    
    
    $
    26,503
 See accompanying notes to unaudited consolidated financial statements. 3




---



##### Table of Contents



HEI, Inc. 
 Consolidated Statements of Operations (Unaudited)
 (In thousands, except per share amounts)
 Three Months Ended
    
    Six Months EndedFebruary 28, 2004
    
    March 1, 2003
    
    February 28, 2004
    
    March 1, 2003Net sales
    
    $
    9,995
    
    
    $
    8,144
    
    
    $
    20,911
    
    
    $
    13,634
Cost of sales
    
    
    9,544
    
    
    
    7,298
    
    
    
    19,396
    
    
    
    12,176Gross profit
    
    
    451
    
    
    
    846
    
    
    
    1,515
    
    
    
    1,458Operating expenses:Selling, general and administrative
    
    
    2,061
    
    
    
    1,612
    
    
    
    3,818
    
    
    
    2,869Research, development and engineering
    
    
    857
    
    
    
    592
    
    
    
    1,579
    
    
    
    1,087Costs related to investigation
    
    
    504
    
    
    
    
    
    
    
    757
    
    
    
    Operating loss
    
    
    (2,971
    )
    
    
    (1,358
    )
    
    
    (4,639
    )
    
    
    (2,498
    )Other income (expenses):Interest expense
    
    
    (98
    )
    
    
    
    
    
    
    (167
    )
    
    
    Gain on prepayment of promissory note
    
    
    
    
    
    
    
    
    
    
    472
    
    
    
    Litigation recovery
    
    
    112
    
    
    
    
    
    
    
    112
    
    
    
    Other income (expense), net
    
    
    (12
    )
    
    
    22
    
    
    
    
    
    
    
    (12
    )Loss before income taxes
    
    
    (2,969
    )
    
    
    (1,336
    )
    
    
    (4,222
    )
    
    
    (2,510
    )Income tax benefit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19Net loss
    
    $
    (2,969
    )
    
    $
    (1,336
    )
    
    $
    (4,222
    )
    
    $
    (2,491
    )Net loss per common share:Basic
    
    $
    (0.41
    )
    
    $
    (0.21
    )
    
    $
    (0.59
    )
    
    $
    (0.40
    )Diluted
    
    $
    (0.41
    )
    
    $
    (0.21
    )
    
    $
    (0.59
    )
    
    $
    (0.40
    )Weighted average common shares outstanding:Basic
    
    
    7,232
    
    
    
    6,418
    
    
    
    7,140
    
    
    
    6,216Diluted
    
    
    7,232
    
    
    
    6,418
    
    
    
    7,140
    
    
    
    6,216
 See accompanying notes to unaudited consolidated financial statements. 4




---



##### Table of Contents



HEI, Inc. 
 Consolidated Statements of Cash Flows (Unaudited)
 (In thousands)
 Six Months EndedFebruary 28, 2004
    
    March 1, 2003Cash flow from operating activities:Net loss
    
    $
    (4,222
    )
    
    $
    (2,491
    )Depreciation and amortization
    
    
    1,347
    
    
    
    1,447Accounts receivable allowance
    
    
    (20
    )
    
    
    Loss on disposal of property and equipment
    
    
    26
    
    
    
    Gain on prepayment of promissory note
    
    
    (472
    )
    
    
    Changes in operating assets and liabilities:Restricted cash related to the deferred litigation recovery
    
    
    (679
    )
    
    
    Accounts receivable
    
    
    553
    
    
    
    (1,571
    )Inventories
    
    
    536
    
    
    
    689Other current assets
    
    
    (37
    )
    
    
    (121
    )Other assets
    
    
    (35
    )
    
    
    34Accounts payable
    
    
    1,223
    
    
    
    1,637Accrued liabilities
    
    
    33
    
    
    
    88Net cash flow used in operating activities
    
    
    (1,747
    )
    
    
    (288
    )Cash flow from investing activities:Additions to property and equipment
    
    
    (309
    )
    
    
    (43
    )Proceeds from sale of assets
    
    
    17
    
    
    
    Additions to patents
    
    
    (39
    )
    
    
    (64
    )AMO acquisition costs paid
    
    
    
    
    
    
    (1,198
    )Cash acquired from CMED
    
    
    
    
    
    
    1,215Sale of technology
    
    
    323
    
    
    
    Net cash flow used in investing activities
    
    
    (8
    )
    
    
    (90
    )Cash flow from financing activities:Proceeds from issuance of stock, net
    
    
    3,239
    
    
    
    Officer note repayment
    
    
    46
    
    
    
    Proceeds from long-term debt, net
    
    
    2,200
    
    
    
    2,600Repayment of long-term debt
    
    
    (2,435
    )
    
    
    (2,101
    )Deferred financing costs
    
    
    
    
    
    
    (91
    )Net repayments on line of credit
    
    
    (490
    )
    
    
    (1,589
    )Restricted cash
    
    
    
    
    
    
    (800
    )Net cash flow provided by (used in) financing activities
    
    
    2,560
    
    
    
    (1,981
    )Net increase (decrease) in cash and cash equivalents
    
    
    805
    
    
    
    (2,359
    )Cash and cash equivalents, beginning of period
    
    
    806
    
    
    
    2,372Cash and cash equivalents, end of period
    
    $
    1,611
    
    
    $
    13Supplemental disclosures of cash flow information:Interest paid
    
    $
    150
    
    
    $
    119Income taxes received
    
    
    
    
    
    
    (19
    )
 See accompanying notes to unaudited consolidated financial statements. 5




---



##### Table of Contents



NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS  (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 year-end 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 six-month
periods ended February 28, 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 its fair
value. 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 $2,969 and $4,222 for the three-month
and six-month periods ended February 28, 2004, and $4,629 for the year ended
August 31, 2003. 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 six-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 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 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. 6




---



##### Table of Contents



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. As a result of the equity raised, we have demanded repayment of our deposit of
$1,430 that the landlord of our Boulder facility now holds on our behalf. We
are in negotiations with the landlord over the disposition of the deposit. At February 28, 2004, our sources of liquidity consisted of $1,611 of cash and
cash equivalents and our revolving credit line agreement, which pursuant to an
extension granted on December 12, 2003, expires on September 1, 2004, and can
be automatically and continually extended by us for successive periods of six
months. The revolving credit line agreement allows for borrowings of up to
$3,000, subject to availability based on accounts receivable. There was no
outstanding balance on the revolving line at February 28, 2004. Our liquidity
is affected by many factors, some of which are based on the normal ongoing
operations 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 numerous measures can be
taken to reduce the expenditure levels including, but not limited to, reduction
of spending for research and development, elimination of budgeted raises and
reduction of non-strategic employees. 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, the replacement and subsequent extension of the revolving and
term credit facilities, and the ability to unilaterally extend the line of
credit agreement for periods of six months, it will meet its short and
long-term debt obligations and operation requirements for at least the next
twelve months. (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: 7




---



##### Table of Contents



Three Months Ended

    
    Six Months EndedFebruary 28, 2004
    
    March 1, 2003
    
    February 28, 2004
    
    March 1, 2003Net loss as reported
    
    $
    (2,969
    )
    
    $
    (1,336
    )
    
    $
    (4,222
    )
    
    $
    (2,491
    )
Add: Stock-based employee compensation
included in reported net income, net of related
tax effects
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
Deduct: Total stock-based employee
compensation income (expense) determined
under fair value based method for all awards
    
    
    (515
    )
    
    
    (537
    )
    
    
    (928
    )
    
    
    (1,070
    )Net loss pro forma
    
    $
    (3,484
    )
    
    $
    (1,873
    )
    
    $
    (5,150
    )
    
    $
    (3,561
    )Basic and diluted net loss per share as reported
    
    $
    (0.41
    )
    
    $
    (0.21
    )
    
    $
    (0.59
    )
    
    $
    (0.40
    )
Stock-based compensation income (expense)
    
    
    (0.07
    )
    
    
    (0.08
    )
    
    
    (0.13
    )
    
    
    (0.17
    )Basic and diluted net loss per share pro forma
    
    $
    (0.48
    )
    
    $
    (0.29
    )
    
    $
    (0.72
    )
    
    $
    (0.57
    )
 There were 332,000 and 347,000 options granted under our stock option plans
during the three-months and six-months ended February 28, 2004. 8




---



##### Table of Contents



(4) Other Financial Statement Data The following provides additional information concerning selected consolidated
balance sheet accounts at February 28, 2004 and August 31, 2003: February 28,
    
    August 31,2004
    
    2003Accounts Receivable, net:Trade accounts receivable
    
    $
    5,853
    
    
    $
    6,406Less: allowance for doubtful accounts
    
    
    (72
    )
    
    
    (92
    )$
    5,781
    
    
    $
    6,314Inventories:Purchased parts
    
    $
    4,227
    
    
    $
    4,297Work in process
    
    
    975
    
    
    
    958Finished goods
    
    
    1,126
    
    
    
    1,609$
    6,328
    
    
    $
    6,864Accrued Liabilities:Employee related costs
    
    $
    1,210
    
    
    $
    1,085Contractual manufacturing obligations
    
    
    220
    
    
    
    498Customer deposits
    
    
    459
    
    
    
    371Current maturities of long-term liabilities
    
    
    741
    
    
    
    741Interest
    
    
    
    
    
    
    156Warranty reserve
    
    
    163
    
    
    
    122Deferred litigation recovery
    
    
    679
    
    
    
    Other accrued liabilities
    
    
    723
    
    
    
    835$
    4,195
    
    
    $
    3,798Other long-term liabilities:Remaining lease obligation, less estimated sublease proceeds
    
    $
    1,812
    
    
    $
    2,183Unfavorable operating lease, net
    
    
    574
    
    
    
    610Other non-current liabilities
    
    
    69
    
    
    
    69Total
    
    $
    2,455
    
    
    $
    2,862Less current maturities
    
    
    741
    
    
    
    741Total other long-term liabilities
    
    $
    1,714
    
    
    $
    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 six months of Fiscal 2004 and 2003
were as follows: 9




---



##### Table of Contents



Warranty
    
    WarrantyBeginning Balance
    
    Provisions
    
    Claims
    
    Ending BalanceFiscal 2004
    
    $
    122
    
    
    $
    97
    
    
    $
    56
    
    
    $
    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 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 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. 10




---



##### Table of Contents



Amortization expense for developed technology for the three-months and
six-months ended February 28, 2004, was $24 and $59, 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. 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 February 28, 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 as set forth in the MKS Agreement. The engineering
development services are targeted for completion in May 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 two were paid on
November 17, 2003, and February 20, 2004, and the remainder of which will be
paid on April 30, 2004, 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 six-months ended February 28, 2004,
include our AMO for the entire periods. The following table presents our
unaudited pro forma consolidated results of operations for the three-months and
six-months ended March 1, 2003, as if the acquisition of our AMO took place on
September 1, 2002. Three Months Ended
    
    Six MonthsMarch 1, 2003
    
    March 1, 2003Net sales
    
    $
    12,917
    
    
    $
    25,820Net loss
    
    
    (1,901
    )
    
    
    (4,703
    )Net loss per share
    
    $
    (0.27
    )
    
    $
    (0.67
    )
 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 three- and six-month periods ended March 1, 2003,
for us and unaudited results of operations for the three- and six-month periods
ended December 31, 2002, for our AMO. 11




---



##### Table of Contents



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. (7) Long-Term Debt Our long-term debt consists of the following: February 28,
    
    August 31,2004
    
    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.
    
    
    141
    
    
    
    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.
    
    
    1,185
    
    
    
    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
located at our Tempe facility.
    
    
    1,041
    
    
    
    Total
    
    
    2,367
    
    
    
    2,952Less current maturities
    
    
    368
    
    
    
    397Total long-term debt
    
    $
    1,999
    
    
    $
    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 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. 12




---



##### Table of Contents



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 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 $6,980 and $5,405, at
February 28, 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
    
    Six Months EndedFebruary 28, 2004
    
    March 1, 2003
    
    February 28, 2004
    
    March 1, 2003Basic:Net loss
    
    $
    (2,969
    )
    
    $
    (1,336
    )
    
    $
    (4,222
    )
    
    $
    (2,491
    )Net loss per share
    
    $
    (0.41
    )
    
    $
    (0.21
    )
    
    $
    (0.59
    )
    
    $
    (0.40
    )Weighted average number of
common shares outstanding
    
    
    7,232
    
    
    
    6,418
    
    
    
    7,140
    
    
    
    6,216Diluted:Net loss
    
    $
    (2,969
    )
    
    $
    (1,336
    )
    
    $
    (4,222
    )
    
    $
    (2,491
    )Net loss per share
    
    $
    (0.41
    )
    
    $
    (0.21
    )
    
    $
    (0.59
    )
    
    $
    (0.40
    )Weighted average number of
common shares outstanding
    
    
    7,232
    
    
    
    6,418
    
    
    
    7,140
    
    
    
    6,216Assumed conversion of
stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
Weighted average common
and assumed conversion
shares
    
    
    7,232
    
    
    
    6,418
    
    
    
    7,140
    
    
    
    6,216
 An aggregate of 1,960,900 and 1,394,175 shares of our Common Stock under stock
options and warrants outstanding as of February 28, 2004 and March 1, 2003 have
been excluded from the calculation of diluted net loss per common share as they
are antidilutive for each three-and six-month period then ended. 13




---



##### Table of Contents



(10) Notes Receivable and Transactions with Former CEO 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 annually (on November 2, 2002 and April
2, 2003) for the first (2) years 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 February 28, 2004, the interest due to us
under these notes receivable was $22, and is payable April 2, 2004. During the
first six months of Fiscal 2004, the former Chief Financial Officer paid $46 of
principal against our note receivable from him. As of February 28, 2004, the
outstanding principal due to us under these notes receivable was $1,210, $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. 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. As of February
28, 2004, the total combined judgment against Mr. Fant was approximately
$1,464. On March 29, 2004, we obtained a 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. 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 obtained $679 from the sale of our Common Stock previously
held by Mr. Fant that will be recognized as a recovery in the third quarter of
Fiscal 2004. The $679 is classified as restricted cash and deferred litigation
recovery at February 28, 2004. Such amounts partially reduce our total
judgment amount of $2,255. 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. Prior to commencing the litigation against Mr. Fant, our Board of Directors
established a Special Committee of Independent Directors (the Special
Committee) to address all issues related to Mr. Fant. The Special Committee
reported to us on December 14, 2003, that it completed a thorough internal
investigation of such issues, including an accounting review relating to
certain expenses incurred by us on behalf of Mr. Fant. During the first
six-months of Fiscal 2004, we directly, and on behalf of the Special Committee,
incurred outside legal and accounting costs of $757 in connection with our
litigation against, and other issues involving, Mr. Fant. The Special Committee also reviewed the actions taken by us to address the
issues related to Mr. Fants activities, which included our litigation against
Mr. Fant, enhancement of our controls over expense reporting and setting a
proper tone at the top from our new Chief Executive Officer, and concluded that
such actions were appropriate. The Special Committee believes that our only
remaining actions with respect to Mr. Fant include (i) continuing to seek to
collect on the remaining judgment amount in Minnesota and other states where it
is believed that Mr. Fant may have non-exempt and unencumbered assets and (ii)
nominating a person other than Mr. Fant to fill the director position currently
held by Mr. Fant when his current term ends at our 2005 Annual Meeting of
Shareholders. 14




---



##### 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 February 28, 2004, and
March 1, 2003, respectively. Three Months Ended
    
    Six Months EndedFebruary 28, 2004
    
    March 1, 2003
    
    February 28, 2004
    
    March 1, 2003Sonic Innovations, Inc.
    
    
    0
    %
    
    
    20
    %
    
    
    3
    %
    
    
    23
    %Siemens, Inc.
    
    
    9
    %
    
    
    17
    %
    
    
    9
    %
    
    
    18
    %GN Resound
    
    
    10
    %
    
    
    0
    %
    
    
    8
    %
    
    
    0
    %GE Medical Systems
    
    
    16
    %
    
    
    14
    %
    
    
    16
    %
    
    
    9
    %Total
    
    
    35
    %
    
    
    51
    %
    
    
    36
    %
    
    
    50
    %
 Accounts receivable from these customers represented 21% and 28%, respectively,
of the total accounts receivable at February 28, 2004, and August 31, 2003,
respectively. 15




---



##### 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) THREE AND SIX MONTHS ENDED FEBRUARY 28, 2004 AND MARCH 1, 2003: The following discussion highlights the significant factors affecting changes
in our financial condition and results of operations. 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. OVERVIEW During the second quarter of Fiscal 2004, we experienced softer results than
expected due to our inability to deliver product on a timely basis. We had
adequate orders in house but were unable to capitalize on this opportunity
because of operational issues encountered in starting many new programs at one
time. As an outcome of these results, the Vice President of Operations for our
Microelectronics Operations was replaced by the Vice President of Operations of
our AMO, giving him authority over our entire operations. The recent success
of our AMO has been linked to the effective use of lean flow manufacturing
techniques that have carved out considerable cost savings. These same
techniques are being deployed at our Victoria facility in an effort to obtain
the same results. In the interim, we have reduced the amount of product being
produced at the Victoria facility. During the first six-months of Fiscal 2004, we launched eleven new significant
customer programs, added five new development projects, and received an
expansion on three existing projects. At present, our research and development
effort is supporting 17 medical clients with 32 active projects. However, the
amount of new programs at our Victoria facility has created issues related to
capacity and caused increased scrap costs and excessive overtime. The implementation of lean flow manufacturing at our Boulder facility has been
completed. In addition, we have begun the process of bringing in-house the
manufacturing of a major product line that was previously outsourced. We
expect the resulting improvement in efficiencies in both of these efforts to
translate into future cost savings. These cost savings will become important
in the future as some of our large customers that purchase products from our
AMO have placed significant pressure on our pricing for the opportunity to
enter into contracts with them for future programs. 16




---



##### Table of Contents



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 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 are required to adopt EITF Issue
00-21 on transactions occurring after September 1, 2003. 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. 17




---



##### Table of Contents



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. FINANCIAL CONDITION AND LIQUIDITY Our net cash
flow used in operating activities was $1,747 for the six-months
ended February 28, 2004, as compared to $288 in the same prior-year period. For
the first six-months of Fiscal 2004, the increase in cash flow used by
operating activities resulted from a number of items. In addition to a large
operating loss, we recognized a non cash gain of $472 for the prepayment of our
Subordinated Promissory Note. Partially offsetting this cash usage, accounts
receivable generated cash of $553 in the first six-months of Fiscal 2004
compared to a cash usage of $1,571 in the first six-months of Fiscal 2003 due
to improved terms with certain large customers. Accounts payable
generated cash of $1,223 primarily as a result of increased billings
from our special investigation of Mr. Fant.
We have obtained $679 from the
sale of our Common Stock previously held by Mr. Fant that will be recognized as
a recovery in the third quarter of Fiscal 2004. The $679 is classified as
restricted cash and deferred litigation recovery at February 28,
2004 and had no impact on operating cash flows. Accounts receivable average days outstanding were 49 days at February 28, 2004,
compared to 46 days at August 31, 2003. Inventory turns were 5.7 for the
six-months ended February 28, 2004, compared to 5.0 for the same period a year
ago. The increased days outstanding are mainly due to one significant slow
paying customer. However, we have collected a substantial amount from this
customer subsequent to the end of the second quarter of Fiscal 2004. Increased
inventory turns for the first six months of Fiscal 2004 were primarily due to
the adoption of lean flow manufacturing techniques at our Boulder facility. Net cash flow used by investing activities was $8 for the six-months ended
February 28, 2004, as compared to $90 for the six-months ended March 1, 2003.
The decrease in cash usage was due to the sale of a certain technology that
came as a part of the AMO acquisition partially offset by an increase in
additions to property and plant. During Fiscal 2004, we intend to spend
approximately $750, including the $309 spent through the second quarter, for
manufacturing equipment and minor facility improvements. Our net cash flow of $2,560 provided by financing activities during the first
six-months ended February 28, 2004, relates primarily $3,540 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. Partially offsetting the increase due to stock proceeds is $490 in
repayments on the line of credit. The result of these activities was an increase in cash by $805 during the first
six-months of Fiscal 2004, compared to a decrease of $2,359 during the first
six-months of Fiscal 2003. Our unrestricted cash balance was $1,611 as of
February 28, 2004. We have a maximum of $3,000 available under our revolving line of credit that
is due to expire on September 1, 2004, and can be automatically and continually
extended by HEI for successive periods of six months. The revolving line of
credit agreement allows for borrowings subject to availability based on
accounts receivable. There was no outstanding balance and $3,000 available on
the revolving line at February 28, 2004. 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, the replacement and subsequent extension of its revolving and
term credit facilities it has obtained, it will meet its short and long-term
debt obligations and operation requirements for at least the next twelve
months. 18




---



##### Table of Contents



RESULTS OF OPERATIONS The following table indicates the dollars and percentages of total revenues
represented by the selected items in our unaudited consolidated statements of
operations: Selected Operating Results: Three Months Ended
    
    Six Months EndedFebruary 28,
    
    
    
    
    
    March 1,
    
    
    
    
    
    February 28,
    
    
    
    
    
    March 1,2004
    
    
    
    
    
    2003
    
    
    
    
    
    2004
    
    
    
    
    
    2003Net sales
    
    $
    9,995
    
    
    
    100
    %
    
    $
    8,144
    
    
    
    100
    %
    
    $
    20,911
    
    
    
    100
    %
    
    $
    13,634
    
    
    
    100
    %Cost of sales
    
    
    9,544
    
    
    
    95
    %
    
    
    7,298
    
    
    
    90
    %
    
    
    19,396
    
    
    
    93
    %
    
    
    12,176
    
    
    
    89
    %Gross profit
    
    
    451
    
    
    
    5
    %
    
    
    846
    
    
    
    10
    %
    
    
    1,515
    
    
    
    7
    %
    
    
    1,458
    
    
    
    11
    %Operating expenses
    
    
    3,422
    
    
    
    34
    %
    
    
    2,204
    
    
    
    27
    %
    
    
    6,154
    
    
    
    29
    %
    
    
    3,956
    
    
    
    29
    %Operating loss
    
    
    (2,971
    )
    
    
    (30
    %)
    
    
    (1,358
    )
    
    
    (17
    %)
    
    
    (4,639
    )
    
    
    (22
    %)
    
    
    (2,498
    )
    
    
    (18
    %)Other income (expense)
    
    
    2
    
    
    
    0
    %
    
    
    22
    
    
    
    1
    %
    
    
    417
    
    
    
    2
    %
    
    
    (12
    )
    
    
    0
    %Loss before income
taxes
    
    
    (2,969
    )
    
    
    (30
    %)
    
    
    (1,336
    )
    
    
    (16
    %)
    
    
    (4,222
    )
    
    
    (20
    %)
    
    
    (2,510
    )
    
    
    (18
    %)Income tax benefit
    
    
    
    
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    (19
    )
    
    
    0
    %Net loss
    
    $
    (2,969
    )
    
    
    (30
    %)
    
    $
    (1,336
    )
    
    
    (16
    %)
    
    $
    (4,222
    )
    
    
    (20
    %)
    
    $
    (2,491
    )
    
    
    (18
    %)
 Net Sales Net sales for the three-months ended February 28, 2004 were $9,995, an increase
of $1,851 or 23%, from the comparable quarter last year. Net sales for the
six-months ended February 28, 2004 were $20,911, an increase of $7,277 or 53%.
This three and six month increase is mainly related to $4,697 and $10,472 in
net sales generated by our AMO, which was acquired in January 2003. The
increase attributed to the addition of our AMO was significantly offset by the
softening revenues in the Communications and Industrial product markets. 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 35%
and 36% of net sales in the three and six months ended February 28, 2004 being
generated by four customers. At February 28, 2004, our backlog for future orders was approximately $18,515,
compared to approximately $18,645 at August 31, 2003. We have experienced a
decrease in demand for our Victoria facility products as a result of our
operational issues. This has been offset by an increase in demand for our AMO
products. Our backlog is not necessarily a firm commitment from our customers
and can change, in some cases materially, beyond our control. 19




---



##### Table of Contents



Net
sales by market for the three and six months ended February 28, 2004 and
March 1, 2003, respectively, are as follows: Three Months Ended
    
    Six Months EndedFebruary 28, 2004
    
    March 1, 2003
    
    February 28, 2004
    
    March 1, 2003Medical/Hearing
    
    $
    8,447
    
    
    $
    6,709
    
    
    $
    17,796
    
    
    $
    10,686RFID
    
    
    786
    
    
    
    656
    
    
    
    1,641
    
    
    
    1,263Communications
    
    
    534
    
    
    
    453
    
    
    
    967
    
    
    
    915Other
    
    
    228
    
    
    
    326
    
    
    
    507
    
    
    
    770Total Net Sales
    
    $
    9,995
    
    
    $
    8,144
    
    
    $
    20,911
    
    
    $
    13,634
 Net sales analysis by market follows: Sales to medical/hearing customers represent 85% of total net sales for the
three and six months ended February 28, 2004, as compared to 82% and 78% for
the three and six months ended March 1, 2003. The increase of
$1,738 and
$7,110 for the three and six 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 $4,697 and $10,472 for the three and six months
ended February 28, 2004 compared to $2,809 for the three and six months ended
March 1, 2003. The offsetting decrease in sales for the three and six months
ended February 28, 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
represent 8%-9% of our total net sales RFID sales increased $130 and $378 for
the three and six months ended Fiscal 2004 as compared to the same period 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. Net sales to the communications products market represents 5%-7% of total net
sales. Communications revenues increased $81 and $52 for the three and six
months of Fiscal 2004 compared to the same period of Fiscal 2003. We are
experiencing increased activity in this market with numerous low volume
purchase orders. Net Sales
to the Industrial products market represent 2%-6% of our total net
sales. Industrial sales have decreased $98 and $263 for the three and six
months ended Fiscal 2004 compared to the same period in Fiscal 2003. The
overall market remains depressed; however we are seeing slight increased
activity in this market with numerous low volume purchase orders. Gross Profit Gross profit was
$451 (5% of net sales) and $1,515 (7%) for the three and six
months ended February 28, 2004, compared to $846 (10%) and $1,458 (11%) for the
three and six months ended March 1, 2003. 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 higher scrap costs
of $405 and $637 for the three and six months ended February 28, 2004. 20




---



##### Table of Contents



Operating Expenses Selling, general and administrative expenses Selling, general and administrative expenses increased by $449, or 28% and $949
or 33%, for the three and six months ended February 28, 2004 compared to the
comparable period last
year. As a percentage of net sales, selling, general
and administrative expenses were 21% and 18% for the three and six months ended
February 28, 2004, as compared to 20% and 21% for the comparable
prior year periods. The increase is primarily related to our AMO business acquired in
January 2003, which contributed $697 and $1,352 in selling, general and
administrative expenses for the three and six months ended February 28, 2004.
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 six
months of Fiscal 2004. 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 quarter of Fiscal 2004 related primarily
to our negotiations with our Boulder landlord. Research, development, and engineering expenses Research, development, and engineering expenses increased $265, or 45% and
$492, or 45%, for the three and six months ended February 28, 2004 compared to
the comparable period last year. As a percentage of net sales, research,
development, and engineering expenses were 9% and 8% for the three and six
months ended February 28, 2004 as compared to 7% and 8% for the three and six
months ended March 1, 2003. The increase in these expenses is primarily a
result of the addition of our AMO in January 2003, which contributed $492 and
$783 in research, development, and engineering expenses during the three and
six months ended February 28, 2004. The remaining decrease of these expenses
is a result of our continued efforts to right-size the business balanced with
our commitment to maintain research and development efforts. Costs related to investigation During the three and six months ended February 28, 2004, we directly, and on
behalf of the Special Committee of our Board of Directors, incurred outside
legal and accounting costs of $504 and $757 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. Other Income (Expense), net We recorded $100 and $584 in net other income during the three and six months
ended February 28, 2004, and $22 and $(12) in net other income (expenses)
during the three and six months ended March 1, 2003. For the three months
ended February 28, 2004, the net other income consists primarily of a $112
judgment recovery related to Mr. Fant. The increase for the six months ended
February 28, 2004 includes the gain of $472 recognized in connection with the
prepayment of the Subordinated Promissory Note. Income Taxes We established a valuation allowance of approximately $6,980 and $5,400 at
February 28, 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 February 28, 2004, we had Federal net operating loss
carryforwards expiring at various dates ranging from 2013 through 2023. 21




---



##### Table of Contents



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. 
 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 new 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




---



##### Table of Contents



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




---



##### Table of Contents



PART II - OTHER INFORMATION 
 Item 1. Legal Proceedings On June 30, 2003, we commenced litigation against Anthony J. Fant, our former
Chairman of the Board, Chief Executive Officer and President and a current
director, in the State of Minnesota, Hennepin County District Court, Fourth
Judicial District. Our Board of Directors has repeatedly requested that Mr.
Fant resign as a Director, but as of yet, he has declined to do so. Our
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 our
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. As of February
28, 2004, the total combined judgment against Mr. Fant was approximately
$1,464. On March 29, 2004, we obtained a 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. We have
obtained, through garnishments, in excess of approximately $112 from Mr. Fants
accounts and $679 from the sale of shares of our Common Stock previously owned
by Mr. Fant. Such amounts partially reduce our total judgment amount of
$2,255. 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. 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities 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. 
 Item 4. Submission of Matters to a Vote of Security Holders The following matters were submitted to a vote by the shareholders of the
Company at the Annual Meeting of Shareholders held on February 11, 2004:  a.
    
    Election of the following directors to serve a three-year term ending in 2007: George M. Heenan For:
    
    
    5,614,457Against:Abstain:Non-Voters:
    
    
    137,159
 Dennis J. Leisz For:
    
    
    5,563,757Against:Abstain:Non-Voters:
    
    
    187,859
 24




---



##### Table of Contents



The following directors also continue to serve: Michael J. Evers (term
expires in 2005), Anthony J. Fant (term expires in 2005), Timothy F. Floeder
(term expires in 2006) and Mack V. Traynor, III (term expires in 2006).  b.
    
    Approval of an amendment to increase the number of shares of common
stock, par value $0.05 per share, authorized for issuance under the
Companys 1998 Stock Option Plan by 350,000: For:
    
    
    1,548,903Against:
    
    
    752,341Abstain:
    
    
    18,611Non-Voters:
    
    
    3,431,761
 
 Item 6. Exhibits and Reports on Form 8-K  a)
    
    Exhibits 2.1
    
    Stock Purchase Agreement dated February 13, 2004, by and among HEI,
Inc. and the Investors listed on Exhibit A thereto.(1)(2)2.2
    
    Registration Rights Agreement dated February 13, 2004, by and among
HEI, Inc. and the Purchasers listed on Schedule 1 thereto.(2)(3)2.3
    
    Form of Warrant issued to the Investors listed on Exhibit A to the
Stock Purchase Agreement dated February 13, 2004 (see Exhibit
2.1).(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)
    
    Pursuant to Item 601(b)(2) of Regulation S-K, the exhibits, other than
Exhibit A (List of Investors), Exhibit B (Form of Warrant incorporated
hereby by reference to Exhibit 2.3 to Amendment No. 1 to the Current
Report on Form 8-K of HEI, Inc. filed with the Securities and Exchange
Commission on February 19, 2004) and Exhibit C (the Registration Rights
Agreement incorporated hereby by reference to Exhibit 2.2 to Amendment No.
1 to the Current Report on Form 8-K of HEI, Inc. filed with the Securities
and Exchange Commission on February 19, 2004), and the schedules, to the
Stock Purchase Agreement have been omitted. HEI, Inc. agrees to
supplementally furnish such schedules and exhibits upon request from the
Securities and Exchange Commission.  (2)
    
    Incorporated hereby by reference to Amendment No. 1 to the Current Report
on Form 8-K of HEI, Inc. filed with the Securities and Exchange Commission
on February 19, 2004. 25




---



##### Table of Contents



(3)
    
    Pursuant to Item 601(b)(2) of Regulation S-K, the acceptance schedules to
the Registration Rights Agreement have been omitted. HEI, Inc. agrees to
supplementally furnish such schedules upon request from the Securities and
Exchange Commission.b)
    
    Reports on Form 8-K On December 2, 2003, 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 $993 on the basis of our
conversion, unjust enrichment, breach of fiduciary duty and corporate waste
claims. On December 16, 2003, we filed a Current Report on Form 8-K announcing, under
Item 5-Other Events, that we had timely filed our Form 10-K for our fiscal year
ending August 31, 2003. On January 14, 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
first quarter results. On January 20, 2004, we filed a Current Report on Form 8-K announcing,
under Item 5-Other Events, that we had issued a press release announcing the
appointment of James C. Vetricek as the Vice President of Operations. On February 12, 2004, we filed a Current Report on Form 8-K announcing,
under Item 5-Other Events, that we had made a presentation at the annual
shareholders meeting held on February 11, 2004 and also announcing that we were
in possession of approximately 250,000 shares of our Common Stock that were
beneficially owned by Anthony J. Fant. On February 18, 2004, we filed a Current Report on Form 8-K announcing, under
Item 5-Other Events, that we had raised $3,540 in gross proceeds through the
sale of 1,180,000 shares of our Common Stock in a private placement. On February 19, 2004, we filed an Amendment No. 1 to our Current Report on
Form 8-K filed with the Securities and Exchange Commission on February 18,
2004, to include current exhibits relating to our private placement of
1,180,000 shares of our Common Stock. 26




---



##### Table of Contents



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: April 13, 2004
    
    /s/ Douglas J. NesbitDouglas J. NesbitChief Financial Officer
 27




---



##### Table of Contents



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.
 28