##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 **** FORM 10-Q **** þ
    
    Quarterly report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934 for the quarterly period
ended May 28, 2005.
 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 of incorporation or organization)
    
    (I.R.S. Employer Identification No.)
 PO Box 5000, 1495 Steiger Lake Lane, Victoria, MN
    
    55386(Address of principal executive offices)
    
    (Zip Code)
 (952) 443-2500
Registrants telephone number, including area code 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 R No £ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). Yes £ No R As of June 30, 2005  8,394,187 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)
    
    
    3Item 1. Financial Statements
    
    
    3Consolidated Balance Sheets
    
    
    3Consolidated Statements of Operations
    
    
    4Consolidated Statements of Cash Flows
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    22Item 4. Controls and Procedures
    
    
    22Part II  Other Information
    
    
    24Item 1. Legal Proceedings
    
    
    24Item 6. Exhibits
    
    
    24Signature
    
    
    24Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 
 Consolidated Balance Sheets
 (In thousands, except per share and share data)
 May 28, 2005
    
    
    August 31, 2004(unaudited)
    
    
    (audited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    508
    
    
    $
    200Restricted cash
    
    
    
    
    
    
    481Accounts receivable, net of allowance for doubtful accounts of $140
and $121, respectively
    
    
    8,330
    
    
    
    6,770Inventories
    
    
    8,315
    
    
    
    6,787Other current assets
    
    
    960
    
    
    
    1,221Total current assets
    
    
    18,113
    
    
    
    15,459Property and equipment:Land
    
    
    216
    
    
    
    216Building and improvements
    
    
    4,323
    
    
    
    4,323Fixtures and equipment
    
    
    22,936
    
    
    
    21,432Accumulated depreciation
    
    
    (20,323
    )
    
    
    (18,580
    )Net property and equipment
    
    
    7,152
    
    
    
    7,391Developed technology, less accumulated amortization of $292 and $231,
respectively
    
    
    93
    
    
    
    185Security deposits
    
    
    1,580
    
    
    
    1,580Other long-term assets
    
    
    511
    
    
    
    497Total assets
    
    $
    27,449
    
    
    $
    25,112Liabilities and Shareholders EquityCurrent liabilities:Line of credit
    
    $
    
    
    
    $
    1,310Current maturities of long-term debt
    
    
    433
    
    
    
    403Accounts payable
    
    
    5,973
    
    
    
    5,663Accrued liabilities
    
    
    4,448
    
    
    
    4,669Total current liabilities
    
    
    10,854
    
    
    
    12,045Other long-term liabilities, less current maturities
    
    
    1,215
    
    
    
    1,277Long-term debt, less current maturities
    
    
    1,762
    
    
    
    1,833Total other long-term liabilities, less current maturities
    
    
    2,977
    
    
    
    3,110Total liabilities
    
    
    13,831
    
    
    
    15,155Shareholders equity:Undesignated stock; 1,833,000 and 4,000,000 shares authorized;
none issued
    
    
    
    
    
    
    Convertible preferred stock, $.05 par; 167,000 shares authorized; 130,538
outstanding; liquidation preference at $26.00 per share
(total liquidation preference $3.4 million)
    
    
    7
    
    
    
    Common stock, $.05 par; 11,000,000 shares authorized; 8,394,000
and 8,357,000 shares issued and outstanding
    
    
    420
    
    
    
    418Paid-in capital
    
    
    26,771
    
    
    
    22,426Accumulated deficit
    
    
    (13,373
    )
    
    
    (12,452
    )Notes receivable-related parties-former officers and directors
    
    
    (207
    )
    
    
    (435
    )Total shareholders equity
    
    
    13,618
    
    
    
    9,957Total liabilities and shareholders equity
    
    $
    27,449
    
    
    $
    25,112
 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 data)
 Three Months Ended
    
    
    Nine Months EndedMay 28, 2005
    
    
    May 29, 2004
    
    
    May 28, 2005
    
    
    May 29, 2004Net sales
    
    $
    13,755
    
    
    $
    11,131
    
    
    $
    41,563
    
    
    $
    32,042Cost of sales
    
    
    11,185
    
    
    
    9,980
    
    
    
    33,170
    
    
    
    29,376Gross profit
    
    
    2,570
    
    
    
    1,151
    
    
    
    8,393
    
    
    
    2,666Operating expenses:Selling, general and administrative
    
    
    1,995
    
    
    
    1,999
    
    
    
    6,381
    
    
    
    5,817Research, development and
engineering
    
    
    690
    
    
    
    737
    
    
    
    2,462
    
    
    
    2,316Gain on claim settlement
    
    
    (300
    )
    
    
    
    
    
    
    (300
    )
    
    
    Costs related to investigation
    
    
    
    
    
    
    94
    
    
    
    
    
    
    
    851Operating income (loss)
    
    
    185
    
    
    
    (1,679
    )
    
    
    (150
    )
    
    
    (6,318
    )Other income
(expenses):Interest expense
    
    
    (148
    )
    
    
    (60
    )
    
    
    (498
    )
    
    
    (227
    )Gain on prepayment of promissory
note
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    472Litigation recovery
    
    
    
    
    
    
    687
    
    
    
    481
    
    
    
    799Other income (expense), net
    
    
    236
    
    
    
    23
    
    
    
    318
    
    
    
    23Income (loss) before
income taxes
    
    
    273
    
    
    
    (1,029
    )
    
    
    151
    
    
    
    (5,251
    )Income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    273
    
    
    $
    (1,029
    )
    
    $
    151
    
    
    $
    (5,251
    )Deemed dividend on Preferred Stock
    
    $
    1,072
    
    
    $
    
    
    
    $
    1,072
    
    
    $
    Net loss attributable
to common stock holders
    
    $
    (799
    )
    
    $
    (1,029
    )
    
    $
    (921
    )
    
    $
    (5,251
    )Earnings (loss) per common share:Basic & Diluted:Net Income (loss)
    
    $
    0.03
    
    
    $
    (0.12
    )
    
    $
    0.02
    
    
    $
    (0.70
    )Deemed dividend on Preferred Stock
    
    $
    (0.13
    )
    
    $
    
    
    
    $
    (0.13
    )
    
    $
    Net loss attributable to
common stock holders
    
    $
    (0.10
    )
    
    $
    (0.12
    )
    
    $
    (0.11
    )
    
    $
    (0.70
    )Weighted average common shares
outstanding:Basic
    
    
    8,381
    
    
    
    8,310
    
    
    
    8,365
    
    
    
    7,533Diluted
    
    
    8,381
    
    
    
    8,310
    
    
    
    8,365
    
    
    
    7,533
 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 28, 2005
    
    
    May 29, 2004Cash flow from operating activities:Net income (loss)
    
    $
    151
    
    
    $
    (5,251
    )Adjustments to reconcile net income (loss) to net cash
used in operating activities:Depreciation and amortization
    
    
    1,893
    
    
    
    2,054Accounts receivable allowance
    
    
    
    
    
    
    (20
    )Loss on disposal of property and equipment
    
    
    40
    
    
    
    18Gain on prepayment of promissory note
    
    
    
    
    
    
    (472
    )Changes in operating assets and liabilities:Restricted cash related to deferred litigation
    
    
    481
    
    
    
    (562
    )Accounts receivable
    
    
    (1,560
    )
    
    
    (724
    )Inventories
    
    
    (1,528
    )
    
    
    (60
    )Other current assets
    
    
    261
    
    
    
    (46
    )Other assets
    
    
    (14
    )
    
    
    (22
    )Accounts payable
    
    
    309
    
    
    
    2,387Accrued liabilities and other long-term liabilities
    
    
    (283
    )
    
    
    (943
    )Net cash flow used in operating activities
    
    
    (250
    )
    
    
    (3,641
    )Additions to property and equipment
    
    
    (1,519
    )
    
    
    (520
    )Proceeds from sale of assets
    
    
    
    
    
    
    17Additions to patents
    
    
    (80
    )
    
    
    (64
    )Sale of technology
    
    
    
    
    
    
    323Net cash flow provided by (used in) investing activities
    
    
    (1,599
    )
    
    
    (244
    )Cash flow from financing activities:Proceeds from issuance of stock, net
    
    
    3,280
    
    
    
    3,374Note repayment
    
    
    227
    
    
    
    70Proceeds from long-term debt
    
    
    
    
    
    
    2,200Repayment of long-term debt
    
    
    (40
    )
    
    
    (2,523
    )Net borrowings (repayments) on line of credit
    
    
    (1,310
    )
    
    
    294Net cash flow provided by financing activities
    
    
    2,157
    
    
    
    3,415Net increase (decrease) in cash and cash equivalents
    
    
    308
    
    
    
    (470
    )Cash and cash equivalents, beginning of period
    
    
    200
    
    
    
    806Cash and cash equivalents, end of period
    
    $
    508
    
    
    $
    336Supplemental disclosures of cash flow information:Interest paid
    
    $
    498
    
    
    $
    210Deemed dividend on preferred stock
    
    $
    1,072
    
    
    $
    Capital lease obligations related to property and equipment
    
    $
    250
    
    
    $
    
 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 data) (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 the 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
financial statements and accompanying notes included in our Annual Report on Form 10-K for our
fiscal year ended August 31, 2004 (Fiscal 2004). Interim results of operations for the three- and
nine-month periods ended May 28, 2005, may not necessarily be indicative of the results to be
expected for the full year. 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. Summary of Significant Accounting Policies Revenue Recognition.Revenue for manufacturing and assembly contracts is generally recognized
upon shipment to the customer which represents the point at which the risks and rewards of
ownership have been transferred to the customer. We have a limited number of customer arrangements
with customers which require that we retain ownership of inventory until it has been received by
the customer, until it is accepted by the customer, or in one instance, until the customer places
the inventory into production at its facility. There are no additional obligations or other rights
of return associated with these agreements. Accordingly, revenue for these arrangements is
recognized upon receipt by the customer, upon acceptance by the customer or when the inventory is
utilized by the customer in its manufacturing process. Our Advanced Medical Operations (AMO)
provides service contracts for some of its products. Billings for services contracts are based on
published renewal rates and revenue is recognized on a straight-line basis over the service period. AMOs development contracts are discrete time and materials projects that generally do not involve
separate deliverables. Development contract revenue is recognized ratably as development activities
occur based on contractual per hour and material reimbursement rates. Development contracts are an
interactive process with customers as different design and functionality is contemplated during the
design phase. Upon reaching the contractual billing maximums, we defer revenue until contract
extensions or purchase orders are received from customers. We occasionally have contractual
arrangements in which part or all of the payment or billing is contingent upon achieving milestones
or customer acceptance. For those contracts we evaluate whether the contract should be accounted
using the completed contract method, as the term of the arrangement is short-term, or using the
percentage of completion method for longer-term contracts. Use of Estimates.The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ significantly from those
estimates. 6




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(2) Private Placement of Preferred Stock and Deemed Dividend Sale of Preferred Stock On May 9, 2005, we completed the sale of 130,538 shares of our Series A convertible preferred
stock, referred to as preferred stock, in a private placement to a group of institutional and
accredited investors. Gross proceeds to us from the offering were $3.4 million. Each share of
preferred stock is convertible into ten shares of our common stock, which in the aggregate would
represent an additional 1,305,380 shares of common stock. The purchase price of the preferred stock
was $26.00 per share. In connection with the financing, we also issued to the investors and the
agent five-year warrants to purchase up to 527,152 shares of common stock at an exercise price of
$3.05 per share. If the warrant holders exercise the warrants in full we would receive an
additional approximately $1.6 million in cash proceeds. There are no dividend, coupon or redemption
rights associated with our preferred stock; however our preferred stock includes a liquidation
preference. We have agreed to register for resale by the investors the common stock issuable upon
conversion of the preferred stock. The preferred stock will not be separately registered or listed
on The Nasdaq Stock Market, Inc. We paid a $25 fee and issued warrants to purchase 25,000
shares of our common stock at an exercise price of $3.05 per share as compensation to the placement
agent who assisted in the private placement. In the event that the Company liquidates or dissolves, the holders of each outstanding share of
preferred stock will be entitled to receive an amount equal to $26.00 per share, plus any declared
but unpaid dividends, in preference to the holders of our common stock or any other class of our
capital stock ranking junior to our preferred stock. After the full payment of the preference
amount to the holders of our preferred stock, and provision or payment of our debts and other
liabilities, our remaining assets or property are distributable upon such liquidation shall be
distributed pro rata among the holders of our common stock. Deemed Dividend on Preferred Stock In view of the fact that the preferred stock contains an embedded beneficial conversion
feature, we have recorded a deemed dividend on preferred stock in our financial statements for the
quarterly period ended May 28, 2005. This non-cash dividend is to reflect the implied economic
value to the preferred stockholders of being able to convert their shares into common stock at a
price which is in excess of the fair value of the preferred stock. In order to determine the
dividend value, we allocated the proceeds of the offering between preferred stock and the common
stock warrants that were issued as part of the offering based on their relative fair values. The
fair value allocated to the warrants of $850 was recorded as equity. The fair value allocated
to the preferred stock of $2,550 together with the original conversion terms were used to
calculate the value of the deemed dividend on the preferred stock of $1,072 at the date of
issuance of the preferred stock. This amount has been charged to accumulated deficit with the
offsetting credit to additional paid-in-capital. We have treated the deemed dividend on preferred
stock as a reconciling item on the statement of operations to adjust our reported net income (loss)
to net income (loss) available to common stockholders. (3) Liquidity The accompanying unaudited consolidated financial statements have been prepared assuming that the
realization of assets and the satisfaction of liabilities will occur in the normal course of
business. We generated net income of $151 for the nine months ended May 28, 2005. We incurred a
net loss of $7,009 for the year ended August 31, 2004. We have historically financed our operations through the public and private sale of equity
securities, bank borrowings, operating equipment leases and cash generated by operations. At May 28, 2005, our sources of liquidity consisted of $508 of cash and cash equivalents and our
accounts receivable agreement (Credit Agreement) with Beacon Bank of Shorewood, Minnesota. The
Credit Agreement, as amended, extends through September 1, 2006 and provides borrowing capacity up
to $5,000, subject to availability based on accounts receivable. There was no amounts outstanding
debt under the Credit Agreement at May 28, 2005. 7




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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, the level of inventories and capital expenditures and maintaining of debt compliance.
The losses due to the operational problems encountered throughout Fiscal 2004 strained our cash
flows and consumed much of the additional funds raised in the year including the proceeds from our
private placement of common stock and the collection of monies from the judgments against our
former Chief Executive Officer, President and Chairman. Over the past six months, our revenue
growth has required a substantial increase in accounts receivable, inventory and other working
capital. We have taken various actions operationally which has resulted in a substantial reduction
in our losses. We are implementing other actions in order to return to profitability in our fiscal
year ending August 31, 2005 (Fiscal 2005) including, but not limited to, production improvement
initiatives and continuing progress in understanding key drivers via systems upgrades that will
improve management decision making. In addition to the operational improvements, we continue to
scrutinize our cost structure for savings. In the event cash flows are not sufficient to fund operations at the present level 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 certain employees. Our
lending arrangements contain debt covenants, several of which we did not maintain in Fiscal 2004
and early Fiscal 2005. We have received waivers for these violations. We do not foresee any
violations of debt agreements, as amended, for the remainder of Fiscal 2005. We will be required to
maintain a debt service coverage ratio of 1.2 to 1 beginning in the quarter ending February 28,
2006 calculated based on operating results for the preceeding twelve month period. During Fiscal 2005, we intend to spend approximately
$1.8 million for manufacturing equipment,
computer software and to make minor facility improvements. These additions, if made, are expected
to increase efficiency through the further integration of the AMO operations and increase
manufacturing capacity to meet anticipated production requirements and add technological
capabilities. It is expected that these expenditures will be funded from operations, existing cash
and cash equivalents and available debt financing for the next 12 months. In the event there is
insufficient capital funds for this spending it will be deferred into the future which may impact
our ability to integrate the operations of all facilities and may prevent us from increasing
manufacturing capacity. Management believes that, as a result of the financial restructuring actions it has taken in Fiscal
2005 and Fiscal 2004 to reduce cash expenditures, the continuing efforts to increase revenues from
continuing customers and to generate new customers in various market sectors, the recent sale of
preferred stock and the extension and increase of our accounts receivable agreement with Beacon
Bank, referred to as the Credit Agreement, we expect to meet our operational working capital and
investment requirements for the next 12 months. If there is a need for additional capital to meet
our short and long-term objectives, we believe that other sources of financing are available
including sales of common stock or our undesignated stock, additional external borrowing, customer
or vendor financing or investments by strategic partners. There can be no assurance that additional
capital will be available to us or on terms that are acceptable. (4) 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 Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, to stock based
employee compensation, our net income (loss) per share would have increased to the pro forma
amounts indicated below: 8




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Three Months Ended
    
    
    Nine Months EndedMay 28, 2005
    
    
    May 29, 2004
    
    
    May 28, 2005
    
    
    May 29, 2004Net loss attributable to
common stockholders as
reported
    
    $
    (799
    )
    
    $
    (1,029
    )
    
    $
    (921
    )
    
    $
    (5,251
    )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
    
    
    (259
    )
    
    
    (461
    )
    
    
    (1,074
    )
    
    
    (1,368
    )Net loss pro forma
    
    $
    (1,058
    )
    
    $
    (1,490
    )
    
    $
    (1,995
    )
    
    $
    (6,619
    )Basic and diluted net loss
per share attributable to
common stockholders as
reported
    
    $
    (0.10
    )
    
    $
    (0.12
    )
    
    $
    (0.11
    )
    
    $
    (0.70
    )Stock-based compensation
income (expense)
    
    
    (0.03
    )
    
    
    (0.06
    )
    
    
    (0.13
    )
    
    
    (0.18
    )Basic and diluted net loss per
share pro forma
    
    $
    (0.13
    )
    
    $
    (0.18
    )
    
    $
    (0.24
    )
    
    $
    (0.88
    )
 There were 80,000 options granted under our stock option plans during the three and nine-months
ended May 28, 2005. (5) Developed Technology Amortization expense for developed technology for the three months and nine months ended May 28,
2005 was $31 and $92, respectively, and for the three months and nine months ended May 29, 2004,
was $26 and $84, respectively. Amortization expense is estimated to be $124 during our fiscal year
ending August 31, 2005, $57 during our fiscal year ending August 31, 2006 and $4 thereafter. (6) Other Financial Statement Data The following provides additional information concerning selected consolidated balance sheet
accounts at May 28, 2005 and August 31, 2004: May 28,
    
    
    August 31,2005
    
    
    2004Inventories:Purchased parts
    
    $
    6,020
    
    
    $
    4,673Work in process
    
    
    865
    
    
    
    789Finished goods
    
    
    1,430
    
    
    
    1,325$
    8,315
    
    
    $
    6,787Accrued Liabilities:Employee related costs
    
    $
    1,198
    
    
    $
    1,474Deferred revenue
    
    
    260
    
    
    
    804Customer deposits
    
    
    1,891
    
    
    
    418Current maturities of long-term
liabilities
    
    
    309
    
    
    
    805Warranty reserve
    
    
    223
    
    
    
    139Other accrued liabilities
    
    
    567
    
    
    
    1,029$
    4,448
    
    
    $
    4,669Other long-term liabilities:Remaining lease obligation, less
estimated sublease proceeds
    
    $
    946
    
    
    $
    1,471Unfavorable operating lease, net
    
    
    578
    
    
    
    611Total
    
    $
    1,524
    
    
    $
    2,082Less current maturities
    
    
    309
    
    
    
    805Total other long-term liabilities
    
    $
    1,215

    
    
    $
    1,277
 9




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(7) 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 and three months of Fiscal 2005 and Fiscal 2004
were as follows: Warranty
    
    
    WarrantyBeginning Balance
    
    
    Provisions
    
    
    Claims
    
    
    Ending BalanceFor the Three Months
EndedMay 28, 2005
    
    $
    160
    
    
    $
    90
    
    
    $
    27
    
    
    $
    223May 29, 2004
    
    $
    163
    
    
    $
    0
    
    
    $
    0
    
    
    $
    163For the Nine Months
EndedMay 28, 2005
    
    $
    139
    
    
    $
    174
    
    
    $
    90
    
    
    $
    223May 29, 2004
    
    $
    122
    
    
    $
    128
    
    
    $
    87
    
    
    $
    163
 (8) Long-Term Debt Our long-term debt consists of the following: May 28,
    
    
    August 31,2005
    
    
    2004Commerce Bank mortgage payable in monthly
installments of principal and interest of $9
based on a twenty-year amortization with a
final payment of approximately $980 due in
November 2009; collateralized by our Victoria
facility
    
    $
    1,149
    
    
    $
    1,174Commerce Financial Group, Inc. equipment loan
payable in fixed monthly principal and
interest installments of $28 through
September 2007; collateralized by our
Victoria facility and equipment located at
our Tempe facility
    
    
    715
    
    
    
    916Capital lease obligation; collateralized with
equipment
    
    
    292
    
    
    
    34Commercial loans payable in fixed monthly
principal installments of $1 through May
2009; collateralized with certain machinery
and equipment
    
    
    24
    
    
    
    33Commercial loans payable in fixed monthly
principal installments of $12 through July
2005; collateralized with certain machinery
and equipment
    
    
    15
    
    
    
    79Total
    
    
    2,195
    
    
    
    2,236Less current maturities
    
    
    433
    
    
    
    403Total long-term debt
    
    $
    1,762
    
    
    $
    1,833
 10




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##### Table of Contents



In Fiscal 2004, we obtained two separate loans in the aggregate amount of $2,350 under new Term
Loan Agreements 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 was executed on October 14, 2003. This note is collateralized by our Victoria,
Minnesota facility. The term of the first note is six years. The original interest rate on this
note was a nominal rate of 6.50% per annum for the first three years, and thereafter the interest
rate will be adjusted on the first date of the fourth loan year to a nominal rate per annum equal
to the then Three Year Treasury Base Rate (as defined) plus 3.00%; provided, however, that in no
event will the interest rate be less than the Prime Rate plus 1.0% per annum. Monthly payment 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 collateralized by our
Victoria facility and equipment located at our Tempe facility. The term of the second note is four
years. The original interest rate on this note was of 8.975% per year through September 27, 2007.
During the first quarter of Fiscal 2005, we violated two covenants of these term loan agreements
and were likely to be in violation of a third covenant as of the end of our second quarter ended
May 28, 2005. As a result, in December 2004, we entered into waivers and amendments with Commerce
Bank and Commerce Financial Group, Inc., respectively, effective as of November 30, 2004, to
address the actual and potential covenant violations. The waivers and amendments increased the
interest rate to be paid under the Commerce Bank note beginning March 1, 2005, to and including
October 31, 2006, from 6.5% to 7.5%, and increased the interest rate to be paid under the Commerce
Financial Group, Inc. note beginning March 1, 2005, to and including September 28, 2007, from
8.975% to 9.975%. Monthly payments of principal and interest in the amount of $28 are paid over a
forty-eight month period beginning on October 28, 2003. In the third quarter we entered into two leases to finance the acquisition of two pieces of
equipment. The total capital cost of the equipment is approximately $250. The leases are for a
three year term and enable us to renew the lease at the end of the term or to purchase the
equipment at a price not to exceed 20% of the original acquisition price. (9) Line of Credit We entered into a Credit Agreement which, as amended, expires on January 1, 2006 and has a maximum
borrowing capacity of $5,000, subject to availability based on accounts receivable. The Credit
Agreement is an accounts receivable backed facility and is additionally collateralized by
inventory, intellectual property and other general intangibles. The Credit Agreement is not subject
to any restrictive financial covenants. There was no balance outstanding on the line of credit as
of May 28, 2005 and $1,310 was outstanding on August 31, 2004. The Credit Agreement bears an
immediate processing fee of 0.50% of each assigned amount, a daily per diem equal to 1/25% on any
uncollected accounts receivable and a monthly minimum of $1.5 in processing fees for the first six
months the Credit Agreement is in place. Borrowings are reduced as collections and payments are
received into a lock box by the bank. The effective interest rate based on our average DSO of 58
days would be 17.9% annualized. During the first quarter of Fiscal 2005, we violated one covenant
of the Credit Agreement and were likely to be in violation of a second covenant. As a result, in
December 2004, we entered into waivers and amendments with Beacon Bank to address the actual and
potential covenant violations. On July 7, 2005 we entered into an amendment of this agreement which revised the interest rate to
Prime plus 2.75% and extended the term of the agreement to September 1, 2006. The maximum
borrowing capacity remains at $5.0 million, subject to availability based on our accounts
receivable balances, and there is an immediate discount of .85% for processing. The Credit
Agreement continues to be collateralized by our accounts receivable, inventory and general intangibles. 11




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##### Table of Contents



(10) 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
$7,450 and $7,650, at May 28, 2005, and August 31, 2004, 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. (11) Net Income (Loss) per Share Computation The components of net income (loss) per basic and diluted share are as follows: Three Months Ended
    
    
    Nine Months EndedMay 28, 2005
    
    
    May 29, 2004
    
    
    May 28, 2005
    
    
    May 29, 2004Basic:Net income (loss)
    
    $
    273
    
    
    $
    (1,029
    )
    
    $
    151
    
    
    $
    (5,251
    )Net loss attributable to
common stockholders
    
    $
    (799
    )
    
    $
    (1,029
    )
    
    $
    (921
    )
    
    $
    (5,251
    )Net income (loss) per share
    
    $
    0.03
    
    
    $
    (0.12
    )
    
    $
    0.02
    
    
    $
    (0.70
    )Net loss attributable to
common stockholders per
share
    
    $
    (0.10
    )
    
    $
    (0.12
    )
    
    $
    (0.11
    )
    
    $
    (0.70
    )Weighted average
number of common
shares outstanding
    
    
    8,381
    
    
    
    8,310
    
    
    
    8,365
    
    
    
    7,533Diluted:Net income (loss)
    
    $
    273
    
    
    $
    (1,029
    )
    
    $
    151
    
    
    $
    (5,251
    )Net loss attributable to
common stockholders
    
    $
    (799
    )
    
    $
    (1,029
    )
    
    $
    (921
    )
    
    $
    (5,251
    )Net income (loss) per share
    
    $
    0.03
    
    
    $
    (0.19
    )
    
    $
    0.02
    
    
    $
    (0.70
    )Net loss attributable to
common stockholders per
share
    
    $
    (0.10
    )
    
    $
    (0.12
    )
    
    $
    (0.11
    )
    
    $
    (0.70
    )Weighted average
number of common
shares outstanding
    
    
    8,381
    
    
    
    8,310
    
    
    
    8,365
    
    
    
    7,533Assumed conversion of
preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Assumed conversion
of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Weighted average
common and assumed
conversion shares
    
    
    8,381
    
    
    
    8,310
    
    
    
    8,365
    
    
    
    7,533
 Approximately 2,366,677 and 1,810,650 shares of our common stock under stock options and warrants
have been excluded from the calculation of diluted net income (loss) per common share as they are
antidilutive for the three-and nine-month period ended May 28, 2005 and May 29, 2004, respectively. (12) Notes Receivable Related Parties   Officers and Former Directors and Transactions with Former
CEO Notes Receivable  Related PartiesOfficers and Former Directors We recorded notes receivable from certain officers and directors in connection with the exercise of
stock options. These notes as amended provide for full recourse to the individuals, bear interest
at prime with the exception of one individual at prime plus 1/2 per annum and have a term of five
years with interest only payments in the first two years and annual principal and interest
installments thereafter through April 2, 2006. The unpaid portion of these notes receivable are
classified as a reduction to shareholders equity on the consolidated balance sheet. 12




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##### Table of Contents



Edwin W. Finch, III, our former director, missed a payment of $93 in principal and interest under
his promissory note to us, which was due on April 2, 2004. Mr. Finch withheld payment on his note
because he claimed that we owed him payments under an employment agreement with him. On October 15,
2004, the parties settled the dispute regarding the employment agreement and the note, and Mr.
Finch subsequently satisfied his obligation for the payment he withheld. We recorded a write-off of
$64 related to this settlement in Fiscal 2004. We received the remaining $20 related to this
payment in the first quarter of Fiscal 2005. As of May 28, 2005, the principal portion of the notes receivable was $208. All principal and
interest payments that were due on April 2, 2005 have been received by the Company. Anthony J. Fant Litigation On June 30, 2003, we commenced litigation against Anthony J. Fant, our former Chairman of the
Board, Chief Executive Officer and President, 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 promissory note to us 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 28, 2005,
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
additional common stock previously held by Mr. Fant, $472 of the proceeds from that sale reduced
judgments against Mr. Fant. This judgment recovery was 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 we recorded as income in the first quarter of Fiscal 2005. As of May 28, 2005, we have
collected approximately $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:
    
    
    
    
    
    $
    2,255Proceeds:Garnishments
    
    
    
    
    
    
    642Sale of stock  reducing judgments
    
    
    1,106Sale of stock  fees paid
    
    
    94Total proceeds from sale of stock
    
    
    
    
    
    
    1,200Litigation recoveries
    
    
    
    
    
    $
    1,842
 (13) Major Customers There were no customers where net sales represented over 10% of our revenue for the three months
and nine months ended May 28, 2005. For the three months ended May 29, 2004 one customer accounted
for 14% and a second customer accounted for 10% of net sales. For the nine months ended May 29,
2004 there was one customer that accounted for 15% of net sales and another customer that accounted
for 12% of net sales. 13




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##### Table of Contents



(14) Geographic Data Sales to customers by geographic region as a percentage of net sales are as follows: Three Months Ended May 28

    
    Nine Months Ended May 282005

    
    2004

    
    2005

    
    2004Dollars
    
    % of Sales
    
    Dollars
    
    % of Sales
    
    Dollars
    
    % of Sales
    
    Dollars
    
    % of SalesUnited States
    
    $
    9,344
    
    
    
    68
    %
    
    $
    7,947
    
    
    
    71
    %
    
    $
    28,939
    
    
    
    70
    %
    
    $
    21,176
    
    
    
    66
    %Canada / Mexico
    
    
    799
    
    
    
    6
    %
    
    
    1,200
    
    
    
    11
    %
    
    
    3,249
    
    
    
    8
    %
    
    
    3,925
    
    
    
    12
    %Europe
    
    
    1,673
    
    
    
    12
    %
    
    
    707
    
    
    
    6
    %
    
    
    4,000
    
    
    
    10
    %
    
    
    3,261
    
    
    
    10
    %Asia-Pacific
    
    
    1,928
    
    
    
    14
    %
    
    
    1,272
    
    
    
    11
    %
    
    
    5,135
    
    
    
    12
    %
    
    
    3,656
    
    
    
    11
    %South America
    
    
    11
    
    
    
    0
    %
    
    
    5
    
    
    
    0
    %
    
    
    240
    
    
    
    1
    %
    
    
    24
    
    
    
    0
    %Total
    
    $
    13,755
    
    
    
    
    
    
    $
    11,131
    
    
    
    
    
    
    $
    41,563
    
    
    
    
    
    
    $
    32,042
 (15) Segments Microelectronics Operations: This segment consists of three facilities  Victoria, Chanhassen, and
Tempe  that design, manufacture and sell ultra miniature microelectronic devices and high
technology products incorporating these devices. Advanced Medical Operations: This segment consists of our Boulder facility that provides design and
manufacturing outsourcing of complex electronic and electromechanical medical devices. Segment information is as follows: Three Months Ended May 28, 2005
    
    
    Nine Months Ended May 28, 2005Microelectronics
    
    
    Advanced Medical
    
    
    
    
    
    
    Microelectronics
    
    
    Advanced MedicalOperations
    
    
    Operations
    
    
    Total
    
    
    Operations
    
    
    Operations
    
    
    TotalNet sales
    
    $
    8,150
    
    
    $
    5,605
    
    
    $
    13,755
    
    
    $
    24,188
    
    
    $
    17,375
    
    
    $
    41,563Gross profit
    
    
    1,356
    
    
    
    1,214
    
    
    
    2,570
    
    
    
    4,130
    
    
    
    4,263
    
    
    
    8,393Operating income
(loss)
    
    
    (481
    )
    
    
    666
    
    
    
    185
    
    
    
    (1,567
    )
    
    
    1,417
    
    
    
    (150
    )Total assets
    
    
    19,379
    
    
    
    8,070
    
    
    
    27,449
    
    
    
    19,379
    
    
    
    8,070
    
    
    
    27,449Depreciation and
Amortization
    
    
    484
    
    
    
    102
    
    
    
    586
    
    
    
    1,590
    
    
    
    303
    
    
    
    1,893Capital expenditures
    
    
    741
    
    
    
    10
    
    
    
    751
    
    
    
    1,554
    
    
    
    45
    
    
    
    1,599
 Three Months Ended May 29, 2004
    
    
    Nine Months Ended May 29, 2004Microelectronics
    
    
    Advanced Medical
    
    
    
    
    
    
    Microelectronics
    
    
    Advanced MedicalOperations
    
    
    Operations
    
    
    Total
    
    
    Operations
    
    
    Operations
    
    
    TotalNet sales
    
    $
    6,077
    
    
    $
    5,054
    
    
    $
    11,131
    
    
    $
    16,516
    
    
    $
    15,526
    
    
    $
    32,042Gross profit
    
    
    303
    
    
    
    848
    
    
    
    1,151
    
    
    
    (360
    )
    
    
    3,026
    
    
    
    2,666Operating income
(loss)
    
    
    (1,438
    )
    
    
    (241
    )
    
    
    (1,679
    )
    
    
    (6,118
    )
    
    
    (200
    )
    
    
    (6,318
    )Total assets
    
    
    17,071
    
    
    
    8,796
    
    
    
    25,867
    
    
    
    17,071
    
    
    
    8,796
    
    
    
    25,867Depreciation and
amortization
    
    
    599
    
    
    
    108
    
    
    
    707
    
    
    
    1,762
    
    
    
    292
    
    
    
    2,054Capital expenditures
    
    
    233
    
    
    
    42
    
    
    
    275
    
    
    
    454
    
    
    
    130
    
    
    
    584
 14




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##### Table of Contents



(16) Commitments and Contingencies We lease a 152,022 square foot facility in Boulder, Colorado for our AMO. On September 27, 2004,
this facility was sold by Eastside Properties, LLC to Titan Real Estate Investment Group, Inc.,
referred to as Titan. On October 1, 2004, we signed a 15-year new lease with Titans affiliate,
Boulder Investors LLC, at substantially reduced rental rates. Under the terms of the new lease,
$1,350 of our deposit will be refunded to us if after completing four consecutive quarters of
positive EBIDTA, as derived from our financial statements and verified by an independent third
party accountant, we deliver to our landlord the greater of 100,000 shares of our common stock or
0.11% of the outstanding shares of our common stock. As a part of the purchase accounting for the
acquisition of our AMO, we had established a $3,110 reserve relating to the future estimated lease
payments of our Boulder facility. Currently, we occupy approximately 100,000 square feet of the
facility and 50,000 is unimproved vacant space. The lease provides for two options to extend the
15-year lease for a period of five years each as defined in the lease agreement. In April 2005, we
entered into a ten year sub-lease of approximately 25,000 square feet of vacant space in this
facility. This lease provides for rental payments and reimbursement of operating costs of
approximately $0.3 million commencing in January 2006. We are continuing to look for sublease
tenants for the remaining 25,000 square feet of vacant space. (17) Gain on claim settlement During the third quarter of Fiscal 2005, we entered into a settlement agreement related to an
outstanding claim against the seller of the AMO operations that we acquired in January 2003. The
net effect of this settlement, after offsetting legal and other related costs was a gain of
$300,000. All the cash related to this settlement was received in the third quarter of Fiscal
2005. 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations (In thousands, except share and per share data) 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, 2004. 15




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##### Table of Contents



Results of Operations Three and Nine months ended May 28, 2005 and May 29, 2004: 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

    
    Nine Months EndedMay 28,
    
    
    
    
    
    
    May 29,
    
    
    
    
    
    
    May 28,
    
    
    
    
    
    
    May 29,2005
    
    
    
    
    
    
    2004
    
    
    
    
    
    
    2005
    
    
    
    
    
    
    2004Net sales
    
    $
    13,755
    
    
    
    100
    %
    
    $
    11,131
    
    
    
    100
    %
    
    $
    41,563
    
    
    
    100
    %
    
    $
    32,042
    
    
    
    100
    %Cost of sales
    
    
    11,185
    
    
    
    81
    %
    
    
    9,980
    
    
    
    90
    %
    
    
    33,170
    
    
    
    80
    %
    
    
    29,376
    
    
    
    92
    %Gross profit
    
    
    2,570
    
    
    
    19
    %
    
    
    1,151
    
    
    
    10
    %
    
    
    8,393
    
    
    
    20
    %
    
    
    2,666
    
    
    
    8
    %Operating expenses
    
    
    2,385
    
    
    
    17
    %
    
    
    2,830
    
    
    
    25
    %
    
    
    8,543
    
    
    
    21
    %
    
    
    8,984
    
    
    
    28
    %Operating loss
    
    
    185
    
    
    
    1
    %
    
    

    (1,679
    )
    
    
    (15
    %)
    
    
    (150
    )
    
    
    (1
    )%
    
    
    (6,318
    )
    
    
    (20
    %)Other income
(expense)
    
    
    88
    
    
    
    1
    %
    
    
    650
    
    
    
    6
    %
    
    
    301
    
    
    
    1
    %
    
    
    1,067
    
    
    
    3
    %Net income (loss)
    
    $
    273
    
    
    
    2
    %
    
    $
    (1,029
    )
    
    
    (9
    %)
    
    $
    151
    
    
    
    1
    %
    
    $
    (5,251
    )
    
    
    (17
    %)
 Net Sales Net sales in the third quarter of Fiscal 2005 were $13,755, an increase of $2,624, or 24%, from the
comparable quarter last year. Net sales for the nine-months ended May 28, 2005 were $41,563 or an
increase of 30% over sales of $32,042 for the comparable period last year. This increase was driven
by increases in sales in our primary markets of medical/hearing and communications products and
improvements in our manufacturing capabilities to produce and ship more products in a quarter. Because sales are generally tied to the customers projected sales and production of the related
product, our sales may be subject to uncontrollable fluctuations. Significant changes in sales to
any one customer could 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. At May 28, 2005, our backlog for future orders was approximately $16,600, compared to approximately
$18,000 at August 31, 2004. This decrease primarily reflects an improvement in our manufacturing
capabilities as we are able to reduce the time between order and shipment. 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 are as follows: Three Months Ended
    
    
    Nine Months EndedMay 28, 2005
    
    
    May 29, 2004
    
    
    May 28, 2005
    
    
    May 29, 2004Medical/Hearing
    
    $
    11,234
    
    
    $
    9,159
    
    
    $
    33,477
    
    
    $
    26,954Communications
    
    
    1,224
    
    
    
    839
    
    
    
    4,486
    
    
    
    1,807Industrial
    
    
    1,297
    
    
    
    1,133
    
    
    
    3,600
    
    
    
    3,281Total Net Sales
    
    $
    13,755
    
    
    $
    11,131
    
    
    $
    41,563
    
    
    $
    32,042
 Net sales analysis by market follows: Net sales to medical/hearing customers increased by $2,075 in the third quarter of Fiscal 2005 as
compared with the third quarter of last fiscal year or an increase of 23%. For the nine month
period of Fiscal 2005, sales in this market increased by $6,523 or 24%. This year sales in this
market segment represented 81% of total net sales, as compared to 82% in both the three and nine
month periods of Fiscal 2004. This increase is driven by sales to new customers, increases in sales
to existing customers, particularly with respect to insulin pump components, and a return to
historical sales levels of products for defibrillators and hearing aids. Sales into new markets,
such as for glucose monitoring systems, also contributed to the sales increase in the quarter. In
addition, improvements in our manufacturing processes and capacity enabled us to manufacture and
ship more product in the quarter. Net sales to the communications products market increased $385 or 46% for the three-month period
ended May 28, 2005, as compared to the third quarter of Fiscal 2004. For the nine month period, net
sales to the communication products market increased $2,679 or 148%. The increases in both the
three and nine month periods is largely a result of the improvement in the telecommunications
markets and the realization of benefits from our much more narrowly focused sales efforts within
the telecommunications market. Significant increases in sales for the quarter were in the areas of
parallel optical interface assemblies and HEI modulator amplifiers. 16




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Net sales to the industrial products market represent 9% of our total net sales for the three and
nine-month periods ended May 28, 2005, as compared to 10% for the three and nine-month periods
ended May 29, 2004. Industrial sales for the third quarter of Fiscal 2005 increased 14% over the
third quarter of the prior year. For the nine month period, industrial sales increased by 10% over
the same period of the prior year. The slight increase in the revenue in this market is due to our
efforts to maintain and grow our sales through active account management in this market as we focus
on expanding our sales activity in our larger market segments. Gross Profit Gross profit was $2,570 or 19% of net sales for the three-months ended May 28, 2005 as compared to
$1,151 or 10% of net sales for the three-months ended May 29, 2004. For the nine-month periods,
gross profit increased to $8,393 in Fiscal 2005 from $2,666 in Fiscal 2004 or an improvement of
$5,727. The improvement in our gross profit was driven primarily by the increase in sales for both
the three and nine-month periods in Fiscal 2005. In addition, during Fiscal 2005, we were able to
realize the improvement in our gross profit margins that are the result of actions taken over the
past year to improve our manufacturing efficiency. The primary reason for the improvement in our
profit margins is that we were able to reduce the time to manufacture products in the quarter and
thereby spread our fixed manufacturing costs over a larger amount of products. In addition, the new
procedures implemented over the past year have resulted in improved yields, reduced scrap, and
reduced overtime in our manufacturing department. Our gross margins, however, are heavily impacted
by fluctuations in net sales, due to the fixed nature of many of our manufacturing costs, and by
the mix of products manufactured in any particular quarter. In addition, the start up of new
customer programs could adversely impact our margins as we implement the complex processes involved
in the design and manufacture of ultra miniature microelectronic devices. We anticipate that our
gross profit margins will remain relatively constant for the remainder of Fiscal 2005. Operating Expenses Selling, general and administrative expenses Selling, general and administrative expenses were $1,995 for the three-month period ended May 28,
2005, which is virtually the same as in the third quarter of Fiscal 2004. As a percentage of net
sales, selling, general and administrative expenses decreased to 15% for the three-month period
ended May 28, 2005, as compared to 18% for the comparable period last year. For the nine-month
period, selling, general and administrative expenses increased $564 or 10% in Fiscal 2005 as
compared with the same period in Fiscal 2004. This increase is due to higher levels of legal and
accounting expenses associated with the completion of our Fiscal 2004 audit, filing of our Annual
Report on Form 10-K, meetings with NASDAQ about our listing status and other internal control
related activities including costs associated with Sarbanes-Oxley requirements. As a percentage of
net sales, selling, general and administrative expenses decreased to 15% for the nine-month period
ended May 28, 2005 versus 18% for the same period in Fiscal 2004. The decreases in these costs as a
percentage of sales is related to the growth in our revenues for both the three and nine month
periods. We expect that our selling, general and administrative expenses will remain flat or
increase slightly in the upcoming quarters. Research, development, and engineering expenses Research, development, and engineering expenses decreased $47 or 6% for the third quarter of Fiscal
2005 as compared to the third quarter of Fiscal 2004. For the nine-months of Fiscal 2005, research,
development and engineering expenses increased $146 or 3% as compared with the first nine months of
Fiscal 2004. This increase is the result of expanded design and development efforts associated with
new customer programs and increased efforts to enhance our proprietary products and manufacturing
processes. As a percentage of net sales, research, development, and engineering expenses were 5%
and 6% for the three and nine-month periods ended May 28, 2005, respectively. In Fiscal 2004,
research, development and engineering expenses as a percentage of net sales were 6% and 7% for the
three and nine-month periods, respectively. The decrease of these expenses as a percentage of net
sales in Fiscal 2005 is a result of the growth in our revenue base and our continued efforts to
balance our commitment to maintain research and development efforts with our revenue levels. We
expect that our research, development and engineering expenses will remain at approximately the
same quarterly levels. 17




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Gain on claim settlement During the third quarter of Fiscal 2005, we entered into a settlement agreement related to an
outstanding claim against the seller of the AMO operations that we acquired in January 2003. The
net effect of this settlement, after offsetting legal and other related costs, was a gain of
$300,000. All the cash related to this settlement was received in the third quarter of Fiscal
2005. Costs related to investigation During the three and nine months of Fiscal 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,
respectively, 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 12 to our
unaudited consolidated financial statements. The Special Committee completed its investigation into
such issues on December 14, 2003. Other Income (Expense), Net Interest expense for the three and nine-month periods ended May 28, 2005 was $148 and $498,
respectively, as compared with $60 and $227 for the three and nine-month periods ended May 29,
2004. The increase in interest expense in Fiscal 2005 is due to higher average borrowing levels
associated with funding the growth in our working capital requirements. As a result of the increase
in sales levels in Fiscal 2005, we have had increases in both accounts receivable and inventories,
which have been funded by additional borrowings on our Credit Agreement. For the three months ended
May 28, 2005, other income included a gain on recoveries on a previously written off note
receivable of approximately $237. In addition, for the nine month period of Fiscal 2005, other
income included a gain of $481 related to additional cash collections against the outstanding
judgments against Mr. Fant. For the three and nine months of Fiscal 2004, other income included a
gain of $687 and $799, respectively, related to cash collections against the outstanding judgments
against Mr. Fant. For the nine-month period ended February 28, 2004, other income also included a
gain of $472 recognized in connection with the prepayment of a promissory note. Income Taxes We did not record a tax provision in Fiscal 2005 or Fiscal 2004 since we have unutilized net
operating loss carryforwards from prior years which will be utilized to offset taxes associated
with our income in the quarter. We have established a valuation allowance 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. The economic benefits of our net operating loss
carryforwards to future years will continue until expired. Deemed Dividend on Preferred Stock In view of the fact that the preferred stock that was issued in the third quarter of Fiscal 2005
contained an embedded beneficial conversion feature, we recorded a deemed dividend on preferred
stock in our financial statements for the quarterly period ended May 28, 2005. This non-cash
dividend is to reflect the implied economic value to the preferred stockholders of being able to
convert their shares into common stock at a price which is in excess of the fair value of the
preferred stock. In order to determine the dividend value, we allocated the proceeds of the
offering between preferred stock and the common stock warrants that were issued as part of the
offering based on their relative fair values. The fair value allocated to the warrants of $850 was
recorded as equity. The fair value allocated to the preferred stock of $2,550 together with the
original conversion terms were used to calculate the value of the deemed dividend on the preferred
stock of $1,072 at the date of issuance of the preferred stock. This amount has been charged to
accumulated deficit with the offsetting credit to additional paid-in-capital. The deemed dividend
on preferred stock is a reconciling item on the statement of operations to adjust reported net
income (loss) to net income (loss) available to common stockholders. 18




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FINANCIAL CONDITION AND LIQUIDITY The accompanying unaudited consolidated financial statements have been prepared assuming that the
realization of our assets and the satisfaction of liabilities will occur in the normal course of
business. We generated net income of $273 for the three months ended May 28, 2005 and of $151 for
the first nine months of Fiscal 2005. We incurred a net loss of $7,009 for the year ended August
31, 2004. We have historically financed our operations through the public and private sale of equity
securities, bank borrowings, operating equipment leases and cash generated by operations. On May 9, 2005, we completed the sale of 130,538 shares of our preferred stock in a private
placement to a group of institutional and accredited investors. Gross proceeds to us from the
offering was $3.4 million. Each share of preferred stock is convertible into ten shares of our
common stock, which in the aggregate would represent an additional 1,305,380 shares of common
stock. The purchase price of the preferred stock was $26.00 per share. In connection with the
financing, we also issued to the investors and the agent five-year warrants to purchase up to
527,152 shares of common stock at an exercise price of $3.05 per share. If the warrant holders
exercise the warrants in full we would receive an additional approximately $1.6 million in cash
proceeds. We utilized the proceeds of the sale of the preferred stock to repay our outstanding
balances on our Credit Agreement and for other working capital purposes. At May 28, 2005, our sources of liquidity consisted of $508 of cash and cash equivalents and our
Credit Agreement with Beacon Bank of Shorewood, Minnesota. The Credit Agreement, as amended,
extends through September 1, 2006 and provides borrowing capacity of up to $5,000, subject to
availability based on accounts receivable. There were no amounts outstanding under the Credit
Agreement at May 28, 2005. We expect to utilize the borrowing facility in the near term for
working capital purposes and to fund capital additions. 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, the level of inventories and capital expenditures and maintaining of debt compliance.
The losses due to the operational problems encountered throughout Fiscal 2004 strained our cash
flows and consumed much of the additional funds raised in the year including the proceeds from our
private placement of common stock and the collection of monies from the judgments against our
former Chief Executive Officer, President and Chairman. Over the past nine months, our revenue
growth has required a substantial increase in accounts receivable, inventory and other working
capital. We have taken various actions operationally which has resulted in a substantial reduction
in our losses. We are implementing other actions in order to return to profitability in Fiscal 2005
including, but not limited to, production improvement initiatives and continuing progress in
understanding key drivers via systems upgrades that will improve management decision making. In
addition to the operational improvements, we continue to scrutinize our cost structure for savings.
In October 2004, we entered into a new lease arrangement for our Boulder facility which is expected
to reduce lease payments approximately $500 per year. There can be no assurance we will return to
profitability in our fiscal year ending August 31, 2005. In the event cash flows are not sufficient to fund operations at the present level 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 certain employees. Our
lending arrangements contain debt covenants, several of which we did not maintain in Fiscal 2004
and early Fiscal 2005. We have received waivers for these violations. We do not foresee any
violations of debt agreements, as amended, for the remainder of Fiscal 2005. We will be required to
maintain a debt service coverage ratio of 1.2 to 1 beginning in the quarter ending February 28,
2006 on our term debt agreements. 19




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During Fiscal 2005, we intend to spend approximately $1.8 million for manufacturing equipment,
computer software and to make minor facility improvements. These additions, if made, are expected
to increase efficiency through the further integration of the Boulder operations and increase
manufacturing capacity to meet anticipated production requirements and add technological
capabilities. It is expected that these expenditures will be funded from operations, existing cash
and cash equivalents and available debt financing for the next 12 months. In the event there is
insufficient capital funds for this spending it will be deferred into the future which may impact
our ability to integrate the operations of all facilities and may prevent us from increasing
manufacturing capacity. Management believes that, as a result of the recent sale of preferred stock, the financial
restructuring actions it has taken in Fiscal 2005 and Fiscal 2004 to reduce cash expenditures, the
continuing efforts to increase revenues from continuing customers and to generate new customers in
various market sectors, and the extension and increase of our Credit Agreement, we expect to meet
our operational working capital and investment requirements for the next 12 months. If there is a
need for additional capital to meet our short and long-term objectives, we believe that other
sources of financing are available including sales of common stock or our undesignated stock,
additional external borrowing, customer or vendor financing or investments by strategic partners.
There can be no assurance that additional capital will be available to us or on terms that are
acceptable. Contractual Obligations In April 2005 we exercised our option to extend our lease on our Tempe, Arizona facility for a
period of five years beyond the current expiration date of July 31, 2005. Base rent will be
approximately $100 per year for the term of the lease. New Accounting Pronouncements In June 2005, FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement
of APB Opinion No. 20 and FASB Statement No. 3. The statement applies to all voluntary changes in
accounting principle, and changes the requirements for accounting for and reporting of a change in
accounting principle. SFAS No. 154 requires retrospective application to prior periods financial
statements of a voluntary change in accounting principle unless it is impracticable. SFAS No. 154
is effective for accounting changes and corrections of errors made in fiscal years beginning after
December 15, 2005. Earlier application is permitted for accounting changes and corrections of
errors made occurring in fiscal years beginning after June 1, 2005. The statement does not change
the transition provisions of any existing accounting pronouncements, including those that are in a
transition phase as of the effective date of this statement. The Company does not expect the
adoption of SFAS No. 154 to have a material effect on its consolidated financial statements. On December 16, 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123(R),
Share-Based Payment, which is a revision of SFAS No. 123 and supersedes APB Opinion No. 25. SFAS
No. 123(R) requires all share-based payments to employees, including grants of employee stock
options, to be valued at fair value on the date of grant, and to be expensed over the applicable
vesting period. Pro forma disclosure of the income statement effects of share-based payments is no
longer an alternative. SFAS No. 123(R) is effective for all share-based awards granted on or after
September 1, 2005. In addition, companies must also recognize compensation expense related to any
awards that are not fully vested as of the effective date. Compensation expense for the unvested
awards will be measured based on the fair value of the awards previously calculated in developing
the pro forma disclosures in accordance with the provisions of SFAS No. 123. We are evaluating the
alternative methods for implementing SFAS No. 123(R). If we elect to implement SFAS No. 123(R) on
September 1, 2005 using the modified prospective method, we expect that the impact on 2006 earnings
will be in the range of $1.5 to $2.6 million. 20




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CRITICAL ACCOUNTING POLICIES The accompanying consolidated financial statements are based on the selection and application of
accounting principles generally accepted in the United States of America (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, 2004,
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. Revenue Recognition.Revenue for manufacturing and assembly contracts is generally recognized
upon shipment to the customer which represents the point at which the risks and rewards of
ownership have been transferred to the customer. We have a limited number of customer arrangements
with customers which require that we retain ownership of inventory until it has been received by
the customer, until it is accepted by the customer, or in one instance, until the customer places
the inventory into production at its facility. There are no additional obligations or other rights
of return associated with these agreements. Accordingly, revenue for these arrangements is
recognized upon receipt by the customer, upon acceptance by the customer or when the inventory is
utilized by the customer in its manufacturing process. Our AMO provides service contracts for some
of its products. Billings for services contracts are based on published renewal rates and revenue
is recognized on a straight-line basis over the service period. AMOs development contracts are discrete time and materials projects that generally do not involve
separate deliverables. Development contract revenue is recognized ratably as development activities
occur based on contractual per hour and material reimbursement rates. Development contracts are an
interactive process with customers as different design and functionality is contemplated during the
design phase. Upon reaching the contractual billing maximums, we defer revenue until contract
extensions or purchase orders are received from customers. We occasionally have contractual
arrangements in which part or all of the payment or billing is contingent upon achieving milestones
or customer acceptance. For those contracts we evaluate whether the contract should be accounted
using the completed contract method, as the term of the arrangement is short-term, or using the
percentage of completion method for longer-term contracts. 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, 2004 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. Quantitative and Qualitative 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 collateralized by our Victoria, Minnesota
facility. The term of the first note is six years and had an original interest rate of 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. In December 2004, we entered into amendments with Commerce Bank to address
actual and potential covenant violations. As part of these amendments, the interest rate on this
note was increased effective March 1, 2005, to and including October 31, 2006 from 6.5% to 7.5%.
The second note, with Commerce Financial Group, Inc., in the amount of $1,150 was executed on
October 28, 2003. The second note is collateralized by our Victoria facility and equipment located
at our Tempe facility. The term of the second note is four years and had an original 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. In
December 2004, we entered into amendments with Commerce Financial Group, Inc. to address actual and
potential covenant violations. As part of these amendments, the interest rate on this note will be
increased effective March 1, 2005, to and including September 28, 2007 from 8.975% to 9.975%. 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. 
 Item 4. Controls and Procedures During the course of their audit of our consolidated financial statements for Fiscal 2004, which
was completed on January 13, 2005 with the filing our Annual Report on Form 10-K for the year ended
August 31, 2004, our former independent registered public accounting firm, KPMG LLP, advised
management and the Audit Committee of our Board of Directors that they had identified three
deficiencies in internal control which were considered to be material weaknesses as defined under
standards established by the American Institute of Certified Public Accountants. The material
weaknesses related to the following: (i) the lack of segregation of duties and financial oversight
controls at our Boulder facility, which in aggregate created an ineffective control environment,
(ii) several revenue recognition errors that were not discovered during our normal closing
procedures, and (iii) financial reporting. On January 12, 2005, KPMG LLP also communicated to our
Audit Committee reportable conditions related to (A) the lack of a formal journal entry approval
process, and (B) the lack of access controls to our SAP system. 22




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Prior to the identification of such deficiencies, we had already undertaken, or were in the process
of undertaking, a number of steps to establish a proper control environment, including:  
    
    the replacement of our Controller at the Boulder facility;
    
    implementing the SAP system for all of our financial reporting, including our Boulder facility;
    
    adding controls and moving control related functions to our Victoria facility to
eliminate opportunities to override controls over cash, accounts receivable and accounts
payable;
    
    the training of our accounting personnel at a KPMG revenue recognition seminar;
    
    providing revenue recognition training for contract administration personnel;
    
    adding revenue recognition review and approval control functions;
    
    adding staff to accommodate the changes required; and
    
    evaluating access controls needed within the SAP system. We have discussed our corrective actions and future plans with our Audit Committee and we believe
the actions outlined above have corrected the deficiencies in internal controls that are considered
to be a material weakness. Our management team, including our 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 as of the end of the period covered by this Form 10-Q. Based on such evaluation,
our Chief Executive Officer and President and Chief Financial Officer have concluded that the
disclosure controls and procedures did provide reasonable assurance of effectiveness as of the end
of such period. We are currently in the process of reviewing and formalizing our internal controls and procedures
for financial reporting in accordance with the Securities and Exchange Commissions rules
implementing the internal control reporting requirements included in Section 404 of the
Sarbanes-Oxley Act of 2002 (Section 404). Changes have been and will be made to our internal
controls over financial reporting as a result of these efforts. We are dedicating significant
resources, including senior management time and effort, and incurring substantial costs in
connection with our ongoing Section 404 assessment. We are in the process of documenting our
internal controls and considering whether any improvements are necessary for maintaining an
effective control environment at our Company. The evaluation of our internal controls is being
conducted under the direction of our senior management in consultation with an independent second
party consulting firm. In addition, our senior management is regularly discussing any proposed
improvements to our control environment with our Audit Committee. We expect to assess our controls
and procedures on a regular basis. We will continue to work to improve our controls and procedures
and to educate and train our employees on our existing controls and procedures in connection with
our efforts to maintain an effective controls infrastructure at our Company. Despite the
mobilization of significant resources for our Section 404 assessment, we, however, cannot provide
any assurance that we will timely complete the evaluation of our internal controls or that, even if
we do complete the evaluation of our internal controls, we do so in time to permit our independent
registered public accounting firm to test our controls and timely complete their attestation
procedures of our controls in a manner that will allow us to comply with applicable Securities and
Exchange Commission rules and regulations, as recently revised, which call for compliance by the
filing deadline for our Annual Report on Form 10-K for Fiscal 2006. In addition, there can be no assurances that our disclosure controls and procedures will detect or
uncover all failure of persons with the Company 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 On August 23, 2004, we commenced litigation against Colorado MEDtech, LLC, referred to as CMED LLC,
its successor, Colorado MEDtech,Inc., referred to as CMED, and a related entity, CIVCO Holding,
Inc. in the United States District Court for the District of Colorado. The complaint alleges breach
of contract/warranty; several counts of fraud including misrepresentation, omission, and fraudulent
transfer; civil conspiracy; and counts for alter ego and successor liability. On May 17, 2005 the parties entered into an agreement to settle this dispute whereby we
received a cash payment of approximately $0.4 million. 
 Item 6. Exhibits Exhibits 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.
 
 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 12, 2005
    /s/ Timothy C. ClaytonTimothy C. ClaytonChief Financial Office 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.
 24