##### 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 May 31, 2003.
|  |  |                                                                                                                                     
|o |  | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
For the transition period from  to .      

Commission File Number 0-10078

HEI, Inc.
(Exact name of Registrant as Specified in Its Charter)

|                                            |  |                                     
|------------------------------------------- |  | ------------------------------------
|Minnesota                                   |  | 41-0944876                          
|(State or other jurisdiction                |  | (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
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 past 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 Exchange Act Rule 12b-2). Yes  No X

Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date: as of July 15, 2003, 7,045,791
shares of common stock, par value $.05.





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TABLE OF CONTENTS



|                                                |                                                                                               |                                            |  |  |  |  |  | 
|----------------------------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I  FINANCIAL INFORMATION                 
|                                                | Item 1. Financial Statements                                                                 
|                                                |                                                                                               | Consolidated Balance Sheets               
|                                                |                                                                                               | Consolidated Statements of Operations     
|                                                |                                                                                               | Consolidated Statements of Cash Flows     
|                                                |                                                                                               | Notes to Consolidated Financial Statements
|                                                | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                                                | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|                                                | Item 4. Controls and Procedures                                                              
|PART II  OTHER INFORMATION                    
|                                                | Item 1. Legal Proceedings                                                                    
|                                                | Item 6. Exhibits and Reports on Form 8-K                                                     
|                                                | Signatures                                                                                   
|                                                | Certifications                                                                               
|EX-10.1 Accounts Receivable Agreement          
|EX-10.2 Letter Re: Subordinated Promissory Note
|EX-99.1 Section 906 Certification of CEO       
|EX-99.2 Section 906 Certification of CFO       



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##### Table of Contents



|                                           |  |                |  |                                                                                       |  |      
|------------------------------------------ |  | -------------- |  | ------------------------------------------------------------------------------------- |  | -----
|Table of Contents                          |  | HEI, Inc.     
|                                           |  |               
|Part I  Financial Information (unaudited) |  |               
|                                          
|                                           |  | Item 1.        |  | Financial Statements                                                                  |  |      
|                                          
|                                           |  |                |  | Consolidated Balance Sheets                                                           |  | 3    
|                                          
|                                           |  |                |  | Consolidated Statements of Operations                                                 |  | 4    
|                                          
|                                           |  |                |  | Consolidated Statements of Cash Flows                                                 |  | 5    
|                                          
|                                           |  |                |  | Notes to Consolidated Financial Statements                                            |  | 6-13 
|                                          
|                                           |  | Item 2.        |  | Managements Discussion and Analysis of Financial Condition
and Results of Operations |  | 14-22
|                                          
|                                           |  | Item 3.        |  | Quantitative and Qualitative Disclosures About
Market Risk                            |  | 23   
|                                          
|                                           |  | Item 4.        |  | Controls and Procedures                                                               |  | 24   
|                                          
|Part II  Other Information                |  |               
|                                          
|                                           |  | Item 1.        |  | Legal Proceedings                                                                     |  | 24   
|                                          
|                                           |  | Item 6.        |  | Exhibits and Reports on Form 8-K                                                      |  | 24   
|                                          
|                                           |  | Signature      |  | 25                                                                                   
|                                          
|                                           |  | Certifications |  | 26-27                                                                                

2



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##### Table of Contents






PART I. FINANCIAL INFORMATION




Item 1. Financial Statements




HEI, Inc.
Consolidated Balance Sheets (Unaudited)

|                                                           |                                                                                                 |                             |        |              |       |   |                 |         |       | 
|---------------------------------------------------------- | ----------------------------------------------------------------------------------------------- | --------------------------- | ------ | ------------ | ----- | - | --------------- | ------- | ----- | 
|(In thousands)                                             |                                                                                                 |                             |        |              |       |   |                 |        
|                                                           |                                                                                                 |                             |        | May 31, 2003 |       |   | August 31, 2002 |        
|                                                           |                                                                                                 |                             |        |              |       |   |                 |        
|Assets                                                     |                                                                                                 |                             |        |              |       |   |                 |        
|Current assets:                                            |                                                                                                 |                             |        |              |       |   |                 |        
|                                                           | Cash and cash equivalents                                                                       |                             | $      | 27           |       |   | $               | 2,372   |      
|                                                           | Restricted cash                                                                                 |                             |        |             |       |   |                 | 1,000   |      
|                                                           | Accounts receivable, net                                                                        |                             |        | 6,336        |       |   |                 | 3,533   |      
|                                                           | Inventories, net                                                                                |                             |        | 6,262        |       |   |                 | 4,027   |      
|                                                           | Other current assets                                                                            |                             |        | 410          |       |   |                 | 383     |      
|                                                           |                                                                                                 |                             |        |              |       |  
|Total current assets                                       |                                                                                                 |                             | 13,035 |              |       |   | 11,315          |        
|                                                           |                                                                                                 |                             |        |              |       |  
|Property and equipment:                                    |                                                                                                 |                             |        |              |       |   |                 |        
|                                                           | Land                                                                                            |                             |        | 216          |       |   |                 | 216     |      
|                                                           | Building and improvements                                                                       |                             |        | 4,316        |       |   |                 | 4,316   |      
|                                                           | Fixtures and equipment                                                                          |                             |        | 23,383       |       |   |                 | 21,259  |      
|                                                           | Accumulated depreciation                                                                        |                             |        | (16,487      | )     |   |                 | (14,439 | )    
|                                                           |                                                                                                 |                             |        |              |       |  
|Net property and equipment                                 |                                                                                                 |                             | 11,428 |              |       |   | 11,352          |        
|                                                           |                                                                                                 |                             |        |              |       |  
|Developed technology, net                                  |                                                                                                 |                             | 521    |              |       |   |                |        
|Security deposits                                          |                                                                                                 |                             | 1,580  |              |       |   |                |        
|Other long-term assets                                     |                                                                                                 |                             | 294    |              |       |   | 322             |        
|                                                           |                                                                                                 |                             |        |              |       |  
|Total assets                                               |                                                                                                 | $                           | 26,858 |              |       | $ | 22,989          |        
|                                                           |                                                                                                 |                             |        |              |       |  
|Liabilities and Shareholders Equity                       |                                                                                                 |                             |        |              |       |   |                 |        
|Current liabilities:                                       |                                                                                                 |                             |        |              |       |   |                 |        
|                                                           | Revolving line of credit                                                                        |                             | $      |             |       |   | $               | 1,589   |      
|                                                           | Current maturities of long-term debt                                                            |                             |        | 227          |       |   |                 | 2,441   |      
|                                                           | Accounts payable                                                                                |                             |        | 4,629        |       |   |                 | 1,815   |      
|                                                           | Warranty reserve                                                                                |                             |        | 416          |       |   |                 | 200     |      
|                                                           | Accrued liabilities                                                                             |                             |        | 2,146        |       |   |                 | 901     |      
|                                                           |                                                                                                 |                             |        |              |       |  
|Total current liabilities                                  |                                                                                                 |                             | 7,418  |              |       |   | 6,946           |        
|                                                           |                                                                                                 |                             |        |              |       |  
|Other long-term liabilities, less current maturities:      |                                                                                                 |                             |        |              |       |   |                 |        
|                                                           |                                                                                                 | Other long-term liabilities |        |              | 2,703 |   |                 |         |      | 
|                                                           |                                                                                                 | Long-term debt              |        |              | 2,729 |   |                 |         | 1,473 | 
|Total other long-term liabilities, less current maturities |                                                                                                 |                             | 5,432  |              |       |   | 1,473           |        
|                                                           |                                                                                                 |                             |        |              |       |  
|Total liabilities                                          |                                                                                                 |                             | 12,850 |              |       |   | 8,419           |        
|                                                           |                                                                                                 |                             |        |              |       |  
|Shareholders equity:                                      |                                                                                                 |                             |        |              |       |   |                 |        
|                                                           | Undesignated stock; 5,000 shares authorized; none issued                                        |                             |        |             |       |   |                 |        |      
|                                                           | Common stock, $.05 par; 10,000 shares authorized;
7,012 and 6,012 shares issued and outstanding |                             |        | 405          |       |   |                 | 301     |      
|                                                           | Paid-in capital                                                                                 |                             |        | 18,899       |       |   |                 | 16,349  |      
|                                                           | Accumulated deficit                                                                             |                             |        | (4,616       | )     |   |                 | (814    | )    
|                                                           | Notes receivable                                                                                |                             |        | (680         | )     |   |                 | (1,266  | )    
|                                                           |                                                                                                 |                             |        |              |       |  
|Total shareholders equity                                 |                                                                                                 |                             | 14,008 |              |       |   | 14,570          |        
|                                                           |                                                                                                 |                             |        |              |       |  
|Total liabilities and shareholders equity                 |                                                                                                 | $                           | 26,858 |              |       | $ | 22,989          |        
|                                                           |                                                                                                 |                             |        |              |       |  

See accompanying notes to unaudited consolidated financial statements.

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HEI, Inc.
Consolidated Statements of Operations (Unaudited)(In thousands, except per share amounts)

|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |        |         |              |        |        |         |       | 
|------------------------------------------- | --------------------------------- | ------------------------------------- | ------- | ------ | ------------------ | ----- | ----- | ----------------- | ----- | ----- | ------------ | ------ | ------- | ------------ | ------ | ------ | ------- | ----- | 
|                                            |                                   |                                       |         |        | Three Months Ended |       |       | Nine Months Ended |      
|                                            |                                   |                                       |         |        | May 31, 2003       |       |       | June 1, 2002      |       |       | May 31, 2003 |        |         | June 1, 2002 |       
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |        |         |              |       
|Net sales                                   |                                   | $                                     | 12,517  |        |                    | $     | 8,500 |                   |       | $     | 26,151       |        |         | $            | 22,424 |       
|Cost of sales                               |                                   |                                       | 9,983   |        |                    |       | 6,346 |                   |       |       | 22,143       |        |         |              | 18,346 |       
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|                                            |                                   | Gross profit                          |         |        | 2,534              |       |       |                   | 2,154 |       |              |        | 4,008   |              |        |        | 4,078   |      
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|Operating expenses:                         |                                   |                                       |         |        |                    |       |       |                   |       |       |              |        |         |              |        |       
|                                            |                                   | Selling, general and administrative   |         |        | 2,178              |       |       |                   | 1,369 |       |              |        | 5,047   |              |        |        | 3,976   |      
|                                            |                                   | Research, development and engineering |         |        | 745                |       |       |                   | 579   |       |              |        | 1,832   |              |        |        | 1,945   |      
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|                                            |                                   | Operating loss                        |         |        | (389               | )     |       |                   | 206   |       |              |        | (2,871  | )            |        |        | (1,843  | )    
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|Other expenses:                             |                                   |                                       |         |        |                    |       |       |                   |       |       |              |        |         |              |        |       
|                                            |                                   | Former officer note write off         |         |        | (681               | )     |       |                   |      |       |              |        | (681    | )            |        |        |        |      
|                                            |                                   | Bank fees                             |         |        | (165               | )     |       |                   | (8    | )     |              |        | (181    | )            |        |        | (29     | )    
|                                            |                                   | Other expense, net                    |         |        | (78                | )     |       |                   | (19   | )     |              |        | (90     | )            |        |        | (80     | )    
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|                                            | Income (loss) before income taxes |                                       |         | (1,313 | )                  |       |       | 179               |       |       |              | (3,823 | )       |              |        | (1,952 | )      
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|Income tax benefit (expense)                |                                   |                                       | 2       |        |                    |       | (64   | )                 |       |       | 21           |        |         |              | 663    |       
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|                                            |                                   | Net Income (loss)                     |         |        | ($1,311            | )     |       | $                 | 115   |       |              |        | ($3,802 | )            |        |        | ($1,289 | )    
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|Net Income (loss) per common share:         |                                   |                                       |         |        |                    |       |       |                   |       |       |              |        |         |              |        |       
|                                            |                                   | Basic                                 |         |        | ($0.19             | )     |       | $                 | 0.02  |       |              |        | ($0.59  | )            |        |        | ($0.22  | )    
|                                            |                                   | Diluted                               |         |        | ($0.19             | )     |       | $                 | 0.02  |       |              |        | ($0.59  | )            |        |        | ($0.22  | )    
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       
|Weighted average common shares outstanding: |                                   |                                       |         |        |                    |       |       |                   |       |       |              |        |         |              |        |       
|                                            |                                   |                                       | Basic   |        |                    | 7,029 |       |                   |       | 5,999 |              |        |         | 6,488        |        |        |         | 5,985 | 
|                                            |                                   |                                       | Diluted |        |                    | 7,029 |       |                   |       | 6,032 |              |        |         | 6,488        |        |        |         | 5,985 | 
|                                            |                                   |                                       |         |        |                    |       |       |                   |       |       |              |       

See accompanying notes to unaudited consolidated financial statements.

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HEI, Inc.
Consolidated Statements of Cash Flows (Unaudited)(In thousands)

|                                                                                                                                                             |                                                         |   |                   |         |   |              |        |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------------------- | - | ----------------- | ------- | - | ------------ | ------ | ------- | -
|                                                                                                                                                             |                                                         |   | Nine Months Ended |        
|                                                                                                                                                             |                                                         |   | May 31, 2003      |         |   | June 1, 2002 |       
|                                                                                                                                                             |                                                         |   |                   |         |   |              |       
|Cash flow from operating activities:                                                                                                                         |                                                         |   |                   |         |   |              |        |        
|                                                                                                                                                             | Net loss                                                |   |                   | ($3,802 | ) |              |        | ($1,289 | )
|                                                                                                                                                             | Depreciation and amortization                           |   |                   | 2,256   |   |              |        | 2,155   |  
|                                                                                                                                                             | Deferred income tax benefit                             |   |                   |        |   |              |        | (395    | )
|                                                                                                                                                             | Allowance for note receivable                           |   |                   | 587     |   |              |        |        |  
|Changes in operating assets and liabilities,
net of affects of acquisition:                                                                                  |                                                         |   |                   |         |   |              |        |        
|                                                                                                                                                             | Accounts receivable                                     |   |                   | (2,503  | ) |              |        | 512     |  
|                                                                                                                                                             | Inventories                                             |   |                   | 619     |   |              |        | 319     |  
|                                                                                                                                                             | Other current assets                                    |   |                   | 83      |   |              |        | (326    | )
|                                                                                                                                                             | Other assets                                            |   |                   | 64      |   |              |        | 97      |  
|                                                                                                                                                             | Accounts payable                                        |   |                   | 2,517   |   |              |        | (160    | )
|                                                                                                                                                             | Accrued liabilities                                     |   |                   | (152    | ) |              |        | (216    | )
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Net cash flow provided by (used for) operating activities                                                                                                    |                                                         |   | (331              | )       |   |              | 697    |        
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Cash flow from investing activities:                                                                                                                         |                                                         |   |                   |         |   |              |        |        
|                                                                                                                                                             | Additions to property and equipment                     |   |                   | (224    | ) |              |        | (2,200  | )
|                                                                                                                                                             | Additions to patents                                    |   |                   | (89     | ) |              |        | (87     | )
|                                                                                                                                                             | AMD acquisition costs paid                              |   |                   | (1,198  | ) |              |        |        |  
|                                                                                                                                                             | Cash acquired from CMED                                 |   |                   | 1,215   |   |              |        |        |  
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Net cash flow used for investing activities                                                                                                                  |                                                         |   | (296              | )       |   |              | (2,287 | )      
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Cash flow from financing activities:                                                                                                                         |                                                         |   |                   |         |   |              |        |        
|                                                                                                                                                             | Issuance of common stock                                |   |                   | 54      |   |              |        | 265     |  
|                                                                                                                                                             | Proceeds from long-term debt                            |   |                   | 204     |   |              |        |        |  
|                                                                                                                                                             | Promissory note payable                                 |   |                   | 2,600   |   |              |        |        |  
|                                                                                                                                                             | Repayment of long-term debt                             |   |                   | (3,895  | ) |              |        | (1,313  | )
|                                                                                                                                                             | Deferred financing costs                                |   |                   | (92     | ) |              |        | (25     | )
|                                                                                                                                                             | Restricted cash                                         |   |                   | 1,000   |   |              |        |        |  
|                                                                                                                                                             | Net borrowings (repayments) on revolving line of credit |   |                   | (1,589  | ) |              |        | 1,745   |  
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Net cash flow provided by (used for) financing activities                                                                                                    |                                                         |   | (1,718            | )       |   |              | 672    |        
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Net decrease in cash and cash equivalents                                                                                                                    |                                                         |   | (2,345            | )       |   |              | (918   | )      
|Cash and cash equivalents, beginning of period                                                                                                               |                                                         |   | 2,372             |         |   |              | 4,393  |        
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Cash and cash equivalents, end of period                                                                                                                     |                                                         | $ | 27                |         |   | $            | 3,475  |        
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Supplemental disclosures of cash flow information:                                                                                                           |                                                         |   |                   |         |   |              |        |        
|Interest paid                                                                                                                                                |                                                         | $ | 224               |         |   | $            | 262    |        
|Income taxes received                                                                                                                                        |                                                         |   | (21               | )       |   |              | (268   | )      
|                                                                                                                                                             |                                                         |   |                   |         |   |             
|Supplemental disclosures of non-cash investing and financing activities:                                                                                     |                                                         |   |                   |         |   |              |        |        
|As more fully described in Note # 1 and 15, the Company issued 1,000,000
shares of its common stock valued at $2,600 in connection with the
AMD acquisition.

See accompanying notes to unaudited consolidated financial statements.

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share and per share amounts)

(1) Basis of Financial Statement Presentation

The accompanying unaudited interim consolidated financial statements have been
prepared by HEI, Inc. pursuant to the rules and regulations of the Securities
and Exchange Commission (SEC). These financial statements contain all normal
recurring adjustments, which are, in our opinion, necessary for a fair
presentation of 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 the fiscal year ended August 31, 2002, as
amended by Amendment No. 1, filed with the SEC on December 20, 2002, and
Amendment No. 2, filed with the SEC on January 7, 2003. Interim results of
operations for the three- and nine-month periods ended May 31, 2003, may not
necessarily be indicative of the results to be expected for the full year.

The unaudited interim consolidated financial statements include our acquisition
on January 24, 2003, of certain assets and liabilities of Colorado MEDtech,
Inc.s (CMED) Colorado Operations (a business unit of CMED) or Advanced
Medical Division (AMD), in a business combination accounted for as a
purchase. The accompanying unaudited interim consolidated financial statements
have been prepared on the basis of assumptions discussed in Note 15, including
a preliminary allocation of the consideration paid for the assets and
liabilities of AMD 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.

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(2) Stock Based Compensation

We apply the intrinsic-value method prescribed in Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees, to account
for the issuance of stock incentives to employees and directors. No
compensation expense related to employees and directors stock incentives has
been recognized in the financial statements, as all options granted under stock
incentive plans had an exercise price equal to the market value of the
underlying common stock on the date of grant. Had we applied the fair value
recognition provisions of Financial Accounting Standards Board (FASB)
Statement No. 123, Accounting for Stock-Based Compensation, to stock based
employee compensation, our net loss per share would have increased to the pro
forma amounts indicated below:

|                                                                                                                         |  |                    |        |   |                   |   |       |              |  |   |              |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------ |  | ------------------ | ------ | - | ----------------- | - | ----- | ------------ |  | - | ------------ | - |  | - | ------ | -
|                                                                                                                         |  | Three Months Ended |        |   | Nine Months Ended |  
|                                                                                                                         |  |                    |        |   |                   |  
|                                                                                                                         |  | May 31, 2003       |        |   | June 1, 2002      |   |       | May 31, 2003 |  |   | June 1, 2002 |  
|                                                                                                                         |  |                    |        |   |                   |   |       |              |  |   |              |  
|Net income (loss)                                                                                                        |  | $                  | (1,311 | ) |                   | $ | 115   |              |  | $ | (3,802       | ) |  | $ | (1,289 | )
|Deduct: Total stock-based
employee compensation
income (expense)
determined under fair
value based method
for all awards |  |                    | (461   | ) |                   |   | (344  | )            |  |   | (1,351       | ) |  |   | (1,058 | )
|                                                                                                                         |  |                    |        |   |                   |   |       |              |  |   |              |  
|Net income (loss) pro forma                                                                                              |  | $                  | (1,772 | ) |                   | $ | (229  | )            |  | $ | (5,153       | ) |  | $ | (2,347 | )
|                                                                                                                         |  |                    |        |   |                   |   |       |              |  |   |              |  
|Basic and diluted net
Income (loss) per share as
reported                                                                |  |                    | (0.19  | ) |                   |   | 0.02  |              |  |   | (0.59        | ) |  |   | (0.22  | )
|Stock-based compensation
income (expense)                                                                                |  |                    | (0.06  | ) |                   |   | (0.06 | )            |  |   | (0.20        | ) |  |   | (0.17  | )
|                                                                                                                         |  |                    |        |   |                   |   |       |              |  |   |              |  
|Basic and diluted net
income (loss) per share
pro forma                                                                  |  | $                  | (0.25  | ) |                   | $ | (0.04 | )            |  | $ | (0.79        | ) |  | $ | (0.39  | )
|                                                                                                                         |  |                    |        |   |                   |   |       |              |  |   |              |  

There were 145,000 options granted under our stock option plans during the
three-months ended May 31, 2003.

(3) Inventories

Inventories are stated at the lower of cost, using the average cost method, or
market and include materials, labor and overhead costs. Inventories consist of
the following:

|                  |  |         |       |  |            |   |       | 
|----------------- |  | ------- | ----- |  | ---------- | - | ----- | 
|                  |  | May 31, |       |  | August 31, |  
|                  |  | 2003    |       |  | 2002       |  
|                  |  |         |       |  |            |  
|Purchased parts   |  | $       | 3,899 |  |            | $ | 1,944 | 
|Work in process   |  |         | 748   |  |            |   | 597   | 
|Finished goods    |  |         | 1,615 |  |            |   | 1,486 | 
|                  |  |         |       |  |            |  
|Total inventories |  | $       | 6,262 |  |            | $ | 4,027 | 
|                  |  |         |       |  |            |  

(4) 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 $4,800 and $3,400, at May 31,
2003, and August 31, 2002,
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.

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(5) Accrued Liabilities

|                                         |  |         |       |  |            |   |     | 
|---------------------------------------- |  | ------- | ----- |  | ---------- | - | --- | 
|                                         |  | May 31, |       |  | August 31, |  
|                                         |  | 2003    |       |  | 2002       |  
|                                         |  |         |       |  |            |  
|Accrued employee related costs           |  | $       | 499   |  |            | $ | 655 | 
|Contractual manufacturing obligations    |  |         | 600   |  |            |   |    | 
|Customer deposits                        |  |         | 407   |  |            |   |    | 
|Current portion of long-term liabilities |  |         | 80    |  |            |   |    | 
|Other accrued liabilities                |  |         | 560   |  |            |   | 246 | 
|                                         |  |         |       |  |            |  
|Total accrued liabilities                |  | $       | 2,146 |  |            | $ | 901 | 
|                                         |  |         |       |  |            |  

(6) Long-Term Debt

Our long-term debt consists of the following:

|                                     |  |         |       |  |            |   |       | 
|------------------------------------ |  | ------- | ----- |  | ---------- | - | ----- | 
|                                     |  | May 31, |       |  | August 31, |  
|                                     |  | 2003    |       |  | 2002       |  
|                                     |  |         |       |  |            |  
|Subordinated promissory note         |  | $       | 2,708 |  |            | $ |      | 
|Industrial development revenue
bonds |  |         |      |  |            |   | 1,735 | 
|Commercial loan                      |  |         | 248   |  |            |   | 104   | 
|Capital expenditure note             |  |         |      |  |            |   | 2,075 | 
|                                     |  |         |       |  |            |  
|Total                                |  |         | 2,956 |  |            |   | 3,914 | 
|Less current maturities              |  |         | 227   |  |            |   | 2,441 | 
|                                     |  |         |       |  |            |  
|Total long-term debt                 |  | $       | 2,729 |  |            | $ | 1,473 | 
|                                     |  |         |       |  |            |  

In April 1996, we issued Industrial Development Revenue Bonds (IDRBs) in
connection with the construction of a new addition to our manufacturing
facility in Victoria, Minnesota, and the purchase of production equipment. On
March 14, 2003, an aggregate of approximately $1,735 of the debt proceeds from
the Subordinated Promissory Note (as defined below) was used to repay the
outstanding principal and interest on the IDRBs.

In connection with the purchase of AMD, we issued a Subordinated Promissory
Note to CMED in the principal amount of $2,628 (the Subordinated Promissory
Note). The terms of the Subordinated Promissory Note include an interest rate
of 10% (increasing to 12% and 14% in July 2003 and January 2004, respectively)
and a due date for all principal and interest on September 30, 2004. There are
no prepayment penalties associated with this Subordinated Promissory Note. We
also recorded a net $132 premium on the Subordinated Promissory Note,
reflecting the difference between existing market rates of interest and the
Subordinated Promissory Note interest rate.

On May 8, 2003, the Subordinated Promissory Note was sold by CMED to Whitebox
Hedged High Yield Partners (Whitebox) for $1,820.

We used the proceeds from the Subordinated Promissory Note to retire our
remaining indebtedness including our IDRBs and capital expenditure notes with
LaSalle Business Credit LLC. The Subordinated Promissory Note continues 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
on the Subordinated Promissory Note; Whitebox will discount the face value of
the Subordinated Promissory Note by $410 if paid by July 15, 2003, or $390 if
paid by August 15, 2003. The principal prepayment would include all accrued
interest through the payment date. In the event that we do not prepay the
Subordinated Promissory Note in full by August 8, 2003, the following terms and
conditions will apply to the ongoing obligation:

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| |  |  | We will grant a first priority mortgage on our facility in Victoria, Minnesota.                                                                                                                                                         
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Accrued and unpaid interest will be capitalized as part of the Subordinated Promissory Note.                                                                                                                                            
|
| |  |  | We will issue 400,000 warrants that are exercisable over
the next five years at an exercise price of 10% above the closing
price of our common stock at August 15, 2003, as a form of
prepayment of interest through September 30, 2004.
|
| |  |  | At our option, we will have the right to extend the
Subordinated Promissory Note to March 31, 2005, at a 12% annual
rate.                                                                                                               
|
| |  |  | We will retain the right to prepay the Subordinated
Promissory Note at any time without premium or penalty.                                                                                                                             

There was no accounting consequence from the modification of the Subordinated
Promissory Note.

On May 29, 2003, we entered into an Accounts Receivable Agreement (the Credit
Agreement) with Beacon Bank of Shorewood, Minnesota for a period of twelve
months. The Credit Agreement is an accounts receivables backed facility and
has inventory, intellectual property and other general intangibles as
additional collateral. The Credit Agreement replaced our revolving line of
credit with LaSalle Business Credit, LLC and is not subject to any restrictive
financial covenants. We have a maximum of $3,000 available under the Credit
Agreement, with the actual lending amount based on accounts receivable invoice
factoring. As of May 31, 2003, there were no borrowings under the Credit
Agreement. Effective May 29, 2003, the Credit Agreement bears a immediate
processing fee of 0.50% of each assigned amount, a per diem equal to 1/25% on
any assigned amount that remains uncollected and a monthly minimum of $1.5 in
processing fees for the first six months the Credit Agreement is in place. The
effected interest rate based on our average DSO of 43 days would be 18.6%
annualized.

(7) Other long-term liabilities

|                                                            |  |         |       |  |            |   |   | 
|----------------------------------------------------------- |  | ------- | ----- |  | ---------- | - | - | 
|                                                            |  | May 31, |       |  | August 31, |  
|                                                            |  | 2003    |       |  | 2002       |  
|                                                            |  |         |       |  |            |  
|Remaining lease obligation less
estimated sublease proceeds |  | $       | 2,010 |  |            | $ |  | 
|Unfavorable operating lease, net                            |  |         | 773   |  |            |   |  | 
|                                                            |  |         |       |  |            |  
|Total                                                       |  |         | 2,783 |  |            |   |  | 
|Less current maturities                                     |  |         | 80    |  |            |   |  | 
|                                                            |  |         |       |  |            |  
|Total long-term liabilities                                 |  | $       | 2,703 |  |            | $ |  | 
|                                                            |  |         |       |  |            |  

The allocation of the purchase price for AMD included $2,010 for future
estimated lease payments ($5,910 for future lease obligations less estimated
sublease payments of $3,900 on excess manufacturing capacity for which we are
in the process of reviewing alternative uses) and a net accrual of $773 related
to an unfavorable operating lease.

(8) Net Income (Loss) Per Weighted Average Common Share

Basic income loss per share is computed by dividing net loss by the weighted
average number of common shares outstanding. Diluted income (losses) per share
are computed by dividing net income (loss) by the
weighted average number of common shares outstanding assuming the exercise of
dilutive stock options. The dilutive effect of stock options is computed using
the average market price per share during each period

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under the treasury stock
method. In periods where losses have occurred, options are considered
anti-dilutive and have not been included in the diluted loss per share
calculations.

|                                              |  |                    |       |  |                   |  |       |              |  |  |              |  |  |  |       | 
|--------------------------------------------- |  | ------------------ | ----- |  | ----------------- |  | ----- | ------------ |  |  | ------------ |  |  |  | ----- | 
|                                              |  | Three Months Ended |       |  | Nine Months Ended | 
|                                              |  |                    |       |  |                   | 
|                                              |  | May 31, 2003       |       |  | June 1, 2002      |  |       | May 31, 2003 |  |  | June 1, 2002 | 
|                                              |  |                    |       |  |                   |  |       |              |  |  |              | 
|Basic common shares                           |  |                    | 7,029 |  |                   |  | 5,999 |              |  |  | 6,488        |  |  |  | 5,985 | 
|Dilutive effect of stock options
and warrants |  |                    |      |  |                   |  | 33    |              |  |  |             |  |  |  |      | 
|                                              |  |                    |       |  |                   |  |       |              |  |  |              | 
|Fully diluted shares                          |  |                    | 7,029 |  |                   |  | 6,032 |              |  |  | 6,488        |  |  |  | 5,985 | 
|                                              |  |                    |       |  |                   |  |       |              |  |  |              | 

(9) Workforce Reductions

With the continued sluggish economy in all markets, revenues continue to be
unpredictable and unstable, although we noted some improvement in this third
quarter. In our continued effort to size our cost structure with anticipated
revenues, we reduced our workforce by 28 employees at the end of the first
quarter of fiscal 2003, an additional 15 employees in the second quarter and 18
employees were reduced at our AMD Colorado division in the third quarter of
2003, for a total of 61 positions and accumulated savings of $737 during the
first three quarters of fiscal 2003. Annualized wages and salaries for the 61
positions that were eliminated was $2,853. The breakdown by employee category
(with annualized wages and salaries in parentheses) was: 25 direct labor
($670), 17 manufacturing ($783), 11 engineering ($703), and 8 administrative
positions ($697). The amount of savings from workforce reductions are affected
by the timing of reductions within the quarter and the amount of associated
severance cost. A total of $184 in severance costs was paid during the first
nine months of fiscal 2003. Substantially all of the severance charges were
paid in the same period the charges were recorded.

We continue to evaluate further reductions along with other cost containment
measures as revenues fluctuate. At the same time, we seek to balance our
ongoing development of new products, increased sales and marketing focus, and
to maintain our ability to react quickly to favorable market demands and
opportunities. In addition, these costs savings will not be realized in their
entirety if increased production demand requires the hiring of additional
personnel.

(10) Intangible Assets

Information regarding intangible assets acquired in the AMD transaction
follows:

|                     |  |              |     |  |                 |   |    |     |  |   |       |          |  |              |             |  |     |   |   |  |  |   |   | 
|-------------------- |  | ------------ | --- |  | --------------- | - | -- | --- |  | - | ----- | -------- |  | ------------ | ----------- |  | --- | - | - |  |  | - | - | 
|                     |  | May 31, 2003 |     |  | August 31, 2002 |  
|                     |  |              |     |  |                 |  
|                     |  | Carrying     |     |  | Accumulated     |   |    |     |  |   |       | Carrying |  |              | Accumulated |  |     |   |   | 
|                     |  | Value        |     |  | Amortization    |   |    | Net |  |   | Value |          |  | Amortization |             |  | Net |  
|                     |  |              |     |  |                 |   |    |     |  |   |       |          |  |              |             |  |     |  
|Developed technology |  | $            | 584 |  |                 | $ | 63 |     |  | $ | 521   |          |  | $            |            |  |     | $ |  |  |  | $ |  | 

Amortization expense for years ending August 31, 2003, 2004, 2005, 2006 and
2007 will be $111, $190, $190, $87, and $6, respectively.

(11) Warranty Guarantees

Sales of our products are subject to limited warranty guarantees. Product
guarantees 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 it deems
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 an 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 nine-month period ended May
31, 2003, are as follows:

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|                                     |  |   |      |  
|------------------------------------ |  | - | ---- | -
|August 31, 2002                      |  | $ | 200  |  
|Balance assumed from AMD acquisition |  |   | 376  |  
|Provisions                           |  |   |     |  
|Claims                               |  |   | (160 | )
|                                     |  |   |     
|May 31, 2003                         |  | $ | 416  |  
|                                     |  |   |     

(12) Significant Customers

The table below sets forth the approximate percentage of net sales to major
customers that represented over 10% of our revenue.

|           |  |                    |      |   |                   |  |      |              |  |  |              |   |  |  |      |  
|---------- |  | ------------------ | ---- | - | ----------------- |  | ---- | ------------ |  |  | ------------ | - |  |  | ---- | -
|           |  | Three Months Ended |      |   | Nine Months Ended | 
|           |  |                    |      |   |                   | 
|           |  | May 31, 2003       |      |   | June 1, 2002      |  |      | May 31, 2003 |  |  | June 1, 2002 |  
|           |  |                    |      |   |                   |  |      |              |  |  |              |  
|Customer A |  |                    | 14.9 | % |                   |  | 30.4 | %            |  |  | 19.2         | % |  |  | 29.3 | %
|Customer B |  |                    | 20.4 | % |                   |  |     |              |  |  | 14.2         | % |  |  |     |  
|Customer C |  |                    | 9.4  | % |                   |  | 29.4 | %            |  |  | 13.9         | % |  |  | 37.3 | %
|           |  |                    |      |   |                   |  |      |              |  |  |              |  
|Total      |  |                    | 44.7 | % |                   |  | 59.8 | %            |  |  | 47.3         | % |  |  | 66.6 | %
|           |  |                    |      |   |                   |  |      |              |  |  |              |  

Customer A has verbally advised us that it intends to discontinue a significant
program with us in order to place it offshore. This program discontinuance
will reduce but not eliminate sales stream from this customer.

Accounts receivable from these customers represented 34% and 50%, respectively,
of the total accounts receivable at May 31, 2003, and August 31, 2002,
respectively.

(13) Note Receivable

The outstanding Directors and Officers loans dated April 2, 2001, as amended on
July 17, 2002, in the aggregate amount of $1,266, required an interest only
payment to be made to us on April 2, 2003. All interest only payments were
made, except that Mr. Anthony Fant, a current director and our former Chairman
of the Board, Chief Executive Officer and President, failed to make his payment
of approximately $10. As of July 15, 2003, Mr. Fant has not paid the interest
payment and remains in default. Despite repeated requests, Mr. Fant has failed
to provide any financial information that is necessary in order for us to
determine the collectibility of his debt. Due to the lack of cooperation from
Mr. Fant and his unknown financial position, we have fully reserved in our
third quarter ending May 31, 2003 all amounts due from Mr. Fant in the amount
of $681. This amount is reflected in the Other Expenses of our Unaudited
Consolidated Statements of Operations.

(14) Litigation

Subsequent to the end of our third quarter, on June 30, 2003, we commenced
litigation against Mr. Fant in the State of Minnesota, Hennepin County District
Court, Fourth Judicial District. The complaint alleges 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 from us in the total amount of approximately $681, and
certain other matters. In the lawsuit, we are seeking recovery of all amounts
owed to us on the promissory note and the other loans, certain expenses
incurred by us on behalf of Mr. Fant, and litigation costs and expenses.

(15) Pro Forma Financial Information

The pro forma information below includes our acquisition of AMD in a business
combination accounted for as a purchase, which was consummated on January 24,
2003. The accompanying pro forma information has been prepared on the basis of
assumptions noted below, including a preliminary allocation of the
consideration paid for the assets and liabilities of AMD based on valuations of
its fair value. This

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allocation includes an accrual of $800 related to an
unfavorable operating lease; $2,010 for future estimated lease payments
($5,910 for future lease obligations less estimated sublease payments of $3,900
on excess manufacturing capacity for which we are in the process of reviewing
alternative uses); and a $600 accrual to fulfill estimated contractual
manufacturing obligations. The final allocation of the consideration to be
paid may differ from those assumptions reflected in the accompanying unaudited
interim consolidated financial statements. In our opinion, all adjustments
necessary to present fairly such financial statements have been made based on
the terms and structure of the AMD acquisition. We continue the process of
gathering information to complete our analysis of the excess lease capacity,
the value of intellectual property and the contractual manufacturing
obligations. Any reductions in these liabilities or increases in assets will
result in a decrease in the carrying value of the intangible assets and fixed
assets. Conversely, an increase in these liabilities or decreases in assets
will increase the carrying values of long-lived assets. At May 31, 2003, the
carrying value of long-lived assets has been reduced by a net of $3,200 by the
allocation of negative goodwill.

Our purposes for acquiring AMD 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 all our
customers and target markets. The design, development and manufacturing
capabilities for medical devices at AMD coupled with our microelectronic
design, development and manufacturing improves our offerings to the market to
retain and gain customers.

The following pro forma information gives affect to the acquisition of AMD in a
business combination accounted for as a purchase, which was closed on January
24, 2003. In exchange for certain assets of AMD, we issued 1,000,000 shares of
our common stock and assumed approximately $900 of AMD liabilities, as well as
AMD operating lease and other contractual commitments.

|                   |  |                    |        |   |                   |   |        |              |  |   |         |  
|------------------ |  | ------------------ | ------ | - | ----------------- | - | ------ | ------------ |  | - | ------- | -
|                   |  | Three Months Ended |        |   | Nine Months Ended |  
|                   |  |                    |        |   |                   |  
|                   |  | June 1, 2002       |        |   | May 31, 2003      |   |        | June 1, 2002 | 
|                   |  |                    |        |   |                   |   |        |              | 
|Net sales          |  | $                  | 20,431 |   |                   | $ | 42,421 |              |  | $ | 59,659  |  
|Net loss           |  |                    | (3,481 | ) |                   |   | (6,714 | )            |  |   | (11,153 | )
|Net loss per share |  | $                  | (0.18  | ) |                   | $ | (0.34  | )            |  | $ | (.59    | )
|                   |  |                    |        |   |                   |   |        |              | 

As AMD had a June 30 year-end and we have an August 31 fiscal year-end, the pro
forma information reflects the combination of different periods for us and AMD.
The Company reported results for the quarter ended May 31, 2003 include the
results of HEI and AMD The nine-month 2003 and 2002 pro forma information
includes unaudited results of operations for the nine-month periods ended May
31, 2003 and June 1, 2002, respectively, for us and unaudited results of
operations for the nine-month periods ended March 31, 2003 and 2002 for AMD,
respectively. The 2002 three-month pro forma information includes unaudited
results of operations for the three-month period ended June 1, 2002 for us and
unaudited results of operations for the three-month period ended March 31, 2002
for AMD.

The unaudited pro forma amounts have been derived by applying pro forma
adjustments to the historical consolidated financial information of us and AMD.
However this pro forma information is not necessarily indicative of what the
actual operating results or financial position would have been for the combined
company had the transaction taken place on August 31, 2001, and do not purport
to indicate the results of future operations.

12



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Below is a table of the estimated acquisition consideration, purchase price
allocation and annual amortization of the intangible assets and goodwill
acquired:

|                           |                                      |  |        |        |   |        |              |  | 
|-------------------------- | ------------------------------------ |  | ------ | ------ | - | ------ | ------------ |  | 
|                           |                                      |  |        |        |   |        | Amortization | 
|                           |                                      |  | Amount |        |   | Period |             
|                           |                                      |  |        |        |   |        |             
|Purchase price allocation: |                                      |  |        |        |   |        |              | 
|                           | Cash                                 |  | $      | 1,215  |   |        |              |  | 
|                           | Accounts receivable                  |  |        | 300    |   |        |              |  | 
|                           | Inventory                            |  |        | 2,854  |   |        |              |  | 
|                           | Property and equipment               |  |        | 1,900  |   |        | 3-10 years  
|                           | Prepaids, deposits and other assets  |  |        | 1,690  |   |        |              |  | 
|                           | Developed technology                 |  |        | 584    |   |        | 3-4 years   
|                           | Customer deposits and other reserves |  |        | (1,638 | ) |        |              |  | 
|                           | Operating lease reserves             |  |        | (2,810 | ) |        |              |  | 
|                           | Accrued transaction costs            |  |        | (1,495 | ) |        |              |  | 
|                           |                                      |  |        |        |   |        |             
|                           | Total purchase price                 |  | $      | 2,600  |   |        |              |  | 
|                           |                                      |  |        |        |   |        |             

We anticipate completing the purchase price allocation in the quarter ending
August 31, 2003.

The estimation of intangible asset values for the developed technology was
determined utilizing discounted cash flow analyses. The discounted cash flow
analyses were based upon three to five-year cash flow projections. The
expected future cash flows attributable to existing technologies were
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 analyses resulted in a valuation for
developed technologies that had reached technological feasibility and therefore
were capitalized.

The cash flow projections were based on estimates and assumptions about
circumstances and events that have not yet taken place. Such estimates and
assumptions are inherently subject to significant economic and competitive
uncertainties and contingencies beyond our control, including, but not limited
to, those with respect to the future courses of our business activity.
Accordingly, there will usually be differences between projected and actual
results because events and circumstances frequently do not occur as expected,
and those differences may be material.

13



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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
(in thousands, except share and per share amounts)

THREE AND NINE MONTHS ENDED MAY 31, 2003 AND JUNE 1, 2002

The following discussion highlights the significant factors affecting the
changes in 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, as amended, for the fiscal year ended August 31, 2002.

OVERALL

On January 24, 2003, we acquired certain assets and liabilities of Colorado
MEDtech, Inc.s (CMED) Colorado Operations (a business unit of CMED) or (the
Advance Medical Division (AMD)) in a business combination accounted for as a
purchase. In connection with this acquisition, we issued 1,000,000 shares of
our common stock and assumed approximately $900 of AMD liabilities, as well as
an operating lease and other contractual commitments. The purchase price of
AMD was $2,600 based upon the closing market price of a share of our common
stock the day the acquisition was finalized and consummated, as quoted on the
NASDAQ National Market. The excess of the fair value of net assets over the
purchase price in the amount of $3,200 has been allocated to reduce the
carrying value of identifiable long-lived tangible and intangible assets.

Net sales in the third quarter were $12,517, $4,017 or 47% higher than the
comparable quarter last year. Net sales for the nine months ended May 31,
2003, were $26,151, $3,727 or 17% higher than the first nine-months of last
year. The third quarter and year-to-date increase is mainly related to $6,240
and $9,049, respectively, in net sales generated by AMD, which was acquired in
January 2003.

We acquired a significant number of new customers and improved current customer
activity in the third quarter of fiscal 2003. New customer activity included
new contracts with four new top 10 hearing original equipment manufacturers
(OEMs) for multiple programs with sales volume anticipated to begin in the
fourth quarter of fiscal 2003. In addition, a new medical implantable OEM was
added with multiple programs, which is anticipated to begin in volume in fiscal
2004. Two new medical imaging programs were added from the customers acquired
in the second quarter of fiscal 2003. AMD added a new large OEM customer for
its Link-it connectivity system and two new large software solutions customers
in the third quarter of fiscal 2003. Business with current customers continued
to pickup in hearing, medical and broadband market sectors contributing to the
growth in sales. We expect these successes will contribute greatly to
increased sales for fiscal 2004 and we anticipate that we will diversify our
customer base and reduce customer concentration. However 45% of our net sales
came from our top three customers for the third quarter of fiscal 2003 and 47%
of our net sales came from our top three customers during the nine-months ended
May 31, 2003. A significant customer has verbally advised us that it intends to discontinue
a significant program with us in order to place it offshore. This program discontinuance
will reduce but not eliminate sales stream from this customer.

In our continued effort to size our cost structure with anticipated revenues,
we reduced our workforce by 28 employees at the end of the first quarter of
fiscal 2003, an additional 15 employees in the second quarter of fiscal 2003
and 18 employees were reduced at our AMD Colorado division in the third quarter
of 2003, for a total of 61 positions and accumulated savings of $737 during the
first three quarters of fiscal 2003. As of May 31, 2003, we had 281 employees,
compared to 209 employees as of June 1, 2002, including as of May 31, 2003, a
net of 123 were added in connection with the acquisition of AMD.

We intend to reduce and contain costs as revenues fluctuate while balancing our
ongoing development of new products, increase marketing/sales efforts and
maintaining our ability to react quickly to favorable market demands and
opportunities. These cost savings, however, will not be realized in their
entirety if increased production demand requires the re-hiring of additional
personnel.

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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 (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 policies 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, Sales returns and Warranty

The SECs Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition
provides guidance on the application of GAAP to selected revenue recognition
issues, and our revenue recognition policies are in compliance with SAB No.
101. We recognize revenue upon shipment of products to customers when all
contractual obligations have been satisfied and collection of the resulting
receivable is reasonably assured. In fiscal 2002, a consignment program was
established with a significant customer where revenue is recognized when the
customer uses the inventory. Sales, payment terms and pricing extended to
customers are governed by the respective contract agreements or binding
purchase orders for each transaction and provide no right of return outside of
contractual warranty terms. Payment terms are seven days for consignment
program sales and four to 45 days for other customers.

We record provisions against net sales for estimated product returns. These
estimates are based on factors that include, but are not limited to, historical
sales returns, analyses of credit memo activities, current economic trends and
changes in the demands of our customers. Provisions are also recorded for
warranty claims that are based on historical trends and known warranty claims.
Should actual product returns exceed estimated allowances, additional
reductions to our net sales would result. As of May 31, 2003, and August 31,
2002, warranty and product reserves were $416 and $200, respectively.

Allowance for uncollectible accounts

We estimate the collectibility of trade receivables and notes receivable which
requires considerable amount of judgment in assessing the realization of these
receivables, including the current credit-worthiness of each customer and
related aging of the past due balances. In order to assess the collectibility
of these receivables, we perform ongoing credit evaluations of our customers
financial condition. Through these evaluations, we may become aware of a
situation where a customer may not be able to meet its financial obligations
due to a deterioration of its financial viability, credit ratings or
bankruptcy. The reserve requirements are based on the best facts available to
us and reevaluated and adjusted as additional information is received. We are
not able to predict changes in the financial condition of our customers, and if
circumstances related to our customers deteriorate, our estimates of the
recoverability of our receivables could be materially affected and it may be
required to record additional allowances for uncollectable accounts.
Alternatively, if we provide more allowances than we need, we may reverse a
portion of such provisions in future periods based on changes in estimates from
our actual collection experience. As of May 31, 2003, and August 31, 2002, we
had accounts receivable allowances of $62 and $85, respectively.

Inventories

We record inventories at the lower of cost, using the average cost method or
market value. Generally all inventory purchases are for customized parts for
customer specific program. Contractual arrangements are typically agreed to
with the customer prior to ordering customized parts to protect us in cases
where the demand decreases, as often times the parts cannot be consumed in
other programs. Even though contractual arrangements may be in place, we are
still required to assess the utilization of inventory. In assessing the
ultimate realization of inventories, judgments as to future demand requirements
are made and compared to the current or committed inventory levels and
contractual inventory holding requirements. Reserve requirements generally
increase as projected demand requirements decrease due to market conditions,
technological and product life cycle changes as well as longer than previously
expected usage
periods. We have experienced significant changes in required reserves in
recent periods due primarily to declining market conditions. It is possible
that significant changes in

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required inventory reserves may continue to occur
in the future if there is a further decline in market conditions. As of May
31, 2003, and August 31, 2002, we had reserves for excess and obsolete
inventory of $368 and $311, respectively.

Long-lived assets

We continually evaluate whether events and circumstances have occurred that
indicate the remaining estimated useful life of long-lived assets may warrant
revision, or that the remaining balance of these assets may not be recoverable.
We evaluate the recoverability of our long-lived assets in accordance with
Statement of Financial Accounting Standards (SFAS) No. 144 Accounting for
the Impairment or Disposal of Long-Lived Assets, which we adopted on July 1,
2002. SFAS No. 144 superseded SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. When deemed
necessary, we complete this evaluation by comparing the carrying amount of the
assets against the estimated undiscounted future cash flows associated with
them. If such evaluations indicate that the future undiscounted cash flows of
long-lived assets are not sufficient to recover the carrying value of such
assets, the assets are adjusted to their estimated fair values. The adoption
of SFAS No. 144 did not have a material impact on our reported results of
operations.

Valuation of Deferred Taxes

Significant management judgment is required in determining the provision for
income taxes, deferred tax assets and liabilities and any valuation allowance
recorded against net deferred tax assets. We record a current provision for
income taxes based on amounts payable or refundable. Deferred tax assets and
liabilities are recognized for the future tax consequences of differences
between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases and operating loss and tax credit
carryforwards. Deferred tax assets and liabilities are measured using enacted
tax rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in
the period that includes the enactment date. The overall change in deferred
tax assets and liabilities for the period measures the deferred tax expense or
benefit for the period. We recognize a valuation allowance for deferred tax
assets when it is more likely than not that deferred assets are not
recoverable.

We recorded valuation allowances of approximately $4,800 and $3,400,
respectively, at May 31, 2003, and August 31, 2002, due to uncertainties as
measured by GAAP related to our ability to utilize certain Federal and state
net income tax loss carryforwards.

Purchase Accounting

The accompanying statements reflect a preliminary allocation of the purchase
price of AMD. This allocation includes an accrual of $800 related to an
unfavorable operating lease; $2,010 for future estimated lease payments
($5,910 for future lease obligations less estimated sublease payments of $3,900
on excess manufacturing capacity for which we are in the process of reviewing
alternative uses); and a $600 accrual to fulfill estimated contractual
manufacturing obligations. We continue the process of gathering information to
complete our analysis of the excess lease capacity and the contractual
manufacturing obligations. Any reductions in these liabilities will result in
a decrease in the carrying value of the intangible assets and fixed assets.
Conversely, an increase in these liabilities will increase the carrying values
of long-lived assets. At May 31, 2003, the carrying value of long-lived and
intangible assets has been reduced by $3,200 due to the allocation of negative
goodwill.

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RECENT ACCOUNTING PRONOUNCEMENTS

In November 2002, FASB issued Interpretation (FIN) No. 45, Guarantors
Accounting and Disclosure Requirements, Including Guarantees of Indebtedness of
Others. FIN No. 45 requires that upon issuance of certain types of guarantees,
a guarantor recognize and account for the fair value of the guarantee as a
liability. FIN No. 45 contains exclusions to this requirement, including the
exclusion of a parents guarantee of its subsidiaries debt to a third party.
The initial recognition and measurement provisions of FIN No. 45 should be
applied on a prospective basis for guarantees issued or modified after December
31, 2002. The disclosure requirements of FIN No. 45 are effective for
financial statements of both interim and annual periods ending after December
31, 2002, which we adopted in the quarter ended March 1, 2003. The adoption of
FIN 45 did not have a material impact on our financial position, results of
operations or cash flows.

In November 2002, Emerging Issues Task Force (EITF) finalized its tentative
consensus on EITF Issue 21, Revenue Arrangements with Multiple Deliverables,
which provides guidance on the timing of revenue recognition for sales
undertakings to deliver more that one product or service. We are required to
adopt EITF 21 on transactions occurring after June 2003 and we are currently
analyzing the impact of its adoption on our financial statements.

In January 2003, FASB issued FIN No. 46, Consolidation of Variable Interest
Entities, which addresses accounting for special-purpose and variable interest
entities. We are required to adopt this guidance for financial statements
issued after December 31, 2002, which we adopted in the quarter ended March 1,
2003. The adoption of FIN 46 did not have a material impact on our financial
position, results of operations or cash flows.

In December 2002, FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure. This statement, which is an
amendment of SFAS No. 123, provides alternative methods of transition for a
voluntary change to the fair value based method of accounting for stock-based
employee compensation. In addition, SFAS No. 148 amends the disclosure
requirements of SFAS No. 123 to require prominent disclosures in both annual
and interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported financial
results. We currently account for stock-based compensation using the intrinsic
value method defined in Accounting Principles Board No. 25 and do not currently
intend to voluntarily change to the fair value method described in SFAS No.
123. As a result, we does not expect the new guidelines found in SFAS No. 148
will have a material effect upon our financial statements at its adoption. The
new interim reporting requirements are effective for interim periods beginning
after December 15, 2002. We have adopted our disclosure provisions. (See note
2 Stock Based Compensation).

In April 2003, the FASB issued Statement of Financial Accounting Standard
(SFAS) No. 149, Amendment of Statement 133 on Derivative Instruments and
Hedging, which amends and clarifies financial accounting and reporting for
derivative instruments. We are required to adopt this statement for
transactions occurring after June 2003, and we are currently analyzing the
impact of its adoption on our financial statements.

On May 15, 2003, the Financial Accounting Standards Board issued Statement No.
150, Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity. The Statement requires issuers to classify as
liabilities (or assets in some circumstance) three classes of freestanding
financial instruments that embody obligations for the issuer. Generally, the
Statement is effective for financial instruments entered into or modified after
May 31, 2003, and is otherwise effective at the beginning of the first interim
period beginning after June 15, 2003. We will adopt the provisions of the
Statement on October 1, 2003. We did not enter into any financial instruments
within the scope of the Statement during the month of June, 2003. We are
currently analyzing the impact of its adoption on our financial statements.

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FINANCIAL CONDITION AND LIQUIDITY

Our cash and cash equivalents totaled approximately $27 at May 31, 2003, and
$2,372 at August 31, 2002. We had $3,000 available under the Credit Agreement
at May 31, 2003.

In connection with the purchase of AMD, we issued a Subordinated Promissory
Note to CMED in the amount of $2,628 (the Subordinated Promissory Note). The
terms of the Subordinated Promissory Note include an interest rate of 10%
(increasing to 12% and 14%, respectively, in July 2003 and January 2004,
respectively) and a due date for all principal and interest on September 30,
2004. There are no prepayment penalties associated with the Subordinated
Promissory Note. During the second quarter of fiscal 2003, the Subordinated
Promissory Note, and approximately $1,215 in cash acquired from CMED, was used
to (i) pay equipment loans of $844, (ii) pay transaction costs of $1,198
related to the AMD acquisition (iii) repay the outstanding Industrial
Development Revenue Bonds (IDRBs) totaling $1,735.

On May 8, 2003, the Subordinated Promissory Note was sold by CMED to Whitebox
Hedged High Yield Partners (Whitebox) for $1,820. To encourage us to prepay
the Subordinated Promissory Note, Whitebox will discount the face value of the
Subordinated Promissory Note by $410 if paid by July 15, 2003, or $390 if paid
by August 15, 2003. In the event we do not prepay the Subordinated Promissory
Note in full by August 15, 2003, the following terms and conditions will apply
to the on going obligation:



| |  |  | We will grant a first priority mortgage on our facility in Victoria, Minnesota.                                                                                                                                                         
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Accrued and unpaid interest will be capitalized as part of Subordinated Promissory Note.                                                                                                                                                
|
| |  |  | We will issue 400,000 warrants that are exercisable over
the next five years at an exercise price of 10% above the closing
price of our common stock at August 15, 2003, as a form of
prepayment of interest through September 30, 2004.
|
| |  |  | At our option, we will have the right to extend the
Subordinated Promissory Note to March 31, 2005, at a 12% annual
rate.                                                                                                               
|
| |  |  | We will retain the right to prepay the Subordinated
Promissory Note at any time without premium or penalty.                                                                                                                             

Operating activities utilized cash of $331 during the nine months ended May 31,
2003, and provided $697 in cash during the nine months ended June 1, 2002.
Cash used by operating activities for the nine months ended May 31, 2003,
resulted primarily from a net loss of $3,802, offset by depreciation, a
decrease in inventory and increase in accounts payable. The increases in
accounts receivable and accounts payable are primarily a result of the
acquisition of AMD. The accounts receivable average days outstanding improved
to 43 days at May 1, 2003, from 53 days as of August 31, 2002. This
improvement resulted from the contractual arrangements for a large, newly
acquired AMD customer that calls for payment within four business days, which
is much faster than our other customers.

Investing activities utilized cash of $296 and $2,287, for the nine months
ended May 31, 2003 and June 1, 2002, respectively. Cash used by investing
activities during the nine months ended May 31, 2003, was primarily attributed
to equipment additions of $224 and payment of $1,198 in transaction costs
related to the acquisition of AMD, offset by the $1,215 in cash acquired in
connection with the acquisition of AMD.

Financing activities utilized $1,718 in cash during the nine months ended May
31, 2003, and provided $672 during the nine months ended June 1, 2002. The
fiscal 2003 activity reflects the payoff of our equipment loan, IDRBs loan and
net reductions in the revolving line of credit, offset by a decrease in
restricted cash and the addition of the Subordinated Promissory Note.

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On May 29, 2003, we entered into an Accounts Receivable Agreement (the Credit
Agreement) with Beacon
 Bank of Shorewood, Minnesota for a period of twelve
months. The Credit Agreement is an accounts receivables backed facility and
has inventory, intellectual property and other general intangibles as
additional collateral. The Credit Agreement replaced our revolving line of
credit with LaSalle Business Credit, LLC and is
not subject to any restrictive financial covenants. We have a maximum of
$3,000 available under the Credit Agreement, with the actual lending amount
based on accounts receivable invoice factoring. As of May 31, 2003, there were
no borrowings under the Credit Agreement. Effective May 29, 2003, the Credit
Agreement bears a immediate processing fee of 0.50% of each assigned amount, a
per diem equal to 1/25% on any assigned amount that remains uncollected and a
monthly minimum of $1.5 in processing fees for the first six months the Credit
Agreement is in place. The effected interest rate based on our average DSO of
43 days would be 18.6% annualized.

We believe that existing cash and cash equivalents, current lending capacity
and cash generated from operations will provide sufficient cash flow to meet
short- and long-term debt obligations and operating requirements. We are in
the process of obtaining additional financing sources to refinance the
Subordinated Promissory Note.

We originally issued 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
were used to fund the repayment of principal and interest on the IDRBs.

During fiscal 2003, we intend to expend no more than $500 for manufacturing and
facility improvements and capital equipment, of which $224 has been expended
during the first three quarters of fiscal 2003. The remaining additions will
only be made to increase manufacturing capacity to the level sufficient to meet
near-term production requirements and, if necessary, add technological
capabilities and are expected to be funded from operations and available debt
financing.

Giving effect to the acquisition of AMD and the assumed operating lease and
other contractual commitments, including (i) the Subordinated Promissory Note
and (ii) the rights and obligations of the operating leases including the
facilities for AMD that has an original 10-year lease commitment, our
contractual obligations at May 31, 2003 are summarized in the following table:

|                              |  |            |     |  |        |   |       |        |  |   |            |  |  |       |        |  |  |   |        | 
|----------------------------- |  | ---------- | --- |  | ------ | - | ----- | ------ |  | - | ---------- |  |  | ----- | ------ |  |  | - | ------ | 
|                              |  | Three      |     |  |        |   |       |        |  |   |            |  |  |       |        |  |  |   |       
|                              |  | Months     |     |  | Fiscal |   |       | Fiscal |  |   |            |  |  |       |        |  | 
|                              |  | Ending     |     |  | Year   |   |       | Year   |  |   |            |  |  |       |        |  | 
|                              |  | August 31, |     |  | Ending |   |       | Ending |  |   |            |  |  |       |        |  | 
|                              |  | 2003       |     |  | 2004   |   |       | 2005   |  |   | Thereafter |  |  | Total |       
|                              |  |            |     |  |        |   |       |        |  |   |            |  |  |       |       
|Long-term debt                |  | $          | 111 |  |        | $ | 144   |        |  | $ | 2,621      |  |  | $     |       |  |  | $ | 2,876  | 
|Operating leases              |  |            | 718 |  |        |   | 2,831 |        |  |   | 2,654      |  |  |       | 17,406 |  |  |   | 23,609 | 
|                              |  |            |     |  |        |   |       |        |  |   |            |  |  |       |       
|Total contractual obligations |  | $          | 829 |  |        | $ | 2,975 |        |  | $ | 5,275      |  |  | $     | 17,406 |  |  | $ | 26,485 | 
|                              |  |            |     |  |        |   |       |        |  |   |            |  |  |       |       

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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 |        |   | Nine Months Ended | 
|                                  |  |                    |        |   |                   | 
|                                  |  | May 31, 2003       |        |   | June 1, 2002      |  |     | May 31, 2003 |  |   | June 1, 2002 |  
|                                  |  |                    |        |   |                   |  |     |              |  |   |              |  
|Net sales                         |  | $                  | 12,517 |   |                   |  | 100 | %            |  | $ | 8,500        |   |  |  | 100 | %  |  | $ | 26,151 |   |  |  | 100 | %  |  | $ | 22,424 |   |  |  | 100 | % 
|Cost of sales                     |  |                    | 9,983  |   |                   |  | 80  | %            |  |   | 6,346        |   |  |  | 75  | %  |  |   | 22,143 |   |  |  | 85  | %  |  |   | 18,346 |   |  |  | 82  | % 
|                                  |  |                    |        |   |                   |  |     |              |  |   |              |   |  |  |     |    |  |   |        |   |  |  |     |   
|Gross profit                      |  |                    | 2,534  |   |                   |  | 20  | %            |  |   | 2,154        |   |  |  | 25  | %  |  |   | 4,008  |   |  |  | 15  | %  |  |   | 4,078  |   |  |  | 18  | % 
|Operating expenses                |  |                    | 2,923  |   |                   |  | 23  | %            |  |   | 1,948        |   |  |  | 23  | %  |  |   | 6,879  |   |  |  | 26  | %  |  |   | 5,921  |   |  |  | 26  | % 
|                                  |  |                    |        |   |                   |  |     |              |  |   |              |   |  |  |     |    |  |   |        |   |  |  |     |   
|Operating income (loss)           |  |                    | (389   | ) |                   |  | (3  | )%           |  |   | 206          |   |  |  | 2   | %  |  |   | (2,871 | ) |  |  | (11 | )% |  |   | (1,843 | ) |  |  | (8  | )%
|Other expense                     |  |                    | (924   | ) |                   |  | (7  | )%           |  |   | (27          | ) |  |  |    | %  |  |   | (952   | ) |  |  | (4  | )% |  |   | (109   | ) |  |  |    | % 
|                                  |  |                    |        |   |                   |  |     |              |  |   |              |   |  |  |     |    |  |   |        |   |  |  |     |   
|Income (loss) before income
taxes |  |                    | (1,313 | ) |                   |  | (10 | )%           |  |   | 179          |   |  |  | 2   | %  |  |   | (3,823 | ) |  |  | (15 | )% |  |   | (1,952 | ) |  |  | (9  | )%
|Income tax (expense) benefit      |  |                    | 2      |   |                   |  |    | %            |  |   | (64          | ) |  |  | (1  | )% |  |   | 21     |   |  |  |    | %  |  |   | 663    |   |  |  | 3   | % 
|                                  |  |                    |        |   |                   |  |     |              |  |   |              |   |  |  |     |    |  |   |        |   |  |  |     |   
|Net Income (loss)                 |  | $                  | (1,311 | ) |                   |  | (10 | )%           |  | $ | 115          |   |  |  | 1   | %  |  | $ | (3,802 | ) |  |  | (15 | )% |  | $ | (1,289 | ) |  |  | (6  | )%
|                                  |  |                    |        |   |                   |  |     |              |  |   |              |   |  |  |     |    |  |   |        |   |  |  |     |   

Net Sales

Our sales fluctuate based on changing product mix and market instability and
are dependent on the level and timing of customer business and other matters
such as customer concentration.

Net sales in the third quarter were $12,517, $4,017 or 47% higher that the
comparable quarter last year. Net sales for the nine months ended May 31,
2003, were $26,151, $3,727 or 17% higher than the first nine months of last
year. The third quarter and year to date increase mainly related to $6,240 and
$9,049, respectively, in net sales generated by the AMD business, which we
acquired in January 2003.

The communications and RFID markets remain soft as customers are awaiting
market acceptance of new products and increased demand for existing products.
As the demand for these products increases, we believe that we are well
positioned for an increase in sales in these markets. We are also experiencing
continued external interest in our proprietary products, for which we are
working on new designs, qualification testing and prototype orders with
numerous customers.

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 45%
of net sales in the third quarter of fiscal 2003 being generated by three
customers. Net sales generated by these customers amounted to 60% for the
third quarter of last year.

At May 31, 2003, our backlog for future orders was approximately $22,037,
compared to approximately $5,387 at August 31, 2002. This increase in backlog
relates to the acquisition of AMD, which had a backlog of $15,100 at May 31,
2003. The AMD backlog includes customer commitments that have longer terms, as
compared to our historical customer commitments. Our backlog is not
necessarily a firm commitment from our customers and can change, in some cases
materially, beyond our control.

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Net sales by market for the three and nine months ended May 31, 2003, and June
1, 2002, respectively, are as follows:

|                    |  |                    |        |  |                   |   |       |              |  |   |              |  |  |   |        | 
|------------------- |  | ------------------ | ------ |  | ----------------- | - | ----- | ------------ |  | - | ------------ |  |  | - | ------ | 
|                    |  | Three Months Ended |        |  | Nine Months Ended |  
|                    |  |                    |        |  |                   |  
|                    |  | May 31, 2003       |        |  | June 1, 2002      |   |       | May 31, 2003 |  |   | June 1, 2002 | 
|                    |  |                    |        |  |                   |   |       |              |  |   |              | 
|Medical             |  | $                  | 7,203  |  |                   | $ | 658   |              |  | $ | 11,870       |  |  | $ | 1,446  | 
|Hearing             |  |                    | 3,337  |  |                   |   | 5,444 |              |  |   | 9,358        |  |  |   | 15,494 | 
|RFID/Communications |  |                    | 1,551  |  |                   |   | 1,996 |              |  |   | 3,801        |  |  |   | 4,719  | 
|Industrial/HDI      |  |                    | 426    |  |                   |   | 402   |              |  |   | 1,122        |  |  |   | 765    | 
|                    |  |                    |        |  |                   |   |       |              |  |   |              | 
|Total Net Sales     |  | $                  | 12,517 |  |                   | $ | 8,500 |              |  | $ | 26,151       |  |  | $ | 22,424 | 
|                    |  |                    |        |  |                   |   |       |              |  |   |              | 

Net sales analysis by market follows:

Medical:The acquisition of the AMD business accounted for the majority of the
$6,545 and $10,424 increase in medical sales for the three- and nine-month
periods ended May 31, 2003, and June 1, 2002, respectively.

Hearing:We continue to experience fluctuations in demand for our hearing
products. Hearing sales for the three- and nine-month periods ended May 31,
2003, and June 1, 2002, decreased 39% and 40%, respectively, to $3,337 and
$9,358, respectively. These decreases are mainly due to excess inventory
positions at significant hearing customers and reflect the general economic
slowdown, which continue to negatively impact the hearing contract
manufacturing markets. During the latter part of fiscal 2002, a major
customers internal manufacturing capabilities increased, which are expected to
reduce annual revenues for fiscal 2003 by approximately $3,000. Also a
significant customer has verbally advised us that it intends to discontinue a
significant program with us in order to place it offshore. This program
discontinuance will reduce but not eliminate sales stream from this customer

RFID/Communications:Net sales to Radio Frequency Identification (RFID) and
Communication customers decreased by $445 or 22% and $918 or 19% for the three-
and nine-month periods ended May 31, 2003, and June 1, 2002, respectively.
This decrease is driven by a significant drop in orders from a major customer
that, in 2002, sold one division and terminated operations of another. We are
also experiencing significant competition from overseas manufacturers in this
market. New products have been developed and capabilities have been expanded
to improve revenue; however, the actual level of market acceptance of these
initiatives is currently unknown.

Industrial/HDI:Net sales to industrial and High Density Interconnect (HDI)
customers for the three-month and nine-month period ended May 31 2003,
increased 6% and 47%, respectively, to $426 and $1,122 respectively. HDI
represents net sales of flexible circuit boards. The overall market remains
depressed, however, demand from a few of our customers increased this quarter
and increased activity is seen in this market with low volume purchase orders.

Gross Profit

Gross profit was $2,534 (20% of net sales) and $4,008 (15%) for the three- and
nine-months ended May 31, 2003, respectively, compared to $2,154 (25%) and
$4,078 (18%) for the three- and nine-months ended June 1, 2002, respectively.
An unfavorable mix of revenue from lower margin manufacturing programs coupled
with lower manufacturing yields drove the decreases in gross margin. Our gross
margins are heavily impacted by fluctuations in revenue, due to the fixed
nature of many of our manufacturing costs.

Operating Expenses

Operating expenses increased by $975 or 50% and by $958 or 16% for the three-
and nine-month periods ended May 31, 2003, and June 1, 2002, respectively. The
increase for the three months ended May 31, 2003, related to the AMD business
acquired in January 2003, representing $1,137 for this period. As a percentage
of net sales, operating expenses in total were 23% and 26%, respectively, for
the three and nine-month periods ended May 31, 2003, respectively, compared to
23% and 26%, respectively, for the comparable periods last year. Factors
having an impact on these expenses include our past cost containment measures,
which, in addition to staff reductions, include decreased insurance, legal and
depreciation costs. These
reductions were mitigated by increases in advertising, travel and severance
costs. Overall expenses continue to decline as a result of our continued
effort to right-size the business balanced with our commitment to maintain our
research and development efforts and continued sales and marketing focus.

21



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Other Income (Expense), net

We recorded $924 and $952 in net other expenses during the three- and
nine-month periods ended May 31, 2003, respectively, and $27 and $109 in net
other expenses during the three- and nine-month ended June 1, 2002,
respectively. Unusual expenses during the three-month period ended May 31,
2003, were non-cash write off of bank fees of $165 related to the terminated
revolving line of credit with LaSalle Business Credit, and a reserve of $681
for Mr. Fants promissory note to us and other loans to Mr. Fant from us due to
the uncollectible nature of the note from Mr. Fant, a current director and our
former Chairman of the Board, Chief Executive Officer and President. Interest
expense was $105 and $224 during the three- and nine-month periods ended May
31, 2003, respectively, and $88 and $262 during the three- and nine-month ended
June 1, 2002, respectively. The improvement for the nine month period relates
to the reduction in our debt.

Income Taxes

We established a valuation allowance of approximately $4,800 and $3,400,
respectively, at May 31, 2003, and August 31, 2002, respectively, to fully
reserve the deferred tax assets because of uncertainties related to our ability
to utilize certain federal and state loss carryforwards as measured by GAAP.
This allowance is based on estimates of taxable income by jurisdiction during
the period over which its deferred tax assets are recoverable. The economic
benefits of our net operating loss carryforwards to future years will continue
until expired. At May 31, 2003, we had Federal net operating loss
carryforwards of $10,761 that expire at various dates ranging from 2013 through
2022.

Forward-Looking Statements

Information in this document, which is not historical, includes forward-looking
statements made pursuant to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. In addition, from time to time, we
or our representatives have made or may make forward-looking statements orally
or in writing. These statements are made based on our current views and
assumptions regarding technology, markets, growth and earnings expectations,
and all of such forward-looking statements involve a number of risks and
uncertainties. There are certain important factors that can cause actual
results to differ materially from the forward-looking statements, including,
without limitation, continuing adverse business and market conditions, our
ability to secure and satisfy customers, the availability and cost of materials
from our suppliers, adverse competitive developments, changes in or
cancellations of customer requirements, integration of AMD, collection of
outstanding debt, our ability to succeed on the merits and defend against
litigation, and other factors discussed from time to time in our filings with
the Securities and Exchange Commission. Readers are cautioned not to place
undue reliance on forward-looking statements and holders of our securities are
specifically referred to such documents with regard to factors and conditions
that may affect future results. We undertake no obligation to update these
statements to reflect ensuing events or circumstances, or subsequent actual
results.

22



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Item 3. Qualitative and Quantitative Disclosures About Market Risk
(in thousands, except share and per share amounts)

We are not exposed to certain market risks with the Credit Agreement and
capital expenditure commercial loans. At May 31, 2003, the outstanding balance
on the Credit Agreement and capital expenditure commercial loans were $0, and
$248, respectively. Effective May 29, 2003, the Credit Agreement bears a
immediate processing fee of 0.50% of each assigned amount, a per diem equal to
1/25% on any assigned amount that remains uncollected and a monthly aggregate
minimum of $1.5 in processing fees for the first six months the Credit
Agreement is in place.

On January 24, 2003, we acquired AMD from CMED in a business combination
accounted for as a purchase. In connection with this acquisition, we issued
1,000,000 shares of our common stock and assumed approximately $900 of AMD
liabilities, as well as AMD operating lease and other contractual commitments.
The purchase price of AMD was $2,600 based upon the closing market price of a
share of our common stock the day the merger was consummated on January 24,
2003, as quoted on the NASDAQ National Market. The excess of the fair value of
net assets over the purchase price has been allocated to identifiable,
long-lived tangible and intangible assets.

In connection with the AMD acquisition, we issued a Subordinated Promissory
Note to CMED in the principal amount of $2,628 (the Subordinated Promissory
Note). The terms of the Subordinated Note include an interest rate of 10%
(increasing to 12% and 14%, in July 2003 and January 2004, respectively), and a
due date for all principal and interest of September 30, 2004. On May 8, 2003,
the Subordinated Promissory Note was sold by CMED to Whitebox Hedged High Yield
Partners (Whitebox) for $1,820.

We used the proceeds from the Subordinated Promissory Note to retire our
remaining indebtedness including our IDRBs and capital expenditure notes with
LaSalle Business Credit LLC. The Subordinated Promissory Note continues 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 on the Subordinated Promissory Note, Whitebox will
discount the face value of the Subordinated Promissory Note by $410 if paid by
July 15, 2003, or $390 if paid by August 15, 2003. The principal prepayment
will include all accrued interest through the payment date. In the event that
we do not prepay the Subordinated Promissory Note in full by August 8, 2003,
the following terms and conditions will apply to the ongoing obligation:



| |  |  | We will grant a first priority mortgage on our facility in Victoria, Minnesota.                                                                                                                                                         
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Accrued and unpaid interest will be capitalized as part of Subordinated Promissory Note.                                                                                                                                                
|
| |  |  | We will issue 400,000 warrants that are exercisable over
the next five years at an exercise price of 10% above the closing
price of our common stock at August 15, 2003, as a form of
prepayment of interest through September 30, 2004.
|
| |  |  | At our option, we will have the right to extend the
Subordinated Promissory Note to March 31, 2005, at a 12% annual
rate.                                                                                                               
|
| |  |  | We will retain the right to prepay the Subordinated
Promissory Note at any time without premium or penalty.                                                                                                                             

We are exposed to market risk associated with the fair value of our common
stock related to the potential issuance of the above noted warrant for 400,000
shares of common stock. For example, if on August 15, 2003, the closing price
of the Companys common stock is $2.50 (based on the high stock price for the
last six months) and $1.75, (based on the low stock price for the last six
months) the Company will recognize interest expense of $607 or $425,
respectively, from that date to September 30, 2004.

23



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Item 4. Controls and Procedures

Based on their evaluation, as of a date within 90 days of the filing date of
this Quarterly Report on Form 10-Q, our principal executive officer and
principal financial officer believe that our disclosure controls and procedures
(as defined in Rules 13a-14(c) and 15d-14(c) under the Exchange Act) are
effective in timely alerting management to material information required to be
included in this Form 10-Q and other Exchange Act filings.

There were no significant changes in our internal controls or in other factors
that could significantly affect those controls subsequent to the date of our
evaluation, and there were no significant deficiencies or material weaknesses
that required corrective actions.




PART II  OTHER INFORMATION




Item 1. Legal Proceedings

Subsequent to the end of our third quarter, on June 30, 2003, we commenced
litigation against Anthony Fant, a current director and 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
alleges 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 from us in the total
amount of approximately $681, and certain other matters. In the lawsuit, we
are seeking recovery of all amounts owed to us on the promissory note and the
other loans, certain expenses incurred by us on behalf of Mr. Fant, and
litigation costs and expenses.




Item 6. Exhibits and Reports on Form 8-K

|   |  |                     |  |                                                                                                                                           
|-- |  | ------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------
|a) |  | Exhibits            |  |                                                                                                                                           
|   |  |                     |  |                                                                                                                                           
|   |  | 10.1                |  | Accounts receivable agreement dated May 29, 2003 between HEI
Inc. and Beacon Bank                                                         
|   |  |                     |  |                                                                                                                                           
|   |  | 10.2                |  | Letter confirming the understanding between HEI Inc. and Whitebox
Hedged High Yield Partners relating to the Subordinated Promissory Note.
|   |  |                     |  |                                                                                                                                           
|   |  | 99.1                |  | Section 906 Certification of the Chief Executive Officer                                                                                  
|   |  |                     |  |                                                                                                                                           
|   |  | 99.2                |  | Section 906 Certification of the Chief Financial Officer                                                                                  
|   |  |                     |  |                                                                                                                                           
|   |  |                     |  |                                                                                                                                           
|b) |  | Reports on Form 8-K

On March 20, 2003, we filed a Current Report on Form 8-K reporting, under Item
5  Other Events, certain information relating to the election of directors and
certain changes regarding our management structure.

On April 10, 2003, we filed a Current Report on Form 8-K reporting, under Item
7  Financial Statements and Exhibits, the audited and unaudited financial
statements for AMD. This filing was an amendment to our previously filed
Current Report on Form 8-K, dated January 24, 2003, regarding our acquisition
of AMD.

On April 22, 2003, we filed a Current Report on Form 8-K reporting, under Item
5  Other Events, certain information regarding the appointment of Mack V.
Traynor, III, as our Chief Executive Officer and President.

24



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##### 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:07/15/03 |  | /s/ Douglas J. Nesbit
Douglas J. Nesbit
Chief Financial Officer

25



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##### Table of Contents






CERTIFICATIONS

I, Mack V. Traynor, III, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of HEI, Inc.;                                                                                                                                                                                                                                                              
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;                   
|  
|4. |  | The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:                                                                                                     



| | a) |  | designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        



|5. |  | The registrants other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent function):
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrants
ability to record, process, summarize and report financial data and
have identified for the registrants auditors any material weaknesses
in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrants
internal controls; and                                                                                                                                        



|6. |  | The registrants other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | /s/ Mack V. Traynor, III
| | ------------------------



| | Mack V. Traynor, IIIChief Executive Officer and President
| | ---------------------------------------------------------

Date: July 15, 2003

26



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##### Table of Contents



I, Douglas J. Nesbit, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of HEI, Inc.;                                                                                                                                                                                                                                                              
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;                   
|  
|4. |  | The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:                                                                                                     



| | a) |  | designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        



|5. |  | The registrants other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent function):
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrants
ability to record, process, summarize and report financial data and
have identified for the registrants auditors any material weaknesses
in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrants
internal controls; and                                                                                                                                        



|6. |  | The registrants other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | /s/ Douglas J. Nesbit
| | ---------------------



| | Douglas J. NesbitChief Financial Officer
| | ----------------------------------------

Date: July 15, 2003

27



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##### Table of Contents



Exhibit Index

|     |  |  |                                                                                                                                    
|---- |  |  | -----------------------------------------------------------------------------------------------------------------------------------
|10.1 |  |  | Accounts receivable agreement dated May 29, 2003 between HEI
Inc. and Beacon Bank                                                  
|     |  |  |                                                                                                                                    
|10.2 |  |  | Letter confirming the understanding between HEI Inc. and Whitebox
Hedged High Yield Partners relating to the Subordinated Promissor
|     |  |  |                                                                                                                                    
|99.1 |  |  | Section 906 Certification of the Chief Executive Officer                                                                           
|     |  |  |                                                                                                                                    
|99.2 |  |  | Section 906 Certification of the Chief Financial Officer