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UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 **** FORM 10-Q **** þ
    
    Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934for the quarterly period ended November 27, 2004.o
    
    Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.For the transition period from ___to ___.
 Commission File Number 0-10078 HEI, Inc.  Minnesota
    
    41-0944876(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)PO Box 5000, 1495 Steiger Lake Lane, Victoria, MN
    
    55386(Address of principal executive offices)
    
    (Zip Code)
 (952) 443-2500
Registrants telephone number, including area code Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes
þ No
o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes
o No
þ As of January 31, 2005, 8,356,805 Common Shares, par value $.05 per share, were outstanding.




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TABLE OF CONTENTS Table of Contents
    
    HEI, Inc.Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
  Part I  Financial Information (unaudited)Item 1. Financial StatementsConsolidated Balance Sheets
    
    
    3Consolidated Statements of Operations
    
    
    4Consolidated Statements of Cash Flows
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    18Item 4. Controls and Procedures
    
    
    19Part II  Other InformationItem 6. Exhibits
    
    
    20Signature
    
    
    21
 2




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements HEI, Inc. 
 Consolidated Balance Sheets  (In thousands, except per share and share data)
 November 27, 2004
    
    
    August 31, 2004(unaudited)
    
    
    (audited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    304
    
    
    $
    200Restricted cash
    
    
    
    
    
    
    481Accounts receivable, net of allowance for doubtful accounts of $140 and $121,
respectively
    
    
    8,246
    
    
    
    6,770Inventories
    
    
    7,595
    
    
    
    6,787Other current assets
    
    
    777
    
    
    
    1,221Total current assets
    
    
    16,922
    
    
    
    15,459Property and equipment:Land
    
    
    216
    
    
    
    216Building and improvements
    
    
    4,323
    
    
    
    4,323Fixtures and equipment
    
    
    22,192
    
    
    
    21,432Accumulated depreciation
    
    
    (19,606
    )
    
    
    (18,580
    )Net property and equipment
    
    
    7,125
    
    
    
    7,391Developed technology, less accumulated amortization of $262 and $231, respectively
    
    
    154
    
    
    
    185Security deposit
    
    
    1,580
    
    
    
    1,580Other long-term assets
    
    
    526
    
    
    
    497Total assets
    
    $
    26,307
    
    
    $
    25,112Liabilities and Shareholders EquityCurrent liabilities:Line of credit
    
    $
    2,687
    
    
    $
    1,310Current maturities of long-term debt
    
    
    356
    
    
    
    403Accounts payable
    
    
    5,944
    
    
    
    5,663Accrued liabilities
    
    
    3,671
    
    
    
    4,669Total current liabilities
    
    
    12,658
    
    
    
    12,045Other long-term liabilities, less current maturities
    
    
    1,480
    
    
    
    1,277Long-term debt, less current maturities
    
    
    1,777
    
    
    
    1,833Total other long-term liabilities, less current maturities
    
    
    3,257
    
    
    
    3,110Total liabilities
    
    
    15,915
    
    
    
    15,155Shareholders equity:Undesignated stock; 4,000,000 shares authorized; none issued
    
    
    
    
    
    
    Common stock, $.05 par; 11,000,000 shares authorized; 8,357,000 and
8,357,000 shares issued and outstanding
    
    
    418
    
    
    
    418Paid-in capital
    
    
    22,426
    
    
    
    22,426Accumulated deficit
    
    
    (12,037
    )
    
    
    (12,452
    )Notes receivable
    
    
    (415
    )
    
    
    (435
    )Total shareholders equity
    
    
    10,392
    
    
    
    9,957Total liabilities and shareholders equity
    
    $
    26,307
    
    
    $
    25,112
 See accompanying notes to unaudited consolidated financial statements. 3




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HEI, Inc. 
 Consolidated Statements of Operations (Unaudited)  (In thousands, except per share data)
 Three Months EndedNovember 27, 2004
    
    
    November 29, 2003Net sales
    
    $
    14,071
    
    
    $
    10,894Cost of sales
    
    
    11,115
    
    
    
    9,821Gross profit
    
    
    2,956
    
    
    
    1,073Operating expenses:Selling, general and administrative
    
    
    2,042
    
    
    
    1,757Research, development and engineering
    
    
    837
    
    
    
    722Costs related to investigation
    
    
    
    
    
    
    253Operating income (loss)
    
    
    77
    
    
    
    (1,659
    )Other income (expenses):Interest expense
    
    
    (169
    )
    
    
    (69
    )Gain on prepayment of promissory note
    
    
    
    
    
    
    472Litigation recovery
    
    
    481
    
    
    
    Other income (expense), net
    
    
    26
    
    
    
    3Income (loss) before income taxes
    
    
    415
    
    
    
    (1,253
    )Income tax benefit
    
    
    
    
    
    
    Net income (loss)
    
    $
    415
    
    
    $
    (1,253
    )Net income (loss) per common share:Basic
    
    $
    0.05
    
    
    $
    (0.18
    )Diluted
    
    $
    0.05
    
    
    $
    (0.18
    )Weighted average common shares outstanding:Basic
    
    
    8,357
    
    
    
    7,046Diluted
    
    
    8,425
    
    
    
    7,046
 See accompanying notes to unaudited consolidated financial statements. 4




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HEI, Inc. 
 Consolidated Statements of Cash Flows (Unaudited)  (In thousands)
 Three Months EndedNovember 27, 2004
    
    
    November 29, 2003Cash flow from operating activities:Net income (loss)
    
    $
    415
    
    
    $
    (1,253
    )Adjustments to reconcile net income (loss) to net cash used in operating activities:Depreciation and amortization
    
    
    645
    
    
    
    676Accounts receivable allowance
    
    
    
    
    
    
    (20
    )Loss on disposal of property and equipment
    
    
    15
    
    
    
    15Gain on prepayment of promissory note
    
    
    
    
    
    
    (472
    )Changes in operating assets and liabilities:Restricted cash related to deferred litigation
    
    
    481
    
    
    
    Accounts receivable
    
    
    (1,476
    )
    
    
    204Inventories
    
    
    (808
    )
    
    
    321Other current assets
    
    
    444
    
    
    
    (115
    )Other assets
    
    
    
    
    
    
    (179
    )Accounts payable
    
    
    281
    
    
    
    (313
    )Accrued liabilities and other long-term liabilities
    
    
    (795
    )
    
    
    (347
    )Net cash flow used in operating activities
    
    
    (798
    )
    
    
    (1,483
    )Cash flow from investing activities:Additions to property and equipment
    
    
    (338
    )
    
    
    (112
    )Proceeds from sale of assets
    
    
    
    
    
    
    17Additions to patents
    
    
    (54
    )
    
    
    (10
    )Sale of technology
    
    
    
    
    
    
    323Net cash flow provided by (used in) investing activities
    
    
    (392
    )
    
    
    218Cash flow from financing activities:Note repayment
    
    
    20
    
    
    
    27Proceeds from long-term debt
    
    
    
    
    
    
    2,350Repayment of long-term debt
    
    
    (103
    )
    
    
    (2,334
    )Net borrowings on line of credit
    
    
    1,377
    
    
    
    117Checks written in excess of cash
    
    
    
    
    
    
    767Net cash flow provided by financing activities
    
    
    1,294
    
    
    
    927Net increase
(decrease) in cash and cash equivalents
    
    
    104
    
    
    
    (338
    )Cash and cash equivalents, beginning of period
    
    
    200
    
    
    
    806Cash and cash equivalents, end of period
    
    $
    304
    
    
    $
    468Supplemental disclosures of cash flow information:Interest paid
    
    $
    169
    
    
    $
    54
 See accompanying notes to unaudited consolidated financial statements. 5




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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data) (1) Basis of Financial Statement Presentation The accompanying unaudited interim consolidated financial statements have been prepared by HEI,
Inc. pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). These
financial statements contain all normal recurring adjustments, which are, in our opinion, necessary
for a fair presentation of the financial position, results of operations and cash flows in
accordance with accounting principles generally accepted in the United States of America (GAAP). Certain information and footnote disclosures normally included in financial statements prepared in
accordance with GAAP have been condensed or omitted. We believe, however, that the disclosures are
adequate to make the information presented not misleading. The year-end balance sheet data was
derived from audited financial statements but does not include all disclosures required by GAAP.
These unaudited interim consolidated financial statements should be read in conjunction with the
financial statements and accompanying notes included in our Annual Report on Form 10-K for our
fiscal year ended August 31, 2004 (Fiscal 2004). Interim results of operations for the
three-month period ended November 27, 2004, may not necessarily be indicative of the results to be
expected for the full year. The unaudited interim consolidated financial statements include our accounts and the accounts of
our wholly owned subsidiary. All significant intercompany transactions and balances have been
eliminated in consolidation. Our quarterly periods end on the Saturday closest to the end of each quarter of our fiscal year
ending August 31. Summary of Significant Accounting Policies Revenue Recognition.Revenue for manufacturing and assembly contracts is recognized upon shipment
when the risk and rewards of ownership have passed to the customer without special acceptance
protocols or payment contingencies. We have a number of customer arrangements in which we retain
ownership of inventory until customer receipt or customer acceptance, and in one instance until the
customer pulls inventory into production at its offshore facility. Revenue is deferred for these
arrangements until the risks and rewards of ownership pass to the customer upon receipt or
acceptance. Our Advanced Medical Operations (AMO) provides service contracts for some of its
products. Billings for services contracts are based on published renewal rates and revenue is
recognized on a straight-line basis over the service period. AMOs development contracts are discrete time and materials projects that generally do not involve
separate deliverables. Development contract revenue is recognized ratably as development activities
occur based on contractual per hour and material reimbursement rates. Development contracts are an
interactive process with customers as different design and functionality is contemplated during the
design phase. Upon reaching the contractual billing maximums, we defer revenue until contract
extensions or purchase orders are received from customers. We occasionally have contractual
arrangements in which part or all of the payment or billing is contingent upon achieving milestones
or customer acceptance. For those contracts we evaluate whether the contract should be accounted
using the completed contract method, as the term of the arrangement is short-term, or using the
percentage of completion method for longer-term contracts. Use of Estimates.The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ significantly from those
estimates. 6




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(2) Liquidity The accompanying unaudited consolidated financial statements have been prepared assuming that the
realization of assets and the satisfaction of liabilities will occur in the normal course of
business. We generated net income of $415 for the three months ended November 27, 2004 and incurred
a net loss of $7,009 for the year ended August 31, 2004. We have historically financed our operations through the public and private sale of equity
securities, bank borrowings, operating equipment leases and cash generated by operations. At November 27, 2004, our sources of liquidity consisted of $304 of cash and cash equivalents and
our accounts receivable agreement (Credit Agreement) with Beacon Bank of Shorewood, Minnesota,
which was due to expire in January 2005. On December 7, 2004, the Credit Agreement was extended to
January 1, 2006 and our borrowing capacity was increased from $3,000 to $4,000, subject to
availability based on accounts receivable. On January 12, 2005, the Credit Agreement was further
amended to increase our borrowing capacity from $4,000 to $5,000, subject to availability based on
accounts receivable. There was $2,687 outstanding debt under the Credit Agreement at November 27,
2004, and $1,809 at December 31, 2004. Our liquidity is affected by many factors, some of which are
based on the normal ongoing operations of our business, and the most significant of which include
the timing of the collection of receivables, the level of inventories and capital expenditures and
maintaining of debt compliance. The losses due to the operational problems encountered throughout
Fiscal 2004 strained our cash flows and consumed much of the additional funds raised in the year
including the proceeds from our private placement of common stock and the collection of monies from
the judgments against our former Chief Executive Officer, President and Chairman. We have taken
various actions operationally in an effort to substantially reduce our losses or to return to
profitability in our fiscal year ending August 31, 2005 (Fiscal 2005) including, but not limited
to, production improvement initiatives and continuing progress in understanding key drivers via
systems upgrades that will improve management decision making. In addition to the operational
improvements, we continue to scrutinize our cost structure for savings. In October 2004, we entered
into a new lease arrangement for our Boulder facility which is expected to reduce lease payments
approximately $500 per year. In the event cash flows are not sufficient to fund operations at the present level measures can be
taken to reduce the expenditure levels including but not limited to reduction of spending for
research and development, elimination of budgeted raises, and reduction of certain employees. Our
lending arrangements contain debt covenants, several of which we did not maintain in Fiscal 2004
and early Fiscal 2005. We have received waivers for these violations. We do not foresee any
violations of debt agreements, as amended, for the remainder of Fiscal 2005. We will be required to
maintain a debt service coverage ratio of 1.2 to 1 beginning the second quarter ending February 28,
2006 on our term debt agreements. During Fiscal 2005, we intend to spend approximately $1.2 million for manufacturing equipment and
to make minor facility improvements. These additions, if made, are expected to increase efficiency
through the further integration of the Boulder operations and increase manufacturing capacity to
meet anticipated production requirements and add technological capabilities. It is expected that
these expenditures will be funded from operations, existing cash and cash equivalents and available
debt financing for the next 12 months. In the event there is
insufficient capital funds for this
spending it will be deferred into the future which may impact our ability to integrate the
operations of all facilities and may prevent us from increasing manufacturing capacity. Management believes that, as a result of the financial restructuring actions it has taken in Fiscal
2005 and Fiscal 2004 to reduce cash expenditures, the continuing efforts to increase revenues from
continuing customers and to generate new customers in various market sectors, and the extension and
increase of our Credit Agreement, we expect to meet our operational working capital and investment
requirements for the next 12 months. 7




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(3) Stock Based Compensation We apply the intrinsic-value method prescribed in Accounting Principles Board (APB) Opinion No.
25, Accounting for Stock Issued to Employees, to account for the issuance of stock incentives to
employees and directors. No compensation expense related to employees and directors stock
incentives has been recognized in the financial statements, as all options granted under stock
incentive plans had an exercise price equal to the market value of the underlying common stock on
the date of grant. Had we applied the fair value recognition provisions of Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, to stock based
employee compensation, our net income (loss) per share would have increased to the pro forma
amounts indicated below: Three Months EndedNovember 27, 2004
    
    
    November 29, 2003Net income (loss) as reported
    
    $
    415
    
    
    $
    (1,253
    )Add: Stock-based employee
compensation included in reported
net income (loss), net of related
tax effects
    
    
    
    
    
    
    Deduct: Total stock-based
employee compensation income
(expense) determined under fair
value based method for all awards
    
    
    (407
    )
    
    
    (413
    )Net income (loss) pro forma
    
    $
    8
    
    
    $
    (1,666
    )Basic and diluted net income
(loss) per share as reported
    
    $
    0.05
    
    
    $
    (0.18
    )Stock-based compensation expense
    
    
    (0.05
    )
    
    
    (0.06
    )Basic and diluted net income
(loss) per share pro forma
    
    $
    
    
    
    $
    (0.24
    )
 There were no options granted under our stock option plans during the three-months ended November
27, 2004. (4) Developed Technology Amortization expense for developed technology for the three-months ended November 27, 2004, and
November 29, 2003, was $31 and $33, respectively. Amortization expense is estimated to be $137
during our fiscal year ending August 31, 2005, $63 during our fiscal year ending August 31, 2006
and $4 thereafter. 8




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(5) Other Financial Statement Data The following provides additional information concerning selected consolidated balance sheet
accounts at November 27, 2004 and August 31, 2004: November 27,
    
    
    August 31,2004
    
    
    2004Inventories:Purchased parts
    
    $
    5,347
    
    
    $
    4,673Work in process
    
    
    796
    
    
    
    789Finished goods
    
    
    1,452
    
    
    
    1,325$
    7,595
    
    
    $
    6,787Accrued Liabilities:Employee related costs
    
    $
    1,239
    
    
    $
    1,474Deferred revenue
    
    
    582
    
    
    
    804Customer deposits
    
    
    1,117
    
    
    
    418Current maturities of long-term liabilities
    
    
    406
    
    
    
    805Warranty reserve
    
    
    140
    
    
    
    139Other accrued liabilities
    
    
    187
    
    
    
    1,029$
    3,671
    
    
    $
    4,669Other long-term liabilities:Remaining lease obligation, less estimated sublease proceeds
    
    $
    1,288
    
    
    $
    1,471Unfavorable operating lease, net
    
    
    598
    
    
    
    611Total
    
    $
    1,886
    
    
    $
    2,082Less current maturities
    
    
    406
    
    
    
    805Total other long-term liabilities
    
    $
    1,480
    
    
    $
    1,277
 (6) Warranty Obligations Sales of our products are subject to limited warranty guarantees that typically extend for a period
of twelve months from the date of manufacture. Warranty terms are included in customer contracts
under which we are obligated to repair or replace any components or assemblies deemed defective due
to workmanship or materials. We do, however, reserve the right to reject warranty claims where we
determine that failure is due to normal wear, customer modifications, improper maintenance, or
misuse. Warranty provisions are based on estimated returns and warranty expenses applied to current
period revenue and historical warranty incidence over the preceding twelve-month period. Both the
experience and the warranty liability are evaluated on an ongoing basis for adequacy. Warranty
provisions and claims for the first three months of Fiscal 2005 and 2004 were as follows: Warranty
    
    
    WarrantyBeginning Balance
    
    
    Provisions
    
    
    Claims
    
    
    Ending BalanceFiscal 2005
    
    $
    139
    
    
    $
    20
    
    
    $
    19
    
    
    $
    140Fiscal 2004
    
    $
    122
    
    
    $
    69
    
    
    $
    28
    
    
    $
    163
 9




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(7) Long-Term Debt Our long-term debt consists of the following: November 27,
    
    
    August 31,2004
    
    
    2004Commerce Bank mortgage payable in monthly
installments of principal and interest of $9 based on
a twenty-year amortization with a final payment of
approximately $980 due in November 2009;
collateralized by our Victoria facility
    
    $
    1,161
    
    
    $
    1,174Commerce Financial Group, Inc. equipment loan payable
in fixed monthly principal and interest installments
of $28 through September 2007; collateralized by our
Victoria facility and equipment located at our Tempe
facility
    
    
    851
    
    
    
    916Capital lease obligation; collateralized with equipment
    
    
    32
    
    
    
    34Commercial loans payable in fixed monthly principal
installments of $1 through May 2009; collateralized
with certain machinery and equipment
    
    
    31
    
    
    
    33Commercial loans payable in fixed monthly principal
installments of $12 through July 2005; collateralized
with certain machinery and equipment
    
    
    58
    
    
    
    79Total
    
    
    2,133
    
    
    
    2,236Less current maturities
    
    
    356
    
    
    
    403Total long-term debt
    
    $
    1,777
    
    
    $
    1,833
 In Fiscal 2004, we obtained two separate loans in the aggregate amount of $2,350 under new Term
Loan Agreements with Commerce Bank, a Minnesota state banking association, and its affiliate,
Commerce Financial Group, Inc., a Minnesota corporation. The first note, with Commerce Bank, in the
amount of $1,200 was executed on October 14, 2003. This note is collateralized by our Victoria,
Minnesota facility. The term of the first note is six years. The original interest rate on this
note was a nominal rate of 6.50% per annum for the first three years, and thereafter the interest
rate will be adjusted on the first date of the fourth loan year to a nominal rate per annum equal
to the then Three Year Treasury Base Rate (as defined) plus 3.00%; provided, however, that in no
event will the interest rate be less than the Prime Rate plus 1.0% per annum. Monthly payment of
principal and interest will be based on a twenty-year amortization with a final payment of
approximately $980 due on November 1, 2009. The second note, with Commerce Financial Group, Inc.,
in the amount of $1,150 was executed on October 28, 2003. The second note is collateralized by our
Victoria facility and equipment located at our Tempe facility. The term of the second note is four
years. The original interest rate on this note was of 8.975% per year through September 27, 2007.
During the first quarter of Fiscal 2005, we violated two covenants of these term loan agreements
and were likely to be in violation of a third covenant as of the end of our second quarter ending
February 28, 2005. As a result, in December 2004, we entered into waivers and amendments with
Commerce Bank and Commerce Financial Group, Inc., respectively, effective as of November 30, 2004,
to address the actual and potential covenant violations. The waivers and amendments increased the
interest rate to be paid under the Commerce Bank note beginning March 1, 2005, to and including
October 31, 2006, from 6.5% to 7.5%, and increased the interest rate to be paid under the Commerce
Financial Group, Inc. note beginning March 1, 2005, to and including September 28, 2007, from
8.975% to 9.975%. Monthly payments of principal and interest in the amount of $28 are paid over a
forty-eight month period beginning on October 28, 2003. (8) Line of Credit On May 29, 2003, we entered into the Credit Agreement for a period of twelve months. On December 7,
2004, the Company extended the Credit Agreement to January 1, 2006 and had the maximum amount of
credit increased to $4,000. On January 12, 2005, the Credit Agreement was further amended to
increase our borrowing capacity from $4,000 to $5,000, subject to availability based on accounts
receivable. The Credit Agreement is an accounts receivable backed facility and is additionally
collateralized by inventory, intellectual property and other general intangibles. The Credit
Agreement is not subject to any restrictive financial covenants. The balance on the line of credit
was $2,687 and $1,310 as of November 27, 2004 and August 31, 2004, respectively. The Credit
Agreement bears an immediate processing fee of 0.50% of each assigned amount, a daily per diem
equal to 1/25% on any uncollected accounts receivable and a monthly minimum of $1.5 in processing
fees for the first six months the Credit Agreement is in place. Borrowings are reduced as
collections and payments are received into a lock box by the bank. The effective interest rate
based on our average DSO of 55 days would be 17.9% annualized. During the first quarter of Fiscal
2005, we violated one covenant of the Credit Agreement and were likely to be in violation of a
second covenant. As a result, in December 2004, we entered into waivers and amendments with Beacon
Bank to address the actual and potential covenant violations. 10




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(9) Deferred Taxes Deferred income taxes reflect the net tax effects of temporary differences between the carrying
amount of assets and liabilities for financial reporting purposes and the amounts used for income
tax purposes. The significant components of our deferred tax assets and liabilities consist of
timing differences related to allowance for doubtful accounts, depreciation, reserves for excess
and obsolete inventory, accrued warranty reserves, and the future benefit associated with Federal
and state net operating loss carryforwards. A valuation allowance has been set at approximately
$7,500 and $7,650, at November 27, 2004, and August 31, 2004, respectively, because of
uncertainties related to the ability to utilize certain Federal and state net loss carryforwards as
determined in accordance with GAAP. The valuation allowance is based on estimates of taxable income
by jurisdiction and the period over which our deferred tax assets are recoverable. (10) Net Income (Loss) per Share Computation The components of net loss per basic and diluted share are as follows: Three Months EndedNovember 27, 2004
    
    
    November 29, 2003Basic:Net income (loss)
    
    $
    415
    
    
    $
    (1,253
    )Net income (loss) per share
    
    $
    0.05
    
    
    $
    (0.18
    )Weighted average number of common
shares outstanding
    
    
    8,357
    
    
    
    7,046Diluted:Net income (loss)
    
    $
    415
    
    
    $
    (1,253
    )Net income (loss) per share
    
    $
    0.05
    
    
    $
    (0.18
    )Weighted average number of common
shares outstanding
    
    
    8,357
    
    
    
    7,046Assumed conversion of stock options
    
    
    68
    
    
    
    Weighted average common and
assumed conversion shares
    
    
    8,425
    
    
    
    7,046
 Approximately 1,850,400 and 1,204,100 shares of our Common Stock under stock options and warrants
have been excluded from the calculation of diluted net income (loss) per common share as they are
antidilutive for the three-month periods ended November 27, 2004 and November 29, 2003,
respectively. (11) Notes Receivable and Transactions with Former CEO Notes Receivable  Officers and Directors The Company has recorded notes receivable from certain officers and directors in connection with
the exercise of stock options. These notes as amended provide for full recourse to the individuals,
bear interest at Prime with the exception of one individual at prime plus 1/2 per annum and have a
term of five years with annual principal and interest installments through April 2, 2006. These
notes receivable are classified as a reduction to shareholders equity on the consolidated balance
sheet. Edwin W. Finch, III, our former director, missed a payment of $93 in principal and interest under
his promissory note to us, which was due on April 2, 2004. Mr. Finch withheld payment on his note
because he claimed that we owed him payments under an employment agreement with him. On October 15,
2004, the parties settled the dispute regarding the employment agreement and the note, and Mr.
Finch subsequently satisfied his obligation for the payment he withheld. We recorded a write-off of
$64 related to this settlement in Fiscal 2004. We received the remaining $20 related to this
payment in the first quarter of Fiscal 2005. As of November 27, 2004, the interest due the Company on these notes was $16 and is payable April
2, 2005. As of November 27, 2004, notes receivable of $415 remains outstanding. 11




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##### Table of Contents



Anthony J. Fant Litigation On June 30, 2003, we commenced litigation against Anthony J. Fant, our former Chairman of the
Board, Chief Executive Officer and President, in the State of Minnesota, Hennepin County District
Court, Fourth Judicial District. The complaint alleged breach of contract, conversion, breach of
fiduciary duty, unjust enrichment and corporate waste resulting from, among other things, Mr.
Fants default on his promissory note to us and other loans and certain other matters. On August
12, 2003, we obtained a judgment against Mr. Fant on the breach of contract count in the amount of
approximately $606. On November 24, 2003, the Court granted an additional judgment to us against
Mr. Fant in the amount of approximately $993 on the basis of our conversion, breach of fiduciary
duty, unjust enrichment and corporate waste claims. On March 29, 2004, we obtained a third judgment
against Mr. Fant relating to our claims for damages for conversion, breach of fiduciary duty, and
our legal and special investigation costs in the amount of approximately $656. As of November 27,
2004, the total combined judgment against Mr. Fant was approximately $2,255. We have obtained, through garnishments, in excess of approximately $112 from Mr. Fants
accounts that was recognized as a recovery in the second quarter of Fiscal 2004. We have also
caused to be sold common stock previously held by Mr. Fant, $634 of the proceeds from that sale
reduced judgments against Mr. Fant. We obtained approximately $49 from other garnishments that were
recognized as a recovery in the third quarter of Fiscal 2004. In May 2004, we caused to be sold
additional common stock previously held by Mr. Fant, $472 of the proceeds from that sale reduced
judgments against Mr. Fant. This judgment recovery was recorded as income in the fourth quarter of
Fiscal 2004. In June 2004, we obtained $481 through a garnishment of assets previously held by Mr.
Fant which we recorded as income in the first quarter of Fiscal 2005. As of November 27, 2004, we
have collected approximately $1,748, which partially reduces our total judgment against Mr. Fant.
We continue to seek to collect on our remaining judgment amount in Minnesota and other states where
it is believed that Mr. Fant may have non-exempt and unencumbered assets. There is no assurance
that we will be able to collect the full amounts of our judgments against Mr. Fant. Total Judgments:
    
    
    
    
    
    $
    2,255Proceeds:Garnishments
    
    
    
    
    
    
    642Sale of stock  reducing judgments
    
    
    1,106Sale of stock  fees paid
    
    
    94Total proceeds from sale of stock
    
    
    
    
    
    
    1,200Litigation recoveries
    
    
    
    
    
    $
    1,842
 (12) Major Customers The table below sets forth the approximate percentage of net sales to major customers that
represented over 10% of our revenue for the three months ended November 27, 2004 and November 29,
2003, respectively. Three Months EndedNovember 27, 2004
    
    
    November 29, 2003Animas Corporation
    
    
    12
    %
    
    
    
    %GE Medical Systems
    
    
    16
    %
    
    
    15
    %CADx Medical Systems
    
    
    1
    %
    
    
    14
    %Total
    
    
    29
    %
    
    
    29
    %
 Accounts receivable from these customers represented 28% and 26%, respectively, of the total
accounts receivable at November 27, 2004, and August 31, 2004, respectively. 12




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##### Table of Contents



(13) Segments Microelectronics Operations: This segment consists of three facilities  Victoria, Chanhassen,
and Tempe  that design, manufacture and sell ultra miniature microelectronic devices and high
technology products incorporating these devices. Advanced Medical Operations: This segment consists of our Boulder facility that provides design
and manufacturing outsourcing of complex electronic and electromechanical medical devices. Segment information is as follows: Three Months Ended November 27, 2004Microelectronics
    
    
    Advanced MedicalOperations
    
    

    Operations
    
    
    TotalNet sales
    
    $
    7,636
    
    
    $
    6,435
    
    
    $
    14,071Gross profit
    
    
    1,137
    
    
    
    1,819
    
    
    
    2,956Operating income (loss)
    
    
    (536
    )
    
    
    613
    
    
    
    77Total assets
    
    
    17,069
    
    
    
    9,238
    
    
    
    26,307Depreciation and amortization
    
    
    564
    
    
    
    81
    
    
    
    645Capital expenditures
    
    
    323
    
    
    
    15
    
    
    
    338
 Three Months Ended November 29, 2003Net sales
    
    $
    5,141
    
    
    $
    5,775
    
    
    $
    10,916Gross profit (loss)
    
    
    (200
    )
    
    
    1,264
    
    
    
    1,064Operating income (loss)
    
    
    (1,986
    )
    
    
    318
    
    
    
    (1,668
    )Total assets
    
    
    15,277
    
    
    
    9,722
    
    
    
    24,999Depreciation and amortization
    
    
    599
    
    
    
    77
    
    
    
    676Capital expenditures
    
    
    60
    
    
    
    52
    
    
    
    112
 (14) Commitments and Contingencies We lease a 152,022 square foot facility in Boulder, Colorado for our AMO. On September 27, 2004,
this facility was sold by Eastside Properties, LLC to Titan. On October 1, 2004, we signed a
15-year new lease with Titans affiliate, Boulder Investors LLC, at substantially reduced rental
rates. Under the terms of the new lease, $1,350 of our deposit will be refunded to us if after
completing four consecutive quarters of positive EBIDTA, as determined in accordance with GAAP and
verified by an independent third party accountant, we deliver to our landlord the greater of
100,000 shares of our common stock or 0.11% of the outstanding shares of our common stock. As a
part of the purchase accounting for the acquisition of our AMO, we had established a $3,110 reserve
relating to the future estimated lease payments of our Boulder facility. Currently, we occupy
approximately 100,000 square feet of the facility and 50,000 is unimproved vacant space. The lease
provides for two options to extend the 15-year lease for a period of five years each as defined in
the lease agreement. 13




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##### Table of Contents



Item 2.
Managements Discussion and Analysis of Financial Condition and Results of Operations
(In thousands, except share and per share data) Overview We provide a comprehensive range of engineering, product design, automation and test,
manufacturing, distribution, and fulfillment services and solutions to our customers in the
hearing, medical device, medical equipment, communications, computing and industrial equipment
industries. We provide these services and solutions on a global basis through integrated facilities
in North America. These services and solutions support our customers products from initial product
development and design through manufacturing to worldwide distribution and aftermarket support. We
leverage our various technology platforms and internal manufacturing capacity to provide bundled
solutions to the markets served. Our current focus is on managing costs and integration of our
business operating units. The following discussion highlights the significant factors affecting changes in our results of
operations and financial condition. This review should be read in conjunction with the Consolidated
Financial Statements, Notes to Consolidated Financial Statements and the Managements Discussion
and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form
10-K for the fiscal year ended August 31, 2004. Results of Operations
Three Months Ended November 27, 2004 and November 29, 2003: 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 EndedNovember 27,
    
    
    
    
    
    
    November 29,2004
    
    
    
    
    
    
    2003Net sales
    
    $
    14,071
    
    
    
    100
    %
    
    $
    10,894
    
    
    
    100
    %Cost of sales
    
    
    11,115
    
    
    
    79
    %
    
    
    9,821
    
    
    
    90
    %Gross profit
    
    
    2,956
    
    
    
    21
    %
    
    
    1,073
    
    
    
    10
    %Operating expenses
    
    
    2,879
    
    
    
    20
    %
    
    
    2,732
    
    
    
    25
    %Operating income (loss)
    
    
    77
    
    
    
    1
    %
    
    
    (1,659
    )
    
    
    (15
    %)Other income (expense)
    
    
    338
    
    
    
    2
    %
    
    
    406
    
    
    
    4
    %Income (loss) before income taxes
    
    
    415
    
    
    
    3
    %
    
    
    (1,253
    )
    
    
    (12
    %)Income tax benefit
    
    
    
    
    
    
    0
    %
    
    
    
    
    
    
    0
    %Net income (loss)
    
    $
    415
    
    
    
    3
    %
    
    $
    (1,253
    )
    
    
    (12
    %)
 Net Sales Net sales in the first quarter of Fiscal 2005 were $14,071, an increase of $3,177, or 29%, from the
comparable quarter last year. This increase was driven by increases in sales in our primary
markets of medical/hearing and communications products and improvements in our manufacturing
capabilities to produce and ship more products in a quarter. In the first quarter of Fiscal 2005
and Fiscal 2004, our four largest customers represented 44% of our revenues. Because sales are generally tied to the customers projected sales and production of the related
product, our sales may be subject to uncontrollable fluctuations. Significant changes in sales to
any one customer could have a significant impact on total sales. In addition, production from one
customer may conclude while production for a new customer may not have begun or is not yet at full
volume. At November 29, 2004, our backlog for future orders was approximately $16,000, compared to
approximately $18,000 at August 31, 2004. This decrease primarily reflects an improvement in our
manufacturing capabilities as we are able to reduce the time between order and shipment. Our
backlog is not necessarily a firm commitment from our customers and can change, in some cases
materially, beyond our control. 14




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##### Table of Contents



Net sales by market are as follows: Three Months EndedNovember 27, 2004
    
    
    November 29, 2003Medical/Hearing
    
    $
    11,294
    
    
    $
    9,328Communications
    
    
    1,574
    
    
    
    433Industrial
    
    
    1,203
    
    
    
    1,133Total Net Sales
    
    $
    14,071
    
    
    $
    10,894
 Net sales analysis by market follows: Sales to medical/hearing customers increased by $1,966 in the first quarter of Fiscal 2005 as
compared with the first quarter of last fiscal year or an increase of 21%. This year sales in this
market segment represented 80% of total net sales, as compared to 86% for the three-month period
ended November 29, 2003. This increase is driven by sales to new customers, increases in sales to
existing customers, particularly with respect to insulin pump components, and a return to
historical sales levels of products for defibrillators and hearing aids. Sales into new markets,
such as for glucose monitoring systems, also contributed to the sales increase in the quarter. In
addition, improvements in our manufacturing processes and capacity enabled us to manufacture and
ship more product in the quarter. Net sales to the communications products market represents 11% of total net sales for the
three-month period ended November 27, 2004, as compared to 4% for the first quarter of Fiscal 2004.
The increase of $1,141, or 163%, from the first quarter of Fiscal 2004 is largely a result of the
improvement in the telecommunications markets and the realization of benefits from our much more
narrowly focused sales efforts which targets key niche customers to obtain the best margin revenue
while improving the efficiencies in developing new business. Significant increases in sales for
the quarter were in the areas of parallel optical interface assemblies and HEI modulator
amplifiers. Net sales to the industrial products market represent 9% of our total net sales for the three-month
period ended November 27, 2004, as compared to 10% for the three-month period ended November 29,
2003. In total, industrial net sales for the first quarter of Fiscal 2005 increased by only $70 as
compared to the same period last year. The slight increase in the revenue in this market is due to
our efforts to maintain and grow our sales through active account management in this market as we
focus on expanding our sales activity in our larger market segments. Gross Profit Gross profit was $2,956 (21% of net sales) for the three-months ended November 27, 2004, compared
to $1,073 (10% of net sales) for the three-months ended November 29, 2003. During the first quarter
of Fiscal 2005, we were able to realize the improvement in our gross profit margins that are the
result of actions taken over the past year to improve our manufacturing efficiency. The primary
reason for the improvement in our profit margins is that we were able to reduce the time to
manufacture products in the quarter and thereby spread our fixed manufacturing costs over a larger
amount of products. In addition, the new procedures implemented over the past year have resulted
in improved yields, reduced scrap, and reduced overtime in our manufacturing department. Our gross
margins, however, are heavily impacted by fluctuations in net sales, due to the fixed nature of
many of our manufacturing costs, and by the mix of products manufactured in any particular quarter.
In addition, the start up of new customer programs could adversely impact our margins as we
implement the complex processes involved in the design and manufacture of ultra miniature
microelectronic devices. We anticipate that our gross profit margins will remain relatively
constant for the remainder of Fiscal 2005. Operating Expenses Selling, general and administrative expenses Selling, general and administrative expenses increased by $285, or 16%, for the three month-period
ended November 27, 2004 as compared to the first quarter of Fiscal 2004. This increase is due to
increase sales costs such as commissions and travel that relates to the increase in sales achieved
in the quarter. In addition, we incurred higher levels of legal and accounting expenses in the
first quarter associated with our restructuring our Boulder lease and our year-end audit. As a
percentage of net sales, selling, general and administrative expenses decreased to 15% for the
three-month period ended November 27, 2004, as compared to 16% for the comparable period last year.
This decrease is primarily related to the growth in our revenues for the quarter. We expect that
our selling, general and administrative expenses will fluctuate modestly in the upcoming quarters. 15




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##### Table of Contents



Research, development, and engineering expenses Research, development, and engineering expenses increased $115, or 16%, for the first quarter of
Fiscal 2005 as compared to the first quarter of Fiscal 2004. This increase is the result of
expanded design and development efforts associated with new customer programs, the continued work
associated with our Link-It technology and increased efforts to enhance our proprietary products
and manufacturing processes. As a percentage of net sales, research, development, and engineering
expenses were 6% for the three-month period ended November 27, 2004 as compared to 7% for the first
quarter of Fiscal 2004. The decrease of these expenses as a percentage of net sales for the period
ended November 27, 2004 is a result of the growth in our revenue base and our continued efforts to
balance our commitment to maintain research and development efforts with our revenue levels. We
expect that our research, development and engineering expenses will remain at approximately the
same quarterly levels for the remainder of the year. Costs related to investigation During the first quarter of Fiscal 2004, we directly, and on behalf of the Special Committee of our
Board of Directors, incurred outside legal and accounting costs of $253 in connection with our
litigation against, and other issues involving, Anthony J. Fant, our former Chairman of the Board,
Chief Executive Officer and President. See Note 10 to our unaudited consolidated financial
statements. The Special Committee completed its investigation into such issues on December 14,
2003. Other Income (Expense), Net We recorded $338 in net other income during the three-month period ended November 27, 2004, and
$406 in net other income during the three-months ended November 29, 2003. In the first quarter of
Fiscal 2005, other income included a gain of $481 related to additional cash collections against
the outstanding judgments against Mr. Fant, our former CEO. This amount was offset by interest
expense in the quarter of $169. For the period ended November 29, 2003, the net other income
consists primarily of a gain of $472 recognized in connection with the prepayment of a promissory
note offset by interest expense of $69. The increase in interest expense of $100 in the first
quarter of Fiscal 2005 from $69 during the three-months ended November 29, 2003 is related to the
two term loans obtained by the Company in the first quarter of Fiscal 2004 and an increase in the
average amounts outstanding on our line of credit. Income Taxes We did not record a tax provision in the first quarter of Fiscal 2005 since we have unutilized net
operating loss carryforwards from prior years which will be utilized to offset taxes associated
with our income in the quarter. In the first quarter of Fiscal 2004, there was no benefit for
income taxes related to our loss in the quarter because we were in a operating loss carryfoward
situation. We have established a valuation allowance to fully reserve the deferred tax assets
because of uncertainties related to our ability to utilize certain federal and state loss
carryforwards as measured by GAAP. 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. FINANCIAL CONDITION AND LIQUIDITY The accompanying unaudited consolidated financial statements have been prepared assuming that the
realization of our assets and the satisfaction of liabilities will occur in the normal course of
business. We generated net income of $415 for the three months ended November 27, 2004 and incurred
a net loss of $7,009 for the year ended August 31, 2004. We have historically financed our operations through the public and private sale of equity
securities, bank borrowings, operating equipment leases and cash generated by operations. At November 27, 2004, our sources of liquidity consisted of $304 of cash and cash equivalents and
our Credit Agreement, which was due to expire in January 2005. On December 7, 2004, the Credit
Agreement was extended to January 1, 2006 and our borrowing capacity was increased from $3,000 to
$4,000, subject to availability based on accounts receivable. On January 12, 2005, the Credit
Agreement was further amended to increase our borrowing capacity from $4,000 to $5,000, subject to
availability based on accounts receivable. There was $2,687 outstanding debt under the Credit
Agreement at November 27, 2004, and $1,809 at December 31, 2004. Our liquidity is affected by many
factors, some of which are based on the normal ongoing operations of our business, and the most
significant of which include the timing of the collection of receivables, the level of inventories
and capital expenditures and maintaining of debt compliance. The losses due to the operational
problems encountered throughout Fiscal 2004 strained our cash 16




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##### Table of Contents



flows and consumed much of the additional funds raised in the year including the proceeds from our
private placement of common stock and the collection of monies from the judgments against our
former Chief Executive Officer, President and Chairman. We have taken various actions operationally
in an effort to substantially reduce our losses or to return to profitability in Fiscal 2005
including, but not limited to, production improvement initiatives and continuing progress in
understanding key drivers via systems upgrades that will improve management decision making. In
addition to the operational improvements, we continue to scrutinize our cost structure for savings.
In October 2004, we entered into a new lease arrangement for our Boulder facility which is expected
to reduce lease payments approximately $500 per year. In the event cash flows are not sufficient to fund operations at the present level measures can be
taken to reduce the expenditure levels including but not limited to reduction of spending for
research and development, elimination of budgeted raises, and reduction of certain employees. Our
lending arrangements contain debt covenants, several of which we did not maintain in Fiscal 2004
and early Fiscal 2005. We have received waivers for these violations. We do not foresee any
violations of debt agreements, as amended, for the remainder of Fiscal 2005. We will be required to
maintain a debt service coverage ratio of 1.2 to 1 beginning the second quarter ending February 28,
2006 on our term debt agreements. During Fiscal 2005, we intend to spend approximately $1.2 million for manufacturing equipment and
to make minor facility improvements. These additions, if made, are expected to increase efficiency
through the further integration of the Boulder operations and increase manufacturing capacity to
meet anticipated production requirements and add technological capabilities. It is expected that
these expenditures will be funded from operations, existing cash and cash equivalents and available
debt financing for the next 12 months. In the event there is
insufficient capital funds for this
spending it will be deferred into the future which may impact our ability to integrate the
operations of all facilities and may prevent us from increasing manufacturing capacity. Management believes that, as a result of the financial restructuring actions it has taken in Fiscal
2005 and Fiscal 2004 to reduce cash expenditures, the continuing efforts to increase revenues from
continuing customers and to generate new customers in various market sectors, and the extension and
increase of our Credit Agreement, we expect to meet our operational working capital and investment
requirements for the next 12 months. CRITICAL ACCOUNTING POLICIES The accompanying consolidated financial statements are based on the selection and application of
accounting principles generally accepted in the United States of America (GAAP), which require
estimates and assumptions about future events that may affect the amounts reported in these
financial statements and the accompanying notes. Future events and their effects cannot be
determined with absolute certainty. Therefore, the determination of estimates requires the exercise
of judgment. Actual results could differ from those estimates, and any such differences may be
material to the financial statements. We believe that the following accounting policy as well as
the policies included in our Annual Report on Form 10-K for our fiscal year ended August 31, 2004,
may involve a higher degree of judgment and complexity in their application and represent the
critical accounting policies used in the preparation of our financial statements. If different
assumptions or conditions were to prevail, the results could be materially different from reported
results. Revenue Recognition.Revenue for manufacturing and assembly contracts is recognized upon shipment
when the risk and rewards of ownership have passed to the customer without special acceptance
protocols or payment contingencies. We have a number of customer arrangements in which we retain
ownership of inventory until customer receipt or customer acceptance, and in one instance until the
customer pulls inventory into production at its offshore facility. Revenue is deferred for these
arrangements until the risks and rewards of ownership pass to the customer upon receipt or
acceptance. Our AMO provides service contracts for some of its products. Billings for services
contracts are based on published renewal rates and revenue is recognized on a straight-line basis
over the service period. AMOs development contracts are discrete time and materials projects that generally do not involve
separate deliverables. Development contract revenue is recognized ratably as development activities
occur based on contractual per hour and material reimbursement rates. Development contracts are an
interactive process with customers as different design and functionality is contemplated during the
design phase. Upon reaching the contractual billing maximums, we defer revenue until contract
extensions or purchase orders are received from customers. We occasionally have contractual
arrangements in which part or all of the payment or billing is contingent upon achieving milestones
or customer acceptance. For those contracts we evaluate whether the contract should be accounted
using the completed contract method, as the term of the arrangement is short-term, or using the
percentage of completion method for longer-term contracts. 17




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##### Table of Contents



Forward-Looking Statements Some of the Information included in this Quarterly Report on Form 10-Q contains forward-looking
statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform
Act of 1995 that involve substantial risks and uncertainties. You can identify these statements by
forward-looking words such as may, will, expect, anticipate, believe, intend,
estimate, continue, and similar words. You should read statements that contain these words
carefully for the following reasons: such statements discuss our future expectations, such
statements contain projections of future earnings or financial condition and such statements state
other forward-looking information. Although it is important to communicate our expectations, there
may be events in the future that we are not accurately able to predict or over which we have no
control. The risk factors included in Item 7 of our Annual Report on Form 10-K for the fiscal year
ended August 31, 2004 provide examples of such risks, uncertainties and events that may cause
actual results to differ materially from our expectations and the forward-looking statements.
Readers are cautioned not to place undue reliance on forward-looking statements, as we undertake no
obligation to update these forward-looking statements to reflect ensuing events or circumstances,
or subsequent actual results. 
 Item 3. Qualitative and Quantitative Disclosures About Market Risk
(In thousands, except share and per share amounts) Market Risk We do not have material exposure to market risk from fluctuations in foreign currency exchange
rates because all sales are denominated in U.S. dollars. Interest Rate Risk We are exposed to a floating interest rate risk from our Term Credit Facilities with Commerce Bank,
a Minnesota state banking association, and, its affiliate, Commerce Financial Group, Inc., a
Minnesota corporation. We obtained two separate loans in the aggregate amount of $2,350. The first
note, with Commerce Bank, in the amount of $1,200, is collateralized by our Victoria, Minnesota
facility. The term of the first note is six years and had an original interest rate of 6.50% per
annum for the first three years. Thereafter the interest rate will be adjusted to the then Three
Year Treasury Base Rate (as defined) plus 3.00%; provided, however, that in no event shall the
interest rate be less than the Prime Rate plus 1.0% per annum. Monthly payments of principal and
interest will be based on a twenty-year amortization with a final payment of approximately $980 due
on November 1, 2009. In December 2004, we entered into amendments with Commerce Bank to address
actual and potential covenant violations. As part of these amendments, the interest rate on this
note was increased effective March 1, 2005, to and including October 31, 2006 from 6.5% to 7.5%.
The second note, with Commerce Financial Group, Inc., in the amount of $1,150 was executed on
October 28, 2003. The second note is collateralized by our Victoria facility and equipment located
at our Tempe facility. The term of the second note is four years and had an original interest rate
of 8.975% per year through September 27, 2007. Monthly payments of principal and interest in the
amount of $28 will be paid over a forty-eight month period that began on October 28, 2003. In
December 2004, we entered into amendments with Commerce Financial Group, Inc. to address actual and
potential covenant violations. As part of these amendments, the interest rate on this note will be
increased effective March 1, 2005, to and including September 28, 2007 from 8.975% to 9.975%. A
change in interest rates is not expected to have a material adverse effect on our near-term
financial condition or results of operation as the first note has a fixed rate for its first three
years and the second note has a fixed rate for its term. 18




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##### Table of Contents



Item 4. Controls and Procedures During the course of their audit of our consolidated financial statements for Fiscal 2004, which
was completed on January 13, 2005 with the filing our Annual Report on Form 10-K for the year ended
August 31, 2004, our former independent registered public accounting firm, KPMG LLP, advised
management and the Audit Committee of our Board of Directors that they had identified three
deficiencies in internal control. The deficiencies are considered to be a material weakness as
defined under standards established by the American Institute of Certified Public Accountants. The
material weaknesses relate to the following: (i) the lack of segregation of duties and financial
oversight controls at our Boulder facility, which in aggregate created an ineffective control
environment, (ii) several revenue recognition errors that were not discovered during our normal
closing procedures, and (iii) financial reporting. On January 12, 2005, KPMG LLP also communicated
to our Audit Committee reportable conditions related to (A) the lack of a formal journal entry
approval process, and (B) the lack of access controls to our SAP system. Prior to the identification of such deficiencies, we had already undertaken, or were in the process
of undertaking, a number of steps to establish a proper control environment, including:  
    the replacement of our Controller;
    implementing the SAP system for all of our financial reporting, including our Boulder facility;
    adding controls and moving control related functions to our Victoria facility to
eliminate opportunities to override controls over cash, accounts receivable and accounts
payable;
    the training of our accounting personnel at a KPMG revenue recognition seminar;
    providing revenue recognition training for contract administration personnel;
    adding revenue recognition review and approval control functions;
    adding staff to accommodate the changes required; and
    evaluating access controls needed within the SAP system. We have discussed our corrective actions and future plans with our Audit Committee and we believe
the actions outlined above have corrected the deficiencies in internal controls that are considered
to be a material weakness. Further, our management, including our Chief Executive Officer and
President and Chief Financial Officer, have conducted an evaluation of the effectiveness of
disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under
the Securities Exchange Act of 1934, as amended (the Exchange Act)) as of the end of the period
covered by this Form 10-Q. Based on such evaluation, our Chief Executive Officer and President and
Chief Financial Officer have concluded that the disclosure controls and procedures did not provide
reasonable assurance of effectiveness as of the end of such period because of the material
weaknesses identified above. The material weaknesses did not, however, impact the quality of the
financial information provided on a quarterly basis. We are currently in the process of reviewing and formalizing our internal controls and procedures
for financial reporting in accordance with the Securities and Exchange Commissions rules
implementing the internal control reporting requirements included in Section 404 of the
Sarbanes-Oxley Act of 2002 (Section 404). Changes have been and will be made to our internal
controls over financial reporting as a result of these efforts. We are dedicating significant
resources, including senior management time and effort, and incurring substantial costs in
connection with our ongoing Section 404 assessment. We are currently documenting and testing our
internal controls and considering whether any improvements are necessary for maintaining an
effective control environment at our Company. The evaluation of our internal controls is being
conducted under the direction of our senior management in consultation with an independent third
party consulting firm. In addition, our senior management is regularly discussing the results of
our testing and any proposed improvements to our control environment with our Audit Committee. We
expect to assess our controls and procedures on a regular basis. We will continue to work to
improve our controls and procedures and to educate and train our employees on our existing controls
and procedures in connection with our efforts to maintain an effective controls infrastructure at
our Company. Despite the mobilization of significant resources for our Section 404 assessment, we,
however, cannot provide any assurance that we will timely complete the evaluation of our internal
controls or that, even if we do complete the evaluation of our internal controls, we do so in time
to permit our independent registered public accounting firm to test our controls and timely
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their attestation procedures of our controls in a manner that will allow us to comply with
applicable Securities and Exchange Commission rules and regulations by the filing deadline for our
Annual Report on Form 10-K for Fiscal 2005. In addition, there can be no assurances that our disclosure controls and procedures will detect or
uncover all failure of persons with the Company to report material information otherwise required
to be set forth in the reports that we file with the Securities and Exchange Commission. 
 PART II - OTHER INFORMATION 
 Item 6. Exhibits a)        Exhibits 31.1
    
    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly authorized HEI, Inc.Date: February 3, 2005
    
    /s/ Timothy C. ClaytonTimothy C. ClaytonChief Financial Officer
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Exhibit Index 31.1
    
    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 22