##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 **** FORM 10-Q **** þ
    
    Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 forthe quarterly period ended February 26, 2005.
 o
    
    Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.For the transition period from
___ to ___.
 Commission File Number 0-10078 HEI,
Inc.   Minnesota
    
    41-0944876(State or other jurisdiction of incorporation or organization)
    
    (I.R.S. Employer Identification No.)PO Box 5000, 1495 Steiger Lake Lane, Victoria, MN
    
    55386(Address of principal executive offices)
    
    (Zip Code)
 (952) 443-2500
Registrants telephone number, including area code Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes 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 March 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.Part I  Financial Information (unaudited)Item 1. Financial Statements
    
    
    3Consolidated Balance Sheets
    
    
    3Consolidated Statements of Operations
    
    
    4Consolidated Statements of Cash Flows
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    12Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    17Item 4. Controls and Procedures
    
    
    17Part II  Other InformationItem 4. Submission of Matters to a Vote of Security Holders.
    
    
    19Item 6. Exhibits
    
    
    19Signature
    
    
    20Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
  2




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements HEI, Inc. 
 Consolidated Balance Sheets  (In thousands, except per share and share data)
 February 26, 2005
    
    
    August 31, 2004(unaudited)
    
    
    (audited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    69
    
    
    $
    200Restricted cash
    
    
    
    
    
    
    481Accounts receivable, net of allowance for doubtful accounts of $140 and $121,
respectively
    
    
    8,816
    
    
    
    6,770Inventories
    
    
    7,932
    
    
    
    6,787Other current assets
    
    
    1,298
    
    
    
    1,221Total current assets
    
    
    18,115
    
    
    
    15,459Property and equipment:Land
    
    
    216
    
    
    
    216Building and improvements
    
    
    4,323
    
    
    
    4,323Fixtures and equipment
    
    
    22,420
    
    
    
    21,432Accumulated depreciation
    
    
    (20,026
    )
    
    
    (18,580
    )Net property and equipment
    
    
    6,933
    
    
    
    7,391Developed technology, less accumulated amortization of $262 and $231, respectively
    
    
    123
    
    
    
    185Security deposit
    
    
    1,580
    
    
    
    1,580Other long-term assets
    
    
    534
    
    
    
    497Total assets
    
    $
    27,285
    
    
    $
    25,112Liabilities and Shareholders EquityCurrent liabilities:Line of credit
    
    $
    3,539
    
    
    $
    1,310Current maturities of long-term debt
    
    
    368
    
    
    
    403Accounts payable
    
    
    6,542
    
    
    
    5,663Accrued liabilities
    
    
    3,631
    
    
    
    4,669Total current liabilities
    
    
    14,080
    
    
    
    12,045Other long-term liabilities, less current maturities
    
    
    1,470
    
    
    
    1,277Long-term debt, less current maturities
    
    
    1,672
    
    
    
    1,833Total other long-term liabilities, less current maturities
    
    
    3,142
    
    
    
    3,110Total liabilities
    
    
    17,222
    
    
    
    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
    
    
    (12,574
    )
    
    
    (12,452
    )Notes receivable
    
    
    (207
    )
    
    
    (435
    )Total shareholders equity
    
    
    10,063
    
    
    
    9,957Total liabilities and shareholders equity
    
    $
    27,285
    
    
    $
    25,112
 See accompanying notes to unaudited consolidated financial statements. 3




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HEI, Inc. 
 Consolidated Statements of Operations (Unaudited)  (In thousands, except per share data)
 Three Months Ended
    
    
    Six Months EndedFebruary 26, 2005
    
    
    February 28, 2004
    
    
    February 26, 2005
    
    
    February 28, 2004Net sales
    
    $
    13,736
    
    
    $
    9,995
    
    
    $
    27,808
    
    
    $
    20,911Cost of sales
    
    
    10,869
    
    
    
    9,544
    
    
    
    21,984
    
    
    
    19,396Gross profit
    
    
    2,867
    
    
    
    451
    
    
    
    5,824
    
    
    
    1,515Operating expenses:Selling, general and
administrative
    
    
    2,344
    
    
    
    2,061
    
    
    
    4,387
    
    
    
    3,818Research, development
and engineering
    
    
    934
    
    
    
    857
    
    
    
    1,771
    
    
    
    1,579Costs related to
investigation
    
    
    
    
    
    
    504
    
    
    
    
    
    
    
    757Operating loss
    
    
    (411
    )
    
    
    (2,971
    )
    
    
    (334
    )
    
    
    (4,639
    )Other income (expenses):Interest expense
    
    
    (180
    )
    
    
    (98
    )
    
    
    (349
    )
    
    
    (167
    )Gain on prepayment of
promissory note
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    472Litigation recovery
    
    
    
    
    
    
    112
    
    
    
    481
    
    
    
    112Other income
(expense), net
    
    
    54
    
    
    
    (12
    )
    
    
    80
    
    
    
    Loss before income taxes
    
    
    (537
    )
    
    
    (2,969
    )
    
    
    (122
    )
    
    
    (4,222
    )Income tax benefit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    $
    (537
    )
    
    $
    (2,969
    )
    
    $
    (122
    )
    
    $
    (4,222
    )Net loss per common
share:Basic
    
    $
    (0.06
    )
    
    $
    (0.41
    )
    
    $
    (0.01
    )
    
    $
    (0.59
    )Diluted
    
    $
    (0.06
    )
    
    $
    (0.41
    )
    
    $
    (0.01
    )
    
    $
    (0.59
    )Weighted average common
shares outstanding:Basic
    
    
    8,357
    
    
    
    7,232
    
    
    
    8,357
    
    
    
    7,140Diluted
    
    
    8,357
    
    
    
    7,232
    
    
    
    8,357
    
    
    
    7,140
 See accompanying notes to unaudited consolidated financial statements. 4




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HEI, Inc. 
 Consolidated Statements of Cash Flows (Unaudited)  (In thousands)
 Six Months EndedFebruary 26, 2005
    
    
    February 28, 2004Cash flow from operating activities:Net income (loss)
    
    $
    (122
    )
    
    $
    (4,222
    )Adjustments to reconcile net income (loss) to net
cash used in operating activities:Depreciation and amortization
    
    
    1,307
    
    
    
    1,347Accounts receivable allowance
    
    
    
    
    
    
    (20
    )Loss on disposal of property and equipment
    
    
    24
    
    
    
    26Gain on prepayment of promissory note
    
    
    
    
    
    
    (472
    )Changes in operating assets and liabilities:Restricted cash related to deferred litigation
    
    
    481
    
    
    
    (679
    )Accounts receivable
    
    
    (2,046
    )
    
    
    553Inventories
    
    
    (1,145
    )
    
    
    536Other current assets
    
    
    (77
    )
    
    
    (37
    )Other assets
    
    
    
    
    
    
    (35
    )Accounts payable
    
    
    879
    
    
    
    1,223Accrued liabilities and other long-term liabilities
    
    
    (845
    )
    
    
    33Net cash flow used in operating activities
    
    
    (1,544
    )
    
    
    (1,747
    )Cash flow from investing activities:Additions to property and equipment
    
    
    (768
    )
    
    
    (309
    )Proceeds from sale of assets
    
    
    
    
    
    
    17Additions to patents
    
    
    (80
    )
    
    
    (39
    )Sale of technology
    
    
    
    
    
    
    323Net cash flow provided by (used in) investing activities
    
    
    (848
    )
    
    
    (8
    )Cash flow from financing activities:Proceeds from issuance of stock, net
    
    
    
    
    
    
    3,239Note repayment
    
    
    227
    
    
    
    46Proceeds from long-term debt
    
    
    
    
    
    
    2,200Repayment of long-term debt
    
    
    (196
    )
    
    
    (2,435
    )Net borrowings (repayments) on line of credit
    
    
    2,229
    
    
    
    (490
    )Net cash flow provided by financing activities
    
    
    2,261
    
    
    
    2,560Net increase (decrease) in cash and cash equivalents
    
    
    (131
    )
    
    
    805Cash and cash equivalents, beginning of period
    
    
    200
    
    
    
    806Cash and cash equivalents, end of period
    
    $
    69
    
    
    $
    1,611Supplemental disclosures of cash flow information:Interest paid
    
    $
    349
    
    
    $
    150
 See accompanying notes to unaudited consolidated financial statements. 5




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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data) (1) Basis of Financial Statement Presentation The accompanying unaudited interim consolidated financial statements have been prepared by HEI,
Inc. pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). These
financial statements contain all normal recurring adjustments, which are, in our opinion, necessary
for a fair presentation of the financial position, results of operations and cash flows in
accordance with accounting principles generally accepted in the United States of America (GAAP). Certain information and footnote disclosures normally included in financial statements prepared in
accordance with GAAP have been condensed or omitted. We believe, however, that the disclosures are
adequate to make the information presented not misleading. The year-end balance sheet data was
derived from audited financial statements but does not include all disclosures required by GAAP.
These unaudited interim consolidated financial statements should be read in conjunction with the
financial statements and accompanying notes included in our Annual Report on Form 10-K for our
fiscal year ended August 31, 2004 (Fiscal 2004). Interim results of operations for the three- and
six-month periods ended February 26, 2005, may not necessarily be indicative of the results to be
expected for the full year. The unaudited interim consolidated financial statements include our accounts and the accounts of
our wholly owned subsidiary. All significant intercompany transactions and balances have been
eliminated in consolidation. Our quarterly periods end on the Saturday closest to the end of each quarter of our fiscal year
ending August 31. Summary of Significant Accounting Policies Revenue Recognition.Revenue for manufacturing and assembly contracts is 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. (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 incurred a net loss of $122 for the six months ended February 26, 2005 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. 6




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At February 26, 2005, our sources of liquidity consisted of $69 of cash and cash equivalents and
our accounts receivable agreement (Credit Agreement) with Beacon Bank of Shorewood, Minnesota.
The Credit Agreement, as amended, extends through January 1, 2006 and provides borrowing capacity
up to $5,000, subject to availability based on accounts receivable. There was $3,539 outstanding
debt under the Credit Agreement at February 26, 2005, 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. Over the past six months, our revenue
growth has required a substantial increase in accounts receivable, inventory and other working
capital. We have taken various actions operationally which has resulted in a substantial reduction
in our losses. We are implementing other actions in order to return to profitability in our fiscal
year ending August 31, 2005 (Fiscal 2005) including, but not limited to, production improvement
initiatives and continuing progress in understanding key drivers via systems upgrades that will
improve management decision making. In addition to the operational improvements, we continue to
scrutinize our cost structure for savings. In October 2004, we entered into a new lease arrangement
for our Boulder facility which is expected to reduce lease payments approximately $500 per year.
There can be no assurance we will return to profitability in our
fiscal year ending August 31, 2005. In the event cash flows are not sufficient to fund operations at the present level measures can be
taken to reduce the expenditure levels including but not limited to reduction of spending for
research and development, elimination of budgeted raises, and reduction of certain employees. Our
lending arrangements contain debt covenants, several of which we did not maintain in Fiscal 2004
and early Fiscal 2005. We have received waivers for these violations. We do not foresee any
violations of debt agreements, as amended, for the remainder of Fiscal 2005. We will be required to
maintain a debt service coverage ratio of 1.2 to 1 beginning in the quarter ending February 28,
2006 on our term debt agreements. During Fiscal 2005, we intend to spend approximately $1.2 million for manufacturing equipment,
computer software and to make minor facility improvements. These additions, if made, are expected
to increase efficiency through the further integration of the Boulder operations and increase
manufacturing capacity to meet anticipated production requirements and add technological
capabilities. It is expected that these expenditures will be funded from operations, existing cash
and cash equivalents and available debt financing for the next 12 months. In the event there is
insufficient capital funds for this spending it will be deferred into the future which may impact
our ability to integrate the operations of all facilities and may prevent us from increasing
manufacturing capacity. Management believes that, as a result of the financial restructuring actions it has taken in Fiscal
2005 and Fiscal 2004 to reduce cash expenditures, the continuing efforts to increase revenues from
continuing customers and to generate new customers in various market sectors, and the extension and
increase of our Credit Agreement, we expect to meet our operational working capital and investment
requirements for the next 12 months. If there is a need for additional capital to meet our short
and long-term objectives, we believe that other sources of financing are available including sales
of common stock or our undesignated stock, additional external borrowing, customer or vendor
financing or investments by strategic partners. There can be no
assurance that additional capital will be available to us or on terms
that are acceptable. (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: 7




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Three Months Ended
    
    
    Six Months EndedFebruary 26, 2005
    
    
    February 28, 2004
    
    
    February 26, 2005
    
    

February 28, 2004Net loss as reported
    
    $
    (537
    )
    
    $
    (2,969
    )
    
    $
    (122
    )
    
    $
    (4,222
    )Add: Stock-based
employee compensation
included in reported net
income, net of related
tax effects
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: Total
stock-based employee
compensation income
(expense) determined
under fair value based
method for all awards
    
    
    (407
    )
    
    
    (515
    )
    
    
    (815
    )
    
    
    (928
    )Net loss pro forma
    
    $
    (944
    )
    
    $
    (3,484
    )
    
    $
    (937
    )
    
    $
    (5,150
    )Basic and diluted net
loss per share as
reported
    
    $
    (0.06
    )
    
    $
    (0.41
    )
    
    $
    (0.01
    )
    
    $
    (0.59
    )Stock-based compensation
income (expense)
    
    
    (0.05
    )
    
    
    (0.07
    )
    
    
    (0.10
    )
    
    
    (0.13
    )Basic and diluted net
loss per share pro forma
    
    $
    (0.11
    )
    
    $
    (0.48
    )
    
    $
    (0..11
    )
    
    $
    (0.72
    )
 There were no options granted under our stock option plans during the three or six-months ended
February 26, 2005. (4) Developed Technology Amortization expense for developed technology for the three-months and six-months ended February
26, 2005, and February 28, 2004, was $31, $62, $26 and $58, respectively. Amortization expense is
estimated to be $124 during our fiscal year ending August 31, 2005, $57 during our fiscal year
ending August 31, 2006 and $4 thereafter. (5) Other Financial Statement Data The following provides additional information concerning selected consolidated balance sheet
accounts at February 26, 2005 and August 31, 2004: February 26,
    
    
    August 31,2005
    
    
    2004Inventories:Purchased parts
    
    $
    5,468
    
    
    $
    4,673Work in process
    
    
    591
    
    
    
    789Finished goods
    
    
    1,873
    
    
    
    1,325$
    7,932
    
    
    $
    6,787Accrued Liabilities:Employee related costs
    
    $
    1,523
    
    
    $
    1,474Deferred revenue
    
    
    372
    
    
    
    804Customer deposits
    
    
    881
    
    
    
    418Current maturities of long-term liabilities
    
    
    406
    
    
    
    805Warranty reserve
    
    
    160
    
    
    
    139Other accrued liabilities
    
    
    289
    
    
    
    1,029$
    3,631
    
    
    $
    4,669Other long-term liabilities:Remaining lease obligation, less estimated sublease proceeds
    
    $
    1,288
    
    
    $
    1,471Unfavorable operating lease, net
    
    
    588
    
    
    
    611Total
    
    $
    1,876
    
    
    $
    2,082Less current maturities
    
    
    406
    
    
    
    805Total other long-term liabilities
    
    $
    1,470
    
    
    $
    1,277
 8




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(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 six months and three months of Fiscal 2005 and Fiscal 2004 were
as follows: Warranty
    
    
    WarrantyBeginning Balance
    
    
    Provisions
    
    
    Claims
    
    
    Ending BalanceFor the Three Months EndedFebruary 26, 2005
    
    $
    140
    
    
    $
    83
    
    
    $
    63
    
    
    $
    160February 28, 2004
    
    $
    163
    
    
    $
    0
    
    
    $
    0
    
    
    $
    163For the Six Months EndedFebruary 26, 2005
    
    $
    139
    
    
    $
    103
    
    
    $
    82
    
    
    $
    160February 28, 2004
    
    $
    122
    
    
    $
    97
    
    
    $
    56
    
    
    $
    163
 (7) Long-Term Debt Our long-term debt consists of the following: February 26,
    
    
    August 31,2005
    
    
    2004Commerce Bank mortgage payable in monthly
installments of principal and interest of $9 based on
a twenty-year amortization with a final payment of
approximately $980 due in November 2009;
collateralized by our Victoria facility
    
    $
    1,165
    
    
    $
    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
    
    
    784
    
    
    
    916Capital lease obligation; collateralized with equipment
    
    
    28
    
    
    
    34Commercial loans payable in fixed monthly principal
installments of $1 through May 2009; collateralized
with certain machinery and equipment
    
    
    27
    
    
    
    33Commercial loans payable in fixed monthly principal
installments of $12 through July 2005; collateralized
with certain machinery and equipment
    
    
    36
    
    
    
    79Total
    
    
    2,040
    
    
    
    2,236Less current maturities
    
    
    368
    
    
    
    403Total long-term debt
    
    $
    1,672
    
    
    $
    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 ended
February 26, 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 The Company has entered into a Credit Agreement which, as amended, expires on January 1, 2006 and
has a maximum borrowing capacity of $5,000, subject to availability based on accounts receivable.
The Credit Agreement is an accounts receivable backed facility and is additionally collateralized
by inventory, intellectual property and other general intangibles. The Credit Agreement is not
subject to any restrictive financial covenants. The balance on the line of credit was $3,539 and
$1,310 as of February 26, 2005 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 58
days would be 18.7% 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. 9




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##### Table of Contents



(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
$7,725 and $7,650, at February 26, 2005, and August 31, 2004, respectively, because of
uncertainties related to the ability to utilize certain Federal and state net loss carryforwards as
determined in accordance with GAAP. The valuation allowance is based on estimates of taxable income
by jurisdiction and the period over which our deferred tax assets are recoverable. (10) Net Income (Loss) per Share Computation The components of net loss per basic and diluted share are as follows: Three Months Ended
    
    
    Six Months EndedFebruary 26, 2005
    
    
    February 28, 2004
    
    
    February 26, 2005
    
    
    February 28, 2004Basic:Net loss
    
    $
    (537
    )
    
    $
    (2,969
    )
    
    $
    (122
    )
    
    $
    (4,222
    )Net loss per share
    
    $
    (0.06
    )
    
    $
    (0.41
    )
    
    $
    (0.01
    )
    
    $
    (0.59
    )Weighted average
number of common
shares outstanding
    
    
    8,357
    
    
    
    7,232
    
    
    
    8,357
    
    
    
    7,140Diluted:Net loss
    
    $
    (537
    )
    
    $
    (2,969
    )
    
    $
    (122
    )
    
    $
    (4,222
    )Net loss per share
    
    $
    (0.06
    )
    
    $
    (0.41
    )
    
    $
    (.01
    )
    
    $
    (0.59
    )Weighted average
number of common
shares outstanding
    
    
    8,357
    
    
    
    7,232
    
    
    
    8,357
    
    
    
    7,140Assumed conversion
of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Weighted average
common and assumed
conversion shares
    
    
    8,357
    
    
    
    7,232
    
    
    
    8,357
    
    
    
    7,140
 Approximately 1,830,900 and 1,960,900 shares of our Common Stock under stock options and warrants
have been excluded from the calculation of diluted net income (loss) per common share as they are
antidilutive for the three-and six-month period ended February 26, 2005 and February 28, 2004,
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. The
unpaid portion of 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 February 26, 2005, the principal portion of the notes receivable was $415 and the interest
due the Company on these notes was $21. All principal and interest payments that were due on April
2, 2005 have been received by the Company and accordingly these receivable balances have been
reclassified as other receivables as of February 26, 2005. 10




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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 February 26,
2005, the total combined judgment against Mr. Fant was approximately $2,255. We have obtained, through garnishments, in excess of approximately $112 from Mr. Fants
accounts that was recognized as a recovery in the second quarter of Fiscal 2004. We have also
caused to be sold common stock previously held by Mr. Fant, $634 of the proceeds from that sale
reduced judgments against Mr. Fant. We obtained approximately $49 from other garnishments that were
recognized as a recovery in the third quarter of Fiscal 2004. In May 2004, we caused to be sold
additional common stock previously held by Mr. Fant, $472 of the proceeds from that sale reduced
judgments against Mr. Fant. This judgment recovery was recorded as income in the fourth quarter of
Fiscal 2004. In June 2004, we obtained $481 through a garnishment of assets previously held by Mr.
Fant which we recorded as income in the first quarter of Fiscal 2005. As of February 26, 2005, we
have collected approximately $1,748, which partially reduces our total judgment against Mr. Fant.
We continue to seek to collect on our remaining judgment amount in Minnesota and other states where
it is believed that Mr. Fant may have non-exempt and unencumbered assets. There is no assurance
that we will be able to collect the full amounts of our judgments against Mr. Fant. Total Judgments:
    
    
    
    
    
    $
    2,255Proceeds:Garnishments
    
    
    
    
    
    
    642Sale of stock  reducing judgments
    
    
    1,106Sale of stock  fees paid
    
    
    94Total proceeds from sale of stock
    
    
    
    
    
    
    1,200Litigation recoveries
    
    
    
    
    
    $
    1,842
 (12) Major Customers There were no customers where net sales represented over 10% of our revenue for the three months
and six months ended February 26, 2005. For the three months ended February 28, 2004 one customer
accounted for 10% and a second customer accounted for 16% of net sales. For the six months ended
February 28, 2004 there was one customer that accounted for 16% of net sales. (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 February 26, 2005
    
    
    Six Months Ended February 26, 2005Microelectronics
    
    
    Advanced Medical
    
    
    
    
    
    
    Microelectronics
    
    
    Advanced MedicalOperations
    
    
    Operations
    
    
    Total
    
    
    Operations
    
    
    Operations
    
    
    TotalNet sales
    
    $
    8,401
    
    
    $
    5,335
    
    
    $
    13,736
    
    
    $
    16,038
    
    
    $
    11,770
    
    
    $
    27,808Gross profit
    
    
    1,637
    
    
    
    1,230
    
    
    
    2,867
    
    
    
    2,775
    
    
    
    3,049
    
    
    
    5,824Operating income (loss)
    
    
    (549
    )
    
    
    138
    
    
    
    (411
    )
    
    
    (1,085
    )
    
    
    751
    
    
    
    (334
    )Total assets
    
    
    19,579
    
    
    
    7,706
    
    
    
    27,285
    
    
    
    19,579
    
    
    
    7,706
    
    
    
    27,285Depreciation and
amortization
    
    
    561
    
    
    
    101
    
    
    
    662
    
    
    
    1106
    
    
    
    201
    
    
    
    1,307Capital expenditures
    
    
    410
    
    
    
    20
    
    
    
    430
    
    
    
    733
    
    
    
    35
    
    
    
    768
 11




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##### Table of Contents



Three Months Ended February 28, 2004
    
    
    Six Months Ended February 28, 2004Microelectronics
    
    
    Advanced Medical
    
    
    
    
    
    
    Microelectronics
    
    
    Advanced MedicalOperations
    
    
    Operations
    
    
    Total
    
    
    Operations
    
    
    Operations
    
    
    TotalNet sales
    
    $
    5,297
    
    
    $
    4,698
    
    
    $
    9,995
    
    
    $
    10,438
    
    
    $
    10,473
    
    
    $
    20,911Gross profit
    
    
    (463
    )
    
    
    914
    
    
    
    451
    
    
    
    (663
    )
    
    
    2,178
    
    
    
    1,515Operating income (loss)
    
    
    (2,694
    )
    
    
    (277
    )
    
    
    (2,971
    )
    
    
    (4,680
    )
    
    
    41
    
    
    
    (4,639
    )Total assets
    
    
    17,425
    
    
    
    8,446
    
    
    
    25,871
    
    
    
    17,425
    
    
    
    8,446
    
    
    
    25,871Depreciation and
amortization
    
    
    564
    
    
    
    107
    
    
    
    671
    
    
    
    1163
    
    
    
    184
    
    
    
    1,347Capital expenditures
    
    
    161
    
    
    
    36
    
    
    
    197
    
    
    
    221
    
    
    
    88
    
    
    
    309
 (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. 
 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 and Six Months Ended February 26, 2005 and February 28, 2004: The following table indicates the dollars and percentages of total revenues represented by the
selected items in our unaudited consolidated statements of operations: 12




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##### Table of Contents



Selected Operating Results Three Months Ended
    
    
    Six Months EndedFebruary 26,
    
    
    
    
    
    
    February 28,
    
    
    
    
    
    
    February 26
    
    
    
    
    
    
    February 28,2005
    
    
    
    
    
    
    2004
    
    
    
    
    
    
    2005
    
    
    
    
    
    
    2004Net sales
    
    $
    13,736
    
    
    
    100
    %
    
    $
    9,995
    
    
    
    100
    %
    
    $
    27,808
    
    
    
    100
    %
    
    $
    20,911
    
    
    
    100
    %Cost of sales
    
    
    10,869
    
    
    
    79
    %
    
    
    9,544
    
    
    
    95
    %
    
    
    21,984
    
    
    
    79
    %
    
    
    19,396
    
    
    
    93
    %Gross profit
    
    
    2,867
    
    
    
    21
    %
    
    
    451
    
    
    
    5
    %
    
    
    5,824
    
    
    
    21
    %
    
    
    1,515
    
    
    
    7
    %Operating expenses
    
    
    3,278
    
    
    
    24
    %
    
    
    3,422
    
    
    
    34
    %
    
    
    6,158
    
    
    
    22
    %
    
    
    6,154
    
    
    
    29
    %Operating loss
    
    
    (411
    )
    
    
    (3
    %)
    
    
    (2,971
    )
    
    
    (30
    %)
    
    
    (334
    )
    
    
    (1
    %)
    
    
    (4,639
    )
    
    
    (22
    %)Other income (expense)
    
    
    (126
    )
    
    
    (1
    %)
    
    
    2
    
    
    
    0
    %
    
    
    (212
    )
    
    
    1
    %
    
    
    417
    
    

    
    2
    %Loss before income
taxes
    
    
    (537
    )
    
    
    (4
    %)
    
    
    (2,969
    )
    
    
    (30
    %)
    
    
    (122
    )
    
    
    (1
    %)
    
    
    (4,222
    )
    
    
    (20
    %)Income tax benefit
    
    
    
    
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    
    
    
    
    0
    %Net loss
    
    $
    (537
    )
    
    
    (4
    %)
    
    $
    (2,969
    )
    
    
    (30
    %)
    
    $
    (122
    )
    
    
    (1
    %)
    
    $
    (4,222
    )
    
    
    (20
    %)
 Net Sales Net sales in the second quarter of Fiscal 2005 were $13,736, an increase of $3,741, or 37%, from
the comparable quarter last year. Net sales for the six-months ended February 26, 2005 were
$27,808 or an increase of 33% over sales of $20,911. This increase was driven by increases in
sales in our primary markets of medical/hearing and communications products and improvements in our
manufacturing capabilities to produce and ship more products in a quarter. Because sales are generally tied to the customers projected sales and production of the related
product, our sales may be subject to uncontrollable fluctuations. Significant changes in sales to
any one customer could have a significant impact on total sales. In addition, production from one
customer may conclude while production for a new customer may not have begun or is not yet at full
volume. At February 26, 2005, our backlog for future orders was approximately $17,000, 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. Net sales by market are as follows: Three Months Ended
    
    
    Six Months EndedFebruary 26, 2005
    
    
    February 28, 2004
    
    
    February 26, 2005
    
    
    February 28, 2004Medical/Hearing
    
    $
    10,948
    
    
    $
    8,447
    
    
    $
    22,243
    
    
    $
    17,796Communications
    
    
    1,688
    
    
    
    534
    
    
    
    3,262
    
    
    
    967Industrial
    
    
    1,100
    
    
    
    1,014
    
    
    
    2,303
    
    
    
    2,148Total Net Sales
    
    $
    13,736
    
    
    $
    9,995
    
    
    $
    27,808
    
    
    $
    20,911
 Net sales analysis by market follows: Sales to medical/hearing customers increased by $2,501 in the second quarter of Fiscal 2005 as
compared with the second quarter of last fiscal year or an increase of 30%. For the six month
period, sales in this market increased by $4,447 or 25%. This year sales in this market segment
represented 80% of total net sales, as compared to 85% in both the three and six month periods of
Fiscal 2004. This increase is driven by sales to new customers, increases in sales to existing
customers, particularly with respect to insulin pump components, and a return to historical sales
levels of products for defibrillators and hearing aids. Sales into new markets, such as for glucose
monitoring systems, also contributed to the sales increase in the quarter. In addition,
improvements in our manufacturing processes and capacity enabled us to manufacture and ship more
product in the quarter. Net sales to the communications products market increased $1,154 or 216% for the three-month period
ended February 26, 2005, as compared to the second quarter of Fiscal 2004. This increase is largely
a result of the improvement in the telecommunications markets and the realization of benefits from
our much more narrowly focused sales efforts within the telecommunications market. Significant
increases in sales for the quarter were in the areas of parallel optical interface assemblies and
HEI modulator amplifiers. Net sales to the industrial products market represent 8% of our total net sales for the three and
six-month periods ended February 26, 2005, as compared to 10% for the three and six-month periods
ended February 28, 2004. Industrial sales for the second quarter of Fiscal 2005 were virtually the
same as the prior year. For the six month period, industrial sales increase by $155 or 7%. The
slight 13




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##### Table of Contents



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 $2,867 or 21% of net sales for the three-months ended February 26, 2005 as
compared to $451 or 4.5% of net sales for the three-months ended February 28, 2004. For the
six-month periods, gross profit increased to $5,824 in Fiscal 2005 from $1,515 in Fiscal 2004 or an
improvement of $4,309. The improvement in our gross profit was driven primarily by the increase in
sales for both the three and six-month periods in Fiscal 2005. In addition, during Fiscal 2005, we
were able to realize the improvement in our gross profit margins that are the result of actions
taken over the past year to improve our manufacturing efficiency. The primary reason for the
improvement in our profit margins is that we were able to reduce the time to manufacture products
in the quarter and thereby spread our fixed manufacturing costs over a larger amount of products.
In addition, the new procedures implemented over the past year have resulted in improved yields,
reduced scrap, and reduced overtime in our manufacturing department. Our gross margins, however,
are heavily impacted by fluctuations in net sales, due to the fixed nature of many of our
manufacturing costs, and by the mix of products manufactured in any particular quarter. In
addition, the start up of new customer programs could adversely impact our margins as we implement
the complex processes involved in the design and manufacture of ultra miniature microelectronic
devices. We anticipate that our gross profit margins will remain relatively constant for the
remainder of Fiscal 2005. Operating Expenses Selling, general and administrative expenses Selling, general and administrative expenses increased by $283 or 14% for the three-month period
ended February 26, 2005 as compared to the second 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
second quarter associated with the completion of our Fiscal 2004 audit, filing of our Annual Report
on Form 10-K, meetings with NASDAQ about our listing status, several system integration activities
and other internal control related activities including costs associated with Sarbanes Oxley
requirements. As a percentage of net sales, selling, general and administrative expenses decreased
to 17% for the three-month period ended February 26, 2005, as compared to 21% for the comparable
period last year. For the six-month period, selling, general and administrative expenses increased
$569 or 15% in Fiscal 2005 as compared with the same period in Fiscal 2004. In addition to the
factors noted above, the increase reflects higher legal expenses associated with restructuring our
Boulder lease. As a percentage of net sales, selling, general and administrative expenses
decreased to 16% for the six-month period ended February 26, 2005 versus 18% for the same period in
Fiscal 2004. The decreases in these costs as a percentage of sales is related to the growth in our
revenues for both the three and six month periods. We expect that our selling, general and
administrative expenses will remain flat or decrease modestly in the upcoming quarters. Research, development, and engineering expenses Research, development, and engineering expenses increased $77 or 9% for the second quarter of
Fiscal 2005 as compared to the second quarter of Fiscal 2004. For the six-months, research,
development and engineering expenses increased $192 or 12% in the first six months of Fiscal 2005
as compared with the first six months 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 7% and 6% for the three and six-month periods ended February 26, 2005, respectively.
In Fiscal 2004, research, development and engineering expenses as a percentage of sales were 9% and
8% for the three and six-month periods, respectively. The decrease of these expenses as a
percentage of net sales in Fiscal 2005 is a result of the growth in our revenue base and our
continued efforts to balance our commitment to maintain research and development efforts with our
revenue levels. We expect that our research, development and engineering expenses will remain at
approximately the same quarterly levels for the remainder of the year. Costs related to investigation During the first and second quarters 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 11 to our unaudited
consolidated financial statements. The Special Committee completed its investigation into such
issues on December 14, 2003. 14




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##### Table of Contents



Other Income (Expense), Net Interest expense for the three and six-month periods ended February 26, 2005 was $180 and $349,
respectively, as compared with $98 and $167 for the three and six-month periods ended February 28,
2004. The increase in interest expense in Fiscal 2005 is due to higher average borrowing levels
associated with funding the growth in our working capital requirements. As a result of the
increase in sales levels in Fiscal 2005, we have had increases in both accounts receivable and
inventories, which have been funded by additional borrowings on our Credit Agreement. For the
first six months 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. For the six-month
period ended February 28, 2004, other income includes a gain of $472 recognized in connection with
the prepayment of a promissory note. Income Taxes We did not record a tax provision in Fiscal 2005 or Fiscal 2004 since we have unutilized net
operating loss carryforwards from prior years which will be utilized to offset taxes associated
with our income in the quarter. We have established a valuation allowance to fully reserve the
deferred tax assets because of uncertainties related to our ability to utilize certain federal and
state loss carryforwards as measured by GAAP. The economic benefits of our net operating loss
carryforwards to future years will continue until expired. 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 incurred a net loss of $188 for the six months ended February 26, 2005 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 February 26, 2005, our sources of liquidity consisted of $69 of cash and cash equivalents and
our accounts receivable agreement (Credit Agreement) with Beacon Bank of Shorewood, Minnesota.
The Credit Agreement, as amended, extends through January 1, 2006 and provides borrowing capacity
of up to $5,000, subject to availability based on accounts receivable. There was $3,539 outstanding
debt under the Credit Agreement at February 26, 2005, 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. Over the past six months, our revenue
growth has required a substantial increase in accounts receivable, inventory and other working
capital. We have taken various actions operationally which has resulted in a substantial reduction
in our losses. We are implementing other actions in order to return to profitability in Fiscal
2005 including, but not limited to, production improvement initiatives and continuing progress in
understanding key drivers via systems upgrades that will improve management decision making. In
addition to the operational improvements, we continue to scrutinize our cost structure for savings.
In October 2004, we entered into a new lease arrangement for our Boulder facility which is expected
to reduce lease payments approximately $500 per year. There can be no
assurance we will return to profitability in our fiscal year ending
August 31, 2005. In the event cash flows are not sufficient to fund operations at the present level measures can be
taken to reduce the expenditure levels including but not limited to reduction of spending for
research and development, elimination of budgeted raises, and reduction of certain employees. Our
lending arrangements contain debt covenants, several of which we did not maintain in Fiscal 2004
and early Fiscal 2005. We have received waivers for these violations. We do not foresee any
violations of debt agreements, as amended, for the remainder of Fiscal 2005. We will be required to
maintain a debt service coverage ratio of 1.2 to 1 beginning in the quarter ending February 28,
2006 on our term debt agreements. During Fiscal 2005, we intend to spend approximately $1.2 million for manufacturing equipment,
computer software and to make minor facility improvements. These additions, if made, are expected
to increase efficiency through the further integration of the Boulder operations and increase
manufacturing capacity to meet anticipated production requirements and add technological
capabilities. It is expected that these expenditures will be funded from operations, existing cash
and cash equivalents and available 15




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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. If there is a need for additional capital to meet our short
and long-term objectives, we believe that other sources of financing are available including sales
of common stock or our undesignated stock, additional external borrowing, customer or vendor
financing or investments by strategic partners. There can be no
assurance that additional capital will be available to us or on terms
that are acceptable. 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. 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. 16




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Item 3. Qualitative and Quantitative Disclosures About Market Risk (In thousands, except share and per share amounts) Market Risk We do not have material exposure to market risk from fluctuations in foreign currency exchange
rates because all sales are denominated in U.S. dollars. Interest Rate Risk We are exposed to a floating interest rate risk from our Term Credit Facilities with Commerce Bank,
a Minnesota state banking association, and, its affiliate, Commerce Financial Group, Inc., a
Minnesota corporation. We obtained two separate loans in the aggregate amount of $2,350. The first
note, with Commerce Bank, in the amount of $1,200, is collateralized by our Victoria, Minnesota
facility. The term of the first note is six years and had an original interest rate of 6.50% per
annum for the first three years. Thereafter the interest rate will be adjusted to the then Three
Year Treasury Base Rate (as defined) plus 3.00%; provided, however, that in no event shall the
interest rate be less than the Prime Rate plus 1.0% per annum. Monthly payments of principal and
interest will be based on a twenty-year amortization with a final payment of approximately $980 due
on November 1, 2009. In December 2004, we entered into amendments with Commerce Bank to address
actual and potential covenant violations. As part of these amendments, the interest rate on this
note was increased effective March 1, 2005, to and including October 31, 2006 from 6.5% to 7.5%.
The second note, with Commerce Financial Group, Inc., in the amount of $1,150 was executed on
October 28, 2003. The second note is collateralized by our Victoria facility and equipment located
at our Tempe facility. The term of the second note is four years and had an original interest rate
of 8.975% per year through September 27, 2007. Monthly payments of principal and interest in the
amount of $28 will be paid over a forty-eight month period that began on October 28, 2003. In
December 2004, we entered into amendments with Commerce Financial Group, Inc. to address actual and
potential covenant violations. As part of these amendments, the interest rate on this note will be
increased effective March 1, 2005, to and including September 28, 2007 from 8.975% to 9.975%. A
change in interest rates is not expected to have a material adverse effect on our near-term
financial condition or results of operation as the first note has a fixed rate for its first three
years and the second note has a fixed rate for its term. 
 Item 4. Controls and Procedures During the course of their audit of our consolidated financial statements for Fiscal 2004, which
was completed on January 13, 2005 with the filing our Annual Report on Form 10-K for the year ended
August 31, 2004, our former independent registered public accounting firm, KPMG LLP, advised
management and the Audit Committee of our Board of Directors that they had identified three
deficiencies in internal control which were considered to be material weaknesses as defined under
standards established by the American Institute of Certified Public Accountants. The material
weaknesses related to the following: (i) the lack of segregation of duties and financial oversight
controls at our Boulder facility, which in aggregate created an ineffective control environment,
(ii) several revenue recognition errors that were not discovered during our normal closing
procedures, and (iii) financial reporting. On January 12, 2005, KPMG LLP also communicated to our
Audit Committee reportable conditions related to (A) the lack of a formal journal entry approval
process, and (B) the lack of access controls to our SAP system. Prior to the identification of such deficiencies, we had already undertaken, or were in the process
of undertaking, a number of steps to establish a proper control environment, including:  
    the replacement of our Controller at the Boulder facility;
    implementing the SAP system for all of our financial reporting, including our Boulder facility;
    adding controls and moving control related functions to our Victoria facility to
eliminate opportunities to override controls over cash, accounts receivable and accounts
payable;
    the training of our accounting personnel at a KPMG revenue recognition seminar;
    providing revenue recognition training for contract administration personnel;
    adding revenue recognition review and approval control functions; 17




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
    adding staff to accommodate the changes required; and
    evaluating access controls needed within the SAP system. We have discussed our corrective actions and future plans with our Audit Committee and we believe
the actions outlined above have corrected the deficiencies in internal controls that are considered
to be a material weakness. Our management team, including our Chief Executive Officer and President and Chief Financial
Officer, have conducted an evaluation of the effectiveness of disclosure controls and procedures
(as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934, as amended (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 provide reasonable assurance of
effectiveness as of the end of such period. We are currently in the process of reviewing and formalizing our internal controls and procedures
for financial reporting in accordance with the Securities and Exchange Commissions rules
implementing the internal control reporting requirements included in Section 404 of the
Sarbanes-Oxley Act of 2002 (Section 404). Changes have been and will be made to our internal
controls over financial reporting as a result of these efforts. We are dedicating significant
resources, including senior management time and effort, and incurring substantial costs in
connection with our ongoing Section 404 assessment. We are in the process of documenting our
internal controls and considering whether any improvements are necessary for maintaining an
effective control environment at our Company. The evaluation of our internal controls is being
conducted under the direction of our senior management in consultation with an independent third
party consulting firm. In addition, our senior management is regularly discussing any proposed
improvements to our control environment with our Audit Committee. We expect to assess our controls
and procedures on a regular basis. We will continue to work to improve our controls and procedures
and to educate and train our employees on our existing controls and procedures in connection with
our efforts to maintain an effective controls infrastructure at our Company. Despite the
mobilization of significant resources for our Section 404 assessment, we, however, cannot provide
any assurance that we will timely complete the evaluation of our internal controls or that, even if
we do complete the evaluation of our internal controls, we do so in time to permit our independent
registered public accounting firm to test our controls and timely complete their attestation
procedures of our controls in a manner that will allow us to comply with applicable Securities and
Exchange Commission rules and regulations, as recently revised, which call for compliance by the
filing deadline for our Annual Report on Form 10-K for Fiscal 2006. In addition, there can be no assurances that our disclosure controls and procedures will detect or
uncover all failure of persons with the Company to report material information otherwise required
to be set forth in the reports that we file with the Securities and Exchange Commission. 18




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PART II - OTHER INFORMATION 
 Item 4. Submission of Matters to a Vote of Security Holders The Companys Annual Meeting of Shareholders was held on March 2, 2005. Of the 8,356,805 shares of
common stock outstanding and entitled to vote at the meeting, 7,252,581 shares were present, either
in person or by proxy. The following describes the matters considered by the Companys
shareholders at the Annual Meeting, as well as the results of the votes cast at the Annual Meeting: 1. To elect two (2) directors to hold office for a term of three years ending
in 2008. Name of Nominee
    
    For
    
    
    WithholdMichael J. Evers
    
    
    6,977,245
    
    
    
    290,174Robert W. Heller
    
    
    7,102,515
    
    
    
    164,904
 The following directors also continue to serve: Timothy Floeder (term expires in 2006), Mack V.
Traynor, III (term expires in 2006), George M. Heenan (term expires in 2007), and Dennis J. Leisz
(term expires in 2007). 2. To approve an amendment to increase the number of shares authorized for
issuance under the Companys 1998 Stock Option Plan from 1,650,000 to 2,000,000. For:
    
    
    1,845,240Against:
    
    
    517,891Abstain:
    
    
    12,187Broker Non-Vote:
    
    
    4,892,101
 This proposal was not approved. 
 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: April 12, 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.
 21