<PAGE>

HEI, INC.
FIVE YEAR SUMMARY OF SELECTED FINANCIAL INFORMATION
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>

YEARS ENDED AUGUST 31                         1996        1995        1994        1993        1992
<S>                                         <C>         <C>         <C>         <C>         <C>
Net sales                                   $20,680     $23,423     $17,295     $18,893     $14,138
Cost of sales                                14,957      17,263      12,497      12,174       9,491

Gross profit                                  5,723       6,160       4,798       6,719       4,647
---------------------------------------------------------------------------------------------------
Operating expenses:
  Selling, general and administrative         2,342       2,401       2,094       2,130       1,963
  Research, development and engineering         849         754         679         614         565
Gain on sale of product line, net               (45)

Operating income                              2,577       3,005       2,025       3,975       2,119
---------------------------------------------------------------------------------------------------
Income before income taxes                    2,833       3,250       2,102       3,997       2,012

Income taxes                                    720       1,210         777       1,459         150

Net income                                  $ 2,113     $ 2,040     $ 1,325     $ 2,538     $ 1,862
---------------------------------------------------------------------------------------------------
Net income per common share                    $.52        $.52        $.34        $.66        $.57
---------------------------------------------------------------------------------------------------
Weighted average number of common and
  common equivalent shares                    4,098       3,899       3,858       3,822       3,285
---------------------------------------------------------------------------------------------------
Balance sheet:
  Working capital                           $10,088     $ 8,380     $ 5,927     $ 4,211     $ 2,147
  Total assets                               22,414      12,857      10,905       8,564       5,850
  Long-term debt, less current maturities     5,271                                             308
  Shareholders' equity                       13,816      10,982       8,671       6,762       3,635
---------------------------------------------------------------------------------------------------
</TABLE>

                                   PHOTOGRAPH

                                                                               1

<PAGE>

TO OUR SHAREHOLDERS


Fiscal year 1996 was a building year for HEI - establishing a foundation for
future growth.  Having nearly reached the limits of our Victoria, Minnesota
plant capacity in fiscal 1995, we undertook a major construction and capacity
expansion program throughout the past year.  Manufacturing floor space was more
than doubled by a 23,000 square foot building addition featuring designed-in
flexibility to accommodate production line layout changes, and extensive
environmental controls critical to the maintenance of our precision and quality
standards.  In addition, we installed over $2 million of new continuous flow
processing equipment and expanded our technical support staff accordingly.  As
one result, HEI's capabilities have been enhanced to include a greater variety
of ultraminiature microelectronic packaging solutions - ceramic, flexible
circuit and laminate - to better satisfy our customers' requirements.

     We closed the year on the upswing; revenue for the fourth quarter of fiscal
1996 was $6,397,000, setting a company record and comparing favorably to revenue
of $5,418,000 for the fourth quarter of the previous year.  Net income for the
fourth quarter of fiscal 1996 was $1,329,000, or $.32 per share.  Of the $.32
recorded, $.07 was due to a one-time favorable adjustment in a deferred tax
item.  Net income for the fourth quarter of fiscal 1995 was $314,000, or $.08
per share.

     Revenue For the 1996 fiscal year was $20,680,000, compared to $23,423,000
for fiscal 1995.  Net income for fiscal 1996 was $2,113,000, or $.52 per share,
compared to net income of $2,040,000, or $.52 per share for fiscal 1995.  Fourth
quarter performance reflected the beginning of higher volume production on a
previously announced program to manufacture microelectronic devices for high
density disk drives.  We were pleased to see volumes on this program increase,
and are aggressively pursuing improved production efficiencies to meet the
significantly lower cost objectives required when the program reaches full
volume pricing.  We do not expect the fourth quarter's higher gross margin rates
to continue throughout  fiscal year 1997.  At present, we anticipate this
program reaching full volume production sometime during the first or second
quarter of fiscal 1997.

     As we have seen in the past, these relatively large and dynamic programs
can increase the volatility of our quarter-to quarter performance.  The phase-
out of one such program resulted in a downturn in fourth quarter results for
fiscal 1995, and had a continuing negative impact on the first three quarters of
fiscal 1996.  During that period, however, we were gratified by the substantial
growth of shipments to the hearing and medical instrument markets, reflecting
previous efforts targeting these sectors.  It is strategically important that we
continue to keep these segments of our business in balance with the more
volatile and unpredictable computer portion.

     On August 29, 1996, we announced the sale of our FastPoint-Registered
Trademark- Light Pen product line.  This product, while a good application of
HEI's technology, represented a relatively small and divergent part of our
overall business, and we anticipate no substantial effect of the sale on our
ongoing performance.  We believe that it is increasingly important and
potentially rewarding to focus all our energies and resources on the growth
opportunities in HEI's mainstream business - the design and manufacture of
custom microelectronic devices for selected niche markets.

     We have continued to strengthen our financial position.  The recent
facility expansion, and certain of the manufacturing process equipment to be
housed therein, have been financed through the issuance of $5.6 million of
Industrial Development Revenue Bonds by the City of Victoria.  As of August 31,
1996, we had $2,455,000 of unexpended proceeds from these bonds, which have a
maturity of seven to fifteen years.  HEI's shareholders' equity was $13,816,000
at August 31, 1996, up $2,834,000 from the end of the previous fiscal year.

2

<PAGE>

1997 PLANS

     Major objectives for 1997 will be growth and productivity improvements as
enabled by the augmentation of our manufacturing capabilities and the expansion
of our base of business - to enhance the stability of our future performance.
The facility addition is expected to help alleviate customer concerns related to
our size and open the door for new opportunities.  We will continue to focus on
target applications in the computer, industrial, medical and hearing
instrumentation markets, and continue efforts to strengthen and expand a
balanced base of accounts for long-term growth.

     As before, we will pursue goals of quality and productivity improvement.
We know that growth brings with it change and challenge, and we expect the ISO
9001 quality standard and our internal quality programs to continue to serve us
well, providing a foundation for these and future improvements.

[PHOTOGRAPH]

     With strong financial position, we expect to be well positioned to deal
with the potential uncertainties of our markets, and to be able to finance the
growth and expansion opportunities available to us in fiscal 1997.  A foundation
of talented employees and loyal customers provides the basis for our growth and
continuous improvement.  We expect that the recent facility and equipment
additions will enhance our ability to compete profitably on larger contracts,
and we look forward to the challenges of 1997 and beyond with enthusiasm and
optimism.


Eugene W. Courtney
PRESIDENT AND
CHIEF EXECUTIVE OFFICER

FORWARD-LOOKING STATEMENTS

     THIS ANNUAL REPORT INCLUDES FORWARD-LOOKING STATEMENTS MADE PURSUANT TO THE
SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.
THESE STATEMENTS CONTAIN INFORMATION REGARDING TECHNOLOGY, MARKETS, GROWTH AND
EARNINGS EXPECTATIONS BASED ON THE COMPANY'S CURRENT ASSUMPTIONS INVOLVING A
NUMBER OF RISKS AND UNCERTAINTIES.  THERE ARE CERTAIN IMPORTANT FACTORS THAT CAN
CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THE FORWARD-LOOKING STATEMENTS,
INCLUDING, WITHOUT LIMITATION, ADVERSE BUSINESS OR MARKET CONDITIONS; THE
ABILITY OF THE COMPANY TO SECURE AND SATISFY CUSTOMERS; THE AVAILABILITY AND
COST OF MATERIALS FROM HEI'S SUPPLIERS; ADVERSE COMPETITIVE DEVELOPMENTS; AND
OTHER FACTORS DISCUSSED FROM TIME TO TIME IN THE COMPANY'S FILINGS WITH THE
SECURITIES AND EXCHANGE COMMISSION.  READERS ARE CAUTIONED NOT TO PLACE UNDUE
RELIANCE ON FORWARD-LOOKING STATEMENTS; HEI UNDERTAKES NO OBLIGATION TO UPDATE
THESE STATEMENTS TO REFLECT ENSUING EVENTS OR CIRCUMSTANCES, OR SUBSEQUENT
ACTUAL RESULTS.

                                                                               3

<PAGE>

MANAGEMENT'S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

FINANCIAL CONDITION

The Company's net cash flow provided by operating activities for the year ended
August 31, 1996, was $2,316,000.  The significant components of this operating
net cash flow were positive cash flow of $2,884,000 from operations before
changes in current operating items offset by a $1,539,000 increase in accounts
receivable.  The increase in accounts receivable is attributable primarily to
higher shipment volumes in the fourth quarter of 1996 compared to the fourth
quarter of 1995.

     Accounts receivable average days outstanding were 41 days as of August 31,
1996 compared to 42 days for the same period a year ago.  Inventory turns were
7.7 turns as of August 31, 1996 compared to 7.5 turns for the same period a year
ago.  The inventory turn increase is primarily due to higher shipments in the
fourth quarter of fiscal 1996 and lower inventory levels at August 31, 1996.

     In addition to purchasing $2,464,000 of fixtures and equipment and
completing a building addition of $2,377,000, the Company increased short-term
investments, primarily in treasury bills, to $5,488,000, up $1,668,000 from a
year ago.  The current ratio at the end of 1996 was 4.4:1 as compared to 6.2:1
at the end of last year.  The lower current ratio is principally due to over $2
million of internally generated funds invested in the Company's plant expansion
and to the increase in current liabilities including current portion of long-
term debt and increased accounts payable, accrued liabilities and income taxes
payable.

     In April 1996, the Company completed a new financing agreement which
provides for a $3,000,000 revolving line of credit.  As of August 31, 1996,
there were no borrowings under the line.  Borrowings under this agreement would
be collateralized by accounts receivable.  The agreement contains certain
restrictive covenants including limitations on other borrowings and maintenance
of specified financial levels and ratios for net income, tangible net worth and
debt to tangible net worth.  Borrowings are limited to the lesser of $3,000,000
or the borrowing base, which is 80% of eligible accounts receivable.  Interest
on the borrowings is based, at the Company's option, on the lender's prime rate
of interest or 2% above the lender's LIBOR rate.

     During fiscal 1996, the Company purchased $4,841,000 of property and
equipment, including a facility addition, manufacturing facility improvements
and capital equipment.  These additions will increase manufacturing capacity to
meet anticipated requirements for continued revenue growth. These expenditures
were funded primarily through the issuance of Industrial Development Revenue
Bonds of $5,625,000, which was completed in April 1996.  Restricted cash of
$2,455,000 at August 31, 1996 represents the unexpended funds from the bonds
which are available to the Company for qualifying capital expenditures during
the next three years.

     During fiscal 1997, the Company intends to expend approximately $1.8
million for manufacturing facility improvements and capital equipment.  These
additions will increase manufacturing capacity to meet anticipated requirements
for continued revenue growth.  It is expected that these expenditures will be
funded primarily through long-term financing.

RESULTS OF OPERATIONS

SALES BY PRODUCT LINE

(IN THOUSANDS)               1996        1995        1994

Microelectronics          $18,545     $21,187     $14,888
Peripheral products         2,060       2,157       2,334
Other                          75          79          73
Total                     $20,680     $23,423     $17,295
--------------------------------------------------------------


SALES.  1996 VS. 1995:  Sales in 1996 decreased $2,743,000 or 12% from fiscal
1995.  Sales of microelectronic circuits, which include opto-electronic
circuits, decreased 12% from $21.2 million to $18.5 million.  This decrease was
primarily due to reduced shipments to the high density disk drive market as two
large programs were completed in late 1995 and early 1996 and was partially
offset by the ramp up in the late second half of fiscal 1996 of shipments to
another computer disk drive manufacturer.  Shipments to the hearing aid and
other medical markets more than doubled over fiscal year 1995 as a result of
increased demand by current customers and shipments to new accounts.

     Because the Company's sales to the computer disk drive market are generally
tied to the customers' projected sales and production of the related product,
the Company's sales levels are subject to fluctuations outside the Company's
control.  To the extent that sales to any one customer represent a significant
portion of the Company's sales, any change in the level of sales to that
customer can have a significant impact on the Company's total revenues.  In
addition,

4

<PAGE>

production for one customer may conclude while production for a new customer has
not yet begun or is not yet at full volume.  These factors may result in
significant fluctuations in sales from quarter to quarter.

     Shipments of peripheral products, primarily light pens, decreased 4% from
fiscal 1995.  The light pen product line was sold to FTG Data Systems in August
1996.

     1995 VS. 1994:  Sales in 1995 increased 35% from fiscal 1994, from $17.3
million to $23.4 million.  Sales of microelectronic circuits increased 42% from
the prior year from $14.9 million to $21.2 million.  This increase was primarily
due to increased shipments in 1995 of microelectronic devices to the computer
disk drive market, primarily to the IBM Corporation and another disk drive
manufacturer.

PERCENTAGE OF SALES
                            1996       1995       1994

Sales                       100%       100%       100%
Gross profit                 28%        26%        28%
Selling, general and
   administrative            11%        10%        12%
Research, development
   and engineering            4%         3%         4%

GROSS PROFIT.  1996 VS. 1995:  The Company's gross profit as a percentage of
sales was 28% in 1996, compared to 26% in 1995.  The increased gross profit rate
reflects primarily the impact of a higher number of products built utilizing
customer supplied materials.  While the gross margin rate for fourth quarter
fiscal 1996 was 36%, the Company does not expect that rate to continue
throughout fiscal 1997.

     1995 VS. 1994:  The Company's gross profit as a percentage of sales was 26%
in 1995, compared to 28% in 1994.  The reduced gross profit rate reflected
primarily the impact of increased competitive pressures to lower prices on new
programs.

OPERATING EXPENSES.  1996 VS. 1995:  Fiscal year 1996 selling, general and
administrative expenses decreased 2% from 1995 and research, development and
engineering expenses increased 13%.  The decrease in selling, general and
administrative expense was primarily due to a reduction in bad debt expense in
1996.  The increase in research, development and engineering was primarily in
support of increased product development for new disk drive, hearing aid and
medical products.  As a percentage of sales, selling, general and administrative
expenses for fiscal 1996 increased to 11% versus 10% for fiscal 1995 reflecting
decreased sales.

     The $45,000 net gain on sale of product line represents the gain on the
sale of the light pen product line to FTG Data Systems, which was completed in
August 1996, partially offset by costs to close down the light pen product line
(see Note 3).

     1995 VS. 1994:  Fiscal year 1995 selling, general and administrative
expenses increased 15% and research, development and engineering expenses
increased 11% from the prior year.  Both increases were in support of increased
product development and production.  As a percentage of sales, selling, general
and administrative expenses for fiscal 1995 decreased to 10% versus 12% for
fiscal 1994 reflecting increased sales.

OTHER INCOME.  1996 VS. 1995:  Other income increased $11,000 over fiscal year
1995 primarily due to increased interest income from higher short-term
investment balances, partially offset by interest expense on the IDRB.

     1995 VS. 1994:  Other income increased $168,000 primarily due to increased
interest income.

NET INCOME.  1996 VS. 1995:  The Company had net income of $2,113,000 for 1996
compared to net income of $2,040,000 for 1995. Operating income of $2,577,000
was down $428,000 from 1995 reflecting a revenue decrease of $2,743,000.  The
increase in net income was primarily due to lower income tax expense.  The
valuation allowance for the deferred tax asset of $274,000 was eliminated in the
fourth quarter of 1996 as a result of the sale and disposal of the light pen
inventory and the determination that the deferred tax assets related to the
remaining inventory allowance will most likely be recoverable.  The elimination
of the remaining deferred tax asset valuation allowance resulted in a reduced
effective tax rate in fiscal 1996.  The effective tax rate for fiscal 1996 was
25% versus 37% for 1995.

     1995 VS. 1994:  The Company had net income of $2,040,000 for 1995 compared
to net income of $1,325,000 for 1994.  This increase was due to a sales increase
of 35%, partially offset by a reduced gross profit rate of 26% in fiscal 1995
compared to 28% in fiscal 1994, and an operating expense increase of $382,000.

                                                                               5

<PAGE>

HEI, INC.
BALANCE SHEET
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>

AS OF AUGUST 31                                                    1996          1995
<S>                                                             <C>           <C>
ASSETS

Current assets:
  Cash and cash equivalents                                     $ 1,186       $ 1,438
  Short-term investments                                          5,488         3,820
                                                                  6,674         5,258
  Accounts receivable, net                                        4,039         2,525
  Inventories                                                     1,561         1,851
  Other, principally deferred tax assets                            764           349

Total current assets                                             13,038         9,983
-------------------------------------------------------------------------------------
Property and equipment:
  Land                                                              216           184
  Building and improvements                                       3,767         1,398
  Fixtures and equipment                                          7,667         5,475
  Accumulated depreciation                                       (4,868)       (4,183)

Net property and equipment                                        6,782         2,874

Restricted cash                                                   2,455
Deferred financing costs                                            139

Total assets                                                    $22,414       $12,857
-------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
  Current portion of long-term debt                             $   354
  Accounts payable                                                  673       $   385
  Accrued liabilities                                             1,354         1,043
  Income taxes payable                                              569           175

Total current liabilities                                         2,950         1,603
-------------------------------------------------------------------------------------
Long-term debt                                                    5,271
Deferred tax liability                                              377           272

Shareholders' equity:
  Undesignated stock; 5,000,000 shares authorized,
    none issued
  Common stock, $.05 par; 10,000,000 shares authorized;
    4,030,427 and 3,791,597 shares issued and outstanding           202           190
  Paid-in capital                                                 6,892         6,183
  Retained earnings                                               6,722         4,609

Total shareholders' equity                                       13,816        10,982

Total liabilities and shareholders' equity                      $22,414       $12,857
-------------------------------------------------------------------------------------
</TABLE>


THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS.

6

<PAGE>

HEI, INC.
STATEMENT OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


YEARS ENDED AUGUST 31                           1996         1995         1994

Net sales                                    $20,680      $23,423      $17,295
Cost of sales                                 14,957       17,263       12,497

Gross profit                                   5,723        6,160        4,798
--------------------------------------------------------------------------------
Operating expenses:
  Selling, general and administrative          2,342        2,401        2,094
  Research, development and engineering          849          754          679
Gain on sale of product line, net                (45)

Operating income                               2,577        3,005        2,025
--------------------------------------------------------------------------------
Other, principally interest income              (256)        (245)         (77)

Income before income taxes                     2,833        3,250        2,102
--------------------------------------------------------------------------------
Income taxes                                     720        1,210          777

Net income                                    $2,113       $2,040       $1,325
--------------------------------------------------------------------------------
Net income per common share                    $0.52        $0.52        $0.34
--------------------------------------------------------------------------------
Weighted average number of common and
  common equivalent shares                 4,097,765    3,898,662    3,857,737
--------------------------------------------------------------------------------

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS.

                                                                               7

<PAGE>

HEI, INC.
STATEMENT OF CHANGES IN
SHAREHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>

                                             COMMON STOCK   COMMON STOCK     PAID-IN    RETAINED
                                                   SHARES         AMOUNT     CAPITAL    EARNINGS
                                              OUTSTANDING    OUTSTANDING
<S>                                          <C>            <C>              <C>        <C>
BALANCE, AUGUST 31, 1993                        3,633,435           $182      $5,336      $1,244
  Net income                                                                               1,325
  Issuance of common shares
    under employee stock purchase
    and option plans                               52,085              2         124
  Tax benefit of nonqualified stock options                                      458

BALANCE, AUGUST 31, 1994                        3,685,520            184       5,918       2,569
  Net income                                                                               2,040
  Issuance of common shares
    under employee stock purchase
    and option plans                              106,077              6         215
  Tax benefit of nonqualified stock options                                       50

BALANCE, AUGUST 31, 1995                        3,791,597            190       6,183       4,609
  Net income                                                                               2,113
  Issuance of common shares
    under employee stock purchase
    and option plans                              238,830             12         636
  Tax benefit of nonqualified stock options                                       73

BALANCE, AUGUST 31, 1996                        4,030,427           $202      $6,892      $6,722
-----------------------------------------------------------------------------------------------------
</TABLE>

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS.

8

<PAGE>

HEI, INC.
STATEMENT OF CASH FLOWS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>

YEARS ENDED AUGUST 31                                           1996       1995       1994
<S>                                                           <C>        <C>        <C>
Cash flow provided by operating activities:
  Net income                                                  $2,113     $2,040     $1,325
  Depreciation and amortization                                  938        759        640
  Provision for doubtful accounts                                 25        141        150
  Deferred income tax benefit                                   (198)
  Other                                                            6          3          4

Changes in current operating items:
  Accounts receivable                                         (1,539)       755     (1,248)
  Inventories                                                    290        (22)      (739)
  Other current assets                                          (112)        21         30
  Accounts payable                                                88       (319)       140
  Accrued liabilities                                            311        179          3
  Income taxes payable                                           394       (191)       306

Net cash flow provided by operating activities                 2,316      3,366        611
-----------------------------------------------------------------------------------------------
Cash flow used for investing activities:
  Purchases of short-term investments                         (7,033)    (6,910)      (936)
  Maturities of short-term investments                         5,365      3,808      1,044
  Additions to property and equipment                         (4,621)      (634)      (825)
  Increase in restricted cash                                 (2,455)

Net cash flow used for investing activities                   (8,744)    (3,736)      (717)
-----------------------------------------------------------------------------------------------
Cash flow provided by financing activities:
  Proceeds from long-term debt                                 5,625
  Increase in deferred financing costs                          (170)
  Principal payments for obligations under capital leases                   (42)       (47)
  Issuance of common stock                                       648        221        126
  Tax benefit of nonqualified stock options                       73         50        458

Net cash flow provided by financing activities                 6,176        229        537
-----------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents            (252)      (141)       431
Cash and cash equivalents, beginning of year                   1,438      1,579      1,148

Cash and cash equivalents, end of year                        $1,186     $1,438     $1,579
-----------------------------------------------------------------------------------------------

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

Interest paid                                                 $   80     $    2     $    6
Income taxes paid                                                515      1,351        429
</TABLE>

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THE FINANCIAL STATEMENTS.

                                                                               9

<PAGE>

NOTES TO FINANCIAL STATEMENTS

NOTE 1

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

HEI, Inc. (the Company) specializes in the design and manufacture of
ultraminiature microelectronic devices and high technology products
incorporating those devices.

CASH AND CASH EQUIVALENTS.  The Company considers its investments in all highly
liquid debt instruments with original maturities of three months or less at date
of purchase to be cash equivalents.  The carrying amount approximates fair value
because of the short maturity of those instruments.

INVENTORIES.  Inventories are stated at the lower of cost or market and include
materials, labor and overhead costs.  The first-in, first-out cost method is
used to value inventories.

     The allowance for excess or obsolete stock is determined based on the
Company's continuing analysis of inventory levels in excess of current
requirements or considered to be obsolete.  The Company has established an
allowance to record such inventories at estimated net realizable value.

PROPERTY AND EQUIPMENT.  Property and equipment are stated at cost.
Depreciation and amortization are provided on the straight-line method over the
estimated useful lives of the property and equipment.

     Maintenance and repairs are charged to expense as incurred.  Major
improvements and tooling costs are capitalized and depreciated over their
estimated useful lives.  The cost and accumulated depreciation of property and
equipment retired or otherwise disposed of are removed from the related
accounts, and any resulting gain or loss charged or credited to operations.

INCOME TAXES.  Deferred income tax assets and liabilities are recognized for the
expected future tax consequences of events that have been included in the
financial statements or tax returns.  Deferred income tax assets and liabilities
are determined based on the differences between the financial statement and tax
bases of assets and liabilities using currently enacted tax rates in effect for
the year in which the differences are expected to reverse.  Valuation allowances
are established when necessary to reduce deferred tax assets to the amount
expected to be realized.  Income tax expense is the tax payable for the periods
and the change during the period in deferred income tax assets and liabilities.

REVENUE RECOGNITION.  Revenue is recognized at the time of shipment.

NET INCOME PER COMMON SHARE.  Net income per common share is based on the
weighted average number of common and common equivalent shares, assuming the
exercise of stock options, when dilutive.

USE OF ESTIMATES.  The preparation of financial statements in conformity with
generally accepted accounting principles 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 expenses during the reporting period.
Actual results could differ from those estimates.

NOTE 2

MAJOR CUSTOMERS, CONCENTRATION OF CREDIT RISK AND GEOGRAPHIC DATA

Major customers, each of which accounted for more than 10% of the Company's
total sales for the years ended August 31, were as follows:


                   1996         1995         1994

Customer A          38%          12%          19%
Customer B          16%
Customer C          10%
Customer D                       27%
Customer E                       30%          49%

     The Company generally sells its products to original equipment
manufacturers in the United States and abroad in accordance with supply
contracts specific to certain manufacturer product programs.  The Company
performs ongoing credit evaluations of its customers' financial conditions and,
generally, does not require collateral from its customers.  The Company's
continued sales to these customers is often dependent upon the continuance of
the customers' product programs.  The Company's ten largest customers accounted
for approximately 88% of sales in 1996, 89% in 1995, and 86% in 1994 and
approximately 90% and 87% of accounts receivable at August 31, 1996 and 1995,
respectively.

     The Company had sales of  $5,924,000 and $2,230,000 to Singapore in 1996
and 1994, respectively, and $2,493,000 to Hong Kong in 1995.  Total export sales
were $7,278,000, $4,995,000 and $2,749,000 in 1996, 1995 and 1994, respectively.

10

<PAGE>

NOTE 3

OTHER FINANCIAL STATEMENT DATA

The Company had $1,282,000 and $1,608,000 of cash and cash equivalents at August
31, 1996 and 1995, respectively, invested with an affiliate of a single banking
institution.  Short-term investments consist of U.S. Treasury bills with
maturities of less than one year.  The short-term investments are carried at
amortized cost which approximates fair value.

     The following provides additional information concerning selected balance
sheet accounts at August 31, 1996 and 1995:

(DOLLARS IN THOUSANDS)                        1996         1995

Accounts receivable, net:
  Trade accounts receivable                 $4,309       $2,793
  Less allowance for doubtful accounts        (270)        (268)

                                            $4,039       $2,525
--------------------------------------------------------------------
Inventories:
  Purchased parts                           $1,394       $1,670
  Work in process                              697          907
  Finished goods                               182          233
  Less allowance for excess
    or obsolete stock                         (712)        (959)

                                            $1,561       $1,851
--------------------------------------------------------------------
Accrued liabilities:
  Vacation and employee benefits              $500         $398
  Payroll related                              255          220
  Real estate taxes                            110           75
  Warranty                                                  100
  Other                                        489          250

                                            $1,354       $1,043
--------------------------------------------------------------------

SALE OF LIGHT PEN PRODUCT LINE.  In August 1996, the Company sold its light pen
product line.  Through this transaction, the buyer acquired certain assets
including manufacturing equipment and related inventory, received product
licenses and assumed all warranties.  In connection with the sale, the Company
received a cash payment for the assets and an agreement for an additional amount
to be paid monthly over the next two years.  As a result of the sale of the
light pen product line, costs associated with the close down of the light pen
product line have been accrued at August 31, 1996 and are included in the
$45,000 net gain from the sale of the light pen product line.  The Company
anticipates no substantial effect of the sale on future operating results.

NOTE 4

FINANCING ARRANGEMENTS

In April 1996, the Company received proceeds of $5,625,000 from the issuance of
Industrial Development Revenue Bonds.  Of these funds, approximately $1,500,000
has been used for the construction of the new addition to the Company's
manufacturing facility, and the remainder will be or has been used for equipment
purchases.  The bonds related to the facility expansion require annual principal
payments of $90,000 in the first year and $95,000 on April 1 of each year
thereafter through 2011.  The bonds related to the equipment require payments
over seven years from the date of purchase of the equipment through no later
than April 1, 2006.  The bonds bear interest at a rate which varies weekly,
based on comparable tax exempt issues, and is limited to a maximum rate of 10%.
The interest rate at August 31, 1996 was 3.95%.  A revolving commitment fee is
paid annually to the bank at a rate of 1% of the average daily unused revolving
commitment.  The agreement contains certain restrictive covenants including
limitations on other borrowings and maintenance of specified financial levels
and ratios for net income, tangible net worth, debt to tangible net worth, cash
flow and indebtedness.  The bonds are collateralized by two irrevocable letters
of credit and essentially all property and equipment.  Restricted cash on the
balance sheet represents cash advanced under the bonds which is held by the bond
trustee in an interest bearing account and will be released to the Company over
the next three years for equipment purchases.  To the extent such funds are not
expended, they will revert back to the bond holders.

     Also in April 1996, the Company extended the due date of its $3,000,000
revolving line of credit to April 1998.  At August 31, 1996 and 1995, there were
no borrowings under the line of credit.  Any borrowings under this agreement are
collateralized by accounts receivable.  The agreement contains certain
restrictive covenants including limitations on other borrowings and maintenance
of specified financial levels and ratios for net income, tangible net worth and
debt to tangible net worth and cash flow.  Borrowings are limited to the lesser
of $3,000,000 or the borrowing base, which is 80% of eligible accounts
receivable.  Interest on the borrowings is based, at the Company's option, on
the lender's prime rate of interest or at 2% above the lender's LIBOR rate.

                                                                              11

<PAGE>

NOTES TO FINANCIAL STATEMENTS
(CONTINUED)

     Principal maturities of long-term debt, excluding the unexpended funds
classified as restricted cash at August 31, 1996 are as follows (in thousands):

Years ending August 31,
1997                                              $ 354
1998                                                359
1999                                                359
2000                                                358
2001                                                358
Thereafter                                        1,382

                                                  3,170

Restricted cash                                   2,455

                                                 $5,625
------------------------------------------------------------

NOTE 5

INCOME TAXES

Income tax expense for the years ended August 31 consisted of the following:

(DOLLARS IN THOUSANDS)      1996         1995       1994

Current:
  Federal                   $829       $1,106       $730
  State                       89          104         47
Deferred                    (198)

Income tax expense          $720       $1,210       $777
------------------------------------------------------------

     The components of the deferred tax assets and liability at August 31, 1996
and 1995 are as follows:

(DOLLARS IN THOUSANDS)                   1996         1995

Deferred tax assets:
  Allowance for doubtful accounts       $ 138       $   99
  Inventories                             199          274
  Accrued liabilities                     162          101
  Other                                    76           72

                                          575          546
Valuation allowance                                   (274)

                                        $ 575       $  272
------------------------------------------------------------
Deferred tax liability:
  Depreciation                          $(377)      $ (272)
------------------------------------------------------------

     Management has eliminated the valuation allowance for the deferred tax
asset related to the allowance established for excess or obsolete inventories
due to the sale and disposal of light pen inventories during the fourth quarter
of fiscal 1996 and the determination that the deferred tax asset related to the
remaining inventory allowance will most likely be recoverable.

     A reconciliation of the statutory federal income tax rate for the years
ended August 31 is as follows:

                                  1996     1995     1994

Federal statutory tax rate       34.0%    34.0%    34.0%
State income tax rate
  (net of federal tax effect)     2.7      3.2      3.0
Reversal of valuation
  allowance                      (9.7)
Other                            (1.6)

Effective tax rate               25.4%    37.2%    37.0%
------------------------------------------------------------


NOTE 6

STOCK BENEFIT PLANS

1989 PLAN.  Under the Company's 1989 Omnibus Stock Compensation Plan (the "1989
Plan"), a maximum of 1,200,000 shares of common stock may be issued, including
qualified and nonqualified stock options, stock purchase rights and other stock-
based awards.

     Stock options granted become exercisable in varying increments and
generally expire five years after date of grant.  The exercise price for options
granted is equal to the market price of the common stock on the date of grant.

     Under the 1989 Plan, substantially all regular full-time employees are
given the opportunity to designate up to 10% of their annual compensation to be
withheld, through payroll deductions, for the purchase of common stock at 85% of
the lower of (i) the market price at the beginning of the plan year, or (ii) the
market price at the end of the plan year.  During fiscal 1996, 1995 and 1994,
26,330, 22,077 and 12,235 shares at prices of $3.96, $3.95 and $4.74,
respectively, were purchased under the 1989 Plan.

12

<PAGE>

DIRECTORS' OPTIONS.  In fiscal 1990, the Company granted to its directors
(including officers who were also directors) options to purchase, in the
aggregate, 227,500 shares of common stock at an average price of $1.34 per
share.  At August 31, 1996, all of these options have been exercised.

DIRECTORS' PLAN.  Under the plan, 400,000 shares are authorized for issuance,
with an annual grant of 10,000 shares to each non-employee director.  These
grants are effective on the first business day following the annual
shareholders' meeting at an exercise price equal to the fair market value on the
date of grant.  The options become exercisable one year after the grant date and
expire five years after the grant date.  Options to purchase 40,000 shares were
granted each year to the four non-employee directors at $6.00 per share, $4.71
per share and $5.425 per share in 1996, 1995 and 1994, respectively.  At August
31, 1996, options on 170,000 shares remain outstanding and options on 200,000
shares are available for grant.

SUMMARY OF ACTIVITY.  The following is a summary of all activity involving
options for the years ended August 31:

                                    1996            1995            1994

Outstanding,
  beginning of year              692,000         398,500         346,100
Granted                          110,000         377,500          92,500
Exercised                       (212,500)        (84,000)        (39,850)
Cancelled                                                           (250)

Outstanding, end of year         589,500         692,000         398,500

---------------------------------------------------------------------------
Exercisable, end of year         253,375         308,500         212,500
Available for grant              214,230         350,560         750,137
Exercise price of options
  outstanding                $.725-$6.60     $.725-$6.60     $.725-$6.60

ACCOUNTING FOR STOCK-BASED COMPENSATION.  In October 1995, the Financial
Accounting Standards Board issued Statement of Financial Accounting Standards
No. 123, a new standard of accounting and reporting for stock-based compensation
plans.  The Company is not required to adopt the new standard until fiscal 1997.
The Company will continue to measure compensation cost, if any, for its stock
option plans using the intrinsic value based method of accounting it has
historically used.  Therefore, the new standard will have no effect on the
Company's operating results.  The Company's financial statement disclosures will
be expanded in fiscal 1997, as required, to include pro forma disclosures as if
the fair value based method of accounting had been followed.

RIGHTS PLAN.  The Company's shareholder rights plan provides for a dividend
distribution of one right for each share of common stock to shareholders of
record at the close of business on June 10, 1988.  With certain exceptions, the
rights will become exercisable only in the event that an acquiring party
accumulates 20% or more of the Company's voting stock or a party announces an
offer to acquire 30% or more of the voting stock.  The rights will expire on
June 10, 1998, if not previously redeemed or exercised.  Each right will entitle
the holder to purchase one-fourth of one common share at a price of $6.00 per
share, subject to adjustment under certain circumstances.  In addition, upon the
occurrence of certain events, holders of the rights will be entitled to purchase
a defined number of shares of an acquiring entity or the Company's common stock
at half its then current market value.   The Company will generally be entitled
to redeem the rights at $.05 per right at any time until the tenth day following
the acquisition of 20% or more or an offer to acquire 30% or more of the
Company's voting stock.

NOTE 7

EMPLOYEE BENEFIT PLANS

The Company has a 401(k) plan covering all eligible employees.  Employees can
make voluntary contributions to the plan of up to 20% of their compensation, not
to exceed the maximum specified by the Internal Revenue Code.  The plan also
provides for a discretionary contribution by the Company.  During fiscal years
1996, 1995 and 1994, the Company contributed $96,000, $75,000 and $65,000,
respectively, to the plan.

                                                                              13

<PAGE>

REPORT OF INDEPENDENT ACCOUNTANTS

TO THE SHAREHOLDERS OF HEI, INC.:

We have audited the accompanying balance sheet of HEI, Inc. as of August 31,
1996 and 1995, and the related statements of operations, changes in
shareholders' equity, and cash flows for the years ended August 31, 1996, 1995
and 1994.  These financial statements are the responsibility of the Company's
management.  Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement.  An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements.  An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of HEI, Inc. as of August 31, 1996
and 1995, and the results of its operations and its cash flows for the years
ended August 31, 1996, 1995 and 1994, in conformity with generally accepted
accounting principles.



Minneapolis, Minnesota
October 4, 1996


STATEMENT OF FINANCIAL RESPONSIBILITY

The accompanying financial statements, including the notes thereto, and other
financial information presented in this Annual Report, were prepared by
management, which is responsible for their integrity and objectivity.  The
financial statements have been prepared in accordance with generally accepted
accounting principles and include amounts that are based upon management's best
estimates and judgments.

The Company maintains a system of internal accounting controls designed to
provide reasonable assurance that the Company's assets are protected and that
transactions are executed in accordance with established authorizations and are
recorded properly.  The reasonable assurance concept is based on recognition
that the cost of a system of internal accounting controls should not exceed the
benefit derived.

The Audit Committee of the Board of Directors is responsible for recommending
the independent accounting firm to be retained for the coming year.  The Audit
Committee meets periodically and privately with the independent public
accountants, as well as with management, to review accounting, auditing, and
financial reporting matters.

The Company's independent accountants, Coopers & Lybrand L.L.P., are engaged to
audit the financial statements of the Company and to issue their report thereon.
Their audit has been performed in accordance with generally accepted auditing
standards.

14

<PAGE>

SUMMARY OF QUARTERLY OPERATING RESULTS (UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)


FISCAL YEAR 1996                    FIRST     SECOND      THIRD     FOURTH

Net sales                          $4,710     $4,917     $4,656     $6,397
Gross profit                        1,050      1,255      1,093      2,325
Operating income                      267        482        284      1,544
Net income                            224        342        218      1,329
----------------------------------------------------------------------------
Net income per share                 $.06       $.08       $.05       $.32
----------------------------------------------------------------------------

FISCAL YEAR 1995                    FIRST     SECOND      THIRD     FOURTH

Net sales                          $5,947     $5,924     $6,134     $5,418
Gross profit                        1,916      1,735      1,328      1,181
Operating income                    1,081        952        526        446
Net income                            710        652        364        314
----------------------------------------------------------------------------
Net income per share                 $.18       $.17       $.09       $.08
----------------------------------------------------------------------------

NOTE:

The summation of quarterly net income per share on a primary basis for 1996 does
not equate to the calculation for the year since the quarterly calculations are
performed on a discrete basis.

                                                                              15

<PAGE>

CORPORATE INFORMATION


HEI INC

BOARD OF DIRECTORS

ROBERT L. BRUECK
CONSULTANT

EUGENE W. COURTNEY
PRESIDENT AND
CHIEF EXECUTIVE OFFICER
HEI, INC.

WILLIAM R. FRANTA
FORMER SENIOR VICE PRESIDENT
NETWORK SYSTEMS CORPORATION

KENNETH A. SCHOEN
EXECUTIVE VICE PRESIDENT (RET.)
3M COMPANY

FREDERICK M. ZIMMERMAN
CHAIR OF MANUFACTURING SYSTEMS
ENGINEERING DEPARTMENT
UNIVERSITY OF ST. THOMAS


CORPORATE OFFICERS
AND MANAGEMENT

EUGENE W. COURTNEY
PRESIDENT AND
CHIEF EXECUTIVE OFFICER

JERALD H. MORTENSON
VICE PRESIDENT OF FINANCE
AND ADMINISTRATION,
CHIEF FINANCIAL OFFICER
AND TREASURER

DALE A. NORDQUIST
VICE PRESIDENT OF SALES
AND MARKETING

THOMAS G. EASTER
DIRECTOR OF MANUFACTURING

SCOTT J. KAZLE
DIRECTOR OF ENGINEERING

WRAY A. WENTWORTH
DIRECTOR OF CORPORATE QUALITY


GENERAL COUNSEL

Moss &  Barnett
A Professional Association
Minneapolis, Minnesota


INDEPENDENT ACCOUNTANTS

Coopers & Lybrand L.L.P.
Minneapolis, Minnesota


STOCK TRANSFER AGENT
AND REGISTRAR

Norwest Bank Minnesota, N.A.
Box 738
161 North Concord Exchange
South St. Paul
Minnesota  55075-0738


CORPORATE HEADQUARTERS

HEI, Inc.
P.O. Box 5000
1495 Steiger Lake Lane
Victoria, Minnesota  55386-5000
(612) 443-2500
E-mail:  headqtrs@heii.com
Internet:  www.heii.com


FORM 10-KSB

A copy of the Company's Annual Report to the Securities and Exchange Commission
on Form 10-KSB is available without charge by written or oral request to:

Shareholder Relations
HEI, Inc.
P.O. Box 5000
Victoria, Minnesota  55386
Phone (612) 443-2500
Facsimile (612) 443-2668


ANNUAL MEETING OF SHAREHOLDERS

The Company's annual meeting of shareholders will be held on January 22, 1997 at
3:00 PM at the Marquette Hotel (4th floor), 710 Marquette Avenue, Minneapolis,
Minnesota.


MARKET PRICE AND RELATED MATTERS

The Company's common stock is currently traded on The Nasdaq National Market
under the symbol HEII.  Below are the high and low closing bid prices for each
quarter of fiscal year 1996 and 1995, as reported on The Nasdaq.  These
quotations represent prices between dealers, do not include retail markups,
markdowns or commissions, and may not represent actual transactions.

1996                      HIGH             LOW
                        ----------------------
First Quarter           $6-7/8          $4-3/4
Second Quarter           6-5/8           5-1/4
Third Quarter                8           5-1/2
Fourth Quarter               8           5-1/2

1995                      HIGH             LOW
                        ----------------------
First Quarter           $    6          $4-1/4
Second Quarter           5-1/2           4-1/8
Third Quarter            5-1/2           4-3/8
Fourth Quarter           6-3/8           4-1/4

As of August 31, 1996, the Company had approximately 3,150 shareholders of which
approximately 560 are shareholders of record.  The Company does not declare cash
dividends.

16