##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-K




(Amendment No. 2)







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|  |  |                                                                                     
|- |  | ------------------------------------------------------------------------------------
|þ |  | ANNUAL REPORT UNDER SECTION 13 OR
	15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934    
| 
|  |  | For fiscal year ended August 31,
	2001.                                             
| 
|o |  | TRANSITION REPORT UNDER SECTION 13 OR
	15(d)
	OF THE SECURITIES EXCHANGE ACT OF 1934
| 
|  |  | For the transition period
	from           to           .                            

Commission file number 0-10078

HEI, Inc.

(Exact name of registrant as specified in its
Charter)


|                                                                                              |  |                                      
|--------------------------------------------------------------------------------------------- |  | -------------------------------------
|                                                                                             
|                                                                                             
|                                                                                             
|                                                                                             
|Minnesota                                                                                     |  | 41-0944876                           
|(State or other jurisdiction of
	incorporation or organization)                               |  | (I.R.S. Employer
	Identification No.)
|                                                                                             
|                                                                                             
|                                                                                             
|                                                                                             
|                                                                                             
|P.O. Box 5000, 1495 Steiger Lake Lane,
	Victoria, MN(Address of principal executive
	offices) |  | 55386(Zip Code)                      

Issuers telephone number, including area
code:

(952) 443-2500


Securities registered pursuant to
Section 12(b) of the Exchange Act:

None


Securities registered pursuant to
Section 12(g) of the Exchange Act:

Common Stock, Par Value $.05 Per
Share

(Title of Class)

Indicate by check
mark whether the issuer (1) filed all reports required to
be filed by Section 13 or 15(d) of the Exchange Act during
the past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past
90 days.     Yes þ          No o

Indicate if no
disclosure of delinquent filers in response to Item 405 of
Regulation S-K is contained in this form, and no disclosure
will be contained, to the best of registrants knowledge,
in definitive proxy or information statements incorporated by
reference in Part III of this
Form 10-K.     þ




The aggregate
market value, in thousands, as of December 10, 2001 (based
on the closing price as reported by The Nasdaq National Market)
of the voting stock held by non-affiliates was approximately
$33,460,639.







As of
December 10, 2001, 5,985,710 Common Shares, par value
$.05 per share, were outstanding.






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TABLE OF CONTENTS



|                                                                 |  |  |  |  |  |  |  | 
|---------------------------------------------------------------- |  |  |  |  |  |  |  | 
|RESULTS OF OPERATIONS                                           
|CONSOLIDATED BALANCE SHEETS                                     
|CONSOLIDATED STATEMENTS OF OPERATIONS                           
|CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY      
|CONSOLIDATED STATEMENTS OF CASH FLOWS                           
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                      
|INDEPENDENT AUDITORS REPORT                                    
|PART III                                                        
|HEI, INC. COMPENSATION COMMITTEE REPORT TO THE BOARD FISCAL 2001
|STOCKHOLDER RETURN PERFORMANCE PRESENTATION                     
|SIGNATURES                                                      
|Promissory Note                                                 
|Subsidiaries of the Registrant                                  
|Consent of KPMG LLP                                             



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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, which involve a number of risks and
uncertainties. There are certain important factors that can
cause actual results to differ materially from the
forward-looking statements, including, without limitation,
adverse business or market conditions; the ability of the
Company to attract and satisfy customers; the availability and
cost of materials from HEIs suppliers; adverse competitive
developments; change in or cancellation of customer
requirements; 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.

HEI, Inc. and subsidiaries are referred to herein
as HEI, the Company, us, we or our, unless the context indicates
otherwise. All dollar amounts are in thousands of US dollars
except for per share amounts.

PART I

(Dollars in thousands)


Item 1.     Description
of Business

(a) Business Development

We are a Minnesota corporation and were
incorporated as Hybrid Electronics Inc. in 1968 and changed our
name to HEI, Inc. in 1969. In fiscal 1997, we sold our
optoelectronic switch assembly business and related assets.
During fiscal year 1999, we formed a subsidiary, HEI Export,
Inc., as a foreign sales corporation. During fiscal year 2000,
we acquired Cross Technology, Inc. (Cross), now our wholly-owned
subsidiary. Under the terms of the acquisition,
600,000 shares of our common stock were exchanged for all
of the outstanding stock of Cross. The transaction has been
accounted for as a pooling of interests and, accordingly, all
prior period financial information has been restated to include
the combined results. The acquisition of Cross was a strategic
move to expand our product offerings in the ultraminiature
markets that we serve. In fiscal 2001, we closed the Mexico
division primarily as a result of lack of profitability,
disposing of some assets and relocating some assets to our other
facilities.

(b) Business of the Company



| |                                   
| | ----------------------------------
| | Principal Products and
	Services 



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Microelectronics
	Our microelectronics division designs and manufactures
	ultraminiature microelectronic devices and high technology
	products incorporating these devices. These custom
	microelectronic devices typically consist of placing or
	assembling one or more integrated circuits (IC) or commonly
	referred to as chips and other passive electrical
	components onto a ceramic or organic substrate. The
	microelectronic assembly typically embodies the primary
	functions of the end products of our customers, such as hearing
	aids, defibrillators and communication components. For example,
	in hearing aids the microelectronic assemblies we design and
	make are contained within a shell and connected to a microphone,
	receiver and battery. For some customers, we procure the
	microphone, receiver and battery from outside vendors and
	assemble all of the components into further assemblies, while
	for others we sell only the microelectronic assembly. Our
	custom-built microelectronics are employed in the hearing,
	medical, telecommunications and ultraminiature radio frequency
	markets.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our newest technology allows us to manufacture
	miniature packages that are specially designed to hold and
	protect high frequency chips for broadband communications. This
	package with the enclosed chip or IC may then easily and
	inexpensively be attached to the circuit board without degrading
	the high-frequency performance of the chip. These packages, and
	the high- frequency chips that they contain, are specifically
	designed for applications in high-speed optical communication
	devices  the

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | individual parts of the fiber-optic
	telecommunications network that companies and individuals use to
	transmit data, voice, and video across both short as well as
	very long distances. They are also used in wireless
	communication devices similar to home satellite dish systems, or
	wireless local area networks that allow computers to communicate
	with each other without having to be connected with wires.
	Another example of our technology is the way we build the driver
	amplifiers for 10 and 40 gigabit per second fiber optic
	transceivers. The fiber-optic telecommunications networks that
	are used today rely on devices that pump the signals
	down the fiber-optic pipeline. The speed that the
	information can travel is measured in gigabits per second. As
	our society requires more and more information to pass down
	these fiber-optic pipelines, it is necessary to have faster and
	faster transmission speeds. Our 10 and 40 gigabit per
	second driver modules represent high-speed amplifiers that are
	both high-performance and can be manufactured at costs we
	believe are significantly lower than our competitors.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | RFID/
	Access Through our
	subsidiary, Cross, wireless smart cards and other
	ultra-miniature radio frequency (RF) applications are
	manufactured. Ultraminiature electronic modules are connected to
	an RF coil, which creates an assembly. This entire assembly is
	contained within a smart card or wireless card (about the same
	size as a credit card) used for financial and security access
	applications.
|
| |  | High Density
	Interconnect Our Tempe,
	Arizona location manufactures and designs high density, high
	quality flex circuits and high-performance laminate-based
	substrates. Significant portions of the substrates produced at
	this location are further processed by us into custom-built
	microelectronics. The high density interconnect location serves
	the hearing, medical and communications markets.     

Manufacturing Process:Our products are manufactured by
fabricating a substrate and placing integrated circuits (IC) and
passive electrical components onto that substrate. Substrates
are made of multi-layer ceramic or laminate materials. The
process of placing components onto the substrate is automated
using sophisticated equipment which picks an integrated circuit
from a wafer or waffle pack and places it onto a substrate with
very high precision. Many of the components require wire bonding
to electrically connect them to the substrate. We then
electrically test the microelectronic assemblies to ensure
required performance.

Customer Supply Agreements:We sell our products through our
Company-employed sales force based at our facilities in
Minnesota and Arizona, as well as through our independent sales
representatives.

We currently have annual agreements with our two
largest customers, Sonic Innovations, Inc. and Siemens, Inc.,
along with several other customers. These agreements typically
include basic understandings related to estimated needs of the
customer as well as range of prices for the products for the
current year. These agreements generally are cancelable by
either party for any reason upon advanced notice given within a
relatively short time period (eight to twelve weeks), and, upon
such cancellation, the customer is liable only for any residual
inventory purchased in accordance with the agreement. Although
these annual agreements do not commit our customers to order
specific quantities of products at specified prices, they are
still useful as they enable us to forecast our customers
orders for the upcoming year.

Actual orders from our customers with whom we
have annual agreements are made through customer supplied
Purchase Orders(PO), and the contractual basis for the
relationship is set forth in the PO. The PO specifies
quantities, price, product lead times, material and quality
requirements, and other general business terms and conditions.

For customers with lower demand requirements we
commonly use only POs to plan production and procure materials.
These programs are subject to our standard terms and conditions
including cancellation clauses, whereby either party may cancel
such PO for any reason upon advanced notice given within a
relatively short time period.

Component Supply Operations:For all application specific, or
custom material, we try to match the quantities and terms
related to the supply of such product of the customer and all
major vendors. We prefer to have long-term agreements with our
vendors. However, we do not currently have any long-term
agreements with vendors. Typically, there are many sources of
raw material supplies available nationally and internationally;
however, many raw materials we use are customer specified and
may only be available from customer specified vendors or
supplied by the customer itself. The integrated circuits that we
assemble onto circuit

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boards are an example of a raw material that is
commonly customer specified and available from specified vendors
or supplied by the customer.


Proprietary Technology:We use proprietary technology and
proprietary processes to incorporate such technology into many
of our products. We protect this technology through patents,
proprietary information agreements with our customers and
vendors, and non-disclosure agreements with many of our
employees. Additionally, we will apply for new patents whenever
appropriate. We hold four microelectronic process and design
patents, which expire at dates ranging from 2018 through 2021.
The two most significant patents held by us are the High Density
Stacked Circuit Module and the Interconnection Device. The High
Density Stacked Circuit Module is a method of stacking two or
more integrated circuits and then electrically interconnecting
them. This approach allows the use of the thickness of the
circuit to add capabilities rather than increase the width and
length. The result is a more compact device than can be attained
using conventional methods. The primary application is in our
hearing market, where smaller circuits make it possible to fit
more people with hearing aides and makes the hearing aid less
obtrusive. Our latest design patent, the Interconnection Device,
allows for the cost effective use of high-speed, millimeter wave
integrated circuits by placing them into surface mount packages.
These surface mount packages allow our customers to cost
effectively incorporate those packages into their products, and
also permits a rapid increase to high volume manufacturing,
using standard high volume assembly equipment.

Government Regulations:Although certain of our
customers products are subject to federal governmental
regulations (such as Food and Drug Administration regulations),
we are not directly subject to such regulations. Instead, our
products and manufacturing processes are subject to customer
review for compliance with such customers specific
requirements. The main purpose of such customer reviews are to
assure manufacturing compliance with customer specifications and
quality. We are not, however, directly subject to any
governmental regulations or industry standards beyond local
environmental regulations.

As a small generator of hazardous substances, we
are subject to local governmental regulations relating to the
storage, discharge, handling, emission, generation, manufacture
and disposal of toxic or other hazardous substances, such as
waste oil, acetone and alcohol, that are used in very small
quantities to manufacture our products. We are currently in
compliance with these county regulations and have valid permits
for the storage and disposal of the hazardous substances we
generate. If we fail to comply with these regulations,
substantial fines could be imposed on us and we could be
required to suspend production, alter manufacturing processes or
cease operations.

Dependence on Single or Few Customers and
Backlog:The table below shows
approximate percentage of our sales to major customers which
accounted for more than 10% of total sales in fiscal years 2001,
2000, and 1999.

|           |  |      |    |      |  |      |    |   |  |  |    |  
|---------- |  | ---- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|Customer   |  | 2001 |    | 2000 |  | 1999
|           |  |      |    |      |  |     
|Customer A |  |      | 26 | %    |  |      | 15 | % |  |  |   |  
|          
|          
|          
|          
|Customer B |  |      | 25 | %    |  |      | 42 | % |  |  | 52 | %
|          
|          
|          
|          
|Customer C |  |      | 10 | %    |  |      |   |   |  |  | 13 | %
|          
|          
|          
|          
|Customer D |  |      |   |      |  |      | 11 | % |  |  |   |  

Customer A and B represent Sonic
Innovations, Inc. and Siemens, Inc., respectively, which both
operate in the hearing market. The increase in business with
Sonic over the last two years is the result of producing higher
value-added products. The decrease in sales with Siemens, Inc.
in fiscal 2001 is largely a result of normal fluctuations in
their products as well as an effort on their part to reduce
inventories during the last half of our fiscal 2001.
Customer C is Agere Systems and is a customer in the
communications market. Customer D represents Motorola,
Inc., which is a customer in the RFID market. The decline in
revenue in fiscal 2001 is a result of Motorolas decision
to sell or close their smart-card businesses. For financial
information about revenues from external customers attributed to
specific geographic areas please see Item 8 
Note 2 to the financial statements.

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Following is the approximate percentage of our
sales by market segment served:

|                 |  |      |     |      |  |      |     |  |  |  |     | 
|---------------- |  | ---- | --- | ---- |  | ---- | --- |  |  |  | --- | 
|Market           |  | 2001 |     | 2000 |  | 1999
|                 |  |      |     |      |  |     
|Hearing/ Medical |  |      | 61% |      |  |      | 63% |  |  |  | 69% | 
|                
|                
|                
|                
|Communications   |  |      | 17% |      |  |      | 10% |  |  |  | 14% | 
|                
|                
|                
|                
|RFID             |  |      | 14% |      |  |      | 20% |  |  |  | 16% | 
|                
|                
|                
|                
|Other            |  |      | 8%  |      |  |      | 7%  |  |  |  | 1%  | 

We believe that diversification between our key
markets is important. Our goals are to have no one market
account for 40% or more of our sales, no one customer at 25% of
sales or greater and no one program at 10% or greater. Likewise
we seek to operate our business to avoid risking concentrations
in our business with one customer or program. Our plans to
achieve our goals include increasing our product offerings,
customer base and programs to increase revenue, which will
result in more diversification.

At August 31, 2001, our backlog of orders
for revenue in fiscal 2002 was approximately $11,000 compared to
approximately $22,450 at August 31, 2000. We expect to fill
our backlog as of August 31, 2001 during fiscal 2002.

Competition:In each
of our product lines, we face significant competition, including
users who may produce the same or similar products themselves.
We obtain new business by identifying customer needs and first,
designing and engineering our products to meet those needs in an
ultraminiature and cost effective way. We then manufacture those
electronic assemblies with a high degree of automation to ensure
quality and low cost. Finally, we compete on the basis of full
service to obtain new and repeat orders. Our competitive
advantage starts with knowledge of the market requirements and
investment in technology to meet those demands. We then design
products to application specific requirements, and automate our
factories to achieve a high level of quality at a low cost.
Application specific requirements typically include: very small
size, low power, high performance and low cost. We are a
full-service supplier and partner with our customers, providing
full turn-key capability.

Research and Development:The amount spent on Company-sponsored
research and development activities aggregated approximately
$2,433, $1,764 and $1,343 for the years ended August 31,
2001, 2000 and 1999, respectively.

Employees:On
August 31, 2001, we employed approximately 207 persons
of whom one was part-time.

Item 2.     Description
of Property

We own a 48,000 square foot facility for
administration and microelectronics production in Victoria,
Minnesota, which was originally built in August 1981. Victoria
is a suburb of Minneapolis. The facility was expanded during
fiscal 1996 from the original 25,000 square feet with an
addition of 23,000 square feet to increase production
capacity. The addition was financed through the issuance of an
Industrial Development Revenue Bond (IDRB) with the City of
Victoria, on the property and certain equipment. The IDRB is
further collateralized by letters of credit from LaSalle
Business Credit, Inc. We mortgaged the property to secure the
credit facility with LaSalle Business Credit, Inc.

We lease a 14,000 square foot facility in
Tempe, Arizona for our high density interconnect business. We
lease a 20,000 square foot facility in Chanhassen,
Minnesota, for part of our RF business and a 3,000 square foot
facility in Eden Prairie used for executive offices. The Tempe,
Arizona and Chanhassen, Minnesota facilities are leased until
July 2005 and October 2007, respectively.

Item 3.     Legal
Proceedings




As of December 10, 2001 there are no
material legal proceedings pending against us or our properties.
From time to time we may become involved in routine litigation
incidental to our business.




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Item 4.     Submission
of Matters to a Vote of Security-Holders

None.

PART II

Item 5.     Market
for Common Equity and Related Stockholder Matters

Our 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 2001
and 2000 for our common stock, as reported by Nasdaq.

|               |  |      |        |     |  |   |       | 
|-------------- |  | ---- | ------ | --- |  | - | ----- | 
|2001           |  | High |        | Low
|               |  |      |        |    
|First Quarter  |  | $    | 23.500 |     |  | $ | 9.000 | 
|              
|              
|              
|              
|Second Quarter |  |      | 15.000 |     |  |   | 8.500 | 
|              
|              
|              
|              
|Third Quarter  |  |      | 12.813 |     |  |   | 4.800 | 
|              
|              
|              
|              
|Fourth Quarter |  |      | 9.730  |     |  |   | 6.350 | 

|               |  |      |        |     |  |   |        | 
|-------------- |  | ---- | ------ | --- |  | - | ------ | 
|2000           |  | High |        | Low
|               |  |      |        |    
|First Quarter  |  | $    | 6.875  |     |  | $ | 5.250  | 
|              
|              
|              
|              
|Second Quarter |  |      | 16.625 |     |  |   | 6.875  | 
|              
|              
|              
|              
|Third Quarter  |  |      | 16.125 |     |  |   | 9.063  | 
|              
|              
|              
|              
|Fourth Quarter |  |      | 23.250 |     |  |   | 11.000 | 




As of December 10, 2001, we had
332 shareholders of record. We have not paid any dividends
on our common stock since our initial public offering on
March 24, 1981. We expect that for the foreseeable future
we will follow a policy of retaining earnings in order to
finance the continued development of our future business.
Payment of dividends is within the discretion of our board of
directors and will depend upon, among other things, our
earnings, capital requirements and operating and financial
condition. In addition, the terms of our agreement with our bank
contains restrictions on our right to pay dividends.




On August 29, 2001, we sold 950,000
unregistered shares of our common stock. These newly issued
shares were sold to: The Paisley Fund, L.P., RS Paisley
Pacific Master Fund Unit Trust, RS Smaller Company Growth,
RS Diversified Growth, Constable Capital, LLC and
ThinkEquity Partners, LLC, all of whom were accredited
investors, pursuant to Rule 506 of Regulation D. The
title of the unregistered shares is HEI Common Stock,
$.05 par value, and the aggregate purchase price for the
shares was $6,650, which we will use to increase working capital
and for future capital expenditures. There was a 5% underwriting
discount and the placement agent, ThinkEquity Partners, LLC,
received 47,500 warrants convertible to shares of our common
stock at a price of $8.05. We are in the process of
registering these shares.

5



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Item 6.     Selected
Financial Data

HEI, INC. AND SUBSIDIARIES

FIVE YEAR SUMMARY OF SELECTED FINANCIAL
INFORMATION

|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |        | 
|------------------------------------------- | --------------------------------------- | ---------------------------------------- | ------ | ------- |  | ------- | ------ | ------- |  | ------- | ------ | ------ |  | - | ------ | ------ |  | - | ------ | ------ | 
|Years Ended August 31                       |                                         | 2001(a)                                  |        | 2000(b) |  | 1999(c) |        | 1998(d) |  | 1997(e)
|                                            |                                         |                                          |        |         |  |         |        |         |  |        
|                                            |                                         |                                         
|                                            |                                         | (In thousands, except per share amounts)
|                                           
|                                           
|                                           
|                                           
|Net sales                                   |                                         | $                                        | 44,832 |         |  | $       | 42,799 |         |  | $       | 29,089 |        |  | $ | 24,766 |        |  | $ | 34,193 |       
|                                           
|                                           
|                                           
|                                           
|Cost of sales                               |                                         |                                          | 36,841 |         |  |         | 35,544 |         |  |         | 22,378 |        |  |   | 19,104 |        |  |   | 26,320 |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Gross profit                                |                                         |                                          | 7,991  |         |  |         | 7,255  |         |  |         | 6,711  |        |  |   | 5,662  |        |  |   | 7,873  |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Operating expenses:                         |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                           
|                                           
|                                           
|                                           
|                                            | Selling, general and administrative     |                                          |        | 5,806   |  |         |        | 6,338   |  |         |        | 4,623  |  |   |        | 3,498  |  |   |        | 3,495  | 
|                                           
|                                           
|                                           
|                                           
|                                            | Research, development and engineering   |                                          |        | 2,433   |  |         |        | 1,764   |  |         |        | 1,343  |  |   |        | 852    |  |   |        | 843    | 
|                                           
|                                           
|                                           
|                                           
|Unusual charges                             |                                         |                                          | 1,693  |         |  |         | 453    |         |  |         | 490    |        |  |   | 5,664  |        |  |   | (215   | )     
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Operating income (loss)                     |                                         |                                          | (1,941 | )       |  |         | (1,300 | )       |  |         | 255    |        |  |   | (4,352 | )      |  |   | 3,750  |       
|                                           
|                                           
|                                           
|                                           
|Other income (expense), net                 |                                         |                                          | (2,182 | )       |  |         | (227   | )       |  |         | 380    |        |  |   | 580    |        |  |   | 447    |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Income (loss) before income taxes           |                                         |                                          | (4,123 | )       |  |         | (1,527 | )       |  |         | 635    |        |  |   | (3,772 | )      |  |   | 4,197  |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Income tax expense (benefit)                |                                         |                                          | (930   | )       |  |         | (372   | )       |  |         | 242    |        |  |   | (1,354 | )      |  |   | 1,497  |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Net income (loss)                           |                                         | $                                        | (3,193 | )       |  | $       | (1,155 | )       |  | $       | 393    |        |  | $ | (2,418 | )      |  | $ | 2,700  |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Net income (loss) per basic share           |                                         | $                                        | (0.65  | )       |  | $       | (0.24  | )       |  | $       | 0.08   |        |  | $ | (0.52  | )      |  | $ | 0.57   |       
|                                           
|                                           
|                                           
|                                           
|Net income (loss) per diluted share         |                                         | $                                        | (0.65  | )       |  | $       | (0.24  | )       |  | $       | 0.08   |        |  | $ | (0.52  | )      |  | $ | 0.55   |       
|                                           
|                                           
|                                           
|                                           
|Weighted average common shares outstanding: |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                           
|                                           
|                                           
|                                           
|                                            | Basic                                   |                                          |        | 4,881   |  |         |        | 4,726   |  |         |        | 4,698  |  |   |        | 4,685  |  |   |        | 4,735  | 
|                                           
|                                           
|                                           
|                                           
|                                            | Diluted                                 |                                          |        | 4,881   |  |         |        | 4,726   |  |         |        | 4,701  |  |   |        | 4,685  |  |   |        | 4,879  | 
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Balance sheet:                              |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                           
|                                           
|                                           
|                                           
|                                            | Working capital                         |                                          | $      | 8,793   |  |         | $      | 5,902   |  |         | $      | 8,333  |  |   | $      | 12,175 |  |   | $      | 15,540 | 
|                                           
|                                           
|                                           
|                                           
|                                            | Total assets                            |                                          |        | 27,528  |  |         |        | 28,936  |  |         |        | 23,739 |  |   |        | 23,878 |  |   |        | 26,264 | 
|                                           
|                                           
|                                           
|                                           
|                                            | Long-term debt, less current maturities |                                          |        | 3,972   |  |         |        | 3,894   |  |         |        | 3,415  |  |   |        | 3,835  |  |   |        | 4,787  | 
|                                           
|                                           
|                                           
|                                           
|                                            | Shareholders equity                    |                                          |        | 18,420  |  |         |        | 15,116  |  |         |        | 15,566 |  |   |        | 15,135 |  |   |        | 17,580 | 
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       



---



|    |  |                                                                                                                                                                                                                                                                                                                
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | In fiscal 2001, Other Unusual Charges consist of
	costs related to the closure of the Mexico division of $425 and
	$1,268 loss on the write-off of accounts receivable primarily
	related to customers of the Mexico Division and Other income
	(expense), net includes the write-off of the investment in MSC.
|   
|(b) |  | In fiscal 2000, Other Unusual Charges of $453
	consist of acquisition transaction costs related to the Cross
	Technology acquisition.                                                                                                                                                                          
|   
|(c) |  | In fiscal 1999, Other Unusual Charges of $490
	related to the severance agreement between the Company and the
	former Chief Executive Officer.                                                                                                                                                                 
|   
|(d) |  | In fiscal 1998, Other Unusual Charges of $5,664
	relates to one-time expenses related to proxy contest and change
	of control costs.                                                                                                                                                                           
|   
|(e) |  | In fiscal 1997, Other Unusual Charges of ($215)
	relates to the gain on sale of a product line.                                                                                                                                                                                                                

6



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##### Table of Contents



Item
7.     Managements Discussion
and Analysis of Financial Condition and Results of
Operations




RESULTS OF OPERATIONS

Percentage of Sales


|                                      |  |      |  |      |  |     
|------------------------------------- |  | ---- |  | ---- |  | ----
|                                      |  | 2001 |  | 2000 |  | 1999
|                                      |  |      |  |      |  |     
|Sales                                 |  | 100% |  | 100% |  | 100%
|                                     
|                                     
|                                     
|                                     
|Gross profit                          |  | 18%  |  | 17%  |  | 23% 
|                                     
|                                     
|                                     
|                                     
|Selling, general and administrative   |  | 13%  |  | 15%  |  | 16% 
|                                     
|                                     
|                                     
|                                     
|Research, development and engineering |  | 5%   |  | 4%   |  | 5%  
|                                     
|                                     
|                                     
|                                     
|Other                                 |  | 4%   |  | 1%   |  | 2%  

Sales

2001 vs. 2000:Sales
in fiscal 2001 increased $2,033, or 5%, as compared to fiscal
2000. This increase in sales occurred in the first half of
fiscal 2001, primarily a result of increases in sales from the
Mexico division, which increased by approximately $1,300 to
$4,700, increases in sales from the high density interconnect
division, which increased by approximately $1,600 to $1,900, and
increases in sales from the microelectronic division, which
increased by approximately $1,400. The Mexico division was
closed in the third quarter for the reasons set forth below
under Operating Expenses. The Mexico division
offered full contract automated manufacturing services and
assembly processes. These increases were offset by a decrease in
Cross revenues of $2,200 as a result of a decline in sales to a
significant customer early in the year. Sales to Siemens in
fiscal 2001 represented 26% of revenue in fiscal 2001 compared
to 42% in fiscal 2000. The decrease in sales with Siemens, Inc.
is largely a result of normal fluctuations in demand for their
products as well as an effort on their part to reduce
inventories during the last half of our fiscal 2001.

We have experienced a decline in quarterly sales
during fiscal 2001, which is a result of the closure of the
Mexico division at the end of the third quarter, a decline in
sales to a significant customer of Cross, as well as a general
economic slowdown in our focus markets specifically in the
hearing, RFID/Access and communication contract manufacturing
markets. The slowdown in these markets has resulted in our
customers carrying high inventory levels of the products that we
make, which they need to reduce before orders begin to increase
significantly. We continue to see a weak market through our
first quarter of fiscal 2002 as our customers continue to work
through their inventory. Based on current backlog and customer
forecasts, however, we expect an increase in sales beginning in
the second quarter of fiscal 2002.

2000 vs. 1999:Sales
in fiscal 2000 increased $13,710, or 47%, as compared to fiscal
1999. This increase was primarily in the hearing aid market in
the microelectronics division. Each division (microelectronics,
Cross Technology, Mexico and high density interconnect)
contributed to the growth in sales. The largest customer,
Siemens, Inc., accounted for 42% of sales in 2000 as compared to
52% in 1999. The reason for the decrease in the percentage of
sales to Siemens in fiscal 2000 is primarily due to the
diversification of our customer base as well as the start up of
operations in Mexico.

Gross Profit

2001 vs. 2000:Our
gross profit as a percentage of sales was 18% in fiscal 2001, as
compared to 17% in fiscal 2000. The increase in gross profit as
a percentage of sales was primarily due to start-up costs in the
prior year for the high density interconnect division, which
were offset by higher operating losses for the Mexico division,
which was closed in the third quarter of fiscal 2001.

Gross profit on our products is largely affected
by the level of sales as a result of the significant fixed costs
related to the manufacturing of our products. We have taken
actions to reduce the variable portion of cost of sales in the
third and fourth quarter to match the lower revenue, however,
gross margins declined to 16% in both the third and fourth
quarters of fiscal 2001. Gross margins will improve as the level
of sales increase. In

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addition, as the market acceptance of our new
Broadband communication products occurs, which will have higher
gross margins than we have historically experienced.


2000 vs. 1999:Our
gross profit as a percentage of sales was 17% in fiscal 2000, as
compared to 23% in fiscal 1999. The reduction in gross profit as
a percentage of sales was primarily due to lower margin sales
for our Mexico division and Cross operations and start-up costs
for the high density interconnect facility. The lower margins
for our Mexico division are primarily a result of higher
material content on revenue and lower than anticipated sales
volumes.

Operating Expenses

2001 vs. 2000:Selling, general and administrative expenses decreased by $532
in fiscal 2001, which is a result of higher costs in fiscal 2000
from implementing a new enterprise resource planning
(ERP) system and start-up costs related to the high density
interconnect division. In fiscal 2002, we expect a decrease in
selling, general and administrative costs in total dollars and
as a percent of sales.

Research, Development and Engineering costs have
increased in fiscal 2001 by $669, or 38%, compared to fiscal
2000. The increase is a result of an emphasis on new product
development, especially in the broadband communications market,
as well as new process and product development in all focus
markets.

Unusual charges of $1,693 in fiscal 2001 relates
to the write-off of accounts receivable related to customers of
the Mexico division of $1,268 in the second quarter and $425 of
costs associated with the shut down of the Mexico division in
the third quarter. The closing of the Mexico division is a
result of the loss from operations for fiscal 2001 of
approximately $2,450, including the write-off of accounts
receivable and closure costs. The continuing revenue base in
Mexico was unable to support the business and was not meeting
our requirements for profitability. In fiscal 2000, other
operating costs of $453 are acquisition transaction costs
related to the acquisition of Cross in March 2000.

2000 vs. 1999:Fiscal 2000 selling, general and administrative and research,
development and engineering expenses increased $2,136, or 36%,
over the previous year. This increase was due to increased
selling costs to develop new business and support new
operations, non-capitalizable costs associated with implementing
a new ERP system and start-up costs related to the high
density interconnect division (which are expensed as incurred)
and increased development costs to support future business
opportunities. In addition to these costs, we incurred $453 of
acquisition transaction costs related to the acquisition of
Cross in March 2000.

Other Income (Expense), Net

2001 vs. 2000:In
the fourth quarter of fiscal 2001, we wrote off its equity
investment in Micro Substrates Corporation (MSC). Including this
write-off, expenses incurred related to MSC for fiscal 2001 were
$1,450.

Other expense in fiscal 2001 of $732 increased
$647 as compared to fiscal 2000, primarily due to higher
interest expense, as a result of decreased average cash balances
and increased short and long-term debt throughout fiscal 2001,
partially offset by interest on loans receivable. We expects
that interest expense for fiscal 2002 will be lower than
fiscal 2001 as a result of the increased cash from the private
placement that was completed in August 2001 and the general
decrease in interest rates.

2000 vs. 1999:Other
income (expense) decreased $523 to a net expense of $85 in
fiscal 2000 as compared to fiscal 1999 primarily due to lower
investment balances and increased short and long-term debt
resulting in higher interest costs.

Income Tax Expense (Benefit)

2001 vs. 2000:The
income tax benefit of $930 in fiscal 2001 increased over fiscal
2000 by $558. The increase is a result of the larger loss before
income taxes in the current year. The effective tax rate of
22.6% in fiscal 2001 is lower than the federal and state
statutory tax rate due to the loss on the MSC investment, which
created a capital loss. The realization of the capital loss will
not occur until we generate capital gains. As it is

8



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more likely than not that such capital gains will
not occur, we have placed a valuation allowance of $510 on the
deferred tax asset arising from the MSC capital loss.


2000 vs. 1999:The
income tax benefit in fiscal 2000 of $372 increased by $614 from
the income tax expense of $242 in fiscal 1999. The effective tax
rates for fiscal 2000 and fiscal 1999 are 24.4% and 38.1%,
respectively. The decrease in the effective rate is largely a
result of the non-deductible nature of the acquisition costs
related to the Cross Technology acquisition in fiscal 2000.

Net Income (Loss)

2001 vs. 2000:We
had a net loss of $3,193 in fiscal 2001 compared to a net loss
of $1,155 in fiscal 2000. The net loss in fiscal 2001 was
primarily a result of the operating loss and closure of the
Mexico division, including the accounts receivable write-off,
and the impairment charge for MSC. Excluding Mexico and MSC, the
net loss for fiscal 2001 was $164. Our future operating results
are highly dependent upon our sales levels. As sales increase in
fiscal 2002 and with the absence of operating losses associated
with the closure of the Mexico division in fiscal 2001, we
expect our net income (loss) to improve.

2000 vs. 1999:We
had a net loss of $1,155 in fiscal 2000 compared to net income
of $393 in fiscal 1999. The loss in fiscal 2000 was a result of
lower gross profit and higher expenses associated with the ramp
up of the Mexico and high density interconnect divisions, ERP
implementation costs, the Cross acquisition costs and higher
debt.

Financial Condition

Our net cash flow provided by operating
activities for the year ended August 31, 2001 was $3,930.
The cash flow generated was a result of improvements in the key
working capital accounts of accounts receivable, inventories and
accounts payable, which resulted in $3,100 with operating
results contributing $700. The decrease in accounts receivable,
inventories and accounts payable is attributable primarily to
the decrease in revenue over the last half of the fiscal year as
compared to the comparable prior year period.

Accounts receivable average days outstanding was
74 days at August 31, 2001 compared to 49 days at
August 31, 2000. Inventory turns were 7.0 and 7.4, for the
years ended August 31, 2001 and 2000, respectively. The
increased days outstanding and decreased inventory turns were
primarily due to the slow down in revenue in the last half of
the fiscal year, as well as a general slow down in customer
payment practices throughout the industry.

The current ratio at the end of fiscal 2001 was
2.7:1 as compared to 1.6:1 at the end of fiscal 2000. The
increased current ratio is principally due to increased cash and
cash equivalents and reduced outstanding revolving line of
credit balances as a result of the $6,222 private placement of
common stock completed in August 2001.




We have a maximum of $5,000 available under the
revolving line of credit, based on the accounts receivable
balance outstanding, and a $8,500 capital expenditure term loan,
each of which both expire in August 2004 (see Notes 5 and 6
under Notes to Consolidated Financial Statements). As of
August 31, 2001, there were $10 and $2,824 of borrowings
under the line of credit and capital expenditure term loan
facility, respectively. These borrowings are subject to certain
restrictive financial covenants, including but not limited to:
tangible net worth, interest coverage ratio, debt service
coverage ratio, annual loss limitations and the ability to
declare or pay dividends. Losses associated with the Mexico
operations and the general economic slowdown in the hearing,
RFID/Access and other electronic contract manufacturing markets
in which we operate have resulted in adverse operating results
in fiscal 2001. Due to these adverse operating results, we were
not in compliance with the interest coverage ratio, debt service
coverage ratio and year to date net loss covenants at
August 31, 2001. We have amended the agreement with the
financial institution, which waives the events of default at
August 31, 2001 and amends the covenants for fiscal 2002.
Both are currently in compliance with the bank covenants and,
based on current projections, we believe that it will meet the
bank covenants going forward and has classified the debt per the
terms of the respective agreements.




9



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Although we are in compliance with the bank
covenants, the financial institution has put certain
restrictions on our ability to borrow additional funds under the
capital expenditure term loan facility. These restrictions
require us to reach a Debt Service Coverage Ratio, as defined in
the Loan Agreement, equal to or greater than 1.15 to 1.0 on a
year-to-date basis, prior to allowing additional borrowings
under the capital expenditure term loan facility. As a result of
these restrictions, we are currently not able to borrow
additional funds under the capital expenditure term loan
facility. We continue to work to increase sales and improve our
operating results to meet this covenant and regain the ability
to borrow additional funds under the capital expenditure loan
facility.







During fiscal 2001, we purchased $3,418 of
property and equipment, primarily for production equipment to
prepare for production orders for our broadband products. These
purchases were funded through cash flow from operations and
utilization of the capital expenditure term loan.




During fiscal 2002, we intend to expend
approximately $2,500 for manufacturing and facility improvements
and capital equipment. These additions will 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.

We believe that our existing cash and cash
equivalents, current lending capacity and cash generated from
operations will provide sufficient cash flow for us to meet its
short and long-term debt obligations and operating requirements.



|         |                                                                           
|-------- | --------------------------------------------------------------------------
|Item 7A. | Qualitative and Quantitative Disclosures
	About Market Risk (In thousands)

We are exposed to certain market risks with its
$5,000 revolving line of credit, capital expenditure loans and,
to a lesser extent, its Industrial Development Bonds (IDRBs). At
August 31, 2001, the outstanding balance on the revolving
line of credit, capital expenditure loans and IDRBs were $10,
$2,824 and $2,435, respectively. The revolving line of credit
agreement bears interest, at our option, at 1% above the prime
rate of interest or 3.5% above the LIBOR rate. The capital
expenditure loans bears interest, at our option, at 1.25% above
the prime rate of interest or 3.75% above the LIBOR rate. At
August 31, 2001 the interest rates on the revolving
commitment and capital expenditure loans were 7.5% and 7.75%,
respectively. The IDRBs bear interest at a rate, which varies
weekly, based on comparable tax-exempt issues, and is limited to
a maximum rate of 10%. At June 2, 2001 the interest rate on
the IDRBs was 2.11%. Consequently, we are exposed to a change in
borrowing costs as interest rates change. We have completed a
market risk sensitivity analysis of these debt instruments based
upon an assumed 1% increase in interest rates at August 31,
2001. If market interest rates had increased by 1% on
August 31, 2001, this would have resulted in an increase to
interest expense of approximately $53 over a one-year period.
Because this is only an estimate, any actual change in expense
due to a change in interest rates could differ from this
estimate.

RISK FACTORS (In thousands except per share
amounts)

This Annual Report on Form 10-K contains
forward-looking statements that are based on our current
expectations and involve a number of risks and uncertainties.
Factors that may materially affect revenues, expenses and
operating results include, without limitation, adverse business
or market conditions, our ability to secure and satisfy
customers, the availability and cost of materials from
suppliers, adverse competitive developments, and change in or
cancellation of customer requirements.

The forward-looking statements included herein
are based on current assumptions that we will continue to
develop, market, manufacture and ship products on a timely
basis, that competitive conditions within our markets will not
change materially or adversely, that we will continue to
identify and satisfy customer needs for products and services,
that we will be able to retain and hire key personnel, that its
equipment, processes, capabilities and resources will remain
competitive and compatible with the current state of technology,
that risks due to shifts in customer demand will be minimized,
and that there will be no material adverse change in our
operations or business. Assumptions relating to the foregoing
involve judgments that are based on incomplete information and
are subject to many factors that can materially affect results.
We operate in a volatile segment of high technology markets and
applications that are subject to rapid change and technical
obsolescence.

10



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Because of these and other factors affecting our
operating results, past financial performance should not be
considered an indicator of future performance, and investors
should not use historical trends to anticipate results or trends
in future periods. The following factors also may materially
affect results and therefore should be considered.

If we are unable to develop new products and
services our revenue could decrease.Our products are subject to rapid obsolescence and our future
success will depend upon our ability to develop new products and
services that meet changing customer and marketplace
requirements. Our products are based upon specifications from
our customers. We may not be able to satisfactorily design and
manufacture customer products based upon these specifications.

If we fail to properly anticipate the market
for new products and service we may lose
revenue.Even if we are able to
successfully identify, develop and manufacture as well as
introduce new products and services, there is no assurance that
a market for these products and services will materialize to the
size and extent that we anticipate. If a market does not
materialize as we anticipate, our business, operating results
and financial condition could be materially adversely affected.
The following factors could affect the success of our products
and services in the microelectronic and other marketplaces:



| |   |                                                                                                                                   
| | - | ----------------------------------------------------------------------------------------------------------------------------------
| |  | the failure to adequately equip our manufacturing
	plant in anticipation of increasing business;                                  
|
| |  | the failure of our design team to develop
	products in a timely manner to satisfy our present and potential
	customers; or        
|
| |  | our limited experience in specific market
	segments in marketing our products and services, specifically in
	the telecom industry.

We may fail to adequately adjust our expenses
to predicted revenue in any given period or we may experience
significant fluctuations in quarterly revenue because the sales
cycle for our products and services is lengthy and
unpredictable.While our sales cycle
varies from customer to customer, it typically has ranged from
two to 12 months. Our pursuit of sales leads typically
involves an analysis of our prospective customers needs,
preparation of a written proposal, one or more presentations and
contract negotiations. Our sales cycle may also be affected by
the complexity of the product to be developed and manufactured
as well as a prospective customers budgetary constraints
and internal acceptance reviews, over which we have little or no
control. As a result of these things combined with the fact that
our expenses are fixed, we may fail to adequately adjust our
expenses to predicted revenue in any given period or we may
experience significant fluctuations in quarterly revenue.

Our business may suffer and cause our stock
price to decline if we are unable to protect our intellectual
property rights.Intellectual property
rights are important to our success and our competitive
position. It is our policy to protect all proprietary
information through the use of a combination of nondisclosure
agreements and other contractual provisions and patent,
trademark, trade secret and copyright law to protect our
intellectual property rights. There is no assurance that these
agreements, provisions and laws will be adequate to prevent the
imitation or unauthorized use of our intellectual property.
Policing unauthorized use of proprietary systems and products is
difficult and, while we are unable to determine the extent to
which infringement of our intellectual property exists, we
expect infringement to be a persistent problem. In addition, the
laws of some foreign countries do not protect our products to
the same extent that the laws of the United States protect our
products. If our intellectual property rights are not protected
our business may suffer if a competitor uses our technology to
capture our business, which could cause our stock price to
decline. Furthermore, even if the agreements, provisions and
intellectual property laws prove to be adequate to protect our
intellectual property rights, our competitors may develop
products or technologies that are both non-infringing and
substantially equivalent or superior to our products or
technologies.

Third-party intellectual property infringement
claims may be costly and may prevent the future sale of our
products.Substantial litigation and
threats of litigation regarding intellectual property rights
exist in our industry. Third parties may claim that our products
infringe upon their intellectual property rights. In particular,
defending against third-party infringement claims may be costly
and divert important management resources. Furthermore, if these
claims are successful, we may have to pay substantial royalties
or damages,

11



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##### Table of Contents



remove the infringing products from the
marketplace or expend substantial amounts in order to modify the
products so that they no longer infringe on the third
partys rights.


We may pursue future acquisitions and
investments that may adversely affect our financial position or
cause our earnings per share to
decline.In the future we may continue
to make acquisitions of and investments in businesses, products
and technologies that could complement or expand our business.
Such acquisitions, though, involve certain risks:



| |   |                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We may not be able to negotiate or finance the
	acquisition successfully.                                                                                                                          
|
| |  | The integration of acquired businesses, products
	or technologies into our existing business may fail.                                                                                             
|
| |  | We may issue equity securities, incur debt,
	assume contingent liabilities or have amortization expenses and
	write-downs of acquired assets, which could cause our earnings
	per share to decline.

If our customers are unable to gain market
acceptance for the products that we develop or manufacture for
them, we may lose revenue.We design
and manufacture components for other companies. We also sell
proprietary products that contain components to other companies
and end-user customers. For products we manufacture
(manufactured for others or those we sell directly), our success
is dependent on the acceptance of those products in their
markets. We have no control over the products or marketing of
products that we sell to our customers. Market acceptance may
depend on a variety of factors, including educating the target
market regarding the use of a new procedure. Market acceptance
and market share are also affected by the timing of market
introduction of competitive products. Some of our customers,
especially emerging growth companies, have limited or no
experience in marketing their products and may be unable to
establish effective sales and marketing and distribution
channels to rapidly and successfully commercialize their
products. If our customers are unable to gain any significant
market acceptance for the products we develop or manufacture for
them, our business will be adversely affected.

If we fail to comply with environmental laws
and regulations we may be fined and prohibited from
manufacturing products.As a small
generator of hazardous substances, we are subject to local
governmental regulations relating to the storage, discharge,
handling, emission, generation, manufacture and disposal of
toxic or other hazardous substances, such as waste oil, acetone
and alcohol, that are used in very small quantities to
manufacture our products. While we are currently in compliance
with applicable regulations, if we fail to comply with these
regulations substantial fines could be imposed on us and we
could be required to suspend production, alter manufacturing
processes or cease operations.

If the products we design and manufacture are
the subject of product recalls or a product liability claim, we
may lose revenue, our business reputation may be damaged and we
may incur significant legal fees.A
number of the components we design or manufacture are for
medical devices. The tolerance for error in the design,
manufacture or use of these products may be small or
nonexistent. If a component we designed or manufactured is found
to be defective, whether due to design or manufacturing defects,
to improper use of the product or to other reasons, the
component or the product in which it is used may need to be
recalled, possibly at our expense. Furthermore, the adverse
effect of a product recall on our business might not be limited
to the cost of the recall. Recalls, especially if accompanied by
unfavorable publicity or termination of customer contracts,
could result in substantial costs, loss of revenues and damage
to our reputation, each of which would have a material adverse
effect on our business, operating results and financial
condition.

Future quarterly and annual operating results
may fluctuate substantially due to a number of factors, many of
which are beyond our control, which may cause our stock price to
decline.We have experienced
substantial fluctuations in our annual and quarterly operating
results, and such fluctuations may continue in future periods.
Our operating results are affected by a number of factors, many
of which are beyond our control, including the following:



| |   |                                                                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | we may manufacture products that are custom
	designed and assembled for a specific customers
	requirement in anticipation of the receipt of volume production
	orders from that customer, which may not always materialize to
	the degree anticipated, if at all;

12



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| |   |                                                                                                                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | we may incur significant start-up costs in the
	production of a particular product, which costs are expensed as
	incurred and for which we attempt to seek reimbursement from the
	customer;                                                                                                                                         
|
| |  | we may experience fluctuations and inefficiencies
	in managing inventories, fixed assets, components and labor, in
	the degree of automation used in the assembly process, in the
	costs of materials, and the mix of materials, labor,
	manufacturing, and overhead costs;                                                          
|
| |  | we may experience unforeseen design or
	manufacturing problems, price competition or functional
	competition (other means of accomplishing the same or similar
	packaging end result);                                                                                                                                               
|
| |  | we may be unable to pass on cost overruns;                                                                                                                                                                                                                                                                                           
|
| |  | we may not have control over the timing of
	expenditures in anticipation of increased sales, customer
	product delivery requirements and the range of services
	provided; and                                                                                                                                                        
|
| |  | we may experience variance in the amount and
	timing of orders placed by a customer due to a number of
	factors, including inventory balancing, changes in manufacturing
	strategy, and variation in product demand attributable to, among
	other things, product life cycles, competitive factors, and
	general economic conditions.

Any one of these factors, or a combination of one
or more factors, could adversely affect our annual and quarterly
operating results, which in turn may cause our stock price to
decline.

We are dependent on a single industry and
adverse trends in that industry may reduce our
revenues.During the past several
years, we have been significantly dependent on a single market.
In fiscal 2001, 61% of our revenues came from sales to hearing
instrument and medical manufacturers. These industries are
characterized by intense competition, relatively short product
life cycles, rapid technological change, significant
fluctuations in product demand and significant pressure on
vendors to reduce or minimize cost. Accordingly, we may be
adversely affected by these industry trends to the extent that
they reduce our revenues. In particular, if the hearing
instrument manufacturers develop new technologies that do not
incorporate our products, or if our competitors offer similar
products at a lower cost to such manufacturers, our revenues may
decrease and our business would be adversely affected.

Although we are attempting to reduce our
dependence on a single industry, we do not expect this historic
dependence to change dramatically or quickly. Moreover, a
significant amount of our non-hearing instrument industry sales
are made in the medical products industry, which is
characterized by trends similar to those in the hearing
instrument manufacturer industry.

Our customer base is highly concentrated and
the loss of a key customer may reduce our operating results and
financial condition.Our customer base
is highly concentrated. In fiscal 2001, 2000 and 1999, our two
largest customers, Siemens, Inc. and Sonic Innovations, Inc., in
the aggregate accounted for 51%, 57% and 65%, respectively, of
net sales. Each of these customers has multiple programs in
production with us. Although we are reducing this concentration,
we expect that sales to a relatively small number of original
equipment manufacturers will continue to account for a
substantial portion of net revenues for the foreseeable future.
The loss of, or a decline in orders from, any one of our key
customers would materially adversely affect our operating
results and financial condition. We are working for
diversification such that no one market would account for 40% or
more in revenue, no one customer at 10% or greater revenue and
no one program at 25% or greater.

We may lose business and revenues if we fail
to successfully compete with our customers for
business.We face competition from the
internal operations of our current and potential original
equipment manufacturer customers and from offshore contract
manufacturers, which, because of their lower labor rates and
other related factors, may enjoy a comparative advantage over us
with respect to high-volume production. We expect to continue to
encounter competition from other electronics manufacturers that
currently provide or may begin to provide contract design and
manufacturing services.

A number of our competitors may have
substantially greater manufacturing, financial, technical,
marketing, and other resources than we have, and may offer a
broader scope and presence of operations on a worldwide basis.
Significant competitive factors in the microelectronics market
include price, quality, design capabilities, responsiveness,
testing capabilities, the ability to manufacture in very high
volumes and proximity to the customers final assembly
facilities. While we have competed favorably in the past with
respect to these

13



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##### Table of Contents



factors, this is a particularly fast changing
market, and there can be no assurance that we will continue to
do so in the future.


We are often one of two or more suppliers on any
particular customer requirement and are, therefore, subject to
continuing competition on existing programs. In order to remain
competitive in any of our markets, we must continually provide
timely and technologically advanced design capabilities and
manufacturing services, ensure the quality of our products, and
compete favorably with respect to turnaround and price. If we
fail to compete favorably with respect to the principal
competitive factors in the markets we serve, we may lose
business and our operating results may be reduced.

Fluctuations in the price and supply of
components used to manufacture our products may reduce our
profits.Substantially all of the our
manufacturing services are provided on a turnkey basis in which
we, in addition to providing design, assembly and testing
services, are responsible for the procurement of the components
that are assembled by us for our customers. Although we attempt
to minimize margin erosion as a result of component price
increases, in certain circumstances we are required to bear some
or all of the risk of such price fluctuations, which could
adversely affect our profits. To date, we have generally been
able to negotiate contracts that allow us to shift much of the
impact of price fluctuations to the customer; however, there can
be no assurance that we will be able to do so in all cases.

In order to assure an adequate supply of certain
key components that have long procurement lead times, such as
integrated circuits, we occasionally must order such components
prior to receiving formal customer purchase orders for the
assemblies that require such components. Failure to accurately
anticipate the volume or timing of customer orders can result in
component shortages or excess component inventory, which in
either case could adversely affect our operating results and
financial condition.

Certain of the assemblies manufactured by us
require one or more components that are ordered from, or which
may be available from, only one source or a limited number of
sources. Delivery problems relating to components purchased from
any of our key suppliers could have a material adverse impact on
our financial performance. From time to time, our suppliers
allocate components among their customers in response to supply
shortages. In some cases, supply shortages will substantially
curtail production of all assemblies using a particular
component. In addition, at various times there have been
industry-wide shortages of electronic components. While we have
not experienced sustained periods of shortages of components in
the recent past, there can be no assurance that substantial
component shortages will not occur in the future. Any such
shortages could reduce our operating results.

Our costs may increase significantly if we are
unable to forecast customer orders and production
schedules.The level and timing of
orders placed by customers vary due to the customers
attempts to balance their inventory, changes in customers
manufacturing strategies, and variations in demand for the
customers products. Due in part to these factors, most of
our customers do not commit to firm production schedules more
than several weeks in advance of requirements. Our inability to
forecast the level of customers orders with certainty
makes it difficult to schedule production and optimize
utilization of manufacturing capacity. This uncertainty could
also significantly increase our costs related to manufacturing
product. In the past, we have been required to increase staffing
and incur other expenses in order to meet the anticipated
demands of our customers. From time to time, anticipated orders
from some of our customers have failed to materialize and
delivery schedules have been deferred as a result of changes in
a customers business needs, both of which have adversely
affected our operating results. On other occasions, customers
have required rapid increases in production that have placed an
excessive burden on our resources. There can be no assurance
that we will not experience similar fluctuations in customer
demand in the future.

We may have a significant accounts receivable
write-off and well as an increase in inventory reserve due to
the inability of our customers to pay their
accounts.We may carry significant
accounts receivable and inventory in connection with providing
manufacturing services to our customers. If one or more of our
principal customers were to become insolvent, or otherwise fail
to pay for the services and materials provided by us, our
operating results and financial condition would be adversely
affected.

Our business success may be adversely affected
by our ability to hire and retain
employees.Our continued growth and
success depend to a significant extent on the continued service
of senior management and other key employees and the hiring of
new qualified employees. We rely upon the acquisition and

14



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##### Table of Contents



retention of employees with extensive
technological experience. Competition for skilled business,
product development, technical and other personnel is intense.
There can be no assurance that we will be successful in
recruiting new personnel and retaining existing personnel. None
of our employees are subject to a long-term employment
agreement, although several key employees are subject to
non-competition agreements. The loss of one or more key
employees may materially adversely affect our growth. We do not
currently have employment contracts with any of our employees.


The price of our common stock may be adversely
affected by significant price fluctuations due to a number of
factors, many of which are beyond our
control.The market price of our
common stock has experienced significant fluctuations and may
continue to fluctuate in the future. The market price of the
common stock may be significantly affected by many factors,
including:



| |   |                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------
| |  | changes in requirements or demands for our
	services;                                                
|
| |  | the announcement of new products or product
	enhancements by us or our competitors;                  
|
| |  | technological innovations by us or our
	competitors;                                                 
|
| |  | quarterly variations in our or our
	competitors operating results;                                  
|
| |  | changes in prices of our or our competitors
	products and services;                                 
|
| |  | changes in our revenue and revenue growth rates;                                                     
|
| |  | changes in earnings estimates by market analysts,
	speculation in the press or analyst community; and
|
| |  | general market conditions or market conditions
	specific to particular industries.                   

The stock prices for many companies in the
technology sector have experienced wide fluctuations that often
have been unrelated to their operating performance. Such
fluctuations may adversely affect the market price of our common
stock.

Our articles of incorporation and bylaws may
discourage lawsuits and other claims against our
directors.Our articles of
incorporation provide, to the fullest extent permitted by
Minnesota law, that our directors shall have no personal
liability for breaches of their fiduciary duties to us. In
addition, our bylaws provide for mandatory indemnification of
directors and officers to the fullest extent permitted by
Minnesota law. These provisions may reduce the likelihood of
derivative litigation against directors and may discourage
shareholders from bringing a lawsuit against directors for a
breach of their duty.

Our operating results may be reduced if we are
unable to utilize our net operating loss
carryforwards.We have net operating
loss carryforwards for federal income tax purposes. We have not,
however, provided a valuation allowance for any deferred tax
assets because we believe that it is more likely than not that
they will be realized. Realization of these assets is dependent
on our achieving profitability levels sufficient to utilize our
net operating loss carryforwards. The write-off of this asset
may be required if we determine that we are unable to utilize
the net operating loss carryforwards. A write-off of this asset
could materially adversely affect our operating results and
financial condition.




If we are unable to register certain shares of
our common stock with the SEC within a specified period of time
from the closing on the private placement of such stock or our
stock is no longer listed on Nasdaq or is otherwise suspended
from trading, we may have to pay out amounts in excess of 125%
of the purchase price of such stock.On August 29, 2001, in connection with the private
placement of 950,000 shares of our common stock to certain of
the selling shareholders named in this Prospectus, we entered
into a stock purchase agreement and a registration rights
agreement. Such agreements provide that, in the event that our
common stock is suspended from trading for 5 or more consecutive
trading days, our common stock is no longer listed on a national
exchange or Nasdaq or such shares of common stock are not
registered with the SEC pursuant to an effective registration
statement within 180 days of August 29, 2001, such selling
shareholders will have the right, for a 30-day period, to put
the shares of common stock purchased under such agreement back
to us at 125% of the aggregate purchase price paid for such
shares (an aggregate amount of $8,312,500). We are unable to
offer assurances that such events will not occur and the put
rights will not be triggered. The




15



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##### Table of Contents






occurrence of any one of these events and the
triggering of the put rights may require us to pay amounts in
excess of the amounts received for such shares, which may have a
material adverse effect on our working capital and financial
condition.





We have issued numerous options to acquire our
common stock that could have a dilutive effect on our common
stock.As of October 31, 2001, we
had options outstanding to acquire 1,037,238 shares of our
common stock, exercisable at prices ranging from $5.125 to
$20.375 per share, with a weighted average exercise price
of approximately $10.64 per share. During the terms of
these options, the holders will have the opportunity to profit
from either an increase in the market price of our common stock
with resulting dilution to the holders of shares who purchased
shares for a price higher than the respective exercise or
conversion price. In addition, the increase in the outstanding
shares of our common stock as a result of the exercise or
conversion of these options could result in a significant
decrease in the percentage ownership of our common stock by the
purchasers of our common stock.

The market price of our common stock may be
reduced by future sales of our common stock in the public
market.Sales of substantial amounts
of common stock in the public market that are not currently
freely tradable, or even the potential for such sales, could
have an adverse effect on the market price for shares of our
common stock and could impair the ability of purchasers of our
common stock to recoup their investment or make a profit. As of
October 31, 2001, these shares consist of:



| |   |                                                                                                                    
| | - | -------------------------------------------------------------------------------------------------------------------
| |  | approximately 1,264,631 shares owned by our
	executive officers and directors of our outstanding common
	stock; and
|
| |  | approximately 1,037,238 shares issuable to
	option holders.                                                        

Unless the shares of our outstanding common stock
owned by our executive officers and directors are further
registered under the securities laws, they may not be resold
except in compliance with Rule 144 promulgated by the SEC,
or some other exemption from registration. Rule 144 does
not prohibit the sale of these shares but does place conditions
on their resale that must be complied with before they can be
resold.

Provisions in our articles of incorporation
allow us, without obtaining shareholder approval, to issue
additional shares of stock that may reduce the value of the
common stock or inhibit a third-party
acquisition.Our articles of
incorporation authorize our Board of Directors to issue up to
10,000,000 shares of common stock and 5,000,000 shares
of undesignated stock, the terms of which may be determined at
the time of issuance by the Board of Directors, without further
action by our shareholders. Undesignated stock authorized by the
Board of Directors may include voting rights, preferences as to
dividends and liquidation, conversion and redemptive rights and
sinking fund provisions. If the Board of Directors authorizes
the issuance of preferred stock in the future, this
authorization could affect the rights of the holders of our
common stock, thereby reducing the value of our common stock,
and could make it more difficult for a third party to acquire
us, even if a majority of the holders of our common stock
approved of an acquisition.




Future quarterly and annual operating results
may fluctuate substantially due to a number of factors, many of
which are beyond our control, which may cause us to be out of
compliance with our debt covenants.We
have experienced substantial fluctuations in our annual and
quarterly operating results and such fluctuations may continue
in future periods. Adverse operating results could result in an
event of default with our bank agreement for not meeting certain
financial and other restrictive covenants, such as, tangible net
worth, interest coverage ratio, debt service coverage ratio and
year to date net loss. Failure to meet these covenants could
require us to:






| |   |                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------
|
| |  | Immediately repay our outstanding balances;                                                            
|
|
|
| |  | Find a new lender, which may cause us to incur
	costs in connection with such new lending relationship;
|
|
|
| |  | Incur increased borrowing rates and amendment
	fees;                                                   
|
|
|
| |  | Incur additional restrictions on our ability to
	borrow additional funds.                              
|




Any one of these factors, or a combination of one
or more factors, could adversely affect our ability to borrow
funds or adversely affect future operating results.




16



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##### Table of Contents



Item 8.     Financial
Statements

Our financial statements as of August 31,
2001 and 2000, and for the years then ended together with the
Independent Auditors Report are included in this
Form 10-K on the pages indicated below.

|                                           |                                                             |          |    |    | 
|------------------------------------------ | ----------------------------------------------------------- | -------- | -- | -- | 
|                                           |                                                             | Page No.
|                                           |                                                             |         
|Consolidated Balance Sheets                |                                                             |          | 18 |   
|                                          
|                                          
|                                          
|                                          
|                                           | Consolidated Statements of Operations                       |          |    | 19 | 
|                                          
|                                          
|                                          
|                                          
|                                           | Consolidated Statements of Changes in
	Stockholders Equity |          |    | 20 | 
|                                          
|                                          
|                                          
|                                          
|                                           | Consolidated Statements of Cash Flows                       |          |    | 21 | 
|                                          
|                                          
|                                          
|                                          
|Notes to Consolidated Financial Statements |                                                             |          | 22 |   
|                                          
|                                          
|                                          
|                                          
|Independent Auditors Report               |                                                             |          | 35 |   
|                                          
|                                          
|                                          
|                                          
|                                           | Statement of Financial Responsibility                       |          |    | 36 | 

17



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##### Table of Contents



HEI, INC.






CONSOLIDATED BALANCE SHEETS


|                                           |                                                                                                   |                           |        |            |   |   |        |         |  
|------------------------------------------ | ------------------------------------------------------------------------------------------------- | ------------------------- | ------ | ---------- | - | - | ------ | ------- | -
|                                           |                                                                                                   | August 31,                |        | August 31,
|                                           |                                                                                                   | 2001                      |        | 2000      
|                                           |                                                                                                   |                           |        |           
|                                           |                                                                                                   |                          
|                                           |                                                                                                   | (In thousands, except per
|                                           |                                                                                                   | share amounts)           
|                                          
|                                          
|                                          
|                                          
|ASSETS                                    
|                                          
|                                          
|                                          
|                                          
|                                          
|Current assets:                            |                                                                                                   |                           |        |            |   |   |        |        
|                                          
|                                          
|                                          
|                                          
|                                           | Cash and cash equivalents                                                                         |                           | $      | 4,393      |   |   | $      | 484     |  
|                                          
|                                          
|                                          
|                                          
|                                           | Restricted cash                                                                                   |                           |        |           |   |   |        | 86      |  
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|                                           |                                                                                                   |                           | 4,393  |            |   |   | 570    |        
|                                          
|                                          
|                                          
|                                          
|                                           | Accounts receivable, net                                                                          |                           |        | 4,617      |   |   |        | 8,582   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Inventories                                                                                       |                           |        | 4,284      |   |   |        | 5,869   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Other current assets                                                                              |                           |        | 635        |   |   |        | 807     |  
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Total current assets                       |                                                                                                   |                           | 13,929 |            |   |   | 15,828 |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Property and equipment:                    |                                                                                                   |                           |        |            |   |   |        |        
|                                          
|                                          
|                                          
|                                          
|                                           | Land                                                                                              |                           |        | 216        |   |   |        | 216     |  
|                                          
|                                          
|                                          
|                                          
|                                           | Building and improvements                                                                         |                           |        | 4,316      |   |   |        | 4,170   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Fixtures and equipment                                                                            |                           |        | 18,810     |   |   |        | 17,265  |  
|                                          
|                                          
|                                          
|                                          
|                                           | Accumulated depreciation                                                                          |                           |        | (11,714    | ) |   |        | (10,457 | )
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Net property and equipment                 |                                                                                                   |                           | 11,628 |            |   |   | 11,194 |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Long-term investments                      |                                                                                                   |                           |       |            |   |   | 1,358  |        
|                                          
|                                          
|                                          
|                                          
|Other long-term assets                     |                                                                                                   |                           | 1,971  |            |   |   | 556    |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Total assets                               |                                                                                                   | $                         | 27,528 |            |   | $ | 28,936 |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|                                          
|                                          
|                                          
|                                          
|                                          
|LIABILITIES AND SHAREHOLDERS
	EQUITY     
|                                          
|                                          
|                                          
|                                          
|Current liabilities:                       |                                                                                                   |                           |        |            |   |   |        |        
|                                          
|                                          
|                                          
|                                          
|                                           | Revolving line of credit                                                                          |                           | $      | 10         |   |   | $      | 2,943   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Current maturities of long-term debt                                                              |                           |        | 1,441      |   |   |        | 1,107   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Accounts payable                                                                                  |                           |        | 1,912      |   |   |        | 4,326   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Accrued employee related costs                                                                    |                           |        | 839        |   |   |        | 947     |  
|                                          
|                                          
|                                          
|                                          
|                                           | Accrued liabilities                                                                               |                           |        | 934        |   |   |        | 603     |  
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Total current liabilities                  |                                                                                                   |                           | 5,136  |            |   |   | 9,926  |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Long-term debt, less current maturities    |                                                                                                   |                           | 3,972  |            |   |   | 3,894  |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Total liabilities                          |                                                                                                   |                           | 9,108  |            |   |   | 13,820 |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Shareholders equity:                      |                                                                                                   |                           |        |            |   |   |        |        
|                                          
|                                          
|                                          
|                                          
|                                           | Undesignated stock; 5,000 shares authorized;
	none issued                                         |                           |        |           |   |   |        |        |  
|                                          
|                                          
|                                          
|                                          
|                                           | Common stock, $.05 par; 10,000 shares
	authorized; 5,956 and 4,777 shares
	issued and outstanding |                           |        | 298        |   |   |        | 239     |  
|                                          
|                                          
|                                          
|                                          
|                                           | Paid-in capital                                                                                   |                           |        | 16,310     |   |   |        | 8,606   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Retained earnings                                                                                 |                           |        | 3,078      |   |   |        | 6,271   |  
|                                          
|                                          
|                                          
|                                          
|                                           | Notes receivable                                                                                  |                           |        | (1,266     | ) |   |        |        |  
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Total shareholders equity                 |                                                                                                   |                           | 18,420 |            |   |   | 15,116 |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        
|Total liabilities and shareholders equity |                                                                                                   | $                         | 27,528 |            |   | $ | 28,936 |        
|                                           |                                                                                                   |                           |        |            |   |   |        |        

The accompanying notes are an integral part of
the consolidated financial statements.

18



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##### Table of Contents



HEI, INC.






CONSOLIDATED STATEMENTS OF
OPERATIONS


|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |       | 
|------------------------------------------ | ------------------------------------- | ------------------------- | ------ | ----- | - | ---- | ------ | ----- | - | - | ------ | ----- | 
|                                           |                                       |                          
|                                           |                                       | Years Ended August 31    
|                                           |                                       |                          
|                                           |                                       | 2001                      |        | 2000  |   | 1999
|                                           |                                       |                           |        |       |   |     
|                                           |                                       |                          
|                                           |                                       | (In thousands,           
|                                           |                                       | except per share amounts)
|                                          
|                                          
|                                          
|                                          
|Net sales                                  |                                       | $                         | 44,832 |       |   | $    | 42,799 |       |   | $ | 29,089 |      
|                                          
|                                          
|                                          
|                                          
|Cost of sales                              |                                       |                           | 36,841 |       |   |      | 35,544 |       |   |   | 22,378 |      
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      
|                                           | Gross profit                          |                           |        | 7,991 |   |      |        | 7,255 |   |   |        | 6,711 | 
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      
|Operating expenses:                        |                                       |                           |        |       |   |      |        |       |   |   |        |      
|                                          
|                                          
|                                          
|                                          
|                                           | Selling, general and administrative   |                           |        | 5,806 |   |      |        | 6,338 |   |   |        | 4,623 | 
|                                          
|                                          
|                                          
|                                          
|                                           | Research, development and engineering |                           |        | 2,433 |   |      |        | 1,764 |   |   |        | 1,343 | 
|                                          
|                                          
|                                          
|                                          
|                                           | Unusual charges                       |                           |        | 1,693 |   |      |        | 453   |   |   |        | 490   | 
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      
|Operating income (loss)                    |                                       |                           | (1,941 | )     |   |      | (1,300 | )     |   |   | 255    |      
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      
|Loss on equity investment                  |                                       |                           | (1,450 | )     |   |      | (142   | )     |   |   | (58    | )    
|                                          
|                                          
|                                          
|                                          
|Other income (expense), net                |                                       |                           | (732   | )     |   |      | (85    | )     |   |   | 438    |      
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      
|Income (loss) before income taxes          |                                       |                           | (4,123 | )     |   |      | (1,527 | )     |   |   | 635    |      
|                                          
|                                          
|                                          
|                                          
|Income tax expense (benefit)               |                                       |                           | (930   | )     |   |      | (372   | )     |   |   | 242    |      
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      
|Net income (loss)                          |                                       | $                         | (3,193 | )     |   | $    | (1,155 | )     |   | $ | 393    |      
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      
|Net income (loss) per common share         |                                       |                           |        |       |   |      |        |       |   |   |        |      
|                                          
|                                          
|                                          
|                                          
|                                           | Basic                                 |                           | $      | (0.65 | ) |      | $      | (0.24 | ) |   | $      | 0.08  | 
|                                          
|                                          
|                                          
|                                          
|                                           | Diluted                               |                           | $      | (0.65 | ) |      | $      | (0.24 | ) |   | $      | 0.08  | 
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      
|Weighted average common shares outstanding |                                       |                           |        |       |   |      |        |       |   |   |        |      
|                                          
|                                          
|                                          
|                                          
|                                           | Basic                                 |                           |        | 4,881 |   |      |        | 4,726 |   |   |        | 4,698 | 
|                                          
|                                          
|                                          
|                                          
|                                           | Diluted                               |                           |        | 4,881 |   |      |        | 4,726 |   |   |        | 4,701 | 
|                                           |                                       |                           |        |       |   |      |        |       |   |   |        |      

The accompanying notes are an integral part of
the consolidated financial statements.

19



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##### Table of Contents



HEI, INC.






CONSOLIDATED STATEMENTS OF CHANGES IN
SHAREHOLDERS EQUITY


|                         |                                                                       |                                      |           |             |  |            |     |          |  |            |        |        |  |   |       |        |   |   |        |        |   |   |        |        |  
|------------------------ | --------------------------------------------------------------------- | ------------------------------------ | --------- | ----------- |  | ---------- | --- | -------- |  | ---------- | ------ | ------ |  | - | ----- | ------ | - | - | ------ | ------ | - | - | ------ | ------ | -
|                         |                                                                       | Common                               |           | Common      |  |            |     |          |  |            |        |       
|                         |                                                                       | Stock                                |           | Stock       |  | Additional |     |          |  |            |        |       
|                         |                                                                       | Shares                               |           | Amount      |  | Paid-In    |     | Retained |  | Notes      |        | Total 
|                         |                                                                       | Outstanding                          |           | Outstanding |  | Capital    |     | Earnings |  | Receivable |        | Equity
|                         |                                                                       |                                      |           |             |  |            |     |          |  |            |        |       
|                         |                                                                       |                                     
|                         |                                                                       | (In thousands, except share amounts)
|                        
|                        
|                        
|                        
|Balance, August 31, 1998 |                                                                       |                                      | 4,695,195 |             |  | $          | 235 |          |  | $          | 7,867  |        |  | $ | 7,033 |        |   |   |       |        |   | $ | 15,135 |       
|                        
|                        
|                        
|                        
|                         | Net income                                                            |                                      |           |            |  |            |     |         |  |            |        |       |  |   |       | 393    |   |   |        |       |   |   |        | 393    |  
|                        
|                        
|                        
|                        
|                         | Issuance of common shares under stock benefit
	plans and option plans |                                      |           | 6,770       |  |            |     |         |  |            |        | 38     |  |   |       |       |   |   |        |       |   |   |        | 38     |  
|                         |                                                                       |                                      |           |             |  |            |     |          |  |            |        |        |  |   |       |        |   |   |        |        |   |   |        |       
|Balance, August 31, 1999 |                                                                       |                                      | 4,701,965 |             |  |            | 235 |          |  |            | 7,905  |        |  |   | 7,426 |        |   |   |       |        |   |   | 15,566 |       
|                        
|                        
|                        
|                        
|                         | Net loss                                                              |                                      |           |            |  |            |     |         |  |            |        |       |  |   |       | (1,155 | ) |   |        |       |   |   |        | (1,155 | )
|                        
|                        
|                        
|                        
|                         | Issuance of common shares under stock benefit
	plans                  |                                      |           | 74,731      |  |            |     | 4        |  |            |        | 438    |  |   |       |       |   |   |        |       |   |   |        | 442    |  
|                        
|                        
|                        
|                        
|                         | Tax benefit of nonqualified stock options                             |                                      |           |            |  |            |     |         |  |            |        | 199    |  |   |       |       |   |   |        |       |   |   |        | 199    |  
|                        
|                        
|                        
|                        
|                         | Stock-based compensation                                              |                                      |           |            |  |            |     |         |  |            |        | 64     |  |   |       |       |   |   |        |       |   |   |        | 64     |  
|                         |                                                                       |                                      |           |             |  |            |     |          |  |            |        |        |  |   |       |        |   |   |        |        |   |   |        |       
|Balance, August 31, 2000 |                                                                       |                                      | 4,776,696 |             |  |            | 239 |          |  |            | 8,606  |        |  |   | 6,271 |        |   |   |       |        |   |   | 15,116 |       
|                        
|                        
|                        
|                        
|                         | Net loss                                                              |                                      |           |            |  |            |     |         |  |            |        |       |  |   |       | (3,193 | ) |   |        |       |   |   |        | (3,193 | )
|                        
|                        
|                        
|                        
|                         | Issuance of common shares under stock benefit
	plans                  |                                      |           | 229,764     |  |            |     | 11       |  |            |        | 1,369  |  |   |       |       |   |   |        |       |   |   |        | 1,380  |  
|                        
|                        
|                        
|                        
|                         | Non-cash CMED expenses                                                |                                      |           |            |  |            |     |         |  |            |        | 161    |  |   |       |       |   |   |        |       |   |   |        | 161    |  
|                        
|                        
|                        
|                        
|                         | Notes receivable                                                      |                                      |           |            |  |            |     |         |  |            |        |       |  |   |       |       |   |   |        | (1,266 | ) |   |        | (1,266 | )
|                        
|                        
|                        
|                        
|                         | Private equity placement                                              |                                      |           | 950,000     |  |            |     | 48       |  |            |        | 6,174  |  |   |       |       |   |   |        |       |   |   |        | 6,222  |  
|                         |                                                                       |                                      |           |             |  |            |     |          |  |            |        |        |  |   |       |        |   |   |        |        |   |   |        |       
|Balance, August 31, 2001 |                                                                       |                                      | 5,956,460 |             |  | $          | 298 |          |  | $          | 16,310 |        |  | $ | 3,078 |        |   | $ | (1,266 | )      |   | $ | 18,420 |       
|                         |                                                                       |                                      |           |             |  |            |     |          |  |            |        |        |  |   |       |        |   |   |        |        |   |   |        |       

The accompanying notes are an integral part of
the consolidated financial statements.

20



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##### Table of Contents



HEI, INC.






CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |        |  
|---------------------------------------------------------- | ------------------------------------------------------- | --------------------- | ------ | ------ | - | ---- | ------ | ------ | - | - | ------ | ------ | -
|                                                           |                                                         |                      
|                                                           |                                                         | Years Ended August 31
|                                                           |                                                         |                      
|                                                           |                                                         | 2001                  |        | 2000   |   | 1999
|                                                           |                                                         |                       |        |        |   |     
|                                                           |                                                         |                      
|                                                           |                                                         | (In thousands)       
|                                                          
|                                                          
|                                                          
|                                                          
|Cash flow from operating activities:                       |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Net income (loss)                                       |                       | $      | (3,193 | ) |      | $      | (1,155 | ) |   | $      | 393    |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Equity in net loss from MSC                             |                       |        | 1,417  |   |      |        | 110    |   |   |        | 32     |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Depreciation and amortization                           |                       |        | 2,862  |   |      |        | 2,407  |   |   |        | 1,577  |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Accounts receivable allowance                           |                       |        | 56     |   |      |        | 75     |   |   |        | (90    | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Deferred income tax expense (benefit)                   |                       |        | (930   | ) |      |        | (571   | ) |   |        | 103    |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Stock-based compensation and other                      |                       |        |       |   |      |        | 244    |   |   |        | 4      |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Non-cash expenses for CMED transaction                  |                       |        | 161    |   |      |        |       |   |   |        |       |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Loss on disposal of property and equipment and
	other   |                       |        | 188    |   |      |        |       |   |   |        |       |  
|                                                          
|                                                          
|                                                          
|                                                          
|Changes in operating assets and liabilities:               |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Accounts receivable                                     |                       |        | 3,909  |   |      |        | (5,275 | ) |   |        | 736    |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Inventories                                             |                       |        | 1,585  |   |      |        | (3,623 | ) |   |        | (531   | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Income taxes                                            |                       |        | 81     |   |      |        | (14    | ) |   |        | 1,243  |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Other current assets                                    |                       |        | 95     |   |      |        | (66    | ) |   |        | 242    |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Accounts payable                                        |                       |        | (2,414 | ) |      |        | 2,697  |   |   |        | (387   | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Accrued employee related costs and accrued
	liabilities |                       |        | 113    |   |      |        | (350   | ) |   |        | 31     |  
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|Net cash flow provided by (used for) operating
	activities |                                                         |                       | 3,930  |        |   |      | (5,521 | )      |   |   | 3,353  |       
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|Cash flow from investing activities:                       |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Purchases of investments                                |                       |        |       |   |      |        |       |   |   |        | (9,536 | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Maturities of investments                               |                       |        |       |   |      |        | 3,744  |   |   |        | 13,962 |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Additions to property and equipment                     |                       |        | (3,418 | ) |      |        | (4,329 | ) |   |        | (3,886 | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Investment in MSC                                       |                       |        |       |   |      |        |       |   |   |        | (1,500 | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Licensing agreement                                     |                       |        |       |   |      |        |       |   |   |        | (129   | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Proceeds from sales of product lines                    |                       |        |       |   |      |        |       |   |   |        | 55     |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Decrease (increase) in restricted cash                  |                       |        | 86     |   |      |        | 292    |   |   |        | (378   | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Additions to patents                                    |                       |        | (115   | ) |      |        |       |   |   |        |       |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Other long term prepaid assets                          |                       |        | (356   | ) |      |        |       |   |   |        |       |  
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|Net cash flow used for investing activities                |                                                         |                       | (3,803 | )      |   |      | (293   | )      |   |   | (1,412 | )     
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|Cash flow from financing activities:                       |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Issuance of common stock and other                      |                       |        | 6,336  |   |      |        | 506    |   |   |        | 38     |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Proceeds from long-term debt                            |                       |        | 1,762  |   |      |        | 1,665  |   |   |        | 239    |  
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Repayments of long-term debt                            |                       |        | (1,350 | ) |      |        | (821   | ) |   |        | (617   | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Increase in deferred financing fees                     |                       |        | (33    | ) |      |        | (38    | ) |   |        | (41    | )
|                                                          
|                                                          
|                                                          
|                                                          
|                                                           | Borrowings on (repayments of) revolving line of
	credit |                       |        | (2,933 | ) |      |        | 2,943  |   |   |        |       |  
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|Net cash flow provided by (used for) financing
	activities |                                                         |                       | 3,782  |        |   |      | 4,255  |        |   |   | (381   | )     
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|Net increase (decrease) in cash and cash
	equivalents      |                                                         |                       | 3,909  |        |   |      | (1,559 | )      |   |   | 1,560  |       
|                                                          
|                                                          
|                                                          
|                                                          
|Cash and cash equivalents, beginning of year               |                                                         |                       | 484    |        |   |      | 2,043  |        |   |   | 483    |       
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|Cash and cash equivalents, end of year                     |                                                         | $                     | 4,393  |        |   | $    | 484    |        |   | $ | 2,043  |       
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|Supplemental disclosures of cash flow
	information:        |                                                         |                       |        |        |   |      |        |        |   |   |        |       
|                                                          
|                                                          
|                                                          
|                                                          
|Interest paid                                              |                                                         | $                     | 466    |        |   | $    | 294    |        |   | $ | 160    |       
|                                                          
|                                                          
|                                                          
|                                                          
|Income taxes paid (received)                               |                                                         |                       | (48    | )      |   |      | 279    |        |   |   | 229    |       
|                                                           |                                                         |                       |        |        |   |      |        |        |   |   |        |       

The accompanying notes are an integral part of
the consolidated financial statements.

21



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##### Table of Contents



HEI, INC.






NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


Note 1



| |                                            
| | -------------------------------------------
| | Summary of Significant Accounting
	Policies

HEI, Inc. and its subsidiaries (the Company)
specialize in the design and manufacture of ultraminiature
microelectronic devices and high technology products
incorporating those devices. The Company also produces quality
flex circuits and high performance laminate based substrates.

Principles of Consolidation.The consolidated financial statements
include the accounts of the Company, HEI Export, Inc. and Cross
Technology, Inc., its wholly-owned subsidiaries. All significant
intercompany transactions and balances have been eliminated in
consolidation.

Business Combination.On March 3, 2000 HEI acquired
Cross Technology, Inc. (Cross), a manufacturer and marketer of
wireless Smart Cards and other ultra-miniature radio frequency
(RF) applications. Under the terms of the agreement,
600,000 shares of HEI common stock were exchanged for all
of the outstanding common stock of Cross. The transaction was
accounted for as a pooling of interests and, accordingly, all
prior period consolidated financial statements include the
results of operations, financial position and cash flows of
Cross Technology, Inc.

The following information presents certain income
statement data of the separate companies for the periods
preceding the acquisition:

|                        |                  |                  |   |            |        |   |   |        |        | 
|----------------------- | ---------------- | ---------------- | - | ---------- | ------ | - | - | ------ | ------ | 
|                        |                  | Six Months Ended |   | Year Ended
|                        |                  | March 4,         |   | August 31,
|                        |                  | 2000             |   | 1999      
|                        |                  |                  |   |           
|                        |                  |                 
|                        |                  | (In thousands)  
|Revenues                |                  |                  |   |            |        |   |   |       
|                       
|                       
|                       
|                       
|                        | HEI              |                  | $ | 14,127     |        |   | $ | 24,323 |       
|                       
|                       
|                       
|                       
|                        | Cross Technology |                  |   | 3,359      |        |   |   | 4,766  |       
|                        |                  |                  |   |            |        |   |   |       
|                        |                  | Consolidated     |   |            | 17,486 |   |   |        | 29,089 | 
|                        |                  |                  |   |            |        |   |   |       
|Operating income (loss) |                  |                  |   |            |        |   |   |       
|                       
|                       
|                       
|                       
|                        | HEI              |                  |   | (2,126     | )      |   |   | (718   | )     
|                       
|                       
|                       
|                       
|                        | Cross Technology |                  |   | (11        | )      |   |   | 973    |       
|                        |                  |                  |   |            |        |   |   |       
|                        |                  | Consolidated     |   |            | (2,137 | ) |   |        | 255    | 
|                        |                  |                  |   |            |        |   |   |       
|Net income (loss)       |                  |                  |   |            |        |   |   |       
|                       
|                       
|                       
|                       
|                        | HEI              |                  |   | (1,968     | )      |   |   | (223   | )     
|                       
|                       
|                       
|                       
|                        | Cross Technology |                  |   | (7         | )      |   |   | 616    |       
|                        |                  |                  |   |            |        |   |   |       
|                        |                  | Consolidated     |   | $          | (1,975 | ) |   | $      | 393    | 
|                        |                  |                  |   |            |        |   |   |       

Cash, Cash Equivalents and Short-Term
Investments.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. Short-term
investments consist mainly of high quality commercial paper with
maturities of less than one year. The short-term
investments are carried at amortized cost, which approximates
fair value, and are classified as held to maturity.

Inventories.Inventories are stated at the lower of
cost or market and include materials, labor and overhead costs.
The moving average cost method is used to value inventories.

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. The

22



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

approximate useful lives of building and
improvements are 10-39 years and fixtures and equipment are
3-10 years.

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 is charged or credited to operations.

Patents.External
costs associated with patents are capitalized and amortized over
60 months or the remaining life of the patent, whichever is
shorter. Management periodically assesses the amortization
period and recoverability of the carrying amount of intangible
assets based upon an estimation of their value and future
benefits of the recorded asset. As of August 31, 2001 the
carrying amount of the intangible assets is realizable.

Long-Lived Assets.Long-lived assets and certain
identifiable intangibles are evaluated for impairment whenever
events or changes in circumstances indicate that the carrying
value of an asset may not be recoverable from future
undiscounted cash flows. Impairment losses are recorded for the
difference between the carrying value and the fair value of the
long-lived asset. As of August 31, 2001, no assets were
impaired.

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 income 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
(benefit) is the tax payable (receivable) for the periods and
the change during the period in deferred income tax assets and
liabilities.

Stock-based Compensation.The Company accounts for stock based
compensation under Accounting Principles Board Opinion
No. 25 (APB 25), Accounting for Stock Issued to
Employees. APB 25 requires compensation cost to be
recorded on the date of the grant only if the current market
price of the underlying stock exceeds the exercise price. The
Company has adopted the disclosure-only provisions of Statement
of Financial Accounting Standards Board
(SFAS) No. 123, Accounting for Stock-based
Compensation.

Revenue Recognition.Revenue and related cost of sales are
generally recognized upon shipment. In fiscal 2002, the Company
began a consignment program with a significant customer, whereas
revenue is recognized when the customer uses the inventory.

Net Income (Loss) Per Weighted Average Common
Share.Basic earnings per share
(EPS) is computed by dividing net income (loss) by the
weighted average number of common shares outstanding during each
period. Diluted earnings per share is computed by dividing net
income (loss) by the weighted average number of common shares
outstanding assuming the exercise of dilutive stock options. The
dilutive effect of the stock options is computed using the
average market price of the Companys stock during each
period under the treasury stock method. During periods of loss,
options are dilutive and are thus excluded from the calculation.

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.

Financial Instruments.The fair value of cash equivalents,
accounts receivable and payable approximate their carrying value
due to the short-term nature of these instruments. The fair
market values of the

23



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Companys borrowings outstanding approximate
their carrying values based upon current market rates of
interest.

Reclassifications.Certain amounts reported in the prior
years have been reclassified to conform to the current year
presentation.

New Accounting Pronouncements.In June 1998, the Financial Accounting
Standards Board (FASB) issued SFAS No. 133,
Accounting for Derivative Instruments and Hedging
Activities, which, as amended, becomes effective for
fiscal years beginning after June 15, 2000.

SFAS No. 133 establishes accounting and
reporting standards for derivative financial instruments and
hedging activities related to those instruments as well as other
hedging activities. It requires an entity to recognize all
derivatives as either assets or liabilities in the statement of
financial position and measures those instruments at fair value,
unless specific hedge accounting requirements are met. The
Company does not generally enter into arrangements that would
fall under the scope of SFAS No. 133 and thus, its adoption
did not affect the Companys financial condition or results
of operations for the year ended August 31, 2001.

In December, 1999, the Securities and Exchange
Commission (SEC) staff issued Staff Accounting Bulletin
No. 101, Revenue Recognition in Financial
Statements (SAB 101). SAB 101 summarizes certain
SEC staffs views in applying generally accepted accounting
principles to revenue recognition in financial statements. The
Company implemented SAB 101 during fiscal 2001, with no
effect on its financial condition or results of operations.

In June 2001, the FASB issued SFAS No. 141,
Business Combinations and SFAS No. 142,
Goodwill and Other Intangible Assets. These
standards revised the rules related to the accounting for
business combinations, goodwill and other intangible assets.
SFAS No. 141 requires that all business combinations
initiated after June 30, 2001 be accounted for using the
purchase accounting method. SFAS No. 142 states that
goodwill is no longer subject to amortization over its useful
life. Rather, goodwill will be subject to annual assessment for
impairment and be written down to its fair value only if the
carrying amount is greater than the fair value. In addition,
intangible assets are separately recognized if the benefit of
the intangible asset can be sold, transferred, licensed, rented
or exchanged, regardless of the acquirers intent to do so.
The amount and timing of non-cash charges related to intangibles
acquired in business combinations will change significantly from
prior practice. The effect of adopting SFAS 141 and 142 in
fiscal 2002 is not expected to have an impact on the
Companys financial position or results of operations.

In June 2001, the FASB issued SFAS No. 143,
Accounting for Asset Retirement Obligations. This
statement established accounting standards for recognition and
measurement of a liability for an asset retirement obligation
and the associated asset retirement cost. It requires an entity
to recognize the fair value of a liability for an asset
retirement obligation in the period in which it is incurred if a
reasonable estimate can be made. The Company is required to
adopt this statement in its fiscal year 2003. The Company has
not yet quantified the potential effect of adoption of SFAS
No. 143.

In October 2001, the FASB issued SFAS
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, which addresses financial accounting
and reporting for the impairment or disposal of long-lived
assets. The Company is required to adopt this statement in its
fiscal year 2003. The Company has not yet quantified the
potential effect of adoption of SFAS No. 144.

24



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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 net sales for the years ended
August 31, were as follows:

|           |  |      |    |      |  |      |    |   |  |  |    |  
|---------- |  | ---- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|           |  | 2001 |    | 2000 |  | 1999
|           |  |      |    |      |  |     
|Customer A |  |      | 26 | %    |  |      | 15 | % |  |  |   |  
|          
|          
|          
|          
|Customer B |  |      | 25 | %    |  |      | 42 | % |  |  | 52 | %
|          
|          
|          
|          
|Customer C |  |      | 10 | %    |  |      |   |   |  |  | 13 | %
|          
|          
|          
|          
|Customer D |  |      |   |      |  |      | 11 | % |  |  |   |  

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 are often
dependent upon the continuance of the customers product
programs. The Companys ten largest customers accounted for
approximately 82%, 89% and 90% of net sales in fiscal years
2001, 2000 and 1999, respectively, and approximately 69% and 88%
of accounts receivable at August 31, 2001 and 2000,
respectively.

The Company had net sales of $11,209, $17,687 and
$14,190 that were shipped to Singapore in fiscal 2001, 2000 and
1999, respectively. Net export sales were $14,711, $20,026, and
$16,658 in fiscal 2001, 2000 and 1999, respectively. The
majority of the international sales were to multinational
companies who instructed HEI to ship products to their offshore
assembly facilities.

Note 3



| |                                
| | -------------------------------
| | Other Financial Statement
	Data

The following provides additional information
concerning selected consolidated balance sheet accounts at
August 31, 2001 and 2000:

|                          |                                       |                |       |       |   |   |       |       |  
|------------------------- | ------------------------------------- | -------------- | ----- | ----- | - | - | ----- | ----- | -
|                          |                                       | 2001           |       | 2000 
|                          |                                       |                |       |      
|                          |                                       |               
|                          |                                       | (In thousands)
|                         
|                         
|                         
|                         
|Accounts receivable, net: |                                       |                |       |       |   |   |       |      
|                         
|                         
|                         
|                         
|                          | Trade accounts receivable             |                | $     | 4,888 |   |   | $     | 8,797 |  
|                         
|                         
|                         
|                         
|                          | Less: allowance for doubtful accounts |                |       | (271  | ) |   |       | (215  | )
|                          |                                       |                |       |       |   |   |       |      
|                          |                                       | $              | 4,617 |       |   | $ | 8,582 |      
|                          |                                       |                |       |       |   |   |       |      
|Inventories:              |                                       |                |       |       |   |   |       |      
|                         
|                         
|                         
|                         
|                          | Purchased parts                       |                | $     | 3,209 |   |   | $     | 5,158 |  
|                         
|                         
|                         
|                         
|                          | Work in process                       |                |       | 387   |   |   |       | 418   |  
|                         
|                         
|                         
|                         
|                          | Finished goods                        |                |       | 688   |   |   |       | 293   |  
|                          |                                       |                |       |       |   |   |       |      
|                          |                                       | $              | 4,284 |       |   | $ | 5,869 |      
|                          |                                       |                |       |       |   |   |       |      
|Other current assets:     |                                       |                |       |       |   |   |       |      
|                         
|                         
|                         
|                         
|                          | Deferred tax assets                   |                | $     | 429   |   |   | $     | 506   |  
|                         
|                         
|                         
|                         
|                          | Other current assets                  |                |       | 206   |   |   |       | 301   |  
|                          |                                       |                |       |       |   |   |       |      
|                          |                                       | $              | 635   |       |   | $ | 807   |      
|                          |                                       |                |       |       |   |   |       |      

25



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

|                          |                          |                |       |       |  |   |     |     | 
|------------------------- | ------------------------ | -------------- | ----- | ----- |  | - | --- | --- | 
|                          |                          | 2001           |       | 2000 
|                          |                          |                |       |      
|                          |                          |               
|                          |                          | (In thousands)
|                         
|                         
|                         
|                         
|Other non-current assets: |                          |                |       |       |  |   |     |    
|                         
|                         
|                         
|                         
|                          | Deferred tax assets      |                | $     | 1,413 |  |   | $   | 374 | 
|                         
|                         
|                         
|                         
|                          | Other non-current assets |                |       | 558   |  |   |     | 182 | 
|                          |                          |                |       |       |  |   |     |    
|                          |                          | $              | 1,971 |       |  | $ | 556 |    
|                          |                          |                |       |       |  |   |     |    

Note 4



| |                
| | ---------------
| | Unusual Charges

During fiscal 2001, unusual charges consist of
$1,268 write-off of accounts receivable primarily related to
Mexico customers, which occurred in the second quarter and $425
of costs related to the closing of the Mexico operations in the
third quarter. The Mexico closure costs consisted of $150 in
severance costs, $185 in facilities costs and $90 of other
costs. The severance costs relate to contractual severance
obligations to contract employees located in Mexico and
non-contract obligations to employees located in Tucson. The
facilities costs relate to the negotiated settlement of
non-cancelable lease payments of $60 on the closed facilities
and the write off of leasehold improvements and fixed assets of
$125. At August 31, 2001, there were no remaining future
cash obligations related to the Mexico closing.

Following is a summary of the costs incurred
related to the closing of the Mexico operations:

|                            |  |           |     |          |  |            |     |  |  |   |   | 
|--------------------------- |  | --------- | --- | -------- |  | ---------- | --- |  |  | - | - | 
|                            |  |           |     | Paid or  |  |           
|                            |  |           |     | Utilized |  |           
|                            |  | Expensed  |     | During   |  | Accrued at
|                            |  | in Fiscal |     | Fiscal   |  | August 31,
|                            |  | 2001      |     | 2001     |  | 2001      
|                            |  |           |     |          |  |           
|Severance costs             |  | $         | 150 |          |  | $          | 150 |  |  | $ |  | 
|                           
|                           
|                           
|                           
|Facilities costs  cash     |  |           | 60  |          |  |            | 60  |  |  |   |  | 
|                           
|                           
|                           
|                           
|Facilities costs  non-cash |  |           | 125 |          |  |            | 125 |  |  |   |  | 
|                           
|                           
|                           
|                           
|Other                       |  |           | 90  |          |  |            | 90  |  |  |   |  | 
|                            |  |           |     |          |  |            |     |  |  |   |   | 
|                            |  | $         | 425 |          |  | $          | 425 |  |  | $ |  | 
|                            |  |           |     |          |  |            |     |  |  |   |   | 

During fiscal 2000, unusual charges consist of
$453 of costs related to the acquisition of Cross Technology in
March 2000. The acquisition costs primarily consist of
investment banker fees, legal fees and audit/ accounting fees.

In fiscal year 1999, the Company incurred $490 of
severance costs related to the employment agreement between the
Company and Eugene W. Courtney, the former Chief Executive
Officer, which is classified as unusual charges on the
statements of operations.

26



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Note 5



| |               
| | --------------
| | Long-Term Debt

Long-term debt consists of the following:

|                                                                                                                                                                                                                                                                                                          |  |                        |       |      |  |   |       | 
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------- | ----- | ---- |  | - | ----- | 
|                                                                                                                                                                                                                                                                                                          |  | 2001                   |       | 2000
|                                                                                                                                                                                                                                                                                                          |  |                        |       |     
|                                                                                                                                                                                                                                                                                                          |  |                       
|                                                                                                                                                                                                                                                                                                          |  | (Dollars in thousands)
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|Industrial Development Revenue Bonds payable on a
	yearly basis with principal installments from $95 to $700
	through April 2011 and variable interest ranging from 2.11% to
	6.35% during fiscal year 2001                                                                                               |  | $                      | 2,435 |      |  | $ | 3,135 | 
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|Commercial loan payable in fixed monthly
	installments of $5 at 8.19% interest maturing June 2004; secured
	with certain machinery and equipment                                                                                                                                                          |  |                        | 154   |      |  |   | 201   | 
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|Capital expenditure notes payable on a monthly
	basis with principal installments of $28 and interest due
	monthly at the prime rate plus 1 1/4% (7.75% at
	August 31, 2001); secured by machinery and equipment and
	cross collateralized with revolving line of credit and letter of
	credit facilities |  |                        | 2,824 |      |  |   | 1,665 | 
|                                                                                                                                                                                                                                                                                                          |  |                        |       |      |  |   |       | 
|Total                                                                                                                                                                                                                                                                                                     |  |                        | 5,413 |      |  |   | 5,001 | 
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                         
|Less current maturities                                                                                                                                                                                                                                                                                   |  |                        | 1,441 |      |  |   | 1,107 | 
|                                                                                                                                                                                                                                                                                                          |  |                        |       |      |  |   |       | 
|Total long-term debt                                                                                                                                                                                                                                                                                      |  | $                      | 3,972 |      |  | $ | 3,894 | 
|                                                                                                                                                                                                                                                                                                          |  |                        |       |      |  |   |       | 

Principal maturities of long-term debt at
August 31, 2001 are as follows (in thousands):

|                        |  |   |       | 
|----------------------- |  | - | ----- | 
|Years ending August 31, |  |   |       | 
|                       
|                       
|                       
|                       
|2002                    |  | $ | 1,441 | 
|                       
|                       
|                       
|                       
|2003                    |  |   | 1,446 | 
|                       
|                       
|                       
|                       
|2004                    |  |   | 1,091 | 
|                       
|                       
|                       
|                       
|2005                    |  |   | 806   | 
|                       
|                       
|                       
|                       
|2006                    |  |   | 154   | 
|                       
|                       
|                       
|                       
|Thereafter              |  |   | 475   | 
|                        |  |   |       | 
|                        |  | $ | 5,413 | 
|                        |  |   |       | 

All of the Companys long-term debt is
subject to certain restrictive financial covenants, including
but not limited to, tangible net worth, interest coverage, debt
service coverage, annual loss limitations and the ability to
declare or pay dividends. The Company was not in compliance with
the interest coverage ratio, debt service coverage ratio and
year to date net loss covenants at August 31, 2001. The
Company has amended the agreement with the financial
institution, which waives the events of default at
August 31, 2001 and amends the covenants for fiscal 2002.
Based on current projections, the Company believes that it will
meet the bank covenants going forward and has classified the
debt per the terms of the respective agreements.

The Company has Industrial Development Revenue
Bonds outstanding totaling $2,435 at August 31, 2001. These
bonds were originally issued April 1996 in connection with the
construction of a new addition to the Companys
manufacturing facility in Minnesota and for equipment purchases.
The bonds related to the facility expansion require annual
principal payments of $95,000 on April 1 through 2011. The
bonds related to the purchased equipment require payments over
seven years from the date of purchase of the equipment through
April 1, 2005. In fiscal 2001 and 2000, the Company made
principal payments of $700 per year in fiscal 2001 and
2000, related to these bonds. 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, 2001

27



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

was 2.11%. The bonds are collateralized by two
irrevocable letters of credit and essentially all property and
equipment. A commitment fee is paid annually to the bank at a
rate of 1.25% of the letters of credit.

The Company has an agreement with a financial
institution for capital expenditure loans. According to the
terms of the loan, the Company will receive up to $8,500
reimbursement for capital equipment expenditures. At
August 31, 2001, unused availability under the loan is
$5,054. Based on the terms of the agreement, the Company is
currently unable to obtain additional advances under the loan
until certain financial covenants are met. The capital
expenditure loan is due and payable in monthly installments or
August 2004 or later, contingent on the renewal of the bank
agreement.

Note 6



| |                           
| | --------------------------
| | Short Term Bank Borrowings

The Company has a revolving commitment with a
financial institution for total borrowings of the lesser of
$5,000 or the borrowing base, as defined in the agreement, with
interest, based on the Companys option, at 1.00% above the
prime rate of interest or 2.5% above the LIBOR rate. At
August 31, 2001 and 2000, the interest rate was 7.50% and
9.50%, respectively, and balance outstanding on the revolving
commitment was $10 and $2,943, respectively. The agreement
requires the Company to maintain certain covenants, including
the following financial covenants as defined in the agreements:
tangible net worth, interest coverage ratio, debt service
coverage ratio, and year to date net loss. The Company was not
in compliance with the interest coverage ratio, debt service
coverage ratio and year to date net loss covenants at
August 31, 2001. The Company has amended the agreement with
the financial institution, which waives the events of default at
August 31, 2001 and amends the covenants for fiscal 2002.
Based on current projections, the Company believes that it will
meet the bank covenants going forward and has classified the
debt per the terms of the respective agreements.

Note 7



| |                                            
| | -------------------------------------------
| | Investment in Micro Substrates
	Corporation

On June 24, 1999, the Company obtained an
exclusive, worldwide license from Micro Substrates
Corporation (MSC) to manufacture and market a new
high-frequency chip carrier for applications in Local Multipoint
Distribution Services, ultra high-speed Internet routing and
satellite communications. In a related transaction, the Company
made an initial cash equity investment of $1,500 in MSC for a
28% equity ownership and the right to supply goods and services,
such as thin film substrate processing, to MSC. The
Companys investment in MSC was accounted for under the
equity method.

During the fourth quarter of fiscal 2001, certain
material adverse changes occurred in MSCs business,
including a weakening of the economy and demand for MSCs
products. As a result, the Company wrote-off the remaining value
of the investment in MSC and the related license agreement
during the fourth quarter of fiscal 2001. Under the stock
purchase agreement between the two companies, HEI obtains
put options relating to its 28% ownership in MSC. Additionally,
Circuit Components, Inc. (CCI), the majority stockholder in MSC,
was granted certain call options for MSC stock held by HEI.
Subsequent to August 31, 2001, CCI exercised its repurchase
call option for HEIs 28% equity in MSC in exchange for a
$750 unsecured five-year interest bearing note, payable in
quarterly installments. Due to the unsecured nature of the note
and the Companys position that the call exercised is not
valid, the $750 is not reflected in the financial statements.
The company is in discussions with CCI and MSC to resolve these
disputes however, these matters remain unresolved.

For the years ended August 31, 2001, 2000
and 1999, the Companys losses associated with MSC were
$1,450, $142 and $58, respectively, and are included in Loss on
equity investment on the Statement of Operations.

28



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Note 8



| |             
| | ------------
| | Income Taxes

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

|                             |         |                |      |      |  |      |      |   |  |   |     |     | 
|---------------------------- | ------- | -------------- | ---- | ---- |  | ---- | ---- | - |  | - | --- | --- | 
|                             |         | 2001           |      | 2000 |  | 1999
|                             |         |                |      |      |  |     
|                             |         |               
|                             |         | (In thousands)
|                            
|                            
|                            
|                            
|Current:                     |         |                |      |      |  |      |      |   |  |   |     |    
|                            
|                            
|                            
|                            
|                             | Federal |                | $    |     |  |      | $    |  |  |   | $   | 103 | 
|                            
|                            
|                            
|                            
|                             | State   |                |      |     |  |      |      |  |  |   |     | 36  | 
|                            
|                            
|                            
|                            
|Deferred                     |         |                | (930 | )    |  |      | (372 | ) |  |   | 103 |    
|                             |         |                |      |      |  |      |      |   |  |   |     |    
|Income tax expense (benefit) |         | $              | (930 | )    |  | $    | (372 | ) |  | $ | 242 |    
|                             |         |                |      |      |  |      |      |   |  |   |     |    

Actual income tax expense (benefit) differs from
the expected amount based upon the statutory federal tax rates
as follows:

|                                                  |  |      |       |      |  |      |       |    |  |  |      |  
|------------------------------------------------- |  | ---- | ----- | ---- |  | ---- | ----- | -- |  |  | ---- | -
|                                                  |  | 2001 |       | 2000 |  | 1999
|                                                  |  |      |       |      |  |     
|Federal statutory tax rate                        |  |      | (34.0 | )%   |  |      | (34.0 | )% |  |  | 34.0 | %
|                                                 
|                                                 
|                                                 
|                                                 
|State income tax rate (net of federal tax effect) |  |      | (1.2  | )    |  |      | (1.9  | )  |  |  | 5.0  |  
|                                                 
|                                                 
|                                                 
|                                                 
|Non-deductible acquisition costs                  |  |      |      |      |  |      | 10.1  |    |  |  |     |  
|                                                 
|                                                 
|                                                 
|                                                 
|Write-off of equity investment                    |  |      | 11.0  |      |  |      |      |    |  |  |     |  
|                                                 
|                                                 
|                                                 
|                                                 
|Other                                             |  |      | 1.6   |      |  |      | 1.4   |    |  |  | (0.9 | )
|                                                  |  |      |       |      |  |      |       |    |  |  |      |  
|Effective tax rate                                |  |      | (22.6 | )%   |  |      | (24.4 | )% |  |  | 38.1 | %
|                                                  |  |      |       |      |  |      |       |    |  |  |      |  

The tax effects of temporary differences that
give rise to significant portions of the deferred tax assets and
liabilities at August 31, 2001 and 2000 are as follows:

|                                                          |                                  |                |       |       |   |   |       |      |  
|--------------------------------------------------------- | -------------------------------- | -------------- | ----- | ----- | - | - | ----- | ---- | -
|                                                          |                                  | 2001           |       | 2000 
|                                                          |                                  |                |       |      
|                                                          |                                  |               
|                                                          |                                  | (In thousands)
|                                                         
|                                                         
|                                                         
|                                                         
|Deferred tax assets (short-term):                         |                                  |                |       |       |   |   |       |     
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Receivables                      |                | $     | 99    |   |   | $     | 79   |  
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Inventories                      |                |       | 200   |   |   |       | 266  |  
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Accrued liabilities              |                |       | 130   |   |   |       | 161  |  
|                                                          |                                  |                |       |       |   |   |       |     
|                                                          |                                  |                | 429   |       |   |   | 506   |     
|                                                          |                                  |                |       |       |   |   |       |     
|Deferred tax assets (long-term):                          |                                  |                |       |       |   |   |       |     
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Net operating loss carry-forward |                |       | 1,984 |   |   |       | 910  |  
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Capital loss carry-forward       |                |       | 510   |   |   |       |     |  
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | AMT credit carry-forward         |                |       | 83    |   |   |       | 86   |  
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Other                            |                |       | 10    |   |   |       | 4    |  
|                                                          |                                  |                |       |       |   |   |       |     
|Gross deferred tax assets (long-term)                     |                                  |                | 2,587 |       |   |   | 1,000 |     
|                                                          |                                  |                |       |       |   |   |       |     
|Less: valuation allowance for capital loss
	carry-forward |                                  |                | (510  | )     |   |   |      |     
|                                                          |                                  |                |       |       |   |   |       |     
|Net deferred tax assets (long-term)                       |                                  |                | 2,077 |       |   |   | 1,000 |     
|                                                          |                                  |                |       |       |   |   |       |     
|Deferred tax liabilities (long-term):                     |                                  |                |       |       |   |   |       |     
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Property and equipment           |                |       | (664  | ) |   |       | (626 | )
|                                                          |                                  |                |       |       |   |   |       |     
|Net deferred tax asset                                    |                                  | $              | 1,842 |       |   | $ | 880   |     
|                                                          |                                  |                |       |       |   |   |       |     

29



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

At August 31, 2001, the Company has net
operating loss carryforwards of approximately $5,048 for federal
income tax purposes and $4,180 for state income tax purposes,
expiring at various dates ranging from 2013 through 2021.

A valuation allowance for capital loss
carry-forward of $510 was established in fiscal 2001. The
difference that resulted in the deferred tax asset was the
write-off of the MSC investment, which resulted in a capital
loss carry-forward. If unused, the capital loss carry-forward
will expire in 2006. Management believes it is uncertain whether
the capital loss carry-forward will be utilized and as a result
has established the valuation allowance in fiscal 2001.

In the recognition of deferred tax assets,
management considers whether it is more likely than not that
some portion or all of the deferred tax assets will not be
realized. Based upon the level of historical taxable income
excluding the Mexico operations and MSC and projections for
future taxable income over the periods during which the deferred
tax assets are deductible, the Company believes it is more
likely than not that the benefit of these deductible differences
will be realized.

Note 9



| |                    
| | -------------------
| | Stock Benefit Plans

1998 Plan.Under the
Companys 1998 Stock Option Plan (the 1998 Plan), a maximum
of 1,000,000 shares of common stock may be issued pursuant
to qualified and nonqualified stock options. Stock options
granted become exercisable in varying increments with a portion
tied to the closing stock price or up to a maximum of ten years,
whichever comes first. The exercise price for options granted is
equal to the closing market price of the common stock on the
date of the grant. At August 31, 2001, the number of shares
available for grant was 90,849.

1989 Plan.Under the
Companys 1989 Omnibus Stock Compensation Plan (the 1989
Plan), a maximum of 2,000,000 shares of common stock may be
issued pursuant to qualified and nonqualified stock options,
stock purchase rights and other stock-based awards.

Stock options granted become exercisable in
varying increments with a portion tied to the closing stock
price or up to a maximum of ten years, whichever comes first.
Generally, the exercise price for options granted is equal to
the average closing market price of the common stock on the date
of the grant or for the five days preceding 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 2001, 2000 and 1999, 1,639, 14,431, and
6,770 shares at prices of $7.97, $4.59 and $4.68,
respectively, were purchased under the 1989 Plan in connection
with the employee stock purchase plan.

At August 31, 2001, the number of shares
available for grant was 125,222.

Directors Plan.During fiscal year 1999, the
shareholders approved the 1998 Stock Option Plan for
Non-employee Directors. This plan replaced and superceded the
Companys prior Stock Option Plan for Non-employee
Directors. Under the new directors plan,
425,000 shares are authorized for issuance, with an initial
year grant of 55,000 shares and an annual grant thereafter
of 10,000 shares to each non-employee director. These
grants are effective on the day of the annual shareholders
meeting upon adjournment at an exercise price equal to the
market price on the date of grant. The options become
exercisable at the earlier of seven years after the grant date
or on the first day the market value equals or exceeds $25.00.
These options expire ten years after the grant date.
Options to purchase 30,000 shares were granted to the three

30



---



##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

non-employee directors at $13.875 and $10.75 in
fiscal 2001 and fiscal 2000, respectively. At August 31,
2001, 160,000 shares remain outstanding and
90,000 shares are available for grant.

Change of Control.Under the terms and conditions of the
Companys 1989 Plan and the Directors Plan, a change
of control in the Companys Board of Directors, under
certain circumstances, requires a liquidation of all unexercised
stock options.

Summary of Activity.The following is a summary of all
activity involving options:

|                         |  |             |           |                  |  |   |        | 
|------------------------ |  | ----------- | --------- | ---------------- |  | - | ------ | 
|                         |  |             |           | Weighted Average
|                         |  | Options     |           | Exercise Price  
|                         |  | Outstanding |           | Per Share       
|                         |  |             |           |                 
|Balance, August 31, 1998 |  |             | 0         |                  |  | $ | 0.000  | 
|                        
|                        
|                        
|                        
|Granted                  |  |             | 629,300   |                  |  |   | 5.610  | 
|                        
|                        
|                        
|                        
|Cancelled                |  |             | (18,000   | )                |  |   | 5.875  | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 1999 |  |             | 611,300   |                  |  |   | 5.602  | 
|                         |  |             |           |                  |  |   |        | 
|Granted                  |  |             | 481,000   |                  |  |   | 10.886 | 
|                        
|                        
|                        
|                        
|Exercised                |  |             | (60,300   | )                |  |   | 6.049  | 
|                        
|                        
|                        
|                        
|Cancelled                |  |             | (39,100   | )                |  |   | 7.949  | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 2000 |  |             | 992,900   |                  |  |   | 8.042  | 
|                         |  |             |           |                  |  |   |        | 
|Granted                  |  |             | 421,050   |                  |  |   | 13.881 | 
|                        
|                        
|                        
|                        
|Exercised                |  |             | (228,125  | )                |  |   | 5.995  | 
|                        
|                        
|                        
|                        
|Cancelled                |  |             | (80,099   | )                |  |   | 10.316 | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 2001 |  |             | 1,105,726 |                  |  | $ | 10.523 | 
|                         |  |             |           |                  |  |   |        | 

The following table summarizes information about
stock options outstanding as of August 31, 2001:

|                         |  |                     |           |                     |  |             |       |           |  |          |     |  |  |  |         |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | ----------- | ----- | --------- |  | -------- | --- |  |  |  | ------- |  |  | - | ----- | 
|                         |  |                     |           |                    
|                         |  | Options outstanding |           | Options exercisable
|                         |  |                     |           |                    
|                         |  |                     |           | Weighted            |  |            
|                         |  |                     |           | Weighted            |  | Average     |       |           |  | Weighted
|                         |  |                     |           | Average             |  | Remaining   |       |           |  | Average 
|                         |  | Number of           |           | Exercise            |  | Contractual |       | Number of |  | Exercise
|Range of Exercise Prices |  | Options             |           | Price               |  | Life        |       | Options   |  | Price   
|                         |  |                     |           |                     |  |             |       |           |  |         
|$4.438-5.99              |  |                     | 299,400   |                     |  | $           | 5.51  |           |  |          | 7.4 |  |  |  | 188,650 |  |  | $ | 5.48  | 
|                        
|                        
|                        
|                        
|$6.00-9.99               |  |                     | 51,875    |                     |  |             | 7.16  |           |  |          | 8.4 |  |  |  | 14,875  |  |  |   | 6.69  | 
|                        
|                        
|                        
|                        
|$10.00-11.99             |  |                     | 292,501   |                     |  |             | 10.74 |           |  |          | 8.4 |  |  |  | 117,814 |  |  |   | 10.74 | 
|                        
|                        
|                        
|                        
|$12.00-14.99             |  |                     | 438,950   |                     |  |             | 13.75 |           |  |          | 9.2 |  |  |  | 30,375  |  |  |   | 13.21 | 
|                        
|                        
|                        
|                        
|$15.00-20.375            |  |                     | 23,00     |                     |  |             | 19.11 |           |  |          | 9.0 |  |  |  |        |  |  |   |      | 
|                        
|                        
|                        
|                        
|$4.438-20.375            |  |                     | 1,105,726 |                     |  | $           | 10.52 |           |  |          | 8.5 |  |  |  | 351,714 |  |  | $ | 7.96  | 

Stock Warrants.In
August 2001, the Board of Directors authorized the Company to
issue up to 100,000 Common Stock Purchase Warrants (Warrants).
In August 2001, the Company issued 47,500 Warrants in connection
with a financing transaction. The Warrants vested immediately at
an exercise price of $8.05 per share of Common Stock and
expire five-years from date of grant.

Accounting for Stock-based Compensation.Had the Company used the
fair-value-based method of accounting for its stock option plans
beginning in fiscal year 1997 and charged compensation cost
against

31



---



##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

income over the vesting period, net loss for
fiscal years 2001, 2000 and 1999 would have been changed to the
following pro forma amounts:

|                                     |  |                       |        |      |  |      |        |   |  |   |      | 
|------------------------------------ |  | --------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ---- | 
|                                     |  | 2001                  |        | 2000 |  | 1999
|                                     |  |                       |        |      |  |     
|                                     |  |                      
|                                     |  | (In thousands, except
|                                     |  | per share amounts)   
|                                    
|                                    
|                                    
|                                    
|Net income (loss)                    |  | $                     | (4,566 | )    |  | $    | (1,899 | ) |  | $ | 155  | 
|                                    
|                                    
|                                    
|                                    
|Net income (loss) per share, diluted |  | $                     | (0.94  | )    |  | $    | (0.46  | ) |  | $ | 0.04 | 

The weighted average grant-date fair value of
options granted during 2001, 2000 and 1999 was $4.29, $4.48 and
$3.30, respectively. The weighted average grant-date fair value
of options was determined separately for each grant under the
Companys various plans by using the fair value of each
option and warrant grant on the date of grant, utilizing the
Black-Scholes option-pricing model and the following key
weighted average assumptions:

|                         |  |                |  |                |  |               
|------------------------ |  | -------------- |  | -------------- |  | --------------
|                         |  | 2001           |  | 2000           |  | 1999          
|                         |  |                |  |                |  |               
|Risk-free interest rates |  | 4.6% to 5.9%   |  | 6.00% to 6.70% |  | 6.00%         
|                        
|                        
|                        
|                        
|Expected life            |  | 0.5 to 5 years |  | 0.5 to 8 years |  | 0.5 to 8 years
|                        
|                        
|                        
|                        
|Expected volatility      |  | 182%           |  | 62%            |  | 61%           
|                        
|                        
|                        
|                        
|Expected dividends       |  | None           |  | None           |  | None          

Note 10



| |                       
| | ----------------------
| | 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 2001, 2000 and 1999, the Company contributed $119,
$130 and $87, respectively, to the plan.

The Company had a defined benefit cash balance
pension plan which was available to all eligible employees of
Cross Technology, Inc. prior to the acquisition by the Company.
Plan benefits were based upon the employees years of
service and compensation. In fiscal 2000, the Company made the
decision to terminate the plan. Termination, settlement and
curtailment costs of $60 were recorded during the year ended
August 31, 2000. The Company terminated the plan on
December 31, 2000 and distributed all funds to the
participants during fiscal year 2001.

|                                             |                                              |                |     |     | 
|-------------------------------------------- | -------------------------------------------- | -------------- | --- | --- | 
|                                             |                                              | (In thousands)
|                                            
|                                            
|                                            
|                                            
|Change in benefit obligation:                |                                              |                |     |    
|                                            
|                                            
|                                            
|                                            
|                                             | Benefit obligation at August 31, 1999        |                | $   | 682 | 
|                                            
|                                            
|                                            
|                                            
|                                             | Service cost                                 |                |     | 138 | 
|                                            
|                                            
|                                            
|                                            
|                                             | Interest cost                                |                |     | 51  | 
|                                             |                                              |                |     |    
|Benefit obligation at August 31, 2000        |                                              | $              | 871 |    
|                                             |                                              |                |     |    
|Change in plan assets:                       |                                              |                |     |    
|                                            
|                                            
|                                            
|                                            
|                                             | Fair value of plan assets at August 31, 1999 |                | $   | 589 | 
|                                            
|                                            
|                                            
|                                            
|                                             | Actual return on plan assets                 |                |     | 88  | 
|                                            
|                                            
|                                            
|                                            
|                                             | Employer contribution                        |                |     | 207 | 
|                                             |                                              |                |     |    
|Fair value of plan assets at August 31, 2000 |                                              | $              | 884 |    
|                                             |                                              |                |     |    

32



---



##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

|                                                                                          |                                               |                |     |     |  
|----------------------------------------------------------------------------------------- | --------------------------------------------- | -------------- | --- | --- | -
|                                                                                          |                                               | (In thousands)
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|Funded status at August 31, 2000:                                                         |                                               |                |     |    
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Unrecognized actuarial gain                   |                | $   | (93 | )
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Unrecognized prior service cost               |                |     |    |  
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Additional liability                          |                |     |    |  
|                                                                                          |                                               |                |     |    
|Net amount recognized                                                                     |                                               | $              | (93 | )  
|                                                                                          |                                               |                |     |    
|Amounts recognized in the statement of financial
	position at August 31, 2000 consist of: |                                               |                |     |    
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Accrued benefit liability                     |                | $   | 80  |  
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|Weighted-average assumptions as of
	August 31, 2000:                                      |                                               |                |     |    
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Discount rate                                 |                |     | 7.5 | %
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Expected return on plan assets                |                |     | 7.5 | %
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Rate of compensation increase                 |                |     |    |  
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|Components of net periodic benefit cost for the
	year ended August 31, 2000:              |                                               |                |     |    
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Service cost                                  |                | $   | 138 |  
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Interest cost                                 |                |     | 51  |  
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Expected return on plan assets                |                |     | (53 | )
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Amortization of prior service costs           |                |     | 6   |  
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                          | Termination, settlement and curtailment costs |                |     | 60  |  
|                                                                                          |                                               |                |     |    
|Total benefit cost                                                                        |                                               | $              | 202 |    
|                                                                                          |                                               |                |     |    

Note 11



| |                 
| | ----------------
| | Notes Receivable

During April 2001, the Company recorded notes
receivable of $1,266 from certain officers and directors in
connection with the exercise of stock options. These notes
provide for full recourse to the individuals, bear interest at
8.25% and have a term of five years with quarterly interest
payments for the first two years and quarterly interest and
principal payments thereafter. These notes receivable are
classified as a reduction to shareholders equity on the
consolidated balance sheet.

Note 12



| |            
| | -----------
| | Commitments

Future commitments under non-cancelable operating
leases, primarily for manufacturing equipment and facilities,
are approximately $738 in 2002, $431 in 2003, $321 in 2004, $319
in 2005, and $505 in 2006 and beyond. Total expense under
non-cancelable operating leases was approximately $696 in 2001,
$533 in 2000 and $457 in 1999.

33



---



##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Note 13



| |                                                          
| | ---------------------------------------------------------
| | Net Income (Loss) Per Weighted Average
	Share Computation

The components of net income (loss) per basic and
diluted share are as follows:

|                                                       |  |                           |        |      |  |      |        |   |  |   |       | 
|------------------------------------------------------ |  | ------------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ----- | 
|                                                       |  | 2001                      |        | 2000 |  | 1999
|                                                       |  |                           |        |      |  |     
|                                                       |  |                          
|                                                       |  | (In thousands,           
|                                                       |  | except per share amounts)
|                                                      
|                                                      
|                                                      
|                                                      
|Basic:                                                 |  |                           |        |      |  |      |        |   |  |   |       | 
|                                                      
|                                                      
|                                                      
|                                                      
|Net income (loss)                                      |  | $                         | (3,193 | )    |  | $    | (1,155 | ) |  | $ | 393   | 
|                                                      
|                                                      
|                                                      
|                                                      
|Net income (loss) per share                            |  | $                         | (0.65  | )    |  | $    | (0.24  | ) |  | $ | 0.08  | 
|                                                      
|                                                      
|                                                      
|                                                      
|Weighted average number of common shares
	outstanding  |  |                           | 4,881  |      |  |      | 4,726  |   |  |   | 4,698 | 
|                                                       |  |                           |        |      |  |      |        |   |  |   |       | 
|Diluted:                                               |  |                           |        |      |  |      |        |   |  |   |       | 
|                                                      
|                                                      
|                                                      
|                                                      
|Net income (loss)                                      |  | $                         | (3,193 | )    |  | $    | (1,155 | ) |  | $ | 393   | 
|                                                      
|                                                      
|                                                      
|                                                      
|Net income (loss) per share                            |  | $                         | (0.65  | )    |  | $    | (0.24  | ) |  | $ | 0.08  | 
|                                                      
|                                                      
|                                                      
|                                                      
|Weighted average number of common shares
	outstanding  |  |                           | 4,881  |      |  |      | 4,726  |   |  |   | 4,698 | 
|                                                      
|                                                      
|                                                      
|                                                      
|Assumed conversion of stock options                    |  |                           |       |      |  |      |       |   |  |   | 3     | 
|                                                       |  |                           |        |      |  |      |        |   |  |   |       | 
|Weighted average common and assumed conversion
	shares |  |                           | 4,881  |      |  |      | 4,726  |   |  |   | 4,701 | 
|                                                       |  |                           |        |      |  |      |        |   |  |   |       | 

Approximately 1,156,000, 993,000 and 608,000
stock options and warrants have been excluded from the
calculation of diluted net income (loss) per common share as
they are antidilutive for fiscal 2001, 2000 and 1999,
respectively.

Note 14



| |                                   
| | ----------------------------------
| | Private Placement of Common
	Stock

On August 29, 2001, the Company completed a
$6,700 private placement of its common stock. HEI sold
950,000 shares of common stock at $7.00 per share. The
Company received net proceeds of approximately $6,200.

34



---



##### Table of Contents






INDEPENDENT AUDITORS REPORT

To the Shareholders of HEI, Inc.:

We have audited the accompanying consolidated
balance sheets of HEI, Inc. and subsidiaries as of
August 31, 2001 and 2000 and the related consolidated
statements of operations, changes in shareholders equity,
and cash flows for each of the years in the three-year period
ended August 31, 2001. These consolidated financial
statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material
misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the
consolidated 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 consolidated financial
statements referred to above present fairly, in all material
respects, the financial position of HEI, Inc. and
subsidiaries as of August 31, 2001 and 2000 and the results
of their operations and their cash flows for each of the years
in the three-year period ended August 31 2001, in
conformity with accounting principles generally accepted in the
United States of America.



| |         
| | --------
| | KPMG LLP

Minneapolis, Minnesota

October 5, 2001


35



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##### Table of Contents



STATEMENT OF FINANCIAL
RESPONSIBILITY

The accompanying consolidated 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 consolidated financial statements have been
prepared in accordance with accounting principles generally
accepted in the United States of America 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 Companys independent
certified public accountants, as well as with management, to
review accounting, auditing, and financial reporting matters.

The Companys independent certified public
accountants, KPMG LLP, are engaged to audit the consolidated
financial statements of the Company and to issue their report
thereon. See the accompanying Independent Auditors Report.

Summary of Quarterly Operating
Results

|                            |         |                                          |        |        |  |       |        |        |   |   |        |       |   |   |        |       |  
|--------------------------- | ------- | ---------------------------------------- | ------ | ------ |  | ----- | ------ | ------ | - | - | ------ | ----- | - | - | ------ | ----- | -
|Fiscal Year 2001            |         | First                                    |        | Second |  | Third |        | Fourth
|                            |         |                                          |        |        |  |       |        |       
|                            |         |                                         
|                            |         | (Unaudited)                             
|                            |         | (In thousands, except per share amounts)
|                           
|                           
|                           
|                           
|Net sales                   |         | $                                        | 13,724 |        |  | $     | 12,881 |        |   | $ | 10,331 |       |   | $ | 7,896  |      
|                           
|                           
|                           
|                           
|Gross profit                |         |                                          | 2,554  |        |  |       | 2,472  |        |   |   | 1,668  |       |   |   | 1,297  |      
|                           
|                           
|                           
|                           
|Unusual charges             |         |                                          |       |        |  |       | 1,268  |        |   |   | 425    |       |   |   |       |      
|                           
|                           
|                           
|                           
|Operating income (loss)     |         |                                          | 488    |        |  |       | (957   | )      |   |   | (887   | )     |   |   | (585   | )    
|                           
|                           
|                           
|                           
|Net income (loss)           |         |                                          | 82     |        |  |       | (765   | )      |   |   | (652   | )     |   |   | (1,858 | )    
|                            |         |                                          |        |        |  |       |        |        |   |   |        |       |   |   |        |      
|Net income (loss) per share |         |                                          |        |        |  |       |        |        |   |   |        |       |   |   |        |      
|                           
|                           
|                           
|                           
|                            | Basic   |                                          | $      | 0.02   |  |       | $      | (0.16  | ) |   | $      | (0.13 | ) |   | $      | (0.37 | )
|                           
|                           
|                           
|                           
|                            | Diluted |                                          | $      | 0.02   |  |       | $      | (0.16  | ) |   | $      | (0.13 | ) |   | $      | (0.37 | )

|                            |         |                                          |       |        |   |       |        |        |   |   |        |      |  |   |        |      | 
|--------------------------- | ------- | ---------------------------------------- | ----- | ------ | - | ----- | ------ | ------ | - | - | ------ | ---- |  | - | ------ | ---- | 
|Fiscal Year 2000            |         | First                                    |       | Second |   | Third |        | Fourth
|                            |         |                                          |       |        |   |       |        |       
|                            |         |                                         
|                            |         | (Unaudited)                             
|                            |         | (In thousands, except per share amounts)
|                           
|                           
|                           
|                           
|Net sales                   |         | $                                        | 8,094 |        |   | $     | 9,392  |        |   | $ | 11,589 |      |  | $ | 13,724 |     
|                           
|                           
|                           
|                           
|Gross profit                |         |                                          | 1,299 |        |   |       | 1,025  |        |   |   | 2,386  |      |  |   | 2,545  |     
|                           
|                           
|                           
|                           
|Unusual charges             |         |                                          |      |        |   |       | 453    |        |   |   |       |      |  |   |       |     
|                           
|                           
|                           
|                           
|Operating income (loss)     |         |                                          | (447  | )      |   |       | (1,690 | )      |   |   | 342    |      |  |   | 495    |     
|                           
|                           
|                           
|                           
|Net income (loss)           |         |                                          | (319  | )      |   |       | (1,656 | )      |   |   | 361    |      |  |   | 459    |     
|                            |         |                                          |       |        |   |       |        |        |   |   |        |      |  |   |        |     
|Net income (loss) per share |         |                                          |       |        |   |       |        |        |   |   |        |      |  |   |        |     
|                           
|                           
|                           
|                           
|                            | Basic   |                                          | $     | (0.07  | ) |       | $      | (0.35  | ) |   | $      | 0.08 |  |   | $      | 0.10 | 
|                           
|                           
|                           
|                           
|                            | Diluted |                                          | $     | (0.07  | ) |       | $      | (0.35  | ) |   | $      | 0.07 |  |   | $      | 0.09 | 
|                            |         |                                          |       |        |   |       |        |        |   |   |        |      |  |   |        |     



---

NOTE:

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


36



---



##### Table of Contents





|        |                                                                                      
|------- | -------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
	Accountants on Accounting and Financial Disclosure

None.




PART III



|         |                                                    
|-------- | ---------------------------------------------------
|Item 10. | Directors and Executive Officers of the
	Registrant

Directors

The following is a list of the names and ages of
each of our directors as of November 30, 2001, and the year
in which each such director was elected is set forth below. Each
director serves a term of one year or until his successor is
elected and qualified.

|                                                                                                   |  |     |    |          |  |  |      | 
|-------------------------------------------------------------------------------------------------- |  | --- | -- | -------- |  |  | ---- | 
|                                                                                                   |  |     |    | Director
|Name and Position                                                                                  |  | Age |    | Since   
|                                                                                                   |  |     |    |         
|Anthony J. Fant, Chairman of the Board and Chief
	Executive Officer                                |  |     | 41 |          |  |  | 1998 | 
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Edwin W. Finch, III, Director                                                                      |  |     | 56 |          |  |  | 1998 | 
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|David W. Ortlieb, Director                                                                         |  |     | 71 |          |  |  | 1998 | 
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Steve E. Tondera, Jr., Vice President of Finance,
	Treasurer, Chief Financial Officer and Director |  |     | 38 |          |  |  | 1998 | 
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Mack V. Traynor, III, Director                                                                     |  |     | 43 |          |  |  | 1998 | 

Anthony J. Fanthas
been our Chief Executive Officer since November 1998.
Mr. Fant has been a director, President and Chief Executive
Officer of Fant Broadcasting Company (including, for these
purposes, various affiliated companies engaged primarily in
television and radio broadcasting) since 1986. From 1986 to
1996, Fant Broadcasting Company acquired, built or managed a
number of television and radio stations. Mr. Fant currently
owns a number of businesses in diverse industries.

Edwin W. Finch, IIIis the President of Diversified Drilling Corporation, a company
which drills municipal water supply wells, and has been a
director and President of FHL Capital Corporation, an investment
banking and business valuation firm specializing in mergers and
acquisitions, since 1984. Mr. Finch also served as
President of Pinson Valley Millworks, Inc., a distributor of
millworks products, from 1988 to 1996.

David W. Ortliebhas
been an independent management consultant since 1994. Mr.
Ortlieb served as a director, President and Chief Executive
Officer of Immunomedics, Inc., a biopharmaceutical company, from
1992 to 1994. Mr. Ortlieb has served as a director and
executive officer of Texas Biotechnology Corporation, American
Optical Corporation, Erbamont, N.V. and Abbott Laboratories

Steve E. Tondera,
Jr.has served as our Vice President
of Finance, Treasurer and Chief Financial Officer since June
2000. Prior to being appointed as the Chief Financial Officer,
he was the Managing Director of our Mexico division. From
October 1994 until June 2000, Mr. Tondera served as the
Chief Financial Officer of Fant Industries, LLC., Fant
Industries, LLC owns a number of businesses in diverse
industries.

Mack V. Traynor, IIIserved as Chief Executive Officer of Do The Good, Inc., a
philanthropic software development company from May 2001 until
October 2001 and as Chief Financial Officer of 10K Partners,
Inc., private investment company, from April 2000 until June
2000. Mr. Traynor also served as President and Chief
Executive Officer of NeoNetworks, a private development stage
company designing high-speed data communications equipment, from
October 1998 to January 1999. Mr. Traynor has served as
President of Manitou Investments, a private investment and
business management firm, since 1998. Mr. Traynor was a
director of Telident, Inc., a telecommunications products and
services company, from 1998 to 2000. Mr. Traynor also
served as a director of Eltrax Systems, Inc., a networking
products and services company, from 1995 to 1999, serving as
Chief Financial Officer from 1995 to 1996 and President, Chief
Executive Officer and Chief Operating Officer from 1995 to 1997.
Mr. Traynor served as President and Chief Operating Officer
of Military Communications Center, Inc., a company that provided
telecommunications services to

37



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##### Table of Contents



U.S. Military personnel, from 1988 to 1995. He
also served as President of U.S. West Enterprises, a division of
U.S. West, Inc.


Executive Officers

The following is a list of our executive
officers, their ages, positions and offices as of
November 30, 2001. Each executive officer serves a term of
one year or until his successor is elected and qualified.

|                      |  |     |    |          |  |                                                                         
|--------------------- |  | --- | -- | -------- |  | ------------------------------------------------------------------------
|Name                  |  | Age |    | Position
|                      |  |     |    |         
|Anthony J. Fant       |  |     | 41 |          |  | Chairman and Chief Executive Officer                                    
|                     
|                     
|                     
|                     
|Donald R. Reynolds    |  |     | 43 |          |  | President and Chief Operating Officer                                   
|                     
|                     
|                     
|                     
|Steve E. Tondera, Jr. |  |     | 38 |          |  | Chief Financial Officer, Treasurer, Vice
	President Finance and Director
|                     
|                     
|                     
|                     
|Stephen K. Petersen   |  |     | 48 |          |  | Vice President Operations                                               

Anthony J. Fant Please see the biography of
Mr. Fant set forth above.

Donald R. Reynoldsjoined us in March 1998 as Executive Vice President and was
appointed President in April 1998 and Chief Operating Officer in
January 1999. Before joining us, beginning in 1995, he was
employed with BF Goodrich Aerospace in senior executive
positions in product engineering, marketing and business unit
management, and most recently as Business Unit Director for a
business unit having approximately $30 million in revenues.
This business unit designed and manufactured high technology
products (sensors, electronics, software) for the aerospace
industry. Mr. Reynolds was responsible for all management
aspects of this unit such as marketing, sales and operations.

Steve E. Tondera,
Jr.Please see the biography of
Mr. Tondera set forth above.

Stephen K. Petersenjoined us in March 1998 as Director of Manufacturing. He was
appointed Vice President of Operations in September 2000. Before
joining us, he was employed with Sheldahl, a manufacturer of
electronic materials and derivatives, in a variety of positions
ranging from Engineer to Plant Manager and most recently as the
Operations Manager. Mr. Petersen was responsible for
production and manufacturing engineering.

Section 16(a) Beneficial Ownership
Reporting Compliance

Section 16(a) of the Exchange Act requires
that our officers and directors and those persons who own more
than 10% of a registered class of our equity securities file
initial reports of ownership and reports of changes in ownership
with the SEC. Such persons are required by SEC regulations to
furnish us with copies of all Section 16(a) forms they
file. Based solely on its review of the copies of such forms
received by it with respect to fiscal 2001 and written
representations from certain reporting persons, we believe that
all filing requirements applicable to its officers and directors
have been complied with.

38



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##### Table of Contents



Item 11.     Executive
Compensation

Summary Compensation Table

The following table sets forth certain
information regarding compensation paid during each of our last
three fiscal years to our Chief Executive Officer and the other
Executive Officers whose total annual compensation for fiscal
2001 (based on salary and bonus) exceeded $100,000 (Named
Executive Officers).

|                            |                                       |        |      |                     |  |              |         |                |  |              |        |        |  |  |         |        |  |   |       |        |    
|--------------------------- | ------------------------------------- | ------ | ---- | ------------------- |  | ------------ | ------- | -------------- |  | ------------ | ------ | ------ |  |  | ------- | ------ |  | - | ----- | ------ | ---
|                            |                                       |        |      |                    
|                            |                                       |        |      | Annual Compensation
|                            |                                       |        |      |                    
|                            |                                       |        |      |                     |  | Long-Term    |         |               
|                            |                                       | Fiscal |      |                     |  | Compensation |         | Other         
|Name and Principle Position |                                       | Year   |      | Salary              |  | Bonus        |         | Awards/Options |  | Compensation
|                            |                                       |        |      |                     |  |              |         |                |  |             
|Anthony J. Fant             |                                       |        | 2001 |                     |  | $            | 187,497 |                |  |              |       |        |  |  | 100,000 |        |  | $ | 1,615 | (2)   
|                            | Chief Executive Officer               |        |      | 2000                |  |              | $       | 150,010        |  |              |        |       |  |  |         | 45,000 |  |   | $     | 2,913  | (2)
|                            |                                       |        | 1999 |                     |  | $            | 75,293  | (1)            |  |              |       |        |  |  | 90,000  |        |  | $ | 216   | (2)   
|                           
|                           
|                           
|                           
|Donald R. Reynolds          |                                       |        | 2001 |                     |  | $            | 164,417 |                |  |              |       |        |  |  | 30,000  |        |  |   |      |       
|                            | President and Chief Operating Officer |        |      | 2000                |  |              | $       | 151,731        |  |              |        |       |  |  |         | 30,000 |  |   |       |       |    
|                            |                                       |        | 1999 |                     |  | $            | 138,788 |                |  |              |       |        |  |  | 25,000  |        |  |   |      |       
|                           
|                           
|                           
|                           
|Steve E. Tondera, Jr.       |                                       |        | 2001 |                     |  | $            | 140,883 |                |  |              |       |        |  |  | 25,000  |        |  | $ | 2,563 | (2)   
|Vice President Finance and  |                                       |        | 2000 |                     |  | $            | 110,011 |                |  |              |       |        |  |  | 30,000  |        |  |   |      |       
|                            | Chief Financial Officer               |        |      | 1999                |  |              | $       | 62,094         |  |              |        |       |  |  |         | 75,000 |  |   |       |       |    
|                           
|                           
|                           
|                           
|Thomas Goodnow(4)           |                                       |        | 2001 |                     |  | $            | 138,798 |                |  | $            | 44,868 |        |  |  | 15,000  |        |  | $ | 3,611 | (2)   
|                            | Vice President Sales and Marketing    |        |      | 2000                |  |              | $       | 137,394        |  |              | $      | 31,792 |  |  |         | 20,000 |  |   | $     | 3,891  | (2)
|                            |                                       |        | 1999 |                     |  | $            | 33,440  |                |  | $            | 12,000 |        |  |  | 50,000  |        |  |   |       |       
|                           
|                           
|                           
|                           
|Stephen K. Peterson         |                                       |        | 2001 |                     |  | $            | 124,718 |                |  |              |       |        |  |  | 12,500  |        |  | $ | 1,772 | (2)   
|                           
|                           
|                           
|                           
|                            | Vice President Operations             |        |      |                     |  |              |         |                |  |              |        |        |  |  |         |        |  |   | $     | 10,750 | (3)
|                            |                                       |        | 2000 |                     |  | $            | 133,286 |                |  |              |       |        |  |  | 17,500  |        |  | $ | 2,665 | (2)   
|                            |                                       |        | 1999 |                     |  | $            | 167,392 |                |  | $            | 15,000 |        |  |  | 18,000  |        |  | $ | 628   | (2)   



---



|    |                                                                                                               
|--- | --------------------------------------------------------------------------------------------------------------
|(1) | Mr. Fant was appointed Chief Executive
	Officer in November 1998 and began to receive salary in January
	1999.
|   
|(2) | Consists of Company matching contributions to
	401(k) plan.                                                   
|   
|(3) | Consists of compensation under exercise of stock
	options.                                                    
|   
|(4) | As of September 4, 2001, Mr. Goodnow is
	no longer with the Company.                                          

Options Granted During Fiscal 2001

The following table sets forth certain
information regarding grants of stock options to the Named
Executive Officers during fiscal year 2001 pursuant to the 1989
Plan and the 1998 Plan.

|                      |  |            |         |            |  |              |      |            |  |                        |        |        |  |  |         |  |  |  |         |  |  |  |           | 
|--------------------- |  | ---------- | ------- | ---------- |  | ------------ | ---- | ---------- |  | ---------------------- | ------ | ------ |  |  | ------- |  |  |  | ------- |  |  |  | --------- | 
|                      |  |            |         |            |  |              |      |            |  |                       
|                      |  |            |         |            |  |              |      |            |  | Potential Realizable  
|                      |  |            |         |            |  |              |      |            |  | Value of Assumed      
|                      |  | Number of  |         | % of Total |  |              |      |            |  | Annual Rates of Stock 
|                      |  | Shares     |         | Options    |  |              |      |            |  | Price Appreciation for
|                      |  | Underlying |         | Granted in |  | Exercise     |      |            |  | Option Term(2)        
|                      |  | Options    |         | Fiscal     |  | Price        |      | Expiration |  |                       
|Name                  |  | Granted(#) |         | 2001       |  | ($/Share)(1) |      | Date       |  | 5%($)                  |        | 10%($)
|                      |  |            |         |            |  |              |      |            |  |                        |        |       
|Anthony J. Fant       |  |            | 100,000 | (3)        |  |              | 23.8 | %          |  | $                      | 13.875 |        |  |  | 1/24/11 |  |  |  | 872,600 |  |  |  | 2,211,300 | 
|                     
|                     
|                     
|                     
|Donald R. Reynolds    |  |            | 30,000  | (3)        |  |              | 7.1  | %          |  | $                      | 13.875 |        |  |  | 1/24/11 |  |  |  | 261,800 |  |  |  | 663,400   | 
|                     
|                     
|                     
|                     
|Steve E. Tondera, Jr. |  |            | 25,000  | (3)        |  |              | 5.9  | %          |  | $                      | 13.875 |        |  |  | 1/24/11 |  |  |  | 218,150 |  |  |  | 552,800   | 
|                     
|                     
|                     
|                     
|W. Thomas Goodnow(4)  |  |            | 15,000  | (3)        |  |              | 3.6  | %          |  | $                      | 13.875 |        |  |  | 1/24/11 |  |  |  | 130,889 |  |  |  | 331,698   | 
|                     
|                     
|                     
|                     
|Stephen K. Petersen   |  |            | 12,500  | (3)        |  |              | 3.0  | %          |  | $                      | 13.875 |        |  |  | 1/24/11 |  |  |  | 109,075 |  |  |  | 276,400   | 



---



|    |                                                                                                                                                                                                           
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | All options are granted at the fair market value
	of the common shares at the date of grant.                                                                                                              
|   
|(2) | The 5% and 10% assumed annual rates of compounded
	stock price appreciation are mandated by rules of the SEC and do
	not represent our estimates or projections of the future prices
	of our common stock.

39



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##### Table of Contents



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    | These amounts represent certain assumed rates of
	appreciation only. Actual gains, if any, on stock option
	exercises are dependent on the future performance of the common
	stock and overall stock market conditions. The amounts reflected
	in this table may not necessarily be achieved.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   
|(3) | These options were granted on January 24,
	2001. The options will become exercisable as follows:
	(i) one-half of the option shares will become cumulatively
	exercisable in 25% increments on each of the first through
	fourth anniversaries of the date of grant, (ii) one-quarter
	of the option shares will become exercisable on the earlier of
	(a) the first date on which the closing price of the Common
	Stock has equaled or exceeded $17.50 for at least five
	consecutive trading days, or (b) the fifth anniversary of
	the date of grant, and (iii) one-quarter of the option
	shares will become cumulatively exercisable (a) in 20%
	increments on each of the fourth through eighth anniversaries of
	the date of grant, or (b) if earlier, on the first date on
	which the closing price of the Common Stock has equaled or
	exceeded $25.00 for at least five consecutive trading days, in
	each case provided that the optionee remains in continuous
	service with us or any of our subsidiaries until the applicable
	anniversary or date.
|   
|(4) | As of September 4, 2001, Mr. Goodnow is
	no longer with the Company.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

Aggregated Option Exercises During Fiscal 2001
and Fiscal Year-End Option Values

|                      |  |          |        |          |  |                   |        |                      |  |  |                |  |  |  |                   | 
|--------------------- |  | -------- | ------ | -------- |  | ----------------- | ------ | -------------------- |  |  | -------------- |  |  |  | ----------------- | 
|                      |  |          |        |          |  | Number of         |        |                     
|                      |  |          |        |          |  | Securities        |        |                     
|                      |  |          |        |          |  | Underlying        |        | Value of Unexercised
|                      |  | Shares   |        |          |  | Unexercised       |        | in-the-Money Options
|                      |  | Acquired |        |          |  | Options at Fiscal |        | at Fiscal Year-End  
|                      |  | on       |        | Value    |  | Year-End          |        | ($)                 
|                      |  | Exercise |        | Realized |  | Exercisable/      |        | Exercisable/        
|Name                  |  | (#)      |        | ($)      |  | Unexerciseable    |        | Unexercisable(1)    
|                      |  |          |        |          |  |                   |        |                     
|Anthony J. Fant       |  |          | 89,375 |          |  |                   |       | (2)                  |  |  | 0/145,625      |  |  |  | $0/$42,438        | 
|                     
|                     
|                     
|                     
|Donald R. Reynolds    |  |          | 12,500 |          |  |                   |       | (2)                  |  |  | 11,250/72,500  |  |  |  | $0/$30,313        | 
|                     
|                     
|                     
|                     
|Steve E. Tondera, Jr. |  |          | 10,000 |          |  |                   |       | (2)                  |  |  | 66,250/120,000 |  |  |  | $150,250/$174,500 | 
|                     
|                     
|                     
|                     
|W. Thomas Goodnow(3)  |  |          |       |          |  |                   |       |                      |  |  | 32,500/52,500  |  |  |  | $96,563/$48,281   | 
|                     
|                     
|                     
|                     
|Stephen K. Petersen   |  |          | 2,000  |          |  | $                 | 10,750 |                      |  |  | 12,625/46,000  |  |  |  | $16,975/$97,191   | 



---



|    |                                                                                                                                                                                                                                                                                                           
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Calculated as the difference between the closing
	price of our common stock on August 31, 2001, which was
	$8.30, and the option exercise price multiplied by the number of
	shares exercisable/unexercisable. If the option price is greater
	than the closing price on August 31, 2001, the value is $0.
|   
|(2) | Value realized on shares acquired on exercise was
	negative as the exercise price at the date of exercise was
	higher than the fair value at the date of exercise.                                                                                                                                        
|   
|(3) | As of September 4, 2001, Mr. Goodnow is
	no longer with the Company.                                                                                                                                                                                                                                      

We do not have any outstanding stock appreciation
rights.

Compensation Committee Interlocks and Insider
Participation

As stated in the Compensation Committee Report
below, Messrs. Traynor, Finch and Ortlieb comprise the
Compensation Committee of the Board of Directors. No member of
the Compensation Committee of the Board of Directors served as
one of our officers, former officers or employees (or as an
officer, former officer or employee of any of our subsidiaries)
during fiscal 2001 or at any other time.

40



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##### Table of Contents








HEI, INC.


COMPENSATION COMMITTEE


REPORT TO THE BOARD


FISCAL 2001


Decisions on compensation of the Companys
executive officers generally have been made by the Compensation
Committee (the Compensation Committee) of the Board.
The members of the Compensation Committee are Chairman Mack V.
Traynor and Messrs. Edwin W. Finch, III, David W. Ortlieb
and Anthony J. Fant.

All decisions by the Compensation Committee
relating to the compensation of the Companys Executive
Officers are reviewed by the full Board. Pursuant to SEC rules
designed to enhance disclosure of the Companys policies
toward executive compensation, set forth below is a report
prepared by the Compensation Committee of the Board of Directors
addressing the Companys compensation policies for the
fiscal year ended August 31, 2001 as they affected the
Companys executive officers.

The Compensation Committees executive
compensation policies are designed to provide competitive levels
of compensation that integrate pay with the Companys
annual objectives and long-term goals, reward above average
corporate performance, recognize individual initiative and
achievements, and assist the Company in attracting and retaining
qualified executives. Executive compensation is set at levels
that the Compensation Committee believes to be competitive with
those offered by employers of comparable size, growth and
profitability in the Companys industry.

There are three elements in the Companys
executive compensation program, each of which is determined by
individual and corporate performance: base salary compensation,
annual incentive compensation and long-term incentive
compensation.

Base salary compensation is determined by the
potential impact the individual may have on the Company, the
skills and experience required by the job, comparisons with
comparable companies and the performance and potential of the
incumbent in the job.

For fiscal 2001, the named Executive Officers of
the Company, together with certain other officers, were eligible
to receive an annual incentive bonus. The Compensation Committee
established a target bonus for each executive officer expressed
as a percentage of base salary. The percentage established for
each executive officer ranged from 25% to 50%. These Executive
Officers would receive this target bonus upon reaching certain
financial thresholds based on the Company reaching seventy-five
(75) percent of plan net income. The bonus program
identifies key performance measures for each officer, although
the Compensation Committee retained discretion in considering
additional factors in awarding bonuses. The Chief Executive
Officer and other Executive Officers are subject to the key
performance measure which is the Company reaching seventy-five
(75) percent of plan net income. Certain other executives,
such as the Vice President of Manufacturing are subject to an
additional performance measure, that of specific corporate
objectives related to that office. Since the Company did not
obtain seventy-five (75) percent of plan net income the
Compensation Committee did not award any annual incentive
bonuses to the named Executive Officers for fiscal 2001.

Long-term incentive compensation, pursuant to the
Companys 1998 Employee Stock Option Plan, to the Chief
Executive Officer, as well as other executive officers of the
Company, is designed to integrate compensation with the
Companys annual objectives and long-term goals, reward
above-average corporate performance, recognize individual
initiative and achievements, assist in the retention of
executives and align the long-term interests of management with
those of the Companys shareholders. The Compensation
Committee makes recommendations to the Board regarding the
granting of restricted stock awards and stock option grants to
executives and key personnel. Awards vest and options become
exercisable based upon criteria established by the Company.

On January 24, 2001, the Compensation
Committee made awards of non-qualified stock options to certain
of the Companys executive officers as follows:
Mr. Anthony Fant, Chairman of the Board and Chief Executive
Officer100,000 shares; Mr. Donald Reynolds, President
and Chief Operating Officer30,000 shares; Mr. Steve
Tondera25,000 shares; Mr. W. Thomas
Goodnow15,000 shares; and Mr. Stephen

41



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##### Table of Contents



Petersen12,500 shares. All options granted
on January 24, 2000 have an exercise price equal to $13.875
per share, the fair market value of the Common Stock on the
grant date. One-half of the shares will become cumulatively
exercisable in 25% increments on each of the first through
fourth anniversaries, one-quarter of the shares will be
cumulatively exercisable on the earlier of (A) the first
date on which the closing price of the Companys stock has
equaled or exceeded $17.50 for at least five consecutive trading
days, or (B) the fifth anniversary of the date of grant and
one-quarter of the shares will become cumulatively exercisable
(A) in 20% increments on each of the fourth through the eighth
anniversaries of the date of grant, or (B) if earlier, on
the first date on which the closing price has equaled or
exceeded $25.00 for at least five consecutive trading days. The
Compensation Committee also recommended that stock options be
granted to certain other non-executive officers of the Company.


The compensation of Mr. Fant, who served as
the Companys Chief Executive Officer in fiscal 2001, was
determined by applying a process and philosophy similar to that
of other executive officers. In fiscal 2001, Mr. Fant
received a base salary of $187,497. Mr. Fant was not
eligible for an annual incentive bonus of approximately fifty
percent (50%) of his base salary due to the Companys
performance during fiscal 2001. As noted above, Mr. Fant
was also granted an option to acquire 100,000 shares of the
Companys common stock at an exercise price equal to
$13.875 per share, the fair market value of the Common Stock on
the grant date. One-half of the shares will become cumulatively
exercisable in 25% increments on each of the first through
fourth anniversaries, one-quarter of the shares will be
cumulatively exercisable on the earlier of (A) the first
date on which the closing price of the Companys stock has
equaled or exceeded $17.50 for at least five consecutive trading
days, or (B) the fifth anniversary of the date of grant and
one-quarter of the shares will become cumulatively exercisable
(A) in 20% increments on each of the fourth through the
eighth anniversaries of the date of grant, or (B) if
earlier, on the first date on which the closing price has
equaled or exceeded $25.00 for at least five consecutive trading
days..

The Compensation Committee does not anticipate
that any of the compensation payable to executive officers of
the Company in the coming year will exceed the limits and
deductibilities set forth in section 162(m) of the Internal
Revenue Code of 1986, as amended. The Compensation Committee has
not established a policy regarding compensation in excess of
these limits, but will continue to monitor this issue.



| |  |                                                                              
| |  | -----------------------------------------------------------------------------
| |  | Mack V. Traynor 
	 Edwin W. Finch, III 
	 David W. Ortlieb 
	 Anthony J. Fant

42



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##### Table of Contents






STOCKHOLDER RETURN PERFORMANCE
PRESENTATION

The following line graph compares the cumulative
total shareholder return on the Companys Common Stock to
the cumulative total return of the Russell 2000 (IUX) and
the PHGILASemiCon (SOX.X) Index for the last five years. Returns
are based on a $100 investment on August 31, 1996 and
are calculated assuming reinvestment of dividends during the
period presented. The Company has not paid any dividends.

TOTAL RETURN to SHAREHOLDERS

AUG 1996 to AUG 2001


LINE GRAPH



|         |                                                                
|-------- | ---------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
	Owners and Management

The following table lists the beneficial
ownership of our common stock owned as of December 3, 2001,
by (i) our directors; (ii) the executive officers
named in the Summary Compensation Table set forth above and
(iii) all of our directors and executive officers as a
group. Except as otherwise indicated, we believe that the
persons listed in the following table have sole voting and
investment powers with respect to the shares owned.

Shares Beneficially Owned

|                                                                                                      |  |                  |           |            |  |  |       | 
|----------------------------------------------------------------------------------------------------- |  | ---------------- | --------- | ---------- |  |  | ----- | 
|Name                                                                                                  |  | Number of Shares |           | Percentage
|                                                                                                      |  |                  |           |           
|Anthony J. Fant, Chairman and Chief
	Executive Officer(1)                                             |  |                  | 1,089,273 |            |  |  | 18.9% | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|Steve E. Tondera, Jr., Vice President of
	Finance, Chief Financial Officer, Treasurer and Director(2) |  |                  | 91,150    |            |  |  | 1.5%  | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|Donald R. Reynolds, President and Chief
	Operating Officer(3)                                         |  |                  | 33,250    |            |  |  | *     | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|Stephen K. Petersen, Vice President
	Operations(4)                                                    |  |                  | 20,833    |            |  |  | *     | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|Edwin W. Finch, III, Director(5)                                                                      |  |                  | 68,250    |            |  |  | 1.1%  | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|David W. Ortlieb, Director(6)                                                                         |  |                  | 65,000    |            |  |  | 1.0%  | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|Mack V. Traynor, III, Director(7)                                                                     |  |                  | 67,000    |            |  |  | 1.1%  | 
|                                                                                                     
|                                                                                                     
|                                                                                                     
|                                                                                                     
|All directors and executive officers as a group
	(7 persons)                                          |  |                  | 1,434,756 |            |  |  | 23.9% | 

43



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---



|  |                                        
|- | ---------------------------------------
|* | Denotes share ownership of less than 1%



|    |                                                                                                                                                        
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes 10,000 shares owned directly by Fant
	Industries, LLC of which Mr. Fant is the sole shareholder.                                              
|   
|(2) | Includes 1,100 shares owned directly by
	Mr. Tonderas spouse and 66,250 shares issuable upon
	exercise of options that are exercisable within 60 days.
|   
|(3) | Includes 11,250 shares issuable upon exercise of
	options that are exercisable within 60 days.                                                         
|   
|(4) | Includes 12,625 shares issuable upon exercise of
	options that are exercisable within 60 days.                                                         
|   
|(5) | Includes 10,000 shares issuable upon exercise of
	options that are exercisable within 60 days.                                                         
|   
|(6) | Includes 65,000 issuable upon exercise of options
	that are exercisable within 60 days.                                                                
|   
|(7) | Includes 10,000 shares issuable upon exercise of
	options that are exercisable within 60 days.                                                         



|         |                                                
|-------- | -----------------------------------------------
|Item 13. | Certain Relationships and Related
	Transactions

Mr. Fant, Mr. Reynolds, Mr. Finch
and Mr. Traynor each issued Promissory Notes to us in
connection with the exercise of stock options. The amounts owing
as of August 31, 2001 are $607,020, $74,985, $252,718 and
$308,977 respectively. The first payment on each such note will
be due April 2, 2002. The rate of interest charged is 8.25%
per annum.



|         |                                                                 
|-------- | ----------------------------------------------------------------
|Item 14. | Exhibits, Financial Statement Schedules and
	Reports on Form 8-K

(a) The following documents are filed as
part of this report:



| |                                                                   
| | ------------------------------------------------------------------
| | (1) Financial Statements 
	see Part II                           
|
| | (2) Schedule II 
	Valuation and Qualifying Accounts  See Part II

(b) Reports on Form 8-K: There
were no filings on Form 8-K during the fourth quarter of
FY2001.

Exhibits:

| |       |  |  |   |  |                                                                                                                                                                                   |  |       
| | ----- |  |  | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------
| | 2.1   |  |  |  |  | Cross Technology, Inc., Agreement and Plan of
	Reorganization                                                                                                                     |  | Note 7
| | 3.1   |  |  |  |  | Restated Articles of Incorporation, as amended.                                                                                                                                   |  | Note 1
| | 3.2   |  |  |  |  | Bylaws, as amended.                                                                                                                                                               |  | Note 6
| | 10.1a |  |  |  |  | Loan and Security Agreement with LaSalle Bank,
	N.A. dated July 31, 2000.                                                                                                         |  | Note 2
| | 10.1b |  |  |  |  | First Amendment to Credit Agreement                                                                                                                                               |  | Note 8
| | 10.1c |  |  |  |  | Second Amendment to Loan Security Agreement                                                                                                                                       |  | Note 8
| | 10.1d |  |  |  |  | Third Amendment to Loan Security Agreement                                                                                                                                        |  | Note 8
| | 10.2a |  |  |  |  | Capital Expenditure Note with LaSalle Bank, N.A.
	dated July 31, 2000.                                                                                                            |  | Note 2
| | 10.2b |  |  |  |  | Amended and Restated Capital Expenditure Note                                                                                                                                     |  | Note 8
| | 10.2c |  |  |  |  | Amended and Restated Capital Expenditure Note                                                                                                                                     |  | Note 8
| | 10.3  |  |  |  |  | Reimbursement Agreement by and between HEI, Inc.
	and LaSalle Bank, N.A. dated July 31, 2000.                                                                                     |  | Note 2
| | 10.4  |  |  |  |  | Mortgage, Security Agreement, Fixture Financing
	Statement and Assignment of Leases and Rents by HEI, Inc. as
	Mortgagor to LaSalle Bank, N.A. as Mortgagee dated July 31,
	2000. |  | Note 2
| | 10.5a |  |  |  |  | Patent, Trademark and License Mortgage by HEI,
	Inc. in favor of LaSalle Bank, N.A. dated July 31, 2000.                                                                          |  | Note 2
| | 10.5b |  |  |  |  | Amendment No. 1 to Patent Trademark and
	License Agreement                                                                                                                        |  | Note 8
| | 10.6  |  |  |  |  | Security Agreement with LaSalle Bank, N.A. dated
	July 31, 2000.                                                                                                                  |  | Note 2
| | 10.7a |  |  |  |  | Revolving Note with LaSalle Bank, N.A. dated
	July 31, 2000.                                                                                                                      |  | Note 2
| | 10.7b |  |  |  |  | Amended and Restated Revolving Note                                                                                                                                               |  | Note 8
| | 10.8  |  |  |  |  | Form of Indemnification Agreement between HEI and
	officers and directors.                                                                                                        |  | Note 3

44



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##### Table of Contents



| |        |  |  |   |  |                                                                                                                                             |  |       
| | ------ |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------- |  | ------
| | *10.9  |  |  |  |  | HEI 1989 Omnibus Stock Compensation Plan adopted
	April 3, 1989, as amended to date.                                                        |  | Note 4
| | *10.10 |  |  |  |  | 1991 Stock Option Plan for Non-employee
	Directors, as amended to date.                                                                     |  | Note 5
| | *10.11 |  |  |  |  | 1998 Stock Option Plan adopted November 18,
	1998.                                                                                          |  | Note 6
| | *10.12 |  |  |  |  | 1998 Stock Option Plan for Non-employee Directors
	adopted November 18, 1998.                                                               |  | Note 6
| | *10.14 |  |  |  |  | Agreement regarding Employment/ Compensation upon
	change in control with Mr. Courtney, dated November 20,
	1998.                           |  | Note 9
| | *10.15 |  |  |  |  | Stock purchase agreement by and among HEI, Inc.
	and the Investors listed on Exhibit A thereto, including
	exhibits, dated August 29, 2001. |  | Note 9
| | 10.16 |  |  |  |  | Promissory Note used in connection with the
	exercise of stock options.                                                                     |  |       
| | 21    |  |  |  |  | Subsidiaries of the Registrant                                                                                                              |  |       
| | 23    |  |  |  |  | Consent of KPMG LLP.                                                                                                                        |  |       



---

Notes to Exhibits above:



|    |                                                                                                                                             
|--- | --------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Filed as an exhibit to Annual Report on
	Form 10-K for the year ended August 31, 1990, and
	incorporated herein by reference.               
|   
|(2) | Filed as an exhibit to this Form 10-KSB for
	the fiscal year ended August 31, 2000.                                                         
|   
|(3) | Filed as an exhibit to Registration Statement on
	Form S-2 (SEC No. 33-37285) filed October 15,
	1990, and incorporated herein by reference.
|   
|(4) | Filed as an exhibit to Annual Report on
	Form 10-KSB for the year ended August 31, 1996 and
	incorporated herein by reference.              
|   
|(5) | Filed as an exhibit to Annual Report on
	Form 10-KSB for the year ended August 31, 1997 and
	incorporated herein by reference.              
|   
|(6) | Filed as an exhibit to Annual Report on
	Form 10-KSB for the year ended August 31, 1998 and
	incorporated herein by reference.              
|   
|(7) | Filed as a Form 8-K on March 21, 2000.                                                                                                      
|   
|(8) | Filed as an exhibit to Annual Report on
	Form 10-K for the fiscal year ended August 31, 2001.                                               
|   
|(9) | Filed with our report on Form 8-K, filed
	September 4, 2001.                                                                                



| |   |                                                                  
| | - | -----------------------------------------------------------------
| | * | Denotes management contract or compensation plan
	or arrangement.



| |                       
| | ----------------------
| |      Filed
	herewith.

45



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##### Table of Contents



SCHEDULE II

Valuation and qualifying accounts

|                                 |  |                           |     |                    |  |              |       |               |  |   |       |  |  |   |     | 
|-------------------------------- |  | ------------------------- | --- | ------------------ |  | ------------ | ----- | ------------- |  | - | ----- |  |  | - | --- | 
|                                 |  | Balance at                |     | Additions          |  |              |       |              
|                                 |  | Beginning                 |     | Charged to         |  | Deductions   |       | Balance at   
|                                 |  | of Period                 |     | Costs and Expenses |  | from Reserve |       | End of Period
|                                 |  |                           |     |                    |  |              |       |              
|                                 |  |                          
|                                 |  | (In thousands of dollars)
|                                
|                                
|                                
|                                
|Allowance for doubtful accounts: |  |                           |     |                    |  |              |       |               |  |   |       |  |  |   |     | 
|                                
|                                
|                                
|                                
|Year ended August 31, 2001       |  | $                         | 215 |                    |  | $            | 1,268 |               |  | $ | 1,212 |  |  | $ | 271 | 
|                                
|                                
|                                
|                                
|Year ended August 31, 2000       |  |                           | 140 |                    |  |              | 75    |               |  |   |      |  |  |   | 215 | 
|                                
|                                
|                                
|                                
|Year ended August 31, 1999       |  |                           | 230 |                    |  |              |      |               |  |   | 90    |  |  |   | 140 | 

46



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##### Table of Contents






SIGNATURES

In accordance with Section 13 or 15(c) of
the Exchange Act, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly
authorized



| |          
| | ---------
| | HEI, INC.



| |     |                    
| | --- | -------------------
| | By: | /s/ ANTHONY J. FANT

| |                                     
| | ------------------------------------
| |                                     
| | Anthony J. Fant                     
| | Chairman and Chief Executive Officer




Date: December 13, 2001




In accordance with the Exchange Act, this report
has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.




|                                               |  |                                                                                        |  |                  
|---------------------------------------------- |  | -------------------------------------------------------------------------------------- |  | -----------------
|                                               |  |                                                                                        |  | Date             
|                                               |  |                                                                                        |  |                  
|                                              
|/s/ ANTHONY J. FANTAnthony J. Fant             |  | Chairman and Chief
	Executive Officer                                                  |  | December 13, 2001
|                                              
|/s/ STEVE E. TONDERA, JR.Steve E. Tondera, Jr. |  | Chief Financial Officer, Treasurer, Secretary,
	Vice President of Finance and Director |  | December 13, 2001
|                                              
|/s/ EDWIN W. FINCH, IIIEdwin W. Finch          |  | Director                                                                               |  | December 13, 2001
|                                              
|/s/ DAVID W. ORTLIEBDavid W. Ortlieb           |  | Director                                                                               |  | December 13, 2001
|                                              
|/s/ MACK V. TRAYNOR, IIIMack V. Traynor, III   |  | Director                                                                               |  | December 13, 2001




47