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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-K



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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 November 8, 2001 (based
on the closing price as reported by The Nasdaq National Market)
of the voting stock held by non-affiliates was approximately
$34,936.

As of
November 8, 2001, 5,985,710 Common Shares, par value
$.05 per share, were outstanding.

Documents Incorporated by Reference

Portions of the
Proxy Statement for Registrants Annual Meeting of
Shareholders to be held January 30, 2002, which will be
filed not later than 120 days from August 31, 2001,
and are incorporated by reference into Part III.



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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                                                  
|INDEPENDENT AUDITORS REPORT                              
|SIGNATURES                                                
|First Amendment to Credit Agreement                       
|Second Amendment to Loan Security Agreement               
|Third Amendment to Loan Security Agreement                
|Amended and Restated Capital Expenditure Note             
|Amended and Restated Capital Expenditure Note             
|*                                                         
|Amended and Restated Capital Expenditure Note             
|Amendment No. 1 to Patent Trademark and License Ag        
|Amended and Restated Revolving 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 or the Company, 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

HEI, Inc. (HEI), a Minnesota
corporation, was incorporated as Hybrid Electronics Inc. in 1968
and changed its name to HEI, Inc. in 1969. In fiscal 1997, the
Company sold its optoelectronic switch assembly business and
related assets. During fiscal year 1999, the Company formed a
subsidiary, HEI Export, Inc., as a foreign sales corporation.
During fiscal year 2000, the Company acquired Cross Technology,
Inc. (Cross), now a wholly-owned subsidiary of HEI. Under the
terms of the acquisition, 600,000 shares of HEI 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, the
Company closed the Mexico division, disposing of some assets and
relocating some assets to its other facilities.

(b)  Business of the Company



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



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Microelectronics HEIs 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 our products, 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. HEIs custom-built microelectronics are employed
	in the hearing, medical, telecommunications and RFID 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 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

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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 the
	Companys 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 The
	Companys 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
	HEI 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:HEI sells through its Company-employed
sales force based at its facilities in Minnesota and Arizona, as
well as through its independent sales representatives.

We strive to obtain annual contracts with our
major customers. Annual contracts allow for favorable vendor
agreements, capacity planning and typically more favorable
contractual terms and conditions. It is common for annual
contracts to specify minimum purchase quantities, product lead
times, material and quality requirements in addition to general
business terms and conditions, including termination clauses,
which help to protect the Company from obsolete inventory.

For customers with lower demand requirements the
Company commonly uses customer supplied Purchase Orders (PO) to
plan production and procure materials. These programs are
subject to our standard terms and conditions including
cancellation clauses.

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
customers and then with our vendors. The Company attempts to
align terms of such agreements with our customers and vendors,
so that they will be consistent with each other in order to
minimize risk of obsolete or unusable inventory. Typically,
there are many sources of raw material supplies available
nationally and internationally; however, some raw materials we
use are customer specified and may only be available from
customer specified vendors or supplied by the customer itself.

Proprietary Technology:The Company has proprietary technology
and proprietary processes to incorporate such technology into
many of our products. We protect this technology through
patents, proprietary information agreements with its customers
and vendors, and non-disclosure agreements with many of its
employees. Additionally, the Company will apply for new patents
whenever appropriate. The Company holds four microelectronic
process and design patents, which expire at dates ranging from
2018 through 2021. The two most significant patents held by the
Company are the High Density Stacked Circuit Module and the

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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. The Companys 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:We are not typically subject directly
to Government regulations. Within the medical product group, the
Company is subject to customer specific audits, which are
consistent with FDA regulations, but focus only on regulatory
requirements specific to our products and manufacturing
processes. In the communications markets, the Company is
typically subject to industry standards (such as Telcordia) for
performance and qualification testing.

Dependence on Single or Few Customers: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. 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.

Following is the approximate percentage of the
Companys 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% or
greater revenue and no one program at 10% or greater. Likewise
we seek to operate our business to avoid risking concentrations
or our business with on customer or program.

Competition:In each
of its product lines, the Company has significant competition,
including users who may produce the same or similar products
themselves. The Company obtains new business by identifying
customer needs and first, designing and engineering its products
to meet those needs in the most ultraminiature and cost
effective way. We then manufacture those electronic assemblies
with the highest 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 the highest level of quality at the lowest cost.
Application specific

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requirements typically include: very small size,
low power, high performance and low cost. We are a full-service
supplier and partner with its 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

The Company owns 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. The Company mortgaged the property to
secure the credit facility with LaSalle Business Credit, Inc.

The Company leases a 14,000 square foot
facility in Tempe, Arizona for its high density interconnect
business. The Company leases a 20,000 square foot facility
in Chanhassen, Minnesota, for part of its RF business. The
Tempe, Arizona and Chanhassen, Minnesota facilities are leased
until July 2005 and October 2007, respectively.

Item 3.     Legal Proceedings

As of November 8, 2001 there are no material
legal proceedings pending against the Company or its properties.
From time to time we may become involved in routine litigation
incidental to our business.

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

None.

PART II

Item 5.     Market for Common Equity and Related Stockholder
Matters

The Companys common stock is currently
traded on The Nasdaq National Market under the symbol HEII.
Below are the high and low closing bid prices for each quarter
of fiscal year 2001 and 2000, 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 November 7, 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

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the company will follow a policy of retaining
earnings in order to finance the continued development of its
future business. Payment of dividends is within the discretion
of our board of directors and will depend upon, among other
things, the earnings, capital requirements and operating and
financial condition of the Company. 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 HEI 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 the company 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
common stock at a price of $8.05. The Company is in the
process of registering these shares.

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.

5



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##### Table of Contents





|    |  |                                                                                                                                               
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------
|(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.                                               

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 the hearing and
medical business, as well as Mexico and laminate sales, which
were offset to a lesser extent by a decrease in Cross revenues
as a result of a decline in sales to a significant customer
early in the year. During the year, the Company continued to
diversify its customer base with the largest customer in fiscal
2001 representing 26% of revenue compared to 42% in fiscal 2000.

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 for
microelectronics. Each division (Microelectronics, Cross
Technology, Mexico and High Density Interconnect) contributed to
the growth in sales. The largest customer accounted for 42% of
sales in 2000. The reason for the decrease in the percentage of
sales to the Companys largest customer is primarily due to
the diversification of the Companys customer base as well
as the start up of operations in Mexico.

Gross Profit

2001 vs. 2000:The
Companys 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.

2000 vs. 1999:The
Companys 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 the Companys Mexico division and Cross
operations and start-up costs for the high density interconnect
facility. The lower margins for the Companys 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

6



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start-up costs related to the high density
interconnect division. In fiscal 2002, the Company expects 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 operations of $1,268 in the second quarter and $425
of costs associated with the shut down of the Mexico operations
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 enterprise resource planning (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, the Company 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, the Company 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. The Company
expects that other income (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 the Company generates capital gains. As it is
more likely than not that such capital gains will not occur, the
Company has 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:The
Company 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

7



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operations, including the accounts receivable
write-off, and the impairment charge for MSC. Excluding Mexico
and MSC, the net loss for fiscal 2001 was $164.


2000 vs. 1999:The
Company 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
facilities, ERP implementation costs, the Cross acquisition
costs and higher debt.

Financial Condition

The Companys 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.

The Company has 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 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,
respectively. Approximately $5,000 of the capital expenditure
term loan will be available for use by the Company after the
Company meets certain financial covenants, which are calculated
monthly, in fiscal 2002 and beyond.

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. Losses associated with the Mexico operations and
the general economic slowdown in the hearing, RFID/ Access and
other electronic contract manufacturing markets that the Company
operates in have resulted in adverse operating results in fiscal
2001. Due to these adverse operating results, 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.

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

During fiscal 2002, the Company intends 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.

8



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##### Table of Contents



The Company believes that its existing cash and
cash equivalents, current lending capacity and cash generated
from operations will provide sufficient cash flow for the
Company to meet its short and long-term debt obligations and
operating requirements.



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

The Company is 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 the Companys option,
at 1% above the prime rate of interest or 3.5% above the LIBOR
rate. The capital expenditure loans bears interest, at the
Companys 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, the Company is 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 contains forward-looking
statements that are based on the Companys 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, the ability of the Company 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 the Company will continue
to develop, market, manufacture and ship products on a timely
basis, that competitive conditions within the Companys
markets will not change materially or adversely, that the
Company will continue to identify and satisfy customer needs for
products and services, that the Company 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 the Companys
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.
The Company operates in a volatile segment of high technology
markets and applications that are subject to rapid change and
technical obsolescence.

Because of these and other factors affecting the
Companys 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.

Our business, operating results and financial
condition may be adversely affected if we are unable to develop
new products and services.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. There is no assurance that we will be able to
successfully:



| |   |                                                                               
| | - | ------------------------------------------------------------------------------
| |  | identify new product and service
	opportunities; or                           
|
| |  | develop and introduce new products and services
	to market in a timely manner.

If we are unable to accomplish these tasks, our
business, operating results and financial condition could be
materially adversely affected.

9



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Our business, operating results and financial
condition may be adversely affected if we fail to properly
anticipate the market for new products and
services.Even if we are able to
successfully identify, develop, and 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 of our business plan to predict
	accurately the rate at which the market for microelectronic
	products and services will grow;                                                         
|
| |  | the failure of our business plan to predict
	accurately the types of products and services the future
	microelectronic marketplace will demand;                                                    
|
| |  | our limited experience in specific market
	segments in marketing our products and services;                                                                                                        
|
| |  | the failure of our business plan to predict
	accurately our future participation in the microelectronic
	marketplace;                                                                              
|
| |  | the failure of our business plan to predict
	accurately the estimated sales cycle, price and acceptance of
	our products and services;                                                             
|
| |  | the development by others of products and
	services that render our products and services noncompetitive or
	obsolete; or                                                                          
|
| |  | our failure to keep pace with the rapidly
	changing technology, evolving industry standards and frequent
	new product and service introductions that characterize the
	microelectronic marketplace.

The sales cycle for our products and services
is lengthy and unpredictable, and we may fail to adequately
adjust our expenses to predicted revenue in any given period or
we may experience significant fluctuations in quarterly
revenue.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 a
prospective customers budgetary constraints and internal
acceptance reviews, over which we have little or no control. As
a result of these things, 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 if we are unable to
protect our intellectual property
rights.Intellectual property rights
are important to our success and our competitive position. We
rely primarily on 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, 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. Any such claim
may have a material adverse affect on our business, which could
cause our stock price to decline. 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,
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.

10



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We may pursue future acquisitions and
investments that may adversely affect our
business.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 identify or make strategic
	acquisitions.                                                                                                                                    
|
| |  | 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.

Our business may be adversely affected if our
customers are unable to gain market acceptance for the products
we develop or manufacture for them.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. 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.

Our business may be adversely affected if we
fail to comply with environmental laws and
regulations.We are subject to a
variety of local, state and federal governmental regulations
relating to the storage, discharge, handling, emission,
generation, manufacture and disposal of toxic or other hazardous
substances used to manufacture our products. 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.

Our business, operating results and financial
condition may be adversely affected if our products or the
products that incorporate our products are deemed to pose health
risks.News reports have asserted that
power levels associated with hand held cellular telephones and
infrastructure equipment may pose health risks. If it were
determined or perceived that electromagnetic waves carried
through wireless communications equipment create a health risk,
the market for our wireless customers products could be
severely reduced, which could in turn have a material adverse
affect on our business, operating results and financial
condition. Moreover, if wireless communications systems or other
systems or devices that rely on or incorporate our products are
determined or alleged to create a health risk, we could be named
as a defendant, and held liable, in product liability lawsuits,
which would materially adversely affect our business, operating
results and financial condition.

Our business, operating results and financial
condition may be adversely affected if the products we design
and manufacture are the subject of product recalls or product
liability claims.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

11



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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;                                                                   
|
| |  | 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 the Companys
annual and quarterly operating results, which in turn may cause
our stock price to decline.

Our customers generally require short delivery
cycles and a substantial portion of our backlog is typically
scheduled for delivery within 90 days. Quarterly sales and
operating results therefore depend in large part on the volume
and timing of bookings received during or immediately prior to
the quarter, which are difficult to forecast in advance of that
time. The short lead-time for our backlog also affects its
ability to accurately project production and inventory levels.
In addition, a significant portion of our operating expenses is
relatively fixed in nature and planned expenditures are based in
part on anticipated orders. Any inability to adjust spending
quickly enough to compensate for any revenue shortfall may
magnify the adverse impact of such revenue shortfall on our
operating results.

We are dependent on a single industry, and our
business and revenues may be adversely affected by trends in
that industry.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
our operating results and financial condition may be adversely
affected by the loss of a key
customer.Our customer base is highly
concentrated. In fiscal 2001, 2000 and 1999, our two largest
customers, Siemens AG 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

12



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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 25% or
greater revenue and no one program at 10% or greater.


We operate in a highly competitive industry
and our business and operating results may be adversely affected
if we fail to compete successfully.We
operate in a highly competitive industry and compete against
several domestic and foreign providers of similar
microelectronics design and/or manufacturing services. We also
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 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, our business and
operating results would be adversely affected.

Our business, operating results and financial
condition may be adversely affected by fluctuations in the price
and supply of components.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 have a material adverse effect on our operating
results.

13



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##### Table of Contents



Our operating results may be adversely
affected by the costs associated with our inability 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. 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.

Our operating results and financial condition
may be adversely affected by the inability of our customers to
pay their accounts.We may carry
significant accounts receivable 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, operating results and financial
condition may be adversely affected if we are unable to develop
technologies that meet the rapidly evolving market requirements
of our customers.Our customers
compete in markets that are characterized by rapid technological
change and short product life cycles. In particular, the
hearing, medical and telecommunications markets are prone to
rapid product obsolescence by new technologies. The
microelectronics industry could experience future competition
from new or emerging technologies that render existing
technology less competitive or obsolete. Our inability to
develop technologies or acquire capability to meet the evolving
market requirements of our customers could have a material
adverse effect on our business, operating results and financial
condition, including our ability to maintain our revenue base.

Our business, operating results and financial
condition may be adversely affected if our growth is not managed
properly.Our sales have varied
significantly as customer demand for our products fluctuate. Our
future operating results will depend on managements
ability to manage periods of both growth and downturn, to be
able to hire, train and retain the appropriate number of
qualified employees, and to forecast revenues and control
expenses. Unexpected declines in revenues, without corresponding
and timely reductions in expenses, may materially adversely
affect our business, operating results and financial condition.

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. 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.

Our business may be adversely affected if we
are unable to secure additional financing, at terms acceptable
to us, when needed.In August 2001, we
received gross proceeds in the amount of $6,650 from a private
placement of our common stock. The net proceeds from this
private placement are expected to fund our operations through
fiscal 2002. We intend to create new marketing programs, hire
additional personnel and increase sales as part of our growth
strategy. In addition, we will consider the acquisition of
complementary or additional businesses or products that our
management believes meet our current or future business
objectives. We may require additional capital to finance future
growth or strategic acquisitions. Required additional capital
could come from a number of sources including sales of
additional shares of capital stock or other securities or loans
from banks or other sources. There is no assurance that
additional financing will be available to us if needed or, if
available, that it will be available on terms acceptable to us.

14



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##### Table of Contents



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 and financial condition
may be adversely affected 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.

We have issued numerous options to acquire our
common stock that could have a dilutive effect on our
shareholders.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
adversely affected 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.                                                        

15



---



##### Table of Contents



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 which must be complied with before they can be
resold.

Our business and financial condition may be
adversely affected if future sales of our common stock in the
public market limit our ability to raise equity
capital.Sales of substantial amounts
of our common stock in the public market pursuant to
Rule 144, upon exercise or conversion of derivative
securities or otherwise, or even the potential for such sales,
could affect our ability to raise capital through the sale of
equity securities. If we are unable to raise capital through the
sale of equity securities, we may not be able to fund operations
or finance our growth strategy and may not be able to continue
certain marketing programs, hire or retain certain employees,
increase sales or acquire certain businesses or products. The
inability to continue with any one or a combination of these
items may adversely affect our business and financial condition.

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 without
obtaining shareholder approval.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.

We do not anticipate paying dividends on our
common stock for the foreseeable
future.We have never paid dividends
on our common stock and do not intend to pay any dividends on
our common stock in the foreseeable future. Any decision by us
to pay dividends on our common stock will depend upon our
profitability at the time, cash available therefore, and other
factors. We anticipate that we will devote profits, if any, to
our future operations.

16



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##### Table of Contents



Item 8.     Financial Statements

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.

17



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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.

18



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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.

19



---



##### 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.

20



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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

21



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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

22



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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.

23



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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   |      
|                          |                                       |                |       |       |   |   |       |      

24



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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.

25



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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

26



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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.

27



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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   |     
|                                                          |                                  |                |       |       |   |   |       |     

28



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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

29



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##### 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

30



---



##### 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 |    
|                                             |                                              |                |     |    

31



---



##### 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.

32



---



##### 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.

33



---



##### 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


34



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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.


35



---



##### Table of Contents





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

None.




PART III



|         |                                                                                                                  
|-------- | -----------------------------------------------------------------------------------------------------------------
|Item 10. | Directors, Executive Officers, Promoters
	and Control Persons; Compliance with Section 16(a) of
	the Exchange Act

The information regarding directors called for by
Item 10 is contained in the Proxy Statement under the
caption Election of Directors and is incorporated
herein by reference.

The following is a list of HEI, Inc. executive
officers, their ages, positions and offices as of
November 9, 2001.

|                      |  |     |    |          |  |                                                                         
|--------------------- |  | --- | -- | -------- |  | ------------------------------------------------------------------------
|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                                               

Business Experience

Anthony J. Fantbecame Chief Executive Officer of the Company in 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.

Donald R. Reynoldsjoined the Company in March 1998 as Executive Vice President and
was appointed President in April 1998 and Chief Operating
Officer in January 1999. Before joining the Company, 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.

Steve E. Tondera,
Jr.joined the Company in January 1999
as Managing Director of HEI-Mexico Division and became Chief
Financial Officer and Treasurer in June 2000. Mr. Tondera
has been Senior Vice President and Chief Financial Officer of
Fant Broadcasting Company (including, for these purposes,
various affiliated companies engaged primarily in television and
radio broadcasting) since 1994.

Stephen K. Petersenjoined the Company in March 1998 as Director of Manufacturing.
He was appointed Vice President of Operations in September 2000.
Before joining the Company, he was employed with Sheldahl in a
variety of positions ranging from Engineer to Plant Manager and
most recently as the Operations Manager.

The information regarding compliance with
Section 16(a) of the Securities Exchange Act of 1934 called
for by Item 10 is contained in the Proxy Statement under
the caption Section 16(a) Beneficial Ownership
Reporting Compliance and is incorporated herein by
reference.

Item 11.     Executive Compensation

The information required by this Item 11 is
incorporated herein by reference to HEIs definitive Proxy
Statement for its Annual Meeting of Stockholders, to be held on
January 30, 2002, to be filed with the Securities and
Exchange Commission pursuant to Schedule 14A under the
Securities Exchange Act of 1934.

36



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##### Table of Contents





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

The information required by this Item 12 is
incorporated herein by reference to HEIs definitive Proxy
Statement for its Annual Meeting of Stockholders, to be held on
January 30, 2002, to be filed with the Securities and
Exchange Commission pursuant to Schedule 14A under the
Securities Exchange Act of 1934.



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

The information required by this Item 13 is
incorporated herein by reference to HEIs definitive Proxy
Statement for its Annual Meeting of Stockholders, to be held on
January 30, 2002, to be filed with the Securities and
Exchange Commission pursuant to Schedule 14A under the
Securities Exchange Act of 1934.



|         |                                                                 
|-------- | ----------------------------------------------------------------
|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
| | 4.1   |  |  |  |  | (Registration, IPO)                                                                                                                                                               |  | Note 8
| | 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
| | 10.2d |  |  |  |  | Amended and Restated Capital Expenditure Note                                                                                                                                     |  | Note 8
| | 10.2e |  |  |  |  | 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
| | *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

37



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##### Table of Contents



| |        |  |  |   |  |                                                                                                                                            |  |       
| | ------ |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------ |  | ------
| | *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 6
| | 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
| | 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.

38



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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 | 

39



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##### Table of Contents






INDEPENDENT AUDITORS REPORT

The Shareholders and the Board of Directors

HEI, Inc.:


Under date of October 5, 2001, we reported
on the 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, as contained in the 2001 annual
report to shareholders. These consolidated financial statements
and our report thereon are incorporated by reference in the
annual report on Form 10-K for the fiscal year ended
August 31, 2001. In connection with our audits of the
aforementioned consolidated financial statements, we have also
audited the related financial statement schedule as listed in
the accompanying index. This financial statement schedule is the
responsibility of the Companys management. Our
responsibility is to express an opinion on this financial
statement schedule based on our audits.

In our opinion, such financial statement
schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly, in all
material respects, the information set forth therein.



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

Minneapolis, Minnesota

October 5, 2001


40



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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: November 9, 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                                                  |  | November 9, 2001
|                                              
|/s/ STEVE E. TONDERA, JR.Steve E. Tondera, Jr. |  | Chief Financial Officer, Treasurer, Secretary,
	Vice President of Finance and Director |  | November 9, 2001
|                                              
|/s/ EDWIN W. FINCH, IIIEdwin W. Finch          |  | Director                                                                               |  | November 9, 2001
|                                              
|/s/ DAVID W. ORTLIEBDavid W. Ortlieb           |  | Director                                                                               |  | November 9, 2001
|                                              
|/s/ MACK V. TRAYNOR, IIIMack V. Traynor, III   |  | Director                                                                               |  | November 9, 2001

41