##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-K

|   |  |                                                                                                 
|-- |  | ------------------------------------------------------------------------------------------------
|þ  |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|  
|   |  | For the fiscal year ended August 31,
    2004.                                                  
|  
|or
|  
|o  |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|  
|   |  | For the transition period
    from           to                                                 

Commission file number: 0-10078



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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)                         

Registrants telephone number, including
area code:

(952) 443-2500


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

None


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

Common Stock, Par Value $.05 Per
Share


(Title of Class)


Indicate by check
mark whether the registrant (1) filed all reports required
to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing
requirements for the past
90 days.     Yes þ          No o

Indicate by check
mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein,
and will not 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 or any amendment to this
Form 10-K.     o

Indicate by check
mark whether the registrant is an accelerated filer (as defined
in Rule 12b-2 of the
Act).     Yes o          No þ

The aggregate
market value, in thousands, of the voting and non-voting common
equity held by non-affiliates as of the last business day of the
registrants most recently completed second fiscal quarter
(based on the closing price as reported by the NASDAQ National
Market) was $22,563,374.

As of
January 12, 2005, 8,356,805 of the registrants common
shares, par value $.05 per share, were outstanding.



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TABLE OF CONTENTS

|                                             |  |                                                                                                        |    |          |    | 
|-------------------------------------------- |  | ------------------------------------------------------------------------------------------------------ | -- | -------- | -- | 
|                                             |  |                                                                                                        |    | Page No.
|                                             |  |                                                                                                        |    |         
|PART I                                      
|ITEM 1.                                      |  | BUSINESS                                                                                               |    |          | 2  | 
|ITEM 2.                                      |  | PROPERTIES                                                                                             |    |          | 6  | 
|ITEM 3.                                      |  | LEGAL
    PROCEEDINGS                                                                                  |    |          | 7  | 
|ITEM 4.                                      |  | SUBMISSION OF MATTERS TO
    VOTE SECURITY HOLDERS                                                     |    |          | 8  | 
|PART II                                     
|ITEM 5.                                      |  | MARKET FOR
    REGISTRANTSS COMMON EQUITY AND RELATED STOCKHOLDERS
    MATTERS                        |    |          | 9  | 
|ITEM 6.                                      |  | SELECTED FINANCIAL
    DATA                                                                            |    |          | 10 | 
|ITEM 7.                                      |  | MANAGEMENTS
    DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
    OPERATIONS          |    |          | 11 | 
|ITEM 7A.                                     |  | QUANTITATIVE AND
    QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                         |    |          | 32 | 
|ITEM 8.                                      |  | FINANCIAL STATEMENTS AND
    SUPPLEMENTARY DATA                                                        |    |          | 33 | 
|ITEM 9.                                      |  | CHANGES IN AND
    DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
    DISCLOSURE           |    |          | 61 | 
|ITEM 9A.                                     |  | CONTROLS AND
    PROCEDURES                                                                            |    |          | 61 | 
|ITEM 9B.                                     |  | OTHER
    INFORMATION                                                                                  |    |          | 63 | 
|PART III                                    
|ITEM 10.                                     |  | DIRECTORS AND EXECUTIVE
    OFFICERS OF THE REGISTRANT                                                 |    |          | 63 | 
|ITEM 11.                                     |  | EXECUTIVE
    COMPENSATION                                                                             |    |          | 66 | 
|ITEM 12.                                     |  | SECURITY OWNERSHIP OF
    CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER
    MATTERS |    |          | 73 | 
|ITEM 13.                                     |  | CERTAIN RELATIONSHIPS AND
    RELATED TRANSACTIONS                                                     |    |          | 74 | 
|ITEM 14.                                     |  | PRINCIPAL ACCOUNTING FEES
    AND SERVICES                                                             |    |          | 75 | 
|PART IV                                     
|ITEM 15.                                     |  | EXHIBITS, FINANCIAL
    STATEMENT SCHEDULES                                                            |    |          | 75 | 
|SIGNATURES                                   |  |                                                                                                        | 81 |         
|Amendment to Accounts Receivable Agreement  
|Employment Agreement - Mack Traynor         
|Letter from KPMG LLP to the SEC             
|Subsidiaries                                
|Consent of KPMG LLP                         
|Certification of CEO Pursuant to Section 302
|Certification of CFO Pursuant to Section 302
|Certification of CEO Pursuant to Section 906
|Certification of CFO Pursuant to Section 906

FORWARD-LOOKING STATEMENTS

Some of the information included in this
Annual Report on Form 10-K contains forward-looking
statements made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995 that involve
substantial risks and uncertainties. You can identify these
statements by forward-looking words such as may,
will, expect, anticipate,
believe, intend, estimate,
continue, and similar words. You should read
statements that contain these words carefully for the following
reasons: such statements discuss our future expectations, such
statements contain projections of future earnings or financial
condition and such statements state other forward-looking
information. Although it is important to communicate our
expectations, there may be events in the future that we are not
accurately able to predict or over which we have no control. The
risk factors included in Item 7 of this Annual Report on
Form 10-K provide examples of such risks, uncertainties and
events that may cause actual results to differ materially from
our expectations and the forward-looking statements. Readers are
cautioned not to place undue reliance on forward-looking
statements, as we undertake no obligation to update these
forward-looking statements to reflect ensuing events or
circumstances, or subsequent actual results.

GENERAL INFORMATION

HEI, Inc. and its subsidiaries are referred to in
this Annual Report on Form 10-K as HEI, the
Company, us, we or
our, unless the context indicates otherwise. All
dollar amounts are in thousands of United States dollars, except
for per share amounts and all amounts included in Part III
of this Annual Report Form 10-K.



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PART I




Item 1. Business.

Business Development

We are a Minnesota corporation and were
incorporated as Hybrid Electronics Inc. in 1968 and changed our
name to HEI, Inc. in 1969. On January 24, 2003, we acquired
certain assets and assumed certain liabilities of Colorado
MEDtech, Inc.s (CMED) Colorado operations (a
business unit of CMED or our Advanced Medical Operations
(AMO)) in a business combination accounted for as a
purchase. In exchange for certain assets of our AMO, we issued
one million shares of our common stock and assumed approximately
$1,364 of liabilities related to our AMO, as well as an
operating lease and other contractual commitments. The
consolidated financial statements of the Company include the
results of these operations since January 24, 2003. Our
purposes for acquiring our AMO were to immediately gain access
to the more stable medical device markets, to expand marketing
and sales opportunities, and to expand our capabilities to
become more full service or one stop shop to our
customers and target markets. We believe that the design,
development and manufacturing capabilities for medical devices
at our AMO coupled with our microelectronic design, development
and manufacturing at our Microelectronics Operations improves
our ability to retain and gain customers.

Business of the Company

Overview:We provide
a comprehensive range of engineering, product design, automation
and test, manufacturing, distribution, and fulfillment services
and solutions to our customers in the hearing, medical device,
medical equipment, communications, computing and industrial
equipment markets. We provide these services and solutions on a
global basis through four integrated facilities in the United
States. These services and solutions support our customers
products from initial product development and design through
manufacturing to worldwide distribution and aftermarket support.
We leverage our various technology platforms to provide unique
solutions to the markets served. Our current focus is on
managing our costs and integration of our business operating
units. For information regarding revenues from external
customers by segment see Note 18  Segments.

In our Victoria, Minnesota facility we design and
manufacture ultra miniature 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)
commonly referred to as chips, and other passive
electrical components onto a ceramic or organic substrate. The
microelectronic assembly typically embodies the primary
functions of the end products of our customers, such as hearing
aids, defibrillators and communication devices. For example, in
hearing aids the microelectronic assemblies we design and make
are contained within a shell and connected to a microphone,
receiver and battery. For some customers, we procure the
microphone, receiver and battery from outside vendors and
assemble all of the components into further assemblies; and to
other customers we may sell only the microelectronic assembly.
Our custom-built microelectronics are employed in the hearing,
medical, telecommunications and ultra miniature radio frequency
markets. Our Victoria, Chanhassen, and Tempe facilities achieved
ISO 9001:2000 certification in August 2003. We refer to our
Victoria operations in this Annual Report on Form 10-K as
our Microelectronics Operations.

Certain proprietary technology employed in our
Victoria facility allows us to manufacture miniature chip
packages that are specially designed to hold and protect high
frequency chips for broadband communications. This package, with
the enclosed chip, may then be easily and inexpensively attached
to a 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 and very long
distances. We manufacture our products by fabricating a
substrate and placing integrated circuits 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

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automated using sophisticated equipment that
picks an IC 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.


Our Boulder, Colorado facility provides four
primary products and services relating to our Advanced Medical
Operations. We provide custom design and development outsourcing
services for customers ranging from large medical device
original equipment manufacturers (OEMs) to emerging
medical device companies worldwide. Our design and development
projects generally include product concept definition,
development of specifications for product features and
functions, product engineering specifications, instrument
design, development, prototype production and testing, and
development of test specifications and procedures. We also
perform various forms of verification and validation testing for
software application and medical devices. We maintain a
technical staff of engineers with backgrounds focused in
electrical, mechanical, software and manufacturing disciplines.
The medical imaging group at our Boulder facility designs,
develops and manufactures a broad range of advanced application
software and major subsystem hardware. Our work includes the
development of leading edge MRI software, cardiac and vascular
diagnostic application software and high-density RF amplifier
systems. Contracts in this business are undertaken with major
OEMs in the medical imaging system market that integrate the
power subsystems into their imaging systems. Third, we provide
medical device manufacturing outsourcing services. We
manufacture complex electronic and electromechanical medical
devices. We are a registered device manufacturer with the Food
and Drug Administration (the FDA) and are required
to meet the FDAs Quality System Regulation
(QSR). Our Boulder facilitys quality system is
certified to, and meets, ISO 9001:1994 and ISO 13485 standards.
Our manufacturing projects include pre-production engineering
and commercialization services, turnkey manufacturing of FDA
Class I, Class II and Class III devices and
system test services. Our manufacturing outsourcing services
generally involve complex high-end devices, as opposed to
commodity or high-volume products. In providing outsourcing
services, we manufacture products for use in blood analysis,
womens health therapies, and cancer detection systems. Our
Boulder facility provides a connectivity solution consisting of
both hardware and software. This technology enables medical
device OEMs and Health Care Information Technology vendors to
add wired and wireless web server connectivity to their products
quickly and cost-effectively.

Our Chanhassen, Minnesota facility manufactures
wireless smart cards and other ultra-miniature RF applications.
Ultra miniature electronic modules are connected to a RF coil,
creating an assembly. This assembly is contained within a smart
card or wireless card (about the same size as a credit card)
that is used for financial, security access and identification
or tacking applications. During the second quarter ended
February 28, 2004 we were developing a plan to move the
RFID operations to Boulder to more effectively use the
additional floor space in that facility. After considerable
analysis it was determined that such a move would not be in our
best interests.

Our Tempe, Arizona facility, manufactures and
designs high density, high quality flex circuits and
high-performance laminate-based substrates. We utilize
specialized tooling strategies and advanced procedures to
minimize circuit handling and ensure that consistent processing
parameters are maintained throughout the assembly process.
Significant portions of the substrates produced at this facility
are transformed into custom-built microelectronics at our
facility in Victoria, Minnesota.

Customers:We sell
our products through our company-employed sales force based at
our facilities in Minnesota, Arizona and Colorado. In addition,
we promote our services through public relations advertising and
exhibitions at industry trade shows.

We currently have annual agreements with our
three largest customers, GE Healthcare, Inc., Siemens, Inc., and
Johnson & Johnson Ethicon Gynacare Division. In
addition, we have annual agreements with 17 of our top 20
customers. These agreements typically include basic
understandings that relate to estimated needs of the customer,
as well as a range of prices for the products for the current
year. These agreements generally are cancelable by either party
for any reason upon advanced notice given within a relatively
short time period (eight to twelve weeks) and, upon such
cancellation, the customer is liable only for any residual
inventory purchased in accordance with the agreement as well as
work in progress. Although these annual agreements

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do not commit our customers to order specific
quantities of products, they set the sale price and are useful
as they enable us to forecast our customers orders for the
upcoming year.


Actual orders from our customers with whom we
have annual agreements are made through customer supplied
purchase orders (POs). POs specify quantity, price,
product lead times, material and quality requirements and other
general business terms and conditions. These programs are
subject to our standard terms and conditions including
cancellation clauses, whereby either party may cancel such POs
for any reason upon advanced notice given within a relatively
short time period.

Component Supply
Operations:For all application
specific or custom material, we try to match the quantities and
terms related to the supply of such product of the customer and
all major vendors. Although we prefer to have long-term
agreements with our vendors, we do not currently have any
long-term agreements with vendors in place. Typically, there are
many sources of raw material supplies available nationally and
internationally; however, many raw materials we use are customer
specified and we are required to use customer specified vendors,
or the customer supplies materials to us. The ICs that we
assemble onto circuit boards are an example of a raw material
that is commonly customer specified and available from specified
vendors or supplied by the customer.

Proprietary
Technology:We use proprietary
technology and proprietary processes to incorporate such
technology into many of our products. We protect this technology
through patents, proprietary information agreements with our
customers and vendors and non-disclosure agreements with
substantially all of our employees. We have approximately 20
different inventions across the spectrum of our activities,
which are either granted as patents or in some stage of active
patent pursuit. We pursue new patentable technologies whenever
practicable. We have a total of nine active and five pending US
patents, and have extended many of these filings in
international venues. Our two most recent granted US patents are
Structures and assembly methods for
radio-frequency-identification (RFID) modules and
Test methods, systems, and probes for high-frequency
wireless-communications devices. The RFID patent covers a
modular package for encapsulating a
radio-frequency-identification chip in a package suitable for
embedding into a card, key-fob, or other such device for use in
security, accessibility, and identification applications. The
test methods patent pertains to a novel test-head design and
method for testing packaged high-frequency integrated circuit
chips. These devices are used predominantly in
telecommunications network applications. We bring value to our
customers, in part, by leveraging our publicly disclosed
technology as well as our internally protected trade secrets and
know-how to provide solutions and enhancements to our
customers products. These capabilities include the
application of multiple manufacturing technologies from both
product performance and product manufacturability perspectives,
manufacturing processes, such as Lean-Flow, that reduce overall
production cost, and systems and methodologies that streamline
development resulting in robust product designs that fulfill the
requirements of the FDA.

Government
Regulations:Certain end products of
our customers that we manufacture in our facilities are subject
to federal governmental regulations (such as FDA regulations).
The Boulder facility is a registered device manufacturer with
the FDA. The Medical Device Amendments of 1976 to the Food, Drug
and Cosmetic Act (the FDC Act), and regulations
issued or proposed under the FDC Act, including the Safe Medical
Devices Act of 1990, provide for regulation by the FDA of the
marketing, design, manufacturing, labeling, packaging and
distribution of medical devices. These regulations apply to
products that are outsourced to us for manufacture, which
include many of our customers products, but not to our
imaging and power generation products. The FDC Act and the
regulations include requirements that manufacturers of medical
products and devices register with, and furnish lists of
products and devices manufactured by them, to the FDA. Prior to
marketing a medical product or device, the company selling the
product or device must obtain FDA clearance. Tests to be
performed for approval range from bench-test data and
engineering analysis to potentially expensive and time-consuming
clinical trials. The types of tasks for a particular product
submission are indicated by the classification of the device and
previous approvals for similar devices. There are also certain
requirements of other federal laws and of state, local and
foreign governments, which may apply to the manufacture and
marketing of our products. We are not directly subject to any
governmental regulations or industry standards at our Victoria,
Chanhassen and Tempe facilities. However, we are subject to
certain industry standards in connection with our ISO 9001:2000
certification. Our products and manufactur-

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ing processes at such facilities are subject to
customer review for compliance with such customers
specific requirements. The main purpose of such customer reviews
is to assure manufacturing compliance with customer
specifications and quality. All facilities are subject to local
environmental regulations.


The FDAs QSR for medical devices sets forth
requirements for the design and manufacturing processes that
require the maintenance of certain records and provide for
unscheduled inspections of our Boulder facilities. The FDA
reviewed our procedures and records during routine general
inspections in 1995 and each fiscal year from 1997 to 2004.

Over 90 countries have adopted the ISO 9000
series of quality management and quality assurance standards.
ISO standards require that a quality system be used to guide
work to assure quality and to produce quality products and
services. ISO 9001, the most comprehensive of the standards,
covers 20 elements. These elements include management
responsibility, design control, training, process control and
servicing. ISO 9001 is the quality systems standard used by
companies providing design, development, manufacturing,
installation and servicing. The quality systems for our AMO are
ISO 9001 and ISO 13485 certified, and our Victoria, Chanhassen,
and Tempe facilities achieved ISO 9001:2000 certification in
August 2003.

There are no material costs or expenses
associated with our compliance with federal, state and local
environmental laws. As a small generator of hazardous
substances, we are subject to local governmental regulations
relating to the storage, discharge, handling, emission,
generation, manufacture and disposal of toxic or other hazardous
substances, such as waste oil, acetone and alcohol that are used
in very small quantities to manufacture our products. We are
currently in compliance with these regulations and we have valid
permits for the storage and disposal of the hazardous substances
we generate. If we fail to comply with these regulations,
substantial fines could be imposed on us and we could be
required to suspend production, alter manufacturing processes or
cease operations.

Dependence on Single or Few Customers and
Backlog:The table below shows the
percentage of our net sales to major customers that accounted
for more than 10% of total net sales in our fiscal years ended
August 31, 2004, 2003, and 2002.

|                        |  |                    |    |      |  |      |    |   |  |  |    |  
|----------------------- |  | ------------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                        |  |                   
|                        |  | Fiscal Years Ended
|                        |  | August 31,        
|                        |  |                   
|Customer                |  | 2004               |    | 2003 |  | 2002
|                        |  |                    |    |      |  |     
|GE Medical Systems      |  |                    | 17 | %    |  |      | 14 | % |  |  |   |  
|Siemens, Inc.           |  |                    | 8  | %    |  |      | 14 | % |  |  | 32 | %
|Sonic Innovations, Inc. |  |                    | 2  | %    |  |      | 17 | % |  |  | 32 | %

Progress has been made in the diversification of
the customer base with only one customer contributing over 10%
of net sales in our fiscal year ended August 31, 2004
(Fiscal 2004). GE Medical Systems
(GEMS), a subsidiary of General Electric Company, is
a customer in the MRI component market of our Advanced Medical
Operations and continues to award new programs to HEI. Although
GEMS was new to the Company during our fiscal year ended
August 31, 2003 (Fiscal 2003), GEMS was a
customer of CMED during CMEDs fiscal years ended
June 30, 2003 and 2002. We sold hearing aid applications to
Sonic Innovations, Inc. and Siemens, Inc. The decrease in
percent of net sales and net sales dollars with both Sonic
Innovations, Inc and Siemens, Inc. during Fiscal 2004 is largely
a result of their increased internal manufacturing capabilities
and off shore out sourcing. We had sales to Sonic Innovations,
Inc. of $883 for Fiscal year 2004. See Note 16 
Major Customer, Concentration of Credit Risk and Geographic
Data  to our Consolidated Financial Statements for
financial information about net sales from external customers
attributed to specific geographic areas.

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The following table illustrates the approximate
percentage of our net sales by markets served.

|                 |  |                    |    |      |  |      |    |   |  |  |    |  
|---------------- |  | ------------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                 |  |                   
|                 |  | Fiscal Years Ended
|                 |  | August 31,        
|                 |  |                   
|Market           |  | 2004               |    | 2003 |  | 2002
|                 |  |                    |    |      |  |     
|Medical/ Hearing |  |                    | 84 | %    |  |      | 82 | % |  |  | 76 | %
|Communications   |  |                    | 6  | %    |  |      | 6  | % |  |  | 11 | %
|RFID             |  |                    | 8  | %    |  |      | 8  | % |  |  | 10 | %
|Other            |  |                    | 2  | %    |  |      | 4  | % |  |  | 3  | %

Our goals are to have no one customer greater
than 25% of net sales and no one program exceeding 10% of net
sales. Our plans to achieve our goals include increasing our
product offerings, customer base and programs to increase net
sales, which are expected to result in more diversification.
During Fiscal 2004 we changed our strategic focus from one of
diversifying between our key markets to one of focusing our
efforts on the Medical/ Hearing market.

At August 31, 2004, our backlog of orders
for net sales was approximately $18,228, compared to
approximately $18,645 at August 31, 2003. We expect to ship
our backlog as of August 31, 2004, during our fiscal year
ending August 31, 2005 (Fiscal 2005). This
slight decline in backlog is mainly due to our customers not
issuing purchase orders out as far into the future as they had
in the past.

Competition:In each
of our product lines, we face significant competition, including
customers who may produce the same or similar products
themselves. We believe that our competitive advantage starts
with knowledge of the market requirements and our investment in
technology to meet those demands. We use proprietary technology
and proprietary processes to create unique solutions for our
customers product development and manufacturing
requirements. We believe that customers engage us because they
view us to be on the leading edge in designing and manufacturing
products that, in turn, help them to deliver better products
faster and cheaper than they could do by themselves. We also
compete on the basis of full service to obtain new and repeat
orders. We are a full-service supplier and partner with our
customers, providing full turn-key capability.

Research and
Development:The amount that we spent
on company-sponsored research and development activities
aggregated approximately $3,165, $2,580 and $2,516 for our
fiscal years ended August 31, 2004, 2003 and 2002,
respectively.

Employees:On
August 31, 2004, we employed 298 full-time persons and
1 part-time person.

Website and Available
Information:Our website is located at
www.heii.com. Information on this website does not
constitute part of this Annual Report on Form 10-K.

We make available, free of charge, our Annual
Reports on Form 10-K, our Quarterly Reports on
Form 10-Q, our Current Reports on Form 8-K and
amendments to such reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities and Exchange Act
of 1934 as soon as reasonably practicable after such forms are
filed with or furnished to the SEC. Copies of these documents
are available to our shareholders at our website or upon written
request to our Chief Financial Officer at P.O. Box 5000,
1495 Steiger Lake Lane, Victoria, Minnesota, 55386.






|        |            
|------- | -----------
|Item 2. | Properties.

We own a 48,000 square foot facility for
administration and microelectronics production in Victoria,
Minnesota, a suburb of Minneapolis, which was originally built
in August 1981. The facility was expanded during our fiscal year
ended August 31, 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 Industrial Development Revenue Bonds
(IDRBs) with the City of Victoria on the property
and certain equipment. On March 14, 2003, the outstanding
principal and interest on these IDRBs were paid from the
proceeds of the subordinated promissory note issued to CMED in
connection with the acquisition of our

6



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AMO. In October 2003, the Company completed a
$1,200 financing that is secured with a mortgage on the
Victoria, Minnesota facility.


We lease a 14,000 square foot facility in
Tempe, Arizona for our high density interconnect business. We
lease two properties in Minnesota: a 20,000 square foot
facility in Chanhassen, Minnesota, for part of our RFID
business, and a 3,100 square foot facility in Eden Prairie,
Minnesota, that was formerly used for corporate offices. In
April 2003, we re-located our corporate offices to our Victoria
facility and sub-leased the Eden Prairie facility through March
2005. The Tempe and Chanhassen facilities are leased until July
2005 and June 2012, respectively, and the Eden Prairie facility
is leased until March 2005.

We lease a 152,022 square foot facility in
Boulder, Colorado for our AMO. On September 27, 2004, this
facility was sold by Eastside Properties, LLC to Titan Real
Estate Investment Group, Inc. (Titan). On
October 1, 2004, we signed a new lease with Titans
affiliate, Boulder Investors LLC, at substantially reduced
rental rates. Beginning in Fiscal 2005, the Company expects to
save approximately $500 annually under this new lease due to a
reduction of approximately $1.08 per square foot in base
rent and approximately $2.21 per square foot in operating
costs. The Boulder facility is leased until September 2019.
Under the terms of the new lease, $1,350 of our deposit will be
refunded to us if after completing four consecutive quarters of
positive EBIDTA, as determined in accordance with GAAP and
verified by an independent third-party accountant, we deliver to
our landlord the greater of 100,000 shares of our common
stock or 0.11% of the then outstanding shares of our common
stock. As a part of the purchase accounting for the acquisition
of our AMO, we have established a $3,110 reserve related to the
future estimated lease payments of the Boulder facility.
Currently, we occupy approximately 100,000 square feet of
the facility and 50,000 is unimproved vacant space. In Fiscal
2003, we entered into an agency agreement with Julien J.
Studley, Inc., a national commercial real estate services firm.
Julien J. Studley has been engaged to assist us in reducing our
occupancy costs at this facility by representing us in
negotiations for the sub-leasing of the 50,000 square foot
addition, performing tenant representation with our landlord,
and assisting us in exploring other options related to our
future use of the Boulder facility. We are currently in
negotiations for such subleases.






|        |                   
|------- | ------------------
|Item 3. | Legal Proceedings.

On June 30, 2003, we commenced litigation
against Anthony J. Fant, our former Chairman of the Board, Chief
Executive Officer and President and a current director, in the
State of Minnesota, Hennepin County District Court, Fourth
Judicial District. The complaint alleged breach of contract,
conversion, breach of fiduciary duty, unjust enrichment and
corporate waste resulting from, among other things,
Mr. Fants default on his promissory note to us and
other loans and certain other matters. On August 12, 2003,
we obtained a judgment against Mr. Fant on our breach of
contract count in the amount of approximately $606. On
November 24, 2003, the Court granted us an additional
judgment against Mr. Fant in the amount of approximately
$993 on the basis of our conversion, breach of fiduciary duty,
unjust enrichment and corporate waste claims. On March 29,
2004, the Court granted us a third judgment against
Mr. Fant in the amount of approximately $656, for a total
aggregate judgment against Mr. Fant of approximately
$2,255. We are engaged in efforts to collect on the judgment and
plan to continue to collect on the judgment in due course. We
have obtained, through garnishments and other execution methods,
approximately $1,750 from Mr. Fants accounts. Such
amount partially reduces the judgment amount. We continue to
seek to collect on the remaining judgment amount in Minnesota
and other states where it is believed that Mr. Fant may
have non-exempt and unencumbered assets.

On August 23, 2004, we commenced litigation
against Colorado MEDtech, LLC (CMED LLC), its
successor, CMED and a related entity, CIVCO Holding, Inc. in the
United States District Court for the District of Colorado. The
complaint alleges breach of contract/warranty; several counts of
fraud including misrepresentation, omission, and fraudulent
transfer; civil conspiracy; and counts for alter ego and
successor liability. The litigation seeks to recover in excess
of $980 (plus attorneys fees in an amount yet to be determined)
for damages we sustained on the Becton Dickinson five milliliter
pipette contract, which was one of the assets we acquired from
CMED in the January 2003 transaction. On September 14,
2004, counsel for CMED LLC filed a disclosure statement and
answer to our complaint. The Court has issued an order for a
scheduling conference on February 19, 2005 in which the
trial date and other deadlines for the case will be set.

7



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

There were no matters submitted to a vote of
shareholders during the fourth quarter of Fiscal 2004.

Executive Officers of the Registrant

The following is a list of our executive
officers, their ages and officers as of December 27, 2004.
Each executive officer serves a term of one year or until his
successor is appointed and qualified.

|                     |  |     |    |          |  |                                      
|-------------------- |  | --- | -- | -------- |  | -------------------------------------
|Name                 |  | Age |    | Position
|                     |  |     |    |         
|Mack V. Traynor, III |  |     | 46 |          |  | Chief Executive Officer and President
|Douglas J. Nesbit    |  |     | 51 |          |  | Chief Financial Officer              
|Nina A. Anderson     |  |     | 41 |          |  | Vice President of Human Resources    
|James P. Barnes      |  |     | 38 |          |  | Chief Information Officer            
|Scott M. Stole       |  |     | 41 |          |  | Chief Technical Officer              
|Simon F. Hawksworth  |  |     | 39 |          |  | Vice President of Sales and Marketing
|James C. Vetricek    |  |     | 47 |          |  | Vice President of Operations         

Mack V. Traynor, IIIhas served as our Chief Executive
Officer and President since March 2003, and has served on our
Board of Directors since 1998. Mr. Traynor currently serves
as President of Manitou Investments, a private investment and
business management firm, a position he has held since 1998.
Although Mr. Traynor currently serves in such capacity with
Manitou Investments, he devotes substantially all of his efforts
to his duties and responsibilities at the Company. Since June
2003, Mr. Traynor has served on the Board of Directors of
ACT Telecommunications (NASDAQ: ACTT), an international
teleconferencing service provider. In December 2003, he was
elected Chairman of the Board of ACTT. Previously,
Mr. Traynor served as President and Chief Executive Officer
of Supreme Companies, Inc., a privately held landscape and
grounds maintenance company, from February 2002 to September
2003. Mr. Traynor also previously served as Chief Executive
Officer of Do The Good, Inc., a philanthropic software
development company, from May 2001 until October 2001, and as
Chief Financial Officer of 10K Partners, Inc., private
investment company, from April 2000 until June 2000.
Mr. Traynor served as President and Chief Executive Officer
of NeoNetworks, a privately-held development stage company
designing high-speed data communications equipment, from October
1998 to April 2000. Mr. Traynor was a director of Telident,
Inc., a publicly-held telecommunications products and services
company, from 1998 to 2000. Mr. Traynor also served as a
director of Eltrax Systems, Inc., a publicly-held networking
products and services company, from 1995 to 1999, serving as
Chief Financial Officer from 1995 to 1996 and President, Chief
Executive Officer and Chief Operating Officer from 1995 to 1997.
Mr. Traynor served as President and Chief Operating Officer
of Military Communications Center, Inc., a company that provided
telecommunications services to U.S. Military personnel,
from 1988 to 1995. He also served as President of U.S. West
Enterprises, a division of U.S. West, Inc.

Douglas J. Nesbithas served as our Chief Financial
Officer since June 2003. Prior to joining HEI, Mr. Nesbit
served as the Chief Financial Officer, Secretary and Treasurer
of LecTec Corporation, a publicly-held consumer health care
company, from 2000 to 2003, as the Corporate Treasurer at Secure
Computing Corporation, a provider of computing system security
tools and devices, from 1997 to 2000, and as Corporate
Controller of ValueRX, a pharmacy benefit management firm, from
1996 to 1997. Mr. Nesbits professional background
also includes public accounting experience with the big four
firm of KPMG LLP. Mr. Nesbit also serves as a Director and
Vice-Chair of the Minnesota Society of Certified Public
Accountants and a participant on the Business and Industry
Conference planning committee for the AICPA.

Scott M. Stole Ph.D.has served as our Chief Technology Officer since 2003.
Previously, from October 2000 to June 2003, Dr. Stole
served as our Director of Advanced Process Development. Prior to
joining HEI, Dr. Stole served as President & CEO
of Questek Innovations, Inc., a developer of advanced hardware
technologies for the disk drive industry, from May 1997 to
October 2000, where he oversaw technology development,
intellectual property protection, corporate strategy and
strategic alliances. Dr. Stole received his

8



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Ph.D. from Iowa State University and his
Bachelors degree from Concordia College, and has 14 years
of experience in the design, development and manufacture of a
wide range of microelectronics and advanced materials-related
products.


Simon F. Hawksworthhas served as our Vice President of
Sales and Marketing since September 2002. Prior to joining us,
he served as Vice President of Sales and Marketing at InnovaComm
Technologies, Inc, a microelectronics manufacturing company and
a spin-off of Maxtek, a wholly-owned subsidiary of Tektronix,
from February 2000 to August 2002. Mr. Hawksworth also
served, from August 1998 to August 2002, in a variety of
positions at Maxtek from Business Development Manager through
Director and Vice President of Sales and Marketing. Prior to
joining us, Mr. Hawksworths positions focused on
winning new business requiring high frequency electronics
packaging solutions.

James P. Barnesjoined us in July 2004 as our Chief
Information Officer. For 15 years prior to joining us,
Mr. Barnes served in various capacities overseeing the use
of information technology to advance the strategic goals of
companies in various industries. Most recently, from February
2003 to May 2004, Mr. Barnes served as an
Account Manager for Odyssey Solutions, a regional SAP
reseller, helping small and mid-sized businesses leverage the
SAP ERP application. From March 2000 to February 2003,
Mr. Barnes held the position of Supply Chain Project
Director for ADC Telecommunications, a global network supplier
of products and services, where he managed projects to improve
the global supply chain. From March 1999 to March 2000,
Mr. Barnes served as the Integration Director for West
Group, a division of Thomson Financial, developing and
implementing ERP solutions in the publishing industry.

James C. Vetricekjoined us in January 2003 in
connection with our acquisition of our AMO as Vice President of
our AMO and was promoted to Vice President of Operations for HEI
in January 2004. Prior to January 2003, Mr. Vetricek served
as Vice President, Quality and Regulatory Affairs of CMED from
February 2001 to January 2003. Mr. Vetricek has over
20 years of experience as a medical device professional
managing facilities with multi-site operations. His
responsibilities have included research and development,
regulatory affairs, pilot manufacturing, and proprietary and
contract manufacturing operations. Mr. Vetriceks
product experience includes sterile single use devices,
implants, bio absorbable surgical materials, electromechanical
surgical systems, anesthesia systems and cardiovascular
monitoring devices. Prior to joining CMED, Mr. Vetricek
served as Vice President of Regulatory Affairs &
Quality Management at Linvatec, a division of Conmed, a medical
equipment manufacturer, from February 1999 to February 2001.
Mr. Vetricek also serve from September 1994 to June 1998 as
Vice President of Regulatory Affairs & Quality
Assurance and R&D at Ohmeda Medical Device, a division of
BOC Group, an industrial producer of gases.

Nina A. Andersonjoined us in January 2003 in
connection with our acquisition of our AMO as Human Resources
Representative of our AMO and was promoted to Vice President of
Human Resources of HEI in July 2004. Ms. Anderson served as
a Payroll and Benefits Administrator and Employee Relations
Manager for CMED from February 1998 to January 2003. Before
joining CMED, Ms. Anderson was employed as a Training
Manager for Southland Corporation, a national convenience store
operator.



PART II






|        |                                                                                                                      
|------- | ---------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for Registrants Common Equity,
    Related Stockholder Matters and Issuer Purchases of Equity
    Securities.

Our common stock is currently traded on the
NASDAQ National Market under the symbol HEII. Below are the high
and low sales prices for each quarter of our fiscal years ending
August 31, 2004 and 2003, for our common stock, as reported
by the NASDAQ National Market.

|                  |  |      |      |     |  |   |      | 
|----------------- |  | ---- | ---- | --- |  | - | ---- | 
|Fiscal Year Ended |  |      |      |    
|August 31, 2004   |  | High |      | Low
|                  |  |      |      |    
|First Quarter     |  | $    | 4.65 |     |  | $ | 2.95 | 
|Second Quarter    |  |      | 3.97 |     |  |   | 2.70 | 
|Third Quarter     |  |      | 3.68 |     |  |   | 2.30 | 
|Fourth Quarter    |  |      | 2.78 |     |  |   | 1.20 | 

9



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|                  |  |      |      |     |  |   |      | 
|----------------- |  | ---- | ---- | --- |  | - | ---- | 
|Fiscal Year Ended |  |      |      |    
|August 31, 2003   |  | High |      | Low
|                  |  |      |      |    
|First Quarter     |  | $    | 5.55 |     |  | $ | 2.77 | 
|Second Quarter    |  |      | 3.20 |     |  |   | 1.70 | 
|Third Quarter     |  |      | 2.85 |     |  |   | 1.65 | 
|Fourth Quarter    |  |      | 4.68 |     |  |   | 2.60 | 

As of December 27, 2004, we had 366 holders
of record of our common stock. We have not paid any dividends on
our common stock since our initial public offering on
March 24, 1981. We expect that for the foreseeable future
we will follow a policy of retaining earnings in order to
finance our continued development. Payment of dividends is
within the discretion of our board of directors and will depend
upon, among other things, our earnings, capital requirements and
operating and financial condition. In addition, the terms of our
term loan agreements provides that we cannot, without our
lenders prior written consent, pay any dividend or make
any distribution of assets to our shareholders or affiliates.

No repurchases of our equity securities were made
during the fourth quarter of Fiscal 2004.






|        |                         
|------- | ------------------------
|Item 6. | Selected Financial Data.

Set forth below is selected financial data on a
historical basis for the Company and its consolidated
subsidiaries for the fiscal years August 31, 2004, 2003,
2002, 2001, and 2000. This information should be read in
conjunction with the consolidated financial statements and notes
to consolidated financial statements appearing in Part II,
Item 8 of this Annual Report on Form 10-K.

|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |        | 
|------------------------------------------- | --------------------------------------- | ---------------------------------------- | ------ | ------- |  | ------- | ------ | ------- |  | ------- | ------ | ------ |  | - | ------ | ------ |  | - | ------ | ------ | 
|                                            |                                         |                                         
|                                            |                                         | Fiscal Years Ended August 31,           
|                                            |                                         |                                         
|                                            |                                         | 2004(a)                                  |        | 2003(b) |  | 2002(c) |        | 2001(d) |  | 2000(e)
|                                            |                                         |                                          |        |         |  |         |        |         |  |        
|                                            |                                         |                                         
|                                            |                                         | (In thousands, except per share amounts)
|Net sales                                   |                                         | $                                        | 43,320 |         |  | $       | 38,440 |         |  | $       | 28,532 |        |  | $ | 44,832 |        |  | $ | 42,799 |       
|Cost of sales                               |                                         |                                          | 39,197 |         |  |         | 31,327 |         |  |         | 23,375 |        |  |   | 36,841 |        |  |   | 35,544 |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Gross profit                                |                                         |                                          | 4,123  |         |  |         | 7,113  |         |  |         | 5,157  |        |  |   | 7,991  |        |  |   | 7,255  |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Operating expenses:                         |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Selling, general and administrative     |                                          |        | 8,113   |  |         |        | 7,639   |  |         |        | 5,335  |  |   |        | 5,806  |  |   |        | 6,338  | 
|                                            | Research, development and engineering   |                                          |        | 3,165   |  |         |        | 2,580   |  |         |        | 2,516  |  |   |        | 2,433  |  |   |        | 1,764  | 
|                                            | Unusual charges                         |                                          |        | 1,359   |  |         |        | 331     |  |         |        |       |  |   |        | 1,693  |  |   |        | 453    | 
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Operating loss                              |                                         |                                          | (8,514 | )       |  |         | (3,437 | )       |  |         | (2,694 | )      |  |   | (1,941 | )      |  |   | (1,300 | )     
|Other income (expense), net                 |                                         |                                          | 1,505  |         |  |         | (1,213 | )       |  |         | (106   | )      |  |   | (2,182 | )      |  |   | (227   | )     
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Loss before income taxes                    |                                         |                                          | (7,009 | )       |  |         | (4,650 | )       |  |         | (2,800 | )      |  |   | (4,123 | )      |  |   | (1,527 | )     
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Income tax expense (benefit)                |                                         |                                          |       |         |  |         | (21    | )       |  |         | 1,092  |        |  |   | (930   | )      |  |   | (372   | )     
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Net loss                                    |                                         | $                                        | (7,009 | )       |  | $       | (4,629 | )       |  | $       | (3,892 | )      |  | $ | (3,193 | )      |  | $ | (1,155 | )     
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Net loss per basic share                    |                                         | $                                        | (0.90  | )       |  | $       | (0.70  | )       |  | $       | (0.65  | )      |  | $ | (0.65  | )      |  | $ | (0.24  | )     
|Net loss per diluted share                  |                                         | $                                        | (0.90  | )       |  | $       | (0.70  | )       |  | $       | (0.65  | )      |  | $ | (0.65  | )      |  | $ | (0.24  | )     
|Weighted average common shares outstanding: |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Basic                                   |                                          |        | 7,745   |  |         |        | 6,629   |  |         |        | 5,992  |  |   |        | 4,881  |  |   |        | 4,726  | 
|                                            | Diluted                                 |                                          |        | 7,745   |  |         |        | 6,629   |  |         |        | 5,992  |  |   |        | 4,881  |  |   |        | 4,726  | 
|Balance sheet as of year end:               |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Working capital                         |                                          | $      | 3,414   |  |         | $      | 5,728   |  |         | $      | 4,369  |  |   | $      | 8,793  |  |   | $      | 5,902  | 
|                                            | Total assets                            |                                          |        | 25,112  |  |         |        | 26,503  |  |         |        | 22,989 |  |   |        | 27,528 |  |   |        | 28,936 | 
|                                            | Long-term debt, less current maturities |                                          |        | 1,833   |  |         |        | 2,555   |  |         |        | 1,473  |  |   |        | 3,972  |  |   |        | 3,894  | 
|                                            | Shareholders equity                    |                                          |        | 9,957   |  |         |        | 13,191  |  |         |        | 14,570 |  |   |        | 18,420 |  |   |        | 15,116 | 
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       



---



|    |  |                                                                                                                                                                                                                           
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | For Fiscal 2004 unusual charges consisted of $894
    in outside legal and accounting costs in connection with our
    litigation against, and other issues involving, Mr. Fant
    and $465 of an asset impairment in our

10



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##### Table of Contents



|    |  |                                                                                                                                                                                                                                                                                                                                                                          
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |  | Microelectronics Operations. Other income
    included $1,361 of judgment recovery against Mr. Fant and a
    $472 gain recognized in connection with the prepayment of a
    Subordinated Promissory Note.                                                                                                                                                              
|   
|(b) |  | For Fiscal 2003 unusual charges consisted of an
    impaired asset write-down of $331. Other expense included costs
    related to the non-cash write off of bank fees of $181 related
    to the terminated revolving line of credit with LaSalle Business
    Credit, LLC and a reserve of $841 for Mr. Fants
    promissory note and other amounts due from Mr. Fant.
|   
|(c) |  | Income tax expense reflects the establishment of
    a $3,420 valuation allowance of which $3,188 was included in
    income tax expense.                                                                                                                                                                                                                                
|   
|(d) |  | For Fiscal 2001 unusual charges consisted of
    costs related to the closure of the Mexico product line of $425
    and a $1,268 loss on the write-off of accounts receivable
    primarily related to customers of the Mexico product line and
    other expense included the write-off of the investment in MSC.                                                      
|   
|(e) |  | For Fiscal 2000 unusual charges of $453 consisted
    of acquisition transaction costs related to the Cross
    acquisition.                                                                                                                                                                                                                                             






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

OVERVIEW

HEI has been in a turnaround mode since mid year
of Fiscal 2003 when new management was brought in. The
turnaround plan began with the financial restructuring of our
outstanding indebtedness. Next, management focus was placed upon
the sales process, with a target of more programs for existing
customers and new programs with new customers. Fiscal 2004 began
with a backlog of approximately $13,000 for the first quarter.
The number of customers in excess of $1,000 in Fiscal 2004 grew
to 15 from 9 in Fiscal 2003. The success in bringing in these
new customers and new programs exposed production problems from
the years of operational neglect under former management. During
Fiscal 2004 we consistently under delivered against orders we
had from our customers. We made a strategic decision to
sacrifice profits in order to keep the customers as satisfied as
possible, while improvements were made to our operations. We
lost no customers during Fiscal 2004, despite our production
problems. The distractions to management following the removal
of the former CEO continued to impact us in Fiscal 2004. In
addition to the civil proceedings against the former CEO, we
hired a forensic auditor to review our financial records for the
time period covering the former management teams tenure. The
result of that forensic audit was no financial restatement of
any prior period financial report.

Fiscal 2004 started off slow with the Company
facing production challenges that continued throughout the
fiscal year. At the same time, we initiated a number of new
programs which also negatively impacted our operating results.
The result has been unsatisfied orders and unfulfilled backlog.
These operational issues have persisted throughout Fiscal 2004.
In order to successfully implement numerous programs at the same
time at our Microelectronics Operations we will have to approach
our business in a different manner with new processes. The
inability to effectively initiate these programs could impair
our revenue opportunity and significantly impact our liquidity.
The resolution of these production issues could take longer than
anticipated which would impact our relationships with our
customers, cause continuing operating losses and negatively
impact the strength of our balance sheet. As of
December 31, 2004, we have not lost any customers due to
the problems we encountered in Fiscal 2004. Net sales in the
first quarter began Fiscal 2004 with the lowest net sales we had
experienced in three quarters at $10,916. That was an 11% drop
in net sales from the fourth quarter of Fiscal 2003. The reduced
net sales in Fiscal 2004 have been accompanied by reduced
margins resulting in a 10% gross profit, the lowest achieved in
the last five years. The Company took a number of steps to
address these operational issues, including replacing our Vice
President of Operations in the second quarter of Fiscal 2004,
and implementing a number of initiatives to resolve the
production problems that were impacting the Companys
ability to ship product on a timely basis. We will continue to
manage our costs and have a goal to lower the quarterly
breakeven point by the end of Fiscal 2005. Our commitment to
research and development continued in Fiscal 2004 and we have
and will continue this effort to maintain and increase our
propriety technology and manufacturing processes. With
production being our biggest issue in Fiscal 2004, we

11



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##### Table of Contents



have begun and intend to continue to deploy our
manufacturing operational efforts with renewed focus and talent.
We are beginning to experience positive results from this
effort. Management intends to continue to concentrate on such
efforts during Fiscal 2005, which is expected to not only
increase margins, but to increase throughput and quality.


CRITICAL ACCOUNTING POLICIES

The accompanying consolidated financial
statements are based on the selection and application of United
States accounting principles generally accepted
(GAAP), which require estimates and assumptions
about future events that may affect the amounts reported in
these financial statements and the accompanying notes. Future
events and their effects cannot be determined with absolute
certainty. Therefore, the determination of estimates requires
the exercise of judgment. Actual results could differ from those
estimates, and any such differences may be material to the
financial statements. We believe that the following accounting
policies may involve a higher degree of judgment and complexity
in their application and represent the critical accounting
policies used in the preparation of our financial statements. If
different assumptions or conditions were to prevail, the results
could be materially different from reported results.

Revenue Recognition, Sales Returns and
Warranty

Revenue for manufacturing and assembly contracts
is recognized upon shipment when the risk and rewards of
ownership have passed to the customer without special acceptance
protocols or payment contingencies. We have a number of customer
arrangements in which we retain ownership of inventory until
customer receipt or customer acceptance, and in one instance
until the customer pulls inventory into production at its
offshore facility. Revenue is deferred for these arrangements
until the risks and rewards of ownership pass to the customer
upon receipt or acceptance. Our AMO provides service contracts
for some of its products. Billings for services contracts are
based on published renewal rates and revenue is recognized on a
straight-line basis over the service period.

Our AMOs development contracts are discrete
time and materials projects that generally do not involve
separate deliverables. Development contract revenue is
recognized ratably as development activities occur based on
contractual per hour and material reimbursement rates.
Development contracts are an interactive process with customers
as different design and functionality is contemplated during the
design phase. Upon reaching the contractual billing maximums, we
defer revenue until contract extensions or purchase orders are
received from customers. We occasionally have contractual
arrangements in which part or all of the payment or billing is
contingent upon achieving milestones or customer acceptance. For
those contracts we evaluate whether the contract should be
accounted using the completed contract method, as the term of
the arrangement is short-term, or using the percentage of
completion method for longer-term contracts. We have not entered
into any significant fixed fee development arrangements or
contracts using the percentage of completion method since we
acquired our AMO. As of August 31, 2004, we had deferred
revenue of $804.

We may establish one or more contractual
relationships with one customer that involves multiple
deliverables including development, manufacturing and service.
Each of these deliverables may be considered a separate unit of
accounting and we evaluate if each element has sufficient
evidence of fair value to allow separate revenue recognition. If
we cannot separately account for the multiple elements in an
arrangement, we may be required to account for the arrangement
as one unit of accounting with recognition over an extended
period of time or upon delivery of all of the contractual
elements. For the year ended August 31, 2004, we did not
have any significant multi-element contracts and deferred
revenue at August 31, 2004 for these arrangements was not
significant.

We record provisions against net sales for
estimated product returns. These estimates are based on factors
that include, but are not limited to, historical sales returns,
analyses of credit memo activities, current economic trends and
changes in the demands of our customers. Provisions are also
recorded for warranty claims that are based on historical trends
and known warranty claims. Should actual product returns exceed
estimated allowances, additional reductions to our net sales
would result. As of August 31, 2004 and 2003, warranty and
product return reserves aggregated $139 and $122, respectively.

12



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Allowance for Uncollectible Accounts

We estimate the collectability of trade
receivables and note receivables, which requires considerable
amount of judgment in assessing the realization of these
receivables, including the current credit-worthiness of each
customer and related aging of the past due balances. In order to
assess the collectability of these receivables, we perform
ongoing credit evaluations of our customers financial
condition. Through these evaluations, we may become aware of a
situation where a customer may not be able to meet its financial
obligations due to a deterioration of its financial viability,
credit ratings or bankruptcy. The reserve requirements are based
on the best facts available to us and reevaluated and adjusted
as additional information is received. We are not able to
predict changes in the financial condition of our customers and,
if circumstances related to our customers deteriorate, our
estimates of the recoverability of our receivables could be
materially affected and we may be required to record additional
allowances for uncollectible accounts. Alternatively, if we
provide more allowances than we need, we may reverse a portion
of such provisions in future periods based on changes in
estimates from our actual collection experience. As of
August 31, 2004 and 2003, we had accounts receivable
allowances of $121 and $92, respectively.

Inventories

We record inventories at the lower of cost, using
the standard and average cost method or market value. Generally,
all inventory purchases are for customized parts for customer
specific programs. Contractual arrangements are typically agreed
to with the customer prior to ordering customized parts as often
times the parts cannot be consumed in other programs. Even
though contractual arrangements may be in place, we are still
required to assess the utilization of inventory. In assessing
the ultimate realization of inventories, judgments as to future
demand requirements are made and compared to the current or
committed inventory levels and contractual inventory holding
requirements. Reserve requirements generally increase as
projected demand requirements decrease due to market conditions,
technological and product life cycle changes as well as longer
than previously expected usage periods. It is possible that
significant charges to record inventory at the lower of cost or
market may occur in the future if there is a further decline in
market conditions. As of August 31, 2004 and 2003, we have
reduced the carrying value to the lower of cost or market for
excess and obsolete inventory by $1,056 and $1,511, respectively.

Long-lived Assets

We evaluate whether events and circumstances have
occurred that indicate the remaining estimated useful life of
long-lived assets may warrant revision, or that the remaining
balance of these assets may not be recoverable. We evaluate the
recoverability of our long-lived assets in accordance with
Statement of Financial Accounting Standards No. 144
Accounting for the Impairment or Disposal of Long-Lived
Assets. When deemed necessary, we complete this evaluation
by comparing the carrying amount of the assets against the
estimated undiscounted future cash flows associated with them.
If such evaluations indicate that the future undiscounted cash
flows of long-lived assets are not sufficient to recover the
carrying value of such assets, the assets are adjusted to their
estimated fair values. The Company assesses the impairment of
its manufacturing equipment at least annually, or whenever
events or changes in circumstances indicate that the carrying
value may not be recoverable. Factors considered important which
could trigger an impairment review, and potentially an
impairment charge, include the following:



| |   |                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Significant underperformance relative to
    historical or projected future operating results;                                                              
|
| |  | Significant changes in the manner of use of the
    acquired assets or the Companys overall business strategy;                                             
|
| |  | Significant negative market or economic
    trends; and                                                                                                     
|
| |  | Significant decline in the Companys stock
    price for a sustained period changing the Companys market
    capitalization relative to its net book value.

Based on the Companys evaluation the
historical losses for the assets in the Microelectronics group
created a trigger for further analysis. Our long-lived assets
relating to our Microelectronics Operations were

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valued by an independent third-party in order to
further evaluate the recoverability of our long-lived assets in
accordance with Statement of Financial Accounting Standards
No. 144 Accounting for Impairment or Disposal of
Long-Lived Assets. The independent valuation firms
appraisal resulted in an impairment charge of $465 in Fiscal
2004. During Fiscal 2003, we recorded asset impairment charges
of $331. Asset impairment evaluations are by nature highly
subjective.


Valuation of Deferred Taxes

Significant management judgment is required in
determining the provision for income taxes, deferred tax assets
and liabilities and any valuation allowance recorded against net
deferred tax assets. We record a current provision for income
taxes based on amounts payable or refundable. Deferred tax
assets and liabilities are recognized for the future tax
consequences of differences between the financial statement
carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit
carryforwards. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in
the years in which those temporary differences are expected to
be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in the period
that includes the enactment date. The overall change in deferred
tax assets and liabilities for the period measures the deferred
tax expense or benefit for the period. We recognize a valuation
allowance for deferred tax assets when it is more likely than
not that deferred assets are not recoverable.

At August 31, 2004 and 2003, we had
valuation allowances of approximately $7,642 and $5,405,
respectively, because of uncertainties related to the ability to
utilize certain Federal and state net loss carryforwards due to
the Companys historical losses and net tax operating loss
carryforward position. The valuation allowance is based on
estimates of taxable income by jurisdiction and the period over
which our deferred tax assets are recoverable.

Purchase Accounting

The accompanying statements reflect the
allocation of the purchase price of our AMO  see
Note 6 to our Consolidated Financial Statements. This
allocation included an accrual of $730 related to an unfavorable
operating lease, $2,380 for future estimated lease payments and
a $760 accrual to fulfill estimated contractual manufacturing
obligations. The $2,380 accrued for estimated lease payments
consists of $5,910 for future lease obligations less estimated
sublease payments of $3,530 on 50,000 square feet of
unoccupied space. In Fiscal 2003, we entered into an agency
agreement with Julien J. Studley, Inc., a national commercial
real estate services firm, to assist us in reducing our
occupancy costs at this facility by representing us in
negotiations for the sub-leasing of the 50,000 square foot
addition, performing tenant representation with our landlord,
and assisting us in exploring other options related to our
future use of the Boulder facility. We are currently in
negotiations for the subleasing of the additional
50,000 square feet. In our opinion, all adjustments
necessary to present fairly such financial statements have been
made based on the terms and structure of the acquisition of our
AMO. At August 31, 2004 and 2003, our AMO lease accruals
aggregated $2,082 and $2,793, respectively.

During the second quarter of Fiscal 2004, we
finalized our purchase price allocation for our January 2003
transaction with CMED. Since our Annual Report on Form 10-K
for Fiscal 2003, we adjusted our developed technologies by $323
related to technology sold to MKS Instruments and we adjusted
other reserves by $160 related to legal costs. The net of these
adjustments resulted in a reduction of property and equipment of
$163.

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RESULTS OF OPERATIONS

Percentage of Net Sales

|                                      |  |                   |    |      |  |      |    |   |  |  |    |  
|------------------------------------- |  | ----------------- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                                      |  |                  
|                                      |  | Fiscal Year Ended
|                                      |  | August 31,       
|                                      |  |                  
|                                      |  | 2004              |    | 2003 |  | 2002
|                                      |  |                   |    |      |  |     
|Gross profit                          |  |                   | 10 | %    |  |      | 19 | % |  |  | 18 | %
|Selling, general and administrative   |  |                   | 19 | %    |  |      | 20 | % |  |  | 19 | %
|Research, development and engineering |  |                   | 7  | %    |  |      | 7  | % |  |  | 9  | %
|Other                                 |  |                   | 2  | %    |  |      | 4  | % |  |  | 0  | %

The following table illustrates the approximate
percentage of our net sales by market served.

|                 |  |                   |    |      |  |      |    |   |  |  |    |  
|---------------- |  | ----------------- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                 |  |                  
|                 |  | Fiscal Year Ended
|                 |  | August 31,       
|                 |  |                  
|Market           |  | 2004              |    | 2003 |  | 2002
|                 |  |                   |    |      |  |     
|Medical/ Hearing |  |                   | 84 | %    |  |      | 82 | % |  |  | 76 | %
|Communications   |  |                   | 6  | %    |  |      | 6  | % |  |  | 11 | %
|RFID             |  |                   | 8  | %    |  |      | 8  | % |  |  | 10 | %
|Other            |  |                   | 2  | %    |  |      | 4  | % |  |  | 3  | %

Net Sales

Our net sales for Fiscal 2004, increased $4,880
or 13%, compared to Fiscal 2003. Our AMOs net sales
increased $6,143 in Fiscal 2004 to $20,572 compared to $14,429
in Fiscal 2003. The increase in our AMO net sales was largely
due to the inclusion of twelve months of net sales from our AMO
in Fiscal 2004 compared to only seven months of net sales from
our AMO being included in Fiscal 2003. The increase in our AMO
net sales was partially offset by declines in net sales
generated by the Microelectronics Operations caused by the
inability to ship against outstanding orders. Our net sales for
Fiscal 2003, increased $9,908 or 35%, compared to Fiscal 2002.
This increase in net sales from Fiscal 2002 was the result of
$14,429 in net sales generated by our AMO, which we acquired in
January 2003. The increase in net sales associated with the
addition of our AMO was partially offset by a decrease in net
sales of approximately $6,300 to two of our major
medical/hearing customers.

The communications and RFID markets remained soft
in Fiscal 2004 and Fiscal 2003 as our customers continue to wait
for market acceptance of new products and increased demand for
existing products. If the demand for these products increases,
we believe that we are positioned for an increase in sales in
these markets. In addition, we are experiencing continued
interest in our proprietary products which have received design
approval for numerous applications with increasing low volume
production. We continue to work on new designs, qualification
testing and continue to receive prototype orders from numerous
customers.

Net sales to medical/hearing customers represents
84% of total net sales for Fiscal 2004 and increased from
$31,691 to $36,347, or by $4,656, or 15% compared to Fiscal
2003. The increase is primarily a result of the acquisition of
our AMO in January 2003 and the inclusion of twelve months of
net sales from our AMO, which in Fiscal 2004 contributed $20,572
for the year in medical sales. In addition, we realized
increased demand for implantable medical devices like cochlear
implants, insulin pumps and defibrillators for our
Microelectronics Operations. The increase associated with our
AMO acquisition and growth of medical implantable business was
partially offset as we continued to experience fluctuations in
demand for our hearing products. The decreases in our hearing
products are mainly due to in-sourcing trends at significant
hearing customers like Siemens and GN Resound and a trend to
moving production to China. During the first quarter of Fiscal
2004, we ended our relationship with Sonic Innovations, but
entered into new programs with GN Resound and Cochlear that were
expected to offset this loss. However, ramp up difficulties with
GN Resound accounted for the decreased level of net sales from
our hearing products.

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Net sales to medical/hearing customers represents
82% of total net sales for Fiscal 2003 and increased from
$21,558 to $31,691, or by $10,133 or 47% compared to Fiscal
2002. The increase is primarily a result of the addition of our
Advanced Medical Operations, which were acquired in January 2003
and contributed $14,429 for the year in medical net sales. The
increase associated with our AMO addition was partially offset
as we continued to experience fluctuations in demand for our
hearing products. The decreases in our hearing products were
mainly due to excess inventory positions at significant hearing
customers and reflected the general economic slowdown, which
continued to negatively impact the hearing related contract
manufacturing markets. During the latter part of Fiscal 2002, a
major customers internal manufacturing capabilities
increased, which reduced annual revenues for Fiscal 2003 by
approximately $3,800. Also a significant customer advised us in
June 2003 that it intended to discontinue a significant program
with us in order to place it offshore. This program was
discontinued in the first quarter of Fiscal 2004 and had net
sales of $883, $6,709, and $9,273 in Fiscal 2004, Fiscal 2003,
and Fiscal 2002, respectively. This program discontinuance will
reduce but not eliminate sales to this customer. During the
first quarter of Fiscal 2002, we entered into a program with
Siemens in which our finished goods inventory is held at Siemens
and we recognize revenue when they use the product. In
connection with this program, certain raw materials used by us
for Siemens products are being consigned to us by Siemens. The
result of this program is that our finished goods inventory has
increased, while raw materials for these programs have decreased.

Net sales to the communications and industrial
products market decreased from $3,864 in Fiscal 2003 to $3,597
in Fiscal 2004, or $267 or 7%. The Fiscal 2004 decrease as
compared to Fiscal 2003 is a result of the continued weakness in
the telecommunications markets. In September 2003, we realigned
our sales emphasis to narrowly focus our efforts to key niche
customers to obtain the best margin revenue while improving the
efficiencies in developing new business. Net sales decreased in
Fiscal 2003 from $4,004 in Fiscal 2002 to $3,864 in Fiscal 2003,
or by $140 or 4%. This decrease comparing Fiscal 2003 to Fiscal
2002 is largely a result of weakness in the telecommunications
markets.

Net sales to the RFID products market increased
from $2,885 in Fiscal 2003 to $3,375 in Fiscal 2004, or by $490
or 17%. This increase was driven by an increase in orders from a
major customer and a significant new customer that has a
position in a related market. RFID sales decreased in Fiscal
2003 from $2,970 in Fiscal 2002 to $2,885 in Fiscal 2003, or by
$85 or 3%, primarily due to the drop in orders from one major
customer that had eliminated its operations in this space.

At August 31, 2004, our backlog of orders
for revenue in Fiscal 2005 was approximately $18,228, compared
to approximately $18,645 and $5,400 at August 31, 2003 and
2002, respectively. We expect to ship our backlog as of
August 31, 2004 during Fiscal 2005. This small decrease in
backlog is reflective of a change in the way our customers do
business in that they are more unwilling to make commitments too
far into the future. The backlog from our AMO includes customer
commitments that have longer terms, as compared to our
historical customer commitments. Our backlog is not necessarily
a firm commitment from our customers and can change, in some
cases materially, beyond our control.

Because our sales are generally tied to the
customers projected sales and production of the related
product, our sales levels are subject to fluctuations beyond our
control. To the extent that sales to any one customer represent
a significant portion of our sales, any change in the sales
levels to that customer can have a significant impact on our
total sales. In addition, production for one customer may
conclude while production for a new customer has not yet begun
or is not yet at full volume. These factors may result in
significant fluctuations in sales from quarter to quarter.

Gross Profit

Our gross profit as a percentage of net sales was
9.5% in Fiscal 2004, as compared to 18.5% in Fiscal 2003 and
18.1% in Fiscal 2002. The Microelectronics Operations
experienced production difficulties that resulted in shipment
delays, excessive overtime costs and unabsorbed manufacturing
overhead. The production delays were due to the number of new
programs initiated at the same time and the increased
complexities of many of the new product offerings. Our gross
margin percent of net sales decreased significantly in Fiscal
2004 due to overall material cost overages due to scrap
resulting in a decline of 0.1% of net sales added to by
increases in

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direct labor of 6.1% and manufacturing costs
increases of 2.7%. Gross margins improved to 13.0% in the fourth
quarter of Fiscal 2004 and we expect gross margins to continue
to improve as we continue to implement process improvement
strategies meant to deal with the problems encountered in the
past.


Our gross profit as a percentage of net sales was
18.5% in Fiscal 2003, as compared to 18.1% in Fiscal 2002. Our
gross margin percent of net sales increased slightly in Fiscal
2003 due to overall material costs improvement resulting in an
improvement of 2.6% of net sales offset by increases in direct
labor of 1.1% and manufacturing costs of 1.1%.

Operating Expenses



| |                                        
| | ---------------------------------------
| | Selling, General and
    Administrative

Selling, general and administrative expenses in
total were 19% of net sales in Fiscal 2004, compared to 20% and
19% in both Fiscal 2003 and Fiscal 2002, respectively. Our AMO
accounted for $2,705 of this total in Fiscal 2004 versus $1,301
of this total in Fiscal 2003. Selling, general and
administrative expenses in Fiscal 2004 increased $448 when
compared to Fiscal 2003. The additional cost is mainly due to
$432 from increases in sales related expenses to expand the
sales effort and additional legal and professional fees of $130
due to efforts to consummate a new lease of our Boulder facility
and to pursue litigation against CMED LLC, its successor, CMED
and a related entity, CIVCO Holding, Inc. (see
Item 3  Legal Proceeding). During Fiscal 2003,
selling, general and administrative expenses increased by $2,304
when compared to Fiscal 2002, due mainly to the acquisition of
our AMO in January 2003, which contributed $2,206 in expenses
for the year. In addition, excluding the depreciation related to
AMO fixed assets, depreciation costs decreased in Fiscal 2003 as
some of our assets, mainly computer software and equipment, were
fully depreciated during the year. These reductions were
mitigated by increases in advertising, travel and other
operational costs.



| |                                                    
| | ---------------------------------------------------
| | Research, Development, and Engineering
    Expenses

Research, development, and engineering expenses
increased $585 in Fiscal 2004, when compared to Fiscal 2003 was
due to development work that was performed to advance the
Link-It technology. Comparing Fiscal 2003 to Fiscal 2002, costs
increased in Fiscal 2003 by $64 or 3%, compared to Fiscal 2002.
In Fiscal 2003 and Fiscal 2002, the increases in research,
development and engineering expenses resulted from our
commitment to maintain our design capabilities to support future
programs and continue the development and enhancement of our
proprietary products and manufacturing processes. We expect
future expenses to decline in this area because of our efforts
to bill out more of our engineering efforts to the beneficiaries
of this work.



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

The unusual charges of $1,359 in Fiscal 2004
relate to $894 in legal and professional fees for the special
investigation of the activities of Mr. Fant, our former
Chief Executive Officer, President and Chairman and $465 in
equipment asset impairments in our Microelectronics Operations.
Our evaluation of the historical losses from our
Microelectronics group created a trigger for further impairment
analysis. Our long-lived assets relating to our Microelectronics
Operations were valued by an independent third-party valuation
firm and resulted in an impairment charge of $465. The unusual
charges of $331 in Fiscal 2003 relate to the impairment of
equipment. The asset impairment in Fiscal 2003 was triggered by
the development of alternative testing that was more efficient
than what could be performed by our existing equipment and
notification in the same quarter that a large portion of a
significant customer program would be moved offshore in the
first quarter of Fiscal 2004.

Other Income (Expense), Net

Other income of $1,505 in Fiscal 2004 improved
$2,718 from Fiscal 2003, which reflects an improvement of $1,611
when compared to Fiscal 2002. The Fiscal 2004 increase is due
primarily to income related to the cash collected against the
outstanding judgment against Mr. Fant of $1,361 and a $472
non-cash gain associated with the prepayment of a promissory
note. Other expenses of $1,213 in Fiscal 2003 increased $1,107
from Fiscal 2002. The increase in Fiscal 2003 was due primarily
to costs related to the non-cash write

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off of deferred financing bank fees of $181
related to the terminated revolving line of credit with LaSalle
Business Credit, LLC, and establishment of a reserve of $841 for
Mr. Fants promissory note and other amounts that were
determined to be uncollectible. Net interest expense for Fiscal
2004 increased by $36 from Fiscal 2003 and $19 from Fiscal 2002
as a result of the higher loan balances carried. The effect of
the increase in average interest rate for Fiscal 2004 was
somewhat offset by the lower average debt of approximately
$3,164, and lower average cash balances of approximately $320.
The increase in interest expense in Fiscal 2003 was a result of
higher average interest and as a result of the higher average
debt in Fiscal 2003 of approximately $3603, and lower average
cash balances of approximately $389. The approximate average
annual interest rate was 11.5%, 9.1%, and 5.7% for Fiscal 2004,
Fiscal 2003 and Fiscal 2002, respectively.


Income Tax Expense (Benefit)

Management performs an analysis of the
realization of the deferred tax asset each fiscal quarter.
During Fiscal 2004 we did not recognize income tax benefit or
expense compared to an income tax benefit of $21, in Fiscal
2003. During Fiscal 2004, we did not recognize a tax benefit for
any of the Companys losses. Comparing Fiscal 2003 to
Fiscal 2002, we recognized a tax benefit of $21 during Fiscal
2003 compared to a tax expense of $1,092 in Fiscal 2002. During
Fiscal 2002, we determined that a valuation allowance of $3,420
should be established for all of our deferred tax assets due to
the softness in our markets, the results of operations for the
fourth quarter, uncertainties about visibility to customer order
rates and a general economic decline. An aggregate of $233 of
tax valuation allowance was reflected as an adjustment to
additional paid-in capital as it represents the tax asset
benefit from stock option exercises that are included in our net
operating loss carry forwards. The Fiscal 2002 deferred tax
expense was partly offset by a federal income tax benefit of
$459.

At the end of Fiscal 2004, we had net operating
loss carryforwards expiring at various dates ranging from 2012
through 2024.

FINANCIAL CONDITION

Our net cash flow used in operating activities
for Fiscal 2004 was $3,937 compared to cash flow provided by
operating activities of $322 and $1,077 for Fiscal 2003 and
Fiscal 2002, respectively. For Fiscal 2004, cash flow from
operating activities was used as a result of increases of $1,712
in accounts payable and $137 in accrued liabilities, more than
offset by increases in accounts receivable of $485, restricted
cash of $481, other assets of $836, and a $2,380 increase in the
net loss from $4,629 in Fiscal 2003 to $7,009 in Fiscal 2004.
Non-cash items for Fiscal 2004 consist of depreciation and
amortization expense of $2,862, the gain on the prepayment of a
promissory note of $472 and a $465 impairment of assets in our
Microelectronics Operations. The decreases in non-cash expenses
were primarily the result of decreased depreciation from the
fully depreciated fixed assets. The Fiscal 2004 increase in
accounts receivable relates to the large amount of sales of
$11,278 for the fourth quarter, while accounts payable balances
have been allowed to grow in response to the growth of accounts
receivable. The increase in accrued liabilities and other assets
is due to the large deferred revenue balance and related costs
associated with that revenue. Net cash provided by operating
activities totaled $322 and $1,077, respectively, in Fiscal 2003
and Fiscal 2002. This decrease was a result of higher revenue in
Fiscal 2002, which caused higher accounts receivable and
inventory balances when compared to Fiscal 2003 due to the
acquisition of AMO.

Our net cash flow used in investing activities
was $479, $634 and $2,423 for Fiscal 2004, Fiscal 2003 and
Fiscal 2002, respectively. We spent $827 on capital expenditures
and patent costs in Fiscal 2004 compared to $580 in Fiscal 2003.
During Fiscal 2002 we spent $2,423 on capital expenditures. We
generated $323 in Fiscal 2004 from the sale of technology. The
capital expenditures in all three years relate to facility
improvements and purchases of manufacturing equipment to enhance
our production capabilities and quality control systems.

Our net cash flow generated from financing
activities in Fiscal 2004 was $3,810. Our net cash flow used in
financing activities in Fiscal 2003 and Fiscal 2002 was $1,254
and $675, respectively. Cash generated from issuance of common
stock was $3,374, $53 and $275, respectively, for Fiscal 2004,
Fiscal 2003 and Fiscal 2002. During Fiscal 2004, $170 of cash
was generated in connection with the collection of officer
notes. During

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Fiscal 2003, in connection with the purchase of
our AMO, we issued a subordinated promissory note to CMED in the
principal amount of $2,600. The $1,000 decrease in restricted
cash for Fiscal 2003 was used to prepay long-term debt as a
result of the December 13, 2002, loan modification. Other
issuances of common stock during Fiscal 2004, Fiscal 2003 and
Fiscal 2002 were from the exercise of stock options. The
majority of other year-to-year changes relate to the borrowings
and repayment under our accounts receivable and term loan
agreements.


The result of these activities was a decrease in
cash by $606, $1,566 and $2,021 during Fiscal 2004, Fiscal 2003,
and Fiscal 2002, respectively. At the end of Fiscal 2004 our
unrestricted cash balance was $200.

Accounts receivable average days outstanding were
55 days at August 31, 2004, compared to 46 and
53 days at August 31, 2003 and 2002, respectively.
Inventory turns were 5.6, 5.7 and 5.0 for Fiscal 2004, Fiscal
2003 and Fiscal 2002, respectively. The increased days
outstanding are mainly due to a large proportion of the revenues
that were generated in the last month of the year and the
continued diversification of the customer base. The inventory
turns for Fiscal 2004 and Fiscal 2003 were essentially flat. The
decreased days outstanding and improved inventory turns in
Fiscal 2003 were primarily due to two large customers that pay
in less than 7 days as a part of their terms and the
increase in revenue with associated cost of sales in the last
quarter of Fiscal 2003 as compared to Fiscal 2002.

The Companys current ratio at the end of
Fiscal 2004 was 1.3:1 as compared to 1.7:1 and 1.6:1 at the end
of Fiscal 2003 and Fiscal 2002, respectively. The decrease in
Fiscal 2004 to Fiscal 2003 is due to the relative larger growth
in accounts payable versus accounts receivable, increase in the
line of credit and the growth in accrued liabilities and other
current assets due to the deferral of revenue and the related
cost of goods sold. The increase in Fiscal 2003 to Fiscal 2002
is slight and is principally due to increased accounts
receivable and inventories offset by increased accounts payable
and accrued liabilities due to the acquisition of our AMO.

TERM-DEBT

Long-Term Debt

During Fiscal 2004 and Fiscal 2003, we have
undertaken a number of activities to restructure our term-debt
The following is a summary of those transactions:

We originally issued IDRBs in April 1996 in
connection with the construction of a new addition to our
manufacturing facility in Victoria, Minnesota, and for the
purchase of production equipment. On March 14, 2003, an
aggregate of approximately $1,735 of debt proceeds from a
subordinated promissory note were used to fund the repayment of
principal and interest on the IDRBs. We also used $845 of the
proceeds from the subordinated promissory note to retire our
capital expenditure notes with LaSalle Business Credit, LLC.

The subordinated promissory note was funded by
CMED at the time of our AMO acquisition in January 2003. On
May 8, 2003 the subordinated promissory note was sold by
CMED to Whitebox Hedged High Yield Partners
(Whitebox) for $1,820 and continued with the same
terms as the original agreement with CMED until August 15,
2003. To encourage early repayment, the terms of the
subordinated promissory note were modified on May 16, 2003
and subsequently modified on September 12, 2003. On
October 15, 2003, we prepaid the subordinated promissory
note for a discount on the principal amount outstanding of $360,
the payment of accrued interest totaling $167 with 47,700
unregistered shares of our common stock valued at $3.50 per
share and forgiveness of interest from September 15, 2003
through October 15, 2003. As a result of the prepayment of
the subordinated promissory note, we recognized a gain on the
early extinguishment of the Subordinated Promissory Note
totaling $472 during the first quarter of Fiscal 2004.

The funds to prepay the subordinated promissory
note were obtained from two separate loans in the aggregate
amount of $2,350 under new Term Loan Agreements with Commerce
Bank, a Minnesota state banking association, and its affiliate,
Commerce Financial Group, Inc., a Minnesota corporation. The
first note, with Commerce Bank, in the amount of $1,200 was
executed on October 14, 2003. This note is secured by our
Victoria, Minnesota facility. The term of the first note is six
years. The original interest rate on this note was a nominal
rate of 6.50% per annum for the first three years, and
thereafter the interest rate will be adjusted

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on the first date of the fourth loan year to a
nominal rate per annum equal to the then Three Year Treasury
Base Rate (as defined) plus 3.00%; provided, however, that in no
event will the interest rate be less than the Prime Rate plus
1.0% per annum. Monthly payment of principal and interest
will be based on a twenty-year amortization with a final payment
of approximately $980 due on November 1, 2009. The second
note, with Commerce Financial Group, Inc., in the amount of
$1,150 was executed on October 28, 2003. The second note is
secured by our Victoria facility and equipment located at our
Tempe facility. The term of the second note is four years. The
original interest rate on this note was of 8.975% per year
through September 27, 2007. During the first quarter of
Fiscal 2005, we violated two covenants of these term loan
agreements relating to our accounting records and the delivery
of our annual financial statements and were likely to be in
violation of a third covenant relating to our ability to meet
the debt service coverage ratio as of the end of our second
quarter ending February 28, 2005. As a result, on
December 3, 2004, we entered into a waivers and amendments
with Commerce Bank and Commerce Financial Group, Inc., effective
as of November 30, 2004, to cure these events of default
and to move the initial measurement of our debt service coverage
ratio to the second quarter ended February 28, 2006, at
which time we must maintain a ration of 1.2 to 1. We
obtained additional waivers and amendments on December 29,
2004, to address the actual and potential covenant violations
relating to our late filing of this Annual Report on
Form 10K and the potential late filing of our 10Q for the
first quarter ended November 27, 2004, by providing an
extension of time to file under the covenant. Additionally, the
waivers and amendments on December 3, 2004, increased the
interest rate to be paid under the Commerce Bank note beginning
March 1, 2005, to and including October 31, 2006, from
6.5% to 7.5%, and increased the interest rate to be paid under
the Commerce Financial Group, Inc. note beginning March 1,
2005, to and including September 28, 2007, from 8.975% to
9.975%. Monthly payments of principal and interest in the amount
of $28 are paid over a forty-eight month period beginning on
October 28, 2003.


Short-Term Debt

On May 29, 2003, we entered into an accounts
receivable agreement (the Credit Agreement) with
Beacon Bank of Shorewood, Minnesota for a period of twelve
months. On December 12, 2003, we extended the term of the
Credit Agreement to September 1, 2004. On July 1 2004
we extended the term of the Credit Agreement to January 1,
2005. On December 7, 2004, the Company entered into an
amendment to the Credit Agreement that extended its term to
January 1, 2006, and expanded the capacity up to $4,000. On
January 12, 2005, the Credit Agreement was amended to
increase borrowing capacity from $4,000 to $5,000. The Credit
Agreement is an accounts receivable backed facility and is
additionally secured by inventory, intellectual property and
other general intangibles. The Credit Agreement is not subject
to any restrictive financial covenants. We have a maximum of
$5,000 available under the Credit Agreement, with the actual
borrowings based on 80% of eligible accounts receivable as
determined by the individual companys credit worthiness.
As of August 31, 2004, there were $1,310 of borrowings
under the Credit Agreement. The Credit Agreement bears an
immediate processing fee of 0.50% of each assigned amount, a
daily per diem equal to 1/25% on any uncollected accounts
receivable and a monthly minimum of $1.5 in processing fees for
the first six months the Credit Agreement was in place, which
ended in November 2003. Borrowings are reduced as collections
and payments are received into a lock box by the bank. The
effective interest rate based on our average DSO of 55 days
would be 17.9% annualized. During the first quarter of Fiscal
2005, we violated one covenant of the Credit Agreement related
to our late filing of this Annual Report on Form 10K and
were likely to be in violation of a second covenant related the
potential late filing of our 10Q for the first quarter ended
November 27, 2004. As a result, on December 29, 2004,
we entered into a notice waiver and amendment with Beacon Bank
to address the actual and potential covenant violations by
providing an extension of time to file our Fiscal 2004 10K and
first quarter Fiscal 2005 10Q under the covenant.

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FISCAL 2005 LIQUIDITY

The accompanying consolidated financial
statements have been prepared assuming that we will continue as
a going concern, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of
business. We incurred net losses of $7,009, $4,629 and $3,892,
respectively, for Fiscal 2004, Fiscal 2003 and Fiscal 2002 and
used $3,937 in operating activities in Fiscal 2004.

We have historically financed our operations
through the public and private sale of equity securities, bank
borrowings, operating equipment leases and cash generated by
operations. Significant financial restructuring continued during
Fiscal 2004, transforming our capital structure to a lower
interest rate and less restrictive structure. On
October 29, 2003 we completed the funding of two separate
loans in the aggregate amount of $2,350 under new Term Credit
Facilities with Commerce Bank, a Minnesota state banking
corporation, and its affiliate, Commerce Financial Group, a
Minnesota corporation. These loans provided us with the
necessary resources to prepay the CMED subordinated promissory
note held by Whitebox (see Note 7  Long-Term
Debt  to our Consolidated Financial Statements). The
terms of the new loans originally had an average interest rate
of 7.75% and after the waiver and amendments dated
November 30, 2004, will have an average interest rate of
8.63% commencing March 1, 2005, as compared to 12.00% for
the retired debt. Throughout Fiscal 2004, we recovered
approximately $1,748 against the total judgment of $2,255
against our former Chief Executive Officer, President and
Chairman (see Note 13  Notes Receivable and
Transactions with Former CEO  to our Consolidated
Financial Statements). On February 13, 2004, we sold
1,180,000 shares of our common stock for gross proceeds of
$3,540 net of transaction costs of $301 (see
Note  12 Private Placement of Common
Stock  to our Consolidated Financial Statements).

At August 31, 2004, our sources of liquidity
consisted of $200 of cash and cash equivalents, $481 of
restricted cash, which restrictions lapse in 2005, and our
Credit Agreement, which was due to expire in January 2005. On
December 7, 2004, the Credit Agreement was extended to
January 1, 2006 and our borrowing capacity was increased
from $3,000 to $4,000, subject to availability based on accounts
receivable. On January 12, 2005, the Credit Agreement was
amended to increase our borrowing capacity from $4,000 to
$5,000, subject to availability based on accounts receivable.
There was $1,310 outstanding debt under the Credit Agreement at
August 31, 2004, and $1,809 at December 31, 2004. Our
liquidity is affected by many factors, some of which are based
on the normal ongoing operations of our business, and the most
significant of which include the timing of the collection of
receivables, the level of inventories and capital expenditures
and maintaining of debt compliance. The losses due to the
operational problems encountered throughout Fiscal 2004 strained
our cash flows and consumed much of the additional funds raised
in the year including the proceeds from our private placement of
common stock and the collection of monies from the judgments
against our former Chief Executive Officer, President and
Chairman. We have taken various actions operationally in an
effort to substantially reduce our losses or to return to
profitability in Fiscal 2005 including, but not limited to,
production improvement initiatives and continuing progress in
understanding key drivers via systems upgrades that will improve
management decision making. In addition to the operational
improvements, we continue to scrutinize our cost structure for
savings long with our efforts to reduce the cost of our Boulder
facility by subletting of the vacant space. In October 2004, we
entered into a new lease arrangement for our Boulder facility
which is expected to reduce lease payments approximately $500
per year. In the event cash flows are not sufficient to fund
operations at the present level measures can be taken to reduce
the expenditure levels including but not limited to reduction of
spending for research and development, elimination of budgeted
raises, and reduction of non-strategic employees. Our lending
arrangements contain debt covenants, several of which we did not
maintain in Fiscal 2004 and early Fiscal 2005. These covenant
violations and debt amendments are fully described under the
caption Term-Debt. We do not foresee any violations
of debt agreements, as amended, for the remainder of Fiscal
2005. We will be required to maintain a debt service coverage
ratio of 1.2 to 1 beginning the second quarter ended
February 28, 2006.

During Fiscal 2005, we intend to spend
approximately $900 for manufacturing equipment, extension of the
SAP Software Solution to our AMO, and to make minor facility
improvements. These additions, if made, are expected to increase
efficiency through the further integration of the Boulder
operations and increase manufacturing capacity to meet
anticipated production requirements and add technological
capabilities. It is expected that these expenditures will be
funded from operations, existing cash and cash equivalents and

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available debt financing for the next
12 months. In the event there is insufficient capital fund
for this spending it will be deferred into the future which may
impact our ability to integrate the operations of all facilities
and may prevent us from increasing manufacturing capacity.


Management believes that, as a result of the
financial restructuring actions it has taken in Fiscal 2004 to
reduce cash expenditures, the continuing efforts to increase
revenues from continuing customers and to generate new customers
in various market sectors, and the extension and increase of our
Credit Agreement, we will meet our operational working capital
and investment requirements for the next 12 months.

CONTRACTUAL OBLIGATIONS

Our contractual obligations at August 31,
2004, as adjusted for the revision to our Boulder facility lease
on October 1, 2004, are summarized in the following table:

|                              |  |                        |        |           |  |       |       |       |  |           |       |  |  |   |       |  |  |   |        | 
|----------------------------- |  | ---------------------- | ------ | --------- |  | ----- | ----- | ----- |  | --------- | ----- |  |  | - | ----- |  |  | - | ------ | 
|                              |  |                       
|                              |  | Payments due by Period
|                              |  |                       
|                              |  |                        |        | Less than |  | 1-3   |       | 3-5   |  | More than
|                              |  | Total                  |        | 1 Years   |  | Years |       | Years |  | 5 Year   
|                              |  |                        |        |           |  |       |       |       |  |          
|Long-term debt obligations    |  | $                      | 2,236  |           |  | $     | 403   |       |  | $         | 713   |  |  | $ | 131   |  |  | $ | 989    | 
|Contractual obligations       |  |                        | 80     |           |  |       | 80    |       |  |           |      |  |  |   |      |  |  |   |       | 
|Operating lease obligations   |  |                        | 26,099 |           |  |       | 1,723 |       |  |           | 3,148 |  |  |   | 3,028 |  |  |   | 18,200 | 
|                              |  |                        |        |           |  |       |       |       |  |           |       |  |  |   |       |  |  |   |        | 
|Total contractual obligations |  | $                      | 28,415 |           |  | $     | 2,206 |       |  | $         | 3,861 |  |  |   | 3,159 |  |  | $ | 19,189 | 
|                              |  |                        |        |           |  |       |       |       |  |           |       |  |  |   |       |  |  |   |        | 

RISK FACTORS

(In thousands except per share
amounts)


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

The forward-looking statements included in this
Annual Report on Form 10-K are based on current assumptions
that we will continue to develop, market, manufacture and ship
products on a timely basis, that competitive conditions within
our markets will not change materially or adversely, that we
will continue to identify and satisfy customer needs for
products and services, that we will be able to retain and hire
key personnel, that our equipment, processes, capabilities and
resources will remain competitive and compatible with the
current state of technology, that risks due to shifts in
customer demand will be minimized, and that there will be no
material adverse change in our operations or business.
Assumptions relating to the foregoing involve judgments that are
based on incomplete information and are subject to many factors
that can materially affect results. We operate in a volatile
segment of high technology markets and applications that are
subject to rapid change and technical obsolescence.

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

Failure to comply with our debt covenants may
require us to immediately repay our outstanding balances and/or
may affect our ability to borrow funds in the future, either of
which may adversely affect our future operating
results.At various times over the
past four years we have not been in compliance with our debt
covenants. In Fiscal 2001 and Fiscal 2002, we violated certain
covenants relating to our borrowings from LaSalle Business
Credit, LLC. During the first quarter of Fiscal 2005, we
violated certain covenants included in our term loan agreements
with Commerce Bank and Commerce Financial Group relating to our
accounting records and the delivery of our annual financial
statements. As a result, on December 3, 2004, we entered
into

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a waivers and amendments with Commerce Bank and
Commerce Financial Group, Inc., effective as of
November 30, 2004, to cure these events of default and to
move the initial measurement of our debt service coverage ratio
to the second quarter ended February 28, 2006, at which
time we must maintain a ration of 1.2 to 1. We obtained
additional waivers and amendments on December 29, 2004, to
address the actual and potential covenant violations relating to
our late filing of this Annual Report on Form 10K and the
potential late filing of our 10Q for the first quarter ended
November 27, 2004, by providing an extension of time to
file under the covenant. See the section entitled Term
Debt in Item 7 of this Annual Report on
Form 10-K for a more detailed discussion regarding such
waivers and amendments. In connection with such waivers and
amendments, we were required to increase the borrowing rate on
our borrowings under such term loan agreements. Failure to meet
our debt covenants in the future may require us to:




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

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

We may fail to have enough liquidity to
operate our business because we may not adequately adjust our
expenses to predicted revenue in any given period, which may
dramatically and negatively impact our cash
flow.Our basis for determining our
ability to fund our operations depends on our ability to
accurately estimate our revenue streams and our ability to
accurately predict, our related expenditures. Furthermore, our
borrowing base is fixed. As a result, we may fail to adequately
adjust our expenses to actual revenue in any given period or we
may experience significant fluctuations in quarterly revenue,
either of which may dramatically and negatively affect our cash
flow.

If we are not able to establish an effective
control environment in Fiscal 2005, we will not comply with
Section 404 of the Sarbanes-Oxley Act relating to internal
controls over financial reporting.Section 404 of the Sarbanes-Oxley Act requires our
independent registered public accounting firm to attest as to
the effectiveness of our internal controls over financial
reporting beginning with our Annual Report on Form 10-K for
Fiscal 2005. During the audits of our consolidated financial
statements for each of Fiscal 2003 and Fiscal 2004, we were
cited by our independent registered public accounting firm for
material weakness and reportable conditions in our internal
controls. See Items 9 and 9A of this Annual Report on
Form 10-K for more detailed discussions regarding these
reportable conditions and material weaknesses. Under applicable
SEC rules and regulations, management may not conclude that a
companys internal control over financial reporting is
effective if there are one or more material weaknesses in the
companys internal control over financial reporting. We are
in the process of implementing changes to our internal controls
to correct such reportable conditions and materials weaknesses
to establish an effective control environment as described in
Items 9 and 9A of this Annual Report on Form 10-K.

Further, as a result of KPMGs decision not
to stand for re-election as our independent registered public
accounting firm for Fiscal 2005, we will be engaging a new
independent registered public accounting firm.

As a result of these events, we cannot provide
any assurance that we will timely complete the evaluation of our
internal controls, including implementation of the necessary
improvements to our internal controls, or that even if we do
complete this evaluation and make such improvements, we do so in
time to permit our new independent registered public accounting
firm to test our controls and complete their attestation
procedures in a manner that will allow us to comply with the
applicable SEC rules and regulations relating to internal
controls over financial reporting by the filing deadline for our
Annual Report on Form 10-K for Fiscal 2005.

If we are unable to effectively initiate and
manage multiple new programs simultaneously at our
Microelectronics Operations, our operating results and business
condition may be impaired.In Fiscal
2004, a

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number of new programs were initiated
simultaneously with the operating results being negatively
impacted. This results in unsatisfied orders and unfulfilled
backlog. These operational issues have persisted throughout
Fiscal 2004. We may not be able to successfully implement
numerous programs at the same time at our Microelectronics
Operations. The inability to effectively initiate these programs
could impair our revenue opportunity and significantly impact
our liquidity. The resolution of these production issues could
take longer than anticipated which would impact our
relationships with our customers, cause continuing operating
losses and negatively impact the strength of our balance sheet.


If we are unable to integrate, operate and
manage our Advanced Medical Operations, our operating results
and business condition may be reduced.On January 24, 2003, we acquired our Advanced Medical
Operations from CMED. While our AMO have been managed by us for
the past twenty-two months efforts still continue to integrate
its business activities into the Company. Plans are underway to
integrate common operating system platforms, further consolidate
duplicative activities and fill the sales pipeline. We may not
be able to successfully and profitably integrate, operate,
maintain and manage our AMO in a competitive environment. In
addition, we may not be able to integrate the newly hired
employees and operational issues may arise as a result of a lack
of integration or our lack of familiarity with issues specific
to this operation. Further, certain of our assumptions relating
to the timing of the integration and the use of the leased
Boulder facility, may not prove to be accurate, causing
increased costs at this facility. The inability to integrate the
operations could impair our combined revenue opportunity and
reduce the return on the assets purchased. The consolidated
integration technology could take longer than anticipated,
limiting the speed of the business combination, not allowing
costs to be removed as quickly as originally forecasted.

If the components that we design and
manufacture are the subject of product recalls or a product
liability claim, our business may be damaged, we may incur
significant legal fees and our results of operations and
financial condition may be adversely
affected.Certain of the components we
design or manufacture are used in medical devices, several of
which may be used in life-sustaining or life-supporting roles.
The tolerance for error in the design, manufacture or use of
these components and 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, improper use of
the product or other reasons, the product may need to be
recalled, possibly at our expense. Further, 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, results of operations and financial
condition.

The manufacture and sale of the medical devices
involves the risk of product liability claims. Although we
generally obtain indemnification from our customers for
components that we manufacture to the customers
specifications and we maintain product liability insurance,
there can be no assurance that the indemnities will be honored
or the coverage of our insurance policies will be adequate.
Further, we generally provide a design defect warranty and
indemnify to our customers for failure of a product to conform
to design specifications and against defects in materials and
workmanship. Product liability insurance is expensive and in the
future may not be available on acceptable terms, in sufficient
amounts, or at all. A successful product liability claim in
excess of our insurance coverage or any material claim for which
insurance coverage was denied or limited and for which
indemnification was not available could have a material adverse
effect on our business, results of operations and financial
condition.

Our customer base is highly concentrated and
the loss of a key customer may reduce our operating results and
financial condition.Our customer base
is highly concentrated. In Fiscal 2004, Fiscal 2003, and Fiscal
2002, our three largest customers, Siemens, Inc., Sonic
Innovations, Inc., and GE Medical Systems, in the aggregate
accounted for 8%, 2%, and 17%, respectively, of net sales. Each
of these customers has multiple programs in production with us.
Although we are reducing this concentration, we expect that
sales to a relatively small number of OEMs will continue to
account for a substantial portion of net revenues for the
foreseeable future. The loss of, or a decline in orders from,
any one of our key customers would materially adversely affect
our operating results and financial condition. We are working
for diversification such that no one market would account for
40% or more in revenue, no one customer at 10% or greater
revenue and no one program at 25% or greater.

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As our customer base becomes more diversified
it may reduce our ability to effectively manage all of our
customer relationships.While our
customer base is currently highly concentrated, we are working
for diversification such that no one program is at 10% or
greater of net sales and no one customer is at 25% or greater of
net sales. New customers and programs can have a significant
ramp up effort associated with getting the product ready for
delivery. The efforts associated with managing a more
diversified customer base and projects could prove to be more
difficult than previously thought and could result in loss of
customers and/or revenues.

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

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



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

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



| |   |                                                                                                                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | we may manufacture products that are custom
    designed and assembled for a specific customers
    requirement in anticipation of the receipt of volume production
    orders from that customer, which may not always materialize to
    the degree anticipated, if at all;         
|
| |  | 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 be unable to gain the benefits
    expected out of lean-flow manufacturing at our
    Victoria, Minnesota facility;                                                                                                                                                       
|
| |  | 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                                                                  

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| |  |                                                                                                                               
| |  | ------------------------------------------------------------------------------------------------------------------------------
| |  | demand attributable to, among other things,
    product life cycles, competitive factors, and general economic
    conditions.

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

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

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

Third-party intellectual property infringement
claims may be costly and may prevent the future sale of our
products.Substantial litigation and
threats of litigation regarding intellectual property rights
exist in our industry. Third parties may claim that our products
infringe upon their intellectual property rights. In particular,
defending against third-party infringement claims may be costly
and divert important management resources. Furthermore, if these
claims are successful, we may have to pay substantial royalties
or damages, remove the infringing products from the marketplace
or expend substantial amounts in order to modify the products so
that they no longer infringe on the third partys rights.

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



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

If our customers are unable to gain market
acceptance for the products that we develop or manufacture for
them, we may lose revenue.We design
and manufacture components for other companies. We also sell
proprietary products that contain components to other companies
and end-user customers. For products we manufacture
(manufactured for others or those we sell directly), our success
is dependent on the acceptance of those products in their
markets. We have no control over the products or marketing of
products that we sell

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to our customers. Market acceptance may depend on
a variety of factors, including educating the target market
regarding the use of a new procedure. Market acceptance and
market share are also affected by the timing of market
introduction of competitive products. Some of our customers,
especially emerging growth companies, have limited or no
experience in marketing their products and may be unable to
establish effective sales and marketing and distribution
channels to rapidly and successfully commercialize their
products. If our customers are unable to gain any significant
market acceptance for the products we develop or manufacture for
them, our business will be adversely affected.


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

We are dependent on a single market and
adverse trends in that market may reduce our
revenues.During the past several
years, we have been significantly dependent on a single market.
In Fiscal 2004, Fiscal 2003, and Fiscal 2002, 84%, 82%, and 76%,
respectively, of our net sales came from the medical/hearing
market. This markets is 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 market trends
to the extent that they reduce our revenues. In particular, if
manufacturers in the medical/hearing market 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. 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.

In certain circumstances, our customers are
permitted to cancel their orders, change production quantities,
delay production and terminate their contracts and any such
event or series of events may adversely affect our gross margins
and operating results. We, as a medical/hearing device
development and manufacturing service provider, must provide
product output that matches the needs of their customers, which
can change from time to time. We generally do not obtain
long-term commitments from our customers and we continue to
experience reduced lead times in customer orders. Customers may
cancel their orders, change production quantities, delay
production, or terminate their contracts for a number of
reasons. In certain situations, cancellations, reductions in
quantities, delays or terminations by a significant customer
could adversely affect our operating results. Such
cancellations, reductions or delays have occurred and may
continue to occur in response to slowdowns in our
customers businesses or for other reasons. In addition, we
make significant decisions, including determining the levels of
business that we will seek and accept, production schedules,
parts procurement commitments, and personnel needs based on our
estimates of customer requirements. Because many of our costs
and operating expenses are relatively fixed, a reduction in
customer demand or a termination of a contract by a customer
could adversely affect our gross margins and operating results.

Inventory risk and production delay may adversely
affect our financial performance. Most of our contract
manufacturing services are provided on a turnkey basis, where we
purchase some or all of the materials required for product
assembling and manufacturing. We bear varying amounts of
inventory risk in providing services in this manner. In
manufacturing operations, we need to order parts and supplies
based on customer forecasts, which may be for a larger quantity
of product than is included in the firm orders ultimately
received from those customers. While many of our customer
agreements include provisions that require customers to
reimburse us for excess inventory which we specifically order to
meet their forecasts, we may not actually be reimbursed or be
able to collect on these obligations. In that case, we could
have excess inventory and/or cancellation or return charges from
our suppliers. Our medical/hearing device manufacturing
customers continue to experience fluctuating demand for their
products, and in response they may ask us to reduce or delay
production. If we delay production, our financial performance
may be adversely affected.

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We may lose business and revenues if we fail
to successfully compete for our customers
business.We face competition from the
internal operations of our current and potential OEM
customers and from offshore contract manufacturers, which,
because of their lower labor rates and other related factors,
may enjoy a competitive 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, we may lose
business and our operating results may be reduced.

Fluctuations in the price and supply of
components used to manufacture our products may reduce our
profits.Substantially all of 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
ICs, we occasionally must order such components prior to
receiving formal customer purchase orders for the assemblies
that require such components. Failure to accurately anticipate
the volume or timing of customer orders can result in component
shortages or excess component inventory, which in either case
could adversely affect our operating results and financial
condition.

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

Our costs may increase significantly if we are
unable to forecast customer orders and production
schedules.The level and timing of
orders placed by customers vary due to the customers
attempts to balance their inventory, changes in customers
manufacturing strategies, and variations in demand for the
customers products. Due in part to these factors, most of
our customers do not commit to firm production schedules more
than several weeks in advance of requirements. Our inability to
forecast the level of customers orders with certainty
makes it difficult to schedule production and optimize
utilization of manufacturing capacity. This uncertainty could
also significantly increase our costs related to manufacturing
product. In the past, we have been required to increase staffing
and incur other expenses in order to meet the anticipated
demands of our customers. From time to time, anticipated orders
from some of our customers have failed to

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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 has placed an excessive burden on
our resources. There can be no assurance that we will not
experience similar fluctuations in customer demand in the future.


We may be unable to realize revenue from our
backlog.We compute our backlog from
purchase orders received from our customers and from other
contractual agreements. Our backlog is typically not a firm
commitment from the customers. As such, even though we may have
contractual agreements or purchase orders for future shipments,
there is no guarantee that this backlog will be realized as
revenue.

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

Our business success may be adversely affected
by our ability to hire and retain
employees.Our continued growth and
success depend to a significant extent on the continued service
of senior management and other key employees and the hiring of
new qualified employees. We rely upon the acquisition and
retention of employees with extensive technological experience.
Competition for skilled business, product development, technical
and other personnel is intense. There can be no assurance that
we will be successful in recruiting new personnel and retaining
existing personnel. Our executive officers are subject to
employment agreements that can be terminated upon providing
90 days advance, written notice by either party. The loss
of one or more key employees may materially adversely affect our
growth.

We operate in a regulated industry, and our
products and revenue are subject to regulatory
risk.We are subject to a variety of
regulatory agency requirements in the United States and foreign
countries relating to many of the products that we develop and
manufacture. The process of obtaining and maintaining required
regulatory approvals and otherwise remaining in regulatory
compliance can be lengthy, expensive and uncertain.

The FDA inspects manufacturers of certain types
of devices before providing a clearance to manufacture and sell
such device, and the failure to pass such an inspection could
result in delay in moving ahead with a product or project. We
are required to comply with the FDAs QSR for the
development and manufacture of medical products. In addition, in
order for devices we design or manufacture to be exported and
for us and our customers to be qualified to use the
CE mark in the European Union, we maintain ISO 9001/
EN 46001 certification which, like the QSR, subjects our
operations to periodic surveillance audits. To ensure compliance
with various regulatory and quality requirements, we expend
significant time, resources and effort in the areas of training,
production and quality assurance. If we fail to comply with
regulatory or quality regulations or other FDA or applicable
legal requirements, the governing agencies can issue warning
letters, impose government sanctions and levy serious penalties.

Noncompliance or regulatory action could have a
negative impact on our business, including the increased cost of
coming into compliance, and an adverse effect on the willingness
of customers and prospective customers to do business with us.
Such noncompliance, as well as any increased cost of compliance,
could have a material adverse effect on our business, results of
operations and financial condition.

If our customers do not promptly obtain
regulatory approval for their products, our projects and revenue
may be adversely affected.The FDA
regulates many of our customers products, and requires
certain clearances or approvals before new medical devices can
be marketed. As a prerequisite to any introduction of a new
device into the medical marketplace, our customers must obtain
necessary product clearances or approvals from the FDA or other
regulatory agencies. This can be a slow and uncertain process,
and there can be no assurance that such clearances or approvals
will be obtained on a timely basis, if at all. In addition,
products intended for use in foreign countries must comply with
similar requirements and be certified for sale in those
countries. A customers failure to comply with the
FDAs requirements can result in the delay or denial of
approval to proceed with the product. Delays in obtaining
regulatory approval are frequent and, in

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turn, can result in delaying or canceling
customer orders. There can be no assurance that our customers
will obtain or be able to maintain all required clearances or
approvals for domestic or exported products on a timely basis,
if at all. The delays and potential product cancellations
inherent in the regulatory approval and ongoing regulatory
compliance of products we develop or manufacture may have a
material adverse effect on our projects and revenue, as well as
our business, reputation, results of operations and financial
condition.


If government or insurance company
reimbursements for our customers products change, our
products, revenues and profitability may be adversely
affected.Governmental and insurance
industry efforts to reform the healthcare industry and reduce
healthcare spending have affected, and will continue to affect,
the market for medical devices. There have been several
instances of changes in governmental or commercial insurance
reimbursement policies that have significantly impacted the
markets for certain types of products or services or that have
had an impact on entire industries, such as recent policies
affecting payment for nursing home and home care services.
Adverse governmental regulation relating to our components or
our customers products that might arise from future
legislative, administrative or insurance industry policy cannot
be predicted and the ultimate effect on private insurer and
governmental healthcare reimbursement is unknown. Government and
commercial insurance companies are increasingly vigorous in
their attempts to contain healthcare costs by limiting both
coverage and the level of reimbursement for new therapeutic
products even if approved for marketing by the FDA. If
government and commercial payers do not provide adequate
coverage and reimbursement levels for uses of our
customers products, the market acceptance of these
products and our revenues and profitability would be adversely
affected.

We have customers located in foreign countries
and our unfamiliarity of the laws and business practices of such
foreign countries could cause us to incur increased
costs.We currently have customers
located in foreign countries and anticipate additional customers
located outside the United States. Our lack of knowledge and
understanding of the laws of, and the customary business
practices in, foreign counties could cause us to incur increased
costs in connection with disputes over contracts, environmental
laws, collection of accounts receivable, holding excess and
obsolete inventory, duties and other import and export fees,
product warranty exposure and unanticipated changes in
governmental regimes.

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 Amended and Restated Articles of
Incorporation and our Amended and Restated Bylaws, as amended,
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

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likelihood of derivative litigation against
directors and may discourage shareholders from bringing a
lawsuit against directors for a breach of their duty.


We have issued numerous options to acquire our
common stock that could have a dilutive effect on our common
stock.As of December 27, 2004,
we had options outstanding to acquire 1,446,100 shares of
our common stock, exercisable at prices ranging from $1.280 to
$20.375 per share, with a weighted average exercise price
of approximately $5.045 per share. During the terms of
these options, the holders will have the opportunity to profit
from either an increase in the market price of our common stock
with resulting dilution to the holders of shares who purchased
shares for a price higher than the respective exercise or
conversion price. In addition, the increase in the outstanding
shares of our common stock as a result of the exercise or
conversion of these options could result in a significant
decrease in the percentage ownership of our common stock by the
purchasers of our common stock.

The market price of our common stock may be
reduced by future sales of our common stock in the public
market.Sales of substantial amounts
of common stock in the public market that are not currently
freely tradable, or even the potential for such sales, could
have an adverse effect on the market price for shares of our
common stock and could impair the ability of purchasers of our
common stock to recoup their investment or make a profit. As of
December 13, 2004, these shares consist of:



| |   |                                                                                   
| | - | ----------------------------------------------------------------------------------
| |  | 771,303 shares beneficially owned by our
    executive officers and directors; and
|
| |  | approximately 1,918,400 shares issuable to
    option and warrant holders.        

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

The trading dynamics of our common stock makes
it subject to large fluctuations in the per share
value.Our common stock is a
micro-stock that is thinly traded on the NASDAQ National Market.
In some cases, our common stock may not trade during any given
day. Small changes in the demand for shares of our common stock
can have a material impact, both negatively and positively, in
the trading share price of our stock.

Our Amended and Restated Articles of
Incorporation contain provisions that could discourage or
prevent a potential takeover, even if such transaction would be
beneficial to our shareholders.Our
Amended and Restated Articles of Incorporation authorize our
Board of Directors to issue up to 11,000,000 shares of
common stock and 4,000,000 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 that could affect the rights of the holders of
our common stock and reduce the value of our common stock. The
issuance of preferred stock could also prevent a potential
takeover because the terms of any issued preferred stock may
require the approval of the holders of the outstanding shares of
preferred stock in order to consummate a merger, reorganization
or sale of substantially all of our assets or other
extraordinary corporate transaction.

Our Amended and Restated Articles of
Incorporation provide for a classified Board of Directors with
staggered, three-year terms. Our Amended and Restated Articles
of Incorporation also require the affirmative vote of a
supermajority (80%) of the voting power for the following
matters:



| |   |                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | to approve the merger or consolidation of HEI or
    any subsidiary with or into any person that directly or
    indirectly beneficially owns, or owned at any time in the
    preceding 12 months, five percent or more of the
    outstanding shares of our stock entitled to vote in elections of
    directors (a Related Person);
|
| |  | to authorize the sale of substantially all of our
    assets to a Related Person;                                                                                                                                                                                                                                                       
|
| |  | to authorize the issuance of any of our voting
    securities in exchange or payment for the securities or assets
    of any Related Person, if such authorization is otherwise
    required by law or any agreement;                                                                                                                   

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| |   |                                                                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | to adopt any plan for the dissolution of
    HEI; and                                                                                                                                                                                                                                          
|
| |  | to adopt any amendment, change or repeal of
    certain articles of the Amended and Restated Articles of
    Incorporation, including the articles that establish the
    authority of the Board of Directors, the supermajority voting
    requirements and the classified Board of Directors.

These provisions may have the effect of deterring
a potential takeover or delaying changes in control or our
management.






|         |                                                                
|-------- | ---------------------------------------------------------------
|Item 7A. | Qualitative and Quantitative Disclosures
    about Market Risk.

Market Risk

We do not have material exposure to market risk
from fluctuations in foreign currency exchange rates because all
sales are denominated in U.S. dollars.

Interest Rate Risk

We are exposed to a floating interest rate risk
from our term credit facilities with Commerce Bank, a Minnesota
state banking association and Commercial Financial Group, Inc.,
a Minnesota corporation. We obtained two separate loans in the
aggregate amount of $2,350. The first note, with Commerce Bank,
in the amount of $1,200, was executed on October 14, 2003.
This note has a floating interest rate. The term of the first
note is six years with interest rate at a nominal rate of
6.50% per annum for the first three years. Thereafter the
interest rate will be adjusted on the first date of the fourth
loan year to a nominal rate per annum equal to the then Three
Year Treasury Base Rate (as defined) plus 3.00%; provided,
however, that in no event will the interest rate be less than
the Prime Rate plus 1.0% per annum. Monthly payments of
principal and interest are based on a twenty-year amortization
with a final payment of approximately $980 due on
November 1, 2009. The second note, with Commerce Financial
Group, Inc., in the amount of $1,150 was executed on
October 28, 2003. The term of the second note is four
years, with a fixed interest rate of 8.975% per year
through September 27, 2007. Monthly payments of principal
and interest in the amount of $28 are paid over a forty-eight
month period beginning on October 28, 2003. In waiver and
amendments between us and each of Commerce Bank and Commerce
Financial Group, Inc., dated November 30, 2004, the
interest rate for both debt instruments were modified. The
interest rate on the note with Commerce Bank has been adjusted
from 6.5% to 7.5% effective March 1, 2005, and the interest
rate on the note with Commerce Financial Group, Inc. has been
adjusted from 8.975% to 9.975% effective March 1, 2005. A
change in interest rates is not expected to have a material
adverse effect on our near-term financial condition or results
of operation as the first note has a fixed rate for its first
three years and the second note has a fixed rate for its term.

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|        |                                                 
|------- | ------------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data.

Our financial statements as of August 31,
2004 and 2003, and for each of the years in the three-year
period ended August 31, 2004, together with the Reports of
our Independent Registered Public Accounting Firm are included
in this Annual Report on Form 10-K on the pages indicated
below.

|                                                                                            |  |          |       | 
|------------------------------------------------------------------------------------------- |  | -------- | ----- | 
|                                                                                            |  | Page No.
|                                                                                            |  |         
|Consolidated Balance Sheets                                                                 |  |          | 33    | 
|Consolidated Statements of Operations                                                       |  |          | 34    | 
|Consolidated Statements of Changes in
    Shareholders Equity                              |  |          | 35    | 
|Consolidated Statements of Cash Flows                                                       |  |          | 36    | 
|Notes to Consolidated Financial Statements                                                  |  |          | 37-55 | 
|Report of Independent Registered Public
    Accounting Firm                                 |  |          | 56    | 
|Report of Independent Registered Public
    Accounting Firm on Financial Statement Schedule |  |          | 57    | 
|Statement of Financial Responsibility                                                       |  |          | 58    | 

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HEI, INC.

CONSOLIDATED BALANCE SHEETS

|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |         |  
|-------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------- | ------------------------- | ------ | ---------- | - | - | ------ | ------- | -
|                                                                                       |                                                                                                                     | August 31,                |        | August 31,
|                                                                                       |                                                                                                                     | 2004                      |        | 2003      
|                                                                                       |                                                                                                                     |                           |        |           
|                                                                                       |                                                                                                                     |                          
|                                                                                       |                                                                                                                     | (In thousands, except    
|                                                                                       |                                                                                                                     | share and per share data)
|ASSETS                                                                                
|Current assets:                                                                        |                                                                                                                     |                           |        |            |   |   |        |        
|                                                                                       | Cash and cash equivalents                                                                                           |                           | $      | 200        |   |   | $      | 806     |  
|                                                                                       | Restricted cash                                                                                                     |                           |        | 481        |   |   |        |        |  
|                                                                                       | Accounts receivable, net of allowance for
    doubtful accounts of $121 and $92, respectively                       |                           |        | 6,770      |   |   |        | 6,314   |  
|                                                                                       | Inventories                                                                                                         |                           |        | 6,787      |   |   |        | 6,864   |  
|                                                                                       | Other current assets                                                                                                |                           |        | 1,221      |   |   |        | 380     |  
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Total current assets                                                                   |                                                                                                                     |                           | 15,459 |            |   |   | 14,364 |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Property and equipment:                                                                |                                                                                                                     |                           |        |            |   |   |        |        
|                                                                                       | Land                                                                                                                |                           |        | 216        |   |   |        | 216     |  
|                                                                                       | Building and improvements                                                                                           |                           |        | 4,323      |   |   |        | 4,316   |  
|                                                                                       | Fixtures and equipment                                                                                              |                           |        | 21,432     |   |   |        | 21,137  |  
|                                                                                       | Accumulated depreciation                                                                                            |                           |        | (18,580    | ) |   |        | (15,769 | )
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Net property and equipment                                                             |                                                                                                                     |                           | 7,391  |            |   |   | 9,900  |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Developed technology, less accumulated
    amortization of $231 and $111, respectively |                                                                                                                     |                           | 185    |            |   |   | 341    |        
|Security deposit                                                                       |                                                                                                                     |                           | 1,580  |            |   |   | 1,580  |        
|Other long-term assets                                                                 |                                                                                                                     |                           | 497    |            |   |   | 318    |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Total assets                                                                           |                                                                                                                     | $                         | 25,112 |            |   | $ | 26,503 |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|LIABILITIES AND SHAREHOLDERS
    EQUITY                                              
|Current liabilities:                                                                   |                                                                                                                     |                           |        |            |   |   |        |        
|                                                                                       | Line of credit                                                                                                      |                           | $      | 1,310      |   |   | $      | 490     |  
|                                                                                       | Current maturities of long-term debt                                                                                |                           |        | 403        |   |   |        | 397     |  
|                                                                                       | Accounts payable                                                                                                    |                           |        | 5,663      |   |   |        | 3,951   |  
|                                                                                       | Accrued liabilities                                                                                                 |                           |        | 4,669      |   |   |        | 3,798   |  
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Total current liabilities                                                              |                                                                                                                     |                           | 12,045 |            |   |   | 8,636  |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|                                                                                       | Other long-term liabilities, less current
    maturities                                                            |                           |        | 1,277      |   |   |        | 2,121   |  
|                                                                                       | Long-term debt, less current maturities                                                                             |                           |        | 1,833      |   |   |        | 2,555   |  
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Total other long-term liabilities, less current
    maturities                         |                                                                                                                     |                           | 3,110  |            |   |   | 4,676  |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Total liabilities                                                                      |                                                                                                                     |                           | 15,155 |            |   |   | 13,312 |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Shareholders equity:                                                                  |                                                                                                                     |                           |        |            |   |   |        |        
|                                                                                       | Undesignated stock; 4,000,000 shares
    authorized; none issued                                                    |                           |        |           |   |   |        |        |  
|                                                                                       | Common stock, $.05 par; 11,000,000 shares
    authorized; 8,357,000 and 7,046,000 shares issued and
    outstanding |                           |        | 418        |   |   |        | 352     |  
|                                                                                       | Paid-in capital                                                                                                     |                           |        | 22,426     |   |   |        | 18,951  |  
|                                                                                       | Accumulated deficit                                                                                                 |                           |        | (12,452    | ) |   |        | (5,443  | )
|                                                                                       | Notes receivable                                                                                                    |                           |        | (435       | ) |   |        | (669    | )
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Total shareholders equity                                                             |                                                                                                                     |                           | 9,957  |            |   |   | 13,191 |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        
|Total liabilities and shareholders equity                                             |                                                                                                                     | $                         | 25,112 |            |   | $ | 26,503 |        
|                                                                                       |                                                                                                                     |                           |        |            |   |   |        |        

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

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HEI, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |           |  
|------------------------------------------ | ------------------------------------------------------- | --------------------------- | ------ | --------- | - | ---- | ------ | --------- | - | - | ------ | --------- | -
|                                           |                                                         |                            
|                                           |                                                         | Years Ended August 31,     
|                                           |                                                         |                            
|                                           |                                                         | 2004                        |        | 2003      |   | 2002
|                                           |                                                         |                             |        |           |   |     
|                                           |                                                         |                            
|                                           |                                                         | (In thousands, except share
|                                           |                                                         | and per share data)        
|Net sales                                  |                                                         | $                           | 43,320 |           |   | $    | 38,440 |           |   | $ | 28,532 |          
|Cost of sales                              |                                                         |                             | 39,197 |           |   |      | 31,327 |           |   |   | 23,375 |          
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|                                           | Gross profit                                            |                             |        | 4,123     |   |      |        | 7,113     |   |   |        | 5,157     |  
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|Operating expenses:                        |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|                                           | Selling, general and administrative                     |                             |        | 8,113     |   |      |        | 7,639     |   |   |        | 5,335     |  
|                                           | Research, development and engineering                   |                             |        | 3,165     |   |      |        | 2,580     |   |   |        | 2,516     |  
|                                           | Asset impairment charges                                |                             |        | 465       |   |      |        | 331       |   |   |        |          |  
|                                           | Costs related to investigation                          |                             |        | 894       |   |      |        |          |   |   |        |          |  
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|Operating loss                             |                                                         |                             | (8,514 | )         |   |      | (3,437 | )         |   |   | (2,694 | )        
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|                                           | Former officer note and other receivables write
    off |                             |        |          |   |      |        | (841      | ) |   |        |          |  
|                                           | Bank fees                                               |                             |        |          |   |      |        | (181      | ) |   |        |          |  
|                                           | Gain on prepayment of promissory note                   |                             |        | 472       |   |      |        |          |   |   |        |          |  
|                                           | Litigation recovery                                     |                             |        | 1,361     |   |      |        |          |   |   |        |          |  
|                                           | Interest expense                                        |                             |        | (364      | ) |      |        | (328      | ) |   |        | (345      | )
|                                           | Other income (expense), net                             |                             |        | 36        |   |      |        | 137       |   |   |        | 239       |  
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|Loss before income taxes                   |                                                         |                             | (7,009 | )         |   |      | (4,650 | )         |   |   | (2,800 | )        
|Income tax expense (benefit)               |                                                         |                             |       |           |   |      | (21    | )         |   |   | 1,092  |          
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|Net loss                                   |                                                         | $                           | (7,009 | )         |   | $    | (4,629 | )         |   | $ | (3,892 | )        
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|Net loss per common share                  |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|                                           | Basic                                                   |                             | $      | (0.90     | ) |      | $      | (0.70     | ) |   | $      | (0.65     | )
|                                           | Diluted                                                 |                             | $      | (0.90     | ) |      | $      | (0.70     | ) |   | $      | (0.65     | )
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|Weighted average common shares outstanding |                                                         |                             |        |           |   |      |        |           |   |   |        |          
|                                           | Basic                                                   |                             |        | 7,745,000 |   |      |        | 6,629,000 |   |   |        | 5,992,000 |  
|                                           | Diluted                                                 |                             |        | 7,745,000 |   |      |        | 6,629,000 |   |   |        | 5,992,000 |  
|                                           |                                                         |                             |        |           |   |      |        |           |   |   |        |          

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

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HEI, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN
SHAREHOLDERS EQUITY

|                         |                                                                          |                                   |           |           |  |            |     |              |  |            |        |        |   |   |         |        |   |   |        |     |  |   |        |        |  
|------------------------ | ------------------------------------------------------------------------ | --------------------------------- | --------- | --------- |  | ---------- | --- | ------------ |  | ---------- | ------ | ------ | - | - | ------- | ------ | - | - | ------ | --- |  | - | ------ | ------ | -
|                         |                                                                          |                                   |           |           |  |            |     | Retained     |  |            |        |       
|                         |                                                                          | Common                            |           |           |  | Additional |     | Earnings     |  |            |        |       
|                         |                                                                          | Stock Shares                      |           | Common    |  | Paid-In    |     | (accumulated |  | Notes      |        | Total 
|                         |                                                                          | Outstanding                       |           | Stock     |  | Capital    |     | deficit)     |  | Receivable |        | Equity
|                         |                                                                          |                                   |           |           |  |            |     |              |  |            |        |       
|                         |                                                                          |                                  
|                         |                                                                          | (In thousands)                   
|                         |                                                                          |                                  
|                         |                                                                          | (In thousands, except share data)
|Balance, August 31, 2001 |                                                                          |                                   | 5,957,000 |           |  | $          | 298 |              |  | $          | 16,310 |        |   | $ | 3,078   |        |   | $ | (1,266 | )   |  | $ | 18,420 |       
|                         | Net loss                                                                 |                                   |           |          |  |            |     |             |  |            |        |       |   |   |         | (3,892 | ) |   |        |    |  |   |        | (3,892 | )
|                         | Tax valuation allowance adjustments                                      |                                   |           |          |  |            |     |             |  |            |        | (233   | ) |   |         |       |   |   |        |    |  |   |        | (233   | )
|                         | Issuance of common shares under stock benefit
    plans and option plans |                                   |           | 55,000    |  |            |     | 3            |  |            |        | 272    |   |   |         |       |   |   |        |    |  |   |        | 275    |  
|                         |                                                                          |                                   |           |           |  |            |     |              |  |            |        |        |   |   |         |        |   |   |        |     |  |   |        |       
|Balance, August 31, 2002 |                                                                          |                                   | 6,012,000 |           |  |            | 301 |              |  |            | 16,349 |        |   |   | (814    | )      |   |   | (1,266 | )   |  |   | 14,570 |       
|                         |                                                                          |                                   |           |           |  |            |     |              |  |            |        |        |   |   |         |        |   |   |        |     |  |   |        |       
|                         | Net loss                                                                 |                                   |           |          |  |            |     |             |  |            |        |       |   |   |         | (4,629 | ) |   |        |    |  |   |        | (4,629 | )
|                         | Note receivable write off                                                |                                   |           |          |  |            |     |             |  |            |        |       |   |   |         |       |   |   |        | 587 |  |   |        | 587    |  
|                         | Payments on officers loans                                               |                                   |           |          |  |            |     |             |  |            |        |       |   |   |         |       |   |   |        | 10  |  |   |        | 10     |  
|                         | Issuance of common shares  CMED                                         |                                   |           | 1,000,000 |  |            |     | 50           |  |            |        | 2,550  |   |   |         |       |   |   |        |    |  |   |        | 2,600  |  
|                         | Issuance of common shares under stock benefit
    plans and option plans |                                   |           | 34,000    |  |            |     | 1            |  |            |        | 52     |   |   |         |       |   |   |        |    |  |   |        | 53     |  
|                         |                                                                          |                                   |           |           |  |            |     |              |  |            |        |        |   |   |         |        |   |   |        |     |  |   |        |       
|Balance, August 31, 2003 |                                                                          |                                   | 7,046,000 |           |  |            | 352 |              |  |            | 18,951 |        |   |   | (5,443  | )      |   |   | (669   | )   |  |   | 13,191 |       
|                         |                                                                          |                                   |           |           |  |            |     |              |  |            |        |        |   |   |         |        |   |   |        |     |  |   |        |       
|                         | Net loss                                                                 |                                   |           |          |  |            |     |             |  |            |        |       |   |   |         | (7,009 | ) |   |        |    |  |   |        | (7,009 | )
|                         | Note receivable write off                                                |                                   |           |          |  |            |     |             |  |            |        |       |   |   |         |       |   |   |        | 64  |  |   |        | 64     |  
|                         | Payments on officers loans                                               |                                   |           |          |  |            |     |             |  |            |        |       |   |   |         |       |   |   |        | 170 |  |   |        | 170    |  
|                         | Issuance of common shares in lieu of
    interest  Whitebox             |                                   |           | 48,000    |  |            |     | 3            |  |            |        | 164    |   |   |         |       |   |   |        |    |  |   |        | 167    |  
|                         | Private equity placement                                                 |                                   |           | 1,180,000 |  |            |     | 59           |  |            |        | 3,180  |   |   |         |       |   |   |        |    |  |   |        | 3,239  |  
|                         | Issuance of common shares under stock benefit
    plans and option plans |                                   |           | 83,000    |  |            |     | 4            |  |            |        | 131    |   |   |         |       |   |   |        |    |  |   |        | 135    |  
|                         |                                                                          |                                   |           |           |  |            |     |              |  |            |        |        |   |   |         |        |   |   |        |     |  |   |        |       
|Balance, August 31, 2004 |                                                                          |                                   | 8,357,000 |           |  | $          | 418 |              |  | $          | 22,426 |        |   | $ | (12,452 | )      |   | $ | (435   | )   |  | $ | 9,957  |       
|                         |                                                                          |                                   |           |           |  |            |     |              |  |            |        |        |   |   |         |        |   |   |        |     |  |   |        |       

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

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HEI, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |        |  
|------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------- | ---------------------- | ------ | ------ | - | ---- | ------ | ------ | - | - | ------ | ------ | -
|                                                                                                                                      |                                                             |                       
|                                                                                                                                      |                                                             | Years Ended August 31,
|                                                                                                                                      |                                                             |                       
|                                                                                                                                      |                                                             | 2004                   |        | 2003   |   | 2002
|                                                                                                                                      |                                                             |                        |        |        |   |     
|                                                                                                                                      |                                                             |                       
|                                                                                                                                      |                                                             | (In thousands)        
|Cash flow from operating activities:                                                                                                  |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|                                                                                                                                      | Net loss                                                    |                        | $      | (7,009 | ) |      | $      | (4,629 | ) |   | $      | (3,892 | )
|                                                                                                                                      | Depreciation and amortization                               |                        |        | 2,862  |   |      |        | 3,295  |   |   |        | 2,909  |  
|                                                                                                                                      | Accounts receivable allowance                               |                        |        | 29     |   |      |        | 7      |   |   |        | (186   | )
|                                                                                                                                      | Reserve for note receivable from former officers            |                        |        | 64     |   |      |        | 597    |   |   |        |       |  
|                                                                                                                                      | Asset impairment charges                                    |                        |        | 465    |   |      |        | 331    |   |   |        |       |  
|                                                                                                                                      | Deferred income tax expense                                 |                        |        |       |   |      |        |       |   |   |        | 1,609  |  
|                                                                                                                                      | Gain on prepayment of promissory note                       |                        |        | (472   | ) |      |        |       |   |   |        |       |  
|                                                                                                                                      | Loss on disposal of property and equipment and
    other    |                        |        |       |   |      |        | 69     |   |   |        |       |  
|Changes in operating assets and liabilities, net
    of impacts of acquisition:                                                       |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|                                                                                                                                      | Restricted cash related to deferred litigation
    recovery |                        |        | (481   | ) |      |        |       |   |   |        |       |  
|                                                                                                                                      | Accounts receivable                                         |                        |        | (485   | ) |      |        | (2,488 | ) |   |        | 1,270  |  
|                                                                                                                                      | Inventories                                                 |                        |        | 77     |   |      |        | 581    |   |   |        | 257    |  
|                                                                                                                                      | Other current assets                                        |                        |        | (836   | ) |      |        | (81    | ) |   |        | (110   | )
|                                                                                                                                      | Accounts payable                                            |                        |        | 1,712  |   |      |        | 2,136  |   |   |        | (97    | )
|                                                                                                                                      | Accrued liabilities                                         |                        |        | 137    |   |      |        | 504    |   |   |        | (683   | )
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Net cash flow provided by (used in) operating
    activities                                                                          |                                                             |                        | (3,937 | )      |   |      | 322    |        |   |   | 1,077  |       
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Cash flow from investing activities:                                                                                                  |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|                                                                                                                                      | Additions to property and equipment                         |                        |        | (743   | ) |      |        | (442   | ) |   |        | (2,291 | )
|                                                                                                                                      | Proceeds from the sale of assets                            |                        |        | 25     |   |      |        |       |   |   |        |       |  
|                                                                                                                                      | Additions to patents                                        |                        |        | (84    | ) |      |        | (138   | ) |   |        | (132   | )
|                                                                                                                                      | AMO acquisition costs paid                                  |                        |        |       |   |      |        | (1,486 | ) |   |        |       |  
|                                                                                                                                      | Cash acquired from CMED                                     |                        |        |       |   |      |        | 1,215  |   |   |        |       |  
|                                                                                                                                      | Proceeds from the sale of technology                        |                        |        | 323    |   |      |        |       |   |   |        |       |  
|                                                                                                                                      | Other long-term assets                                      |                        |        |       |   |      |        | 217    |   |   |        |       |  
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Net cash flow used in investing activities                                                                                            |                                                             |                        | (479   | )      |   |      | (634   | )      |   |   | (2,423 | )     
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Cash flow from financing activities:                                                                                                  |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|                                                                                                                                      | Issuance of common stock under stock plans                  |                        |        | 135    |   |      |        | 53     |   |   |        | 275    |  
|                                                                                                                                      | Proceeds from private placement                             |                        |        | 3,239  |   |      |        |       |   |   |        |       |  
|                                                                                                                                      | Officer note repayment                                      |                        |        | 170    |   |      |        |       |   |   |        |       |  
|                                                                                                                                      | Proceeds from long-term debt                                |                        |        | 2,282  |   |      |        | 2,804  |   |   |        |       |  
|                                                                                                                                      | Repayments of long-term debt                                |                        |        | (2,784 | ) |      |        | (3,906 | ) |   |        | (1,499 | )
|                                                                                                                                      | Deferred financing fees                                     |                        |        | (48    | ) |      |        | (106   | ) |   |        | (30    | )
|                                                                                                                                      | Decrease (increase) in restricted cash                      |                        |        |       |   |      |        | 1,000  |   |   |        | (1,000 | )
|                                                                                                                                      | Net borrowings on (repayments of) line of credit            |                        |        | 820    |   |      |        | (1,099 | ) |   |        | 1,579  |  
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Net cash flow provided by (used in) financing
    activities                                                                          |                                                             |                        | 3,810  |        |   |      | (1,254 | )      |   |   | (675   | )     
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Net decrease in cash and cash equivalents                                                                                             |                                                             |                        | (606   | )      |   |      | (1,566 | )      |   |   | (2,021 | )     
|Cash and cash equivalents, beginning of year                                                                                          |                                                             |                        | 806    |        |   |      | 2,372  |        |   |   | 4,393  |       
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Cash and cash equivalents, end of year                                                                                                |                                                             | $                      | 200    |        |   | $    | 806    |        |   | $ | 2,372  |       
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Supplemental disclosures of cash flow
    information:                                                                                |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Interest paid                                                                                                                         |                                                             | $                      | 364    |        |   | $    | 328    |        |   | $ | 395    |       
|Income taxes paid (received)                                                                                                          |                                                             |                        | 6      |        |   |      | (21    | )      |   |   | (351   | )     
|                                                                                                                                      |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|Supplemental disclosures of non-cash
    financing and investing activities:                                                          |                                                             |                        |        |        |   |      |        |        |   |   |        |       
|In 2004, the Company issued common shares for
    repayment of Whitebox interest payable valued at $167.                             
|In 2004, the Company acquired fixed assets under
    capital leases at $34.                                                          
|In connection with the acquisition of AMO, the
    Company issued one million shares of its common stock, valued at
    $2.9 million.

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

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HEI, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

(Amounts in thousands except share and per
share data)


Note 1



| |         
| | --------
| | Overview

HEI, Inc. and subsidiaries are referred to herein
as HEI, the Company, us,
we or our, unless the context indicates
otherwise. All dollar amounts are in thousands of US dollars
except for per share amounts. We provide a comprehensive range
of engineering, product design, automation and test,
manufacturing, distribution, and fulfillment services and
solutions to our customers in the hearing, medical device,
medical equipment, communications, computing and industrial
equipment markets. We provide these services and solutions on a
global basis through four integrated facilities in North
America. These services and solutions support our
customers products from initial product development and
design through manufacturing to worldwide distribution and
aftermarket support. We leverage our various technology
platforms to provide bundled solutions to the markets served.
Our current focus is on managing costs and integration of our
business operating units.



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

Principles of
Consolidation.The consolidated
financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All significant inter-company
transactions and balances have been eliminated in consolidation.

Revenue Recognition.Revenue for manufacturing and assembly contracts is recognized
upon shipment when the risk and rewards of ownership have passed
to the customer without special acceptance protocols or payment
contingencies. We have a number of customer arrangements in
which we retain ownership of inventory until customer receipt or
customer acceptance, and in one instance until the customer
pulls inventory into production at its offshore facility.
Revenue is deferred for these arrangements until the risks and
rewards of ownership pass to the customer upon receipt or
acceptance. Our Advanced Medical Operations (AMO)
provides service contracts for some of its products. Billings
for services contracts are based on published renewal rates and
revenue is recognized on a straight-line basis over the service
period.

AMOs development contracts are discrete
time and materials projects that generally do not involve
separate deliverables. Development contract revenue is
recognized ratably as development activities occur based on
contractual per hour and material reimbursement rates.
Development contracts are an interactive process with customers
as different design and functionality is contemplated during the
design phase. Upon reaching the contractual billing maximums, we
defer revenue until contract extensions or purchase orders are
received from customers. We occasionally have contractual
arrangements in which part or all of the payment or billing is
contingent upon achieving milestones or customer acceptance. For
those contracts we evaluate whether the contract should be
accounted using the completed contract method, as the term of
the arrangement is short-term, or using the percentage of
completion method for longer-term contracts.

Cash Equivalents.The Company considers its investments in all highly liquid debt
instruments with original maturities of three months or less at
date of purchase to be cash equivalents.

Inventories.Inventories are stated at the lower of cost or market and
include materials, labor, and overhead costs. The majority of
the inventory is purchased based upon contractual forecasts and
customer POs, in which case excess or obsolete inventory is
generally the customers responsibility.

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

38



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 is removed from the related accounts, and
any resulting gain or loss is credited or charged to operations.

Intangible Assets.Intangible assets are related to the acquisition of our AMO and
are amortized on a straight-line basis over periods ranging from
three to four years.

Patents.External
costs associated with patents are capitalized and amortized over
60 months or the remaining life of the patent, whichever is
shorter.

Impairment of Notes
Receivable.The Company routinely
performs an analysis as to the probability that the receivable
is collectable. A note receivable is impaired when, based on
current information and events, it is probable that the Company
will be unable to collect all amounts due according to the
contractual terms of the note receivable agreement including
scheduled interest payments. When a note receivable is impaired
we measure impairment based on the present value of expected
future cash flows discounted at the note receivable effective
interest rate, the Company may measure impairment based on a
note receivables observable market price, or the fair value of
the collateral if the note receivable is collateral dependent.
Regardless of the measurement method, we shall measure
impairment based on the fair value of the collateral when we
determine that foreclosure is probable. A note receivable is
collateral dependent if the repayment of the note is expected to
be provided solely by the underlying collateral. We may choose a
measurement method on a note-by-note basis. When an impairment
is recognized a reserve is created for note losses.

Impairment of Long-lived and Intangible
Assets.We continually evaluate
whether events and circumstances have occurred that indicate the
remaining estimated useful life of long-lived assets may warrant
revision, or that the remaining balance of these assets may not
be recoverable. We evaluate the recoverability of our long-lived
assets in accordance with Statement of Financial Accounting
Standards (SFAS) No. 144 Accounting for
the Impairment or Disposal of Long-Lived Assets. When
deemed necessary, we complete this evaluation by comparing the
carrying amount of the assets against the estimated undiscounted
future cash flows associated with them. If such evaluations
indicate that the future undiscounted cash flows of long-lived
assets are not sufficient to recover the carrying value of such
assets, the assets are adjusted to their estimated fair values.
The Company assesses the impairment of its manufacturing
equipment at least annually, or whenever events or changes in
circumstances indicate that the carrying value may not be
recoverable. Factors considered important which could trigger an
impairment review, and potentially an impairment charge, include
the following:



| |   |                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Significant underperformance relative to
    historical or projected future operating results;                                                              
|
| |  | Significant changes in the manner of use of the
    acquired assets or the Companys overall business strategy;                                             
|
| |  | Significant negative market or economic
    trends; and                                                                                                     
|
| |  | Significant decline in the Companys stock
    price for a sustained period changing the Companys market
    capitalization relative to its net book value;

Based on the Companys evaluation the
historical losses for the assets in the Microelectronics group
created a trigger for further analysis. During Fiscal 2004 and
2003, we recorded asset impairment charges of $465 and $331,
respectively. Asset impairment evaluations are by nature highly
subjective.

Research, Development and
Engineering.The Company expenses all
engineering and development costs as incurred.

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

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HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 amounts more
likely than not to be realized. Income tax expense (benefit) is
the tax payable (receivable) for the period and the change
during the period in deferred income tax assets and liabilities.

Stock-based
Compensation.We apply the
intrinsic-value method prescribed in Accounting Principles Board
(APB) Opinion No. 25, Accounting for
Stock Issued to Employees, to account for the issuance of
stock incentives to employees and directors. No compensation
expense related to employees and directors stock
incentives has been recognized in the financial statements, as
all options granted under stock incentive plans had an exercise
price equal to the market value of the underlying common stock
on the date of grant. Had we applied the fair value recognition
provisions of SFAS No. 123, Accounting for
Stock-Based Compensation, to stock based employee
compensation, our net loss per share would have increased to the
pro forma amounts indicated below:

|                                                                                                                      |  |                               |        |      |  |      |        |   |  |   |        |  
|--------------------------------------------------------------------------------------------------------------------- |  | ----------------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                                                                                      |  |                              
|                                                                                                                      |  | Fiscal Years Ended August 31,
|                                                                                                                      |  |                              
|                                                                                                                      |  | 2004                          |        | 2003 |  | 2002
|                                                                                                                      |  |                               |        |      |  |     
|Net loss as reported                                                                                                  |  | $                             | (7,009 | )    |  | $    | (4,629 | ) |  | $ | (3,892 | )
|Add: Stock-based employee compensation included
    in reported net loss, net of related tax effects                  |  |                               |       |      |  |      |       |   |  |   |       |  
|Deduct: Total stock-based employee compensation
    (expense determined under fair value based method for all awards) |  |                               | (1,940 | )    |  |      | (2,170 | ) |  |   | (2,197 | )
|                                                                                                                      |  |                               |        |      |  |      |        |   |  |   |        |  
|Net loss pro forma                                                                                                    |  | $                             | (8,949 | )    |  | $    | (6,799 | ) |  | $ | (6,089 | )
|                                                                                                                      |  |                               |        |      |  |      |        |   |  |   |        |  
|Basic and diluted net loss per share as reported                                                                      |  | $                             | (0.90  | )    |  | $    | (0.70  | ) |  | $ | (0.65  | )
|Stock-based compensation expense                                                                                      |  | $                             | (0.26  | )    |  | $    | (0.33  | ) |  | $ | (0.37  | )
|                                                                                                                      |  |                               |        |      |  |      |        |   |  |   |        |  
|Basic and diluted net loss per share pro forma                                                                        |  | $                             | (1.16  | )    |  | $    | (1.03  | ) |  | $ | (1.02  | )
|                                                                                                                      |  |                               |        |      |  |      |        |   |  |   |        |  

Customer Deposits.Customer deposits result from cash received in advance of
manufacturing services being performed.

Net Loss Per Common
Share.Basic earnings loss per share
(EPS) is computed by dividing net loss by the
weighted average number of common shares outstanding during each
period. Diluted earnings per share are computed by dividing net
income by the weighted average number of common shares
outstanding assuming the exercise of dilutive stock options and
warrants. The dilutive effect of the stock options and warrants
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 and warrants are antidilutive 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 Companys
borrowings outstanding approximate their carrying values based
upon current market rates of interest.

40



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

Recent Accounting
Pronouncements.In November 2002,
Emerging Issues Task Force (EITF) finalized its
consensus on EITF Issue 00-21, Revenue Arrangements
with Multiple Deliverables, which provides guidance on the
timing of revenue recognition for sales undertaking to deliver
more that one product or service. The Company was required to
adopt EITF Issue 00-21 on transactions occurring after
September 1, 2003. The adoption of EITF 00-21 did not
have a material effect on our financial statements for the
fiscal year ending August 31, 2004.

On May 15, 2003, SFAS No. 150,
Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity was issued.
The Statement requires issuers to classify as liabilities (or
assets in some circumstance) three classes of freestanding
financial instruments that embody obligations for the issuer.
Generally, the Statement is effective for financial instruments
entered into or modified after May 31, 2003, and is
otherwise effective at the beginning of the first interim period
beginning after June 15, 2003. We adopted the provisions of
the Statement on October 1, 2003. The adoption of
SFAS No. 150 did not have an impact on the
Companys financial statements.

On November 24, 2004,
SFAS No. 151, Inventory Costs, an amendment of
ARB No. 43, Chapter 4 was issued. The statement
amends the guidance in ARB No. 43, Chapter 4, to
clarify the accounting for abnormal amounts of idle facility
expense, freight, handling costs, and wasted material
(spoilage). We are required to adopt this statement in Fiscal
2006. We have not quantified the potential effect of adopting
this statement.

On December 16, 2004, SFAS No. 123
(revised 2004), Share-Based Payment was issued. This
statement replaces SFAS No. 123, Accounting for
Stock-Based Compensation, and supersedes APB Opinion
No. 25, Accounting for Stock Issued to
Employees. This statement requires that the compensation
cost relating to share-based payment transactions be recognized
in financial statements. We are required to adopt this statement
in Fiscal 2006. We have not quantified the potential effect of
adopting this statement.

Note 2



| |          
| | ---------
| | Liquidity

The accompanying consolidated financial
statements have been prepared assuming that we will continue as
a going concern, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of
business. We incurred net losses of $7,009, $4,629 and $3,892,
respectively, for Fiscal 2004, Fiscal 2003 and Fiscal 2002 and
used $3,937 in operating activities in Fiscal 2004.

We have historically financed our operations
through the public and private sale of equity securities, bank
borrowings, operating equipment leases and cash generated by
operations. Significant financial restructuring continued during
Fiscal 2004, transforming our capital structure to a lower
interest rate and less restrictive structure. On
October 29, 2003 we completed the funding of two separate
loans in the aggregate amount of $2,350 under new Term Credit
Facilities with Commerce Bank, a Minnesota state banking
corporation, and its affiliate, Commerce Financial Group, a
Minnesota corporation. These loans provided us with the
necessary resources to prepay the CMED subordinated promissory
note held by Whitebox (see Note 7  Long-Term
Debt  to our Consolidated Financial Statements). The
terms of the new loans originally had an average interest rate
of 7.75% and after the waiver and amendments dated
November 30, 2004, will have an average interest rate of
8.63% commencing March 1, 2005, as compared to 12.00% for
the retired debt. Throughout Fiscal 2004, we recovered
approximately $1,748 against the total judgment of $2,255
against our former Chief Executive Officer, President and
Chairman (see Note 13  Notes Receivable and
Transactions with Former CEO  to our Consolidated
Financial Statements). On February 13, 2004, we sold
1,180,000 shares of our

41



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HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

common stock for gross proceeds of
$3,540 net of transaction costs of $301 (see
Note  12 Private Placement of Common
Stock  to our Consolidated Financial Statements).

At August 31, 2004, our sources of liquidity
consisted of $200 of cash and cash equivalents, $481 of
restricted cash, which restrictions lapse in 2005, and our
Credit Agreement, which was due to expire in January 2005. On
December 7, 2004, the Credit Agreement was extended to
January 1, 2006 and our borrowing capacity was increased
from $3,000 to $4,000, subject to availability based on accounts
receivable. On January 12, 2005, the Credit Agreement was
amended to increase our borrowing capacity from $4,000 to
$5,000, subject to availability based on accounts receivable.
There was $1,310 outstanding debt under the Credit Agreement at
August 31, 2004, and $1,809 at December 31, 2004. Our
liquidity is affected by many factors, some of which are based
on the normal ongoing operations of our business, and the most
significant of which include the timing of the collection of
receivables, the level of inventories and capital expenditures
and maintaining of debt compliance. The losses due to the
operational problems encountered throughout Fiscal 2004 strained
our cash flows and consumed much of the additional funds raised
in the year including the proceeds from our private placement of
common stock and the collection of monies from the judgments
against our former Chief Executive Officer, President and
Chairman. We have taken various actions operationally in an
effort to substantially reduce our losses or to return to
profitability in Fiscal 2005 including, but not limited to,
production improvement initiatives and continuing progress in
understanding key drivers via systems upgrades that will improve
management decision making. In addition to the operational
improvements, we continue to scrutinize our cost structure for
savings long with our efforts to reduce the cost of our Boulder
facility by subletting of the vacant space. In October 2004, we
entered into a new lease arrangement for our Boulder facility
which is expected to reduce lease payments approximately $500
per year. In the event cash flows are not sufficient to fund
operations at the present level measures can be taken to reduce
the expenditure levels including but not limited to reduction of
spending for research and development, elimination of budgeted
raises, and reduction of non-strategic employees. Our lending
arrangements contain debt covenants, several of which we did not
maintain in Fiscal 2004 and early Fiscal 2005. These covenant
violations and debt amendments are fully described under the
caption Term-Debt. We do not forsee any violations
of debt agreements, as amended, for the remainder of Fiscal
2005. We will be required to maintain a debt service coverage
ratio of 1.2 to 1 beginning the second quarter ended
February 28, 2006.

During Fiscal 2005, we intend to spend
approximately $900 for manufacturing equipment, extension of the
SAP Software Solution to our AMO, and to make minor facility
improvements. These additions, if made, are expected to increase
efficiency through the further integration of the Boulder
operations and increase manufacturing capacity to meet
anticipated production requirements and add technological
capabilities. It is expected that these expenditures will be
funded from operations, existing cash and cash equivalents and
available debt financing for the next 12 months. In the
event there is insufficient capital fund for this spending it
will be deferred into the future which may impact our ability to
integrate the operations of all facilities and may prevent us
from increasing manufacturing capacity.

Management believes that, as a result of the
financial restructuring actions it has taken in Fiscal 2004 to
reduce cash expenditures, the continuing efforts to increase
revenues from continuing customers and to generate new customers
in various market sectors, and the extension and increase of our
Credit Agreement, we will meet our operational working capital
and investment requirements for the next 12 months.

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HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 3



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

The following provides additional information
concerning selected consolidated balance sheet accounts at
August 31, 2004 and 2003:

|                                  |                                                                  |           |       |       |  |   |       |       | 
|--------------------------------- | ---------------------------------------------------------------- | --------- | ----- | ----- |  | - | ----- | ----- | 
|                                  |                                                                  |          
|                                  |                                                                  | August 31
|                                  |                                                                  |          
|                                  |                                                                  | 2004      |       | 2003 
|                                  |                                                                  |           |       |      
|Inventories:                      |                                                                  |           |       |       |  |   |       |      
|                                  | Purchased parts                                                  |           | $     | 4,673 |  |   | $     | 4,297 | 
|                                  | Work in process                                                  |           |       | 789   |  |   |       | 958   | 
|                                  | Finished goods                                                   |           |       | 1,325 |  |   |       | 1,609 | 
|                                  |                                                                  |           |       |       |  |   |       |      
|                                  |                                                                  | $         | 6,787 |       |  | $ | 6,864 |      
|                                  |                                                                  |           |       |       |  |   |       |      
|Accrued liabilities:              |                                                                  |           |       |       |  |   |       |      
|                                  | Employee related costs                                           |           | $     | 1,474 |  |   | $     | 1,085 | 
|                                  | Deferred revenue                                                 |           |       | 804   |  |   |       | 498   | 
|                                  | Contractual manufacturing obligations                            |           |       |      |  |   |       | 498   | 
|                                  | Customer deposits                                                |           |       | 418   |  |   |       | 371   | 
|                                  | Current maturities of long-term liabilities                      |           |       | 805   |  |   |       | 741   | 
|                                  | Interest                                                         |           |       |      |  |   |       | 156   | 
|                                  | Warranty reserve                                                 |           |       | 139   |  |   |       | 122   | 
|                                  | Other accrued liabilities                                        |           |       | 1,029 |  |   |       | 825   | 
|                                  |                                                                  |           |       |       |  |   |       |      
|                                  |                                                                  | $         | 4,669 |       |  | $ | 3,798 |      
|                                  |                                                                  |           |       |       |  |   |       |      
|Other long-term liabilities:      |                                                                  |           |       |       |  |   |       |      
|                                  | Remaining lease obligation, less estimated
    sublease proceeds |           | $     | 1,471 |  |   | $     | 2,183 | 
|                                  | Unfavorable operating lease, net (see
    Note 17)               |           |       | 611   |  |   |       | 610   | 
|                                  | Other non-current liabilities                                    |           |       |      |  |   |       | 69    | 
|                                  |                                                                  |           |       |       |  |   |       |      
|Total                             |                                                                  | $         | 2,082 |       |  | $ | 2,862 |      
|Less current maturities           |                                                                  |           | 805   |       |  |   | 741   |      
|                                  |                                                                  |           |       |       |  |   |       |      
|Total other long-term liabilities |                                                                  | $         | 1,277 |       |  | $ | 2,121 |      
|                                  |                                                                  |           |       |       |  |   |       |      

43



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HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 4



| |                     
| | --------------------
| | Warranty Obligations

Sales of our products are subject to limited
warranty guarantees that typically extend for a period of twelve
months from the date of manufacture. Warranty terms are included
in customer contracts under which we are obligated to repair or
replace any components or assemblies it deems defective due to
workmanship or materials. We do, however, reserve the right to
reject warranty claims where we determine that failure is due to
normal wear, customer modifications, improper maintenance, or
misuse. Warranty provisions are based on an estimated returns
and warranty expenses applied to current period revenue and
historical warranty incidence over the preceding twelve-month
period. Both the experience and the warranty liability are
evaluated on an ongoing basis for adequacy. The following is a
roll forward of the Companys product warranty accrual for
each of the fiscal years in the three-year period ending
August 31, 2004:

|            |  |                   |     |            |  |        |     |             |  |   |     |  |  |   |     | 
|----------- |  | ----------------- | --- | ---------- |  | ------ | --- | ----------- |  | - | --- |  |  | - | --- | 
|            |  | Balance at        |     |            |  |        |     | Balance at 
|            |  | Beginning of Year |     | Provisions |  | Claims |     | End of Year
|            |  |                   |     |            |  |        |     |            
|Fiscal 2004 |  | $                 | 122 |            |  | $      | 133 |             |  | $ | 116 |  |  | $ | 139 | 
|Fiscal 2003 |  |                   | 200 |            |  |        | 168 |             |  |   | 246 |  |  |   | 122 | 
|Fiscal 2002 |  |                   | 40  |            |  |        | 275 |             |  |   | 115 |  |  |   | 200 | 

Note 5



| |                         
| | ------------------------
| | Asset Impairment Charges

Based on our evaluation the historical losses for
the assets in our Microelectronics group created a trigger for
further analysis. Our long-lived assets relating to our
Microelectronics Operations were valued by an independent third
party in order to further evaluate the recoverability of our
long-lived assets in accordance with SFAS No. 144
Accounting for Impairment of Disposal of Long-Lived
Assets. The independent valuation firms appraisal
resulted in an impairment charge of $465 in Fiscal 2004. The
asset impairment charges of $331 in Fiscal 2003, relate to the
impairment of equipment. The Fiscal 2003 asset impairment was
triggered in the fourth quarter of Fiscal 2003, by the
development of alternative testing that was more efficient than
what could be performed by our existing equipment and
notification in the same quarter that a large portion of a
significant customer program would be moved offshore in the
first quarter of Fiscal 2004.

Note 6



| |            
| | -----------
| | Acquisition

On January 24, 2003, we acquired certain
assets and assumed certain liabilities of CMEDs Colorado
operations (a business unit of CMED or our AMO) in a business
combination accounted for as a purchase. In exchange for certain
assets of our AMO, we issued one million shares of our common
stock, and assumed approximately $1,364 of liabilities related
to our AMO, as well as an operating lease and other contractual
commitments. Our consolidated financial statements include the
results of our AMO since January 24, 2003. Our purposes for
acquiring our AMO were to immediately gain access to the more
stable medical sector, to consolidate marketing and sales
efforts, and to expand our resources to become more full service
or one stop shop to our customers and target
markets. The design, development and manufacturing capabilities
for medical devices at our AMO, coupled with our microelectronic
design, development and manufacturing, improves our offerings to
the market to retain and gain customers.

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HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

During the second quarter ended February 28,
2004, we finalized our purchase price allocation for this
acquisition. Since our Annual Report of Form 10-K for the
fiscal year ended August 31, 2003, we have increased the
balance for our developed technologies by $323 related to
technology sold to MKS Instruments and we increased other
reserves by $160 related to legal costs. The net of these
adjustments resulted in a reduction of property and equipment of
$163. Below is a table of the acquisition consideration,
purchase price allocation and annual amortization of the
intangible assets acquired in the acquisition of our AMO:

|                           |                                      |        |       |        |  
|-------------------------- | ------------------------------------ | ------ | ----- | ------ | -
|                           |                                      | Amount
|                           |                                      |       
|Purchase price allocation: |                                      |        |       |       
|                           | Cash                                 |        | $     | 1,215  |  
|                           | Accounts receivable                  |        |       | 300    |  
|                           | Inventories                          |        |       | 3,418  |  
|                           | Property and equipment               |        |       | 1,348  |  
|                           | Prepaids, deposits and other assets  |        |       | 1,690  |  
|                           | Developed technology                 |        |       | 738    |  
|                           | Customer deposits and other reserves |        |       | (1,504 | )
|                           | Operating lease reserves             |        |       | (3,110 | )
|                           | Transaction costs                    |        |       | (1,495 | )
|                           |                                      |        |       |       
|                           |                                      | $      | 2,600 |       
|                           |                                      |        |       |       

The intangible asset value for the developed
technology of our AMO was determined utilizing discounted cash
flow analyses. The discounted cash flow analysis was based on
three to five-year cash flow projections. The expected future
cash flows attributable to developed technology was discounted
to present value at discount rates ranging from 23% to 40%,
taking into account risks related to the characteristics and
applications of the developed technology, our anticipated
courses of business activities, historical financial market
rates of return, and assessments of the stage of the
technologys life cycle. The developed technology had
reached technological feasibility and therefore was capitalized.

Amortization expense for developed technology for
the fiscal year ended August 31, 2004 and 2003, was $120
and $111, respectively. Amortization expense is estimated to be
$137 during our fiscal year ending August 31, 2005, $63
during our fiscal year ending August 31, 2006 and $4
thereafter.

The purchase allocation included an accrual of
$730 related to an unfavorable operating lease, $2,380 for
future estimated lease payments and a $760 accrual to fulfill
estimated contractual manufacturing obligations. The $2,380
accrued for estimated lease payments consists of $5,910 for
future lease obligations less estimated sublease payments of
$3,530 on 50,000 square feet of unoccupied space for which
we are in the process of reviewing alternative uses since we do
not intend to occupy. We have entered into an agency agreement
with Julien J. Studley, Inc., a national commercial real estate
services firm. Julien J. Studley has been engaged to assist us
in reducing our occupancy costs at this facility by representing
us in negotiations in the sub-leasing of the 50,000 square
foot addition, performing tenant representation with our
landlord, and assisting us in exploring other options related to
our future use of the Boulder facility. We are currently in
negotiations for the subleasing of the additional
50,000 square feet. The carrying value of long-lived assets
was reduced by a net of $3,914 by the allocation of negative
goodwill.

On October 31, 2003, we entered into an
agreement with MKS Instruments, Inc. (the MKS
Agreement), wherein MKS Instruments, Inc. purchased our
solid state radio frequency power amplifier technology. This
technology focused on Tesla 1.5 magnetic resonance imaging
(MRI) applications but could be scaled for use in
other MRI equipment. The value of the transaction was $423. The
first two milestone payments totaling $323 were paid by wire
transfer on October 31, 2003. The remaining $100 of

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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

revenue was billed on May 31, 2004 based on
our satisfaction the terms as set forth in the MKS Agreement
with the payment being received shortly thereafter. The
engineering development services were completed on May 31,
2004. The MKS Agreement contains a non-compete clause
restricting us from developing and selling competing solid state
amplifiers in the MRI market for a period of two years. This
non-compete clause does not restrict us from fulfilling our
traditional role as a contract manufacturer of third party solid
state MRI amplifiers.

On November 17, 2003, we entered into a
Settlement Agreement and Mutual Release (the BD Settlement
Agreement) with Becton Dickinson (BD),
pursuant to which, among other things, we agreed to pay to BD
the sum of $400. Such amount will be paid in five installments
of $80, of which the initial four were paid on November 17,
2003, February 20, 2004, April 21, 2004 and
July 26, 2004 and the remainder of which was paid on
August 25, 2004. Except for cash flow, the BD Settlement
Agreement did not impact our results of operations as we had
established a full reserve in the purchase accounting
adjustments for this matter. Our dispute was based on certain
equipment that was shipped to BD prior to the acquisition of our
AMO that did not meet the customers acceptance criteria.

The following table presents the unaudited pro
forma consolidated results of operations of the Company for the
fiscal years ended August 31, 2003 and 2002, as if the
acquisition of our AMO took place on October 1, 2001:

|                   |  |                    |        |      |  |   |         |  
|------------------ |  | ------------------ | ------ | ---- |  | - | ------- | -
|                   |  |                   
|                   |  | Fiscal Years Ended
|                   |  | August 31,        
|                   |  |                   
|                   |  | 2003               |        | 2002
|                   |  |                    |        |     
|Net sales          |  | $                  | 54,710 |      |  | $ | 74,804  |  
|Net loss           |  |                    | (6,096 | )    |  |   | (13,180 | )
|                   |  |                    |        |      |  |   |         |  
|Net loss per share |  | $                  | (0.31  | )    |  | $ | (0.69   | )
|                   |  |                    |        |      |  |   |         |  

As our AMO had a June 30 year-end and
the Company has an August 31 fiscal year-end, the pro forma
information reflects the combination of different periods for
the Company and our AMO. The twelve-month 2003 and 2002 pro
forma information includes unaudited results of operations for
the twelve-month periods ended August 31, 2003 and 2002,
respectively, for the Company and unaudited results of
operations for the twelve-month periods ended June 30, 2003
and 2002, for our AMO, respectively.

The unaudited pro forma amounts have been derived
by applying pro forma adjustments to the historical consolidated
financial information of the Company and our AMO. The unaudited
pro-forma results are for comparative purposes only and do not
necessarily reflect the results that would have been recorded
had the acquisition occurred at the beginning of the period
presented or the results which might occur in the future.

46



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 7



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

Long-term debt consists of the following:

|                                                                                                                                                                                                                                         |  |                   |       |      |  |   |       | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ----- | ---- |  | - | ----- | 
|                                                                                                                                                                                                                                         |  |                  
|                                                                                                                                                                                                                                         |  | Fiscal Year Ended
|                                                                                                                                                                                                                                         |  | August 31        
|                                                                                                                                                                                                                                         |  |                  
|                                                                                                                                                                                                                                         |  | 2004              |       | 2003
|                                                                                                                                                                                                                                         |  |                   |       |     
|Commerce Bank mortgage payable in monthly
    installments of principal and interest of $9 based on a
    twenty-year amortization with a final payment of approximately
    $980 due in November 2009; secured by our Victoria facility |  | $                 | 1,174 |      |  | $ |      | 
|Commerce Financial Group, Inc. equipment loan
    payable in fixed monthly principal and interest installments of
    $28 through September 2007; secured by our Victoria facility and
    equipment located at our Tempe facility       |  |                   | 916   |      |  |   |      | 
|Subordinated Promissory Note, paid in full in 2004                                                                                                                                                                                       |  |                   |      |      |  |   | 2,740 | 
|Capital lease obligation; secured with machinery
    and equipment                                                                                                                                                                       |  |                   | 34    |      |  |   |      | 
|Commercial loans payable in fixed monthly
    installments of $1 through May 2009; secured with certain
    machinery and equipment                                                                                                      |  |                   | 33    |      |  |   |      | 
|Commercial loans payable in fixed monthly
    installments of $12 through July 2005; secured with certain
    machinery and equipment                                                                                                    |  |                   | 79    |      |  |   | 162   | 
|Commercial loans payable in fixed monthly
    installments of $4 through May 2004; secured with certain
    machinery and equipment                                                                                                      |  |                   |      |      |  |   | 50    | 
|                                                                                                                                                                                                                                         |  |                   |       |      |  |   |       | 
|Total                                                                                                                                                                                                                                    |  |                   | 2,236 |      |  |   | 2,952 | 
|Less current maturities                                                                                                                                                                                                                  |  |                   | 403   |      |  |   | 397   | 
|                                                                                                                                                                                                                                         |  |                   |       |      |  |   |       | 
|Total long-term debt                                                                                                                                                                                                                     |  | $                 | 1,833 |      |  | $ | 2,555 | 
|                                                                                                                                                                                                                                         |  |                   |       |      |  |   |       | 



| |                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | During our fiscal years ended August 31,
    2004 and 2003, we have undertaken a number of activities to
    restructure our term-debt. The following is a summary of those
    transactions:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We originally issued Industrial Development
    Revenue Bonds (IDRBs) in April 1996 in connection
    with the construction of a new addition to our manufacturing
    facility in Victoria, Minnesota, and for the purchase of
    production equipment. On March 14, 2003, an aggregate of
    approximately $1,735 of debt proceeds from the Subordinated
    Promissory Note were used to fund the repayment of principal and
    interest on the IDRBs. We also used $845 of the proceeds from
    the Subordinated Promissory Note to retire our capital
    expenditure notes with LaSalle Business Credit LLC.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| | The Subordinated Promissory Note was funded by
    CMED at the time of our AMO acquisition in January 2003. On
    May 8, 2003 the Subordinated Promissory Note was sold by
    CMED to Whitebox Hedged High Yield Partners
    (Whitebox) for $1,820 and continued with the same
    terms as the original agreement with CMED until August 15,
    2003. To encourage early repayment, the terms of the
    Subordinated Promissory Note were modified on May 16, 2003
    and subsequently modified on September 12, 2003. On
    October 15, 2003, we prepaid the Subordinated Promissory
    Note for a discount on the principal amount outstanding of $360,
    the payment of accrued interest totaling $167 with 47,700
    unregistered common shares of HEI stock valued at $3.50 per
    share and forgiveness of interest from September 15, 2003
    through October 15, 2003. As a result of the prepayment of
    the Subordinated Promissory Note, the Company recognized a gain
    on the early extinguishment of the Subordinated Promissory Note
    totaling $472 during the first quarter of Fiscal 2004.
|
| | The funds to prepay the subordinated promissory
    note were obtained from two separate loans in the aggregate
    amount of $2,350 under new Term Loan Agreements with Commerce
    Bank, a Minnesota state                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

47



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | banking association, and its affiliate, Commerce
    Financial Group, Inc., a Minnesota corporation. The first note,
    with Commerce Bank, in the amount of $1,200 was executed on
    October 14, 2003. This note is secured by our Victoria,
    Minnesota facility. The term of the first note is six years. The
    original interest rate on this note was a nominal rate of
    6.50% per annum for the first three years, and thereafter
    the interest rate will be adjusted on the first date of the
    fourth loan year to a nominal rate per annum equal to the then
    Three Year Treasury Base Rate (as defined) plus 3.00%; provided,
    however, that in no event will the interest rate be less than
    the Prime Rate plus 1.0% per annum. Monthly payment of
    principal and interest will be based on a twenty-year
    amortization with a final payment of approximately $980 due on
    November 1, 2009. The second note, with Commerce Financial
    Group, Inc., in the amount of $1,150 was executed on
    October 28, 2003. The second note is secured by our
    Victoria facility and equipment located at our Tempe facility.
    The term of the second note is four years. The original interest
    rate on this note was of 8.975% per year through
    September 27, 2007. During the first quarter of Fiscal
    2005, we violated two covenants of these term loan agreements
    and were likely to be in violation of a third covenant as of the
    end of our second quarter ending February 28, 2005. As a
    result, on December 3, 2004, we entered into waiver and
    amendments with Commerce Bank and Commerce Financial Group,
    Inc., respectively, effective as of November 30, 2004, and
    additional waivers and amendments on December 29, 2004, in
    each case to address the actual and potential covenant
    violations. Additionally, the waiver and amendments on
    December 3, 2004 increased the interest rate to be paid
    under the Commerce Bank note beginning March 1, 2005, to
    and including October 31, 2006, from 6.5% to 7.5%, and
    increased the interest rate to be paid under the Commerce
    Financial Group, Inc. note beginning March 1, 2005, to and
    including September 28, 2007, from 8.975% to 9.975%.
    Monthly payments of principal and interest in the amount of $28
    are paid over a forty-eight month period beginning on
    October 28, 2003.

Principal maturities of long-term debt at
August 31, 2004, are as follows:

|                    |  |   |       | 
|------------------- |  | - | ----- | 
|Fiscal Years Ending |  |  
|August 31,          |  |  
|                    |  |  
|2005                |  | $ | 403   | 
|2006                |  |   | 341   | 
|2007                |  |   | 372   | 
|2008                |  |   | 81    | 
|2009                |  |   | 50    | 
|Thereafter          |  |   | 989   | 
|                    |  |   |       | 
|                    |  | $ | 2,236 | 
|                    |  |   |       | 

Note 8



| |               
| | --------------
| | Line of Credit

On May 29, 2003, we entered into an accounts
receivable agreement (the Credit Agreement) with
Beacon Bank of Shorewood, Minnesota for a period of twelve
months. On December 7, 2004, the Company extended the
Credit Agreement to January 1, 2006 and had the maximum
amount of credit increased to $4,000. On January 12, 2005,
the Credit Agreement was amended to increase our borrowing
capacity from $4,000 to $5,000, subject to availability based on
accounts receivable. The Credit Agreement is an accounts
receivable backed facility and is additionally secured by
inventory, intellectual property and other general intangibles.
The Credit Agreement is not subject to any restrictive financial
covenants. At year end we had a maximum of $3,000 available
under the Credit Agreement, with the actual borrowings based on
80% of eligible accounts receivable. The balance on the line of
credit was $1,310 and $490 as of August 31, 2004 and 2003,
respectively. The Credit Agreement bears an immediate processing
fee of 0.50% of each assigned amount, a daily per diem equal to
1/25% on any uncollected accounts receivable and a monthly
minimum of

48



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

$1.5 in processing fees for the first six months
the Credit Agreement is in place. Borrowings are reduced as
collections and payments are received into a lock box by the
bank. The effective interest rate based on our average DSO of
56 days would be 17.9% annualized. During the first quarter
of Fiscal 2005, we violated one covenant of the Credit Agreement
and were likely to be in violation of a second covenant. As a
result, on December 29, 2004, we entered into waivers and
amendments with Beacon Bank to address the actual and potential
covenant violations.

Note 9



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

Income tax expense (benefit) for the fiscal years
ended August 31, 2004, 2003 and 2002 consisted of the
following:

|                             |         |                              |   |      |  |      |     |     |   |   |       |      |  
|---------------------------- | ------- | ---------------------------- | - | ---- |  | ---- | --- | --- | - | - | ----- | ---- | -
|                             |         |                             
|                             |         | Fiscal Year Ended August 31,
|                             |         |                             
|                             |         | 2004                         |   | 2003 |  | 2002
|                             |         |                              |   |      |  |     
|                             |         |                             
|                             |         | (In thousands)              
|Current:                     |         |                              |   |      |  |      |     |     |   |   |       |     
|                             | Federal |                              | $ |     |  |      | $   | (21 | ) |   | $     | (459 | )
|                             | State   |                              |   |     |  |      |     |    |   |   |       | (58  | )
|Deferred                     |         |                              |  |      |  |      |    |     |   |   | 1,609 |     
|                             |         |                              |   |      |  |      |     |     |   |   |       |     
|Income tax expense (benefit) |         | $                            |  |      |  | $    | (21 | )   |   | $ | 1,092 |     
|                             |         |                              |   |      |  |      |     |     |   |   |       |     

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

|                                                  |  |                              |       |      |  |      |       |    |  |  |       |   
|------------------------------------------------- |  | ---------------------------- | ----- | ---- |  | ---- | ----- | -- |  |  | ----- | --
|                                                  |  |                             
|                                                  |  | Fiscal Year Ended August 31,
|                                                  |  |                             
|                                                  |  | 2004                         |       | 2003 |  | 2002
|                                                  |  |                              |       |      |  |     
|Federal statutory tax rate                        |  |                              | (34.0 | )%   |  |      | (34.0 | )% |  |  | (34.0 | )%
|State income tax rate (net of federal tax effect) |  |                              |      |      |  |      |      |    |  |  | 6.2   |   
|Reversal of reserve for contingencies             |  |                              |      |      |  |      |      |    |  |  | (14.0 | ) 
|Change in valuation allowance                     |  |                              | 34.0  |      |  |      | 33.0  |    |  |  | 77.5  |   
|Other                                             |  |                              |      |      |  |      | 1.1   |    |  |  | 3.3   |   
|                                                  |  |                              |       |      |  |      |       |    |  |  |       |   
|Effective tax rate                                |  |                              |      | %    |  |      | (0.1  | )% |  |  | 39.0  | % 
|                                                  |  |                              |       |      |  |      |       |    |  |  |       |   

The tax effects of temporary differences that
give rise to significant portions of the deferred tax assets and
liabilities at August 31, 2004 and 2003 are as follows:

|                               |                     |                |     |      |  |  |     |     | 
|------------------------------ | ------------------- | -------------- | --- | ---- |  |  | --- | --- | 
|                               |                     |               
|                               |                     | August 31     
|                               |                     |               
|                               |                     | 2004           |     | 2003
|                               |                     |                |     |     
|                               |                     |               
|                               |                     | (In thousands)
|Deferred tax assets (current): |                     |                |     |      |  |  |     |    
|                               | Receivables         |                | $   | 32   |  |  | $   | 34  | 
|                               | Inventories         |                |     | 524  |  |  |     | 340 | 
|                               | Accrued liabilities |                |     | 258  |  |  |     | 129 | 
|                               |                     |                |     |      |  |  |     |    
|                               |                     |                | 814 |      |  |  | 503 |    
|                               |                     |                |     |      |  |  |     |    

49



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                              |                                  |                |        |       |  |   |        |       | 
|--------------------------------------------- | -------------------------------- | -------------- | ------ | ----- |  | - | ------ | ----- | 
|                                              |                                  |               
|                                              |                                  | August 31     
|                                              |                                  |               
|                                              |                                  | 2004           |        | 2003 
|                                              |                                  |                |        |      
|                                              |                                  |               
|                                              |                                  | (In thousands)
|Deferred tax assets (long-term):              |                                  |                |        |       |  |   |        |      
|                                              | Net operating loss carry-forward |                |        | 6,961 |  |   |        | 5,546 | 
|                                              | Capital loss carry-forward       |                |        | 235   |  |   |        | 286   | 
|                                              | Licensing agreement reserve      |                |        | 196   |  |   |        | 196   | 
|                                              | Other                            |                |        | 293   |  |   |        | 16    | 
|                                              |                                  |                |        |       |  |   |        |      
|Gross deferred tax assets (long-term)         |                                  |                | 7,685  |       |  |   | 6,044  |      
|                                              |                                  |                |        |       |  |   |        |      
|Less: Deferred tax assets valuation allowance |                                  |                | (7,642 | )     |  |   | (5,405 | )    
|Net deferred tax assets (long-term)           |                                  |                | 43     |       |  |   | 639    |      
|                                              |                                  |                |        |       |  |   |        |      
|Deferred tax liabilities (long-term):         |                                  |                |        |       |  |   |        |      
|Property and equipment                        |                                  |                | (795   | )     |  |   | (1,040 | )    
|Patents                                       |                                  |                | (62    | )     |  |   | (102   | )    
|                                              |                                  |                |        |       |  |   |        |      
|Net deferred tax asset                        |                                  | $              |       |       |  | $ |       |      
|                                              |                                  |                |        |       |  |   |        |      

The Company has a federal net operating loss
carry-forward at August 31, 2004, of approximately $17,898,
which is available to reduce income taxes payable in future
years. If not used, this carry-forward will expire in years 2012
through 2024. Under the Tax Reform Act of 1986, the utilization
of this tax loss carry-forward may be limited as a result of
significant changes in ownership. In addition, the Company has a
capital loss carry-forward of $691 which is available to offset
any future capital gains. If not used, this carry-forward will
expire in 2007.

The valuation allowance for deferred tax assets
as of August 31, 2004, was $7,642 and as of August 31,
2003, was $5,405. The total valuation allowance for the fiscal
years ended August 31, 2004 and 2003, increased by $2,237
and $1,985, respectively. In assessing the recovery of the
deferred tax asset, management considers whether it is more
likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of
deferred tax assets is dependent upon the generation of future
taxable income in the periods in which those temporary
differences become deductible. Management considers the
scheduled reversals of future deferred tax liabilities,
projected future taxable income, and tax planning strategies in
making this assessment.

Note 10



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

1998 Plan.Under the
Companys 1998 Stock Option Plan (the 1998
Plan), a maximum of 1,650,000 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,
2004, the number of shares available for grant was 375,325.

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 closing market price of the common stock on the date of the
grant.

50



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 our fiscal years ended August 31, 2004, 2003, and
2002, 83,314, 34,035 and 20,271 shares at prices of $1.62,
$1.59 and $5.12, respectively, were purchased under the 1989
Plan in connection with the employee stock purchase plan. At
August 31, 2004, the number of shares available for grant
was 67,727.

Directors
Plan.During Fiscal 1999, the
shareholders approved the 1998 Stock Option Plan for
Non-employee Directors (the Directors Plan).
Under the Directors 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 each year upon adjournment of the annual
shareholders meeting 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, in the aggregate, were granted
annually to three non-employee directors at $3.40, $2.16 and
$5.95, during our fiscal years ended August 31, 2004, 2003
and 2002, respectively. At August 31, 2004, there were no
shares available for grant. An additional option to
purchase 10,000 shares were granted to a non-employee
director at $3.40 during our fiscal year ended August 31,
2004, from the 1998 Plan as the Directors Plan did not
have shares remaining to grant.

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

Summary of Activity.The following is a summary of all activity involving the above
stock option plans:

|                         |  |             |           |                  |  |   |        | 
|------------------------ |  | ----------- | --------- | ---------------- |  | - | ------ | 
|                         |  |             |           | Weighted Average
|                         |  | Options     |           | Exercise Price  
|                         |  | Outstanding |           | Per Share       
|                         |  |             |           |                 
|Balance, August 31, 2001 |  |             | 1,105,726 |                  |  | $ | 10.523 | 
|                         |  |             |           |                  |  |   |        | 
|Granted                  |  |             | 528,471   |                  |  |   | 6.529  | 
|Exercised                |  |             | (55,296   | )                |  |   | 4.977  | 
|Cancelled                |  |             | (86,376   | )                |  |   | 10.446 | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 2002 |  |             | 1,492,525 |                  |  |   | 9.305  | 
|                         |  |             |           |                  |  |   |        | 
|Granted                  |  |             | 519,035   |                  |  |   | 2.898  | 
|Exercised                |  |             | (34,035   | )                |  |   | 1.590  | 
|Cancelled                |  |             | (577,925  | )                |  |   | 9.431  | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 2003 |  |             | 1,399,600 |                  |  |   | 7.020  | 
|                         |  |             |           |                  |  |   |        | 
|Granted                  |  |             | 577,814   |                  |  |   | 2.771  | 
|Exercised                |  |             | (83,314   | )                |  |   | 1.620  | 
|Cancelled                |  |             | (448,000  | )                |  |   | 8.775  | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 2004 |  |             | 1,446,100 |                  |  |   | 5.045  | 
|                         |  |             |           |                  |  |   |        | 

51



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table summarizes information about
stock options outstanding as of August 31, 2004:

|                         |  |                     |           |                     |  |                  |       |           |  |                  |     |  |  |  |         |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | ---------------- | ----- | --------- |  | ---------------- | --- |  |  |  | ------- |  |  | - | ----- | 
|                         |  |                     |           |                    
|                         |  | Options Outstanding |           | Options Exercisable
|                         |  |                     |           |                    
|                         |  |                     |           | Weighted Average    |  |                 
|                         |  | Number of           |           | Weighted Average    |  | Remaining        |       | Number of |  | Weighted Average
|Range of Exercise Prices |  | Options             |           | Exercise Price      |  | Contractual Life |       | Options   |  | Exercise Price  
|                         |  |                     |           |                     |  |                  |       |           |  |                 
|$ 1.680-3.180            |  |                     | 552.500   |                     |  | $                | 2.23  |           |  |                  | 9.0 |  |  |  | 231,850 |  |  | $ | 1.30  | 
|$ 3.181-5.99             |  |                     | 556,050   |                     |  |                  | 4.29  |           |  |                  | 8.0 |  |  |  | 174,800 |  |  |   | 5.31  | 
|$ 6.00-9.99              |  |                     | 107,150   |                     |  |                  | 7.50  |           |  |                  | 7.2 |  |  |  | 51,663  |  |  |   | 7.33  | 
|$10.00-11.99             |  |                     | 83,750    |                     |  |                  | 10.76 |           |  |                  | 5.5 |  |  |  | 71,125  |  |  |   | 10.73 | 
|$12.00-14.99             |  |                     | 141,650   |                     |  |                  | 13.68 |           |  |                  | 6.1 |  |  |  | 63,675  |  |  |   | 13.55 | 
|$15.00-20.375            |  |                     | 5,000     |                     |  |                  | 20.38 |           |  |                  | 6.0 |  |  |  | 1,875   |  |  |   | 20.37 | 
|                         |  |                     |           |                     |  |                  |       |           |  |                  |     |  |  |  |         |  |  |   |       | 
|                         |  |                     | 1,446,100 |                     |  | $                | 5.045 |           |  |                  | 8.0 |  |  |  | 594,988 |  |  | $ | 5.854 | 
|                         |  |                     |           |                     |  |                  |       |           |  |                  |     |  |  |  |         |  |  |   |       | 

The weighted average grant-date fair value of
options granted during our fiscal years ended August 31,
2004, 2003 and 2002, was $1.96, $1.84 and $3.37, respectively.
The weighted average 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:

|                         |  |                               |                |      |  |      |                 |  |  |  |                | 
|------------------------ |  | ----------------------------- | -------------- | ---- |  | ---- | --------------- |  |  |  | -------------- | 
|                         |  |                              
|                         |  | Fiscal Years Ended August 31,
|                         |  |                              
|                         |  | 2004                          |                | 2003 |  | 2002
|                         |  |                               |                |      |  |     
|Risk-free interest rates |  |                               | 2.74% to 3.74% |      |  |      | 2.31% to 3.52%  |  |  |  | 3.97% to 4.93% | 
|Expected life            |  |                               | 5 to 10 years  |      |  |      | 7 to 8.5  years |  |  |  | 2 to 5 years   | 
|Volatility               |  |                               | 73%            |      |  |      | 73%             |  |  |  | 70%            | 
|Expected dividends       |  |                               | None           |      |  |      | None            |  |  |  | None           | 

Common Stock.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.

In February 2004, the Company issued 424,800
warrants in connection the private equity placement. The
warrants vested immediately at an exercise price of
$3.72 per share and expire five years from date of grant.

52



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 11



| |                                   
| | ----------------------------------
| | Net Loss Per Share
    Computation

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

|                                                          |  |                               |           |      |  |      |           |   |  |   |           |  
|--------------------------------------------------------- |  | ----------------------------- | --------- | ---- |  | ---- | --------- | - |  | - | --------- | -
|                                                          |  |                              
|                                                          |  | Fiscal Years Ended August 31,
|                                                          |  |                              
|                                                          |  | 2004                          |           | 2003 |  | 2002
|                                                          |  |                               |           |      |  |     
|Basic:                                                    |  |                               |           |      |  |      |           |   |  |   |           |  
|Net loss                                                  |  | $                             | (7,009    | )    |  | $    | (4,629    | ) |  | $ | (3,892    | )
|Net loss per share                                        |  | $                             | (0.90     | )    |  | $    | (0.70     | ) |  | $ | (0.65     | )
|Weighted average number of common shares
    outstanding  |  |                               | 7,745,000 |      |  |      | 6,629,000 |   |  |   | 5,922,000 |  
|Diluted:                                                  |  |                               |           |      |  |      |           |   |  |   |           |  
|Net loss                                                  |  | $                             | (7,009    | )    |  | $    | (4,629    | ) |  | $ | (3,892    | )
|Loss per share                                            |  | $                             | (0.90     | )    |  | $    | (0.70     | ) |  | $ | (0.65     | )
|Weighted average number of common shares
    outstanding  |  |                               | 7,745,000 |      |  |      | 6,629,000 |   |  |   | 5,992,000 |  
|Assumed conversion of stock options                       |  |                               |          |      |  |      |          |   |  |   |          |  
|                                                          |  |                               |           |      |  |      |           |   |  |   |           |  
|Weighted average common and assumed conversion
    shares |  |                               | 7,745,000 |      |  |      | 6,629,000 |   |  |   | 5,992,000 |  
|                                                          |  |                               |           |      |  |      |           |   |  |   |           |  

Approximately 1,918,400, 1,447,100 and
1,540,000 shares under stock options and warrants have been
excluded from the calculation of diluted net loss per common
share as they are antidilutive for our fiscal years ended
August 31, 2004, 2003 and 2002, respectively.

Note 12



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

On February 13, 2004, we sold
1,180,000 shares of our common stock together with
five-year warrants to purchase up to 354,000 shares of our
common stock at an exercise price of $3.72 per share in a
private placement to a group of 18 institutional and accredited
investors. We received gross proceeds of $3,540, excluding
transaction costs of $301, for the shares and warrants sold,
which will be used to increase working capital and for future
capital expenditures. The shares and warrants were sold in
reliance on the exemption afforded under Rule 506 of
Regulation D promulgated under the Securities Act of 1933,
as amended. We paid a 6% underwriting discount in connection
with the sale and the placement agent, ThinkEquity Partners,
LLC, also received warrants to purchase up to 70,800 shares
of our common stock at an exercise price of $3.72 per share
as additional compensation for the private placement.

Note 13



| |                                                      
| | -----------------------------------------------------
| | Notes Receivable and Transactions with
    Former CEO



| |                                              
| | ---------------------------------------------
| | Notes Receivable  Officers and
    Directors

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 were
amended on July 2002 and provide for full recourse to the
individuals, bear interest at Prime with the exception of one
individual at prime plus 1/2 per annum and have a term of
five years with interest only payments to be made annually
(November 2, 2002 and April 2, 2003) for the first
(2) years and annual principal and interest installments
through April 2, 2006. These notes receivable are
classified as a reduction to shareholders equity on the
consolidated balance sheet.

53



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Edwin W. Finch, III, our former director,
missed a payment of $93 in principal and interest under his
promissory note to us, which was due on April 2, 2004.
Mr. Finch withheld payment on his note because he claimed
that we owed him payments under an employment agreement with
him. On October 15, 2004, the parties settled the dispute
regarding the employment agreement and the note, and
Mr. Finch subsequently satisfied his obligation for the
payment he withheld. We recorded a write-off of $64 related to
this settlement in Fiscal 2004.

As of August 31, 2004, the interest due the
Company on these notes was $24 and is payable April 2,
2005. As of August 31, 2004, notes receivable of $435
remains outstanding.



| |                           
| | --------------------------
| | Anthony J. Fant Litigation

On June 30, 2003, we commenced litigation
against Mr. Fant, in the State of Minnesota, Hennepin
County District Court, Fourth Judicial District. The complaint
alleged breach of contract, conversion, breach of fiduciary
duty, unjust enrichment and corporate waste resulting from,
among other things, Mr. Fants default on his
promissory note to us and other loans and certain other matters.
On August 12, 2003, we obtained a judgment against
Mr. Fant on the breach of contract count in the amount of
approximately $606. On November 24, 2003, the Court granted
an additional judgment to us against Mr. Fant in the amount
of approximately $993 on the basis of our conversion, breach of
fiduciary duty, unjust enrichment and corporate waste claims. On
March 29, 2004, we obtained a third judgment against
Mr. Fant relating to our claims for damages for conversion,
breach of fiduciary duty, and our legal and special
investigation costs in the amount of approximately $656. As of
August 31, 2004, the total combined judgment against
Mr. Fant was approximately $2,255.

We have obtained, through garnishments, in excess
of approximately $112 from Mr. Fants accounts that
was recognized as a recovery in the second quarter of Fiscal
2004. We have also caused to be sold common stock previously
held by Mr. Fant, $634 of the proceeds from that sale
reduced judgments against Mr. Fant. We obtained
approximately $49 from other garnishments that were recognized
as a recovery in the third quarter of Fiscal 2004. In May 2004,
we caused to be sold additional common stock previously held by
Mr. Fant, $472 of the proceeds from that sale reduced
judgments against Mr. Fant. This judgment recovery was
recorded as income in the fourth quarter of Fiscal 2004. In June
2004, we obtained $481 through a garnishment of assets
previously held by Mr. Fant which will be recorded as
income in the first quarter of Fiscal 2005. As of
August 31, 2004, we have collected approximately $1,748,
which partially reduces our total judgment against
Mr. Fant. We continue to seek to collect on our remaining
judgment amount in Minnesota and other states where it is
believed that Mr. Fant may have non-exempt and unencumbered
assets. There is no assurance that we will be able to collect
the full amounts of our judgments against Mr. Fant.

|                      |                                        |                                   |  |       |  |   |       |     |       | 
|--------------------- | -------------------------------------- | --------------------------------- |  | ----- |  | - | ----- | --- | ----- | 
|Total Judgments:      |                                        |                                   |  |       |  | $ | 2,255 |    
|                      |                                        |                                   |  |       |  |   |       |    
|Proceeds:             |                                        |                                   |  |       |  |   |       |    
|                      | Garnishments                           |                                   |  |       |  |   |       | 642 |      
|                      | Sale of stock  reducing judgments     |                                   |  | 1,106 |  |   |       |     |      
|                      | Sale of stock  fees paid              |                                   |  | 94    |  |   |       |     |      
|                      |                                        |                                   |  |       |  |   |       |    
|                      |                                        | Total proceeds from sale of stock |  |       |  |   |       |     | 1,200 | 
|                      |                                        |                                   |  |       |  |   |       |    
|                      |                                        |                                   |  |       |  |   | 1,842 |    
|                      |                                        |                                   |  |       |  |   |       |    
|                      | Less: proceeds deferred to Fiscal 2005 |                                   |  |       |  |   |       | 481 |      
|                      |                                        |                                   |  |       |  |   |       |    
|Litigation recoveries |                                        |                                   |  |       |  | $ | 1,361 |    
|                      |                                        |                                   |  |       |  |   |       |    

54



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Note 14



| |                       
| | ----------------------
| | 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 90% 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
our fiscal years ended August 31, 2004, 2003 and 2002, the
Company contributed $105, $77 and $45, respectively, to the plan.

Note 15



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

The Company leases certain office and
manufacturing space and equipment under noncancelable operating
leases. Rental expense under these leases was approximately
$2,045 in Fiscal 2004, $1,367 in Fiscal 2003 and $649 in Fiscal
2002. The operating lease and other contractual commitments,
future minimum lease payments, excluding executory costs such as
real estate taxes, insurance and maintenance expense, by year,
and reflects the revision to our Boulder facility lease on
October 1, 2004 as described in Note 17 as follows:

|                             |  |                   |        | 
|---------------------------- |  | ----------------- | ------ | 
|                             |  | Minimum Operating
|Year Ending August 31,       |  | Lease Commitments
|                             |  |                  
|2005                         |  | $                 | 1,723  | 
|2006                         |  |                   | 1,651  | 
|2007                         |  |                   | 1,497  | 
|2008                         |  |                   | 1,492  | 
|2009                         |  |                   | 1,536  | 
|Thereafter                   |  |                   | 18,200 | 
|                             |  |                   |        | 
|Total minimum lease payments |  | $                 | 26,099 | 
|                             |  |                   |        | 

Note 16



| |                                                                      
| | ---------------------------------------------------------------------
| | Major Customers, Concentration of Credit
    Risk and Geographic Data

The table below sets forth the approximate
percentage of net sales to major customers that represented over
10% of our revenue.

|                       |  |                    |    |      |  |      |    |   |  |  |    |  
|---------------------- |  | ------------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                       |  |                   
|                       |  | Fiscal Years Ended
|                       |  | August 31,        
|                       |  |                   
|                       |  | 2004               |    | 2003 |  | 2002
|                       |  |                    |    |      |  |     
|GE Medical Systems     |  |                    | 17 | %    |  |      | 14 | % |  |  |   |  
|Siemens, Inc.          |  |                    | 8  | %    |  |      | 14 | % |  |  | 32 | %
|Sonic Innovations, Inc |  |                    | 2  | %    |  |      | 17 | % |  |  | 32 | %
|                       |  |                    |    |      |  |      |    |   |  |  |    |  
|Total                  |  |                    | 27 | %    |  |      | 45 | % |  |  | 64 | %
|                       |  |                    |    |      |  |      |    |   |  |  |    |  

Accounts receivable from these customers
represented 8%, 28% and 28%, respectively, of the total accounts
receivable at August 31, 2004, 2003 and 2002, respectively.

The Company generally sells its products to OEMs
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.

55



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Companys continued sales to these
customers are often dependent upon the continuance of the
customers product programs.

The Company had net sales of $3,279, $5,298, and
$9,062, that were shipped to Singapore during its fiscal years
ended August 31, 2004, 2003 and 2002, respectively. Total
net export sales were $11,346, $10,823 and $11,475, during the
Companys fiscal years ended August 31, 2004, 2003 and
2002, respectively. The majority of the international sales were
to multinational companies who instructed HEI to ship products
to their offshore assembly facilities. The Company had net sales
of $31,974, $27,617, and $17,057, that were shipped to
domestically during its fiscal years ended August 31, 2004,
2003 and 2002, respectively.

Note 17



| |                  
| | -----------------
| | Subsequent Events

We lease a 152,022 square foot facility in
Boulder, Colorado for our AMO. On September 27, 2004, this
facility was sold by Eastside Properties, LLC to Titan. On
October 1, 2004, we signed a new lease with Titans
affiliate, Boulder Investors LLC, at substantially reduced
rental rates. Under the terms of the new lease, $1,350 of our
deposit will be refunded to us if after completing four
consecutive quarters of positive EBIDTA, as determined in
accordance with GAAP and verified by an independent third party
accountant, we deliver to our landlord the greater of
100,000 shares of our common stock or 0.11% of the
outstanding shares of our common stock. As a part of the
purchase accounting for the acquisition of our AMO, we had
established a $3,110 reserve relating to the future estimated
lease payments of our Boulder facility. Currently, we occupy
approximately 100,000 square feet of the facility and
50,000 is unimproved vacant space. In Fiscal 2003, we entered
into an agency agreement with Julien J. Studley, Inc., a
national commercial real estate services firm. Julien J. Studley
has been engaged to assist us in reducing our occupancy costs at
this facility by representing us in negotiations for the
sub-leasing of the 50,000 square foot addition, performing
tenant representation with our landlord, and assisting us in
exploring other options related to our future use of the Boulder
facility. As a result of this transaction, we reduced by $578
the reserve related to the approximately 50,000 square feet
of unimproved vacant space as of the date of the transaction.
The following pro forma condensed balance sheet reflects our
assets and liabilities as if this transaction had been
consummated on August 31, 2004:

|                                     |                                                          |  |   |        | 
|------------------------------------ | -------------------------------------------------------- |  | - | ------ | 
|Assets:                              |                                                          |  |   |       
|                                     | Current assets                                           |  | $ | 15,459 | 
|                                     | Property and equipment, net                              |  |   | 6,813  | 
|                                     | Other noncurrent assets                                  |  |   | 2,262  | 
|                                     |                                                          |  |   |       
|                                     | Total assets                                             |  | $ | 24,534 | 
|                                     |                                                          |  |   |       
|Liabilities and Shareholders Equity
|                                     | Current liabilities                                      |  | $ | 11,807 | 
|                                     | Other long-term liabilities, less current
    maturities |  |   | 2,770  | 
|                                     | Shareholders Equity                                     |  |   | 9,957  | 
|                                     |                                                          |  |   |       
|                                     | Total liabilities and shareholders equity               |  | $ | 24,534 | 
|                                     |                                                          |  |   |       

Note 18



| |         
| | --------
| | Segments

During Fiscal 2003, we reported one segment. In
late Fiscal 2004, we reevaluated the criteria for aggregation of
our Microelectronics Operations and Advanced Medical Operations
and determined that we

56



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

had two segments. The determination to report two
segments was the result of the changing economics of the two
segments.

Microelectronics Operations: This segment
consists of three facilities  Victoria, Chanbassen,
and Tempe  that design, manufacture and sell ultra
miniature microelectronic devices and high technology products
incorporating these devices.

Advanced Medical Operations: This segment
consists of our Boulder facility that provides design and
manufacturing outsourcing of complex electronic and
electromechanical medical devices. Our Advanced Medical
Operations for Fiscal 2003 includes approximately seven months
of the results from these operations since January 24,
2003, when these operations were acquired.

Segment information for Fiscal 2004 and Fiscal
2003 was as follows:

|               |  |                  |        |                  |  |       |        |   |  |   |        |  
|-------------- |  | ---------------- | ------ | ---------------- |  | ----- | ------ | - |  | - | ------ | -
|               |  |                 
|               |  | Fiscal 2004     
|               |  |                 
|               |  | Microelectronics |        | Advanced Medical |  |      
|               |  | Operations       |        | Operations       |  | Total
|               |  |                  |        |                  |  |      
|Net sales      |  | $                | 22,748 |                  |  | $     | 20,572 |   |  | $ | 43,320 |  
|Gross profit   |  |                  | 158    |                  |  |       | 3,965  |   |  |   | 4,123  |  
|Operating loss |  |                  | (8,142 | )                |  |       | (372   | ) |  |   | (8,514 | )
|Total assets   |  |                  | 15,846 |                  |  |       | 9,266  |   |  |   | 25,112 |  

|                        |  |             |        |   |  |   |        |  |  |   |        |  
|----------------------- |  | ----------- | ------ | - |  | - | ------ |  |  | - | ------ | -
|                        |  |            
|                        |  | Fiscal 2003
|                        |  |            
|Net sales               |  | $           | 24,011 |   |  | $ | 14,429 |  |  | $ | 38,440 |  
|Gross profit            |  |             | 4,052  |   |  |   | 3,061  |  |  |   | 7,113  |  
|Operating income (loss) |  |             | (3,662 | ) |  |   | 225    |  |  |   | (3,437 | )
|Total assets            |  |             | 16,835 |   |  |   | 9,668  |  |  |   | 26,503 |  

57



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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

The Shareholders and the Board of Directors

HEI, Inc.:


We have audited the accompanying consolidated
balance sheets of HEI, Inc. and subsidiaries as of
August 31, 2004 and 2003, 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, 2004. 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 the
standards of the Public Company Accounting Oversight Board
(United States). 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, 2004 and 2003, and the results of their
operations and their cash flows for each of the years in the
three-year period ended August 31, 2004, in conformity with
U.S. generally accepted accounting principles.



| |             
| | ------------
| | /s/ KPMG LLP

Minneapolis, Minnesota

January 12, 2005


58



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##### Table of Contents



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM

ON FINANCIAL STATEMENT SCHEDULE


The Shareholders and the Board of Directors

HEI, Inc.:


Under date of January 12, 2005, we reported
on the consolidated balance sheets of HEI, Inc. and subsidiaries
as of August 31, 2004 and 2003, 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, 2004, as
contained in the annual report on Form 10-K for the fiscal
year ended August 31, 2004. 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.



| |             
| | ------------
| | /s/ KPMG LLP

Minneapolis, Minnesota

January 12, 2005


59



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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 registered public accounting
firm, KPMG LLP, were engaged to audit the consolidated financial
statements of the Company and to issue their report thereon. See
the accompanying Report of Independent Registered Public
Accounting Firm.

Summary of Quarterly Operating
Results

|                            |         |                                          |        |        |   |       |        |        |   |   |        |       |   |   |        |       |  
|--------------------------- | ------- | ---------------------------------------- | ------ | ------ | - | ----- | ------ | ------ | - | - | ------ | ----- | - | - | ------ | ----- | -
|Fiscal Year 2004            |         | First                                    |        | Second |   | Third |        | Fourth
|                            |         |                                          |        |        |   |       |        |       
|                            |         |                                         
|                            |         | (Unaudited)                             
|                            |         |                                         
|                            |         | (In thousands, except per share amounts)
|Net sales                   |         | $                                        | 10,916 |        |   | $     | 9,995  |        |   | $ | 11,131 |       |   | $ | 11,278 |      
|Gross profit                |         |                                          | 1,064  |        |   |       | 451    |        |   |   | 1,151  |       |   |   | 1,457  |      
|Asset impairment charges    |         |                                          |       |        |   |       |       |        |   |   |       |       |   |   | 465    |      
|Special investigation costs |         |                                          | 253    |        |   |       | 504    |        |   |   | 94     |       |   |   | 43     |      
|Operating loss              |         |                                          | (1,668 | )      |   |       | (2,971 | )      |   |   | (1,679 | )     |   |   | (2,196 | )    
|Net loss                    |         |                                          | (1,253 | )      |   |       | (2,969 | )      |   |   | (1,029 | )     |   |   | (1,758 | )    
|                            |         |                                          |        |        |   |       |        |        |   |   |        |       |   |   |        |      
|Net loss per share          |         |                                          |        |        |   |       |        |        |   |   |        |       |   |   |        |      
|                            | Basic   |                                          | $      | (0.18  | ) |       | $      | (0.41  | ) |   | $      | (0.12 | ) |   | $      | (0.21 | )
|                            | Diluted |                                          | $      | (0.18  | ) |       | $      | (0.41  | ) |   | $      | (0.12 | ) |   | $      | (0.21 | )

|                         |         |                                          |        |        |   |       |        |        |   |   |        |       |   |   |        |       |  
|------------------------ | ------- | ---------------------------------------- | ------ | ------ | - | ----- | ------ | ------ | - | - | ------ | ----- | - | - | ------ | ----- | -
|Fiscal Year 2003         |         | First                                    |        | Second |   | Third |        | Fourth
|                         |         |                                          |        |        |   |       |        |       
|                         |         |                                         
|                         |         | (Unaudited)                             
|                         |         |                                         
|                         |         | (In thousands, except per share amounts)
|Net sales                |         | $                                        | 5,490  |        |   | $     | 8,144  |        |   | $ | 12,517 |       |   | $ | 12,289 |      
|Gross profit             |         |                                          | 612    |        |   |       | 846    |        |   |   | 2,490  |       |   |   | 3,165  |      
|Asset impairment charges |         |                                          |       |        |   |       |       |        |   |   |       |       |   |   | 331    |      
|Operating loss           |         |                                          | (1,140 | )      |   |       | (1,358 | )      |   |   | (437   | )     |   |   | (502   | )    
|Net loss                 |         |                                          | (1,155 | )      |   |       | (1,336 | )      |   |   | (1,311 | )     |   |   | (827   | )    
|                         |         |                                          |        |        |   |       |        |        |   |   |        |       |   |   |        |      
|Net loss per share       |         |                                          |        |        |   |       |        |        |   |   |        |       |   |   |        |      
|                         | Basic   |                                          | $      | (0.19  | ) |       | $      | (0.21  | ) |   | $      | (0.19 | ) |   | $      | (0.12 | )
|                         | Diluted |                                          | $      | (0.19  | ) |       | $      | (0.21  | ) |   | $      | (0.19 | ) |   | $      | (0.12 | )

NOTE:

The summation of quarterly net 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.

60



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##### Table of Contents








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

KPMG LLP (KPMG) has been serving as
our principal accountants. On October 1, 2004, we received
verbal notification from representatives of KPMG of their
decision not to stand for re-election as our independent
registered public accounting firm for Fiscal 2005, and that, as
a result, our client-auditor relationship with KPMG will cease
upon completion of the audit of our consolidated financial
statements for Fiscal 2004, and the filing of our Annual Report
on Form 10-K for Fiscal 2004. Prior to receiving the
notification from KPMG, the Audit Committee of our Board of
Directors had decided to contact several smaller independent
public accounting firms to determine their ability and
willingness to serve as our independent registered public
accounting firm. Our Audit Committee will continue its
discussions with such independent registered public accounting
firms and will engage a new independent registered public
accounting firm as soon as reasonably practicable.

The reports of KPMG on our consolidated financial
statements for each of Fiscal 2004 and Fiscal 2003 did not
contain an adverse opinion or disclaimer of opinion, nor were
such consolidated financial statements qualified or modified as
to uncertainty, audit scope or accounting principles.

During Fiscal 2004 and Fiscal 2003, and through
January 13, 2005, there were (i) no disagreements with
KPMG on any matter of accounting principles or practices,
financial statement disclosure or auditing scope or procedure
which, if not resolved to the satisfaction of KPMG, would have
caused KPMG to make reference to the subject matter in
connection with their opinion on our consolidated financial
statements for such years; and (ii) there were no
reportable events as defined in Item 304(a)(1)(v) of
Regulation S-K, except that:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | As previously disclosed in our Annual Report on
    Form 10-K for Fiscal 2003, KPMG cited a material weakness
    in its communication to our Audit Committee on December 12,
    2003, related to the overriding, by our former President, Chief
    Executive Officer and Chairman and former Chief Financial
    Officer, of internal controls relating to the payment of certain
    expenses not supported by proper documentation. On
    December 12, 2003, KPMG also communicated to our Audit
    Committee reportable conditions related to revenue recognition
    at our Boulder facility, and the lack of substantiation of
    general ledger account balances and computer-based vendor
    payment controls.
|
| |  | On January 12, 2005, KPMG cited three
    material weaknesses in its communication to our Audit Committee,
    relating to (i) the control environment at our Boulder
    facility and, in particular, the lack of segregation of duties
    and financial oversight controls, (ii) revenue recognition
    and (iii) financial reporting. On January 12, 2005,
    KPMG also communicated to our Audit Committee reportable
    conditions related to (A) the lack of a formal journal
    entry approval process, and (B) the lack of access controls
    to our SAP system.                                                                                                                                              

Our steps to establish a proper control
environment and address our control deficiencies are described
under Item 9A of this Annual Report on Form 10-K.

We have requested KPMG to furnish us with a
letter, addressed to the Securities and Exchange Commission,
stating whether it agrees with the statements made by us under
this Item 9. Attached as Exhibit 16 to this Annual
Report on Form 10-K is a copy of KPMGs letter to the
Securities and Exchange Commission dated January 13, 2005.






|         |                         
|-------- | ------------------------
|Item 9A. | Controls and Procedures.

During the course of their audit of our
consolidated financial statements for Fiscal 2004, our
independent registered public accounting firm, KPMG, advised
management and the Audit Committee of our Board of Directors
that they had identified three deficiencies in internal control.
The deficiencies are considered to be a material
weakness as defined under standards established by the
American Institute of Certified Public Accountants. The material
weaknesses relate to the following: (i) the lack of
segregation of duties and financial oversight controls at our
Boulder facility, which in aggregate created an ineffective
control environment, (ii) several revenue recognition
errors that were not discovered during our normal closing
procedures, and (iii) financial reporting. On
January 12, 2004, KPMG also communicated to our Audit

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Committee reportable conditions related to (A)
the lack of a formal journal entry approval process, and
(B) the lack of access controls to our SAP system.


Prior to the identification of such deficiencies,
we had already undertaken, or were in the process of
undertaking, a number of steps to establish a proper control
environment, including:



| |   |                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the replacement of our Controller;                                                                                                                                                            
|
| |  | implementing the SAP system for all of our
    financial reporting, including our Boulder facility;                                                                                           
|
| |  | adding controls and moving control related
    functions to our Victoria facility to eliminate opportunities to
    override controls over cash, accounts receivable and accounts
    payable;
|
| |  | the training of our accounting personnel at a
    KPMG revenue recognition seminar;                                                                                                           
|
| |  | providing revenue recognition training for
    contract administration personnel;                                                                                                             
|
| |  | adding revenue recognition review and approval
    control functions;                                                                                                                         
|
| |  | adding staff to accommodate the changes
    required; and                                                                                                                                     
|
| |  | evaluating access controls needed within the SAP
    system.                                                                                                                                  

We have discussed our corrective actions and
future plans with our Audit Committee and KPMG and, as of the
date of this Annual Report on Form 10-K, we believe the
actions outlined above have corrected the deficiencies in
internal controls that are considered to be a material weakness.
Further, our management, including our Chief Executive Officer
and President and Chief Financial Officer, have conducted an
evaluation of the effectiveness of disclosure controls and
procedures (as such term is defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended
(the Exchange Act)) as of the end of the period
covered by this Annual Report on Form 10-K. Based on such
evaluation, our Chief Executive Officer and President and Chief
Financial Officer have concluded that the disclosure controls
and procedures did not provide reasonable assurance of
effectiveness as of the end of Fiscal 2004 because of the
material weaknesses identified above. The material weaknesses
did not, however, impact the quality of the financial
information provided on a quarterly basis.

We are currently in the process of reviewing and
formalizing our internal controls and procedures for financial
reporting in accordance with the Securities and Exchange
Commissions rules implementing the internal control
reporting requirements included in Section 404 of the
Sarbanes-Oxley Act of 2002 (Section 404).
Changes have been and will be made to our internal controls over
financial reporting as a result of these efforts. We are
dedicating significant resources, including senior management
time and effort, and incurring substantial costs in connection
with our ongoing Section 404 assessment. We are currently
documenting and testing our internal controls and considering
whether any improvements are necessary for maintaining an
effective control environment at our Company. The evaluation of
our internal controls is being conducted under the direction of
our senior management in consultation with an independent third
party consulting firm. In addition, our senior management is
regularly discussing the results of our testing and any proposed
improvements to our control environment with our Audit
Committee. We expect to assess our controls and procedures on a
regular basis. We will continue to work to improve our controls
and procedures and to educate and train our employees on our
existing controls and procedures in connection with our efforts
to maintain an effective controls infrastructure at our Company.
Despite the mobilization of significant resources for our
Section 404 assessment, we, however, cannot provide any
assurance that we will timely complete the evaluation of our
internal controls or that, even if we do complete the evaluation
of our internal controls, we do so in time to permit our
independent registered public accounting firm to test our
controls and timely complete their attestation procedures of our
controls in a manner that will allow us to comply with
applicable Securities and Exchange Commission rules and
regulations by the filing deadline for our Annual Report on
Form 10-K for Fiscal 2005.

In addition, there can be no assurances that our
disclosure controls and procedures will detect or uncover all
failure of persons with the Company to report material
information otherwise required to be set forth in the reports
that we file with the Securities and Exchange Commission.

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|         |                  
|-------- | -----------------
|Item 9B. | Other Information

None.




PART III






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

Information regarding executive officers required
by this Item 10 is set forth in Part I of this Annual
Report on Form 10-K pursuant to Instruction 3 to
Item 401(b) of Regulation S-K.

Directors

The following is a list of the names and ages of
each of our directors as of December 29, 2004, the year in
which each such director was first elected, and the year each
such directors current three year term will expire.

|                                       |  |     |    |                    |  |                       |      |  |  |  |      | 
|-------------------------------------- |  | --- | -- | ------------------ |  | --------------------- | ---- |  |  |  | ---- | 
|                                       |  |     |    | Year First Elected |  | Expiration of Current
|Name and Position                      |  | Age |    | as Director        |  | Three-Year Term      
|                                       |  |     |    |                    |  |                      
|Dennis J. Leisz, Chairman of the Board |  |     | 51 |                    |  |                       | 2002 |  |  |  | 2007 | 
|George M. Heenan, Director             |  |     | 65 |                    |  |                       | 2003 |  |  |  | 2007 | 
|Michael J. Evers, Director             |  |     | 69 |                    |  |                       | 2003 |  |  |  | 2005 | 
|Anthony J. Fant, Director              |  |     | 44 |                    |  |                       | 1998 |  |  |  | 2005 | 
|Timothy F. Floeder, Director           |  |     | 46 |                    |  |                       | 2002 |  |  |  | 2006 | 
|Mack V. Traynor, Director              |  |     | 46 |                    |  |                       | 1998 |  |  |  | 2006 | 

Dennis J. Leisz,age 51, has served as Chairman of the Board of Directors
since March 2003, and as a director of the Company since
December 2002. Mr. Leisz is the founder of Wavecrest
Corporation, a corporation that manufactures test and
measurement instruments for the design and production test of
semiconductors, optical components and systems, and has acted as
its President and Chief Executive Officer since its inception in
May 1985, and as its Treasurer since April 1992. From 1983 to
1985, Mr. Leisz served as Marketing Manager for the Test
Systems Division of Micro Component Technology, Inc., a
Shoreview, Minnesota manufacturer of semiconductor test
equipment, where he was responsible for product marketing, new
product development and applications engineering. Prior to 1983,
Mr. Leisz was the Marketing Manager for FSI, a Chaska,
Minnesota manufacturer of semiconductor processing equipment.

George M. Heenan,age 65, has served as a director
of the Company since June 2003. Mr. Heenan is the former
Director of the Institute of Strategic Management at the
University of St. Thomas. He served as the Director from 1996
until 2004. He currently serves as an Executive Fellow for the
University of St. Thomas College of Business. In
2004, Mr. Heenan founded Excelsius Partners Consulting
where he is owner and a principal. Mr. Heenans
background includes experience in start-up, emerging growth,
Fortune 500 and Fortune 200 companies, as well as the
management of venture capital partnerships. He has previously
held a number of management and executive positions at Medtronic
Inc., Control Data, Medical Industrial Capital, Clarus Medical,
Bissell Healthcare Company, and Camp Preston Group. Over the
course of his career, Mr. Heenan has served on a number of
public, private, and advisory boards. Mr. Heenan currently
serves on the Board of Directors of Midwest Wireless Holdings,
LLC, a privately held wireless telecommunications company, since
2003; and Minnesota Scientific Inc., a privately held supplier
of surgical equipment, since 1998. Mr. Heenan is a graduate
of St. Ambrose College with a B.S. in Physics. He also attended
the University of Wisconsin-Madison and has completed the
Operations Management Program at Harvard University.

Michael J.
Evers, Ph.D., age 69, has
served as a director of the Company since June 2003.
Dr. Evers is Dean Emeritus and Professor of Strategic
Management at the College of Business at the University of
St. Thomas. He served as Dean of the Graduate School of
Business from 1984 to 1995, growing the graduate programs and
application-oriented education centers to be one of the largest
graduate business schools in the

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United States. He was instrumental in the
development of the Minneapolis campus of the University of
St. Thomas. From 1998 to 2000, he served as interim
President/ Chief Executive Officer of the Minnesota Center for
Corporate Responsibility and led the re-invention of the
non-profit business association into the Center for Ethical
Business Cultures, affiliated with St. Thomas and the University
of Minnesota. Prior to his university positions, he held
managerial positions in manufacturing, engineering, program
management and marketing at North American Rockwell,
McDonnell-Douglas, Emerson Electric and National Distribution
Services, respectively. He served thirty years in the Active and
Reserve U.S. Air Force as a Senior Contracting Officer and
Detachment Commander, retiring in the rank of Colonel. He
received his Ph.D., MBA and BBA from the University of
Minnesota. He also currently serves on the Board of Directors
for Minnesota Scientific, Inc., Wavecrest Corporation and
Infinite Graphics, Inc.


Anthony J. Fant,age 44, has served as a director of the Company since 1998.
However, Mr. Fant was inactive as a director during Fiscal
2004. Mr. Fant served as the Companys President,
Chief Executive Officer and Chairman from November 1998 to March
2003. We believe that Mr. Fant has been a Director and the
President and Chief Executive Officer of Fant Broadcasting
Company (and various affiliated companies), which is 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.

Timothy F. Floeder,age 46, has served as a director of the Company since
December 2002. Mr. Floeder is currently the Vice President
of Business Development for Compex Technologies, Inc., a
publicly-held company that designs, manufactures and sells
home-use devices to improve pain management, rehabilitation,
fitness, health and wellness for healthcare and consumer markets
in the US and Europe. Mr. Floeder previously was an
investment banker, most recently serving as Managing Director of
Mergers and Acquisitions for Miller Johnson Steichen Kinnard,
Inc., a regional investment securities firm, from 1996 until
2002. He also served in a variety of financial positions,
including Chief Financial Officer and Director for a large
privately-held regional electrical contractor and industrial
products distributor, from 1984 to 1996, and held both public
and private accounting positions from 1980 to 1984.
Mr. Floeder is a CPA (inactive) and has received an
MBA in finance from the Carlson School of Management, a BSB in
accounting from the University of Minnesota, and completed the
Management Executive Program at the Carlson School of Management.

Mack V.
Traynor, III,age 46, has
served as the Companys Chief Executive Officer and
President since March 2003, and has served on the Board since
1998. Mr. Traynor currently serves as President of Manitou
Investments, a private investment and business management firm,
a position he has held since 1998. Although Mr. Traynor
currently serves in such capacity with Manitou Investments, he
devotes substantially all of his efforts to his duties and
responsibilities at the Company. Since June 2003,
Mr. Traynor has served on the Board of Directors of ACT
Telecommunications, an international teleconferencing service
provider. Previously, Mr. Traynor served as President and
Chief Executive Officer of Supreme Companies, Inc., a privately
held landscape and grounds maintenance company, from February
2002 to September 2003. Mr. Traynor also previously served
as Chief Executive Officer of Do The Good, Inc., a philanthropic
software development company, from May 2001 until October 2001,
and as Chief Financial Officer of 10K Partners, Inc., private
investment company, from April 2000 until June 2000.
Mr. Traynor served as President and Chief Executive Officer
of NeoNetworks, a privately-held development stage company
designing high-speed data communications equipment, from October
1998 to April 2000. Mr. Traynor was a director of Telident,
Inc., a publicly-held telecommunications products and services
company, from 1998 to 2000. Mr. Traynor also served as a
director of Eltrax Systems, Inc., a publicly-held networking
products and services company, from 1995 to 1999, serving as
Chief Financial Officer from 1995 to 1996 and President, Chief
Executive Officer and Chief Operating Officer from 1995 to 1997.
Mr. Traynor served as President and Chief Operating Officer
of Military Communications Center, Inc., a company that provided
telecommunications services to U.S. Military personnel,
from 1988 to 1995. He also served as President of U.S. West
Enterprises, a division of U.S. West, Inc.

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Audit Committee Financial Expert

The Board of Directors has determined that Mr.
Floeder is an audit committee financial expert, as
that term is defined in Item 401(h) of Regulation S-K.
Mr. Floeder is independent, as that term is
defined in Item 7(d)(3)(iv) of Schedule 14A under the
Exchange Act.

Audit Committee

We have a separately-designated standing Audit
Committee of our Board of Directors established in accordance
with Section 3(a)(58)(A) of the Exchange Act. Our Audit
Committee currently consists of Messrs. Floeder (Chair), Leisz
and Heenan and Dr. Evers, each of whom satisfies the audit
committee independence standard under Rule 10A-3(b)(1) of
the Exchange Act and the definition of Independence
set forth in the NASDAQ Marketplace Rules.

Director Nominations

At its meeting on October 5, 2004, our Board
of Directors established a Nominating and Corporation Governance
Committee and adopted the Charter of the Nominating and
Corporate Governance Committee. Such charter formalized our
policies regarding director candidates recommended by
shareholders. It is the general policy of the Nominating and
Corporate Governance Committee that it will consider a director
candidate recommended by a shareholder who appears to be
qualified to serve on the Board of Directors. The Nominating and
Corporate Governance Committee may choose not to consider an
unsolicited recommendation is no vacancy exists on the Board of
the Directors and the Nominating and Corporate Governance
Committee does not perceive a need to increase the size of the
Board of Directors.

The Nominating and Corporate Governance Committee
has established the following procedures for shareholders to
submit such recommendations and only those director candidates
recommend in accordance with such procedures will be considered
by the Nominating and Corporate Governance Committee:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | if a shareholder would like to recommend a
    director candidate for our next annual meeting, the shareholder
    must deliver such recommendation to our Corporate Secretary at
    our principal offices no later than the 120th calendar day
    before the date that our proxy statement was released to
    shareholders in connection with the previous years annual
    meeting, advanced by one year;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| |  | recommendations for candidates must be
    accompanied by (i) personal information regarding the
    candidate, including the name of the candidate, a list of the
    candidates references, the candidates resume or
    curriculum vitae and any information that is required to be
    disclosed in solicitations of proxies for election of directors
    pursuant to Schedule 14A under the Exchange Act,
    (ii) the written consent of the person being recommended to
    being named in the proxy statement as a nominee and to serving
    as a director if elected; and (iii) certain information
    regarding the shareholder making the recommendation, including
    the shareholders name and address, as they appear on the
    our books, the number and class of shares of our capital stock
    owned, either directly or indirectly, by the shareholder (and,
    if owned indirectly, a current written statement from the record
    holder of the stock that reflects ownership in such stock), and
    a statement disclosing whether such shareholder is acting with
    or on behalf of any other person and, if applicable, the
    identity of such other person;
|
| |  | a shareholder recommending a candidate may be
    asked to submit additional information regarding himself or
    herself or the candidate as determined by our Corporate
    Secretary or as necessary to satisfy the listing standards of
    the NASDAQ National Market System, SEC rules and regulations or
    any other applicable rules and regulations; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|
| |  | if a shareholders recommendation is
    received on or before the date set forth above and is
    accompanied by the information set forth above, the Nominating
    and Corporate Governance Committee will evaluate such candidate,
    along with the other candidates being evaluated by the
    committee, in accordance with its charter and any other policies
    and procedures established by the Nominating and Corporate
    Governance Committee or the Board of Directors.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

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The Nominating and Corporate Governance Committee
does not use different standards to evaluate nominees depending
upon whether they are proposed by a member of our Board of
Directors, our management or shareholders.

Section 16(a) Beneficial Ownership
Reporting Compliance

Section 16(a) of the Exchange Act requires
that our directors, executive officers and shareholders who own
more than 10% of our common stock file reports of ownership and
changes in ownership of our common stock with the SEC. To our
knowledge, based on a review of the copies of such reports
furnished to us and other information available to us, we
believe that each of Nina A. Anderson, James P. Barnes, Timothy
F. Floeder, Simon F. Hawksworth, George M. Heenan, Dennis J.
Leisz, Douglas J. Nesbit, Scott M. Stole and James C. Vetricek
filed a late Form 3; Michael J. Evers failed to timely file
two Forms 4 to report the grant of options in each of June
2003 and February 2004; Anthony J. Fant failed to timely file
two Forms 4 to report the sale of common stock in each of
February 2004 and April 2004; Mr. Floeder failed to timely
file three Forms 4 to report the grant of options in each of
February 2003, January 2004 and February 2004;
Mr. Hawksworth failed to timely file two Forms 4 to report
the grant of options in each of March 2003 and August 2003;
Mr. Heenan failed to timely file one Form 4 to report
the grant of options in June 2003; Mr. Leisz failed to
timely file four Forms 4 to report the grant of options in each
of February 2003, March 2003, January 2004 and February 2004;
Mr. Nesbit failed to timely file one Form 4 to report
the grant of options in June 2003; Mr. Stole failed to
timely file two Forms 4 to report the grant of options in each
of August 2003 and February 2004; and Mr. Vetricek failed
to timely file two Forms 4 to report the grant of options in
each of March 2003 and August 2003. Each of Messrs. Evers,
Floeder, Hawksworth, Heenan, Leisz, Nesbit, Stole and Vetricek
filed a Form 5 on October 15, 2004 reporting the
grants of the foregoing options. In addition, Ms. Anderson
failed to timely file a Form 4 to report a grant of options
in July 2004; Mr. Barnes failed to timely file a
Form 4 to report a grant of options in July 2004; and
Mr. Heenan failed to timely file a Form 4 to report
the grant of options in February 2004.

Code of Ethics

We have adopted a Code of Business Conduct and
Ethics that applies to all of our employees, officers and
directors, including our chief executive officer, chief
financial officer, chief accounting officer, and controller and
all other senior financial officers. In addition, we have
adopted a Code of Ethics for Senior Financial Officers that
applies to our chief executive officer, chief financial officer,
treasurer and controller and assistant controller. Both codes
are located on our website at www.heii.com under Investor
Relations  Overview. Information on our website
does not constitute part of this Annual Report on Form 10-K.






|         |                        
|-------- | -----------------------
|Item 11. | Executive Compensation.

Director Compensation

Directors
Fees.During Fiscal 2004, each
non-employee director received an annual fee of $30,000 for
board participation except that Anthony J. Fant, who was an
inactive member of the Board of Directors during Fiscal 2004,
received no annual fee. Additional fees were related to
committee participation. On an annual basis the Audit Committee
members received $5,000, with the chair of the committee
receiving an additional $2,500, Compensation Committee members
received $2,500, and Special Committee members received $2,500
paid on a quarterly basis. The Nominating and Corporate
Governance Committee was established on October 5, 2004,
and we anticipate that members of that committee will receive
$1,000 annually for participation on such committee.

Directors Stock
Options.Non-employee directors are
entitled to participate in the Companys 1998 Stock Option
Plan for Non-Employee Directors, as amended (the
1998 Director Plan). We adopted the
1998 Director Plan effective as of November 18, 1998,
and such plan was approved by our shareholders at our Annual
Meeting of Shareholders held on January 20, 1999.

The 1998 Director Plan is administered by
the full Board. The Board has the power to interpret the
1998 Director Plan, to determine all questions thereunder
and to adopt and amend rules and regulations for

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the administration of the 1998 Director
Plan. The Board has no authority, discretion or power, however,
to determine the number or timing of options to be granted under
the 1998 Director Plan.


Subject to adjustment in the event of certain
significant corporate transactions, the number of shares of
common stock issued or transferred, plus the number of shares
covered by outstanding options, under the 1998 Director
Plan may not exceed 425,000 (including any shares remaining
under the 1991 Stock Option Plan for Non-Employee Directors, as
amended to date). Shares of common stock covered by an option
that is cancelled or terminated will again be available to be
issued or to be the subject of a stock option granted under the
1998 Director Plan. Effective as of November 18, 1998,
each individual who was then a non-employee director was granted
options to purchase 55,000 shares of common stock,
subject to the approval of the adoption of the
1998 Director Plan by the shareholders of the Company.
Thereafter, commencing with the 2000 Annual Meeting of
Shareholders, each individual who is a non-employee director
upon the adjournment of the annual meeting will automatically be
granted options to purchase 10,000 shares of common
stock, effective as of the date of such annual meeting. All of
the options granted under the 1998 Director Plan will have
an exercise price per share equal to the fair market value of a
share of common stock on the date of grant. Options granted
under the 1998 Director Plan will become exercisable in
full upon the earliest to occur of (i) the seventh
anniversary of the date of grant, (ii) the first date after
the date of grant on which the fair market value of the common
stock (as adjusted to reflect any antidilution event) equals or
exceeds $25.00 per share, (iii) the date of the
non-employee directors death or disability (as defined in
the 1998 Director Plan), or (iv) the effective date of
a change in control of the Company (as defined in the
1998 Director Plan).

The exercise price of stock options granted under
the 1998 Director Plan may be paid in cash,
non-forfeitable, non-restricted shares of common stock that are
already owned by the optionee or a combination of cash and such
shares of common stock. Any grant may provide for deferred
payment of the option price from the proceeds of sale through a
broker of some or all of the shares of common stock to which the
exercise relates. Shares of common stock issued pursuant to the
1998 Director Plan may be authorized but unissued shares or
treasury stock. Fractional shares will not be issued in
connection with the exercise of a stock option, and cash in lieu
thereof will be paid by the Company. No option granted under the
1998 Director Plan may be exercised more than ten years
from the date of grant. Options are not transferable other than
(i) by will or the laws of descent or distribution,
(ii) to one or more members of the non-employee
directors immediate family, or (iii) to a trust
established for the benefit of the non-employee director and/or
one or more members of his or her immediate family. In addition,
options may not be exercised during a non-employee
directors lifetime except by (i) the non-employee
director, (ii) a permitted transferee of the non-employee
director, or (iii) in the event of the legal incapacity of
the non-employee director or any such transferee, by the
guardian or legal representative of the non-employee director or
such transferee (as applicable) acting in a fiduciary capacity
on behalf thereof under state law and court supervision.

The Board may at any time amend or terminate the
1998 Director Plan. Notwithstanding the foregoing,
(i) except for the adjustments described above, without the
approval of the shareholders of the Company, no such amendment
may increase the maximum number of shares covered by the
1998 Director Plan or cause the 1998 Director Plan or
any grant made pursuant thereto to cease to satisfy any
applicable condition of Rule 16b-3 under the Exchange Act,
and (ii) no amendment or termination will adversely affect
any outstanding award without the consent of the director
holding such award.

Options under the 1998 Director Plan are
granted automatically. The number of options to be granted will
depend on the number of non-employee directors elected to the
Board and the timing of any such election. No options may be
granted under the 1998 Director Plan after the tenth
anniversary of its effective date. The options to
purchase 55,000 shares of common stock granted to each
of the non-employee directors as of November 18, 1998, have
an exercise price of $5.50 per share. On January 20,
2000, options to purchase 10,000 shares of common
stock were granted to each of the non-employee directors with an
exercise price of $10.75 per share. On January 24,
2001, options to purchase 10,000 shares of common
stock were granted to each of the non-employee directors with an
exercise price of $13.875 per share. On February 20,
2002, options to purchase 10,000 shares of common
stock were granted to each of the non-employee directors with an
exercise price of $5.95 per share. On February 5,
2003, options to purchase 10,000 shares of common
stock were granted to each of the non-employee directors with an
exercise price of $2.16 per share. On

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February 11, 2004, options to
purchase 10,000 shares of common stock were granted to
each of the non-employee directors other than Mr. Fant with
an exercise price of $3.40 per share.


Directors are also eligible to participate in the
Companys 1998 Stock Option Plan.

Executive Compensation

Summary Compensation Table

The following table sets forth certain
information regarding compensation paid during each of our last
three fiscal years to our Chief Executive Officer and our four
most highly compensated executive officers other than Chief
Executive Officer who were serving at August 30, 2004 (the
Named Executive Officers).

|                            |                           |        |      |                     |  |              |         |                  |  |             |         |                  |  |   |        |        |  |  |        |         |  |   |       |        |    
|--------------------------- | ------------------------- | ------ | ---- | ------------------- |  | ------------ | ------- | ---------------- |  | ----------- | ------- | ---------------- |  | - | ------ | ------ |  |  | ------ | ------- |  | - | ----- | ------ | ---
|                            |                           |        |      |                     |  |              |         |                  |  | Long-Term   |         |                 
|                            |                           |        |      |                     |  | Compensation |         |                 
|                            |                           |        |      | Annual Compensation |  |              |         |                 
|                            |                           |        |      |                     |  | Securities   |         |                 
|                            |                           | Fiscal |      |                     |  | Other Annual |         | Underlying       |  | Other      
|Name and Principle Position |                           | Year   |      | Salary ($)          |  | Bonus ($)    |         | Compensation ($) |  | Options (#) |         | Compensation ($)
|                            |                           |        |      |                     |  |              |         |                  |  |             |         |                 
|Mack V. Traynor, III(1)     |                           |        | 2004 |                     |  | $            | 200,000 |                  |  | $           | 135,500 |                  |  | $ | 4,000  | (2)    |  |  |       |         |  |   |      |       
|                            | Chief Executive Officer   |        |      | 2003                |  |              | $       | 83,077           |  |             | $       | 25,000           |  |   |        |       |  |  |        | 110,000 |  |   |       |       |    
|                            | and President             |        |      | 2002                |  |              |         |                 |  |             |         |                 |  |   |        |       |  |  |        |        |  |   |       |       |    
|Douglas J. Nesbit(3)        |                           |        | 2004 |                     |  | $            | 140,000 |                  |  |             |        |                  |  |   |       |        |  |  |       |         |  | $ | 1,373 | (4)   
|                            | Chief Financial Officer,  |        |      | 2003                |  |              | $       | 18,846           |  |             |         |                 |  |   |        |       |  |  |        | 75,000  |  |   |       |       |    
|                            | Treasurer and Secretary   |        |      | 2002                |  |              |         |                 |  |             |         |                 |  |   |        |       |  |  |        |        |  |   |       |       |    
|James C. Vetricek(5)        |                           |        | 2004 |                     |  | $            | 145,000 |                  |  |             |        |                  |  |   |       |        |  |  |       |         |  | $ | 2,064 | (4)   
|                            | Vice President Operations |        |      | 2003                |  |              | $       | 96,527           |  |             |         |                 |  |   |        |       |  |  |        | 75,000  |  |   | $     | 455    | (4)
|                            |                           |        |      | 2002                |  |              |         |                 |  |             |         |                 |  |   |        |       |  |  |        |        |  |   |       |        |    
|Simon Hawksworth(6)         |                           |        | 2004 |                     |  | $            | 139,501 |                  |  |             |        |                  |  | $ | 70,767 |        |  |  |       |         |  |   |       |       
|                            | Vice President Sales and  |        |      | 2003                |  |              | $       | 122,123          |  |             |         |                 |  |   | $      | 17,013 |  |  |        | 75,000  |  |   | $     | 18,602 | (4)
|                            | Marketing                 |        |      | 2002                |  |              |         |                 |  |             |         |                 |  |   |        |       |  |  |        |        |  |   |       |       |    
|Scott M. Stole(8)           |                           |        | 2004 |                     |  | $            | 122,367 |                  |  |             |        |                  |  |   |       |        |  |  | 24,500 |         |  | $ | 3,671 | (4)   
|                            | Chief Technical Officer   |        |      | 2003                |  |              | $       | 103,928          |  |             |         |                 |  |   |        |       |  |  |        | 20,000  |  |   | $     | 799    | (4)
|                            |                           |        | 2002 |                     |  |              |        |                  |  |             |        |                  |  |   |       |        |  |  |       |         |  |   |      |       



---



|    |                                                                                                                                                                 
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Mr. Traynor was appointed to the positions
    of Chief Executive Officer and President on March 19, 2003.                                                      
|   
|(2) | Consists of a $500 per month automobile
    allowance for eight months beginning January 2004.                                                                  
|   
|(3) | Mr. Nesbit was appointed to the position of
    Chief Financial Officer, Treasurer and Secretary on
    June 30, 2003.                                          
|   
|(4) | Consists of matching contributions to the
    Companys 401(k) Plan.                                                                                            
|   
|(5) | Mr. Vetricek was appointed to the position
    of VP Operations of AMO in January 2003, and to the position of
    Vice President of Operations in January 2004.
|   
|(6) | Mr. Hawksworth was appointed to the position
    of Vice President Sales and Marketing on September 3, 2002.                                                    
|   
|(7) | Consists of moving expense reimbursements.                                                                                                                      
|   
|(8) | Dr. Stole was appointed to the position of
    Chief Technical Officer on June 20, 2003.                                                                        

68



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##### Table of Contents



Options Granted During Fiscal 2004

The following table sets forth certain
information regarding grants of stock options to the Named
Executive Officers during Fiscal 2004 pursuant to our 1998 Stock
Option Plan.

|                     |  |             |        |              |  |              |     |            |  |                        |      |         |  |  |          |  |  |   |        |  |  |   |         | 
|-------------------- |  | ----------- | ------ | ------------ |  | ------------ | --- | ---------- |  | ---------------------- | ---- | ------- |  |  | -------- |  |  | - | ------ |  |  | - | ------- | 
|                     |  |             |        |              |  |              |     |            |  |                       
|                     |  |             |        |              |  |              |     |            |  | Potential Realizable  
|                     |  |             |        |              |  |              |     |            |  | Value of Assumed      
|                     |  | Number of   |        | % of Total   |  |              |     |            |  | Annual Rates of Stock 
|                     |  | Shares      |        | Options      |  |              |     |            |  | Price Appreciation for
|                     |  | Underlying  |        | Granted to   |  | Exercise of  |     |            |  | Option Term(2)        
|                     |  | Options     |        | Employees in |  | Base Price   |     | Expiration |  |                       
|Name                 |  | Granted (#) |        | Fiscal 2004  |  | ($/Share)(1) |     | Date       |  | 5% ($)                 |      | 10% ($)
|                     |  |             |        |              |  |              |     |            |  |                        |      |        
|Mack V. Traynor, III |  |             |       |              |  |              |    |            |  |                        |     |         |  |  |         |  |  |   |       |  |  |   |        | 
|Douglas J. Nesbit    |  |             |       |              |  |              |    |            |  |                        |     |         |  |  |         |  |  |   |       |  |  |   |        | 
|James C. Vetricek    |  |             |       |              |  |              |    |            |  |                        |     |         |  |  |         |  |  |   |       |  |  |   |        | 
|Simon Hawksworth     |  |             |       |              |  |              |    |            |  |                        |     |         |  |  |         |  |  |   |       |  |  |   |        | 
|Scott M. Stole       |  |             | 24,500 | (3)          |  |              | 0.7 | %          |  | $                      | 3.40 |         |  |  | 02/11/14 |  |  | $ | 52,387 |  |  | $ | 132,759 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | All options are granted at the fair market value
    of the common shares at the date of grant.                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   
|(2) | The 5% and 10% assumed annual rates of compounded
    stock price appreciation are mandated by rules of the SEC and do
    not represent the Companys estimates or projections of the
    future prices of its common stock. These amounts represent
    certain assumed rates of appreciation only. Actual gains, if
    any, on stock option exercises are dependent on the future
    performance of the common stock and overall stock market
    conditions. The amounts reflected in this table may not
    necessarily be achieved.
|   
|(3) | These options were granted on February 11,
    2004, and will be exercisable in four equal installments on each
    of February 11, 2005, 2006, 2007 and 2008.                                                                                                                                                                                                                                                                                                                                                                             

Aggregated Option Exercises During Fiscal 2004
and Fiscal Year-End Option Values

|                     |  |              |   |              |  |                            |   |                              |  |  |                |  |  |   |          | 
|-------------------- |  | ------------ | - | ------------ |  | -------------------------- | - | ---------------------------- |  |  | -------------- |  |  | - | -------- | 
|                     |  |              |   |              |  | Number of Securities       |   | Value of Unexercised        
|                     |  | Shares       |   |              |  | Underlying Unexercised     |   | In-the-Money Options at     
|                     |  | Acquired on  |   | Value        |  | Options at Fiscal Year-End |   | Fiscal Year-End ($)         
|Name                 |  | Exercise (#) |   | Realized ($) |  | Exercisable/Unexercisable  |   | Exercisable/Unexercisable(1)
|                     |  |              |   |              |  |                            |   |                             
|Mack V. Traynor, III |  |              | 0 |              |  | $                          | 0 |                              |  |  | 120,000/30,000 |  |  | $ | 8,000/$0 | 
|Douglas J. Nesbit    |  |              | 0 |              |  | $                          | 0 |                              |  |  | 50,000/25,000  |  |  | $ | 0/$0     | 
|James C. Vetricek    |  |              | 0 |              |  | $                          | 0 |                              |  |  | 25,000/50,000  |  |  | $ | 0/$0     | 
|Simon Hawksworth     |  |              | 0 |              |  | $                          | 0 |                              |  |  | 25,001/49,999  |  |  | $ | 0/$0     | 
|Scott M. Stole       |  |              | 0 |              |  | $                          | 0 |                              |  |  | 18,730/56,270  |  |  | $ | 0/$0     | 



---



|    |                                                                                                                                                                                                                                                                                                                                         
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Calculated as the difference between the closing
    price of the Companys common stock on August 31,
    2004, which was $1.76, and the option exercise price multiplied
    by the number of shares exercisable/unexercisable. Since the
    option price was greater than the closing price on
    August 31, 2004, the value is $0.

Stock Option Plans

In addition to the 1998 Director Plan, we
have adopted, and our shareholders have approved, two stock
option plans pursuant to which we may provide stock-based awards
to our officers, directors, employees and consultants. Our
Compensation Committee administers these plans and determines to
whom awards are to be granted and the terms and conditions,
including the number of shares and the period of exercisability,
thereof.

1998 Stock Option
Plan.Our 1998 Stock Option Plan (the
1998 Option Plan) authorizes the grant of option
rights, stock appreciation rights, awards of restricted shares
and awards of deferred shares. The number of shares of common
stock that may be issued or transferred and covered by
outstanding awards granted under the 1998 Option Plan may not in
the aggregate exceed 1,300,000 shares.

1989 Omnibus Stock Compensation
Plan.Our 1989 Omnibus Stock
Compensation Plan (the 1989 Option Plan) provides
for grants of both incentive stock options, intended to qualify
as such under

69



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Section 422 of the Internal Revenue Code of
1986, as amended (the Code), and non-statutory stock
options, stock appreciation rights, restricted stock, deferred
stock, stock purchase rights and other stock-based awards.
Except for the authority to grant incentive stock options, which
expired in 1999, the 1989 Option Plan has no expiration date but
may be terminated by the Board at any time, subject to the
rights of the holders of options or other awards previously
granted under the 1989 Option Plan. The number of shares of
common stock that may be issued or transferred and covered by
outstanding awards granted under the 1989 Option Plan may not in
the aggregate exceed 2,000,000 shares.


Compensation Committee Interlocks and Insider
Participation

No member of our Compensation Committee is a
former or current officer or employee of the Company or any of
its subsidiaries. Mack V. Traynor, our Chief Executive Officer
and President, is a director of Wavecrest Corporation. Dennis J.
Leisz, a director of the Company and member of our Compensation
Committee, is the Chief Executive Officer and President of
Wavecrest Corporation. No other executive officer of the Company
serves as an officer, director or member of a compensation
committee of any entity whose executive officer or director is a
director of the Company.

70



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##### Table of Contents



Stockholder return performance
presentation

The following line graph compares the cumulative
total shareholder return on our common stock to the cumulative
total return of the Russell 2000 (RUX) and the PHGILA
SemiCon (SOXX) Index for the last five years. Returns are
based on a $100 investment on September 1, 1999, and are
calculated assuming reinvestment of dividends during the period
presented. The Company has not paid any dividends.

TOTAL RETURN TO SHAREHOLDERS

(PERFORMANCE GRAPH)

|           |  |           |        |              |  |               |        |  |  |  |        | 
|---------- |  | --------- | ------ | ------------ |  | ------------- | ------ |  |  |  | ------ | 
|          
|          
|August 31, |  | HEI, Inc. |        | Russell 2000 |  | PHGILASemiCon
|          
|          
|2000       |  |           | 355.98 |              |  |               | 121.63 |  |  |  | 220.89 | 
|          
|2001       |  |           | 127.08 |              |  |               | 78.88  |  |  |  | 107.81 | 
|          
|2002       |  |           | 77.32  |              |  |               | 65.81  |  |  |  | 57.51  | 
|          
|2003       |  |           | 66.45  |              |  |               | 83.74  |  |  |  | 87.37  | 
|          
|2004       |  |           | 26.95  |              |  |               | 92.24  |  |  |  | 71.08  | 
|          

Employment contracts, terminations of
employment and change-in-control arrangements

Effective October 1, 2003, we entered into
an employment agreements with Mr. Nesbit, Dr. Stole
and Mr. Hawksworth. The agreement with Mr. Nesbit
provides for Mr. Nesbits employment as Chief
Financial Officer and an annualized base salary of $140,000. The
agreement with Dr. Stole provides for Dr. Stoles
employment as Chief Technical Officer and an annualized base
salary of $125,000. The Agreement with Mr. Hawksworth
provides for Mr. Hawksworths employment as Vice
President of Sales and Marketing and an annualized base salary
of $140,000. In addition, effective April 19, 2004, we
entered into an employment agreement to employ Mr. Traynor
as Chief Executive Officer and President for an annualized base
salary of $200,000, a $25,000 signing bonus, options to
purchase 100,000 shares of common stock and a
$500 monthly car allowance. Each of these agreements
provides that such salary may be adjusted from time to time by
the Company based on the employees performance and the
Companys business and financial situation.

Each of these agreements further provides for
annually-renewable one year terms. The Company may elect not to
renew the agreement by providing the employee with 30 days
advance written notice of non-renewal prior to the expiration of
a given term. In addition, during any renewable one year term,
each such

71



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##### Table of Contents



agreement may be terminated (a) by the
Company for Cause (as that term is defined in each such
agreement); (b) by the Company without Cause; (c) upon
the death, disability (as defined in each such agreement) or
incapacity of the employee; (d) by the employee within six
months of a Change of Control (as defined in each such
agreement) upon providing 30 days advance written notice to
the Company; and (e) by the employee at any time upon
providing 90 days advance written notice to the Company. In
the event that any of Mr. Nesbit, Dr. Stole or
Mr. Hawksworth are terminated by the Company without Cause,
such person may be entitled to receive monthly severance
payments equal to 1/12th of his annualized base salary at the
time of termination, less applicable withholdings, for up to the
earlier of (a) three months from his termination date or
(b) the date on which he begins earning income from other
work activities. In the event that any of Mr. Nesbit,
Dr. Stole or Mr. Hawksworth terminates his employment
within six months of a Change of Control, such person may be
entitled to receive monthly severance payments equal to 1/12th
of his annualized base salary at the time of termination for up
to the earlier of (a) twelve months from his termination
date or (b) the date on which he begins earning income from
other work activities. In the event Mr. Traynor is
terminated by the Company without Cause or Mr. Traynor
terminates his employment within six months of a Change of
Control, he may be entitled to receive monthly severance
payments equal to the sum of 18 months of his annualized
base salary at the time of termination for 18 months from
his termination date. To obtain this severance pay in either
termination situation, each of Mr. Traynor,
Mr. Nesbit, Dr. Stole and Mr. Hawksworth must
meet various conditions set out in their respective employment
agreements, including but not limited to signing a satisfactory
separation and release agreement.


Each of these agreements contain standard
confidential information and invention assignment provisions, as
well as 18 month post-employment noncompete and
nonsolicitation provisions. Each of the agreements also contain
an arbitration clause.

Report of the Compensation Committee on
Executive Compensation

Decisions on compensation of our executive
officers generally have been made by the Compensation Committee
of the Board. The current members of the Compensation Committee
are Messrs. Heenan and Leisz and Dr. Evers.

Pursuant to SEC rules designed to enhance
disclosure of our policies toward executive compensation, set
forth below is a report prepared by the Compensation Committee
of the Board addressing our compensation policies for the fiscal
year ended August 31, 2004, as they affected our executive
officers.

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

There are three elements in our executive
compensation program, each of which is determined by individual
and corporate performance; base salary compensation, annual
incentive compensation and long-term incentive compensation.
Base salary compensation is determined by the potential impact
the individual may have on us, the skills and experience
required by the job, comparisons with companies similar to us
and the performance and potential of the incumbent in the job.

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

72



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##### Table of Contents



During Fiscal 2004, the Compensation Committee
made awards of incentive stock options to certain of our
executive officers as follows: James P. Barnes, Chief
Information Officer  45,000; Nina A. Anderson, Vice
President Human Resources  25,000; and Scott M.
Stole, Chief Technical Officer  24,500. The
Compensation Committee also recommended that stock options be
granted to certain other non-executive officers of the Company.

The compensation of Mr. Traynor, who served
as our Chief Executive Officer and President for Fiscal 2004,
was determined by applying a process and philosophy similar to
that of other executive officers. In Fiscal 2004,
Mr. Traynor received a base salary of $200,000.
Mr. Traynor also received a bonus in the amount of $135,500
pursuant to agreement with Compensation Committee approved at
beginning of Mr. Traynors transition to Chief
Executive Officer and President.

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



| |                 
| | ----------------
| | Michael J. Evers
| | George M. Heenan
| | Dennis J. Leisz 






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

The following table shows as of December 27,
2004, information regarding the share ownership of (i) each
person or group known to us to own beneficially more than five
percent of our outstanding shares of Common Stock,
(ii) each of our directors, (iii) each Named Executive
Officer, and (iv) all directors and executive officers as a
group.

Except as otherwise indicated, we believe that
the persons listed in the following table have sole voting and
investment powers with respect to the shares owned.

|                                                                             |  |           |         |            |  |  |     |  
|---------------------------------------------------------------------------- |  | --------- | ------- | ---------- |  |  | --- | -
|                                                                             |  | Number    |         |           
|Name                                                                         |  | of Shares |         | Percentage
|                                                                             |  |           |         |           
|Mack V. Traynor, III, Chief Executive
    Officer, President and Director(1) |  |           | 120,000 |            |  |  | 1.4 | %
|Douglas J. Nesbit, Chief Financial Officer,
    Treasurer and Secretary(2)   |  |           | 50,000  |            |  |  | *   |  
|James C. Vetricek, Vice President
    Operations(3)                          |  |           | 29,303  |            |  |  | *   |  
|Simon F. Hawksworth, Vice President of Sales
    and Marketing(4)            |  |           | 25,001  |            |  |  |    |  
|Scott M. Stole, Chief Technical Officer(5)                                   |  |           | 32,917  |            |  |  | *   |  
|Michael J. Evers, Director(6)                                                |  |           | 15,000  |            |  |  | *   |  
|Timothy F. Floeder, Director(7)                                              |  |           | 35,000  |            |  |  |    |  
|George M. Heenan, Director(8)                                                |  |           | 10,000  |            |  |  | *   |  
|Dennis J. Leisz, Chairman of the Board(9)                                    |  |           | 35,000  |            |  |  | *   |  
|Perkins Capital Management, Inc.(10)                                         |  |           | 710,400 |            |  |  | 8.5 | %
|All directors and executive officers as a
    group(9 persons)               |  |           | 352,221 |            |  |  | 4.2 | %



---



| |     |                                                                                                                                                                        
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Includes 120,000 shares issuable upon
    exercise of options that are currently exercisable within
    60 days.                                                       
|
| | (2) | Includes 50,000 shares issuable upon
    exercise of options that are currently exercisable within
    60 days.                                                        
|
| | (3) | Includes 25,000 shares issuable upon
    exercise of options that are currently exercisable within
    60 days and 4,303 shares of beneficially owned common
    stock.
|
| | (4) | Includes 25,001 shares issuable upon
    exercise of options that are currently exercisable within
    60 days.                                                        

73



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##### Table of Contents





| |     |                                                                                                                                                                        
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (5) | Includes 30,917 shares issuable upon
    exercise of options that are currently exercisable within
    60 days and 2,000 shares of beneficially owned common
    stock.
|
| | (6) | Includes 10,000 shares issuable upon
    exercise of options that are currently exercisable within
    60 days and 5,000 shares of beneficially owned common
    stock.
|
| | (7) | Includes 35,000 shares issuable upon
    exercise of options that are currently exercisable within
    60 days.                                                        
|
| | (8) | Includes 10,000 shares issuable upon
    exercise of options that are currently exercisable within
    60 days.                                                        
|
| | (9) | Includes 35,000 shares issuable upon
    exercise of options that are currently exercisable within
    60 days.                                                        



|     |                                                                                                                                                                                                                                                                               
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Based on information provided by Perkins Capital
    Management, Inc. in a Schedule 13G filed with the SEC on
    February 4, 2004. The address provided in the
    Schedule 13G/ A for Perkins Capital Management, Inc. is 730
    East Lake Street, Wayzata, MN, 55391-1769.



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

Equity Compensation Plan Information

The following table sets forth certain
information about the common stock that may be issued upon the
exercise of options, warrants and rights under all of the
existing equity compensation plans as of August 31, 2004.

|                                                                |  |                            |           |                      |  |                                 |       |  |  |  |         | 
|--------------------------------------------------------------- |  | -------------------------- | --------- | -------------------- |  | ------------------------------- | ----- |  |  |  | ------- | 
|                                                                |  |                            |           |                      |  | Number of Securities           
|                                                                |  |                            |           |                      |  | Remaining Available for        
|                                                                |  | Number of Securities to be |           | Weighted-Average     |  | Future Issuance under          
|                                                                |  | Issued Upon Exercise of    |           | Exercise Price of    |  | Equity Compensation Plans      
|                                                                |  | Outstanding Options,       |           | Outstanding Options, |  | (Excluding Securities Reflected
|Plan Category                                                   |  | Warrants and Rights        |           | Warrants and Rights  |  | in the First Column)           
|                                                                |  |                            |           |                      |  |                                
|Equity plan compensation plans approved by
    shareholders     |  |                            | 1,918,400 |                      |  | $                               | 4.826 |  |  |  | 443,052 | 
|Equity plan compensation plans not approved by
    shareholders |  |                            |          |                      |  |                                 |      |  |  |  |        | 
|                                                                |  |                            |           |                      |  |                                 |       |  |  |  |         | 
|Total                                                           |  |                            | 1,918,400 |                      |  | $                               | 4.826 |  |  |  | 443,052 | 
|                                                                |  |                            |           |                      |  |                                 |       |  |  |  |         | 






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

We hold a promissory note from Mr. Traynor,
our Chief Executive Officer and President, in the amount of
$201,500. This promissory note, dated April 2, 2001, and
amended on July 17, 2003, was issued in exchange for a loan
from us that Mr. Traynor used to exercise options to
purchase common stock. Interest on this promissory note is paid
annually in arrears on the unpaid balance from the date of the
promissory note. In accordance with generally accepted
accounting principles, the rate of interest on this note is a
fair value rate based on Mr. Traynors incremental
floating rate for a similar loan. The term of this promissory
note is five years and is due and payable on April 2, 2006.
Interest only payments are required for the first two years,
with annual installments plus interest to be paid for the
remainder of the term.

Mr. Traynor made a payment of $13,604 in
interest under his note, but missed a payment of $100,833 in
principal under his note which was due on April 2, 2004.
Mr. Traynor has since paid the principal, accrued interest
and penalty on the note to bring it up to date.

74



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##### Table of Contents








|         |                                            
|-------- | -------------------------------------------
|Item 14. | Principal Accountant Fees and
    Services.

Fees

The following table presents the aggregate fees
billed to us in each of Fiscal 2003 and Fiscal 2004 for
professional services rendered by KPMG LLP.

|                      |  |             |         |             |  |   |         | 
|--------------------- |  | ----------- | ------- | ----------- |  | - | ------- | 
|                      |  | Fiscal 2003 |         | Fiscal 2004
|                      |  |             |         |            
|Audit Fees(1)         |  | $           | 443,090 |             |  | $ | 441,805 | 
|Audit Related Fees(2) |  | $           | 12,000  |             |  | $ | 10,500  | 
|Tax Fees              |  |             |        |             |  |   |        | 
|All Other Fees(3)     |  |             |        |             |  | $ | 108,500 | 
|                      |  |             |         |             |  |   |         | 
|Total Fees            |  | $           | 445,090 |             |  | $ | 560,805 | 
|                      |  |             |         |             |  |   |         | 



---



|    |                                                                                                                                                                                                                                                                                                       
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Fiscal 2003 Audit Fees include $361,849 related
    to the three-year AMO carve out audits and interim reviews filed
    with the SEC. Fiscal 2004 Audit Fees include $47,000 related to
    interim reviews filed with the SEC and $23,500 related to
    finalizing the purchase accounting for AMO.
|   
|(2) | Audit Related fees consisted principally of fees
    for audits of financial statements of the 401(k) benefit plan.                                                                                                                                                                                   
|   
|(3) | All Other Fees consisted of $18,500 for the
    reviews of Registration Statements on Forms S-3 and S-8 and
    $90,000 in fees related to the investigation involving the
    activities of Mr. Fant.                                                                                                

Audit Committee Pre-Approval Policy

The Audit Committee has adopted a formal policy
concerning approval of audit and non-audit services to be
provided by the independent auditor to the Company. The policy
requires that all services to be provided by KPMG LLP, the
Companys independent auditor, including audit services and
permitted audit-related and non-audit services, must be
pre-approved by the Committee. The Committee pre-approved all
audit and non-audit services provided by the Companys
independent auditor, KPMG LLP, during Fiscal 2004.




PART IV






|         |                                             
|-------- | --------------------------------------------
|Item 15. | Exhibits, Financial Statement
    Schedules.

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



| |                                                                                           
| | ------------------------------------------------------------------------------------------
| | (1) Financial Statements 
    see Part II, Item 8 of this Annual Report on
    Form 10-K.
|
| | (2) Schedule II 
    Valuation and Qualifying Accounts                                   

(b) Exhibits:

| |    |    |  |                                                                                                                          |  |        
| | -- | -- |  | ------------------------------------------------------------------------------------------------------------------------ |  | -------
| | 2  | .2 |  | Purchase Agreement, dated as of January 24,
    2003, by and between HEI, Inc. and Colorado MEDtech, Inc.                |  | Note 1 
| | 2  | .3 |  | Registration Rights Agreement, dated as of
    January 24, 2003, by and between HEI, Inc. and Colorado
    MEDtech, Inc. |  | Note 1 
| | 3  | .1 |  | Amended and Restated Articles of Incorporation of
    HEI, Inc.                                                          |  | Note 2 
| | 3  | .2 |  | Amended and Restated Bylaws of HEI, Inc.                                                                                 |  | Note 2 
| | 3  | .3 |  | Amendments to the Amended and Restated Bylaws of
    HEI, Inc., effective as of March 19, 2003                           |  | Note 14
| | 3  | .4 |  | Certificate of Designation of Common Stock of
    HEI, Inc.                                                              |  | Note 15
| | 10 | .1 |  | Loan and Security Agreement, dated July 31,
    2000, among HEI, Inc. and LaSalle Business Credit, Inc.                  |  | Note 3 

75



---



##### Table of Contents



| |     |     |  |                                                                                                                                                                                                                         |  |        
| | --- | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------
| | 10  | .2  |  | First Amendment to Credit Agreement, dated
    August 31, 2000, by and between HEI, Inc. and LaSalle
    Business Credit, Inc.                                                                                          |  | Note 4 
| | 10  | .3  |  | Second Amendment to Loan and Security Agreement,
    dated April 16, 2001, between HEI, Inc. and LaSalle
    Business Credit, Inc.                                                                                      |  | Note 4 
| | 10  | .4  |  | Third Amendment to Loan and Security Agreement,
    dated October 31, 2001, between HEI, Inc., Cross
    Technology, Inc. and LaSalle Business Credit, Inc.                                                             |  | Note 4 
| | 10  | .5  |  | Seventh Amendment to Loan and Security Agreement,
    dated December 1, 2002, by and among HEI, Inc., Cross
    Technology, Inc. and LaSalle Business Credit, Inc.                                                      |  | Note 5 
| | 10  | .6  |  | Eighth Amendment to Loan and Security Agreement,
    dated April 9, 2003, between HEI, Inc., Cross Technology,
    Inc. and LaSalle Business Credit, LLC.                                                               |  | Note 6 
| | 10  | .7  |  | Capital Expenditure Note, executed as of
    July 31, 2000, by HEI, Inc. in favor of LaSalle Business
    Credit, Inc.                                                                                                  |  | Note 3 
| | 10  | .8  |  | Amended and Restated Capital Expenditure Note,
    executed as of October 31, 2001, by HEI, Inc. and Cross
    Technology, Inc. in favor of LaSalle Business Credit, Inc.                                               |  | Note 4 
| | 10  | .9  |  | Amended and Restated Capital Expenditure Note,
    executed as of October 31, 2001, by HEI, Inc. and Cross
    Technology, Inc. in favor of LaSalle Business Credit, Inc.                                               |  | Note 4 
| | 10  | .10 |  | Amended and Restated Capital Expenditure Note,
    executed as of October 31, 2001, by HEI, Inc. and Cross
    Technology, Inc. in favor of LaSalle Business Credit, Inc.                                               |  | Note 4 
| | 10  | .11 |  | Amended and Restated Capital Expenditure Note,
    executed as of October 31, 2001, by HEI, Inc. and Cross
    Technology, Inc. in favor of LaSalle Business Credit, Inc.                                               |  | Note 4 
| | 10  | .12 |  | Reimbursement Agreement, dated July 31,
    2000, by and between HEI, Inc., LaSalle Bank, N.A. and LaSalle
    Business Credit, Inc.                                                                                    |  | Note 3 
| | 10  | .13 |  | Mortgage, Security Agreement, Fixture Financing
    Statement and Assignment of Lease and Rents, dated July 31,
    2000, by HEI, Inc., as Mortgagor, to LaSalle Business Credit,
    Inc., as Mortgagee                |  | Note 3 
| | 10  | .14 |  | Patent, Trademark and License Mortgage, dated
    July 31, 2000, by HEI, Inc. in favor of LaSalle Business
    Credit, Inc.                                                                                             |  | Note 3 
| | 10  | .15 |  | Amendment No. 1 to Patent, Trademark and
    License Agreement, undated, by HEI, Inc., in favor of LaSalle
    Business Credit, Inc.                                                                                    |  | Note 4 
| | 10  | .16 |  | Security Agreement, dated July 31, 2000, by
    and between HEI, Inc. and LaSalle Business Credit, Inc.                                                                                                                 |  | Note 3 
| | 10  | .17 |  | Revolving Note, executed as of July 31,
    2000, by HEI, Inc. in favor of LaSalle Business Credit, Inc.                                                                                                                |  | Note 3 
| | 10  | .18 |  | Amended and Restated Revolving Note, executed as
    of October 31, 2001, by HEI, Inc. and Cross Technology,
    Inc. in favor of LaSalle Business Credit, Inc.                                                         |  | Note 4 
| | 10  | .19 |  | Amended and Restated Revolving Note, executed as
    of December 1, 2002, by HEI, Inc. and Cross Technology,
    Inc. in favor of LaSalle Business Credit, Inc.                                                         |  | Note 5 
| | *10 | .20 |  | Form of Indemnification Agreement between HEI and
    officers and directors                                                                                                                                            |  | Note 7 
| | *10 | .21 |  | HEI, Inc. 1989 Omnibus Stock Compensation Plan,
    adopted April 3, 1989, and as Amended and Restated
    effective November 15, 1991, and as amended effective
    April 29, 1992, May 11, 1994, and October 31, 1996 |  | Note 8 
| | *10 | .22 |  | HEI, Inc. 1998 Stock Option Plan, adopted
    November 18, 1998, and amended effective January 20,
    2000, January 24, 2001, and February 20, 2002.                                                                   |  | Note 9 
| | *10 | .23 |  | HEI, Inc. 1998 Stock Option Plan for Nonemployee
    Directors, adopted November 18, 1998, and amended effective
    June 7, 1999 and December 12, 2002.                                                                |  | Note 14
| | 10  | .24 |  | Registration Rights Agreement, dated
    August 29, 2001, by and among HEI, Inc. and Certain
    Investors listed on Exhibit A thereto.                                                                                 |  | Note 11
| | 10  | .25 |  | Sample Promissory Note of Certain Officers and
    Directors in connection with the Exercise of Stock Options.                                                                                                          |  | Note 10
| | 10  | .26 |  | Subordinated Promissory Note, dated as of
    January 24, 2003, issued by HEI, Inc. and accepted by
    Colorado MEDtech, Inc.                                                                                          |  | Note 1 

76



---



##### Table of Contents



| |     |     |  |                                                                                                                                                                                            |  |        
| | --- | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------
| | 10  | .27 |  | Lease, dated as of January 7, 2002, by and
    between Eastside Properties, LLC and Colorado MEDtech, Inc.,
    subsequently assigned to HEI, Inc.                                         |  | Note 12
| | 10  | .28 |  | First Addendum to Lease, dated September 12,
    2002, by and between Eastside Properties, LLC and Colorado
    MEDtech, Inc., subsequently assigned to HEI, Inc.                          |  | Note 12
| | 10  | .29 |  | Second Addendum to Lease, dated January 23,
    2003, by and between Eastside Properties, LLC and Colorado
    MEDtech, Inc., subsequently assigned to HEI, Inc.                           |  | Note 12
| | 10  | .30 |  | Agreement Regarding Additional Security Deposit,
    undated, by and between Eastside Properties, Inc. and HEI, Inc.                                                                       |  | Note 12
| | 10  | .31 |  | Letter Agreement, dated May 16, 2003,
    between HEI, Inc. and Whitebox Hedged High Yield Partners.                                                                                       |  | Note 13
| | 10  | .32 |  | Accounts Receivable Agreement, dated May 29,
    2003, by and between HEI, Inc. and Beacon Bank.                                                                                           |  | Note 13
| | *10 | .33 |  | Confidential Separation Agreement and Release,
    dated June 20, 2003, between HEI, Inc. and Steve E.
    Tondera, Jr.                                                                    |  | Note 14
| | *10 | .34 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Douglas Nesbit.                                                                                                     |  | Note 14
| | *10 | .35 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Stephen Peterson.                                                                                                   |  | Note 14
| | *10 | .36 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Scott Stole.                                                                                                        |  | Note 14
| | *10 | .37 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Simon Hawksworth.                                                                                                   |  | Note 14
| | *10 | .38 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and James Vetricek.                                                                                                     |  | Note 14
| | 10  | .39 |  | Note Prepayment Agreement, dated October 15,
    2003, between HEI, Inc. and Whitebox Hedged High Yield Partners.                                                                          |  | Note 14
| | 10  | .40 |  | Promissory Note, dated October 14, 2003, by
    HEI, Inc. in favor of Commerce Bank.                                                                                                       |  | Note 14
| | 10  | .41 |  | Term Loan Agreement, dated October 14, 2003,
    by HEI, Inc. and Commerce Bank.                                                                                                           |  | Note 14
| | 10  | .42 |  | Combination Mortgage, Security Agreement,
    Assignment of Rents and Fixture Financing Statement, dated
    October 14, 2003, by HEI, Inc. in favor of Commerce Bank.                     |  | Note 14
| | 10  | .43 |  | Environmental Investigation Letter, dated
    October 14, 2003, by HEI, Inc. in favor of Commerce Bank.                                                                                    |  | Note 14
| | 10  | .44 |  | Promissory Note, dated October 28, 2003, by
    HEI, Inc. in favor of Commerce Financial Group, Inc.                                                                                       |  | Note 14
| | 10  | .45 |  | Term Loan Agreement, dated October 28, 2003,
    by HEI, Inc. and Commerce Financial Group, Inc.                                                                                           |  | Note 14
| | 10  | .46 |  | Commercial Security Agreement, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group, Inc.                                                                     |  | Note 14
| | 10  | .47 |  | Combination Mortgage, Security Agreement,
    Assignment of Rents and Fixture Financing Statement, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group, Inc. |  | Note 14
| | 10  | .48 |  | Environmental Investigation Letter, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group, Inc.                                                                |  | Note 14
| | 10  | .49 |  | Asset Purchase Agreement, dated October 31,
    2003, by HEI, Inc. and MKS Instruments, Inc.                                                                                               |  | Note 14
| | 10  | .50 |  | Amendment dated December 12, 2003, to
    Accounts Receivable Agreement, dated May 29, 2003, by and
    among HEI, Inc. and Beacon Bank.                                                   |  | Note 14
| | 10  | .51 |  | Registration Rights Agreement, dated as of
    November 5, 2003, between HEI, Inc. and Whitebox Hedged
    High Yield Partners.                                                            |  | Note 16

77



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##### Table of Contents



| |      |     |  |                                                                                                                                                                                                                                                 |  |        
| | ---- | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------
| | 10   | .52 |  | Stock Purchase Agreement, dated February 13,
    2004, by and among HEI, Inc. and the Investors listed on
    Exhibit A thereto.                                                                                                                |  | Note 17
| | 10   | .53 |  | Registration Rights Agreement, dated
    February 13, 2004, by and among HEI, Inc. and the
    Purchasers listed on Exhibit A thereto.                                                                                                          |  | Note 17
| | 10   | .54 |  | Form of Registration Rights Agreement, dated as
    of February 23, 2004, among HEI, Inc. and the Purchasers of
    an aggregate of 251,380 shares of HEI, Inc.                                                                                 |  | Note 16
| | 10   | .55 |  | Form of Registration Rights Agreement, dated as
    of May 7, 2004, among HEI, Inc. and the Purchasers of an
    aggregate of 631,524 shares of HEI, Inc.                                                                                       |  | Note 15
| | 10  | .56 |  | Amendment dated July 1, 2004, to Accounts
    Receivable Agreement, dated May 29, 2003, and previously
    amended on December 12, 2003, by and among HEI, Inc. and
    Beacon Bank.                                                            |  |        
| | 10   | .57 |  | Lease Agreement, dated October 1, 2004, by
    and between HEI, Inc. and Boulder Investors LLC.                                                                                                                                                 |  | Note 18
| | 10   | .58 |  | Waiver and Amendment, dated November 30,
    2004, and executed as of December 3, 2004, by and between
    HEI, Inc. and Commerce Bank.                                                                                                         |  | Note 19
| | 10   | .59 |  | Waiver and Amendment, dated November 30,
    2004, and executed as of December 3, 2004, by and between
    HEI, Inc. and Commerce Financial Group, Inc.                                                                                         |  | Note 19
| | 10   | .60 |  | Amendment dated December 7, 2004, to
    Accounts Receivable Agreement, dated May 29, 2003, and
    previously amended on December 12, 2003, and July 1,
    2004, by and among HEI, Inc. and Beacon Bank.                                      |  | Note 20
| | *10 | .61 |  | Employment Agreement, dated April 19, 2004,
    between HEI Inc. and Mack Traynor.                                                                                                                                                              |  |        
| | 10   | .62 |  | Waiver and Amendment, dated December 29,
    2004, and executed as of January 5, 2005, by and between
    HEI, Inc. and Commerce Bank.                                                                                                          |  | Note 21
| | 10   | .63 |  | Waiver and Amendment, dated December 29,
    2004, and executed as of January 5, 2005, by and between
    HEI, Inc. and Commerce Financial Group, Inc.                                                                                          |  | Note 21
| | 10   | .64 |  | Notice, Waiver and Amendment, dated
    December 29, 2004, and executed as of January 5, 2005,
    by and between HEI, Inc. and Beacon Bank.                                                                                                    |  | Note 21
| | 10   | .65 |  | Amendment dated January 12, 2005, to
    Accounts Receivable Agreement, dated May 29, 2003, and
    previously amended December 12, 2003, July 1, 2004,
    December 7, 2004 and December 29, 2004, by and among
    HEI, Inc. and Beacon Bank. |  | Note 22
| | 16  |     |  | Letter from KPMG LLP to the Securities and
    Exchange Commission dated January 13, 2005.                                                                                                                                                      |  |        
| | 21  |     |  | Subsidiaries of the Registrant.                                                                                                                                                                                                                 |  |        
| | 23  |     |  | Consent of KPMG LLP.                                                                                                                                                                                                                            |  |        
| | 31  | .1  |  | Certification of Chief Executive Officer pursuant
    to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                         |  |        
| | 31  | .2  |  | Certification of Chief Financial Officer pursuant
    to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                         |  |        
| | 32  | .1  |  | Certification of Chief Executive Officer pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                         |  |        
| | 32  | .2  |  | Certification of Chief Financial Officer pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                         |  |        



---

Notes to Exhibits above:



| |     |                                                                                                                                                                                                                                            
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Filed as an exhibit to the Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on February 10, 2003, and incorporated herein by reference.                                                               
|
| | (2) | Filed as an exhibit to the Definitive Proxy
    Statement on Schedule 14A for the 2002 Annual Meeting of
    Shareholders, filed with the Securities and Exchange Commission
    on January 23, 2002, and incorporated herein by reference.

78



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##### Table of Contents





| |     |                                                                                                                                                                                                           
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (3) | Filed as an exhibit to the Annual Report on
    Form 10-KSB for the fiscal year ended August 31, 2000,
    and incorporated herein by reference.                                                          
|
| | (4) | Filed as an exhibit to the Annual Report on
    Form 10-K for the fiscal year ended August 31, 2001,
    and incorporated herein by reference.                                                            
|
| | (5) | Filed as an exhibit to the Quarterly Report on
    Form 10-Q for the quarterly period ending November 30,
    2002, and incorporated herein by reference.                                                 
|
| | (6) | Filed as an exhibit to the Quarterly Report on
    Form 10-Q for the quarterly period ending February 28,
    2003, and incorporated herein by reference.                                                 
|
| | (7) | Filed as an exhibit to the Registration Statement
    on Form S-2 (SEC No. 33-37285), filed with the
    Securities and Exchange Commission on October 15, 1990, and
    incorporated herein by reference.
|
| | (8) | Filed as an exhibit to the Annual Report on
    Form 10-KSB for the fiscal year ended August 31, 1996,
    and incorporated herein by reference.                                                          
|
| | (9) | Filed as an exhibit to the Annual Report on
    Form 10-KSB for the fiscal year ended August 31, 1998,
    and incorporated herein by reference.                                                          



|     |                                                                                                                                                                                                          
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Filed as an exhibit to the Annual Report on
    Form 10-K for the fiscal year ended August 31, 2002,
    and incorporated herein by reference.                                                           
|    
|(11) | Filed as an exhibit to the Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on September 4, 2001, and incorporated herein by reference.                             
|    
|(12) | Filed as an exhibit to the Current Report on
    Form 8-K/ A (Amendment No. 1), filed with the
    Securities and Exchange Commission on April 10, 2003, and
    incorporated herein by reference.       
|    
|(13) | Filed as an exhibit to the Quarterly Report on
    Form 10-Q for the quarterly period ended May 31, 2003,
    and incorporated herein by reference.                                                      
|    
|(14) | Filed as an exhibit to the Annual Report on
    Form 10-K for the fiscal year ended August 31, 2003,
    and incorporated herein by reference.                                                           
|    
|(15) | Filed as an exhibit to the Registration Statement
    on Form S-3 (SEC No. 333-115982), filed with the
    Securities and Exchange Commission on May 28, 2004, and
    incorporated herein by reference. 
|    
|(16) | Filed as an exhibit to the Registration Statement
    on Form S-3 (SEC No. 333-113419), filed with the
    Securities and Exchange Commission on March 9, 2004, and
    incorporated herein by reference.
|    
|(17) | Filed as an exhibit to the Current Report on
    Form 8-K/ A (Amendment No. 1), filed with the
    Securities and Exchange Commission on February 19, 2004,
    and incorporated herein by reference.    
|    
|(18) | Filed as an exhibit to the Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on December 21, 2004.                                                                   
|    
|(19) | Filed as an exhibit to the Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on December 9, 2004, and incorporated herein by reference.                              
|    
|(20) | Filed as an exhibit to the Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on December 10, 2004, and incorporated herein by reference.                             
|    
|(21) | Filed as an exhibit to the Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on January 5, 2005, and incorporated herein by reference.                               
|    
|(22) | Filed as an exhibit to the Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on January 13, 2005.                                                                    



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



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

79



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##### Table of Contents



SCHEDULE II

Valuation and Qualifying Accounts

|                                 |  |                           |     |                      |  |                 |    |               |  |   |     |  |  |   |     | 
|-------------------------------- |  | ------------------------- | --- | -------------------- |  | --------------- | -- | ------------- |  | - | --- |  |  | - | --- | 
|                                 |  | Balance at                |     | Additions Charged to |  | Deductions      |    | Balance at   
|                                 |  | Beginning of Period       |     | Costs and Expenses   |  | from Reserve(1) |    | End of Period
|                                 |  |                           |     |                      |  |                 |    |              
|                                 |  |                          
|                                 |  | (In thousands of dollars)
|Allowance for doubtful accounts: |  |                           |     |                      |  |                 |    |               |  |   |     |  |  |   |     | 
|Year ended August 31, 2004       |  | $                         | 92  |                      |  | $               | 39 |               |  | $ | 10  |  |  | $ | 121 | 
|Year ended August 31, 2003       |  |                           | 85  |                      |  |                 | 30 |               |  |   | 23  |  |  |   | 92  | 
|Year ended August 31, 2002       |  |                           | 271 |                      |  |                 | 6  |               |  |   | 192 |  |  |   | 85  | 



---



|    |                                                           
|--- | ----------------------------------------------------------
|(1) | Represents charge-off of accounts receivable
    balances.

80



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, as amended, the
registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized



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



| |     |                        
| | --- | -----------------------
| | By: | /s/ MACK V. TRAYNOR III

| |                                          
| | -----------------------------------------
| |                                          
| | Mack V. Traynor III                      
| | Chief Executive Officer and
    President

Date: January 13, 2005

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, 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/ MACK V. TRAYNOR IIIMack V. Traynor III |  | Chief Executive Officer and President |  | January 13, 2005
|                                          
|/s/ DOUGLAS J. NESBITDouglas J. Nesbit     |  | Chief Financial Officer               |  | January 13, 2005
|                                          
|/s/ DENNIS J. LEISZDennis J. Leisz         |  | Director                              |  | January 13, 2005
|                                          
|/s/ TIMOTHY F. FLOEDERTimothy F. Floeder   |  | Director                              |  | January 13, 2005
|                                          
|/s/ MIKE EVERSMike Evers                   |  | Director                              |  | January 13, 2005
|                                          
|/s/ GEORGE HEENANGeorge Heenan             |  | Director                              |  | January 13, 2005
|                                          
|Anthony J. Fant                            |  | Director                              |  |                 

81



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##### Table of Contents



INDEX TO EXHIBITS

| |    |     |  |                                                                                                                                                                                     
| | -- | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10 | .56 |  | Amendment dated July 1, 2004, to Accounts
    Receivable Agreement, dated May 29, 2003, and previously
    amended on December 12, 2003, by and among HEI, Inc. and
    Beacon Bank.
| | 10 | .61 |  | Employment Agreement, dated April 19, 2004,
    between HEI, Inc. and Mack Traynor.                                                                                                 
| | 16 |     |  | Letter from KPMG LLP to the Securities and
    Exchange Commission dated January 13, 2005.                                                                                          
| | 21 |     |  | Subsidiaries of the Registrant.                                                                                                                                                     
| | 23 |     |  | Consent of KPMG LLP.                                                                                                                                                                
| | 31 | .1  |  | Certification of Chief Executive Officer pursuant
    to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                             
| | 31 | .2  |  | Certification of Chief Financial Officer pursuant
    to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                             
| | 32 | .1  |  | Certification of Chief Executive Officer pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                             
| | 32 | .2  |  | Certification of Chief Financial Officer pursuant
    to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                             

82