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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




---

Form 10-K

|   |  |                                                                                       
|-- |  | --------------------------------------------------------------------------------------
|þ  |  | ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934    
|  
|   |  | For fiscal year ended August 31,
    2003.                                            
|  
|or
|  
|o  |  | TRANSITION REPORT UNDER SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|  
|   |  | For the transition period
    from           to          .                            

Commission file number 0-10078



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HEI, Inc.

(Exact name of registrant as specified in its
Charter)


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

Issuers telephone number, including area
code:

(952) 443-2500


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

None


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

Common Stock, Par Value $.05 Per
Share


(Title of Class)


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

Indicate 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 Exchange Act
Rule 12b-2).     Yes o          No þ

The aggregate
market value, in thousands, of the voting and non-voting common
equity held by nonaffiliates 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): $12,907,000.

As of
December 15, 2003, 7,045,791 Common Shares, par value $.05
per share, were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the
Definitive Proxy Statement for the Registrants 2004 Annual
Meeting of Shareholders to be filed with the Securities and
Exchange Commission are incorporated by reference into
Part III of this Annual Report on Form 10-K.



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TABLE OF CONTENTS



|                                                           |                                                                                                                          |  |  |  |  |  |  | 
|---------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  | 
|FORWARD-LOOKING STATEMENTS                                
|PART I                                                    
|                                                           | Item 2. Properties.                                                                                                     
|                                                           | Item 3. Legal Proceedings.                                                                                              
|                                                           | Item 4. Submission of Matters to a Vote of Security-Holders                                                             
|PART II                                                   
|                                                           | Item 6. Selected Financial Data.                                                                                        
|                                                           | Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations. (In thousands of dollars)
|CRITICAL ACCOUNTING POLICIES                              
|RESULTS OF OPERATIONS                                     
|FINANCIAL CONDITION                                       
|TERM-DEBT                                                 
|FISCAL 2004 LIQUIDITY                                     
|CONTRACTUAL OBLIGATIONS                                   
|RISK FACTORS                                              
|                                                           | Item 7A. Qualitative and Quantitative Disclosures About Market Risk. (In thousands)                                     
|                                                           | Item 8. Financial Statements and Supplementary Data.                                                                    
|CONSOLIDATED BALANCE SHEETS                               
|CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|STATEMENT OF FINANCIAL RESPONSIBILITY                     
|PART III                                                  
|PART IV                                                   
|SCHEDULE II                                               
|SIGNATURES                                                
|EX-3.3 Amendment, dated March 19, 2003 to Bylaws          
|EX-10.24 1998 Stock Option Plan                           
|EX-10.34 Separation Agreement and Release                 
|EX-10.35 Employment Agreement - Douglas J. Nesbit         
|EX-10.36 Employment Agreement - Stephen K Petersen        
|EX-10.37 Employment Agreement - Scott M. Stole            
|EX-10.38 Employment Agreement - Simon F Hawksworth        
|EX-10.39 Employment Agreement - James C. Vetricek         
|EX-10.40 Note Prepayment Agreement                        
|EX-10.41 Promissory Note                                  
|EX-10.42 Term Loan Agreement                              
|EX-10.43 Combination Mortgage, Secruity Agreement         
|EX-10.44 Environmental Investigation Letter               
|EX-10.45 Promissory Note                                  
|EX-10.46 Term Loan Agreement                              
|EX-10.47 Commercial Security Agreement                    
|EX-10.48 Combination Mortgage, Secruity Agreement         
|EX-10.49 Environmental Investigation Letter               
|EX-10.50 Asset Purchase Agreement                         
|EX-10.51 Accounts Receivable Agreement Amendment          
|EX-21 Subsidiaries of the Registrant                      
|EX-23 Consent of KPMG LLP                                 
|EX-31.1 Certification of Chief Executive Officer          
|EX-31.2 Certification of Chief Financial Officer          
|EX-32.1 Certification of Chief Executive Officer          
|EX-32.2 Certification of Chief Financial Officer          



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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.

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






PART I




|        |          
|------- | ---------
|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. During our fiscal year ended
August 31, 2000 (Fiscal 2000), we acquired
Cross Technology, Inc. (Cross), now our wholly owned
subsidiary. The acquisition of Cross was a strategic move to
expand our product offerings in the ultraminiature markets that
we serve. We opened our Mexico operation in Fiscal 2000 focusing
on low cost contract assembly and closed this facility during
our fiscal year ended August 31, 2001 (Fiscal
2001), primarily as a result of lack of profitability,
disposing of some assets and relocating some assets to our other
facilities.

On January 24, 2003, we acquired certain
assets and assumed certain liabilities of Colorado MEDtech,
Inc.s (CMED) Colorado operations
(Advance Medical Operations or AMO) in a
business combination accounted for as a purchase. In connection
with this acquisition, we issued one million shares of our
common stock and assumed approximately $900 of AMO liabilities,
as well as an operating lease and other contractual commitments.
The purchase price of AMO was $2,600 based upon the closing
market price of a share of our common stock the day the
acquisition was finalized and consummated, as quoted on the
NASDAQ National Market. The excess of the fair value of net
assets over the purchase price in the amount of $3,760 has been
allocated to reduce the carrying value of identifiable
long-lived tangible and intangible assets.

Business of the Company



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



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

HEI provides a comprehensive range of
engineering, product design, automation and test, manufacturing
and fulfillment services and solutions to our customers in the
hearing, medical device, medical equipment, communications,
computing and industrial equipment industries. We provide these
services and solutions on a global basis through 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. HEI uses the leverage
created by its various technology platforms to

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provide bundled solutions to the markets served.
In doing so, the Company uses much of its internal manufacturing
capacity to create these solutions. For example, the
Link-itTM connectivity solution uses flex
circuitry, circuit board assembly, radio frequency
(RF), software code and engineering services
developed and delivered by our different internal capabilities.
All of our facilities are ISO 9001:2000 certified.


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 components. For example,
in hearing aids the microelectronic assemblies we design and
make are contained within a shell and connected to a microphone,
receiver and battery. For some customers, we procure the
microphone, receiver and battery from outside vendors and
assemble all of the components into further assemblies; and we
may sell only the microelectronic assembly to other customers.
Our custom-built microelectronics are employed in the hearing,
medical, telecommunications and ultra miniature radio frequency
markets. Our microelectronics facilities achieved
ISO 9001:2000 certification in August 2003.

Certain proprietary technology employed in our
Victoria facility allows us to manufacture miniature packages
that are specially designed to hold and protect high frequency
chips for broadband communications. This package, with the
enclosed chip, 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 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.

In our Boulder, Colorado facility we provide four
primary products and services. First, 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. Second, Boulders medical
imaging group 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). This 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. Fourth, Boulder
provides a connectivity solution consisting of both hardware and
software. This technology enables medical device Original

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Equipment Manufactures (OEMs) and Health Care
Information Technology (HCIT) 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 an 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.

In our Tempe, Arizona facility, we manufacture
and design 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, as well as
through our independent sales representatives. In addition, we
promote our services through industry advertising and exhibition
at industry trade shows.

We currently have annual agreements with our
three largest customers, Siemens, Inc., GN ReSound AS and GE
Medical Systems (GEMS), a subsidiary of General
Electric Company, along with several other 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. Although these annual agreements
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. For customers with lower
demand requirements we commonly use their POs only to plan
production and procure materials. These programs are subject to
our standard terms and conditions including cancellation
clauses, whereby either party may cancel such 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 seven active and ten pending
patents. Two of our most significant patents are the High
Density Stacked Circuit Module and the Interconnection Device.
The High Density Stacked Circuit Module is a method of stacking
two or more ICs and then electrically interconnecting them. This
approach allows us to use the thickness of the circuit to add
capabilities rather than increase the width and length. The
result is a more compact device than can be attained using
conventional methods. The primary application is in our hearing
market, where smaller circuits make it possible to fit more
people with hearing aides and makes the hearing aid less
obtrusive. Our latest design patent, the Interconnection Device,

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allows for the cost effective use of high-speed
millimeter wave ICs by placing them into surface mount packages.
These surface mount packages allow our customers to cost
effectively incorporate those packages into their products, and
also permits a rapid increase to high volume manufacturing,
using standard high volume assembly equipment.


Government
Regulations: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 manufacturing
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 Quality System Regulation 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 year from 1997 to
2003.

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.

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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, 2003, 2002, and 2001.

|                         |  |                    |    |      |  |      |    |   |  |  |    |  
|------------------------ |  | ------------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                         |  |                   
|                         |  | Fiscal Years Ended
|                         |  | August 31,        
|                         |  |                   
|Customer                 |  | 2003               |    | 2002 |  | 2001
|                         |  |                    |    |      |  |     
|Sonic Innovations, Inc.  |  |                    | 17 | %    |  |      | 32 | % |  |  | 26 | %
|Siemens, Inc.            |  |                    | 14 | %    |  |      | 32 | % |  |  | 25 | %
|GE Medical Systems       |  |                    | 14 | %    |  |      |   |   |  |  |   |  
|Triquint Optoelectronics |  |                    |   |      |  |      |   |   |  |  | 10 | %

Sonic Innovations, Inc. and Siemens, Inc. operate
in the human hearing-aid market. The decrease in percent of
sales and sales dollars with both Sonic Innovations, Inc and
Siemens, Inc. during our fiscal year ended August 31, 2003
(Fiscal 2003), is largely a result of their
increased internal manufacturing capabilities and off shore out
sourcing. GE Medical Systems, a subsidiary of General Electric
Company, is a customer in the MRI component market of our
Advanced Medical Operations and, although AMO was new to HEI in
Fiscal 2003, GEMS was a customer of CMED during CMEDs
fiscal years ended June 30, 2003, 2002 and 2001. Triquint
Optoelectronics is a customer in the communications market.
Reduced revenue from Triquint Optoelectronics is attributed to
the overall downturn in the telecommunications market. For
financial information about revenues from external customers
attributed to specific geographic areas see
Item 8  Note 17 to Consolidated Financial
Statements.

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

|                 |  |                    |    |      |  |      |    |   |  |  |    |  
|---------------- |  | ------------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                 |  |                   
|                 |  | Fiscal Years Ended
|                 |  | August 31,        
|                 |  |                   
|Market           |  | 2003               |    | 2002 |  | 2001
|                 |  |                    |    |      |  |     
|Medical/ Hearing |  |                    | 82 | %    |  |      | 76 | % |  |  | 61 | %
|Communications   |  |                    | 6  | %    |  |      | 11 | % |  |  | 17 | %
|RFID             |  |                    | 8  | %    |  |      | 10 | % |  |  | 14 | %
|Other            |  |                    | 4  | %    |  |      | 3  | % |  |  | 8  | %

We believe that diversification between our key
markets is important. Our goals are to have no one market
account for 40% or more of our net sales, 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
revenue, which will result in more diversification.

At August 31, 2003, our backlog of orders
for revenue for our fiscal year ending August 31, 2004
(Fiscal 2004) was approximately $18,645 compared to
approximately $5,400 at August 31, 2002. We expect to ship
our backlog as of August 31, 2003, during Fiscal 2004. This
increase in backlog is mainly due to increased order activity
from the overall stronger economic conditions in our markets and
$10,864 from the acquisition of AMO.

Competition:In each
of our product lines, we face significant competition, including
customers who may produce the same or similar products
themselves. 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 HEI because they view us to be the leading
edge in designing and manufacturing products that help them, in
turn, delivering better products faster and cheaper than they
could do by themselves. Finally, we 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 $2,580, $2,516 and $2,433 for our
fiscal years ended August 31, 2003, 2002 and 2001,
respectively.

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Employees:On
August 31, 2003, we employed 284 full-time persons and
1 part-time person.






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 AMO (the
Subordinated Promissory Note) 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 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 150,022 square foot facility in
Boulder, Colorado for our Advanced Medical Operations. The
Boulder facility is leased until April 2013. As a part of the
purchase accounting for the acquisition of our AMO, HEI has
established a $3,110 reserve related to the future estimated
lease payments of the Boulder facility, which is currently not
being fully utilized. In addition, we intend to reduce our
occupancy costs at this facility by sub-leasing the 50,000
square foot addition.






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
August 12, 2003, the Court did not rule on the other counts
in the complaint, reserving to a later time such determination.
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. 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, in excess of approximately $112 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.






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 our fiscal year ended
August 31, 2003.

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Executive Officers of the Registrant

The following is a list of our executive
officers, their ages and offices as of December 16, 2003.
Each executive officer serves a term of one year or until his
successor is appointed and qualified.

|                     |  |     |    |          |  |                                                  
|-------------------- |  | --- | -- | -------- |  | -------------------------------------------------
|Name                 |  | Age |    | Position
|                     |  |     |    |         
|Mack V. Traynor, III |  |     | 45 |          |  | Chief Executive Officer and President            
|Douglas J. Nesbit    |  |     | 51 |          |  | Chief Financial Officer                          
|Stephen K. Petersen  |  |     | 51 |          |  | Vice President of the Micro Electronics Operation
|Scott M. Stole       |  |     | 40 |          |  | Chief Technical Officer                          
|Simon F. Hawksworth  |  |     | 37 |          |  | Vice President of Sales and Marketing            
|James C. Vetricek    |  |     | 46 |          |  | Vice President of the Advanced Medical Operation 

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. 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 of the Minnesota Society of Certified
Public Accountants and a participant on the CPE advisory
committee for the AICPA.

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

Scott M. Stole Ph.D.joined us in October 2000 as Director
of Advanced Process Development. In June 2003, he was
promoted to Chief Technical Officer. 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,

7



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corporate strategy and strategic alliances.
Dr. Stole received his Ph.D. from Iowa State University and
his Bachelors degree from Concordia College, and has
13 years of experience in the design, development and
manufacture of a wide range of microelectronics and advanced
materials-related products.


Simon F. Hawksworthjoined us in September 2002 as
Vice President of Sales and Marketing. 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 C. Vetricekjoined us in January 2003 in
connection with our acquisition of our AMO as Vice President of
our AMO. Prior to such acquisition, 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, he 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.

8



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##### Table of Contents








PART II


Item 5.     Market
for Registrants Common Equity and Related Stockholder
Matters.

Our common stock is currently traded on the
NASDAQ National Market under the symbol HEII. Below are the high
and low sales prices for each quarter of our fiscal years ending
August 31, 2003 and 2002, for our common stock, as reported
by NASDAQ National Market.

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

|                  |  |      |      |     |  |   |      | 
|----------------- |  | ---- | ---- | --- |  | - | ---- | 
|Fiscal Year Ended |  |      |      |    
|August 31, 2002   |  | High |      | Low
|                  |  |      |      |    
|First Quarter     |  | $    | 8.70 |     |  | $ | 6.00 | 
|Second Quarter    |  |      | 7.90 |     |  |   | 5.50 | 
|Third Quarter     |  |      | 8.33 |     |  |   | 5.76 | 
|Fourth Quarter    |  |      | 7.80 |     |  |   | 4.30 | 

As of December 12, 2003, we had 310
shareholders of record. We have not paid any dividends on our
common stock since our initial public offering on March 24,
1981. We expect that for the foreseeable future we will follow a
policy of retaining earnings in order to finance 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 loan agreements with
our lender provides that we cannot, without the lenders
prior written consent, pay any dividend or make any distribution
of assets to our shareholders or affiliates.

9



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

HEI, Inc. and Subsidiaries

Five-Year Summary of Selected Financial
Information


|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |        | 
|------------------------------------------- | --------------------------------------- | ---------------------------------------- | ------ | ------- |  | ------- | ------ | ------- |  | ------- | ------ | ------ |  | - | ------ | ------ |  | - | ------ | ------ | 
|                                            |                                         |                                         
|                                            |                                         | Fiscal Years Ended August 31,           
|                                            |                                         |                                         
|                                            |                                         | 2003(a)                                  |        | 2002(b) |  | 2001(c) |        | 2000(d) |  | 1999(e)
|                                            |                                         |                                          |        |         |  |         |        |         |  |        
|                                            |                                         |                                         
|                                            |                                         | (In thousands, except per share amounts)
|Net sales                                   |                                         | $                                        | 38,440 |         |  | $       | 28,532 |         |  | $       | 44,832 |        |  | $ | 42,799 |        |  | $ | 29,089 |       
|Cost of sales                               |                                         |                                          | 31,327 |         |  |         | 23,375 |         |  |         | 36,841 |        |  |   | 35,544 |        |  |   | 22,378 |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Gross profit                                |                                         |                                          | 7,113  |         |  |         | 5,157  |         |  |         | 7,991  |        |  |   | 7,255  |        |  |   | 6,711  |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Operating expenses:                         |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Selling, general and administrative     |                                          |        | 7,639   |  |         |        | 5,335   |  |         |        | 5,806  |  |   |        | 6,338  |  |   |        | 4,623  | 
|                                            | Research, development and engineering   |                                          |        | 2,580   |  |         |        | 2,516   |  |         |        | 2,433  |  |   |        | 1,764  |  |   |        | 1,343  | 
|Unusual charges                             |                                         |                                          | 331    |         |  |         |       |         |  |         | 1,693  |        |  |   | 453    |        |  |   | 490    |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Operating income (loss)                     |                                         |                                          | (3,437 | )       |  |         | (2,694 | )       |  |         | (1,941 | )      |  |   | (1,300 | )      |  |   | 255    |       
|Other income (expense), net                 |                                         |                                          | (1,213 | )       |  |         | (106   | )       |  |         | (2,182 | )      |  |   | (227   | )      |  |   | 380    |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Income (loss) before income taxes           |                                         |                                          | (4,650 | )       |  |         | (2,800 | )       |  |         | (4,123 | )      |  |   | (1,527 | )      |  |   | 635    |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Income tax expense (benefit)                |                                         |                                          | (21    | )       |  |         | 1,092  |         |  |         | (930   | )      |  |   | (372   | )      |  |   | 242    |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Net income (loss)                           |                                         | $                                        | (4,629 | )       |  | $       | (3,892 | )       |  | $       | (3,193 | )      |  | $ | (1,155 | )      |  | $ | 393    |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Net income (loss) per basic share           |                                         | $                                        | (0.70  | )       |  | $       | (0.65  | )       |  | $       | (0.65  | )      |  | $ | (0.24  | )      |  | $ | 0.08   |       
|Net income (loss) per diluted share         |                                         | $                                        | (0.70  | )       |  | $       | (0.65  | )       |  | $       | (0.65  | )      |  | $ | (0.24  | )      |  | $ | 0.08   |       
|Weighted average common shares outstanding: |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Basic                                   |                                          |        | 6,629   |  |         |        | 5,992   |  |         |        | 4,881  |  |   |        | 4,726  |  |   |        | 4,698  | 
|                                            | Diluted                                 |                                          |        | 6,629   |  |         |        | 5,992   |  |         |        | 4,881  |  |   |        | 4,726  |  |   |        | 4,701  | 
|Balance sheet as of year end:               |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Working capital                         |                                          | $      | 5,885   |  |         | $      | 4,369   |  |         | $      | 8,793  |  |   | $      | 5,902  |  |   | $      | 8,333  | 
|                                            | Total assets                            |                                          |        | 26,503  |  |         |        | 22,989  |  |         |        | 27,528 |  |   |        | 28,936 |  |   |        | 23,739 | 
|                                            | Long-term debt, less current maturities |                                          |        | 2,689   |  |         |        | 1,473   |  |         |        | 3,972  |  |   |        | 3,894  |  |   |        | 3,415  | 
|                                            | Shareholders equity                    |                                          |        | 13,191  |  |         |        | 14,570  |  |         |        | 18,420 |  |   |        | 15,116 |  |   |        | 15,566 | 
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       



---



|    |                                                                                                                                                                                                                                                                                                                                                                     
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) | 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 and a reserve of $841 for Mr. Fants promissory
    note and other amounts due from Mr. Fant.
|   
|(b) | Income tax expense reflects the establishment of
    a $3,420 valuation allowance of which $3,188 was included in
    income tax expense.                                                                                                                                                                                                                           
|   
|(c) | 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.                                                 
|   
|(d) | For Fiscal 2000 unusual charges of $453 consisted
    of acquisition transaction costs related to the Cross
    acquisition.                                                                                                                                                                                                                                        
|   
|(e) | For our fiscal year ended August 31, 1999,
    unusual charges of $490 related to the severance agreement
    between the Company and the former Chief Executive Officer.                                                                                                                                                                                           

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|        |                                                                                                                         
|------- | ------------------------------------------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations.
    (In thousands of dollars)

Fiscal 2003 started off slow but was bolstered by
the acquisition of our AMO in the second quarter. Revenue in the
first quarter began the year with the lowest revenue we have
experienced in thirteen quarters at $5,490. That was a 10% drop
in revenue from our first quarter of our fiscal year ended
August 31, 2002 (Fiscal 2002). The cost
reduction plan implemented in second quarter of Fiscal 2002
continued into Fiscal 2003. It is important to note that our
variable costs have historically represented as much as
approximately 75% of our revenue, which makes us extremely
volume sensitive The cost reduction plan has lowered our
quarterly breakeven point to approximately $13,000 as of the end
of Fiscal 2003. We will continue to manage our costs and have a
goal to lower the quarterly breakeven point by the end of Fiscal
2004. Our commitment to research and development continued in
Fiscal 2003 and we have and will continue this effort to
maintain and increase our propriety technology and manufacturing
process. With revenue continuing to be our biggest issue in
Fiscal 2003 we have streamlined and improved our sales and
marketing efforts with renewed focus and talent. We are
experiencing positive results from this effort and will continue
to concentrate on this during Fiscal 2004 to not only increase
our sales, but to increase our diversification of revenue.






CRITICAL ACCOUNTING POLICIES


The accompanying consolidated financial
statements are based on the selection and application of
accounting principles generally accepted in the United States
(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

We recognize revenue upon shipment of products to
customers, when all contractual obligations have been satisfied
and collection of the resulting receivable is reasonably
assured. For inventory shipped on consignment, revenue is
recognized upon transfer of title when the customer uses the
inventory. In the normal course of business we enter into a
number of contracts with our customers under which we provide
engineering services on a per project basis. We recognize
revenue on these services based upon meeting certain milestones
and or benchmarks that are attributable to the different
contractual elements of the overall contract. Based on the
accomplishments of these goals we use the percentage of
completion methodology to recognize the revenue and related
costs to generate the revenues. Sales, payment terms and pricing
extended to customers are governed by the respective contract
agreements or binding POs for each transaction and provide no
right of return outside of contractual warranty terms. Payment
terms are seven days for consignment program sales and from four
to 60 days for other customers. For items delivered with
contingent payment terms, revenue is deferred for the greater of
the amount of the contingent payment or the fair value of the
undelivered elements and recognized when the contingency is
resolved. We provide engineering and product development
services to our customers pursuant to written contracts. The
majority of these arrangements are time and material contracts.
We recognize revenue as time is incurred or materials are
consumed. To a lesser extent we have fixed-price contracts which
are accounted for using either the completed contract method or
the percentage of completion method.

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

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estimated allowances, additional reductions to
our net sales would result. As of August 31, 2003 and 2002,
warranty and product return reserves were $122 and $200,
respectively.


Allowance for uncollectible accounts

We estimate the collectibility 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 collectibility 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, 2003 and 2002, we had accounts receivable
allowances of $92 and $85, 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 to
protect us in cases where the demand decreases, 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, 2003 and 2002, we have
reduced the carrying value to the lower of cost or market for
excess and obsolete inventory by $1,511 and $311, respectively.

Long-lived 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 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. During
Fiscal 2003 we recorded asset impairment charges of $331. For
Fiscal 2002 we did not record any long-lived asset impairment
charges. During Fiscal 2001 we recorded asset impairment charges
of $125 for leasehold improvements and fixed assets related to
the Mexico facilities closing.

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.

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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, 2003 and 2002, we had
valuation allowances of approximately $5,400 and $3,400,
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 set forth in
Note 6 to our Consolidated Financial Statements reflect a
preliminary allocation of the purchase price of our AMO. This
allocation includes an accrual of $730 related to an unfavorable
operating lease, $2,380 for future estimated lease payments and
a $600 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 unoccupied space for which we are
in the process of reviewing alternative uses. We have entered
into an agency agreement with Julien J. Studley, Inc., a
national commercial real estate services firm, to assist HEI in
reducing its occupancy costs at this facility by sub-leasing the
50,000 square foot addition. The final allocation of the
consideration to be paid may differ from those assumptions
reflected in the accompanying audited consolidated financial
statements. In our opinion, all adjustments necessary to present
fairly such financial statements have been made based on the
terms and structure of the AMO acquisition. We continue the
process of gathering information to complete our analysis of the
excess lease capacity and the contractual manufacturing
obligations. Any reductions in these liabilities will result in
a decrease in the carrying value of the intangible assets and
fixed assets. Conversely, an increase in these liabilities
increases the carrying values of long-lived assets. At
August 31, 2003, the carrying value of long-lived assets
has been reduced by a net of $3,760 by the allocation of
negative goodwill.






RESULTS OF OPERATIONS


Percentage of Net Sales

|                                      |  |                   |     |      |  |      |     |  |  |  |     | 
|------------------------------------- |  | ----------------- | --- | ---- |  | ---- | --- |  |  |  | --- | 
|                                      |  |                  
|                                      |  | Fiscal Year Ended
|                                      |  | August 31,       
|                                      |  |                  
|                                      |  | 2003              |     | 2002 |  | 2001
|                                      |  |                   |     |      |  |     
|Gross profit                          |  |                   | 19% |      |  |      | 18% |  |  |  | 18% | 
|Selling, general and administrative   |  |                   | 20% |      |  |      | 19% |  |  |  | 13% | 
|Research, development and engineering |  |                   | 7%  |      |  |      | 9%  |  |  |  | 5%  | 
|Other                                 |  |                   | 4%  |      |  |      | 0%  |  |  |  | 4%  | 

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

|                |  |                   |     |      |  |      |     |  |  |  |     | 
|--------------- |  | ----------------- | --- | ---- |  | ---- | --- |  |  |  | --- | 
|                |  |                  
|                |  | Fiscal Year Ended
|                |  | August 31,       
|                |  |                  
|Market          |  | 2003              |     | 2002 |  | 2001
|                |  |                   |     |      |  |     
|Medical/Hearing |  |                   | 82% |      |  |      | 76% |  |  |  | 61% | 
|Communications  |  |                   | 6%  |      |  |      | 11% |  |  |  | 17% | 
|RFID            |  |                   | 8%  |      |  |      | 10% |  |  |  | 14% | 
|Other           |  |                   | 4%  |      |  |      | 3%  |  |  |  | 8%  | 

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Net Sales

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
sales associated with the addition of our AMO was partially
offset by a decrease in sales of approximately $6,300 to two of
our major medical/ hearing customers. Net sales in Fiscal 2002
decreased $16,300 or 36%, compared to Fiscal 2001. The decrease
in net sales from Fiscal 2001 was largely a result of the
general economic slowdown and the resulting impact in the
medical/ hearing, communications, RFID and electronic contract
manufacturing markets. Additionally, during the fourth quarter
of Fiscal 2002, the internal manufacturing capacity of one of
our customers increased, resulting in approximately $3,800
reduced sales of our products in Fiscal 2003.

The communications and RFID markets remain soft
as our customers are awaiting market acceptance of new products
and increased demand for existing products. As 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.

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 contributed $14,429 for the
year in medical revenue. 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 are mainly due to excess inventory
positions at significant hearing customers and reflect the
general economic slowdown, which continues 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 $6,709, $9,273 and $11,271 in
Fiscal 2003, Fiscal 2002, and Fiscal 2001, 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.

Fiscal 2002 sales to medical/hearing customers
decreased from $27,356 in Fiscal 2001 to $21,558, or by $5,798,
or 21%. The decrease in demand comparing Fiscal 2002 to Fiscal
2001 is a result of the general economic slowdown impacting the
hearing contract manufacturing markets. Also, during the latter
part of Fiscal 2002 one of our customers internal
manufacturing capabilities increased, negatively impacting
revenue by approximately $1,450 in Fiscal 2002.

Net sales to the communications and industrial
products market decreased from $4,004 in Fiscal 2002 to $3,864
in Fiscal 2003, or $140 or 3%. The Fiscal 2003 decrease as
compared to Fiscal 2002 is largely a result of the current
weakness in the telecommunications markets. We are experiencing
increased activity in this market with numerous low volume
purchase orders. In September 2002, 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 2002
from $6,342 in Fiscal 2001 to $4,004 in Fiscal 2002, or by
$2,338 or 37%. This decrease comparing Fiscal 2002 to Fiscal
2001 is largely a result of weakness in the telecommunications
markets.

Net sales to the RFID products market represents
decreased from $2,970 in Fiscal 2002 to $2,885 in Fiscal 2003 or
by $85 or 3%. This decrease was driven by a drop in orders from
a major customer that, in Fiscal 2002, sold one division and
terminated operations of another. We are also experiencing
competition from overseas manufacturers in this market. New
products have been developed and capabilities have been

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expanded to improve revenue; however, the actual
level of market acceptance of these initiatives is currently
unknown. RFID sales decreased in Fiscal 2002 from $6,389 in
Fiscal 2001 to $2,970, or by $3,419 or 54%, primarily due to the
above mentioned drop in orders from one major customer.


At August 31, 2003, our backlog of orders
for revenue in Fiscal 2004 was approximately $18,645, compared
to approximately $5,400 and $11,000 at August 31, 2002 and 2001,
respectively. We expect to ship our backlog as of
August 31, 2003 during Fiscal 2004. This increase in
backlog is mainly due to increased order activity from the
overall stronger economic conditions in our markets and $10,864
from the acquisition of AMO. 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
18.5% in Fiscal 2003, as compared to 18.1% in Fiscal 2002 and
17.8% in Fiscal 2001. 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%. In future periods, we expect gross margins to be
impacted in a similar manner as revenues fluctuate.

Our gross profit as a percentage of sales was
18.1% in Fiscal 2002, as compared to 17.8% in Fiscal 2001. While
our gross margin percentages are heavily impacted by revenue,
due to the fixed nature of many of our manufacturing costs, we
were able to improve gross margins in Fiscal 2002 from Fiscal
2001 despite a 36% decrease in net sales. This improvement is
due to a reduction of 35 direct labor and manufacturing
employees in Fiscal 2002 resulting in a savings of $649 in
direct labor and $77 in administrative salary costs, improved
manufacturing yields to 94.4% in Fiscal 2002 from 92.7% in
Fiscal 2001, reduced scrap expense to 3.8% in Fiscal 2002 from
4.5% in Fiscal 2001 (calculated as a percentage of gross sales),
and from the closure of the Mexico product line, which generated
negative gross margins of $624 during Fiscal 2001.

Operating Expenses



| |                                        
| | ---------------------------------------
| | Selling, general and
    administrative

Selling, general and administrative expenses in
total were 20% of net sales in Fiscal 2003, compared to 19% and
13% in Fiscal 2002 and Fiscal 2001, respectively. Selling,
general and administrative expenses in Fiscal 2003 increased
$2,304 when compared to Fiscal 2002. The increase is mainly due
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 board of director fees. During Fiscal 2002, selling,
general and administrative expenses decreased by $471 when
compared to Fiscal 2001, due to the closure of the Mexico
operations and other cost reductions, including reduction of
employees, travel and other operational costs. These reductions
were offset by increases in professional fees and insurance
costs totaling $196. An 11-employee reduction during Fiscal 2002
resulted in decreased selling, general and administrative
expenses of $178 during Fiscal 2002. These overall decreasing
expenses are a result of our continued efforts to size our cost
structure to revenue while balancing our commitment to maintain
our research and development efforts and continued sales and
marketing focus.

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| |                                                    
| | ---------------------------------------------------
| | Research, development, and engineering
    expenses

Research, development, and engineering expenses
increased $64 in Fiscal 2003, when compared to Fiscal 2002, and
increased $147, when compared to Fiscal 2001. Comparing Fiscal
2002 to Fiscal 2001, costs increased in Fiscal 2002 by $83 or
3%, compared to Fiscal 2001. In Fiscal 2003 and Fiscal 2002, the
increases in research, development and engineering expenses are
a result of our commitment to maintain our design capabilities
to support future programs and continue the development and
enhancement of our proprietary products and manufacturing
processes.



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

The unusual charges of $331 in the current year
relate to the impairment of equipment. The 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 will be moved offshore in the first
quarter of Fiscal 2004. The unusual charges of $1,693 incurred
in Fiscal 2001 relate to the write-off of accounts receivable
related to customers of the Mexico operations and the closure of
those operations.

Other Income (Expense), Net

Other expenses of $1,213 in Fiscal 2003 increased
$1,107 from Fiscal 2002, which reflects a decrease of $969 when
compared to Fiscal 2001. The current-year increase is due
primarily to costs related to the non-cash write off of deferred
financing bank fees of $181 related to the terminated revolving
line of credit with LaSalle Business Credit, and establishment
of a reserve of $841 for Mr. Fants promissory note
and other amounts that were determined to be uncollectible.
Other expense in Fiscal 2002 of $106 decreased by $626 as
compared to Fiscal 2001, primarily due to lower interest
expense. Net interest expense for Fiscal 2002 decreased by $158
from Fiscal 2001 as a result of the lower average debt in Fiscal
2002 of approximately $2,000, and higher average cash balances
of approximately $4,000, along with average interest rates of
approximately 2% lower during Fiscal 2002 compared to Fiscal
2001. The lower average debt and higher average cash balances
are the result of the net offering proceeds of $6,222 received
in August 2001. In addition, other expense, net for Fiscal 2001
of $732 includes a non-cash charge of $161 ($106 net of tax)
related to costs associated with the abandoned CMED transaction.

Income Tax Expense (Benefit)

Management performs an analysis of the
realization of the deferred tax asset each fiscal quarter.
During Fiscal 2003 we recognized an income tax benefit of $21
compared to an income tax expense of $1,092 in Fiscal 2002.
During Fiscal 2003, we did not recognize a tax benefit for any
of the Companys losses. The Fiscal 2002 tax expense
resulted from the establishment of a deferred tax valuation
allowance to fully reserve all of our deferred tax assets.
During the fourth quarter of 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
recovery. 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 carryforwards. The
Fiscal 2002 deferred tax expense was partly offset by a federal
income tax benefit of $459.

Comparing Fiscal 2002 to Fiscal 2001, we
recognized tax expense of $1,092 during Fiscal 2002 compared to
a tax benefit of $930 in Fiscal 2001. During Fiscal 2001 we
benefited the net operating loss carryforwards created by the
Company resulting in a $930 tax benefit. As noted above, we
established a deferred tax valuation allowance for all the
deferred income tax assets as of August 31, 2002.

At the end of Fiscal 2003, we had net operating
loss carryforwards expiring at various dates ranging from 2012
through 2023. Even though valuation allowances have been
established, we still retain all the economic benefits of the
net operating loss in future years.

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FINANCIAL CONDITION


Our net cash flow provided by operating
activities for Fiscal 2003 was $322 compared to $1,077 and
$3,930 for Fiscal 2002 and Fiscal 2001, respectively. For Fiscal
2003, cash flow from operating activities was generated as a
result of a decrease of $581 in inventories, an increase in
accounts payable of $2,136 and accrued liabilities of $504,
offset by an increase in accounts receivable of $2,488, and a
$737 increase in the net loss from $3,892 in Fiscal 2002 to
$4,629 in Fiscal 2003. Non-cash expenses for Fiscal 2003 consist
of depreciation of $3,295. The increases in non-cash expenses
were primarily the result of increased depreciation from the
acquisition of our AMO, the establishment of an allowance for
note receivable of $597 and impaired assets charges of $331. The
Fiscal 2003 increase in accounts receivable, accounts payable
and accrued liability balances is attributable primarily to the
post acquisition activity of our AMO. The decrease in inventory
is due to reduced requirements at year end for major programs
from two significant customers, Sonic Innovations, Inc and
Siemens, Inc. Net cash provided by operating activities totaled
$1,077 and $3,930,respectively, in Fiscal 2002 and Fiscal 2001.
This decrease was a result of higher revenue in Fiscal 2001,
which caused higher accounts receivable and inventory balances
when compared to Fiscal 2002.

Our net cash flow used in investing activities
was $634, $2,423 and $3,889 for Fiscal 2003, Fiscal 2002 and
Fiscal 2001, respectively. We spent $580 on capital expenditures
and patent costs in Fiscal 2003 compared to $2,423 in Fiscal
2002. During Fiscal 2001 we spent $3,533 on capital
expenditures. 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 used in financing activities
was $1,254 and $675, respectively for Fiscal 2003 and Fiscal
2002, and our net cash flow provided by financing activities was
$3,868 for Fiscal 2001. Cash generated from issuance of common
stock was $53, $275 and $6,336 for Fiscal 2003, Fiscal 2002 and
Fiscal 2001, respectively. During Fiscal 2003, in connection
with the purchase of AMO, we issued the 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. During Fiscal 2001, we completed a private
placement of common stock that generated $6,200 in net proceeds.
Other issuances of common stock during the past three Fiscal
years were from the exercise of stock options. The majority of
other year-to-year changes relate to the borrowings and
repayment under the Companys revolving line of credit and
term debt agreements.

The result of these activities was a decrease in
cash by $1,566 and $2,021 during Fiscal 2003 and Fiscal 2002,
respectively, and an increase in cash of $3,909 during Fiscal
2001. At the end of Fiscal 2003 our unrestricted cash balance
was $806.

Accounts receivable average days outstanding were
46 days at August 31, 2003, compared to 53 and
74 days at August 31, 2002 and 2001, respectively.
Inventory turns were 5.7, 5.0 and 7.0, for the Fiscal 2003,
Fiscal 2002 and Fiscal 2001, respectively. The decreased days
outstanding are mainly due to two significant customers that pay
seven or less day terms. Increased inventory turns for Fiscal
2003 were primarily due to the increase in revenue with
associated cost of sales in the last quarter of the Fiscal 2003
as compared to Fiscal 2002. The decreased days outstanding and
decreased inventory turns in Fiscal 2002 were primarily due to
the slow down in revenue in the last quarter of Fiscal 2002 as
compared to Fiscal 2001.

The Companys current ratio at the end of
Fiscal 2003 was 1.7:1 as compared to 1.6:1 and 2.7:1 at the end
of Fiscal 2002 and Fiscal 2001, respectively. 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. The decrease in Fiscal 2002 as compared
to Fiscal 2001 is principally due to the receipt of $6,200 from
the closing of a private placement in August 2001, off set by
additions to property and equipment and payments on long-term
debt with the $1,000 increase in current maturities of long-term
debt exceeding the $1,100 generated by operating activities in
Fiscal 2002. Based on the modified bank covenants, amended
December 13, 2002, and the required repayment of $1,000 of
long-term debt, the current ratio at the end of Fiscal 2002
would have been 1.7:1.

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TERM-DEBT


Long-term debt

During Fiscal 2003 and early Fiscal 2004, 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 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 will recognize 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 Credit Facilities 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 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 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, with
an interest rate of 8.975% per year through September 27,
2007. Monthly payments of principal and interest in the amount
of $28 will be paid over a forty-eight month period 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, the Company extended the
Credit Agreement to September 1, 2004. The Credit Agreement
is an accounts receivable backed facility and is additionally
secured by inventory, intellectual property and other general
intangibles. The Credit Agreement replaced our revolving line of
credit with LaSalle Business Credit, LLC, and is not subject to
any restrictive financial covenants. We have a maximum of $3,000
available under the Credit Agreement, with the actual borrowings
based on eligible accounts receivable. As of August 31,
2003, there were $490 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 is
in place. Borrowings are reduced as collections and payments are
received into a lock box by the bank. The effected interest rate
based on our average DSO of 46 days would be 18.3%
annualized.

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FISCAL 2004 LIQUIDITY


The accompanying consolidated financial
statements have been prepared assuming the Company will continue
as a going concern, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of
business. The Company incurred net losses of $4,629, $3,892 and
$3,193 for the years ended August 31, 2003, 2002 and 2001,
respectively.

We have historically financed our operations
through the public and private sale of debt and equity
securities, bank borrowings under lines of credit, operating
equipment leases and cash generated by operations. Significant
financial restructuring occurred during our fiscal year ended
August 31, 2003, and early in our current fiscal year
ending August 31, 2004, transforming our capital structure
to a lower interest rate and less restrictive structure. We
replaced a revolving line of credit with LaSalle Business
Credit, LLC with an accounts receivable backed credit agreement
with Beacon Bank that does not have restrictive covenants.

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. The first note, with Commerce
Bank in the amount of $1,200, is secured by our Victoria,
Minnesota facility. The second note, with Commerce Financial
Group, Inc. in the amount of $1,150, is secured by our Victoria
facility and equipment located at our Tempe facility. These
loans provided us with the necessary resources to prepay the
subordinated promissory note from the Colorado MEDtech, Inc.
(CMED) acquisition held by Whitebox Hedged High
Yield Partners (see note 8). The terms of the new loans
have an average interest rate of 7.75% as compared to 12.00% for
the retired debt.

At August 31, 2003, our sources of liquidity
consisted of $806 of cash and cash equivalents and our revolving
credit line agreement, which was due to expire in May 2004. On
December 12, 2003 the revolving line was extended to
September 1, 2004. The credit line agreement allows for
borrowings of up to $3,000 subject to availability based on
accounts receivable. There was $490 outstanding debt at
August 31, 2003, leaving an available credit of $2,510 at
year-end. Our liquidity is affected by many factors, some of
which are based on the normal ongoing operations of our
business, the most significant of which include the timing of
the collection of receivables, the level of inventories and
capital expenditures. In the event cash flows are not sufficient
to fund operations at the present level numerous 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.

During Fiscal 2004, we intend to spend
approximately $750 for manufacturing equipment, extend the SAP
Software Solution to our AMO and minor facility improvements.
These additions, if made, will increase efficiency though 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.

We generated cash flows from operating activities
of $653, during fourth quarter of Fiscal 2003. We believe that
existing cash and cash equivalents, current lending capacity and
cash generated from operations will supply sufficient cash flow
to meet short- and long-term debt obligations and operating
requirements during the next 12 months.

Management believes that, as a result of the
financial restructuring actions it has taken to reduce cash
expenditures, the continuing efforts to increase revenues from
continuing customers and to generate new customers in various
industry sectors, the replacement and subsequent extension of
its revolving and term credit facilities it has obtained, it
will meet for its fiscal year ending August 31, 2004.






CONTRACTUAL OBLIGATIONS


Giving effect to the refinancing in the first
quarter of Fiscal 2004 of our Subordinated Promissory Note with
the two notes from Commerce Bank and its affiliate, Commerce
Financial Group, Inc., and the resulting $472 gain that has been
reflected below as a reduction of contractual obligations, our
contractual obligations at August 31, 2003, are summarized
in the following table:

|                              |  |        |       |        |  |        |       |            |  |              |       |  |  |   |        |  |  |   |        | 
|----------------------------- |  | ------ | ----- | ------ |  | ------ | ----- | ---------- |  | ------------ | ----- |  |  | - | ------ |  |  | - | ------ | 
|                              |  | Fiscal |       | Fiscal |  | Fiscal |       |            |  | Total Amount
|                              |  | 2004   |       | 2005   |  | 2006   |       | Thereafter |  | Committed   
|                              |  |        |       |        |  |        |       |            |  |             
|Long-term debt                |  | $      | 397   |        |  | $      | 381   |            |  | $            | 330   |  |  | $ | 1,454  |  |  | $ | 2,562  | 
|Contractual obligation        |  |        | 320   |        |  |        | 80    |            |  |              |      |  |  |   |       |  |  |   | 400    | 
|Operating leases              |  |        | 2,110 |        |  |        | 1,993 |            |  |              | 1,853 |  |  |   | 12,054 |  |  |   | 18,010 | 
|                              |  |        |       |        |  |        |       |            |  |              |       |  |  |   |        |  |  |   |        | 
|Total contractual obligations |  | $      | 2,827 |        |  | $      | 2,454 |            |  | $            | 2,183 |  |  |   | 13,508 |  |  | $ | 20,972 | 
|                              |  |        |       |        |  |        |       |            |  |              |       |  |  |   |        |  |  |   |        | 

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RISK FACTORS


(In thousands except per share
amounts)


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

The forward-looking statements included herein
are based on current assumptions that we will continue to
develop, market, manufacture and ship products on a timely
basis, that competitive conditions within our markets will not
change materially or adversely, that we will continue to
identify and satisfy customer needs for products and services,
that we will be able to retain and hire key personnel, that 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.

If we are unable to integrate, operate and
manage the Advanced Medical Operations, our operating results
and business condition may be reduced.On January 24, 2003, we acquired
our Colorado business unit from CMED. This business unit
incurred substantial losses during CMEDs fiscal years
ended June 30, 2002 and 2001 and for the six-months ended
December 31, 2002. We may not be able to successfully and
profitably integrate, operate, maintain and manage our Advanced
Medical Operations 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 facility
in Boulder, Colorado, 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

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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 2003, Fiscal 2002, and Fiscal
2001, our three largest customers, Siemens, Inc., Sonic
Innovations, Inc., and GE Medical Systems, in the aggregate
accounted for 45%, 65%, and 51%, 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.

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 industry.

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.

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.

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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 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.

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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 have control over the timing of
    expenditures in anticipation of increased sales, customer
    product delivery requirements and the range of services
    provided; and                                                                                                                                                              
|
| |  | we may experience variance in the amount and
    timing of orders placed by a customer due to a number of
    factors, including inventory balancing, changes in manufacturing
    strategy, and variation in product demand attributable to, among
    other things, product life cycles, competitive factors, and
    general economic conditions.

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

We are dependent on a single industry and
adverse trends in that industry may reduce our revenues.During the past several years, we have
been significantly dependent on a single market. In Fiscal 2003,
Fiscal 2002, and Fiscal 2001, 82%, 76%, and 61%, respectively of
our net sales came from the hearing instrument and medical
device manufacturers. These industries are characterized by
intense competition, relatively short product life cycles, rapid
technological change, significant fluctuations in product demand
and significant pressure on vendors to reduce or minimize cost.
Accordingly, we may be adversely affected by these industry
trends to the extent that they reduce our revenues. In
particular, if the hearing instrument manufacturers develop new
technologies that do not incorporate our products, or if our
competitors offer similar products at a lower cost to such
manufacturers, our revenues may decrease and our business would
be adversely affected.

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

Our 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 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

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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 imaging and medical 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.

We may lose business and revenues if we fail
to successfully compete with our customers for business.We face competition from the internal
operations of our current and potential 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

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components purchased from any of our key
suppliers could have a material adverse impact on our financial
performance. From time to time, our suppliers allocate
components among their customers in response to supply
shortages. In some cases, supply shortages will substantially
curtail production of all assemblies using a particular
component. In addition, at various times there have been
industry-wide shortages of electronic components. While we have
not experienced sustained periods of shortages of components in
the recent past, there can be no assurance that substantial
component shortages will not occur in the future. Any such
shortages could reduce our operating results.


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

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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 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;                               

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| |   |                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------
| |  | 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 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 15, 2003,
we had options outstanding to acquire 1,399,600 shares of our
common stock, exercisable at prices ranging from $1.680 to
$20.375 per share, with a weighted average exercise price of
approximately $7.054 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 15, 2003, these shares consist of:



| |   |                                                                                                 
| | - | ------------------------------------------------------------------------------------------------
| |  | approximately 866,000 shares beneficially owned
    by our executive officers and directors; and
|
| |  | approximately 1,447,100 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 10,000,000 shares of common
stock and 5,000,000 shares of undesignated stock, the terms of
which may be determined at the time of issuance by the Board of
Directors, without further action by our shareholders.
Undesignated stock authorized by the Board of Directors may
include voting rights, preferences as to dividends and
liquidation,

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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;                                                                                                                 
|
| |  | 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. (In thousands)

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 new Term Credit Facilities with Commerce Bank, a
Minnesota state banking association. 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 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 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 will be paid over a forty-eight
month period beginning on October 28, 2003. 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.

28



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##### Table of Contents








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

Our financial statements as of August 31,
2003 and 2002, and for each of the years in the three-year
period ended August 31, 2003, 2002 and 2001, together with
the Independent Auditors Reports are included in this
Form 10-K on the pages indicated below.

|                                                                 |  |          |    | 
|---------------------------------------------------------------- |  | -------- | -- | 
|                                                                 |  | Page No.
|                                                                 |  |         
|Consolidated Balance Sheets                                      |  |          | 30 | 
|Consolidated Statements of Operations                            |  |          | 31 | 
|Consolidated Statements of Changes in
    Shareholders Equity   |  |          | 32 | 
|Consolidated Statements of Cash Flows                            |  |          | 33 | 
|Notes to Consolidated Financial Statements                       |  |          | 34 | 
|Independent Auditors Report                                     |  |          | 53 | 
|Independent Auditors Report on Financial
    Statement Schedule |  |          | 54 | 
|Statement of Financial Responsibility                            |  |          | 55 | 

29



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HEI, INC.






CONSOLIDATED BALANCE SHEETS


|                                                               |                                                                                                     |                |        |            |   |   |        |         |  
|-------------------------------------------------------------- | --------------------------------------------------------------------------------------------------- | -------------- | ------ | ---------- | - | - | ------ | ------- | -
|                                                               |                                                                                                     | August 31,     |        | August 31,
|                                                               |                                                                                                     | 2003           |        | 2002      
|                                                               |                                                                                                     |                |        |           
|                                                               |                                                                                                     |               
|                                                               |                                                                                                     | (In thousands)
|ASSETS                                                        
|Current assets:                                                |                                                                                                     |                |        |            |   |   |        |        
|                                                               | Cash and cash equivalents                                                                           |                | $      | 806        |   |   | $      | 2,372   |  
|                                                               | Restricted cash                                                                                     |                |        |           |   |   |        | 1,000   |  
|                                                               | Accounts receivable, net                                                                            |                |        | 6,314      |   |   |        | 3,533   |  
|                                                               | Inventories                                                                                         |                |        | 6,864      |   |   |        | 4,027   |  
|                                                               | Other current assets                                                                                |                |        | 403        |   |   |        | 383     |  
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Total current assets                                           |                                                                                                     |                | 14,387 |            |   |   | 11,315 |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Property and equipment:                                        |                                                                                                     |                |        |            |   |   |        |        
|                                                               | Land                                                                                                |                |        | 216        |   |   |        | 216     |  
|                                                               | Building and improvements                                                                           |                |        | 4,316      |   |   |        | 4,316   |  
|                                                               | Fixtures and equipment                                                                              |                |        | 21,137     |   |   |        | 21,259  |  
|                                                               | Accumulated depreciation                                                                            |                |        | (15,769    | ) |   |        | (14,439 | )
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Net property and equipment                                     |                                                                                                     |                | 9,900  |            |   |   | 11,352 |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Developed technology, net                                      |                                                                                                     |                | 341    |            |   |   |       |        
|Security deposit                                               |                                                                                                     |                | 1,580  |            |   |   |       |        
|Other long-term assets                                         |                                                                                                     |                | 295    |            |   |   | 322    |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Total assets                                                   |                                                                                                     | $              | 26,503 |            |   | $ | 22,989 |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|LIABILITIES AND SHAREHOLDERS
    EQUITY                      
|Current liabilities:                                           |                                                                                                     |                |        |            |   |   |        |        
|                                                               | Line of credit                                                                                      |                | $      | 490        |   |   | $      | 1,589   |  
|                                                               | Current maturities of long-term debt                                                                |                |        | 397        |   |   |        | 2,441   |  
|                                                               | Accounts payable                                                                                    |                |        | 3,951      |   |   |        | 1,815   |  
|                                                               | Accrued liabilities                                                                                 |                |        | 3,798      |   |   |        | 1,101   |  
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Total current liabilities                                      |                                                                                                     |                | 8,636  |            |   |   | 6,946  |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|                                                               | Other long-term liabilities, less current
    maturities                                            |                |        | 2,121      |   |   |        |        |  
|                                                               | Long-term debt, less current maturities                                                             |                |        | 2,555      |   |   |        | 1,473   |  
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Total other long-term liabilities, less current
    maturities |                                                                                                     |                | 4,676  |            |   |   | 1,473  |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Total liabilities                                              |                                                                                                     |                | 13,312 |            |   |   | 8,419  |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Shareholders equity:                                          |                                                                                                     |                |        |            |   |   |        |        
|                                                               | Undesignated stock; 5,000 shares authorized; none
    issued                                        |                |        |           |   |   |        |        |  
|                                                               | Common stock, $.05 par; 10,000 shares authorized;
    7,046 and 6,012 shares issued and outstanding |                |        | 352        |   |   |        | 301     |  
|                                                               | Paid-in capital                                                                                     |                |        | 18,951     |   |   |        | 16,349  |  
|                                                               | Accumulated deficit                                                                                 |                |        | (5,443     | ) |   |        | (814    | )
|                                                               | Notes receivable                                                                                    |                |        | (669       | ) |   |        | (1,266  | )
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Total shareholders equity                                     |                                                                                                     |                | 13,191 |            |   |   | 14,570 |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        
|Total liabilities and shareholders equity                     |                                                                                                     | $              | 26,503 |            |   | $ | 22,989 |        
|                                                               |                                                                                                     |                |        |            |   |   |        |        

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

30



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HEI, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

(In thousands, except per share
amounts)


|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |        |  
|------------------------------------------ | ------------------------------------------------------- | --------------------- | ------ | ----- | - | ---- | ------ | ----- | - | - | ------ | ------ | -
|                                           |                                                         |                      
|                                           |                                                         | Years Ended August 31
|                                           |                                                         |                      
|                                           |                                                         | 2003                  |        | 2002  |   | 2001
|                                           |                                                         |                       |        |       |   |     
|Net sales                                  |                                                         | $                     | 38,440 |       |   | $    | 28,532 |       |   | $ | 44,832 |       
|Cost of sales                              |                                                         |                       | 31,327 |       |   |      | 23,375 |       |   |   | 36,841 |       
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|                                           | Gross profit                                            |                       |        | 7,113 |   |      |        | 5,157 |   |   |        | 7,991  |  
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|Operating expenses:                        |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|                                           | Selling, general and administrative                     |                       |        | 7,639 |   |      |        | 5,335 |   |   |        | 5,806  |  
|                                           | Research, development and engineering                   |                       |        | 2,580 |   |      |        | 2,516 |   |   |        | 2,433  |  
|                                           | Unusual charges                                         |                       |        | 331   |   |      |        |      |   |   |        | 1,693  |  
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|Operating loss                             |                                                         |                       | (3,437 | )     |   |      | (2,694 | )     |   |   | (1,941 | )     
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|                                           | Former officer note and other receivables write
    off |                       |        | (841  | ) |      |        |      |   |   |        |       |  
|                                           | Bank fees                                               |                       |        | (181  | ) |      |        |      |   |   |        |       |  
|                                           | Loss on equity investment                               |                       |        |      |   |      |        |      |   |   |        | (1,450 | )
|                                           | Interest expense                                        |                       |        | (328  | ) |      |        | (345  | ) |   |        | (504   | )
|                                           | Other income (expense), net                             |                       |        | 137   |   |      |        | 239   |   |   |        | (228   | )
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|Loss before income taxes                   |                                                         |                       | (4,650 | )     |   |      | (2,800 | )     |   |   | (4,123 | )     
|Income tax expense (benefit)               |                                                         |                       | (21    | )     |   |      | 1,092  |       |   |   | (930   | )     
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|Net loss                                   |                                                         | $                     | (4,629 | )     |   | $    | (3,892 | )     |   | $ | (3,193 | )     
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|Net loss per common share                  |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|                                           | Basic                                                   |                       | $      | (0.70 | ) |      | $      | (0.65 | ) |   | $      | (0.65  | )
|                                           | Diluted                                                 |                       | $      | (0.70 | ) |      | $      | (0.65 | ) |   | $      | (0.65  | )
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|Weighted average common shares outstanding |                                                         |                       |        |       |   |      |        |       |   |   |        |       
|                                           | Basic                                                   |                       |        | 6,629 |   |      |        | 5,992 |   |   |        | 4,881  |  
|                                           | Diluted                                                 |                       |        | 6,629 |   |      |        | 5,992 |   |   |        | 4,881  |  
|                                           |                                                         |                       |        |       |   |      |        |       |   |   |        |       

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

31



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HEI, INC.






CONSOLIDATED STATEMENTS OF CHANGES IN
SHAREHOLDERS EQUITY


|                         |                                                                          |                |       |              |  |            |     |              |  |            |        |        |   |   |        |        |   |   |        |        |   |   |        |        |  
|------------------------ | ------------------------------------------------------------------------ | -------------- | ----- | ------------ |  | ---------- | --- | ------------ |  | ---------- | ------ | ------ | - | - | ------ | ------ | - | - | ------ | ------ | - | - | ------ | ------ | -
|                         |                                                                          |                |       |              |  |            |     | Retained     |  |            |        |       
|                         |                                                                          | Common         |       | Common       |  | Additional |     | Earnings     |  |            |        |       
|                         |                                                                          | Stock Shares   |       | Stock Amount |  | Paid-In    |     | (accumulated |  | Notes      |        | Total 
|                         |                                                                          | Outstanding    |       | Outstanding  |  | Capital    |     | deficit)     |  | Receivable |        | Equity
|                         |                                                                          |                |       |              |  |            |     |              |  |            |        |       
|                         |                                                                          |               
|                         |                                                                          | (In thousands)
|Balance, August 31, 2000 |                                                                          |                | 4,777 |              |  | $          | 239 |              |  | $          | 8,606  |        |   | $ | 6,271  |        |   | $ |       |        |   | $ | 15,116 |       
|                         |                                                                          |                |       |              |  |            |     |              |  |            |        |        |   |   |        |        |   |   |        |        |   |   |        |       
|                         | Net loss                                                                 |                |       |             |  |            |     |             |  |            |        |       |   |   |        | (3,193 | ) |   |        |       |   |   |        | (3,193 | )
|                         | Issuance of common shares under stock benefit
    plans and option plans |                |       | 230          |  |            |     | 11           |  |            |        | 1,369  |   |   |        |       |   |   |        |       |   |   |        | 1,380  |  
|                         | Non-cash CMED expenses                                                   |                |       |             |  |            |     |             |  |            |        | 161    |   |   |        |       |   |   |        |       |   |   |        | 161    |  
|                         | Notes receivable                                                         |                |       |             |  |            |     |             |  |            |        |       |   |   |        |       |   |   |        | (1,266 | ) |   |        | (1,266 | )
|                         | Private equity placement                                                 |                |       | 950          |  |            |     | 48           |  |            |        | 6,174  |   |   |        |       |   |   |        |       |   |   |        | 6,222  |  
|                         |                                                                          |                |       |              |  |            |     |              |  |            |        |        |   |   |        |        |   |   |        |        |   |   |        |       
|Balance, August 31, 2001 |                                                                          |                | 5,957 |              |  |            | 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           |  |            |     | 3            |  |            |        | 272    |   |   |        |       |   |   |        |       |   |   |        | 275    |  
|                         |                                                                          |                |       |              |  |            |     |              |  |            |        |        |   |   |        |        |   |   |        |        |   |   |        |       
|Balance, August 31, 2002 |                                                                          |                | 6,012 |              |  |            | 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        |  |            |     | 50           |  |            |        | 2,550  |   |   |        |       |   |   |        |       |   |   |        | 2,600  |  
|                         | Issuance of common shares under stock benefit
    plans and option plans |                |       | 34           |  |            |     | 1            |  |            |        | 52     |   |   |        |       |   |   |        |       |   |   |        | 53     |  
|                         |                                                                          |                |       |              |  |            |     |              |  |            |        |        |   |   |        |        |   |   |        |        |   |   |        |       
|Balance, August 31, 2003 |                                                                          |                | 7,046 |              |  | $          | 352 |              |  | $          | 18,951 |        |   | $ | (5,443 | )      |   | $ | (669   | )      |   | $ | 13,191 |       
|                         |                                                                          |                |       |              |  |            |     |              |  |            |        |        |   |   |        |        |   |   |        |        |   |   |        |       

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

32



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HEI, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |        |  
|------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------- | ---------------------- | ------ | ------ | - | ---- | ------ | ------ | - | - | ------ | ------ | -
|                                                                                                                                      |                                                          |                       
|                                                                                                                                      |                                                          | Years Ended August 31,
|                                                                                                                                      |                                                          |                       
|                                                                                                                                      |                                                          | 2003                   |        | 2002   |   | 2001
|                                                                                                                                      |                                                          |                        |        |        |   |     
|                                                                                                                                      |                                                          |                       
|                                                                                                                                      |                                                          | (In thousands)        
|Cash flow from operating activities:                                                                                                  |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|                                                                                                                                      | Net loss                                                 |                        | $      | (4,629 | ) |      | $      | (3,892 | ) |   | $      | (3,193 | )
|                                                                                                                                      | Equity in net loss from MSC                              |                        |        |       |   |      |        |       |   |   |        | 1,417  |  
|                                                                                                                                      | Depreciation and amortization                            |                        |        | 3,295  |   |      |        | 2,909  |   |   |        | 2,862  |  
|                                                                                                                                      | Accounts receivable allowance                            |                        |        | 7      |   |      |        | (186   | ) |   |        | 56     |  
|                                                                                                                                      | Reserve for note receivable from former officer          |                        |        | 597    |   |      |        |       |   |   |        |       |  
|                                                                                                                                      | Asset impairment charges                                 |                        |        | 331    |   |      |        |       |   |   |        |       |  
|                                                                                                                                      | Deferred income tax expense (benefit)                    |                        |        |       |   |      |        | 1,609  |   |   |        | (930   | )
|                                                                                                                                      | Non-cash expenses for CMED transaction                   |                        |        |       |   |      |        |       |   |   |        | 161    |  
|                                                                                                                                      | Loss on disposal of property and equipment and
    other |                        |        | 69     |   |      |        |       |   |   |        | 188    |  
|Changes in operating assets and liabilities, net
    of acquisition:                                                                  |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|                                                                                                                                      | Accounts receivable                                      |                        |        | (2,488 | ) |      |        | 1,270  |   |   |        | 3,909  |  
|                                                                                                                                      | Inventories                                              |                        |        | 581    |   |      |        | 257    |   |   |        | 1,585  |  
|                                                                                                                                      | Other current assets                                     |                        |        | (81    | ) |      |        | (110   | ) |   |        | 176    |  
|                                                                                                                                      | Accounts payable                                         |                        |        | 2,136  |   |      |        | (97    | ) |   |        | (2,414 | )
|                                                                                                                                      | Accrued liabilities                                      |                        |        | 504    |   |      |        | (683   | ) |   |        | 113    |  
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Net cash flow provided by operating activities                                                                                        |                                                          |                        | 322    |        |   |      | 1,077  |        |   |   | 3,930  |       
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Cash flow from investing activities:                                                                                                  |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|                                                                                                                                      | Additions to property and equipment                      |                        |        | (442   | ) |      |        | (2,291 | ) |   |        | (3,418 | )
|                                                                                                                                      | Additions to patents                                     |                        |        | (138   | ) |      |        | (132   | ) |   |        | (115   | )
|                                                                                                                                      | AMO acquisition costs paid                               |                        |        | (1,486 | ) |      |        |       |   |   |        |       |  
|                                                                                                                                      | Cash acquired from CMED                                  |                        |        | 1,215  |   |      |        |       |   |   |        |       |  
|                                                                                                                                      | Other long-term assets                                   |                        |        | 217    |   |      |        |       |   |   |        | (356   | )
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Net cash flow used in investing activities                                                                                            |                                                          |                        | (634   | )      |   |      | (2,423 | )      |   |   | (3,889 | )     
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Cash flow from financing activities:                                                                                                  |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|                                                                                                                                      | Issuance of common stock                                 |                        |        | 53     |   |      |        | 275    |   |   |        | 6,336  |  
|                                                                                                                                      | Proceeds from long-term debt                             |                        |        | 2,804  |   |      |        |       |   |   |        | 1,762  |  
|                                                                                                                                      | Repayments of long-term debt                             |                        |        | (3,906 | ) |      |        | (1,499 | ) |   |        | (1,350 | )
|                                                                                                                                      | Deferred financing fees                                  |                        |        | (106   | ) |      |        | (30    | ) |   |        | (33    | )
|                                                                                                                                      | Decrease (increase) in restricted cash                   |                        |        | 1,000  |   |      |        | (1,000 | ) |   |        | 86     |  
|                                                                                                                                      | Net borrowings on (repayments of) line of credit         |                        |        | (1,099 | ) |      |        | 1,579  |   |   |        | (2,933 | )
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Net cash flow provided by (used in) financing
    activities                                                                          |                                                          |                        | (1,254 | )      |   |      | (675   | )      |   |   | 3,868  |       
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Net increase (decrease) in cash and cash
    equivalents                                                                              |                                                          |                        | (1,566 | )      |   |      | (2,021 | )      |   |   | 3,909  |       
|Cash and cash equivalents, beginning of year                                                                                          |                                                          |                        | 2,372  |        |   |      | 4,393  |        |   |   | 484    |       
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Cash and cash equivalents, end of year                                                                                                |                                                          | $                      | 806    |        |   | $    | 2,372  |        |   | $ | 4,393  |       
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Supplemental disclosures of cash flow
    information:                                                                                |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Interest paid                                                                                                                         |                                                          | $                      | 328    |        |   | $    | 395    |        |   | $ | 466    |       
|Income taxes received                                                                                                                 |                                                          |                        | (21    | )      |   |      | (351   | )      |   |   | (48    | )     
|                                                                                                                                      |                                                          |                        |        |        |   |      |        |        |   |   |        |       
|Supplemental disclosures of non-cash
    financing and investing activities:                                                         
|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.

33



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##### Table of Contents



HEI, INC.






NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


(Amounts in thousands except share and per
share data)


Note 1



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

HEI, Inc. and its subsidiaries specialize in the
design and manufacture of ultraminiature microelectronic devices
and high technology products incorporating those devices. 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. The Company produces quality flex circuits and
high performance laminate based substrates. HEI is also a
provider of advanced medical products and comprehensive
engineering and manufacturing outsourcing services for
healthcare companies worldwide. The Companys products are
system components that are sold to medical imaging original
equipment manufacturers (OEMs). The Companys
services include development and manufacturing of electronic and
electromechanical devices and instrumentation, product
definition, rapid prototyping, engineering, risk analysis,
agency submissions, validation testing and value engineering.



| |                                               
| | ----------------------------------------------
| | 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 intercompany
transactions and balances have been eliminated in consolidation.

Revenue Recognition.The Company recognizes revenue upon shipment of products to
customers, when all contractual obligations have been satisfied
and collection of the resulting receivable is reasonably
assured. For inventory shipped on consignment, revenue is
recognized upon transfer of title when the customer uses the
inventory. In the normal course of business we enter into a
number of contracts with our customers under which we provide
engineering services on a per project basis. The Company
recognizes revenue on these services based upon meeting certain
milestones and or benchmarks that are attributable to the
different contractual elements of the overall contract. Based on
the accomplishments of these goals we use the percentage of
completion methodology to recognize the revenue and related
costs to generate said revenues. Sales, payment terms and
pricing extended to customers are governed by the respective
contract agreements or binding POs for each transaction and
provide no right of return outside of contractual warranty
terms. Payment terms are seven days for consignment program
sales and four to 60 days for other customers. For items
delivered with contingent payment terms, revenue is deferred for
the greater of the amount of the contingent payment or the fair
value of the undelivered elements and recognized when the
contingency is resolved. We provide engineering and product
development services to our customers pursuant to written
contracts. The majority of these arrangements are time and
material contracts. We recognize revenue as time is incurred or
materials are consumed. To a lesser extent we have fixed-price
contracts which are accounted for using either the completed
contract method or the percentage of completion method.

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.

34



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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.The Company accounts for
impairment of long-lived assets in accordance with the
provisions of Statement of Financial Accounting Standard
(SFAS) No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS
No. 144 requires that long-lived and intangible assets be
reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may
not be recoverable. Recoverability of assets to be held and used
is measured by a comparison of the carrying amount of an asset
to future net undiscounted cash flows expected to be generated
by the asset. If the carrying amount of an asset exceeds its
estimated future cash flows, an impairment charge is recognized
by the amount by which the carrying amount of the asset exceeds
the fair value of the asset. Assets to be disposed of are
reported at the lower of the carrying amount or fair value less
costs to sell.

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

Capitalized Software Development
Costs.The Company has not capitalized
software development costs for marketable software (Link-It) as
the costs incurred in the period between the establishment of
technical feasibility and its market launch was not significant.
There were no costs capitalized during the periods presented.

Income Taxes.Deferred income tax assets and liabilities are recognized for
the expected future tax consequences of events that have been
included in the financial statements or income tax returns.
Deferred income tax assets and liabilities are determined based
on the differences between the financial statement and tax bases
of assets and liabilities using currently enacted tax rates in
effect for the year in which the differences are expected to
reverse. Valuation allowances are established when necessary to
reduce deferred tax assets to the 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

35



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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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 Financial
Accounting Standards Board (FASB) Statement
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,
|                                                                                                                                 |  |                              
|                                                                                                                                 |  | 2003                          |        | 2002 |  | 2001
|                                                                                                                                 |  |                               |        |      |  |     
|Net loss                                                                                                                         |  | $                             | (4,629 | )    |  | $    | (3,892 | ) |  | $ | (3,193 | )
|Deduct: Total stock-based employee compensation
    income (expense) determined under fair value based method for
    all awards |  |                               | (2,170 | )    |  |      | (2,197 | ) |  |   | (1,135 | )
|                                                                                                                                 |  |                               |        |      |  |      |        |   |  |   |        |  
|Pro forma net loss                                                                                                               |  | $                             | (6,799 | )    |  | $    | (6,089 | ) |  | $ | (4,328 | )
|                                                                                                                                 |  |                               |        |      |  |      |        |   |  |   |        |  
|Basic and diluted net loss per share as reported                                                                                 |  | $                             | (0.70  | )    |  | $    | (0.65  | ) |  | $ | (0.65  | )
|                                                                                                                                 |  |                               |        |      |  |      |        |   |  |   |        |  
|Pro forma basic and diluted net loss per share                                                                                   |  | $                             | (1.03  | )    |  | $    | (1.02  | ) |  | $ | (0.89  | )
|                                                                                                                                 |  |                               |        |      |  |      |        |   |  |   |        |  

Customer Deposits.Customer deposits result from cash received in advance of
services 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. The
dilutive effect of the stock options is computed using the
average market price of the Companys stock during each
period under the treasury stock method. During periods of loss,
options are dilutive and are thus excluded from the calculation.

Use of Estimates.The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could
differ significantly from those estimates.

Financial
Instruments.The fair value of cash
equivalents, accounts receivable and payable approximate their
carrying value due to the short-term nature of these
instruments. The fair market values of the Companys
borrowings outstanding approximate their carrying values based
upon current market rates of interest.

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

Recent Accounting
Pronouncements.In November 2002, FASB
issued Interpretation (FIN) No. 45,
Guarantors Accounting and Disclosure Requirements,
Including Guarantees of Indebtedness of Others. FIN
No. 45 requires that upon issuance of certain types of
guarantees, a guarantor recognize and account for the fair value
of the guarantee as a liability. FIN No. 45 contains
exclusions to this requirement, including the exclusion of a
parents guarantee of its subsidiaries debt to a
third party. The initial recognition and measurement provisions
of FIN No. 45 is required to be applied on a prospective
basis for guarantees issued or modified after December 31,
2002. The disclosure requirements of FIN No. 45 are
effective for financial statements of both interim and annual
periods ending after December 31, 2002, which we adopted in
the quarter ended March 1, 2003. The adoption of
FIN 45 did not have a material impact on our financial
position, results of operations or cash flows.

36



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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 is required to adopt EITF
Issue 00-21 on transactions occurring after
September 1, 2003. The Company does not expect the adoption
of EITF 00-21 will have a material effect on its financial
statements since revenue associated with these projects during
its fiscal year ending August 31, 2004, is projected to be
immaterial.

In January 2003, FASB issued FIN No. 46,
Consolidation of Variable Interest Entities, which
addresses accounting for special-purpose and variable interest
entities. The adoption of FIN 46 did not have a impact on
our financial position, results of operations or cash flows.

In December 2002, FASB issued SFAS No. 148,
Accounting for Stock-Based Compensation 
Transition and Disclosure. This statement, which is an
amendment of SFAS No. 123, provides alternative methods of
transition for a voluntary change to the fair value based method
of accounting for stock-based employee compensation. In
addition, SFAS No. 148 amends the disclosure requirements
of SFAS No. 123 to require prominent disclosures in both
annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect
of the method used on reported financial results. The Company
currently accounts for stock-based compensation using the
intrinsic value method defined in Accounting Principles Board
No. 25 and do not currently intend to voluntarily change to
the fair value method described in SFAS No. 123. As a
result, the Company does not expect the new guidelines found in
SFAS No. 148 will have a material effect upon our financial
statements at its adoption. The new interim reporting
requirements are effective for interim periods beginning after
December 15, 2002. The Company has adopted the disclosure
provisions.

In April 2003, the FASB issued SFAS No. 149,
Amendment of Statement 133 on Derivative Instruments
and Hedging, which amends and clarifies financial
accounting and reporting for derivative instruments. The
adoption of SFAS No. 149 did not have an impact on the
Companys financial statements.

On May 15, 2003, the FASB issued Statement
No. 150, Accounting for Certain Financial Instruments
with Characteristics of Both Liabilities and Equity. 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.

Note 2



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

The accompanying consolidated financial
statements have been prepared assuming the Company will continue
as a going concern, which contemplates the realization of assets
and the satisfaction of liabilities in the normal course of
business. The Company incurred net losses of $4,629, $3,892 and
$3,193 for the years ended August 31, 2003, 2002 and 2001,
respectively.

We have historically financed our operations
through the public and private sale of debt and equity
securities, bank borrowings under lines of credit, operating
equipment leases and cash generated by operations. Significant
financial restructuring occurred during our fiscal year ended
August 31, 2003, and early in our current fiscal year
ending August 31, 2004, transforming our capital structure
to a lower interest rate and less restrictive structure. We
replaced a revolving line of credit with LaSalle Business
Credit, LLC with an accounts receivable backed credit agreement
with Beacon Bank that does not have restrictive covenants.

37



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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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. The first note, with Commerce
Bank in the amount of $1,200, is secured by our Victoria,
Minnesota facility. The second note, with Commerce Financial
Group, Inc. in the amount of $1,150, is secured by our Victoria
facility and equipment located at our Tempe facility. These
loans provided us with the necessary resources to prepay the
subordinated promissory note from the Colorado MEDtech, Inc.
(CMED) acquisition held by Whitebox Hedged High
Yield Partners (see note 8). The terms of the new loans
have an average interest rate of 7.75% as compared to 12.00% for
the retired debt.

At August 31, 2003, our sources of liquidity
consisted of $806 of cash and cash equivalents and our revolving
credit line agreement, which was due to expire in May 2004. On
December 12, 2003 the revolving line was extended to
September 1, 2004. The credit line agreement allows for
borrowings of up to $3,000 subject to availability based on
accounts receivable. There was $490 outstanding debt at
August 31, 2003, leaving an available credit of $2,510 at
year-end. Our liquidity is affected by many factors, some of
which are based on the normal ongoing operations of our
business, the most significant of which include the timing of
the collection of receivables, the level of inventories and
capital expenditures. In the event cash flows are not sufficient
to fund operations at the present level numerous 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.

Management believes that, as a result of the
financial restructuring actions it has taken to reduce cash
expenditures, the continuing efforts to increase revenues from
continuing customers and to generate new customers in various
industry sectors, the replacement and subsequent extension of
its revolving and term credit facilities it has obtained, it
will meet for its fiscal year ending August 31, 2004.

38



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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, 2003 and 2002:

|                                  |                                                                  |           |       |       |   |   |       |       |  
|--------------------------------- | ---------------------------------------------------------------- | --------- | ----- | ----- | - | - | ----- | ----- | -
|                                  |                                                                  |          
|                                  |                                                                  | August 31
|                                  |                                                                  |          
|                                  |                                                                  | 2003      |       | 2002 
|                                  |                                                                  |           |       |      
|Accounts receivable, net:         |                                                                  |           |       |       |   |   |       |      
|                                  | Trade accounts receivable                                        |           | $     | 6,406 |   |   | $     | 3,618 |  
|                                  | Less: allowance for doubtful accounts                            |           |       | (92   | ) |   |       | (85   | )
|                                  |                                                                  |           |       |       |   |   |       |      
|                                  |                                                                  | $         | 6,314 |       |   | $ | 3,533 |      
|                                  |                                                                  |           |       |       |   |   |       |      
|Inventories:                      |                                                                  |           |       |       |   |   |       |      
|                                  | Purchased parts                                                  |           | $     | 4,297 |   |   | $     | 1,944 |  
|                                  | Work in process                                                  |           |       | 958   |   |   |       | 597   |  
|                                  | Finished goods                                                   |           |       | 1,609 |   |   |       | 1,486 |  
|                                  |                                                                  |           |       |       |   |   |       |      
|                                  |                                                                  | $         | 6,864 |       |   | $ | 4,027 |      
|                                  |                                                                  |           |       |       |   |   |       |      
|Accrued liabilities:              |                                                                  |           |       |       |   |   |       |      
|                                  | Accrued employee related costs                                   |           | $     | 1,085 |   |   | $     | 655   |  
|                                  | Contractual manufacturing obligations                            |           |       | 498   |   |   |       |      |  
|                                  | Customers deposits                                               |           |       | 371   |   |   |       |      |  
|                                  | Current maturities of long-term liabilities                      |           |       | 741   |   |   |       |      |  
|                                  | Interest accrued                                                 |           |       | 156   |   |   |       |      |  
|                                  | Warranty reserve                                                 |           |       | 122   |   |   |       | 200   |  
|                                  | Other accrued liabilities                                        |           |       | 825   |   |   |       | 246   |  
|                                  |                                                                  |           |       |       |   |   |       |      
|                                  |                                                                  | $         | 3,798 |       |   | $ | 1,101 |      
|                                  |                                                                  |           |       |       |   |   |       |      
|Other long-term liabilities:      |                                                                  |           |       |       |   |   |       |      
|                                  | Remaining lease obligation, less estimated
    sublease proceeds |           | $     | 2,183 |   |   | $     |      |  
|                                  | Unfavorable operating lease, net                                 |           |       | 610   |   |   |       |      |  
|                                  | Other non-current liabilities                                    |           |       | 69    |   |   |       |      |  
|                                  |                                                                  |           |       |       |   |   |       |      
|Total                             |                                                                  | $         | 2,862 |       |   | $ |      |      
|Less current maturities           |                                                                  |           | 741   |       |   |   |      |      
|Total other long-term liabilities |                                                                  | $         | 2,121 |       |   | $ |      |      
|                                  |                                                                  |           |       |       |   |   |       |      

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

39



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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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,
2003, 2002 and 2001:

|            |  |                   |     |            |  |        |     |                        |  |   |     |  |  |   |     | 
|----------- |  | ----------------- | --- | ---------- |  | ------ | --- | ---------------------- |  | - | --- |  |  | - | --- | 
|            |  | Balance at        |     |            |  |        |     |                       
|            |  | Beginning of Year |     | Provisions |  | Claims |     | Balance at End of Year
|            |  |                   |     |            |  |        |     |                       
|Fiscal 2003 |  | $                 | 200 |            |  | $      | 168 |                        |  | $ | 246 |  |  | $ | 122 | 
|Fiscal 2002 |  |                   | 40  |            |  |        | 275 |                        |  |   | 115 |  |  |   | 200 | 
|Fiscal 2001 |  |                   | 40  |            |  |        | 224 |                        |  |   | 224 |  |  |   | 40  | 

Note 5



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

The unusual charges of $331 in the current year
relate to the impairment of equipment. The asset impairment was
triggered in the fourth quarter of our fiscal year ended
August 31, 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 will be moved
offshore in the first quarter of our current fiscal year ending
August 31, 2004. The unusual charges of $1,693 incurred in
our fiscal year ending August 31, 2001, relate to the
write-off of accounts receivable related to customers of the
Mexico products and the closure of that operation.

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

Note 6



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

On January 24, 2003, the Company acquired
certain assets and assumed certain liabilities of CMEDs
Colorado operations (a business unit of CMED) (the
Advanced Medical Operation or AMO) in a
business combination accounted for as a purchase. In exchange
for certain assets of AMO, we issued 1,000 shares of our common
stock and assumed approximately $900 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 this operation since
January 24, 2003. Our purposes for acquiring 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 AMO coupled with our microelectronic design, development and
manufacturing improves our offerings to the market to retain and
gain customers.

40



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Below is a table of the estimated acquisition
consideration, preliminary purchase price allocation and annual
amortization of the intangible assets acquired:

|                           |                                      |        |   |        |  
|-------------------------- | ------------------------------------ | ------ | - | ------ | -
|                           |                                      | Amount
|                           |                                      |       
|Purchase price allocation: |                                      |        |   |       
|                           | Cash                                 |        | $ | 1,215  |  
|                           | Accounts receivable                  |        |   | 300    |  
|                           | Inventories                          |        |   | 3,418  |  
|                           | Property and equipment               |        |   | 1,466  |  
|                           | Prepaids, deposits and other assets  |        |   | 1,690  |  
|                           | Developed technology                 |        |   | 451    |  
|                           | Customer deposits and other reserves |        |   | (1,344 | )
|                           | Operating lease reserves             |        |   | (3,110 | )
|                           | Transaction costs                    |        |   | (1,486 | )
|                           |                                      |        |   |       
|                           | Total purchase price                 |        | $ | 2,600  |  
|                           |                                      |        |   |       

The intangible asset value for the developed
technology was determined utilizing discounted cash flow
analyses. The discounted cash flow analyses 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.

On October 31, 2003, MKS Instruments, Inc.
(NASDAQ: MKSI) and HEI, Inc. signed an agreement wherein
MKS purchased HEIs solid state radio frequency power
amplifier technology. The technology is focused on Tesla 1.5
magnetic resonance imaging (MRI) applications but
can be scaled for use in other MRI equipment. The value of the
transaction is $423,000. The first two milestone payments
($323,000) were paid by wire transfer on October 31, 2003.
The remaining payment ($100,000) will become due upon HEIs
completion of the engineering support milestone. The engineering
support milestone is targeted for completion in May 2004.

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

The preliminary purchase allocation includes an
accrual of $730 related to an unfavorable operating lease;
$2,380 for future estimated lease payments and a $600 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 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,
to assist HEI in reducing its occupancy costs at this facility
by sub-leasing the 50,000 square foot addition. The final
allocation of the consideration to be paid may differ from those
assumptions reflected in the accompanying audited consolidated
financial statements. 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. We
continue the process of gathering information to complete our
analysis of the excess lease capacity and the contractual
manufacturing obligations. Any reductions in these liabilities
will result in a decrease in the carrying value of the
intangible assets and fixed assets. Conversely, an increase in
these liabilities increases the carrying values of long-lived
assets. At

41



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

August 31, 2003, the carrying value of
long-lived assets has been reduced by a net of $3,760 by the
allocation of negative goodwill. We anticipate completing the
purchase price allocation prior to January 24, 2004.

The following table presents the unaudited pro
forma consolidated results of operations of the Company for the
fiscal years ended August 31, 2003, 2002 and 2001, as if
the acquisition of our AMO took place on October 1, 2002,
2001 and 2000, respectively:

|                   |  |                               |        |      |  |      |         |   |  |   |         |  
|------------------ |  | ----------------------------- | ------ | ---- |  | ---- | ------- | - |  | - | ------- | -
|                   |  |                              
|                   |  | Fiscal Years Ended August 31,
|                   |  |                              
|                   |  | 2003                          |        | 2002 |  | 2001
|                   |  |                               |        |      |  |     
|Net sales          |  | $                             | 54,710 |      |  | $    | 74,804  |   |  | $ | 102,377 |  
|Net loss           |  |                               | (6,096 | )    |  |      | (13,180 | ) |  |   | (10,383 | )
|                   |  |                               |        |      |  |      |         |   |  |   |         |  
|Net loss per share |  | $                             | (0.31  | )    |  | $    | (.69    | ) |  | $ | (.59    | )
|                   |  |                               |        |      |  |      |         |   |  |   |         |  

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, 2002 and 2001
pro forma information includes unaudited results of operations
for the twelve-month periods ended August 31, 2003, 2002
and 2001, respectively, for the Company and unaudited results of
operations for the twelve-month periods ended June 30,
2003, 2002 and 2001, 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 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.

Note 7



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

Long-term debt consists of the following:

|                                                                                                                                                                                                                        |  |                   |       |      |  |   |       | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ----- | ---- |  | - | ----- | 
|                                                                                                                                                                                                                        |  |                  
|                                                                                                                                                                                                                        |  | Fiscal Year Ended
|                                                                                                                                                                                                                        |  | August 31        
|                                                                                                                                                                                                                        |  |                  
|                                                                                                                                                                                                                        |  | 2003              |       | 2002
|                                                                                                                                                                                                                        |  |                   |       |     
|Subordinated Promissory Note, due
    September 30, 2004.                                                                                                                                                               |  | $                 | 2,740 |      |  | $ |      | 
|Commercial loans payable in fixed monthly
    installments of $12 though May 2004 and July 2005; secured with
    certain machinery and equipment                                                                       |  |                   | 212   |      |  |   | 104   | 
|Capital expenditure notes payable. We used the
    proceeds from the Subordinated Promissory Note to retire our
    remaining indebtedness on the capital expenditure notes with
    LaSalle Business Credit LLC        |  |                   |      |      |  |   | 2,075 | 
|Industrial Development Revenue Bonds. On
    March 14, 2003, an aggregate of $1,735 of the debt proceeds
    from the Subordinated Promissory was used to repay the
    outstanding principal and interest on the IDRBs |  |                   |      |      |  |   | 1,735 | 
|                                                                                                                                                                                                                        |  |                   |       |      |  |   |       | 
|Total                                                                                                                                                                                                                   |  |                   | 2,952 |      |  |   | 3,914 | 
|Less current maturities                                                                                                                                                                                                 |  |                   | 397   |      |  |   | 2,441 | 
|                                                                                                                                                                                                                        |  |                   |       |      |  |   |       | 
|Total long-term debt                                                                                                                                                                                                    |  | $                 | 2,555 |      |  | $ | 1,473 | 
|                                                                                                                                                                                                                        |  |                   |       |      |  |   |       | 

42



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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

During our fiscal year ended August 31, 2003
and our current fiscal year ending August 31, 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 will recognize 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 Credit Facilities 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 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 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, with
an interest rate of 8.975% per year through September 27,
2007. Monthly payments of principal and interest in the amount
of $28 will be paid over a forty-eight month period beginning on
October 28, 2003.

43



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Principal maturities of long-term debt at
August 31, 2003, giving effect to the refinancing in
October 2003 of our Subordinated Promissory Note with the two
notes from Commerce Bank, and related reduction in principal
payments, are as follows:

|                         |  |   |       | 
|------------------------ |  | - | ----- | 
|Fiscal Years Ending      |  |  
|August 31,               |  |  
|                         |  |  
|Refinancing gain in 2004 |  | $ | 472   | 
|2004                     |  |   | 397   | 
|2005                     |  |   | 381   | 
|2006                     |  |   | 330   | 
|2007                     |  |   | 360   | 
|2008                     |  |   | 68    | 
|Thereafter               |  |   | 944   | 
|                         |  |   |       | 
|                         |  | $ | 2,952 | 
|                         |  |   |       | 

The above table of principal maturities of
long-term debt has been reduced by $472 from the Companys
August 31, 2003, balance to reflect a gain of early
repayment of the debt refinancing in October 2003.

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 12, 2003, the Company extended the
Credit Agreement to September 1, 2004. The Credit Agreement
is an accounts receivable backed facility and is additionally
secured by inventory, intellectual property and other general
intangibles. The Credit Agreement replaced our revolving line of
credit with LaSalle Business Credit, LLC, and is not subject to
any restrictive financial covenants. We have a maximum of $3,000
available under the Credit Agreement, with the actual borrowings
based on eligible accounts receivable. As of August 31,
2003, there were $490 of borrowings under the Credit Agreement.
Effective August 31, 2003, the Credit Agreement bears an
immediate processing fee of 0.50% of each assigned amount, a
daily per diem equal to 1/25% on any uncollected accounts
receivable and a monthly minimum of $1.5 in processing fees for
the first six months the Credit Agreement is in place.
Borrowings are reduced as collections and payments are received
into a lock box by the bank. The effected interest rate based on
our average DSO of 46 days would be 18.3% annualized.

Note 9



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

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

During the fourth quarter of our fiscal year
ended August 31, 2001, certain material adverse changes
occurred in MSCs business, including a weakening of the
economy and demand for MSCs products. The Company
wrote-off the remaining value of the investment in MSC and the
related license agreement. Circuit Components Inc.
(CCI), the majority stockholder in MSC ultimately
exercised its call options for the Companys 28% interest
in MSC under the stock purchase agreement between the Company
and CCI. This

44



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

call provided the Company with a $750 five-year
interest-bearing note, payable in quarterly installments. This
note is secured by 700,000 shares of MSC, which is released
to CCI prorata as the Company receives payments. The Company has
fully reserved the $750 note, therefore, the payments on the
note are being recognized as other income when the principal and
interest payments are received. The Company adopted a cash basis
of accounting for the loan due to the unsecured nature of the
note and the inability to obtain CCI financial data.

For the fiscal year ended August 31, 2003,
the Company recognized $150 in other income and $28 in interest
income related to payments under this note. At August 31,
2003, $525 remains outstanding on the note.

For the fiscal year ended August 31, 2001
the Companys losses associated with MSC were $1,450 and
are included in loss on equity investment on the statement of
operations.

Note 10



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

Income tax expense (benefit) for the fiscal
years ended August 31, 2003, 2002 and 2001 consisted of the
following:

|                             |         |                             |     |      |   |      |       |      |   |   |      |   | 
|---------------------------- | ------- | --------------------------- | --- | ---- | - | ---- | ----- | ---- | - | - | ---- | - | 
|                             |         |                            
|                             |         | Fiscal Year Ended August 31
|                             |         |                            
|                             |         | 2003                        |     | 2002 |   | 2001
|                             |         |                             |     |      |   |     
|                             |         |                            
|                             |         | (In thousands)             
|Current:                     |         |                             |     |      |   |      |       |      |   |   |      |  
|                             | Federal |                             | $   | (21  | ) |      | $     | (459 | ) |   | $    |  | 
|                             | State   |                             |     |     |   |      |       | (58  | ) |   |      |  | 
|Deferred                     |         |                             |    |      |   |      | 1,609 |      |   |   | (930 | )
|                             |         |                             |     |      |   |      |       |      |   |   |      |  
|Income tax expense (benefit) |         | $                           | (21 | )    |   | $    | 1,092 |      |   | $ | (930 | )
|                             |         |                             |     |      |   |      |       |      |   |   |      |  

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

|                                                  |  |                             |       |      |  |      |       |    |  |  |       |   
|------------------------------------------------- |  | --------------------------- | ----- | ---- |  | ---- | ----- | -- |  |  | ----- | --
|                                                  |  |                            
|                                                  |  | Fiscal Year Ended August 31
|                                                  |  |                            
|                                                  |  | 2003                        |       | 2002 |  | 2001
|                                                  |  |                             |       |      |  |     
|Federal statutory tax rate                        |  |                             | (34.0 | )%   |  |      | (34.0 | )% |  |  | (34.0 | )%
|State income tax rate (net of federal tax effect) |  |                             |      |      |  |      | 6.2   |    |  |  | (1.2  | ) 
|Reversal of reserve for contingencies             |  |                             |      |      |  |      | (14.0 | )  |  |  |      |   
|Change in valuation allowance                     |  |                             | 33.0  |      |  |      | 77.5  |    |  |  |      |   
|Write-off of equity investment                    |  |                             |      |      |  |      |      |    |  |  | 11.0  |   
|Other                                             |  |                             | 1.1   |      |  |      | 3.3   |    |  |  | 1.6   |   
|                                                  |  |                             |       |      |  |      |       |    |  |  |       |   
|Effective tax rate                                |  |                             | (0.1  | )%   |  |      | 39.0  | %  |  |  | (22.6 | )%
|                                                  |  |                             |       |      |  |      |       |    |  |  |       |   

45



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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The tax effects of temporary differences that
give rise to significant portions of the deferred tax assets and
liabilities at August 31, 2003 and 2002 are as follows:

|                                              |                                  |                |        |       |  |   |        |       | 
|--------------------------------------------- | -------------------------------- | -------------- | ------ | ----- |  | - | ------ | ----- | 
|                                              |                                  |               
|                                              |                                  | August 31     
|                                              |                                  |               
|                                              |                                  | 2003           |        | 2002 
|                                              |                                  |                |        |      
|                                              |                                  |               
|                                              |                                  | (In thousands)
|Deferred tax assets (current):                |                                  |                |        |       |  |   |        |      
|                                              | Receivables                      |                | $      | 34    |  |   | $      | 33    | 
|                                              | Inventories                      |                |        | 340   |  |   |        | 219   | 
|                                              | Accrued liabilities              |                |        | 129   |  |   |        | 197   | 
|                                              | Other                            |                |        |      |  |   |        | 18    | 
|                                              |                                  |                |        |       |  |   |        |      
|                                              |                                  |                | 503    |       |  |   | 467    |      
|                                              |                                  |                |        |       |  |   |        |      
|Deferred tax assets (long-term):              |                                  |                |        |       |  |   |        |      
|                                              | Net operating loss carry-forward |                |        | 5,546 |  |   |        | 3,364 | 
|                                              | Capital loss carry-forward       |                |        | 286   |  |   |        | 510   | 
|                                              | Licensing agreement reserve      |                |        | 196   |  |   |        |      | 
|                                              | Other                            |                |        | 16    |  |   |        | 18    | 
|                                              |                                  |                |        |       |  |   |        |      
|Gross deferred tax assets (long-term)         |                                  |                | 6,044  |       |  |   | 3,892  |      
|                                              |                                  |                |        |       |  |   |        |      
|Less: Deferred tax assets valuation allowance |                                  |                | (5,405 | )     |  |   | (3,420 | )    
|Net deferred tax assets (long-term)           |                                  |                | 639    |       |  |   | 472    |      
|                                              |                                  |                |        |       |  |   |        |      
|Deferred tax liabilities (long-term):         |                                  |                |        |       |  |   |        |      
|Property and equipment                        |                                  |                | (1,040 | )     |  |   | (851   | )    
|Patents                                       |                                  |                | (102   | )     |  |   | (88    | )    
|                                              |                                  |                |        |       |  |   |        |      
|Net deferred tax asset                        |                                  | $              |       |       |  | $ |       |      
|                                              |                                  |                |        |       |  |   |        |      

The Company has a federal net operating loss
carry-forward at August 31, 2003, of approximately $13,235,
which is available to reduce income taxes payable in future
years. If not used, this carry-forward will expire in years 2012
through 2023. 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 $84 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, 2003, was $5,405 and as of August 31,
2002, was $3,420. The total valuation allowance for the fiscal
year ended August 31, 2003, increased by $1,985 and the
valuation allowance for the fiscal year ended August 31,
2002, increased by $2,910. 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 11



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

1998 Plan.Under the
Companys 1998 Stock Option Plan (the 1998
Plan), a maximum of 1,300,000 shares of common stock may
be issued pursuant to qualified and nonqualified stock options.
Stock options

46



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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, 2003,
the number of shares available for grant was 41,825.

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.

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, 2003, 2002, and
2001, 34,035, 20,271 and 1,639 shares at prices of $1.59, $5.12,
and $7.97, respectively, were purchased under the 1989 Plan in
connection with the employee stock purchase plan. At
August 31, 2003, the number of shares available for grant
was 151,041.

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 to the three non-employee directors at $2.16,
$5.95, and $13.875 during our fiscal years ended August 31,
2003, 2002 and 2001, respectively. At August 31, 2003,
30,000 shares were available for 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 liquidation of all unexercised stock options.

47



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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, 2000 |  |             | 993   |                |  | $ | 8.042  | 
|Granted                  |  |             | 423   |                |  |   | 13.858 | 
|Exercised                |  |             | (230  | )              |  |   | 6.009  | 
|Cancelled                |  |             | (80   | )              |  |   | 10.316 | 
|                         |  |             |       |                |  |   |        | 
|Balance, August 31, 2001 |  |             | 1,106 |                |  |   | 10.523 | 
|                         |  |             |       |                |  |   |        | 
|Granted                  |  |             | 528   |                |  |   | 6.529  | 
|Exercised                |  |             | (55   | )              |  |   | 4.977  | 
|Cancelled                |  |             | (86   | )              |  |   | 10.446 | 
|                         |  |             |       |                |  |   |        | 
|Balance, August 31, 2002 |  |             | 1,493 |                |  |   | 9.305  | 
|                         |  |             |       |                |  |   |        | 
|Granted                  |  |             | 519   |                |  |   | 2.898  | 
|Exercised                |  |             | (34   | )              |  |   | 1.590  | 
|Cancelled                |  |             | (578  | )              |  |   | 9.431  | 
|                         |  |             |       |                |  |   |        | 
|Balance, August 31, 2003 |  |             | 1,400 |                |  |   | 7,218  | 
|                         |  |             |       |                |  |   |        | 

The following table summarizes information about
stock options outstanding as of August 31, 2003:

|                         |  |                     |       |                     |  |             |       |           |  |          |     |  |  |  |     |  |  |   |       | 
|------------------------ |  | ------------------- | ----- | ------------------- |  | ----------- | ----- | --------- |  | -------- | --- |  |  |  | --- |  |  | - | ----- | 
|                         |  |                     |       |                     |  |            
|                         |  | Options Outstanding |       |                    
|                         |  |                     |       | Options Exercisable
|                         |  |                     |       | Weighted            |  |            
|                         |  |                     |       | Weighted            |  | Average     |       |           |  | Weighted
|                         |  |                     |       | Average             |  | Remaining   |       |           |  | Average 
|                         |  | Number of           |       | Exercise            |  | Contractual |       | Number of |  | Exercise
|Range of Exercise Prices |  | Options             |       | Price               |  | Life        |       | Options   |  | Price   
|                         |  |                     |       |                     |  |             |       |           |  |         
|$1.680-3.180             |  |                     | 340   |                     |  | $           | 2.22  |           |  |          | 9.6 |  |  |  | 100 |  |  | $ | 1.83  | 
|$3.181-5.99              |  |                     | 433   |                     |  |             | 5.31  |           |  |          | 7.7 |  |  |  | 181 |  |  |   | 5.67  | 
|$6.00-9.99               |  |                     | 212   |                     |  |             | 7.24  |           |  |          | 7.9 |  |  |  | 54  |  |  |   | 6.90  | 
|$10.00-11.99             |  |                     | 172   |                     |  |             | 10.75 |           |  |          | 6.4 |  |  |  | 121 |  |  |   | 10.74 | 
|$12.00-14.99             |  |                     | 227   |                     |  |             | 13.63 |           |  |          | 7.1 |  |  |  | 85  |  |  |   | 13.48 | 
|$15.00-20.375            |  |                     | 16    |                     |  |             | 18.90 |           |  |          | 7.0 |  |  |  | 4   |  |  |   | 18.90 | 
|                         |  |                     |       |                     |  |             |       |           |  |          |     |  |  |  |     |  |  |   |       | 
|                         |  |                     | 1,400 |                     |  | $           | 7.020 |           |  |          | 7.9 |  |  |  | 545 |  |  | $ | 7.536 | 
|                         |  |                     |       |                     |  |             |       |           |  |          |     |  |  |  |     |  |  |   |       | 

The weighted average grant-date fair value of
options granted during our fiscal years ended August 31,
2003, 2002 and 2001, was $1.84, $3.37 and $8.27, 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

48



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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,
|                            |  |                              
|                            |  | 2003                          |                 | 2002 |  | 2001
|                            |  |                               |                 |      |  |     
|Risk-free interest rates    |  |                               | 2.31% to 3.52%  |      |  |      | 3.97% to 4.93% |  |  |  | 4.6% to 5.9% | 
|Expected life               |  |                               | 7 to 8.5  years |      |  |      | 2 to 5 years   |  |  |  | 5 years      | 
|Volatility                  |  |                               | 73%             |      |  |      | 70%            |  |  |  | 69%          | 
|Expected dividends          |  |                               | None            |      |  |      | None           |  |  |  | None         | 
|Weighted average fair value |  |                               | $1.84           |      |  |      | $3.37          |  |  |  | $8.27        | 

Stock Warrants.In
August 2001, the Board of Directors authorized the Company to
issue up to 100,000 Common Stock Purchase Warrants
(Warrants). In August 2001, the Company issued
47,700 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.

Note 12



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

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

|                                                          |  |                               |        |      |  |      |        |   |  |   |        |  
|--------------------------------------------------------- |  | ----------------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                          |  |                              
|                                                          |  | Fiscal Years Ended August 31,
|                                                          |  |                              
|                                                          |  | 2003                          |        | 2002 |  | 2001
|                                                          |  |                               |        |      |  |     
|Basic:                                                    |  |                               |        |      |  |      |        |   |  |   |        |  
|Net loss                                                  |  | $                             | (4,629 | )    |  | $    | (3,892 | ) |  | $ | (3,193 | )
|Net loss per share                                        |  | $                             | (0.70  | )    |  | $    | (0.65  | ) |  | $ | (0.65  | )
|Weighted average number of common shares
    outstanding  |  |                               | 6,629  |      |  |      | 5,922  |   |  |   | 4,881  |  
|Diluted:                                                  |  |                               |        |      |  |      |        |   |  |   |        |  
|Net loss                                                  |  | $                             | (4,629 | )    |  | $    | (3,892 | ) |  | $ | (3,193 | )
|Loss per share                                            |  | $                             | (0.70  | )    |  | $    | (0.65  | ) |  | $ | (0.65  | )
|Weighted average number of common shares
    outstanding  |  |                               | 6,629  |      |  |      | 5,992  |   |  |   | 4,881  |  
|Assumed conversion of stock options                       |  |                               |       |      |  |      |       |   |  |   |       |  
|                                                          |  |                               |        |      |  |      |        |   |  |   |        |  
|Weighted average common and assumed conversion
    shares |  |                               | 6,629  |      |  |      | 5,992  |   |  |   | 4,881  |  
|                                                          |  |                               |        |      |  |      |        |   |  |   |        |  

Approximately 1,447,100 1,540,000 and 1,156,000
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, 2003,
2002 and 2001, respectively.

Note 13



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

On August 29, 2001, the Company completed a
$6,700 private placement of its common stock. HEI sold 950,000
shares of common stock at $7.00 per share. The Company received
net proceeds of approximately $6,336.

49



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Note 14



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

During April 2001, the Company recorded notes
receivable of $1,266 from certain officers and directors in
connection with the exercise of stock options. These notes 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. As of August 31, 2003, the
interest due the Company on these notes was $10 and is payable
April 2, 2004. As of August 31, 2003, notes receivable
of $1,256 remains outstanding with $587 reserved due to its
uncollectible nature.

On June 30, 2003, we commenced litigation
against Anthony J. Fant, the 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
August 12, 2003, the Court did not rule on the other counts
in the complaint, reserving to a later time such determination.
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. 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, in excess of approximately $112 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.

Note 15



| |                       
| | ----------------------
| | 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, 2003, 2002 and 2001, the
Company contributed $77, $45 and $119, respectively, to the plan.

Note 16



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

The Company leases certain office and
manufacturing space and equipment under noncancelable operating
leases. Giving effect to the acquisition of AMO and the assumed
operating lease and other

50



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

contractual commitments, future minimum lease
payments, excluding executory costs such as real estate taxes,
insurance and maintenance expense, by year and in the aggregate
are as follows:

|                             |  |                   |        | 
|---------------------------- |  | ----------------- | ------ | 
|                             |  | Minimum Operating
|Year Ending August 31,       |  | Lease Commitments
|                             |  |                  
|2004                         |  | $                 | 2,110  | 
|2005                         |  |                   | 1,993  | 
|2006                         |  |                   | 1,853  | 
|2007                         |  |                   | 1,711  | 
|2008                         |  |                   | 1,712  | 
|Thereafter                   |  |                   | 8,631  | 
|                             |  |                   |        | 
|Total minimum lease payments |  | $                 | 18,010 | 
|                             |  |                   |        | 

Note 17



| |                                                                      
| | ---------------------------------------------------------------------
| | 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,        
|                         |  |                   
|                         |  | 2003               |    | 2002 |  | 2001
|                         |  |                    |    |      |  |     
|Sonic Innovations, Inc.  |  |                    | 17 | %    |  |      | 32 | % |  |  | 26 | %
|Siemens, Inc.            |  |                    | 14 | %    |  |      | 32 | % |  |  | 25 | %
|GE Medical Systems       |  |                    | 14 | %    |  |      |   |   |  |  |   |  
|Triquint Optoelectronics |  |                    |   |      |  |      |   |   |  |  | 10 | %
|                         |  |                    |    |      |  |      |    |   |  |  |    |  
|Total                    |  |                    | 45 | %    |  |      | 64 | % |  |  | 61 | %
|                         |  |                    |    |      |  |      |    |   |  |  |    |  

Sonic Innovations, Inc. has verbally advised us
that it intends to discontinue a significant program with us in
order to place it offshore. This program discontinuance will
reduce but not eliminate sales to this customer.

Accounts receivable from these customers
represented 28%, 28%, and 52% respectively, of the total
accounts receivable at August 31, 2003, 2002 and 2001,
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. 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 $5,298, $9,062 and
$11,209 that were shipped to Singapore during its fiscal years
ended August 31, 2003, 2002 and 2001, respectively. Total
net export sales were $10,823, $11,475, and $14,711 during the
Companys fiscal years ended August 31, 2003, 2002 and
2001, respectively. The majority of the international sales were
to multinational companies who instructed HEI to ship products
to their offshore assembly facilities.

51



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Note 18



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

On October 31, 2003, MKS Instruments, Inc.
(NASDAQ: MKSI) and HEI, Inc. signed an agreement wherein
MKS purchased HEIs solid state radio frequency power
amplifier technology. The technology is focused on
Tesla 1.5 magnetic resonance imaging (MRI)
applications but can be scaled for use in other MRI equipment.
The value of the transaction is $423,000. The first two
milestone payments ($323,000) were paid by wire transfer on
October 31, 2003. The remaining payment ($100,000) will
become due upon HEIs completion of the engineering support
milestone. The engineering support milestone is targeted for
completion in May 2004.

The agreement contains a non-compete clause
restricting HEI from developing and selling competing solid
state amplifiers in the MRI market for a period of two years.
The non-compete clause does not restrict HEI from fulfilling its
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 Settlement
Agreement) with Becton Dickinson (BD),
pursuant to which, among other things, we agreed to pay to BD
the sum of $400,000. Such amount will be paid in five
installments of $80,000, the first of which was paid on
November 17, 2003, and the remainder of which will be paid
on January 31, 2004, April 30, 2004, July 31,
2004 and September 30, 2004, respectively. Except for cash
flow, the Settlement Agreement will not impact our financial
statements since a full reserve existed based on the purchase
accounting entry at time of acquisition of CMED. The dispute was
based upon certain equipment that was shipped prior to the
acquisition of our AMO and did not meet the acceptance criteria
per agreement with the customer. The Settlement Agreement will
settle all claims know and unknown regarding the 5ml equipment.

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
August 12, 2003, the Court did not rule on the other counts
in the complaint, reserving to a later time such determination.
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. 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, in excess of approximately $112 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.

Prior to commencing the litigation against
Mr. Fant, our board of directors established a special
committee of independent directors (the Special
Committee) to address all issues related to Mr. Fant.
The Special Committee has reported to us that it has completed a
thorough internal investigation of such issues, including an
accounting review relating to certain expenses incurred by us on
behalf of Mr. Fant.

The Special Committee also reviewed the actions
taken by us to address the issues related to
Mr. Fants actions, which included our litigation
against Mr. Fant, enhancement of our controls over expense
reporting and setting a proper tone at the top from our new CEO,
and concluded that such actions were appropriate. The Special
Committee believes that our only remaining actions with respect
to Mr. Fant include (i) continuing 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 and (ii) nominating a person other than
Mr. Fant to fill the director position currently held by
Mr. Fant when Mr. Fants current term ends at our
2005 Annual Meeting of Shareholders.

52



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##### Table of Contents



INDEPENDENT AUDITORS REPORT

The Shareholders and the Board of Directors

of HEI, Inc.:


We have audited the accompanying consolidated
balance sheets of HEI, Inc. and subsidiaries as of
August 31, 2003 and 2002, 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, 2003. These consolidated financial
statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the financial position of HEI, Inc. and subsidiaries
as of August 31, 2003 and 2002, and the results of their
operations and their cash flows for each of the years in the
three-year period ended August 31, 2003, in conformity with
accounting principles generally accepted in the United States of
America.



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

Minneapolis, Minnesota

December 12, 2003


53



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##### Table of Contents



INDEPENDENT AUDITORS REPORT ON FINANCIAL
STATEMENT SCHEDULE

The Shareholders and the Board of Directors

HEI, Inc.:


Under date of December 12, 2003, we reported
on the consolidated balance sheets of HEI, Inc. and subsidiaries
as of August 31, 2003 and 2002, 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, 2003, as
contained in the annual report on Form 10-K for the fiscal
year ended August 31, 2003. 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

December 12, 2003


54



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##### Table of Contents








STATEMENT OF FINANCIAL
RESPONSIBILITY


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

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

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

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

Summary of Quarterly Operating
Results

|                   |         |                                          |        |        |   |       |        |        |   |   |        |       |   |   |        |       |  
|------------------ | ------- | ---------------------------------------- | ------ | ------ | - | ----- | ------ | ------ | - | - | ------ | ----- | - | - | ------ | ----- | -
|Fiscal Year 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    |        |   |       | 862    |        |   |   | 2,534  |       |   |   | 3,105  |      
|Unusual charges    |         |                                          |       |        |   |       |       |        |   |   |       |       |   |   | 331    |      
|Operating loss     |         |                                          | (1,140 | )      |   |       | (1,342 | )      |   |   | (389   | )     |   |   | (566   | )    
|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 | )

|                            |         |                                          |        |        |   |       |       |        |   |   |       |      |  |   |        |       |  
|--------------------------- | ------- | ---------------------------------------- | ------ | ------ | - | ----- | ----- | ------ | - | - | ----- | ---- |  | - | ------ | ----- | -
|Fiscal Year 2002            |         | First                                    |        | Second |   | Third |       | Fourth
|                            |         |                                          |        |        |   |       |       |       
|                            |         |                                         
|                            |         | (Unaudited)                             
|                            |         | (In thousands, except per share amounts)
|Net sales                   |         | $                                        | 6,126  |        |   | $     | 7,799 |        |   | $ | 8,500 |      |  | $ | 6,108  |      
|Gross profit                |         |                                          | 385    |        |   |       | 1,539 |        |   |   | 2,154 |      |  |   | 1,075  |      
|Operating income (loss)     |         |                                          | (1,637 | )      |   |       | (412  | )      |   |   | 206   |      |  |   | (850   | )    
|Net income (loss)           |         |                                          | (1,094 | )      |   |       | (310  | )      |   |   | 115   |      |  |   | (2,602 | )    
|                            |         |                                          |        |        |   |       |       |        |   |   |       |      |  |   |        |      
|Net income (loss) per share |         |                                          |        |        |   |       |       |        |   |   |       |      |  |   |        |      
|                            | Basic   |                                          | $      | (0.18  | ) |       | $     | (0.05  | ) |   | $     | 0.02 |  |   | $      | (0.43 | )
|                            | Diluted |                                          | $      | (0.18  | ) |       | $     | (0.05  | ) |   | $     | 0.02 |  |   | $      | (0.43 | )

NOTE:

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

55



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##### Table of Contents



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

None.

Item 9A.     Controls
and Procedures.

During the course of their audit of our
Consolidated Financial Statements for the fiscal year ended
August 31, 2003, our independent auditors, KPMG LLP,
advised management and Audit Committee of our Board of Directors
that they had identified a deficiency in internal control. The
deficiency is considered to be a material weakness
as defined under standards established by the American Institute
of Certified Public Accountants. The material weakness relates
to the overriding, by our former Chief Executive Officer and
Chief Financial Officer, of internal controls relating to the
payment of certain expenses not supported by proper
documentation.

Prior to the identification of such deficiency,
we had already undertaken, or began to undertake, a number of
steps to establish a proper control environment, including:



| |   |                                                                                                                                                                                                                                                   
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the replacement of the chief executive officer
    and chief financial officer,                                                                                                                                                                   
|
| |  | the establishment of a special committee of
    independent directors to address all issues relating to the
    former chief executive officer;                                                                                                   
|
| |  | the completion of an accounting review by an
    independent accounting firm relating to the payment of certain
    expenses not supported by proper documentation;                                                                               
|
| |  | the elimination of opportunities to override
    appropriate controls over expense reporting by elimination of
    substantially all corporate credits cards and the requirement of
    approved expense reports for any travel reimbursement; and
|
| |  | the establishment by our current Chief Executive
    Officer of a tone at the top that overriding of internal
    controls will not be tolerated.                                                                                                 

In addition, we are in the process of
establishing a whistle blower policy and process. We will
continue to evaluate the effectiveness of our internal controls
and procedures on an ongoing basis, we will implement actions to
enhance our resources and training in the area of financial
reporting and disclosure responsibilities and we will review
such actions with our Audit Committee and KPMG LLP.

We have discussed our corrective actions and
plans with the Audit Committee and KPMG LLP and, as of the date
of this report, we believe the actions outlined have corrected
the deficiencies in internal controls that are considered to be
a material weakness. Further, our management, including the
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 report. Based on such
evaluation, our Chief Executive Officer and President and Chief
Financial Officer have concluded that, as of the end of such
period, our disclosure controls and procedures are effective.

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






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
Repot on Form 10-K pursuant to Instruction 3 to
Item 401(b) of Regulation S-K. The other information
required by this Item 10 is incorporated herein by
reference to the discussions under the sections captioned

56



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##### Table of Contents



Proposal No. 1  Election of
Directors and Section 16(a) Beneficial
Ownership Reporting Compliance to be included in
HEIs Definitive Proxy Statement for its 2004 Annual
Meeting of Shareholders to be filed with the Securities and
Exchange Commission.


Item 11.     Executive
Compensation.

The information required by this Item 11 is
incorporated herein by reference to the discussions under the
sections captioned Director Compensation and
Executive Compensation, but excluding the
discussions included under the subsections captioned
Executive Compensation  Report of the
Compensation Committee on Executive Compensation,
Executive Compensation  Stockholder Return
Performance Presentation and Executive
Compensation  Certain Relationships and Related
Transactions, to be included HEIs definitive Proxy
Statement for its 2004 Annual Meeting of Shareholders to be
filed with the Securities and Exchange Commission.



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

The information required by this Item 12 is
incorporated herein by reference to the discussion under the
section captioned Shares Beneficially Owned to be
included in HEIs Definitive Proxy Statement for its 2004
Annual Meeting of Shareholders to be filed with the Securities
and Exchange Commission.

Item 13.     Certain
Relationships and Related Transactions

The information required by this Item 13 is
incorporated herein by reference to the discussion under the
section captioned Executive Compensation 
Certain Relationships and Related Transactions to be
included in HEIs Definitive Proxy Statement for its 2004
Annual Meeting of Shareholders to be filed with the Securities
and Exchange Commission.






PART IV


Item 15.     Exhibits,
Financial Statement Schedules and Reports on
Form 8-K.

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



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

(b) Reports on Form 8-K

On June 3, 2003, we filed a Current Report
on Form 8-K reporting, under Item 9 
Regulation FD Disclosure, that certain officers delivered
an investor presentation

On July 15, 2003, we filed a Current Report
on Form 8-K reporting, under Item 7 
Financial Statements and Exhibits, that we issued a press
release regarding our results for our third quarter of our
fiscal year ending August 31, 2003.

On July 17, 2003, we filed a Current Report
on Form 8-K reporting, under Item 5  Other
Events, that we issued several press releases regarding the
following: (i) that we signed a value-added reseller
(VAR) agreement with SAMSys Technologies Inc.;
(ii) that we entered into a Credit Agreement with Beacon
Bank of Shorewood, Minnesota; (iii) that we would attend
the Medical Design and Manufacturing Conference and Exposition
East in New York, NY, on June 2-4, 2003, to demonstrate our
combined microelectronic packaging, high density interconnection
and advanced medical device development and manufacturing
capabilities; (iv) that Steve Tondera resigned as our Chief
Financial Officer and as a member of our Board of Directors and
that Douglas Nesbit was appointed to replace Mr. Tondera
effective as of June 30, 2003; (v) that we commenced
litigation against Anthony J. Fant, our former Chairman of the
Board, Chief Executive Officer and President and a current
member of the Board of Directors, and established a special
committee of the independent members of the Board of Directors
to address all issues related to

57



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Mr. Fant,; (vi) that Scott Stole was
promoted to the position of Chief Technical Officer; and
(vii) that we signed an agreement with Cerner Corporation
to develop and supply certain bedside healthcare integration
products.


On August 13, 2003, we filed a Current
Report on Form 8-K reporting, under Item 5 
Other Events, that we issued a press release announcing that we
had received a default judgment in our lawsuit against
Anthony J. Fant, our former Chairman, Chief Executive
Officer and President and a current member of our Board of
Directors.

On August 28, 2003, we filed a Current
Report on Form 8-K reporting, under Item 5 
Other Events, that we issued a press release announcing that we
successfully completed our external assessment to the
international standard for Quality Management Systems,
ISO9001:2000 by the NSAI.

(c) Exhibits:

| |       |  |  |                                                                                                                                                                                                                                              |  |       
| | ----- |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------
| | 2.1   |  |  | Agreement and Plan of Reorganization, dated
    February 25, 2000, by and among HEI, Inc., Leonard
    Acquisition Corp., Cross Technology, Inc., Mart Diana (as
    Shareholders Agent) and the Shareholders of Cross
    Technology, Inc. |  | Note 1
| | 2.2   |  |  | Purchase Agreement, dated as of January 24,
    2003, by and between HEI, Inc. and Colorado MEDtech, Inc.                                                                                                                                    |  | Note 2
| | 2.3   |  |  | Registration Rights Agreement, dated as of
    January 24, 2003, by and between HEI, Inc. and Colorado
    MEDtech, Inc.                                                                                                                     |  | Note 2
| | 3.1   |  |  | Amended and Restated Articles of Incorporation of
    HEI, Inc.                                                                                                                                                                              |  | Note 3
| | 3.2   |  |  | Amended and Restated Bylaws of HEI, Inc.                                                                                                                                                                                                     |  | Note 3
| | 3.3  |  |  | Amendment, dated March 19, 2003, to the
    Amended and Restated Bylaws of HEI, Inc.                                                                                                                                                         |  |       
| | 10.1  |  |  | Loan and Security Agreement, dated July 31,
    2000, among HEI, Inc. and LaSalle Business Credit, Inc.                                                                                                                                      |  | Note 4
| | 10.2  |  |  | First Amendment to Credit Agreement, dated
    August 31, 2000, by and between HEI, Inc. and LaSalle
    Business Credit, Inc.                                                                                                               |  | Note 5
| | 10.3  |  |  | Second Amendment to Loan and Security Agreement,
    dated April 16, 2001, between HEI, Inc. and LaSalle
    Business Credit, Inc.                                                                                                           |  | Note 5
| | 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 5
| | 10.5  |  |  | Seventh Amendment to Loan and Security Agreement,
    dated December 1, 2002, between HEI, Inc., Cross
    Technology, Inc. and LaSalle Business Credit, Inc.                                                                                |  | Note 6
| | 10.6  |  |  | Eighth Amendment to Loan and Security Agreement,
    dated April 9, 2003, between HEI, Inc., Cross Technology,
    Inc. and LaSalle Business Credit, Inc.                                                                                    |  | Note 7
| | 10.7  |  |  | Capital Expenditure Note, executed as of
    July 31, 2000, by HEI, Inc. in favor of LaSalle Business
    Credit, Inc.                                                                                                                       |  | Note 4
| | 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 5
| | 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 5
| | 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 5
| | 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 5
| | 10.12 |  |  | Reimbursement Agreement, dated July 31,
    2000, by and between HEI, Inc., LaSalle Bank, N.A. and LaSalle
    Business Credit, Inc.                                                                                                         |  | Note 4
| | 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 4

58



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##### Table of Contents



| |         |  |  |                                                                                                                                                                   |  |        
| | ------- |  |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------
| | 10.14   |  |  | Patent, Trademark and License Mortgage, dated
    July 31, 2000, by HEI, Inc. in favor of LaSalle Business
    Credit, Inc.                                       |  | Note 4 
| | 10.15   |  |  | Amendment No. 1 to Patent, Trademark and
    License Agreement, undated, between HEI, Inc. and LaSalle
    Business Credit, Inc.                                  |  | Note 5 
| | 10.16   |  |  | Security Agreement, dated July 31, 2000, by
    and between HEI, Inc. and LaSalle Business Credit, Inc.                                                           |  | Note 4 
| | 10.17   |  |  | Revolving Note, executed as of July 31,
    2000, by HEI, Inc. in favor of LaSalle Business Credit, Inc.                                                          |  | Note 4 
| | 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 5 
| | 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 6 
| | *10.20  |  |  | Form of Indemnification Agreement between HEI and
    officers and directors                                                                                      |  | Note 8 
| | *10.21  |  |  | HEI, Inc. 1989 Omnibus Stock Compensation Plan
    adopted April 3, 1989, as amended to date.                                                                     |  | Note 9 
| | *10.22  |  |  | HEI, Inc. 1991 Stock Option Plan for Non-employee
    Directors, as amended to date.                                                                              |  | Note 10
| | *10.23  |  |  | HEI, Inc. 1998 Stock Option Plan adopted
    November 18, 1998.                                                                                                   |  | Note 11
| | *10.24 |  |  | HEI, Inc. 1998 Stock Option Plan for Non-Employee
    Directors adopted November 18, 1998, as amended to date.                                                    |  |        
| | 10.25   |  |  | Stock Purchase Agreement by and among HEI, Inc.
    and Certain Investors listed on Exhibit A thereto, dated
    August 29, 2001.                                 |  | Note 13
| | 10.26   |  |  | Sample Promissory Note of Certain Officers
    and Directors in connection with the Exercise of Stock Options.                                                    |  | Note 12
| | 10.27   |  |  | Subordinated Promissory Note, dated as of
    January 24, 2003, issued by HEI, Inc. and accepted by
    Colorado MEDtech, Inc.                                    |  | Note 14
| | 10.28   |  |  | Lease, dated as of January 7, 2002, by and
    between Eastside Properties, LLC and Colorado MEDtech, Inc.,
    subsequently assigned to HEI, Inc.                |  | Note 14
| | 10.29   |  |  | First Addendum to Lease, dated September 12,
    2002, by and between Eastside Properties, LLC and Colorado
    MEDtech, Inc., subsequently assigned to HEI, Inc. |  | Note 14
| | 10.30   |  |  | Second Addendum to Lease, dated January 23,
    2003, by and between Eastside Properties, LLC and Colorado
    MEDtech, Inc., subsequently assigned to HEI, Inc.  |  | Note 14
| | 10.31   |  |  | Agreement Regarding Additional Security Deposit
    by and between Eastside Properties, Inc. and HEI, Inc.                                                        |  | Note 14
| | 10.32   |  |  | Letter Agreement, dated May 16, 2003,
    between HEI, Inc. and Whitebox Hedged High Yield Partners.                                                              |  | Note 15
| | 10.33   |  |  | Accounts Receivable Agreement, dated May 29,
    2003, by and between HEI, Inc. and Beacon Bank.                                                                  |  | Note 15
| | *10.34 |  |  | Separation Agreement and Release, dated
    June 20, 2003, between HEI, Inc. and Steve E Tondera, Jr.                                                             |  |        
| | *10.35 |  |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Douglas J. Nesbit.                                                                         |  |        
| | *10.36 |  |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Stephen K. Peterson.                                                                       |  |        
| | *10.37 |  |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Scott M. Stole.                                                                            |  |        
| | *10.38 |  |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Simon F. Hawksworth.                                                                       |  |        
| | *10.39 |  |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and James C. Vetricek.                                                                         |  |        

59



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| |        |  |  |                                                                                                                                                                                       |  | 
| | ------ |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | 
| | 10.40 |  |  | Note Prepayment Agreement, dated October 15,
    2003, between HEI, Inc. and Whitebox Hedged High Yield Partners.                                                                     |  | 
| | 10.41 |  |  | Promissory Note, dated October 14, 2003, by
    HEI, Inc. in favor of Commerce Bank.                                                                                                  |  | 
| | 10.42 |  |  | Term Loan Agreement, dated October 14, 2003,
    by HEI, Inc. and Commerce Bank.                                                                                                      |  | 
| | 10.43 |  |  | Combination Mortgage, Security Agreement,
    Assignment of Rents and Fixture Financing Statement, dated
    October 14, 2003, by HEI, Inc. in favor of Commerce Bank.                |  | 
| | 10.44 |  |  | Environmental Investigation Letter, dated
    October 14, 2003, by HEI, Inc. in favor of Commerce Bank.                                                                               |  | 
| | 10.45 |  |  | Promissory Note, dated October 28, 2003, by
    HEI, Inc. in favor of Commerce Financial Group.                                                                                       |  | 
| | 10.46 |  |  | Term Loan Agreement, dated October 28, 2003,
    by HEI, Inc. and Commerce Financial Group                                                                                            |  | 
| | 10.47 |  |  | Commercial Security Agreement, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group.                                                                     |  | 
| | 10.48 |  |  | Combination Mortgage, Security Agreement,
    Assignment of Rents and Fixture Financing Statement, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group. |  | 
| | 10.49 |  |  | Environmental Investigation Letter, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group.                                                                |  | 
| | 10.50 |  |  | Asset Purchase Agreement, dated October 31,
    2003, by HEI, Inc. and MKS Instruments, Inc.                                                                                          |  | 
| | 10.51 |  |  | Accounts Receivable Agreement Amendment, dated
    December 12, 2003, by and between HEI, Inc. and Beacon Bank.                                                                       |  | 
| | 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 March 21, 2000, and incorporated herein by reference.                                                                  
|   
|(2) | 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.                                                               
|   
|(3) | 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.
|   
|(4) | 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.                                                                                           
|   
|(5) | 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.                                                                                             
|   
|(6) | 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.                                                                                  

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|    |                                                                                                                                                                                                           
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(7) | 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.                                                 
|   
|(8) | 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.
|   
|(9) | 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.                                                          



|     |                                                                                                                                                                                                   
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Filed as an exhibit to the Annual Report on
    Form 10-KSB for the fiscal year ended August 31, 1997,
    and incorporated herein by reference.                                                  
|    
|(11) | 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.                                                  
|    
|(12) | 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.                                                    
|    
|(13) | 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.                      
|    
|(14) | 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.
|    
|(15) | 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.                                               



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

     Filed
herewith.

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SCHEDULE II


Valuation and qualifying accounts

|                                 |  |                           |     |                   |  |                 |       |               |  |   |       |  |  |   |     | 
|-------------------------------- |  | ------------------------- | --- | ----------------- |  | --------------- | ----- | ------------- |  | - | ----- |  |  | - | --- | 
|                                 |  | Balance at                |     | Additions Charged |  |                 |       |              
|                                 |  | Beginning                 |     | to Costs and      |  | Deductions      |       | Balance at   
|                                 |  | of Period                 |     | Expenses          |  | from Reserve(1) |       | End of Period
|                                 |  |                           |     |                   |  |                 |       |              
|                                 |  |                          
|                                 |  | (In thousands of dollars)
|Allowance for doubtful accounts: |  |                           |     |                   |  |                 |       |               |  |   |       |  |  |   |     | 
|Year ended August 31, 2003       |  | $                         | 85  |                   |  | $               | 30    |               |  | $ | 23    |  |  | $ | 92  | 
|Year ended August 31, 2002       |  |                           | 271 |                   |  |                 | 6     |               |  |   | 192   |  |  |   | 85  | 
|Year ended August 31, 2001       |  |                           | 215 |                   |  |                 | 1,268 |               |  |   | 1,212 |  |  |   | 271 | 



---



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

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SIGNATURES


In accordance with Section 13 or 15(c) 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: December 15, 2003

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

|                                           |  |                                           |  |                   |  |     
|------------------------------------------ |  | ----------------------------------------- |  | ----------------- |  | ----
|                                           |  |                                           |  |                   |  | Date
|                                           |  |                                           |  |                   |  |     
|                                          
|/s/ MACK V. TRAYNOR IIIMack V. Traynor III |  | Chief Executive Officer
    and President |  | December 15, 2003
|                                          
|/s/ DOUGLAS J. NESBITDouglas J. Nesbit     |  | Chief Financial Officer                   |  | December 15, 2003
|                                          
|/s/ DENNIS J. LEISZDennis J. Leisz         |  | Director                                  |  | December 15, 2003
|                                          
|/s/ TIMOTHY F. FLOEDERTimothy F. Floeder   |  | Director                                  |  | December 15, 2003
|                                          
|/s/ MIKE EVERSMike Evers                   |  | Director                                  |  | December 15, 2003
|                                          
|/s/ GEORGE HEENANGeorge Heenan             |  | Director                                  |  | December 15, 2003
|                                          
|Anthony J. Fant                            |  | Director                                  |  |                  

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INDEX TO EXHIBITS

|      |  |                                                                                                                                                                                      
|----- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.3   |  | Amendment, dated March 19, 2003, to the
    Amended and Restated Bylaws of HEI, Inc.                                                                                                 
|10.24 |  | HEI, Inc. 1998 Stock Option Plan for Non-Employee
    Directors adopted November 18, 1998, as amended to date.                                                                       
|10.34 |  | Separation Agreement and Release, dated
    June 20, 2003, between HEI, Inc. and Steve E Tondera, Jr.                                                                                
|10.35 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Douglas J. Nesbit.                                                                                            
|10.36 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Stephen K. Petersen                                                                                           
|10.37 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Scott M. Stole                                                                                                
|10.38 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and Simon F. Hawksworth                                                                                           
|10.39 |  | Employment Agreement, dated October 1, 2003,
    between HEI, Inc. and James C. Vetricek                                                                                             
|10.40 |  | Note Prepayment Agreement, dated October 15,
    2003, between HEI, Inc. and Whitebox Hedged High Yield Partners.                                                                    
|10.41 |  | Promissory Note, dated October 14, 2003, by
    HEI, Inc. in favor of Commerce Bank.                                                                                                 
|10.42 |  | Term Loan Agreement, dated October 14, 2003,
    by HEI, Inc. and Commerce Bank.                                                                                                     
|10.43 |  | Combination Mortgage, Security Agreement,
    Assignment of Rents and Fixture Financing Statement, dated
    October 14, 2003, by HEI, Inc. in favor of Commerce Bank.               
|10.44 |  | Environmental Investigation Letter, dated
    October 14, 2003, by HEI, Inc. in favor of Commerce Bank.                                                                              
|10.45 |  | Promissory Note, dated October 28, 2003, by
    HEI, Inc. in favor of Commerce Financial Group.                                                                                      
|10.46 |  | Term Loan Agreement, dated October 28, 2003,
    by HEI, Inc. and Commerce Financial Group                                                                                           
|10.47 |  | Commercial Security Agreement, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group.                                                                    
|10.48 |  | Combination Mortgage, Security Agreement,
    Assignment of Rents and Fixture Financing Statement, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group.
|10.49 |  | Environmental Investigation Letter, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group.                                                               
|10.50 |  | Asset Purchase Agreement, dated October 31,
    2003, by HEI, Inc. and MKS Instruments, Inc.                                                                                         
|10.51 |  | Accounts Receivable Agreement Amendment, dated
    December 12, 2003, by and between HEI, Inc. and Beacon Bank.                                                                      
|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.                                                                              

64