##### Table of Contents



UNITED STATES SECURITIES AND
    EXCHANGE COMMISSION
 Washington, D.C.
    20549
      Form 10-K
  þ

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended
    September 2, 2006.oro

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934For the transition period
    from          
    to   Commission file number: 0-10078
      HEI, Inc.
 (Exact name of registrant as
    specified in its Charter)
  Minnesota

41-0944876(State or other jurisdiction
    of
    incorporation or organization)

(I.R.S. Employer
    Identification No.)P.O. Box 5000,
    1495 Steiger Lake Lane,
    Victoria, MN

55386(Zip Code)(Address of principal executive
    offices)   Registrants telephone number, including area code:
  (952) 443-2500
  Securities registered pursuant to Section 12(b) of the
    Act:
  Common Stock, Par Value $.05 Per Share
 (Title of Class)
  Securities registered pursuant to Section 12(g) of the
    Act:
  None
  o þ
  o þ
  þ o
  Regulation S-K Form 10-K Form 10-K. þ
  Rule 12b-2
  Large
    accelerated filer o
    Accelerated
    filer o
    Non-accelerated
    filer
    þ  Rule 12b-2 o þ




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##### 



TABLE OF
    CONTENTS
  
  PAGE #PART IITEM 1.


BUSINESS


4ITEM 1A.


RISK FACTORS


8ITEM 1B.


UNRESOLVED STAFF COMMENTS


18ITEM 2.


PROPERTIES


18ITEM 3.


LEGAL PROCEEDINGS


18ITEM 4.


SUBMISSION OF MATTERS TO VOTE OF
    SECURITY HOLDERS


19PART IIITEM 5.


MARKET FOR REGISTRANTS
    COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES
    OF EQUITY SECURITIES


20ITEM 6.


SELECTED FINANCIAL DATA


21ITEM 7.


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


22ITEM 7A.


QUANTITATIVE AND QUALITATIVE
    DISCLOSURES ABOUT MARKET RISK


34ITEM 8.


FINANCIAL STATEMENTS AND
    SUPPLEMENTARY DATA


36ITEM 9.


CHANGES IN AND DISAGREEMENTS WITH
    ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE


70ITEM 9A.


CONTROLS AND PROCEDURES


71ITEM 9B.


OTHER INFORMATION


72PART IIIITEM 10.


DIRECTORS AND EXECUTIVE OFFICERS
    OF THE REGISTRANT


72ITEM 11.


EXECUTIVE COMPENSATION


72ITEM 12.


SECURITY OWNERSHIP OF CERTAIN
    BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS


72ITEM 13.


CERTAIN RELATIONSHIPS AND RELATED
    TRANSACTIONS


72ITEM 14.


PRINCIPAL ACCOUNTANT FEES AND
    SERVICES


72PART IVITEM 15.


EXHIBITS AND FINANCIAL
    STATEMENT SCHEDULES


73SIGNATURES


77Severance and Release Agreement2006 Amendment to 1998 Stock Option PlanSubsidiaries of the RegistrantConsent of Virchow, Krause & Company, LLPConsent of KPMG LLPSection 302 Certification of CEO and CFOSection 906 Certification of CEO and CFO    Documents
    Incorporated By Reference
  Form 10-K Form 10-K,
 2




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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 1A of this
    Annual Report on
    Form 10-K
    provide examples of such risks, uncertainties and events that
    may cause actual results to differ materially from our
    expectations and the forward-looking statements. Readers are
    cautioned not to place undue reliance on forward-looking
    statements, as we undertake no obligation to update these
    forward-looking statements to reflect ensuing events or
    circumstances, or subsequent actual results.
  GENERAL
    INFORMATION
  Form 10-K
   3




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PART I  Item 1.
    Business.  Business
    of the Company
  Overview:
          Microelectronics
    Operations
       4




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Advanced
    Medical Operations
    Customers:
      Component Supply Operations:
 5




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Proprietary Technology:
  Government Regulations:
         6




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Dependence on Single or Few Customers and
    Backlog:
  Fiscal Years EndedCustomer

2006


2005


2004Crystalaid


14%







GE Medical Systems


9%



12
%


17
%       Fiscal Years EndedMarket

2006


2005


2004Medical/Hearing


78%



81%



84%Communications


14%



10%



6%Industrial


8%



9%



10%       Competition:
  Engineering, Research and Development:
 7




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Employees:
  Geographical Information:
  Website and Available Information: www.heii.com Form 10-K.
  Form 10-K, Form 10-Q, Form 8-K
 Item 1A.  Risk
    Factors.    We have a history of losses. mainstream
  We may need to raise additional capital if we do not quickly
    become profitable.
  Recent financing from our Chairman is short term and may
    create conflicts of interest.
 8




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The price of our stock has been volatile and we could be
    delisted from the NADSAQ Global Market. penny
    stock penny stock
  We may lose business and revenues if we fail to successfully
    compete for our customers business.
      Fluctuations in the price and supply of components used to
    manufacture our products may reduce our
    profits.
     9




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Our costs may increase significantly if we are unable to
    forecast customer orders and production
    schedules.
  We may be unable to realize net sales from our
    backlog.
  Future quarterly and annual operating results may fluctuate
    substantially due to a number of factors, many of which are
    beyond our control and could cause our stock price to
    decline.
  
    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 similarly packaged end result);
    we may be unable to pass on cost overruns;
    we may not be able to gain the benefits expected out of
    lean-flow manufacturing at our Victoria facility;
    we may not have control over the timing of expenditures in
    anticipation of increased sales, customer product delivery
    requirements and the range of services provided; and
    we may experience variance in the amount and timing of orders
    placed by a customer due to a number of factors, including
    inventory balancing, changes in manufacturing strategy, and
    variation in product demand attributable to, among other things,
    product life cycles, competitive factors, and general economic
    conditions.   10




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We may fail to adequately adjust our expenses to predicted
    revenue in any given period or we may experience significant
    fluctuations in quarterly net sales because the sales cycle for
    our products and services is lengthy and
    unpredictable.
  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.
  Our business success may be adversely affected by our ability
    to hire and retain employees.
  We operate in a regulated industry, and our products and
    revenue are subject to regulatory risk.
      If our customers do not promptly obtain regulatory approval
    for their products, our projects and net sales may be adversely
    affected.
 11




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Failure to comply with our debt covenants may require us to
    immediately repay our outstanding balances
    and/or may
    affect our ability to borrow funds in the future, either of
    which may adversely affect our future operating
    results.
    
    further increase borrowing rates;
    incur amendment fees;
    incur additional restrictions on our ability to borrow
    additional funds;
    immediately repay our outstanding balances;
    find a new lender, which may cause us to incur costs in
    connection with such new lending relationship; and
    reduce the number of potential alterative lenders.    We may fail to have enough liquidity to operate our business
    because we may not adequately adjust our expenses to actual
    revenue in any given period, which may dramatically and
    negatively impact our cash flow.
  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.
    The loss of a key customer may reduce our operating results
    and financial condition.
 12




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If we are unable to develop new products and services our
    revenue could decrease.
  If we fail to properly anticipate the market for new products
    and service we may lose revenue.
  
    the failure to adequately equip our manufacturing plant in
    anticipation of increasing business;
    the failure of our design team to develop products in a timely
    manner to satisfy our present and potential customers; and
    our limited experience in specific market segments in marketing
    our products and services, specifically in the telecom market.  Our business may suffer if we are unable to protect our
    intellectual property rights.
  Third-party intellectual property infringement claims may be
    costly and may prevent the future sale of our customers
    products.
 13




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We may pursue future significant corporate transactions, such
    as acquisitions, divestitures or investments that may adversely
    affect our financial position or cause our net sales to decline
    or loss per share to increase.
  
    we may not be able to negotiate acceptable terms, with respect
    to an acquisition, divestiture or investment, or finance an
    acquisition or investment successfully;
    a divestiture could reduce consolidated sales volumes and any
    economies associated with a larger enterprise;
    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, accept credit risk 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.
  If we fail to comply with environmental laws and regulations
    we may be fined and prohibited from manufacturing
    products.
  We are dependent on a single market, and adverse trends in
    that market may reduce our revenues.
  Our orders are subject to cancellation and cancellation can
    disrupt our business.
 14




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Inventory management is critical to maximizing our cash
    flow. and/or
  If government or insurance company reimbursements for our
    customers products change, our products, revenues and
    profitability may 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 have excess space available for sublease at our Colorado
    facility and may not be able to find qualified sublease
    tenants.
  Our Amended and Restated Articles of Incorporation and our
    Amended and Restated Bylaws, as amended, may discourage lawsuits
    and other claims against our directors.
 15




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We have issued numerous options to acquire our common stock
    that could have a dilutive effect on our common
    stock.
  The market price of our common stock may be reduced by future
    sales of our common stock in the public
    market.
  
    1,543,754 shares beneficially owned by our executive
    officers and directors; and
    approximately 2,289,000 shares issuable to option and
    warrant holders.    The trading dynamics of our common stock makes it subject to
    large fluctuations in the per share value.
  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.
    
    to approve the merger or consolidation of us 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, referred to as 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 us; 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. 16




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If we are not able to establish an effective control
    environment in Fiscal 2007, we will not comply with
    Section 404 of the Sarbanes-Oxley Act relating to internal
    controls over financial
    reporting. Form 10-K Form 10-K
  The market price of our shares may experience significant
    price and volume fluctuations for reasons over which we have
    little control.
  
    new products or services offered by us or our competitors;
    failure to meet any publicly announced revenue projections;
    actual or anticipated variations in quarterly operating results;
    changes in financial estimates by securities analysts;
    announcements of significant acquisitions, strategic
    partnerships, joint ventures, capital commitments or
    divestitures by us or our competitors;
    issuances of debt or equity securities;
    changes in requirements or demands for our services;
    technological innovations by us or our competitors;
    quarterly variations in our or our competitors operating
    results;
    changes in prices of our or our competitors products and
    services;
    changes in our revenue and revenue growth rates;
    changes in earnings estimates by market analysts;
    speculation in the press or analyst community;
    general market conditions or market conditions specific to
    particular industries; and
    other events or factors, many of which are beyond our control. 17




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Item 1B.
    Unresolved
    Staff Comments.    Item 2.
    Properties.            Item 3.
    Legal
    Proceedings.   18




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Item 4.
    Submission
    of Matters to a Vote of Security-Holders   19




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PART II  Item 5.
    Market
    for Registrants Common Equity, Related Stockholder Matters
    and Issuer Purchases of Equity Securities.    Fiscal Year Ended September 2, 2006

High


LowFirst Quarter

$
4.00


$
3.10Second Quarter


4.53



2.50Third Quarter


2.99



2.27Fourth Quarter


2.76



1.85Fiscal Year Ended
    August 31, 2005First Quarter

$
2.46


$
1.62Second Quarter


3.12



1.78Third Quarter


3.33



2.71Fourth Quarter


3.93



2.88         Equity
    Compensation Plan Information
    Number of SharesWeighted-


Remaining AvailableNumber of Shares to


Average Exercise


for Future Issuancebe Issued Upon


Price of


Under EquityExercise of


Outstanding


Compensation PlansOutstanding


Options,


(Excluding SharesOptions, Warrants


Warrants and


Reflected in thePlan Category

and Rights


Rights


First Column)Equity compensation plans approved
    by shareholders


1,336,975


$
4.80



836,045Equity compensation plans not
    approved by shareholders










Total


1,336,975


$
4.80



836,045  20




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Item 6.
    Selected
    Financial Data.  Form 10-K.
  Fiscal Year Ended2006(a)


2005(b)


2004(c)


2003(d)


2002(e)(In thousands, except per share amounts)Net sales

$
52,631


$
56,631


$
43,320


$
38,440


$
28,532Cost of sales


44,669



45,047



39,197



31,327



23,375Gross profit


7,962



11,584



4,123



7,113



5,157Operating expenses:Selling, general and administrative


8,963



8,383



8,113



7,639



5,335Research, development and
    engineering


4,238



3,264



3,165



2,580



2,516Unusual charges (gains)






(300
)


1,359



331



Operating income (loss)


(5,239
)


237



(8,514
)


(3,437
)


(2,694
)Other income (expense), net


(818
)


118



1,505



(1,213
)


(106
)Income (loss) before income taxes


(6,057
)


355



(7,009
)


(4,650
)


(2,800
)Income tax expense (benefit)














(21
)


1,092Net income (loss)


(6,057
)


355



(7,009
)


(4,629
)


(3,892
)Deemed dividend on preferred stock






1,072











Net loss attributable to common
    shareholders

$
(6,057
)

$
(717
)

$
(7,009
)

$
(4,629
)

$
(3,892
)Net income (loss) per common
    share Basic and Diluted:Net income (loss)

$
(0.64
)

$
0.04


$
(0.90
)

$
(0.70
)

$
(0.65
)Deemed dividend on preferred stock






(0.13
)










Net loss attributable to common
    shareholders

$
(0.64
)

$
(0.09
)

$
(0.90
)

$
(0.70
)

$
(0.65
)Weighted average common shares
    outstanding:Basic


9,469



8,382



7,745



6,629



5,992Diluted


9,469



8,958



7,745



6,629



5,992Balance sheet as of year end:Working capital

$
3,702


$
8,964


$
3,414


$
5,728


$
4,369Total assets


26,042



27,677



25,112



26,503



22,989Long-term debt, less current
    maturities


2,824



1,813



1,833



2,555



1,473Shareholders equity


8,764



13,796



9,957



13,191



14,570     (a)
    
    Fiscal 2006 includes a charge to cost of sales of approximately
    $1 million from to our change in accounting estimate
    relating to our inventory overhead calculations, which adversely
    impacted our gross profit by the same amount.(b)
    
    Fiscal 2005 includes an unusual net gain of $300,000 from the
    settlement of an outstanding claim against the seller of the AMO
    operations that we acquired in January 2003. 21




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(c)
    
    Fiscal 2004 unusual charges consisted of $894,000 in outside
    legal and accounting costs in connection with our litigation
    against, and other issues involving, Mr. Fant and $465,000
    of an asset impairment. Other income included $1,361,000 of
    judgment recovery against Mr. Fant and a $472,000 gain
    recognized in connection with the prepayment of a subordinated
    promissory note.(d)
    
    Fiscal 2003 unusual charges consisted of an impaired asset
    write-down of $331,000. Other expense included costs related to
    the non-cash write off of bank fees of $181,000 related to the
    terminated revolving line of credit with LaSalle Business
    Credit, LLC and a reserve of $841,000 for Mr. Fants
    promissory note and other amounts due from Mr. Fant.(e)
    
    The write-off of the deferred tax asset established in 2001 and
    prior years which related to a minority interest, recorded under
    the equity method, resulted in a tax expense in 2002.  Item 7.
    Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations.  CRITICAL
    ACCOUNTING POLICIES
    Revenue
    recognition, sales returns and warranty
       22




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Allowance
    for Doubtful Accounts Estimation
    Inventories
    Long-lived
    Assets
    
    Significant underperformance relative to historical or projected
    future operating results;
    Significant changes in the manner of use of our assets or our
    overall business strategy;
    Significant negative market or economic trends; and
    Significant decline in our stock price for a sustained period
    changing our market capitalization relative to our net book
    value.   23




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Valuation
    of Deferred Taxes
      RESULTS
    OF OPERATIONS
  Percentage
    of Net Sales
  Fiscal Year Ended2006


2005


2004Net Sales


100
%


100
%


100
%Cost of Sales


85
%


80
%


90
%Gross profit


15
%


20
%


10
%Selling, general and administrative


17
%


15
%


19
%Research, development and
    engineering


8
%


6
%


7
%Other


2
%


(1
)%


2
%     Fiscal Year EndedMarket

2006


2005


2004Medical/Hearing


78%



81%



84%Communications


14%



10%



6%Industrial


8%



9%



10%   Net
    Sales
     24




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Gross
    Profit
   25




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Operating
    Expenses
  Selling,
    general and administrative
    Research,
    development, and engineering expenses
   26




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Gain
    on Settlement
    Asset
    Impairment Charges
    Costs
    relating to Investigation and Litigation Recovery
    Gain on
    Prepayment of Promissory Note
    Interest
    Expense
    Income
    Tax Expense (Benefit)
   27




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Deemed
    Dividend on Preferred Stock
  paid-in-capital.
  FINANCIAL
    CONDITION
       28




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TERM-DEBT
  Long-term
    debt
       29




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Short-term
    debt
   30




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31




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FISCAL
    2006 LIQUIDITY
              
    Expanding our sales efforts to existing customers and to find
    new customers for our products. We will accomplish this through
    the restructuring of our sales staff in Boulder and Victoria and
    by adding an additional sales person to support our flexible
    substrate business in Tempe. 32




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
    Focusing on gross margin improvements at all divisions. We will
    accomplish this by focusing on our costs and looking at all
    areas for improvements including material costs, labor costs and
    overhead structures.
    Structuring our staffing to work within our current sales levels
    for all of our general and administrative costs and engineering
    costs, and to reorganize the staff as necessary to position the
    Company for growth.
    Pursuing additional sublease tenants for the excess space in our
    Boulder facility while allowing for adequate room for expansion
    in that division. This will help to offset a portion of the
    operating costs and lease costs of that facility.
    Refinancing our debt to improve cash flow. To that end,
    subsequent to the end of Fiscal 2006, the Company paid off the
    Credit Agreement with Beacon Bank and replaced the funding
    through a $5,000,000 one-year term secured loan from Thomas F.
    Leahy, the Companys Chairman of the Board. The new term
    loan was undertaken to provide the Company with the opportunity
    to establish a relationship with a new asset-based lender during
    Fiscal 2007. This transaction allowed the Company to have direct
    access again to the collection of its accounts receivables,
    which should reduce the days outstanding and improve cash flow
    from collections. In addition, the loan provided additional
    future working capital of approximately $1.8 million after
    the Credit Agreement was repaid and current working capital was
    funded.
    Reduction in inventories by reviewing buying procedures and
    reducing any excess on hand inventory while maintaining the
    required inventories to meet customer demand. These initiatives
    are targeted to reduce inventories by $1 million by the end
    of Fiscal 2007.          Off
    Balance Sheet Arrangements
   33




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Contractual
    Obligations
    Payments Due By PeriodMoreLess Than


1-3


3-5


ThanTotal


1 Year


Years


Years


5 YearsIn thousands (000s)Long-term debt obligations

$
1,767


$
450


$
258


$
1,059


$
Capital lease obligations


2,893



960



1,675



258



Operating lease obligations


24,392



1,847



3,771



3,611



15,163Total contractual obligations

$
29,052


$
3,257


$
5,704


$
4,928


$
15,163   New
    Accounting Pronouncements
      Item 7A.
    Qualitative
    and Quantitative Disclosures About Market Risk.  Market
    Risk
    Interest
    Rate Risk
     34




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35




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Item 8.
    Financial
    Statements and Supplementary Data.  Form 10-K
  Page No.Consolidated
    Balance Sheets


37Consolidated
    Statements of Operations


38Consolidated
    Statements of Changes in Shareholders Equity


39Consolidated
    Statements of Cash Flows


40Notes to
    Consolidated Financial Statements


42-67Report of
    Independent Registered Public Accounting Firm


68Report of
    Independent Registered Public Accounting Firm


69  36




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HEI,
    INC.
  CONSOLIDATED
    BALANCE SHEETS
  September 2,


August 31,2006


2005(In thousands, except share and per share data)ASSETSCurrent assets:Cash and cash equivalents

$
674


$
351Accounts receivable, net of
    allowance for doubtful accounts of $124 and $157, respectively


9,205



9,278Inventories


7,000



8,044Security deposit






1,350Deferred income taxes


830



817Other current assets


316



1,136Total current assets


18,025



20,976Property and equipment:Land


216



216Building and improvements


4,374



4,323Fixtures and equipment


24,406



23,214Accumulated depreciation


(21,279
)


(20,864
)Net property and equipment


7,717



6,889Developed technology, less
    accumulated amortization of $414 and $352, respectively






62Security deposit


550



230Other long-term assets


580



337Total assets

$
26,872


$
28,494LIABILITIES AND
    SHAREHOLDERS EQUITYCurrent liabilities:Line of credit

$
5,948


$
2,563Current maturities of long-term
    debt


1,038



484Accounts payable


3,735



4,019Accrued liabilities


2,772



4,129Total current liabilities


13,493



11,195Deferred income taxes


830



817Other long-term liabilities, less
    current maturities


961



873Long-term debt, less current
    maturities


2,824



1,813Total other long-term liabilities,
    less current maturities


4,615



3,503Total liabilities


18,108



14,698Commitments and contingenciesShareholders equity:Undesignated stock;
    5,000,000 shares authorized; none issued






Convertible preferred stock, $.05
    par; 167,000 shares authorized; 32,000 shares issued
    and outstanding; liquidation preference at $26 per share
    (total liquidation preference $832,000)


2



2Common stock, $.05 par; 20,000,000
    and 13,000,000 shares authorized; 9,563,000 and
    9,379,000 shares issued and 9,504,000 and 9,379,000
    outstanding


475



469Paid-in capital


27,581



26,701Accumulated deficit


(19,226
)


(13,169
)Notes receivable-related
    parties-officers and former directors


(68
)


(207
)Total shareholders equity


8,764



13,796Total liabilities and
    shareholders equity

$
26,872


$
28,494    37




---



##### Table of Contents



HEI,
    INC.
  CONSOLIDATED
    STATEMENTS OF OPERATIONS
  Fiscal Year EndedSeptember 2,


August 31,


August 31,2006


2005


2004(In thousands, except shareand per share data)Net sales

$
52,631


$
56,631


$
43,320Cost of sales


44,669



45,047



39,197Gross profit


7,962



11,584



4,123Operating expenses:Selling, general and administrative


8,963



8,383



8,113Research, development and
    engineering


4,238



3,264



3,165Gain on settlement






(300
)


Asset impairment charges










465Costs related to investigation










894Operating income (loss)


(5,239
)


237



(8,514
)Gain on prepayment of promissory
    note










472Litigation recovery






481



1,361Interest expense


(776
)


(667
)


(364
)Other income (expense), net


(42
)


304



36Income (loss) before income taxes


(6,057
)


355



(7,009
)Income tax expense (benefit)










Net income (loss)


(6,057
)


355



(7,009
)Deemed dividend on preferred stock






1,072



Loss attributable to common
    shareholders

$
(6,057
)

$
(717
)

$
(7,009
)Net income (loss) per common shareBasic and Diluted:Net income (loss)

$
(0.64
)

$
0.04


$
(0.90
)Deemed dividend on preferred stock






(0.13
)


Net loss attributable to common
    shareholders

$
(0.64
)

$
(0.09
)

$
(0.90
)Weighted average common shares
    outstandingBasic


9,469,000



8,382,000



7,745,000Diluted


9,469,000



8,958,000



7,745,000    38




---



##### Table of Contents



HEI,
    INC.
  CONSOLIDATED
    STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
  Convertible











Related


TotalCommon





Preferred


Convertible


Additional





Party 


Share-Stock Shares


Common


Stock Shares


Preferred


Paid-In


Accumulated


Notes


HoldersOutstanding


Stock


Outstanding


Stock


Capital


Deficit


Receivable


Equity(In thousands, except share data)Balance, August 31,
    2003


7,046,000


$
352






$



$
18,951


$
(5,443
)

$
(669
)

$
13,191Net loss






















(7,009
)






(7,009
)Note receivable write off


























64



64Payments on officers loans


























170



170Issuance of common shares in lieu
    of interest  Whitebox


48,000



3











164











167Private equity placement


1,180,000



59











3,180











3,239Issuance of common shares under
    stock benefit plans and option plans


83,000



4











131











135Balance, August 31,
    2004


8,357,000



418











22,426



(12,452
)


(435
)


9,957Net income






















355







355Payments on officers loans


























228



228Issuance of Convertible Preferred
    Stock and warrants, net of expenses










130,538



7



3,155











3,162Conversion of Convertible Preferred
    Stock into common stock


985,000



49



(98,538
)


(5
)


(44
)










Issuance of common shares under
    stock benefit plans and option plans


37,000



2











92











94Deemed dividend on preferred stock


















1,072



(1,072
)






Balance, August 31,
    2005


9,379,000



469



32,000



2



26,701



(13,169
)


(207
)


13,796Net loss






















(6,057
)






(6,057
)Payments on officers loans


























139



139Stock based compensation expense


















503











503Issuance of common stock to
    landlord recognized as long-term asset


100,000



5











331











336Issuance of common shares under
    stock benefit plans and option plans


25,000



1











46











47Balance, September 2,
    2006


9,504,000


$
475



32,000


$
2


$
27,581


$
(19,226
)

$
(68
)

$
8.764    39




---



##### Table of Contents



HEI,
    INC.
  CONSOLIDATED
    STATEMENTS OF CASH FLOWS
  Fiscal Year EndedSeptember 2,


August 31,


August 31,2006


2005


2004(In thousands, except share data)Cash flow from operating
    activities:Net income (loss)

$
(6,057
)

$
355


$
(7,009
)Depreciation and amortization


2,473



2,454



2,862Accounts receivable allowance
    (recovery)


(33
)


36



29Reserve for note receivable from
    former officers










64Asset impairment charges










465Gain on prepayment of promissory
    note










(472
)(Gain) loss on disposal of
    property and equipment and other


49



(130
)


Stock based compensation expense


503







Changes in operating assets and
    liabilities:Restricted cash related to
    deferred litigation recovery






481



(481
)Accounts receivable


106



(2,544
)


(485
)Inventories


1,044



(1,257
)


77Other current assets


820



85



(836
)Other long-term assets






152



Accounts payable


(284
)


(1,644
)


1,712Accrued liabilities


(1,269
)


(944
)


137Net cash flow provided by (used
    in) operating activities


(2,648
)


(2,956
)


(3,937
)Cash flow from investing
    activities:Additions to property and equipment


(955
)


(1,314
)


(743
)Proceeds from the sale of assets


96



155



25Additions to patents


(22
)


(90
)


(84
)Security deposit


1,030







Proceeds from the sale of
    technology










323Net cash flow provided by (used
    in) investing activities


149



(1,249
)


(479
)Cash flow from financing
    activities:Issuance of common stock under
    stock plans


47



94



135Proceeds from private placement










3,239Proceeds from issuance of
    convertible preferred stock and warrants, net of expenses






3,162



Officer note repayment


139



228



170Proceeds from long-term debt










2,282Repayments of long-term debt


(749
)


(381
)


(2,788
)Deferred financing fees










(48
)Net borrowings on line of credit


3,385



1,253



820Net cash flow provided by
    financing activities


2,822



4,356



3,810Net increase (decrease) in cash
    and cash equivalents


323



151



(606
)Cash and cash equivalents,
    beginning of year


351



200



806Cash and cash equivalents, end of
    year

$
674


$
351


$
200 40




---



##### Table of Contents



Fiscal Year EndedSeptember 2,


August 31,


August 31,2006


2005


2004(In thousands, except share data)Supplemental disclosures of
    cash flow information:Interest paid

$
799


$
645


$
364Income taxes paid










6  Supplemental disclosures of non-cash financing and
    investing activities:
         41




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL STATEMENTS
  Note 1
  Overview
    Fiscal Year.
  Summary
    of Significant Accounting Policies
  Principles of Consolidation.
  Revenue Recognition.
    Cash Equivalents.
  Accounts Receivable.
 42




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Inventories.
  Property and Equipment. 3-10 years.
    Intangible Assets.
  Patents.
  Impairment of Notes Receivable. note-by-note
  Impairment of Long-lived and Intangible
    Assets.
 43




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    
    Significant underperformance relative to historical or projected
    future operating results;
    Significant changes in the manner of use of the acquired assets
    or the Companys overall business strategy;
    Significant negative market or economic trends; and
    Significant decline in the Companys stock price for a
    sustained period changing the Companys market
    capitalization relative to its net book value.    Research, Development and Engineering.
  Shipping and Handling.
  Advertising.
  Income Taxes.
  Stock-based Compensation.
   44




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
                Fiscal Year EndedAugust 31,


August 31,2005


2004(In thousands, except share data)Loss attributable to common
    shareholders as reported

$
(717
)

$
(7,009
)Add: Stock-based employee
    compensation included in reported net loss, net of related tax
    effects






Deduct: Total stock-based employee
    compensation (expense determined under fair value based method
    for all awards)


(2,974
)


(1,940
)Loss attributable to common
    shareholders pro forma

$
(3,691
)

$
(8,949
)Basic and diluted loss
    attributable to common shareholders per share as reported

$
(0.09
)

$
(0.90
)Stock-based compensation expense


(0.35
)


(0.26
)Basic and diluted loss
    attributable to common shareholders per share pro forma

$
(0.44
)

$
(1.16
)  45




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Customer Deposits.
  Net Income (Loss) Per Common Share.
  Use of Estimates.
  Change in Accounting Estimate.
  Financial Instruments.
  Reclassifications.
  New Accounting Pronouncements.
   46




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Note 2
  Liquidity
           47




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      
    Expanding our sales efforts to existing customers and to find
    new customers for our products. We will accomplish this through
    the restructuring of our sales staff in Boulder and Victoria and
    by adding an additional sales person to support our flexible
    substrate business in Tempe.
    Focusing on gross margin improvements at all divisions. We will
    accomplish this by focusing on our costs and looking at all
    areas for improvements including material costs, labor costs and
    overhead structures.
    Structuring our staffing to work within our current sales levels
    for all of our general and administrative costs and engineering
    costs, and to reorganize the staff as necessary to position the
    Company for growth.
    Pursuing additional sublease tenants for the excess space in our
    Boulder facility while allowing for adequate room for expansion
    in that division. This will help to offset a portion of the
    operating costs and lease costs of that facility.
    Refinancing our debt to improve cash flow. To that end,
    subsequent to the end of Fiscal 2006, the Company paid off the
    Credit Agreement with Beacon Bank and replaced the funding
    through a $5,000,000 one-year term secured loan from Thomas F.
    Leahy, the Companys Chairman of the Board. The new term
    loan was undertaken to provide the Company with the opportunity
    to establish a relationship with a new asset-based lender during
    Fiscal 2007. This transaction allowed the Company to have direct
    access again to the collection of its accounts receivables,
    which should reduce the days outstanding and improve cash flow
    from collections. In addition, the loan provided additional
    future working capital of approximately $1.8 million after
    the Credit Agreement was repaid and current working capital was
    funded.
    Reduction in inventories by reviewing buying procedures and
    reducing any excess on hand inventory while maintaining the
    required inventories to meet customer demand. These initiatives
    are targeted to reduce inventories by $1 million by the end
    of Fiscal 2007.       48




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 3
  Other
    Financial Statement Data
    Fiscal Year EndedSeptember 2,


August 31,2006


2005(In thousands)Inventories:Purchased parts

$
4,735


$
5,881Work in process


671



590Finished goods


1,594



1,573$
7,000


$
8,044Accrued liabilities:Employee related costs

$
1,346


$
1,786Deferred revenue






440Real estate taxes


193



130Customers deposits


126



589Current maturities of long-term
    liabilities


79



247Warranty reserve


12



132Other accrued liabilities


1,016



805$
2,772


$
4,129Other long-term liabilities:Remaining sublease lease obligation

$
513


$
552Unfavorable operating lease, net


527



568Total


1,040



1,120Less current maturities


79



247Total other long-term liabilities

$
961


$
873   Note 4
  Warranty
    Obligations
   49




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Balance at








Balance atBeginning of Year


Provisions


Claims


End of Year(In thousands)Fiscal 2006

$
132


$
(79
)

$
41


$
12Fiscal 2005


139



125



132



132Fiscal 2004


122



133



116



139   Note 5
  Asset
    Impairment Charges
   50




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 6
  Long-Term
    Debt
    September 2,


August 31,2006


2005(In thousands)Commerce Bank mortgage payable in
    monthly installments of principal and interest of $9 based on a
    twenty-year amortization with a final payment of approximately
    $1,050 due in November 2009; collateralized by our Victoria
    facility

$
1,122


$
1,145Commerce Financial Group, Inc.
    equipment loan payable in fixed monthly principal and interest
    installments of $28 through September 2007; collateralized by
    our Victoria facility and equipment located at our Tempe facility


361



673Capital lease obligation; payable
    in installments of $1 through February 2009; collateralized with
    equipment


18



25Commercial loans payable in fixed
    monthly installments of $1 through May 2009; collateralized with
    certain machinery and equipment


17



22Capital lease obligations; payable
    in fixed monthly installments of $16 through July 2008;
    collateralized with certain machinery and equipment


292



423Capital lease obligations; payable
    in fixed monthly installments of $4 through September 2008;
    collateralized with certain machinery and equipment


87



Capital lease obligations; payable
    in fixed monthly installments of $1 through November 2008;
    collateralized with certain machinery and equipment


17



Capital lease obligations; payable
    in fixed monthly installments of $4 through January 2009;
    collateralized with certain machinery and equipment


89



Capital lease obligations; payable
    in fixed monthly installments of $9 with a final payment of
    approximately $70 due in February 2009; collateralized with
    certain machinery and equipment


268



Capital lease obligations; payable
    in fixed monthly installments of $2 through March 2009;
    collateralized with certain machinery and equipment


46



Capital lease obligations; payable
    in fixed monthly installments of $2 with a final payment of
    approximately $10 due in April 2009; collateralized with certain
    machinery and equipment


48



Capital lease obligations; payable
    in fixed monthly installments of $10 with a final payment of
    approximately $72 due in June 2009; collateralized with certain
    machinery and equipment


325



Capital lease obligations; payable
    in fixed monthly installments of $2 through May 2009;
    collateralized with certain machinery and equipment


52



Capital lease obligations; payable
    in fixed monthly installments of $3 with a final payment of
    approximately $18 due in June 2009; collateralized with certain
    machinery and equipment


105



Capital lease obligations; payable
    in fixed monthly installments of $22 with a final payment of
    approximately $141 due in November 2009; collateralized with
    certain machinery and equipment


775



Capital lease obligations; payable
    in fixed monthly installments of $6 with a final payment of
    approximately $43 due in February 2010; collateralized with
    certain machinery and equipment


240



Commercial loans payable paid in
    full during Fiscal 2006






9Total


3,862



2,297Less current maturities


1,038



484Total long-term debt

$
2,824


$
1,813  51




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
           52




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
              Fiscal Years Ending

(In thousands)2007

$
3432008


672009


272010


1,0462011


Total

$
1,483  53




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Fiscal Years Ending

(In thousands)2007

$
9602008


9312009


7442010


258Total


2,893Less: amount representing interest


(514
)Present value of future minimum
    lease payments


2,379Less: current portion


(695
)Capital lease obligations, net of
    current portion

$
1,684   Note 7
  Line
    of Credit
     54




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 8
  Income
    Taxes
    Fiscal Year EndedSeptember 2,


August 31,


August 31,2006


2005


2004(In thousands)Current:Federal

$



$



$
State










Deferred










Income tax expense (benefit)

$



$



$
     Fiscal Year EndedSeptember 2,


August 31,


August 31,2006


2005


2004Federal statutory tax rate


34.0
%


(34.0
)%


(34.0
)%State income tax rate (net of
    federal tax effect)


5.2







Reversal of reserve for
    contingencies










Change in valuation allowance


(43.3
)


34.0



34.0Other


4.1







Effective tax rate



%



%



%     Fiscal Year EndedSeptember 2,


August 31,2006


2005(In thousands)Deferred tax assets (current):Receivables

$
46


$
59Inventories


402



365Accrued liabilities


382



393830



817Deferred tax assets (long-term):Net operating loss carry-forward


8,929



6,423Capital loss carry-forward


235



235Licensing agreement reserve


196



196Stock based compensation


188



Other


189



270 55




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Fiscal Year EndedSeptember 2,


August 31,2006


2005(In thousands)Gross deferred tax assets
    (long-term)


9,737



7,124Less: Deferred tax assets
    valuation allowance


(9,821
)


(7,195
)Net deferred tax assets (long-term)


(84
)


(71
)Deferred tax liabilities
    (long-term):Property and equipment


(746
)


(746
)Net deferred tax liabilities
    (long-term)


(746
)


(746
)Net deferred tax asset

$



$
       Note 9
  Stock
    Benefit Plans
  1998 Plan.
  1989 Plan.
   56




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Directors Plan.
  2005 HEI, Inc. Employee Stock Purchase
    Plan.
  Eligibility.
  Contribution Period.
  Purchase Price.
  Change of Control.
 57




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Summary of Activity.
  WeightedAverageOptions


Exercise Price


Aggregate IntrinsicOutstanding


Per Share


ValueBalance, August 31,
    2003


1,399,600


$
7.02Granted


577,814



2.77Exercised


(83,314
)


1.62Cancelled


(448,000
)


8.78Balance, August 31,
    2004


1,446,100



5.05Granted


384,000



2.96Exercised






Cancelled


(173,125
)


5.01Balance, August 31,
    2005


1,656,975



4.59Granted


5,000



3.69Exercised


(25,000
)


1.87Cancelled


(300,000
)


3.87Balance, September 2,
    2006


1,336,975


$
4.80


$
915,000Options exercisable


857,250


$
5.47


$
638,650   in-the-money
   58




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Options OutstandingWeighted


Options ExercisableWeighted


Average





WeightedAverage


Remaining





AverageNumber of


Exercise


Contractual


Number of


ExerciseRange of Exercise Prices

Options


Price


Life


Options


Price$1.28-1.68


200,000


$
1.58



6.87



175,000


$
1.63$1.98-2.75


237,500



2.46



7.61



142,500



2.48$2.99-3.79


439,500



3.22



8.00



125,525



3.22$4.38-5.95


183,925



5.52



3.31



161,925



5.46$6.43-9.00


88,200



7.47



5.25



88,200



7.47$10.75-13.88


177,850



12.65



3.85



154,100



12.53$14.56-20.38


10,000



17.47



3.93



10,000



17.471,336,975


$
4.80



6.35



857,250


$
5.47     Fiscal Year EndedSeptember 2,

August 31,

August 31,2006

2005

2004Risk-free interest rates

4.50%

3.72%

2.74% to 3.74%Expected life

4 years

8 years

5 to 10 yearsVolatility

61%

72%

73%Expected dividends

None

None

None   Common Stock Warrants.
  Restricted Stock Awards.
 59




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Weighted


WeightedAverage


AverageGrant


RemainingDate Fair


ContractualShares


Value


TermUnvested, beginning of period





$
Granted


79,800



3.26Vested






Forfeited


(21,000
)


3.32Unvested, end of period


58,800


$
3.24



3.37 years     Note 10
  Net
    Income (Loss) Per Share Computation
    Fiscal Year EndedSeptember 2,


August 31,


August 31,2006


2005


2004(In thousand, except share data)Basic:Net income (loss)

$
(6,057
)

$
355


$
(7,009
)Loss attributable to common
    shareholders

$
(6,057
)

$
(717
)

$
(7,009
)Net income (loss) per share

$
(0.64
)

$
0.04


$
(0.90
)Deemed dividend on convertible
    preferred stock

$



$
(0.13
)

$
Loss attributable to common
    shareholders per share

$
(0.64
)

$
(0.09
)

$
(0.90
)Weighted average number of common
    shares outstanding


9,469,000



8,382,000



7,745,000Diluted:Net income (loss)

$
(6,057
)

$
355


$
(7,009
)Loss attributable to common
    shareholders

$
(6,057
)

$
(717
)

$
(7,009
)Net income (loss) per share

$
(0.64
)

$
0.04


$
(0.90
)Deemed dividend on convertible
    preferred stock

$



$
(0.13
)

$
Loss attributable to common
    shareholders per share

$
(0.64
)

$
(0.09
)

$
(0.90
)Weighted average number of common
    shares outstanding


9,469,000



8,382,000



7,745,000Effect of convertible preferred
    stock






382,000



Effect of dilutive stock options






194,000



Weighted average shares assuming
    dilution


9,469,000



8,958,000



7,745,000  60




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Note 11
  Equity
    Offerings and Deemed Dividend
  Sale of
    Convertible Preferred Stock
      .
  Deemed
    Dividend on Convertible Preferred Stock
  paid-in-capital.
  Private
    Placement of Common Stock
   61




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Note 12
  Notes Receivable 
    Related Parties  Officers and Former
    Directors
    Note 13
  Litigation
    Recoveries
      Note 14
  Employee
    Benefit Plans
   62




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 15
  Commitments
    and Contingencies
            Minimum OperatingFiscal Year Ending

Lease Commitments(In thousands)2007

$
1,8472008


1,8902009


1,8812010


1,8362011


1,775Thereafter


15,163Total minimum lease payments

$
24,392    63




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 16
  Major
    Customers, Concentration of Credit Risk and Geographic
    Data
    Fiscal Year Ended2006


2005


2004Crystalaid


14
%






GE Medical Systems


9
%


12
%


17
%Total


23
%


12
%


17
%       Note 17
  Geographic
    Data
    Fiscal Year EndedSeptember 2, 2006


August 31, 2005


August 31, 2004Dollars


% of Sales


Dollars


% of Sales


Dollars


% of Sales(In thousands)





(In thousands)





(In thousands)United States

$
37,699



72
%

$
39,498



70
%

$
31,974



74
%Canada/Mexico


1,469



3
%


3,661



6
%


2,694



6
%Europe


5,340



10
%


5,863



10
%


4,025



9
%Asia-Pacific


8,081



15
%


7,361



13
%


4,588



11
%South America


42



0
%


248



0
%


39



0
%Total

$
52,631



100
%

$
56,631



100
%

$
43,320



100
%   Note 18
  Segment
    Information
    Microelectronics Operations:
  Advanced Medical Operations:
 64




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Fiscal 2006Microelectronics


Advanced MedicalCorporate


Operations


Operations


TotalNet sales

$



$
34,753


$
17,878


$
52,631Gross profit






6,309



1,653



7,962Operating expense


7,400



4,283



1,518



13,201Operating income (loss)


(7,400
)


2,026



135



(5,239
)Total assets






20,575



5,467



26,042Depreciation and amortization






2,135



338



2,473Capital expenditures






637



318



955   Fiscal 2005Microelectronics


Advanced MedicalCorporate


Operations


Operations


TotalNet sales

$



$
33,377


$
23,254


$
56,631Gross profit






6,669



4,915



11,584Operating expense


7,046



2,377



1,924



11,347Operating income (loss)


(7,046
)


3,613



3,670



237Total assets






18,260



9,417



27,677Depreciation and amortization






2,049



405



2,454Capital expenditures






1,195



119



1,314   Fiscal 2004Microelectronics


Advanced MedicalCorporate


Operations


Operations


TotalNet sales

$



$
22,748


$
20,572


$
43,320Gross profit






158



3,965



4,123Operating expense


6,309



2,206



4,122



12,637Operating income (loss)


(6,309
)


(2,048
)


(157
)


(8,514
)Total assets






15,846



9,266



25,112Depreciation and amortization






2,405



457



2,862Capital expenditures






593



150



743   Note 19
  Settlement
    Gain
    Note 20
  Subsequent
    Events
   65




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Form 10-K.
          Note 21
  Summary
    of Quarterly Operating Results (Unaudited)
    Fiscal Year 2006

First


Second


Third


Fourth(Unaudited)(In thousands, except per share amounts)Net sales

$
13,787


$
11,718


$
13,219


$
13,907Gross profit


2,724



1,746



2,438



1,054Operating income (loss)


(532
)


(1,588
)


(871
)


(2,248
)Net loss

$
(630
)

$
(1,688
)

$
(1,111
)

$
(2,628
)Net loss per shareBasic

$
(0.07
)

$
(0.18
)

$
(0.12
)

$
(0.27
)Diluted

$
(0.07
)

$
(0.18
)

$
(0.12
)

$
(0.27
)  66




---



##### Table of Contents



HEI,
    INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Fiscal Year 2005

First


Second


Third


Fourth(Unaudited)(In thousands, except per share amounts)Net sales

$
14,071


$
13,736


$
13,755


$
15,068Gross profit


2,956



2,867



2,570



3,191Operating income (loss)


77



(411
)


185



387Net income (loss)


415



(537
)


273



204Deemed dividend










(1,072
)


Loss attributable to common
    shareholders

$
415



(537
)

$
(799
)

$
204Net income (loss) per share:Basic and Diluted:Net income (loss)

$
0.05


$
(0.06
)

$
0.03


$
0.02Deemed dividend









$
(0.13
)


Loss attributable to common
    shareholders

$
0.05


$
(0.06
)

$
(0.10
)

$
0.02  67




---



##### Table of Contents



REPORT OF
    INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM              
    68




---



##### Table of Contents



REPORT OF
    INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM           
    69




---



##### Table of Contents



Item 9.
    Changes
    in and Disagreements with Accountants on Accounting and
    Financial Disclosures.  Regulation S-K.
  Form 10-K
    Regulation S-K,
  
    As previously disclosed in our Annual Report on
    Form 10-K
    for Fiscal 2003, KPMG cited a material weakness in its
    communication to our Audit Committee on December 12, 2003,
    related to the overriding, by our former President, Chief
    Executive Officer and Chairman and former Chief Financial
    Officer, of internal controls relating to the payment of certain
    expenses not supported by proper documentation. On
    December 12, 2003, KPMG also communicated to our Audit
    Committee reportable conditions related to revenue recognition
    at our Boulder facility, and the lack of substantiation of
    general ledger account balances and computer-based vendor
    payment controls.
    On January 12, 2005, KPMG cited three material weaknesses
    in its communication to our Audit Committee, relating to
    (i) the control environment at our Boulder facility and, in
    particular, the lack of segregation of duties and financial
    oversight controls, (ii) revenue recognition and
    (iii) financial reporting. On January 12, 2005, KPMG
    also communicated to our Audit Committee reportable conditions
    related to (A) the lack of a formal journal entry approval
    process, and (B) the lack of access controls to our SAP
    system.  Form 10-K Regulation S-X.
      Regulation S-K, Regulation S-K Regulation S-K, Regulation S-K.
 70




---



##### Table of Contents



Item 9A.
    Controls
    and Procedures.      Form 10-K
    
    the replacement of our Controller at the Boulder facility;
    implementing the SAP system for all of our financial reporting,
    including our Boulder facility;
    adding controls and moving control related functions to our
    Victoria facility to eliminate opportunities to override
    controls over cash, accounts receivable and accounts payable;
    the training of our accounting personnel at a revenue
    recognition seminar;
    providing revenue recognition training for contract
    administration personnel;
    adding revenue recognition review and approval control functions;
    adding staff to accommodate the changes required; and
    evaluating access controls needed within the SAP system.    Rules 13a-15(e) 15d-15(e) Form 10-K.
   71




---



##### Table of Contents



Form 10-K
    Item 9B.
    Other
    Information   PART III  Item 10.
    Directors
    and Executive Officers of the Registrant.    Item 11.
    Executive
    Compensation.    Item 12.
    Security
    Ownership of Certain Beneficial Owners and Management and
    Related Stockholder Maters.    Item 13.
    Certain
    Relationships and Related Transactions.    Item 14.
    Principal
    Accounting Fees and Services.   72




---



##### Table of Contents



PART IV  Item 15.
    Exhibits,
    Financial Statement Schedules.    Form 10-K.
  Exhibits:
  2
.1

Purchase Agreement, dated as of
    January 24, 2003, by and between HEI, Inc. and Colorado
    MEDtech, Inc.

Note 12
.2

Registration Rights Agreement,
    dated as of January 24, 2003, by and between HEI, Inc. and
    Colorado MEDtech, Inc.

Note 13
.1

Amended and Restated Articles of
    Incorporation of HEI, Inc.

Note 23
.2

Amended and Restated Bylaws of
    HEI, Inc.

Note 23
.3

Amendments to the Amended and
    Restated Bylaws of HEI, Inc., effective as of March 19, 2003

Note 103
.4

Articles of Amendment of the
    Amended and Restated Articles of Incorporation of HEI, Inc.

Note 213
.5

Second Amended and Restated Bylaws
    of HEI, Inc.

Note 224
.1

Certificate of Designation of
    Common Stock of HEI, Inc.

Note 114
.2

Second Certificate of Designation
    of Common Stock of HEI, Inc.

Note 234
.3

Certificate of Designation of
    Series A Convertible Preferred Stock of HEI, Inc.

Note 234
.4

Form of Stock Certificate for
    shares of Series A Convertible Preferred Stock of HEI,
    Inc.

Note 24*10
.1

Form of Indemnification Agreement
    between HEI and officers and directors

Note 3*10
.2

HEI, Inc. 1989 Omnibus Stock
    Compensation Plan, adopted April 3, 1989, and as Amended
    and Restated effective November 15, 1991, and as amended
    effective April 29, 1992, May 11, 1994, and
    October 31, 1996

Note 4*10
.3

HEI, Inc. 1998 Stock Option Plan,
    adopted November 18, 1998, and amended effective
    January 20, 2000, January 24, 2001, February 20,
    2002 and January 12, 2006.

Note 5*10
.4

HEI, Inc. 1998 Stock Option Plan
    for Nonemployee Directors, adopted November 18, 1998, and
    amended effective June 7, 1999 and December 12, 2002.

Note 1010
.5

Registration Rights Agreement,
    dated August 29, 2001, by and among HEI, Inc. and Certain
    Investors listed on Exhibit A thereto.

Note 710
.6

Sample Promissory Note of Certain
    Officers and Directors in connection with the Exercise of Stock
    Options.

Note 610
.7

Lease, dated as of January 7,
    2002, by and between Eastside Properties, LLC and Colorado
    MEDtech, Inc., subsequently assigned to HEI, Inc.

Note 810
.8

First Addendum to Lease, dated
    September 12, 2002, by and between Eastside Properties, LLC
    and Colorado MEDtech, Inc., subsequently assigned to HEI,
    Inc.

Note 810
.9

Second Addendum to Lease, dated
    January 23, 2003, by and between Eastside Properties, LLC
    and Colorado MEDtech, Inc., subsequently assigned to HEI,
    Inc.

Note 810
.10

Agreement Regarding Additional
    Security Deposit, undated, by and between Eastside Properties,
    Inc. and HEI, Inc.

Note 810
.11

Letter Agreement, dated
    May 16, 2003, between HEI, Inc. and Whitebox Hedged High
    Yield Partners.

Note 910
.12

Accounts Receivable Agreement,
    dated May 29, 2003, by and between HEI, Inc. and Beacon
    Bank.

Note 910
.13

Note Prepayment Agreement,
    dated October 15, 2003, between HEI, Inc. and Whitebox
    Hedged High Yield Partners.

Note 1010
.14

Promissory Note, dated
    October 14, 2003, by HEI, Inc. in favor of Commerce Bank.

Note 1010
.15

Term Loan Agreement, dated
    October 14, 2003, by HEI, Inc. and Commerce Bank.

Note 1010
.16

Combination Mortgage, Security
    Agreement, Assignment of Rents and Fixture Financing Statement,
    dated October 14, 2003, by HEI, Inc. in favor of Commerce
    Bank.

Note 10 73




---



##### Table of Contents



10
.17

Environmental Investigation
    Letter, dated October 14, 2003, by HEI, Inc. in favor of
    Commerce Bank.

Note 1010
.18

Promissory Note, dated
    October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group, Inc.

Note 1010
.19

Term Loan Agreement, dated
    October 28, 2003, by HEI, Inc. and Commerce Financial
    Group, Inc.

Note 1010
.20

Commercial Security Agreement,
    dated October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group, Inc.

Note 1010
.21

Combination Mortgage, Security
    Agreement, Assignment of Rents and Fixture Financing Statement,
    dated October 28, 2003, by HEI, Inc. in favor of Commerce
    Financial Group, Inc.

Note 1010
.22

Environmental Investigation
    Letter, dated October 28, 2003, by HEI, Inc. in favor of
    Commerce Financial Group, Inc.

Note 1010
.23

Asset Purchase Agreement, dated
    October 31, 2003, by HEI, Inc. and MKS Instruments,
    Inc.

Note 1010
.24

Amendment dated December 12,
    2003, to Accounts Receivable Agreement, dated May 29, 2003,
    by and among HEI, Inc. and Beacon Bank.

Note 1010
.25

Registration Rights Agreement,
    dated as of November 5, 2003, between HEI, Inc. and
    Whitebox Hedged High Yield Partners.

Note 1210
.26

Stock Purchase Agreement, dated
    February 13, 2004, by and among HEI, Inc. and the Investors
    listed on Exhibit A thereto.

Note 1310
.27

Registration Rights Agreement,
    dated February 13, 2004, by and among HEI, Inc. and the
    Purchasers listed on Exhibit A thereto.

Note 1310
.28

Form of Registration Rights
    Agreement, dated as of February 23, 2004, among HEI, Inc.
    and the Purchasers of an aggregate of 251,380 shares of
    HEI, Inc.

Note 1210
.29

Form of Registration Rights
    Agreement, dated as of May 7, 2004, among HEI, Inc. and the
    Purchasers of an aggregate of 631,524 shares of HEI, Inc.

Note 1110
.30

Amendment dated July 1, 2004,
    to Accounts Receivable Agreement, dated May 29, 2003, and
    previously amended on December 13, 2003, by and among HEI,
    Inc. and Beacon Bank.

Note 1710
.31

Lease Agreement, dated
    October 1, 2004, by and between HEI, Inc. and Boulder
    Investors LLC.

Note 1410
.32

Waiver and Amendment, dated
    November 30, 2004, and executed as of December 3,
    2004, by and between HEI, Inc. and Commerce Bank.

Note 1510
.33

Waiver and Amendment, dated
    November 30, 2004, and executed as of December 3,
    2004, by and between HEI, Inc. and Commerce Financial Group,
    Inc.

Note 1510
.34

Amendment dated December 7,
    2004, to Accounts Receivable Agreement, dated May 29, 2003,
    and previously amended on December 13, 2003, and
    July 1, 2004, by and among HEI, Inc. and Beacon Bank.

Note 16*10
.35

Employment Agreement, dated
    April 19, 2004, between HEI Inc. and Mack Traynor.

Note 1810
.36

Amendment dated July 7, 2005,
    to Accounts Receivable Agreement, dated May 29, 2003, and
    previously amended on July 1, 2004 and December 13,
    2003, by and among HEI, Inc. and Beacon Bank.

Note 2510
.37

Consulting Agreement, dated
    January 12, 2005, between Emerging Capital and HEI,
    Inc.

Note 2010
.38

Letter from KPMG, LLP to the
    Securities and Exchange Commission dated December 21, 2004

Note 1910
.39

Waiver and Amendment dated as of
    December 29, 2004, and executed as of January 5, 2005,
    by and between HEI, Inc. and Commerce Bank.

Note 2610
.40

Waiver and Amendment dated as of
    December 29, 2004, and executed as of January 5, 2005,
    by and between HEI, Inc. and Commerce Financial Group, Inc.

Note 2610
.41

Notice, Waiver and Amendment dated
    as of December 29, 2004, and executed as of January 5,
    2005, by and between HEI, Inc. and Beacon Bank.

Note 2610
.42

Amendment dated January 12,
    2005 to the Accounts Receivable Agreement dated May 29,
    2003, and previously amended December 12, 2003,
    July 1, 2004, December 7, 2004 and December 29,
    2004 by and between HEI, Inc. and Beacon Bank.

Note 27 74




---



##### Table of Contents



10
.43

Waiver and Release Agreement dated
    January 26, 2005 between HEI, Inc. and Douglas Nesbit.

Note 28*10
.44

Engagement Letter dated
    January 12, 2005, effective as of February 28, 2005,
    between HEI, Inc. and Emerging Capital.

Note 29*10
.45

HEI, Inc. 2006 Nonemployee
    Director Stock Purchase Plan, dated January 13, 2006.

Note 30*10
.46

Nonemployee Director Stock
    Purchase Agreement.

Note 3010
.47

Form of Commercial Loan Agreement
    and Note dated as of April 18, 2006 by and between HEI,
    Inc. and Beacon Bank.

Note 3110
.48

Waiver and Amendment dated as of
    May 27, 2006 by and between HEI, Inc. and Commerce Bank.

Note 3210
.49

Waiver and Amendment dated as of
    May 27, 2006 by and between HEI, Inc. and Commerce
    Financial Group, Inc.

Note 3210
.50

Waiver dated as of May 27,
    2006 by and between HEI, Inc. and Commerce Leasing Corporation,
    a division of Commerce Financial Group, Inc.

Note 32*10
.51

Independent Contractor Agreement
    dated June 26, 2006 between HEI, Inc. and Mark Thomas
    Enterprises, LLC.

Note 33*10
.52

Employment Agreement dated
    July 10, 2006 between HEI, Inc. and Nina Anderson.

Note 34*10
.53

Employment Agreement dated
    July 10, 2006 between HEI, Inc. and Scott Stole.

Note 34*10
.54

Severance and Release Agreement
    dated October 20, 2006 between HEI, Inc. and Mack V.
    Traynor III*10
.55

Promissory Note dated
    November 3, 2006 made payable to Thomas F. Leahy in the
    original principal amount of $5,000,000.

Note 35*10
.56

2005 Employee Stock Purchase Plan.

Note 36*10
.57

2006 Amendment to 1998 Stock
    Option Plan.21


Subsidiaries of the Registrant. 23
.1

Consent of Virchow,
    Krause & Company, LLP23
.2

Consent of KPMG LLP.31
.1

Certification of Chief Executive
    Officer and Chief Financial Officer pursuant to Section 302
    of the Sarbanes-Oxley Act of 2002.32
.1

Certification of Chief Executive
    Officer and Chief Financial Officer pursuant to Section 906
    of the Sarbanes-Oxley Act of 2002.      (1)
    
    Filed as an exhibit to the Current Report on
    Form 8-K,
    filed with the Securities and Exchange Commission on
    February 10, 2003, and incorporated herein by reference.(2)
    
    Filed as an exhibit to the Definitive Proxy Statement on
    Schedule 14A for the 2002 Annual Meeting of Shareholders,
    filed with the Securities and Exchange Commission on
    January 23, 2002, and incorporated herein by reference.(3)
    
    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.(4)
    
    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.(5)
    
    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.(6)
    
    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.(7)
    
    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.(8)
    
    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. 75




---



##### Table of Contents



(9)
    
    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.(10)
    
    Filed as an exhibit to the Annual Report on
    Form 10-K
    for the fiscal year ended August 31, 2003, and incorporated
    herein by reference.(11)
    
    Filed as an exhibit to the Registration Statement on
    Form S-3
    (SEC No.
    333-115982),
    filed with the Securities and Exchange Commission on
    May 28, 2004, and incorporated herein by reference.(12)
    
    Filed as an exhibit to the Registration Statement on
    Form S-3
    (SEC No.
    333-113419),
    filed with the Securities and Exchange Commission on
    March 9, 2004, and incorporated herein by reference.(13)
    
    Filed as an exhibit to the Current Report on
    Form 8-K/A
    (Amendment No. 1), filed with the Securities and Exchange
    Commission on February 19, 2004, and incorporated herein by
    reference.(14)
    
    Filed as an exhibit to the Current Report on
    Form 8-K,
    filed with the Securities and Exchange Commission on
    December 21, 2004.(15)
    
    Filed as an exhibit to the Current Report on
    Form 8-K,
    filed with the Securities and Exchange Commission on
    December 9, 2004, and incorporated herein by reference.(16)
    
    Filed as an exhibit to the Current Report on
    Form 8-K,
    filed with the Securities and Exchange Commission on
    December 10, 2004, and incorporated herein by reference.(17)
    
    Filed as an exhibit to the Annual Report on
    Form 10-K
    for the fiscal year ended August 31, 2004, and incorporated
    herein by reference.(18)
    
    Filed as an exhibit to the Annual Report on
    Form 10-K
    for the fiscal year ended August 31, 2004, and incorporated
    herein by reference.(19)
    
    Filed as an exhibit to the Annual Report on
    Form 10-K
    for the fiscal year ended August 31, 2004, and incorporated
    herein by reference.(20)
    
    Filed as an exhibit to the Current Report on
    Form 8-K,
    filed with the Securities and Exchange Commission on
    January 18, 2005, and incorporated herein by reference.(21)
    
    Form of which was filed as Appendix C to the Definitive
    Proxy Statement on Schedule 14A for the 2006 Annual Meeting
    of the Shareholders filed with the SEC on December 12, 2005(22)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on March 8, 2005.(23)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on May 11, 2005.(24)
    
    Filed as Exhibit 3.6 to the Registration Statement on
    Form S-1
    filed with the SEC on June 23, 2005.(25)
    
    Filed as an exhibit to the Annual Report on
    Form 10-K
    for the fiscal year ended August 31, 2005, and incorporated
    herein by reference.(26)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on January 5, 2005.(27)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on January 13, 2005.(28)
    
    Filed as an exhibit to the Current Report on Amendment
    No. 1 to
    Form 8-K
    filed with the SEC on February 1, 2005.(29)
    
    Filed as an exhibit to the Current Report on Amendment
    No. 1 to
    Form 8-K
    filed with the SEC on March 4, 2005.(30)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on January 13, 2006.(31)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on April 18, 2006.(32)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on June 22, 2006.(33)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on June 30, 2006.(34)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on July 11, 2006.(35)
    
    Filed as an exhibit to the Current Report on
    Form 8-K
    filed with the SEC on November 3, 2006.(36)
    
    Filed as Appendix B to the Definitive Proxy Statement on
    Schedule 14A for the 2006 Annual Meeting of the
    Shareholders filed with the SEC on December 12, 2005.*
    
    Denotes management contract or compensation plan or arrangement.
    
    Filed herewith. 76




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##### Table of Contents



SIGNATURES      By:
    /s/  MARK
    B. THOMAS    Principal Executive Officer and Principal Financial
    Officer
      Date/s/  THOMAS
    F. LEAHYThomas
    F. Leahy

Director

November 30, 2006/s/  TIMOTHY
    F. FLOEDERTimothy
    F. Floeder

Director

November 30, 2006/s/  MICHAEL
    J. EVERSMichael
    J. Evers

Director

November 30, 2006/s/  GEORGE
    M. HEENANGeorge
    M. Heenan

Director

November 30, 2006/s/  ROBERT
    W. HELLERRobert
    W. Heller

Director

November 30, 2006/s/  MARK
    B. THOMASMark
    B. Thomas

Principal Executive Officer and
    Principal Financial Officer

November 30, 2006  77




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##### Table of Contents



INDEX TO
    EXHIBITS
  The
    following exhibits are filed with this annual Report on
    Form 10-K:
  10
.54

Severance and Release Agreement
    dated October 20, 2006 between HEI, Inc. and Mack V.
    Traynor III10
.57

2006 Amendment to 1998 Stock
    Option Plan21


Subsidiaries of the Registrant23
.1

Consent of Virchow,
    Krause & Company, LLP23
.2

Consent of KPMG LLP.31
.1

Certification of Chief Executive
    Officer/Chief Financial Officer pursuant to Section 302 of
    the Sarbanes-Oxley Act of 2002.32
.1

Certification of Chief Executive
    Officer/Chief Financial Officer pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.  78