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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-K



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|  |  |                                                                                           
|- |  | ------------------------------------------------------------------------------------------
|þ |  | ANNUAL REPORT UNDER SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
| 
|  |  | For fiscal year ended August 31,
    2002.                                                
| 
|o |  | TRANSITION REPORT UNDER SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
| 
|  |  | For the transition period
    from           to           .                               

Commission file number 0-10078

HEI, Inc.

(Exact name of registrant as specified in its
Charter)


|                                                                                                     |  |                                         
|---------------------------------------------------------------------------------------------------- |  | ----------------------------------------
|Minnesota                                                                                            |  | 41-0944876                              
|(State or other jurisdiction of
    incorporation or organization)                                   |  | (I.R.S. Employer
    Identification No.)
|                                                                                                    
|6385 Old Shady Oak Road, Suite 280,
    Eden Prairie, MN(Address of principal executive
    offices) |  | 55344(Zip Code)                         

Issuers telephone number, including area
code:

(952) 443-2500


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

None


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

Common Stock, Par Value $.05 Per
Share

(Title of Class)

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

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

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, as of December 12,
2002 (based on the closing price as reported by The Nasdaq
National Market) of the voting stock held by non-affiliates was
approximately $11,742.

As
of December 12, 2002, 6,011,756 Common Shares, par value
$.05 per share, were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the
Registrants Annual Meeting of Shareholders to be held
January 16, 2003, which will be filed not later than
120 days from August 31, 2002, are incorporated by
reference into Part III of this Annual Report on Form 10-K.



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TABLE OF CONTENTS



|                                                           |  |  |  |  |  |  |  | 
|---------------------------------------------------------- |  |  |  |  |  |  |  | 
|PART II                                                   
|CONSOLIDATED BALANCE SHEETS                               
|CONSOLIDATED STATEMENTS OF OPERATIONS                     
|CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
|CONSOLIDATED STATEMENTS OF CASH FLOWS                     
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|INDEPENDENT AUDITORS REPORT                              
|PART III                                                  
|SIGNATURES                                                
|EX-10.10 1991 Stock Option Plan                           
|EX-10.16 Promissory Notes                                 
|EX-21 Subsidiaries of the Registrant                      
|EX-23 Consent of KPMG LLP                                 
|EX-99.1 Certification Pursuant to Section 906             



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FORWARD-LOOKING STATEMENTS

This Annual Report includes forward-looking
statements made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. These
statements contain information regarding technology, markets,
growth and earnings expectations based on the Companys
current assumptions, which involve a number of risks and
uncertainties. There are certain important factors that can
cause actual results to differ materially from the
forward-looking statements, including, without limitation,
adverse business or market conditions; the ability of the
Company to attract and satisfy customers; the availability and
cost of materials from HEIs suppliers; adverse competitive
developments; change in or cancellation of customer
requirements; and other factors discussed from time to time in
the Companys filings with the Securities and Exchange
Commission. Readers are cautioned not to place undue reliance on
forward-looking statements; HEI undertakes no obligation to
update these statements to reflect ensuing events or
circumstances, or subsequent actual results.

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

PART I

Item 1.     Description
of Business

(a) Business Development

We are a Minnesota corporation and were
incorporated as Hybrid Electronics Inc. in 1968 and changed our
name to HEI, Inc. in 1969. In fiscal 1997, we sold our
optoelectronic switch assembly business and related assets.
During fiscal year 1999, we formed a subsidiary, HEI Export,
Inc., as a foreign sales corporation. During fiscal year 2000,
we acquired Cross Technology, Inc. (Cross), now our wholly owned
subsidiary. The acquisition of Cross was a strategic move to
expand our product offerings in the ultraminiature markets that
we serve. In fiscal 2001, we closed the Mexico division
primarily as a result of lack of profitability, disposing of
some assets and relocating some assets to our other facilities.

(b) Business of the Company



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



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Microelectronics
    Our microelectronics division designs and manufactures
    ultraminiature microelectronic devices and high technology
    products incorporating these devices. These custom
    microelectronic devices typically consist of placing or
    assembling one or more integrated circuits (IC) 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. We may procure the microphone, receiver
    and battery from outside vendors and assemble all of the
    components into further assemblies for some customers, and we
    may sell only the microelectronic assembly to others. Our
    custom-built microelectronics are employed in the hearing,
    medical, telecommunications and ultraminiature radio frequency
    markets.



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our newest technology allows us to manufacture
    miniature packages that are specially designed to hold and
    protect high frequency chips for broadband communications. This
    package, with the enclosed chip or IC, may then be easily and
    inexpensively attached to the circuit board without degrading
    the high-frequency performance of the chip. These packages, and
    the high-frequency chips that they contain, are specifically
    designed for applications in high-speed optical communication
    devices  the individual parts of the fiber-optic
    telecommunications network that companies and individuals use to
    transmit data, voice, and video across both short and very long
    distances. They are also used in wireless communication devices
    similar to home satellite dish systems, or wireless local area
    networks that

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | allow computers to communicate with each other
    without having to be connected with wires. Another example of
    our technology is the way we build the driver amplifiers for 10
    and 40 gigabit per second fiber optic transceivers. The
    fiber-optic telecommunications networks that are used today rely
    on devices that pump the signals down the
    fiber-optic pipeline. The speed that the information
    can travel is measured in gigabits per second. As our society
    requires more and more information to pass down these
    fiber-optic pipelines, it is necessary to have faster and faster
    transmission speeds. Our 10 and 40 gigabit per second driver
    modules represent high-speed amplifiers that are
    high-performance and that can be manufactured at costs we
    believe are significantly lower than our competitors.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | RFID/
    Access Through our
    subsidiary, Cross, we manufacture wireless smart cards and other
    ultra-miniature radio frequency (RF) applications.
    Ultraminiature 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.
|
| |  | High Density
    Interconnect Our Tempe,
    Arizona location manufactures and designs high density, high
    quality flex circuits and high-performance laminate-based
    substrates. We further process significant portions of the
    substrates produced at this location into custom-built
    microelectronics at our facility in Minnesota. The high density
    interconnect location serves the hearing, medical and
    communications markets.     

Manufacturing Process:We manufacture our products by
fabricating a substrate and placing ICs 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.

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

We currently have annual agreements with our two
largest customers, Sonic Innovations, Inc. and Siemens, Inc.,
along with several other customers. These agreements typically
include basic understandings that relate to estimated needs of
the customer as well as range of prices for the products for the
current year. These agreements generally are cancelable by
either party for any reason upon advanced notice given within a
relatively short time period (eight to twelve weeks), and, upon
such cancellation, the customer is liable only for any residual
inventory purchased in accordance with the agreement. Although
these annual agreements do not commit our customers to order
specific quantities of products 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 (PO), and the contractual basis for the
relationship is set forth in the PO. The PO specifies
quantities, price, product lead times, material and quality
requirements, and other general business terms and conditions.

For customers with lower demand requirements we
commonly use their PO 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 PO for any reason upon advanced notice given
within a relatively short time period.

Component Supply Operations:For all application specific or custom
material, we try to match the quantities and terms related to
the supply of such product of the customer and all major
vendors. 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
may only be available from customer specified vendors or
supplied by the customer itself. The ICs that we assemble onto
circuit boards

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


Proprietary Technology:We use proprietary technology and
proprietary processes to incorporate such technology into many
of our products. We protect this technology through patents,
proprietary information agreements with our customers and
vendors, and non-disclosure agreements with many of our
employees. Additionally, we will apply for new patents whenever
appropriate. We hold four microelectronic process and design
patents, which expire on dates ranging from 2018 through 2021.
Our two 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, allows for the cost
effective use of high-speed millimeter wave integrated circuits
by placing them into surface mount packages. These surface mount
packages allow our customers to cost effectively incorporate
those packages into their products, and also permits a rapid
increase to high volume manufacturing, using standard high
volume assembly equipment.

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

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

Dependence on Single or Few Customers and
Backlog:The table below shows
approximate percentage of our net sales to major customers which
accounted for more than 10% of total net sales in fiscal years
2002, 2001, and 2000.

|           |  |      |    |      |  |      |    |   |  |  |    |  
|---------- |  | ---- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|Customer   |  | 2002 |    | 2001 |  | 2000
|           |  |      |    |      |  |     
|Customer A |  |      | 32 | %    |  |      | 26 | % |  |  | 15 | %
|Customer B |  |      | 32 | %    |  |      | 25 | % |  |  | 42 | %
|Customer C |  |      |   |      |  |      | 10 | % |  |  |   |  
|Customer D |  |      |   |      |  |      |   |   |  |  | 11 | %

Customer A and B represent Sonic
Innovations, Inc. and Siemens, Inc., respectively, which both
operate in the human hearing-aid market. The increase in
business with Sonic over the last two years is the result of
producing higher value-added products. The decrease in sales
dollars with Siemens, Inc. in fiscal 2002 and 2001 is largely a
result of their increased internal manufacturing capabilities.
Customer C is Agere Systems and is a customer in the
communications market. Reduced revenue from Agere is attributed
to the overall downturn in the telecommunications market.
Customer D represents Motorola, Inc., which is a customer in the
Radio Frequency Identification (RFID) market. The decline
in revenue in fiscal 2001 is a result of Motorolas
decision to eliminate their smart-card businesses. For financial
information about revenues from external customers attributed to
specific geographic areas please see Item 8 
Note 2 to the consolidated financial statements.

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

|                 |  |      |    |      |  |      |    |   |  |  |    |  
|---------------- |  | ---- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|Market           |  | 2002 |    | 2001 |  | 2000
|                 |  |      |    |      |  |     
|Hearing/ Medical |  |      | 76 | %    |  |      | 61 | % |  |  | 63 | %
|Communications   |  |      | 11 | %    |  |      | 17 | % |  |  | 10 | %
|RFID             |  |      | 10 | %    |  |      | 14 | % |  |  | 20 | %
|Other            |  |      | 3  | %    |  |      | 8  | % |  |  | 7  | %

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. Likewise we seek to operate our business to avoid
risking concentrations in our business with one customer or
program. Our plans to achieve our goals include increasing our
product offerings, customer base and programs to increase
revenue, which will result in more diversification.

At August 31, 2002, our backlog of orders
for revenue in fiscal 2003 was approximately $5,400 compared to
approximately $11,000 at August 31, 2001. We expect to ship
our backlog as of August 31, 2002 during fiscal 2003. This
decrease in backlog is mainly due to two factors; first, net
sales are down overall from the weak economic conditions in our
markets and secondly, from customers being reluctant to issue
long-term purchase orders based on lack of visibility for future
demand and fluctuations in over all market conditions.

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 obtain new business by first identifying
customer needs and designing and engineering our products to
meet those needs in an ultraminiature and cost effective way. We
then design products to application specific requirements of the
customer and then manufacture those electronic assemblies with a
high degree of automation to ensure quality and low cost.
Finally, we compete on the basis of full service to obtain new
and repeat orders. Application specific requirements typically
include: very small size, low power, high performance and low
cost. We are a full-service supplier and partner with our
customers, providing full turn-key capability.

Research and Development:The amount spent on research and
development activities aggregated approximately $2,516, $2,433
and $1,764 for the years ended August 31, 2002, 2001 and
2000, respectively.

Employees:On
August 31, 2002, we employed 193 full-time and no part-time
persons.

Item 2.     Description
of Property

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 fiscal year
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. The IDRBs are further collateralized by
letters of credit from LaSalle Business Credit, Inc. We
mortgaged the property to secure the credit facility with
LaSalle Business Credit, Inc.

We lease a 14,000 square foot facility in Tempe,
Arizona for our high density interconnects business. We lease 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 used for corporate offices. The Tempe and
Chanhassen facilities are leased until July 2005 and October
2007, respectively and the Eden Prairie location is leased until
March 2005.

Item 3.     Legal
Proceedings

As of November 1, 2002 there were no
material legal proceedings pending against our properties or us.
From time to time we may become involved in routine litigation
incidental to our business.

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

There were no matters submitted to a vote of
shareholders during the fourth quarter of the fiscal year ended
August 31, 2002.

Executive
Officers

The following is a list of our executive
officers, their ages, positions and offices as of
December 12, 2002. Each executive officer serves a term of
one year or until his successor is appointed and qualified.

|                      |  |     |    |          |  |                                               
|--------------------- |  | --- | -- | -------- |  | ----------------------------------------------
|Name                  |  | Age |    | Position
|                      |  |     |    |         
|Anthony J. Fant       |  |     | 42 |          |  | Chairman and Chief Executive Officer          
|Steve E. Tondera, Jr. |  |     | 39 |          |  | Chief Financial Officer, Treasurer,           
|                      |  |     |    |          |  | Vice President Finance and Director, Secretary
|Stephen K. Petersen   |  |     | 50 |          |  | Chief Operating Officer                       
|Simon F. Hawksworth   |  |     | 36 |          |  | Vice President of Sales and Marketing         

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

Steve E. Tondera,
Jr.has served as our Vice President
of Finance, Treasurer and Chief Financial Officer since June
2000 and as our Secretary since May 2002. Prior to being
appointed to his current positions, Mr. Tondera was the
Managing Director of our Mexico division from June 1999 to June
2000. From October 1994 until June 1999, Mr. Tondera served
as the Chief Financial Officer of Fant Industries, LLC, which
owned a number of businesses in diverse industries.

Stephen K. Petersenjoined us in March 1998 as Director of Manufacturing. He was
appointed Vice President of Operations in September 2000 and as
Chief Operating Officer in October 2002. 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.

Simon F. Hawksworthjoined us in September 2002 as Vice President of Sales and
Marketing. Prior to this appointment he was 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. Mr. Hawksworth served
Maxtek in a variety of positions from Business Development
Manager through Director and Vice President of Sales and
Marketing. His former role focused on winning new business
requiring high frequency electronics packaging solutions.

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PART II

Item 5.     Market
for Common Equity and Related Stockholder Matters

Our common stock is currently traded on the
Nasdaq National Market under the symbol HEII. Below are the high
and low closing bid prices for each quarter of fiscal year 2002
and 2001 for our common stock, as reported by Nasdaq.

|               |  |      |       |     |  |   |       | 
|-------------- |  | ---- | ----- | --- |  | - | ----- | 
|2002           |  | High |       | Low
|               |  |      |       |    
|First Quarter  |  | $    | 8.700 |     |  | $ | 6.000 | 
|Second Quarter |  |      | 7.900 |     |  |   | 5.500 | 
|Third Quarter  |  |      | 8.330 |     |  |   | 5.760 | 
|Fourth Quarter |  |      | 7.800 |     |  |   | 4.300 | 

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

As of December 12, 2002, 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 the continued
development of our future business. Payment of dividends is
within the discretion of our board of directors and will depend
upon, among other things, our earnings, capital requirements and
operating and financial condition. In addition, the terms of our
loan agreement with our bank requires advance approval to pay
dividends.

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Item 6.     Selected
Financial Data

HEI, INC. AND SUBSIDIARIES

FIVE-YEAR SUMMARY OF SELECTED FINANCIAL
INFORMATION

|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |        | 
|------------------------------------------- | --------------------------------------- | ---------------------------------------- | ------ | ------- |  | ------- | ------ | ------- |  | ------- | ------ | ------ |  | - | ------ | ------ |  | - | ------ | ------ | 
|Years Ended August 31                       |                                         | 2002(a)                                  |        | 2001(b) |  | 2000(c) |        | 1999(d) |  | 1998(e)
|                                            |                                         |                                          |        |         |  |         |        |         |  |        
|                                            |                                         |                                         
|                                            |                                         | (In thousands, except per share amounts)
|Net sales                                   |                                         | $                                        | 28,532 |         |  | $       | 44,832 |         |  | $       | 42,799 |        |  | $ | 29,089 |        |  | $ | 24,766 |       
|Cost of sales                               |                                         |                                          | 23,375 |         |  |         | 36,841 |         |  |         | 35,544 |        |  |   | 22,378 |        |  |   | 19,104 |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Gross profit                                |                                         |                                          | 5,157  |         |  |         | 7,991  |         |  |         | 7,255  |        |  |   | 6,711  |        |  |   | 5,662  |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Operating expenses:                         |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Selling, general and administrative     |                                          |        | 5,335   |  |         |        | 5,806   |  |         |        | 6,338  |  |   |        | 4,623  |  |   |        | 3,498  | 
|                                            | Research, development and engineering   |                                          |        | 2,516   |  |         |        | 2,433   |  |         |        | 1,764  |  |   |        | 1,343  |  |   |        | 852    | 
|Unusual charges                             |                                         |                                          |       |         |  |         | 1,693  |         |  |         | 453    |        |  |   | 490    |        |  |   | 5,664  |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Operating income (loss)                     |                                         |                                          | (2,694 | )       |  |         | (1,941 | )       |  |         | (1,300 | )      |  |   | 255    |        |  |   | (4,352 | )     
|Other income (expense), net                 |                                         |                                          | (106   | )       |  |         | (2,182 | )       |  |         | (227   | )      |  |   | 380    |        |  |   | 580    |       
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Income (loss) before income taxes           |                                         |                                          | (2,800 | )       |  |         | (4,123 | )       |  |         | (1,527 | )      |  |   | 635    |        |  |   | (3,772 | )     
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Income tax expense (benefit)                |                                         |                                          | 1,092  |         |  |         | (930   | )       |  |         | (372   | )      |  |   | 242    |        |  |   | (1,354 | )     
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Net income (loss)                           |                                         | $                                        | (3,892 | )       |  | $       | (3,193 | )       |  | $       | (1,155 | )      |  | $ | 393    |        |  | $ | (2,418 | )     
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Net income (loss) per basic share           |                                         | $                                        | (0.65  | )       |  | $       | (0.65  | )       |  | $       | (0.24  | )      |  | $ | 0.08   |        |  | $ | (0.52  | )     
|Net income (loss) per diluted share         |                                         | $                                        | (0.65  | )       |  | $       | (0.65  | )       |  | $       | (0.24  | )      |  | $ | 0.08   |        |  | $ | (0.52  | )     
|Weighted average common shares outstanding: |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Basic                                   |                                          |        | 5,992   |  |         |        | 4,881   |  |         |        | 4,726  |  |   |        | 4,698  |  |   |        | 4,685  | 
|                                            | Diluted                                 |                                          |        | 5,992   |  |         |        | 4,881   |  |         |        | 4,726  |  |   |        | 4,701  |  |   |        | 4,685  | 
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|Balance sheet:                              |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       
|                                            | Working capital                         |                                          | $      | 4,369   |  |         | $      | 8,793   |  |         | $      | 5,902  |  |   | $      | 8,333  |  |   | $      | 12,175 | 
|                                            | Total assets                            |                                          |        | 22,989  |  |         |        | 27,528  |  |         |        | 28,936 |  |   |        | 23,739 |  |   |        | 23,878 | 
|                                            | Long-term debt, less current maturities |                                          |        | 1,473   |  |         |        | 3,972   |  |         |        | 3,894  |  |   |        | 3,415  |  |   |        | 3,835  | 
|                                            | Shareholders equity                    |                                          |        | 14,570  |  |         |        | 18,420  |  |         |        | 15,116 |  |   |        | 15,566 |  |   |        | 15,135 | 
|                                            |                                         |                                          |        |         |  |         |        |         |  |         |        |        |  |   |        |        |  |   |        |       



---



|    |  |                                                                                                                                                                                                                                                                                                                      
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) |  | In fiscal 2002, the Company did not recognize any
    Unusual charges. However Income tax expense (benefit) does
    reflect the establishment of a $3,420 valuation allowance of
    which $3,188 was included in income tax expense.                                                                               
|   
|(b) |  | In fiscal 2001, Unusual charges consist of costs
    related to the closure of the Mexico division of $425 and $1,268
    loss on the write-off of accounts receivable primarily related
    to customers of the Mexico Division and Other income (expense),
    net includes the write-off of the investment in MSC.
|   
|(c) |  | In fiscal 2000, Unusual charges of $453 consist
    of acquisition transaction costs related to the Cross Technology
    acquisition.                                                                                                                                                                                
|   
|(d) |  | In fiscal 1999, Unusual charges of $490 related
    to the severance agreement between the Company and the former
    Chief Executive Officer.                                                                                                                                                                       
|   
|(e) |  | In fiscal 1998, Unusual charges of $5,664 relates
    to one-time expenses related to proxy contest and change of
    control costs.                                                                                                                                                                                 

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

General

Fiscal year 2002 was a very difficult year for
us. Revenue in quarter one began the year with the lowest
revenue we have experienced in nine quarters at $6,126. That was
over a 50% drop in revenue from quarter one of fiscal 2001.
During the second quarter of 2002 we implemented a cost
reduction plan to better match our cost structure with our
anticipated revenues. This plan continues into fiscal 2003. It
is important to note that our variable costs are approximately
50 to 55% of our revenue, which makes us extremely volume or
revenue dependent. The cost reduction plan has lowered our
quarterly breakeven point from $10,000 at the beginning of
fiscal 2002 to $7,500 at the end of the fiscal year. We have
continued to manage our costs and have a goal to lower the
quarterly breakeven point to $7,000 by the end of fiscal 2003.
Our commitment to research and development continued in fiscal
2002 and we have and will continue this effort to maintain and
increase our propriety technology and manufacturing process.
With revenue being our biggest issue in fiscal 2002 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 2003 to not only increase our sales, but to increase our
diversification of revenue.

Workforce Reductions

The events of September 11, 2001 and the
continued sluggish economy in all of our markets during the
first fiscal quarter of 2002 resulted in our reporting the
lowest revenue in nine quarters. In order to size our cost
structure with anticipated revenue we reduced our employee base
by 13 persons at the end of the second quarter of fiscal
year 2002. Even though our revenue continued to increase in the
third quarter, we continued our efforts to reduce cost by
eliminating an additional 21 employees. In the fourth quarter of
fiscal 2002, sales declined and an additional 12 positions were
eliminated.

In 2002 we eliminated a total of
46 positions (30 direct labor, 5 manufacturing, 6
engineering and 5 administrative positions). The amount of
savings ($904) from workforce reductions are tied to the timing
within a quarter and the amount of associated severance cost.
Annualized wages and salaries for the 46 positions that
were eliminated are $1,596.

Cost savings for the year ended August 31,
2002 are summarized as follows:

|                                    |  |                 |     | 
|----------------------------------- |  | --------------- | --- | 
|                                    |  | Year Ended     
|                                    |  | August 31, 2002
|                                    |  |                
|                                    |  | (In thousands) 
|Direct Labor                        |  | $               | 649 | 
|Manufacturing                       |  | $               | 77  | 
|Selling, General and Administrative |  | $               | 78  | 
|Research and Development            |  | $               | 100 | 

The Company has paid an aggregate of $39 related
to severance through August 31, 2002. Substantially all of
the severance charges were paid in the same period the charges
were recorded.

We have continued staff reductions during the
first and second quarter of fiscal 2003. A total of 52 positions
have been eliminated in fiscal 2003 (32 direct labor
($853), 9 manufacturing ($428), 5 engineering ($272),
and 6 administrative positions ($451). Annualized wages and
salaries for the 52 positions that were eliminated are
$2,004.

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##### Table of Contents



In the aggregate, the Company has eliminated 98
positions through December 16, 2002 with annualized costs
savings of approximately $3.6 million (32 direct labor
($1,566), 9 manufacturing ($662), 6 administrative positions
($718), and 5 engineering ($654). These reductions are expected
to positively impact operating costs as compared to prior-year
quarterly amounts and in the aggregate for the year ended
August 31, 2003 as compared to fiscal 2002 as follows:

|                                    |  |                |     |               |  |               |       |               |  |            |       |  |  |   |       |  |  |   |       | 
|----------------------------------- |  | -------------- | --- | ------------- |  | ------------- | ----- | ------------- |  | ---------- | ----- |  |  | - | ----- |  |  | - | ----- | 
|                                    |  | Quarter Ended  |     | Quarter Ended |  | Quarter Ended |       | Quarter Ended |  | Year End  
|                                    |  | November 30,   |     | March 1,      |  | May 31,       |       | August 31,    |  | August 31,
|                                    |  | 2002           |     | 2003          |  | 2003          |       | 2003          |  | 2003      
|                                    |  |                |     |               |  |               |       |               |  |           
|                                    |  |               
|                                    |  | (In thousands)
|Direct Labor                        |  | $              | 178 |               |  | $             | 440   |               |  | $          | 474   |  |  | $ | 474   |  |  | $ | 1,566 | 
|Manufacturing                       |  |                | 59  |               |  |               | 201   |               |  |            | 201   |  |  |   | 201   |  |  |   | 662   | 
|Selling, General and Administrative |  |                | 67  |               |  |               | 217   |               |  |            | 217   |  |  |   | 217   |  |  |   | 718   | 
|Research & Development              |  |                | 96  |               |  |               | 186   |               |  |            | 186   |  |  |   | 186   |  |  |   | 654   | 
|                                    |  |                |     |               |  |               |       |               |  |            |       |  |  |   |       |  |  |   |       | 
|Total                               |  | $              | 400 |               |  | $             | 1,044 |               |  | $          | 1,078 |  |  | $ | 1,078 |  |  | $ | 3,600 | 
|                                    |  |                |     |               |  |               |       |               |  |            |       |  |  |   |       |  |  |   |       | 

We will attempt to reduce and contain cost as
revenues fluctuate. At the same time we seek to balance our
ongoing development of new products and maintain our ability to
react quickly to favorable market demands and opportunities. In
addition, these costs savings will not be realized in their
entirety if increased production demand requires the hiring of
additional personnel.

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are based
on the selection and application of accounting principles
generally accepted in the United States, which require us to
make estimates and assumptions about future events that affect
the amounts reported in our 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
our reported results.

Revenue recognition, Sales Returns and
Warranty

The SECs Staff Accounting Bulletin
(SAB) No. 101, Revenue recognition
provides guidance on the application of GAAP to selected revenue
recognition issues, and our revenue recognition policies are in
compliance with SAB 101. We recognize revenue upon shipment
of product to our customers when all contractual obligations
have been satisfied and collection of the resulting receivable
is reasonably assured. In fiscal 2002, we began a consignment
program with a significant customer, where revenue is recognized
when the customer uses the inventory. Our sales terms to our
customers provide no right of return outside of contractual
warranty claims. Sales and payment terms and pricing extended to
our customers are governed by the respective contract
agreements, together with binding purchase orders for each
transaction. Payment terms are 7 days for consignment
program sales and 30 to 45 for other customers.

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 our customers demand. We also record estimated
provisions for warranty claims based on historical trends and
known warranty claims. Should our actual product returns exceed
our estimated allowances, additional reductions to our revenue
would result. As of August 31,2002 and 2001 we had an
aggregate amount of $200 and $50, respectively, in our warranty
and product return reserves.

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##### Table of Contents



Allowance for Uncollectible Accounts

We estimate the collectibility of our trade
receivables and notes receivable 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. Significant increases in
reserves have been recorded in recent periods and may occur in
the future due to evolving market conditions. 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. Alternatively, if we provide more allowances than we
need, we may reverse a portion of such provisions in future
periods based on changes in estimate from our actual collection
experience. As of August 31, 2002 and 2001 we had $85 and
$271, respectively, in our accounts receivable allowance.

Inventories

We record our inventories at the lower of cost or
market value. Generally all inventory purchases are for
customized parts for a specific customer program. As such,
contractual arrangements are typically agreed too with the
customer in order to protect the Company in cases were the
demand decreases, as often times the parts cannot be consumed in
other programs. Even though contractual arrangements maybe in
place we are still required to assess the utilization of our
inventory. In assessing the ultimate realization of inventories,
we make judgments as to future demand requirements and compare
that with the current or committed inventory levels and
contractual inventory holding requirements. Our reserve
requirements generally increase as our projected demand
requirements decrease due to market conditions, technological
and product life cycle changes as well as longer than previously
expected usage periods. We have experienced significant changes
in required reserves in recent periods due primarily to
declining market conditions. It is possible that significant
changes in required inventory reserves may continue to occur in
the future if there is a further decline in market conditions.
As of August 31, 2002 and 2001 we had $311 and $383,
respectively, reserved for our excess and obsolete inventory.

Valuation of Deferred Taxes

Significant management judgment is required in
determining the provision for incomes taxes, deferred tax assets
and liabilities and any valuation allowance recorded against net
deferred tax assets. We are required to estimate our income
taxes in each jurisdiction where we operate. This process
involves estimating our actual current tax exposure together
with assessing temporary differences resulting from differing
treatment of items, such as the depreciable life of fixed assets
for tax and accounting purposes. These differences result in
deferred tax assets and liabilities, which are included in our
consolidated balance sheet. We then assess the likelihood that
our deferred tax assets will be recovered from future taxable
income and to the extent we believe recovery is unlikely, we
must establish a valuation allowance. To the extent we establish
a valuation allowance or increase the valuation allowance in a
given period, we must increase tax expense within our statement
of operations.

We have recorded a valuation allowance of
$3.4 million at August 31, 2002 to write-off all of
our deferred tax assets due to uncertainties related to our
ability to utilize certain state and foreign tax credits and
loss carryforwards. The valuation allowance is based on our
estimates of taxable income by jurisdiction and the period over
which our deferred tax assets are recoverable.

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##### Table of Contents



Results of Operations

Percentage of Net Sales

for fiscal years ended
August 31,


|                                      |  |      |      |      |  |      |      |  |  |  |      | 
|------------------------------------- |  | ---- | ---- | ---- |  | ---- | ---- |  |  |  | ---- | 
|                                      |  | 2002 |      | 2001 |  | 2000
|                                      |  |      |      |      |  |     
|Net sales                             |  |      | 100% |      |  |      | 100% |  |  |  | 100% | 
|Gross profit                          |  |      | 18%  |      |  |      | 18%  |  |  |  | 17%  | 
|Selling, general and administrative   |  |      | 19%  |      |  |      | 13%  |  |  |  | 15%  | 
|Research, development and engineering |  |      | 9%   |      |  |      | 5%   |  |  |  | 4%   | 
|Other                                 |  |      | 0%   |      |  |      | 4%   |  |  |  | 1%   | 

Sales

Our net sales for the fiscal year ended
August 31, 2002 decreased $16,300 or 36%, compared to
fiscal year 2001. The current year decrease in net sales from
2001 is largely a result of the general economic slowdown and
the resulting impact in the hearing, communications, RFID/
Access and electronic contract manufacturing markets.
Additionally, during the fourth quarter of 2002 the internal
manufacturing capacity of one of our customers increased,
resulting in reduced demand for our products. We began fiscal
year 2002 with net sales of $6,126 in the first quarter, a
nine-quarter low, resulting primarily from the world wide
economic recession and the impact of September 11, 2001. We
experienced quarterly increases in revenue of 27%, and 9%
respectively in the second and third quarters and a decrease of
28% in the fourth quarter. Sales in fiscal 2001 increased
$2,033, or 5%, as compared to fiscal 2000. This increase in
sales occurred in the first half of fiscal 2001, primarily a
result of increases in sales from the Mexico division, which
increased by approximately $1,300 to $4,700, increases in sales
from the high density interconnect division, which increased by
approximately $1,600 to $1,900, and increases in sales from the
microelectronic division, which increased by approximately
$1,400.

We continue to experience fluctuations in demand
for our hearing products and expect this to continue into the
first half of 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 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. At August 31,
2002, our backlog of orders for revenue in fiscal 2003 was
approximately $5,400 compared to approximately $11,000 and
$22,450 at August 31, 2001 and 2000 respectively. We expect
to ship our backlog as of August 31, 2002 during fiscal
2003. This decrease in backlog is mainly due to two factors;
first, net sales are down overall from the weak economic
conditions in our markets and secondly, from customers being
reluctant to issue long-term purchase orders based on lack of
visibility for future demand and fluctuations in over all market
conditions. The Companys backlog at December 13, 2002
was $6,298.

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 the 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.

Sales to hearing/medical customers for fiscal
2002 decreased by $5,798, or 21% compared to fiscal 2001. This
decrease in demand comparing fiscal 2002 to 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 the fourth quarter fiscal 2002. In
fiscal 2003 we expect the impact from this customer will be a
further reduction in annual net sales by $4,200. We have
received increased orders from customers in the

11



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##### Table of Contents



medical markets and we expect this trend to
continue in fiscal 2003. 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. We are anticipating
a slight increase in net sales to the hearing/medical customers
for fiscal 2003 verses 2002. Fiscal 2001 sales increased by
$7,372 or 37% compared to fiscal 2000. This increase is mainly
the result of increased demand for hearing products from two of
our main customers.


The closure of our Mexico division late in fiscal
2001 resulted in decreased sales of $4,745 for fiscal 2002 as
compared to fiscal 2001 and decreased $3,326 compared to fiscal
2000. None of the product manufactured in Mexico was transferred
to our other facilities.

Sales to the RFID products market decreased
$3,419 or 54% in fiscal 2002, as compared to fiscal 2001. RFID
sales decreased in fiscal 2001 by $2,237 or 26% as compared to
fiscal 2000. This decrease comparing fiscal 2002 to 2001 is
primarily due to a significant drop in revenue from one major
customer. This significant customer sold one division and
terminated operations of another division during the first
quarter of fiscal 2002. We have designed, developed and are
producing new products and expanded our capabilities to improve
revenue; however, the actual level of market acceptance is
currently unknown.

Sales to the communications and industrial (non
Mexico) products market decreased $2,338, or 37% in fiscal 2002,
as compared to fiscal 2001. Sales increased in fiscal 2001 of
$224 or 2% as compared to fiscal 2000. This decrease comparing
fiscal 2002 to 2001 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.

Gross Profit

Our gross profit as a percentage of sales was
18.1% in fiscal 2002, as compared to 17.8% in fiscal 2001 and
17.0% in fiscal 2000. 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 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 (from 94.4% in fiscal 2002
to 92.7% in 2001), reduced scrap expense (from 3.8% in fiscal
2002 to 4.5% in 2001, calculated as a percentage of gross sales)
and from the closure of the Mexico division, which generated
negative gross margins of $624 during fiscal 2001. In future
periods, we expect gross margins to be impacted in a similar
manner as revenues increase and decrease. In addition, when, and
if, market acceptance of our proprietary broadband
communications products occurs, we expect gross margins to
increase, as these products are expected to have higher gross
margin than we have historically experienced. Our gross profit
as a percentage of sales was 17.8% in fiscal 2001, as compared
to 17.0% in fiscal 2000. The increase in gross profit as a
percentage of sales was primarily due to start-up costs in the
prior year for the high density interconnect division, which
were offset by higher operating losses for the Mexico division,
which was closed in the third quarter of fiscal 2001.

Operating Expenses

Operating expenses in total were 28% of net sales
in fiscal 2002, compared to 22% and 20% in fiscal 2001 and 2000,
respectively. Operating expenses in 2002 decreased $2,081 when
compared to fiscal 2001. Fiscal 2001 also reflected an increase
of $1,377 when compared to fiscal 2000. Selling, general and
administrative expenses decreased by $471 when compared to
fiscal 2001 mainly due to the closure of the Mexico operations
and our constant attention to other cost containment measures,
including reduction of employees, travel and other operational
costs. These reductions were offset by increases in professional
fees and insurance costs totaling $196. The reduction of 11
employees 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

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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.
Comparing fiscal 2001 to 2000 selling, general and
administrative costs, decreased by $532 in fiscal 2001, which is
a result of higher costs in fiscal 2000 from implementing a new
enterprise resource planning (ERP) system and start-up costs
related to the high density interconnect division. During the
same period research, development and engineering costs
increased by $669, or 38%, due to increase emphasis on new
product development, especially in the broadband communications
market. We expect that our operating expenses will further
decrease by approximately $1,300 in fiscal 2003 as the result of
fiscal 2002 and the first half of fiscal 2003 work force
reductions.


Research, development, and engineering expenses
increased $83 in fiscal 2002, when compared to fiscal 2001 and
increased $752 when compared to fiscal year 2000. These
increases 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. Comparing fiscal 2001 to 2000 costs
increased in fiscal 2001 by $669, or 38%, compared to fiscal
2000. The increase is a result of an emphasis on new product
development, especially in the broadband communications market,
as well as new process and product development in all focus
markets

The unusual charges of $1,693 incurred in fiscal
year 2001 relates to the write-off of accounts receivable
related to customers of the Mexico division and the closure of
that division.

Other Income (Expense), Net

Other expense of $106 in fiscal 2002 is $626 less
than our other expenses in fiscal 2001 which reflects an
increase of $21 when compared to fiscal 2000. 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 the current-year period compared to the prior-year
period. The lower average debt and higher average cash balances
are the result of the net offering proceeds of $6,222 received
in August 2001. 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 Colorado MEDtech
transaction. Comparing fiscal 2001 to 2000 other expense in
fiscal 2001 of $732 increased $647 as compared to fiscal 2000,
primarily due to higher interest expense, as a result of
decreased average cash balances and increased short and
long-term debt throughout fiscal 2001, partially offset by
interest on loans receivable. In the fourth quarter of fiscal
2001, we wrote off our equity investment in Micro Substrates
Corporation (MSC). Including this write-off, expenses incurred
related to MSC for fiscal 2001 were $1,450.

Income Tax Expense (Benefit)

Management performs an analysis of the
realization of the deferred tax asset each fiscal quarter.
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, and uncertainties
about visibility to customer order rates, and a general economic
recovery. For fiscal 2002 we recognized tax expense of $1,092
compared to a tax benefit of $930 and $372 in fiscal 2001 and
2000 respectively. Comparing fiscal 2002 to 2001 the primary
difference in the tax expense between the periods is the
establishment of a $3,420 deferred tax allowance of which $3,188
was included in income tax expense. 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. Management will monitor this deferred tax
asset going forward. At the end of fiscal 2002, we had net
operating loss carryforwards expiring at various dates ranging
from 2013 through 2022. Even though this valuation allowance has
been established, we still retain all the economic benefits of
the net operating loss in future years. Comparing fiscal 2001 to
2000, the income tax benefit of $930 in fiscal 2001 increased
over fiscal 2000 by $558. The increase is a result of the larger
loss before income taxes in the current year. The effective tax
rate of 22.6% in fiscal 2001 is lower than the federal and state
statutory tax rate due to the loss on the MSC investment, which
created a capital loss. The realization of the capital loss will
not occur until we generate capital gains. During fiscal 2001,
the Company concluded it was more likely than not that such

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capital gains will not occur and the Company
placed a valuation allowance of $510 on the deferred tax asset
arising from the MSC capital loss.


Net Income (Loss)

We had a net loss of $3,892 in fiscal 2002
compared to net loss of $3,193 and $1,155 for fiscal 2001 and
2000 respectively. The loss in fiscal 2002 was partly
attributable to the establishment of a valuation allowance for
the deferred tax asset. Other factors include the rapid decline
in revenue during the year matched against the fixed costs of
our manufacturing as well as our commitment to continue our
research and development. The net loss in fiscal 2001 was
primarily a result of the operating loss and closure of the
Mexico division, including the accounts receivable write-off,
and the impairment charge for MSC. Excluding Mexico and MSC, the
net loss for fiscal 2001 was $164.

Financial Condition

Our net cash flow provided by operating
activities for fiscal 2002 was $1,077 compared to net cash
provided (used) of $3,930 and ($5,521) for fiscal 2001 and
2000, respectively. For fiscal 2002 the cash flow generated was
mainly a result of decreases in accounts receivable ($1,270) and
from the non-cash expense of depreciation ($2,909) and deferred
income tax asset of ($1,609). These improvements offset the net
loss for the year of $3,892. The decrease in accounts
receivable, and inventories is attributable primarily to the
decrease in revenue over the last quarter of fiscal 2002 as
compared to fiscal 2001. Net cash provided by operating
activities totaled $3,930 in fiscal 2001 compared to net cash
used in operating activities of $5,521 for fiscal 2000. This was
a result of higher revenue in fiscal 2000, which caused higher
accounts receivable and inventory balances offset by higher
accounts payable balances when compared to fiscal 2001.

Our net cash flow used in investing activities
was $3,423, $3,803 and $293 for fiscal 2002, 2001 and 2000,
respectively. The Company spent $2,423 on capital expenditures
and patent costs in fiscal 2002 compared to $3,533 in fiscal
2001. The $1 million increase in restricted cash for fiscal
2002 is the result of the December 13, 2002 loan
modification, which requires an additional repayment of the
Companys long-term debt. During fiscal 2000 we spent
$4,329 on capital expenditures offset by the maturities of
investments of $3,744. 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 fiscal 2003 capital expenditure
plan is currently approximately $900.

Our net cash flow provided by financing
activities was $325, $3,782 and $4,255 for fiscal 2002, 2001 and
2000, respectively. Cash generated from issuance of common stock
was $275, $6,336 and $506 for fiscal year 2002, 2001 and 2000
respectively. During fiscal 2001 the company completed a private
placement of common stock that generated $6,200 in net proceeds.
Other issuance 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 revolving line of credit and term debt.

The result of these activities was that cash
increased/(decreased) by ($2,021), $3,909 and ($1,559) during
fiscal 2002, 2001 and 2000 respectively. At the end of fiscal
2002 our unrestricted cash balance was $2,372. As a result of
the amended bank covenants on December 13, 2002, $1,000 of
cash will be used to reduce our long-term bank debt and has been
reflected as restricted cash on the August 31, 2002 balance
sheet.

Accounts receivable average days outstanding was
53 days at August 31, 2002, compared to 74 and
49 days at August 31, 2001 and 2000 respectively.
Inventory turns were 5.0, 7.0 and 7.4, for the years ended
August 31, 2002, 2001 and 2000, respectively. The decreased
days outstanding and decreased inventory turns were primarily
due to the slow down in revenue in the last quarter of the
fiscal 2002 versus fiscal 2001 and during the last half of
fiscal 2001 compared to fiscal 2000, due to a general slow down
in the economy and throughout the industry and the markets we
serve.

The current ratio at the end of fiscal 2002 was
1.9:1 as compared to 2.7:1 and 1.6:1 at the end of fiscal 2001
and 2000, respectively. The decrease in fiscal 2002 to fiscal
2001 is principally due to additions to

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property and equipment and payments on long-term
debt with the $1 million increase in current maturities of
long-term debt exceeding the $1.1 million generated by
operating activities. Based on the modified bank covenants,
amended December 13, 2002, and the retroactive repayment of
$1 million of long-term debt, the current ratio at the end
of fiscal 2002 would have been 1.6:1. The increase in fiscal
2001 over fiscal 2000 is mainly due to increased cash and cash
equivalents and reduced outstanding revolving line of credit
balances as a result of the $6,200 private placement of common
stock completed in August 2001.


We have a maximum of $3,000 available under the
revolving line of credit, based on the accounts receivable
balance outstanding, and a $4,456 capital expenditure term loan,
subject to certain restrictions listed below, each of which
expire in August 2004 (see Notes 6 and 7 under Notes to
Consolidated Financial Statements). As of August 31, 2002,
there were $1,589 and $2,075 of borrowings under the line of
credit and capital expenditure term loan facility, respectively.
These borrowings are subject to certain restrictive financial
covenants, including but not limited to: tangible net worth,
interest coverage ratio, debt service coverage ratio, annual
loss limitations and the ability to declare or pay dividends.
The general economic slowdown in the hearing, RFID and other
electronic contract manufacturing markets in which we operate
have resulted in adverse operating results in fiscal 2002 and
the first quarter of fiscal 2003. Due to these adverse operating
results, we were not in compliance with the covenants at
August 31, 2002 and November 30, 2002. On
November 1, 2002 we amended the agreement with the
financial institution, which waived the events of default at
August 31, 2002 and on December 13, 2002 we amended
the agreements to waive the defaults as of November 30,
2002. The December 13, 2002, amendment also reset the
covenants for the remainder fiscal 2003. These revised bank
covenants reduced the overall revolving line of credit from
maximum amount of $5,000 to $3,000 and required the Company to
prepay $1 million on December 13, 2002 of long-term
debt relating to the financing of manufacturing equipment. We
are currently in compliance with the new bank covenants and,
based on current financial projections and new covenants, we
believe that we will meet the bank covenants going forward and
have classified the debt per the terms of the respective
agreements.

We have experienced substantial fluctuations in
our annual and quarterly operating results and such fluctuations
may continue in future periods. Adverse operating results could
result in an event of default with our bank agreement for not
meeting certain financial and other restrictive covenants, such
as, tangible net worth, interest coverage ratio, debt service
coverage ratio and year to date net loss. Failure to meet these
covenants could require us to: immediately repay our outstanding
balances; find a new lender, which may cause us to incur costs
in connection with such new lending relationship; incur
increased borrowing rates and amendment fees; incur additional
restrictions on our ability to borrow additional funds. Any one
of these factors, or a combination of one or more factors, could
adversely affect our ability to borrow funds or adversely affect
future operating results.

We have IDRBs outstanding totaling $1,735. These
bonds were originally issued in April 1996 in connection with
the construction of a new addition to the Companys
manufacturing facility in Victoria, Minnesota, and for
production equipment purchases. In April of each year, these
bonds require annual principal payments of $700. The Company has
limited market risk with of the variability of the interest rate
on these bonds. The bonds bear interest at a rate, which varies
weekly, based on comparable tax-exempt issues, and are limited
to a maximum rate of 10%. The interest rate at August 31,
2002 and, 2001 was 1.44% and 2.11%, respectively. The bonds are
collateralized by two irrevocable letters of credit and
essentially all of our property and equipment. A commitment fee
is paid annually to the bank at a rate of 4.25% of the letters
of credit.

At various times over the past two years we have
not been in compliance with our bank covenants. We have
successfully been able to obtain waivers and reset the covenants
in the past. However, if we were not in compliance and could not
obtain waivers or amendments, it would have severe negative
impact our cash position and require us to seek alternative
funding sources of which there can be no assurance as to their
availability.

Although we are in compliance with the bank
covenants, the financial institution has put certain
restrictions on our ability to borrow additional funds under the
capital expenditure term loan facility. These restrictions
require us to be profitable for four consecutive quarters prior
to allowing additional borrowings

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under the capital expenditure term loan facility.
As a result of these restrictions, we are currently not able to
borrow additional funds under the capital expenditure term loan
facility. We continue to work to increase sales and improve our
operating results to meet this covenant and regain the ability
to borrow additional funds under the capital expenditure loan
facility.


During fiscal 2003, the Company intends to expend
approximately $900 for manufacturing equipment and minor
facility improvements. These additions, if made, will increase
manufacturing capacity to meet anticipated production
requirements and add technological capabilities. It is expected
that these expenditures will be funded from operations, existing
cash and cash equivalents and available debt financing for the
next 12 months.

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

The Companys contractual cash obligations
at August 31, 2002 are summarized in the following table:

|                              |  |      |       |      |  |            |       |       |  |   |     |  |  |   |       | 
|----------------------------- |  | ---- | ----- | ---- |  | ---------- | ----- | ----- |  | - | --- |  |  | - | ----- | 
|                              |  | 2003 |       | 2004 |  | Thereafter |       | Total
|                              |  |      |       |      |  |            |       |      
|Long-term debt                |  | $    | 2,441 |      |  | $          | 1,095 |       |  | $ | 378 |  |  | $ | 3,914 | 
|Operating leases              |  |      | 488   |      |  |            | 402   |       |  |   | 603 |  |  |   | 1,493 | 
|                              |  |      |       |      |  |            |       |       |  |   |     |  |  |   |       | 
|Total contractual obligations |  | $    | 2,929 |      |  | $          | 1,497 |       |  | $ | 981 |  |  | $ | 5,407 | 
|                              |  |      |       |      |  |            |       |       |  |   |     |  |  |   |       | 

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.

Liquidity and capital resources.As a result of fiscal 2002 operating
losses and the downturn in the economy, which has adversely
affected our sales trends, our current cash flows may not be
sufficient to meet our liquidity needs. Our cash needs are
further impacted by: (i) the lower sales volumes in fiscal
year 2002, (ii) the volatility we continue to experience
from our customers demand for the products we produce,
(iii) our ability to maintain the credit facilities
currently in place with our senior lender.

At various times over the past two years we have
not been in compliance with our bank covenants. We have
successfully been able to obtain waivers and reset the covenants
in the past. However, if we were not in compliance and could not
obtain waivers or amendments, it would have severe negative
impact our cash position and require us to seek alternative
funding sources.

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Since February 2002, we have undertaken efforts
to substantially reduce our cost structure as outlined above in
 Workforce Reductions and in the
Managements Discussion and Analysis of Financial
Condition and Results of Operations. In response to the
continued depressed economy and evaluation of the related impact
on our anticipated sales volumes, we implemented further cost
saving initiatives in fiscal 2003.

See Managements Discussion and
Analysis of Financial Condition and Results of
Operations  Financial Condition.

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

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 2002, 2001 and 2000, our two
largest customers, Siemens, Inc. and Sonic Innovations, Inc., in
the aggregate accounted for 64%, 51% and 57%, respectively, of
net sales. Each of these customers has multiple programs in
production with us. Although we are reducing this concentration,
we expect that sales to a relatively small number of original
equipment manufacturers will continue to account for a
substantial portion of net revenues for the foreseeable future.
The loss of, or a decline in orders from, any one of our key
customers would materially adversely affect our operating
results and financial condition. We are working for
diversification such that no one market would account for 40% or
more in revenue, no one customer at 10% or greater revenue and
no one program at 25% or greater.

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

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



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

We may fail to adequately adjust our expenses
to predicted revenue in any given period or we may experience
significant fluctuations in quarterly revenue because the sales
cycle for our products and services is lengthy and
unpredictable.While our sales cycle
varies from customer to customer, it typically has ranged from
two to 12 months. Our pursuit of sales leads typically
involves an analysis of our prospective customers needs,
preparation of a written proposal, one or more presentations and
contract negotiations. Our sales cycle may also be affected by
the complexity of the product to be developed and manufactured
as well as a

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prospective customers budgetary constraints
and internal acceptance reviews, over which we have little or no
control. As a result of these things combined with the fact that
our expenses are fixed, we may fail to adequately adjust our
expenses to predicted revenue in any given period or we may
experience significant fluctuations in quarterly revenue.


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

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

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



| |   |                                                                                                                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We may not be able to negotiate or finance the
    acquisition successfully.                                                                                                                               
|
| |  | The integration of acquired businesses, products
    or technologies into our existing business may fail.                                                                                                  
|
| |  | 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

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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.


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 2002,
2001 and 2000, 76%, 61% and 63%, respectively of our net sales
came from the hearing instrument and medical manufacturers.
These industries are characterized by intense competition,
relatively short product life cycles, rapid technological
change, significant fluctuations in product demand and
significant pressure on vendors to reduce or minimize cost.
Accordingly, we may be adversely affected by these industry
trends to the extent that they reduce our revenues. In
particular, if the hearing instrument manufacturers develop new
technologies that do not incorporate our products, or if our
competitors offer similar products at a lower cost to such
manufacturers, our revenues may decrease and our business would
be adversely affected.

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

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

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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
integrated circuits, we occasionally must order such components
prior to receiving formal customer purchase orders for the
assemblies that require such components. Failure to accurately
anticipate the volume or timing of customer orders can result in
component shortages or excess component inventory, which in
either case could adversely affect our operating results and
financial condition.

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

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

We may have a significant accounts receivable
write-off and well as an increase in inventory reserve due to
the inability of our customers to pay their accounts.We may carry significant accounts
receivable and

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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. None of our employees are subject to a
long-term employment agreement, although several key employees
are subject to non-competition agreements. The loss of one or
more key employees may materially adversely affect our growth.
We do not currently have employment contracts with any of our
employees.

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



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

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

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

We have issued numerous options to acquire our
common stock that could have a dilutive effect on our common
stock.As of December 12, 2002,
we had options outstanding to acquire 1,492,525 shares of our
common stock, exercisable at prices ranging from $4.438 to
$20.375 per share, with a weighted average exercise price of
approximately $9.305 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

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common stock and could impair the ability of
purchasers of our common stock to recoup their investment or
make a profit. As of December 12, 2002, these shares
consist of:




| |   |                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------
| |  | approximately 993,693 shares beneficially owned
    by our executive officers and directors of our outstanding
    common stock; and
|
| |  | approximately 1,540,025 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.

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, 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,
and 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 twelve 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; or                                                                                                                                                                                                                                                                                          
|
| |  | 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.

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



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

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| |   |                                                                             
| | - | ----------------------------------------------------------------------------
| |  | Incur additional restrictions on our ability to
    borrow additional funds.

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

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

We are exposed to certain market risks with our
revolving line of credit, capital expenditure loans and, to a
lesser extent, our IDRBs. At August 31, 2002, the
outstanding balance on the revolving line of credit, capital
expenditure loans and IDRBs were $1,589, $2,075 and $1,735,
respectively. Effective December 1, 2002 the revolving line
of credit agreement bears interest, at the Companys
option, at 2.75% above the prime rate of interest or 5.25% above
the LIBOR rate. The capital expenditure loans bears interest, at
the Companys option, at 3.00% above the prime rate of
interest or 5.50% above the LIBOR rate. At August 31, 2002,
the interest rates on the revolving commitment and capital
expenditure loans were 5.50% and 5.75%, respectively. The IDRBs
bear interest at a rate, which varies weekly, based on
comparable tax-exempt issues, and is limited to a maximum rate
of 10%. At August 31, 2002, the interest rate on the IDRBs
was 1.44%. Consequently, the Company is exposed to a change in
borrowing costs as interest rates change. We have completed a
market risk sensitivity analysis of these debt instruments based
upon an assumed 1% increase in interest rates at August 31,
2002. If market interest rates had increased by 1% on
August 31, 2002, this would have resulted in an increase to
interest expense of approximately $55 over a one-year period.
Because this is only an estimate, any actual change in expense
due to a change in interest rates could differ from this
estimate.

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##### Table of Contents



Item 8.     Financial
Statements

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

|                                                                 |                                                                |          |    |    | 
|---------------------------------------------------------------- | -------------------------------------------------------------- | -------- | -- | -- | 
|                                                                 |                                                                | Page No.
|                                                                 |                                                                |         
|Consolidated Balance Sheets                                      |                                                                |          | 25 |   
|                                                                 | Consolidated Statements of Operations                          |          |    | 26 | 
|                                                                 | Consolidated Statements of Changes in
    Stockholders Equity |          |    | 27 | 
|                                                                 | Consolidated Statements of Cash Flows                          |          |    | 28 | 
|Notes to Consolidated Financial Statements                       |                                                                |          | 29 |   
|Independent Auditors Report                                     |                                                                |          | 44 |   
|Independent Auditors Report on Financial
    Statement Schedule |                                                                |          | 45 |   
|                                                                 | Statement of Financial Responsibility                          |          |    | 46 | 

24



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HEI, INC.






CONSOLIDATED BALANCE SHEETS


|                                           |                                                                                                     |                |        |            |   |   |        |         |  
|------------------------------------------ | --------------------------------------------------------------------------------------------------- | -------------- | ------ | ---------- | - | - | ------ | ------- | -
|                                           |                                                                                                     | August 31,     |        | August 31,
|                                           |                                                                                                     | 2002           |        | 2001      
|                                           |                                                                                                     |                |        |           
|                                           |                                                                                                     |               
|                                           |                                                                                                     | (In thousands)
|ASSETS                                    
|                                          
|Current assets:                            |                                                                                                     |                |        |            |   |   |        |        
|                                           | Cash and cash equivalents                                                                           |                | $      | 2,372      |   |   | $      | 4,393   |  
|                                           | Restricted cash                                                                                     |                |        | 1,000      |   |   |        |        |  
|                                           | Accounts receivable, net                                                                            |                |        | 3,533      |   |   |        | 4,617   |  
|                                           | Inventories                                                                                         |                |        | 4,027      |   |   |        | 4,284   |  
|                                           | Other current assets                                                                                |                |        | 383        |   |   |        | 635     |  
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Total current assets                       |                                                                                                     |                | 11,315 |            |   |   | 13,929 |        
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Property and equipment:                    |                                                                                                     |                |        |            |   |   |        |        
|                                           | Land                                                                                                |                |        | 216        |   |   |        | 216     |  
|                                           | Building and improvements                                                                           |                |        | 4,316      |   |   |        | 4,316   |  
|                                           | Fixtures and equipment                                                                              |                |        | 21,259     |   |   |        | 18,810  |  
|                                           | Accumulated depreciation                                                                            |                |        | (14,439    | ) |   |        | (11,714 | )
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Net property and equipment                 |                                                                                                     |                | 11,352 |            |   |   | 11,628 |        
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Other long-term assets                     |                                                                                                     |                | 322    |            |   |   | 1,971  |        
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Total assets                               |                                                                                                     | $              | 22,989 |            |   | $ | 27,528 |        
|                                           |                                                                                                     |                |        |            |   |   |        |        
|                                          
|LIABILITIES AND SHAREHOLDERS
    EQUITY  
|Current liabilities:                       |                                                                                                     |                |        |            |   |   |        |        
|                                           | Revolving line of credit                                                                            |                | $      | 1,589      |   |   | $      | 10      |  
|                                           | Current maturities of long-term debt                                                                |                |        | 2,441      |   |   |        | 1,441   |  
|                                           | Accounts payable                                                                                    |                |        | 1,815      |   |   |        | 1,912   |  
|                                           | Accrued employee related costs                                                                      |                |        | 655        |   |   |        | 839     |  
|                                           | Accrued liabilities                                                                                 |                |        | 446        |   |   |        | 934     |  
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Total current liabilities                  |                                                                                                     |                | 6,946  |            |   |   | 5,136  |        
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Long-term debt, less current maturities    |                                                                                                     |                | 1,473  |            |   |   | 3,972  |        
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Total liabilities                          |                                                                                                     |                | 8,419  |            |   |   | 9,108  |        
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Shareholders equity:                      |                                                                                                     |                |        |            |   |   |        |        
|                                           | Undesignated stock; 5,000 shares authorized; none
    issued                                        |                |        |           |   |   |        |        |  
|                                           | Common stock, $.05 par; 10,000 shares authorized;
    6,012 and 5,956 shares issued and outstanding |                |        | 301        |   |   |        | 298     |  
|                                           | Paid-in capital                                                                                     |                |        | 16,349     |   |   |        | 16,310  |  
|                                           | Retained earnings (accumulated deficit)                                                             |                |        | (814       | ) |   |        | 3,078   |  
|                                           | Notes receivable                                                                                    |                |        | (1,266     | ) |   |        | (1,266  | )
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Total shareholders equity                 |                                                                                                     |                | 14,570 |            |   |   | 18,420 |        
|                                           |                                                                                                     |                |        |            |   |   |        |        
|Total liabilities and shareholders equity |                                                                                                     | $              | 22,989 |            |   | $ | 27,528 |        
|                                           |                                                                                                     |                |        |            |   |   |        |        

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

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##### Table of Contents



HEI, INC.






CONSOLIDATED STATEMENTS OF
OPERATIONS


|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |       |  
|------------------------------------------ | ------------------------------------- | ------------------------- | ------ | ----- | - | ---- | ------ | ----- | - | -- | ------ | ----- | -
|                                           |                                       |                          
|                                           |                                       | Years Ended August 31    
|                                           |                                       |                          
|                                           |                                       | 2002                      |        | 2001  |   | 2000
|                                           |                                       |                           |        |       |   |     
|                                           |                                       |                          
|                                           |                                       | (In thousands,           
|                                           |                                       | except per share amounts)
|Net sales                                  |                                       | $                         | 28,532 |       |   | $    | 44,832 |       |   | $  | 42,799 |      
|Cost of sales                              |                                       |                           | 23,375 |       |   |      | 36,841 |       |   |    | 35,544 |      
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      
|                                           | Gross profit                          |                           |        | 5,157 |   |      |        | 7,991 |   |    |        | 7,255 |  
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      
|Operating expenses:                        |                                       |                           |        |       |   |      |        |       |   |    |        |      
|                                           | Selling, general and administrative   |                           |        | 5,335 |   |      |        | 5,806 |   |    |        | 6,338 |  
|                                           | Research, development and engineering |                           |        | 2,516 |   |      |        | 2,433 |   |    |        | 1,764 |  
|                                           | Unusual charges                       |                           |        |      |   |      |        | 1,693 |   |    |        | 453   |  
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      
|Operating loss                             |                                       |                           | (2,694 | )     |   |      | (1,941 | )     |   |    | (1,300 | )    
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      
|Loss on equity investment                  |                                       |                           |       |       |   |      | (1,450 | )     |   |    | (142   | )    
|Other income (expense), net                |                                       |                           | (106   | )     |   |      | (732   | )     |   |    | (85    | )    
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      
|Loss before income taxes                   |                                       |                           | (2,800 | )     |   |      | (4,123 | )     |   |    | (1,527 | )    
|Income tax expense (benefit)               |                                       |                           | 1,092  |       |   |      | (930   | )     |   |    | (372   | )    
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      
|Net Loss                                   |                                       | ($                        | 3,892  | )     |   | ($   | 3,193  | )     |   | ($ | 1,155  | )    
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      
|Net (loss) per common share                |                                       |                           |        |       |   |      |        |       |   |    |        |      
|                                           | Basic                                 |                           | ($     | 0.65  | ) |      | ($     | 0.65  | ) |    | ($     | 0.24  | )
|                                           | Diluted                               |                           | ($     | 0.65  | ) |      | ($     | 0.65  | ) |    | ($     | 0.24  | )
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      
|Weighted average common shares outstanding |                                       |                           |        |       |   |      |        |       |   |    |        |      
|                                           | Basic                                 |                           |        | 5,992 |   |      |        | 4,881 |   |    |        | 4,726 |  
|                                           | Diluted                               |                           |        | 5,992 |   |      |        | 4,881 |   |    |        | 4,726 |  
|                                           |                                       |                           |        |       |   |      |        |       |   |    |        |      

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

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##### Table of Contents



HEI, INC.






CONSOLIDATED STATEMENTS OF CHANGES IN
SHAREHOLDERS EQUITY


|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |        |   |   |       |        |   |   |        |        |   |   |        |        |  
|------------------------ | ------------------------------------------------------------------------ | -------------- | --------- | ----------- |  | ---------- | --- | ------------ |  | ---------- | ------ | ------ | - | - | ----- | ------ | - | - | ------ | ------ | - | - | ------ | ------ | -
|                         |                                                                          | Common         |           | Common      |  |            |     | Retained     |  |            |        |       
|                         |                                                                          | Stock          |           | Stock       |  | Additional |     | Earnings     |  |            |        |       
|                         |                                                                          | Shares         |           | Amount      |  | Paid-In    |     | (accumulated |  | Notes      |        | Total 
|                         |                                                                          | Outstanding    |           | Outstanding |  | Capital    |     | deficit)     |  | Receivable |        | Equity
|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |       
|                         |                                                                          |               
|                         |                                                                          | (In thousands)
|Balance, August 31, 1999 |                                                                          |                | 4,701,965 |             |  | $          | 235 |              |  | $          | 7,905  |        |   | $ | 7,426 |        |   |   |       |        |   | $ | 15,566 |       
|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |        |   |   |       |        |   |   |        |        |   |   |        |       
|                         | Net Loss                                                                 |                |           |            |  |            |     |             |  |            |        |       |   |   |       | (1,155 | ) |   |        |       |   |   |        | (1,155 | )
|                         | Issuance of common shares under stock benefit
    plans and option plans |                |           | 74,731      |  |            |     | 4            |  |            |        | 438    |   |   |       |       |   |   |        |       |   |   |        | 442    |  
|                         | Tax benefit of nonqualified stock options                                |                |           |            |  |            |     |             |  |            |        | 199    |   |   |       |       |   |   |        |       |   |   |        | 199    |  
|                         | Stock-based compensation                                                 |                |           |            |  |            |     |             |  |            |        | 64     |   |   |       |       |   |   |        |       |   |   |        | 64     |  
|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |        |   |   |       |        |   |   |        |        |   |   |        |       
|Balance, August 31, 2000 |                                                                          |                | 4,776,696 |             |  |            | 239 |              |  |            | 8,606  |        |   |   | 6,271 |        |   |   |       |        |   |   | 15,116 |       
|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |        |   |   |       |        |   |   |        |        |   |   |        |       
|                         | Net Loss                                                                 |                |           |            |  |            |     |             |  |            |        |       |   |   |       | (3,193 | ) |   |        |       |   |   |        | (3,193 | )
|                         | Issuance of common shares under stock benefit
    plans and option plans |                |           | 229,764     |  |            |     | 11           |  |            |        | 1,369  |   |   |       |       |   |   |        |       |   |   |        | 1,380  |  
|                         | Non-cash CMED expenses                                                   |                |           |            |  |            |     |             |  |            |        | 161    |   |   |       |       |   |   |        |       |   |   |        | 161    |  
|                         | Notes receivable                                                         |                |           |            |  |            |     |             |  |            |        |       |   |   |       |       |   |   |        | (1,266 | ) |   |        | (1,266 | )
|                         | Private equity placement                                                 |                |           | 950,000     |  |            |     | 48           |  |            |        | 6,174  |   |   |       |       |   |   |        |       |   |   |        | 6,222  |  
|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |        |   |   |       |        |   |   |        |        |   |   |        |       
|Balance, August 31, 2001 |                                                                          |                | 5,956,460 |             |  |            | 298 |              |  |            | 16,310 |        |   |   | 3,078 |        |   |   | (1,266 | )      |   |   | 18,420 |       
|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |        |   |   |       |        |   |   |        |        |   |   |        |       
|                         | Net Loss                                                                 |                |           |            |  |            |     |             |  |            |        |       |   |   |       | (3,892 | ) |   |        |       |   |   |        | (3,892 | )
|                         | Tax valuation allowance adjustments                                      |                |           |            |  |            |     |             |  |            |        | (233   | ) |   |       |       |   |   |        |       |   |   |        | (233   | )
|                         | Issuance of common shares under stock benefit
    plans and option plans |                |           | 55,296      |  |            |     | 3            |  |            |        | 272    |   |   |       |       |   |   |        |       |   |   |        | 275    |  
|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |        |   |   |       |        |   |   |        |        |   |   |        |       
|Balance, August 31, 2002 |                                                                          |                | 6,011,756 |             |  | $          | 301 |              |  | $          | 16,349 |        |   | $ | (814  | )      |   | $ | (1,266 | )      |   | $ | 14,570 |       
|                         |                                                                          |                |           |             |  |            |     |              |  |            |        |        |   |   |       |        |   |   |        |        |   |   |        |       

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

27



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##### Table of Contents



HEI, INC.






CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |        |  
|------------------------------------------------------------- | -------------------------------------------------------------- | --------------------- | ------ | ------ | - | ---- | ------ | ------ | - | - | ------ | ------ | -
|                                                              |                                                                |                      
|                                                              |                                                                | Years Ended August 31
|                                                              |                                                                |                      
|                                                              |                                                                | 2002                  |        | 2001   |   | 2000
|                                                              |                                                                |                       |        |        |   |     
|                                                              |                                                                |                      
|                                                              |                                                                | (In thousands)       
|Cash flow from operating activities:                          |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|                                                              | Net loss                                                       |                       | ($     | 3,892  | ) |      | ($     | 3,193  | ) |   | ($     | 1,155  | )
|                                                              | Equity in net loss from MSC                                    |                       |        |       |   |      |        | 1,417  |   |   |        | 110    |  
|                                                              | Depreciation and amortization                                  |                       |        | 2,909  |   |      |        | 2,862  |   |   |        | 2,407  |  
|                                                              | Accounts receivable allowance                                  |                       |        | (186   | ) |      |        | 56     |   |   |        | 75     |  
|                                                              | Deferred income tax expense (benefit)                          |                       |        | 1,609  |   |      |        | (930   | ) |   |        | (571   | )
|                                                              | Stock-based compensation and other                             |                       |        |       |   |      |        |       |   |   |        | 244    |  
|                                                              | Non-cash expenses for CMED transaction                         |                       |        |       |   |      |        | 161    |   |   |        |       |  
|                                                              | Loss on disposal of property and equipment and
    other       |                       |        |       |   |      |        | 188    |   |   |        |       |  
|Changes in operating assets and liabilities:                  |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|                                                              | Accounts receivable                                            |                       |        | 1,270  |   |      |        | 3,909  |   |   |        | (5,275 | )
|                                                              | Inventories                                                    |                       |        | 257    |   |      |        | 1,585  |   |   |        | (3,623 | )
|                                                              | Income taxes                                                   |                       |        | (166   | ) |      |        | 81     |   |   |        | (14    | )
|                                                              | Other current assets                                           |                       |        | 56     |   |      |        | 95     |   |   |        | (66    | )
|                                                              | Accounts payable                                               |                       |        | (97    | ) |      |        | (2,414 | ) |   |        | 2,697  |  
|                                                              | Accrued employee related costs and accrued
    liabilities     |                       |        | (683   | ) |      |        | 113    |   |   |        | (350   | )
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Net cash flow provided by (used for) operating
    activities |                                                                |                       | 1,077  |        |   |      | 3,930  |        |   |   | (5,521 | )     
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Cash flow from investing activities:                          |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|                                                              | Maturities of investments                                      |                       |        |       |   |      |        |       |   |   |        | 3,744  |  
|                                                              | Additions to property and equipment                            |                       |        | (2,291 | ) |      |        | (3,418 | ) |   |        | (4,329 | )
|                                                              | Decrease (increase) in restricted cash                         |                       |        | (1,000 | ) |      |        | 86     |   |   |        | 292    |  
|                                                              | Additions to patents                                           |                       |        | (132   | ) |      |        | (115   | ) |   |        |       |  
|                                                              | Other long-term prepaid assets                                 |                       |        |       |   |      |        | (356   | ) |   |        |       |  
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Net cash flow used for investing activities                   |                                                                |                       | (3,423 | )      |   |      | (3,803 | )      |   |   | (293   | )     
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Cash flow from financing activities:                          |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|                                                              | Issuance of common stock and other                             |                       |        | 275    |   |      |        | 6,336  |   |   |        | 506    |  
|                                                              | Proceeds from long-term debt                                   |                       |        |       |   |      |        | 1,762  |   |   |        | 1,665  |  
|                                                              | Repayments of long-term debt                                   |                       |        | (1,499 | ) |      |        | (1,350 | ) |   |        | (821   | )
|                                                              | Increase in deferred financing fees                            |                       |        | (30    | ) |      |        | (33    | ) |   |        | (38    | )
|                                                              | Net borrowings on (repayments of) revolving line
    of credit |                       |        | 1,579  |   |      |        | (2,933 | ) |   |        | 2,943  |  
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Net cash flow provided by financing activities                |                                                                |                       | 325    |        |   |      | 3,782  |        |   |   | 4,255  |       
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Net increase (decrease) in cash and cash
    equivalents      |                                                                |                       | (2,021 | )      |   |      | 3,909  |        |   |   | (1,559 | )     
|Cash and cash equivalents, beginning of year                  |                                                                |                       | 4,393  |        |   |      | 484    |        |   |   | 2,043  |       
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Cash and cash equivalents, end of year                        |                                                                | $                     | 2,372  |        |   | $    | 4,393  |        |   | $ | 484    |       
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Supplemental disclosures of cash flow
    information:        |                                                                |                       |        |        |   |      |        |        |   |   |        |       
|Interest paid                                                 |                                                                | $                     | 395    |        |   | $    | 466    |        |   | $ | 294    |       
|Income taxes paid (received)                                  |                                                                |                       | (351   | )      |   |      | (48    | )      |   |   | 279    |       
|                                                              |                                                                |                       |        |        |   |      |        |        |   |   |        |       

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

28



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##### Table of Contents



HEI, INC.






NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


Note 1



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

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

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

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

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

|               |                  |                  |   |        |        |  
|-------------- | ---------------- | ---------------- | - | ------ | ------ | -
|               |                  | Six Months Ended
|               |                  | March 4, 2000   
|               |                  |                 
|               |                  | (In thousands)  
|Revenues       |                  |                  |   |       
|               | HEI              |                  | $ | 14,127 |       
|               | Cross Technology |                  |   | 3,359  |       
|               |                  |                  |   |       
|               |                  | Consolidated     |   |        | 17,486 |  
|               |                  |                  |   |       
|Operating loss |                  |                  |   |       
|               | HEI              |                  |   | (2,126 | )     
|               | Cross Technology |                  |   | (11    | )     
|               |                  |                  |   |       
|               |                  | Consolidated     |   |        | (2,137 | )
|               |                  |                  |   |       
|Net loss       |                  |                  |   |       
|               | HEI              |                  |   | (1,968 | )     
|               | Cross Technology |                  |   | (7     | )     
|               |                  |                  |   |       
|               |                  | Consolidated     |   | $      | (1,975 | )
|               |                  |                  |   |       

Cash, Cash Equivalents and Short-Term
Investments.The Company considers its
investments in all highly liquid debt instruments with original
maturities of three months or less at date of purchase to be
cash equivalents. The carrying amount approximates fair value
because of the short maturity of those instruments. Short-term
investments consist mainly of high quality commercial paper with
maturities of less than one year. The short-term investments are
carried at amortized cost, which approximates fair value, and
are classified as held to maturity.

Restricted Cash.Pursuant to the Companys amended
loan agreement dated December 1, 2002, the Company is
required to remit $1 million to the bank to pay down
certain loan balances. This amount is reflected as restricted
cash at August 31, 2002.

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

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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

purchased on behalf of the customer and any
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.

Maintenance and repairs are charged to expense as
incurred. Major improvements and tooling costs are capitalized
and depreciated over their estimated useful lives. The cost and
accumulated depreciation of property and equipment retired or
otherwise disposed of are removed from the related accounts, and
any resulting gain or loss is charged or credited to operations.

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

Long-Lived Assets.Long-lived assets and certain
identifiable intangibles are evaluated for impairment whenever
events or changes in circumstances indicate that the carrying
value of an asset may not be recoverable from future
undiscounted cash flows. Impairment losses are recorded for the
difference between the carrying value and the fair value of the
long-lived asset.

Income Taxes.Deferred income tax assets and
liabilities are recognized for the expected future tax
consequences of events that have been included in the financial
statements or income tax returns. Deferred income tax assets and
liabilities are determined based on the differences between the
financial statement and tax bases of assets and liabilities
using currently enacted tax rates in effect for the year in
which the differences are expected to reverse. Valuation
allowances are established when necessary to reduce deferred tax
assets to the amount expected to be realized. Income tax expense
(benefit) is the tax payable (receivable) for the
periods and the change during the period in deferred income tax
assets and liabilities.

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

Revenue Recognition.The SECs Staff Accounting
Bulletin (SAB) No. 101, Revenue
recognition provides guidance on the application of GAAP
to selected revenue recognition issues, and our revenue
recognition policies are in compliance with SAB 101. We
recognize revenue upon shipment of product to our customers when
all contractual obligations have been satisfied and collection
of the resulting receivable is reasonably assured. In fiscal
2002, we began a consignment program with a significant
customer, where revenue is recognized when the customer uses the
inventory. Our sales terms to our customers provide no right of
return outside of contractual warranty claims. Sales and payment
terms and pricing extended to our customers are governed by the
respective contract agreements, together with binding purchase
orders for each transaction. Payment terms are 7 days for
consignment program sales and 30 to 45 for other customers.

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.

30



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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.

New Accounting Pronouncements.In June 2001, the FASB issued SFAS
No. 141, Business Combinations and SFAS
No. 142, Goodwill and Other Intangible Assets.
These standards revised the rules related to the accounting for
business combinations, goodwill and other intangible assets.
SFAS No. 141 requires that all business combinations
initiated after June 30, 2001 be accounted for using the
purchase accounting method. SFAS No. 142 states that
goodwill is no longer subject to amortization over its useful
life. Rather, goodwill will be subject to annual assessment for
impairment and be written down to its fair value only if the
carrying amount is greater than the fair value. In addition,
intangible assets are separately recognized if the benefit of
the intangible asset can be sold, transferred, licensed, rented
or exchanged, regardless of the acquirers intent to do so.
The amount and timing of non-cash charges related to intangibles
acquired in business combinations will change significantly from
prior practice.

In October 2001, the FASB issued SFAS
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, which addresses financial accounting
and reporting for the impairment or disposal of long-lived
assets. The Company is required to adopt this statement in its
fiscal year 2003. The effect of adopting SFAS 141, 142 and
146 in fiscal 2003 is not expected to have an impact on the
Companys financial position or results of operations.

In June 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities. SFAS No. 146 addresses the financial accounting
and reporting for costs associated with exit and disposal
activities and nullifies Emerging Issues Task Force
(EITF) Issue No. 94-3,Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit
and Activity (including Certain Costs Incurred in
restructuring). The provisions of SFAS No. 146 are
effective for exit or disposal activities that are initiated
after December 31, 2002, with early application encouraged.
The Company plans to adopt the provisions of SFAS No. 146
for exit and disposal activities occurring January 1, 2003
and thereafter.

Note 2



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

The Company incurred net losses of $3,892, $3,193
and $1,155 for the years ended August 31, 2002, 2001 and
2000, respectively. The events of September 11, 2001 and
the continued sluggish economy in all of our markets during the
first fiscal quarter of 2002 resulted in our reporting the
lowest revenue in nine quarters. In order to size our cost
structure with anticipated revenue we reduced our employee base
by 13 persons at the end of the second quarter of fiscal
year 2002. Even though our revenue continued to increase in the
third quarter, we continued our efforts to reduce cost by
eliminating an additional 21 employees. In the fourth
quarter of fiscal 2002, sales declined and an additional
12 positions were eliminated. In 2002 we eliminated a total
of 46 positions (30 direct labor,
5 manufacturing, 6 engineering and
5 administrative positions). The amount of savings ($904)
from workforce reductions are tied to the timing within a
quarter and the amount of associated severance cost. Annualized
wages and salaries for the 46 positions that were
eliminated are $1,596.

31



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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Cost savings for the year ended August 31,
2002 are summarized as follows:

|                                    |  |                 |     | 
|----------------------------------- |  | --------------- | --- | 
|                                    |  | Year Ended     
|                                    |  | August 31, 2002
|(In thousands)                      |  |                
|Direct Labor                        |  | $               | 649 | 
|Manufacturing                       |  | $               | 77  | 
|Selling, General and Administrative |  | $               | 78  | 
|Research and Development            |  | $               | 100 | 

The Company has paid an aggregate of
$39 related to severance through August 31, 2002.
Substantially all of the severance charges were paid in the same
period the charges were recorded.

We have continued staff reductions during the
first and second quarter of fiscal 2003. A total of
52 positions have been eliminated in fiscal 2003
(32 direct labor, ($853), 9 manufacturing ($428),
5 engineering ($272), and 6 administrative positions
($451). Annualized wages and salaries for the 52 positions
that were eliminated are $2,004.

We have a maximum of $3,000 available under the
revolving line of credit, based on the accounts receivable
balance outstanding, and a $4,456 capital expenditure term loan,
subject to certain restrictions listed below, each of which both
expire in August 2004 (see Notes 6 and 7). As of
August 31, 2002, there were $1,589 and $2,075 of borrowings
under the line of credit and capital expenditure term loan
facility, respectively. These borrowings are subject to certain
restrictive financial covenants, including but not limited to:
tangible net worth, interest coverage ratio, debt service
coverage ratio, annual loss limitations and the ability to
declare or pay dividends. The general economic slowdown in the
hearing, RFID and other electronic contract manufacturing
markets in which we operate have resulted in adverse operating
results in fiscal 2002 and first quarter of fiscal 2003. Due to
these adverse operating results, we were not in compliance with
the covenants at August 31, 2002 and November 30,
2002. On November 1, 2002 we amended the agreement with the
financial institution, which waived the events of default at
August 31, 2002 and on December 13, 2002 we amended
the agreements to waive the anticipated defaults as of
November 30, 2002. The December 13, 2002, amendment
also reset the covenants for the remainder fiscal 2003. These
revised bank covenants reduced the overall revolving line of
credit from maximum amount of $5,000 to $3,000 and required the
Company to prepay $1 million of long-term debt relating to
the financing of manufacturing equipment.

We are currently in compliance with the bank
covenants and, based on current financial projections and new
covenants, we believe that we will meet the bank covenants going
forward and have classified the debt per the terms of the
respective agreements. We have experienced substantial
fluctuations in our annual and quarterly operating results and
such fluctuations may continue in future periods. Adverse
operating results could result in an event of default with our
bank agreement for not meeting certain financial and other
restrictive covenants, such as, tangible net worth, interest
coverage ratio, debt service coverage ratio and year to date net
loss. Failure to meet these covenants could require us to:
immediately repay our outstanding balances; find a new lender,
which may cause us to incur costs in connection with such new
lending relationship; incur increased borrowing rates and
amendment fees; incur additional restrictions on our ability to
borrow additional funds. Any one of these factors, or a
combination of one or more factors, could adversely affect our
ability to borrow funds or adversely affect future operating
results.

If we continue to experience downturns in
revenues we will take necessary steps to reduce cost to better
match our cost structure with anticipated revenues. If we are
not able to meet our debt covenants, there is no assurance that
the bank will waive events of default.

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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Note 3



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

Major customers, each of which accounted for more
than 10% of the Companys net sales for the years ended
August 31, were as follows:

|           |  |      |    |      |  |      |    |   |  |  |    |  
|---------- |  | ---- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|           |  | 2002 |    | 2001 |  | 2000
|           |  |      |    |      |  |     
|Customer A |  |      | 32 | %    |  |      | 26 | % |  |  | 15 | %
|Customer B |  |      | 32 | %    |  |      | 25 | % |  |  | 42 | %
|Customer C |  |      |   |      |  |      | 10 | % |  |  |   |  
|Customer D |  |      |   |      |  |      |   |   |  |  | 11 | %

The Company generally sells its products to
original equipment manufacturers in the United States and abroad
in accordance with supply contracts specific to certain
manufacturer product programs. The Company performs ongoing
credit evaluations of its customers financial conditions
and, generally, does not require collateral from its customers.
The Companys continued sales to these customers are often
dependent upon the continuance of the customers product
programs. The Companys ten largest customers accounted for
approximately 88%, 82% and 89% of net sales in fiscal years
2002, 2001 and 2000, respectively, and approximately 80% and 69%
of accounts receivable at August 31, 2002 and 2001,
respectively.

The Company had net sales of $9,062, $11,209 and
$17,687 that were shipped to Singapore in fiscal 2002, 2001 and
2000, respectively. Total net export sales were $11,475,
$14,711, and $20,026 in fiscal 2002, 2001 and 2000,
respectively. The majority of the international sales were to
multinational companies who instructed HEI to ship products to
their offshore assembly facilities.

Note 4



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

The following provides additional information
concerning selected consolidated balance sheet accounts at
August 31, 2002 and 2001:

|                          |                                       |                |       |       |   |   |       |       |  
|------------------------- | ------------------------------------- | -------------- | ----- | ----- | - | - | ----- | ----- | -
|                          |                                       | 2002           |       | 2001 
|                          |                                       |                |       |      
|                          |                                       |               
|                          |                                       | (In thousands)
|Accounts receivable, net: |                                       |                |       |       |   |   |       |      
|                          | Trade accounts receivable             |                | $     | 3,618 |   |   | $     | 4,888 |  
|                          | Less: allowance for doubtful accounts |                |       | (85   | ) |   |       | (271  | )
|                          |                                       |                |       |       |   |   |       |      
|                          |                                       | $              | 3,533 |       |   | $ | 4,617 |      
|                          |                                       |                |       |       |   |   |       |      
|Inventories:              |                                       |                |       |       |   |   |       |      
|                          | Purchased parts                       |                | $     | 2,475 |   |   | $     | 3,209 |  
|                          | Work in process                       |                |       | 597   |   |   |       | 387   |  
|                          | Finished goods                        |                |       | 955   |   |   |       | 688   |  
|                          |                                       |                |       |       |   |   |       |      
|                          |                                       | $              | 4,027 |       |   | $ | 4,284 |      
|                          |                                       |                |       |       |   |   |       |      
|Other current assets:     |                                       |                |       |       |   |   |       |      
|                          | Deferred tax assets                   |                | $     | 0     |   |   | $     | 429   |  
|                          | Other current assets                  |                |       | 383   |   |   |       | 206   |  
|                          |                                       |                |       |       |   |   |       |      
|                          |                                       | $              | 383   |       |   | $ | 635   |      

33



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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

|                        |                          |                |     |      |  |   |       |       | 
|----------------------- | ------------------------ | -------------- | --- | ---- |  | - | ----- | ----- | 
|                        |                          | 2002           |     | 2001
|                        |                          |                |     |     
|                        |                          |               
|                        |                          | (In thousands)
|Other long-term assets: |                          |                |     |      |  |   |       |      
|                        | Deferred tax assets      |                | $   | 0    |  |   | $     | 1,413 | 
|                        | Other non-current assets |                |     | 322  |  |   |       | 558   | 
|                        |                          |                |     |      |  |   |       |      
|                        |                          | $              | 322 |      |  | $ | 1,971 |      
|                        |                          |                |     |      |  |   |       |      

Note 5



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

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

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

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

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

34



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HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Note 6



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

Long-term debt consists of the following:

|                                                                                                                                                                                                                                                                                                                     |  |             |       |      |  |   |       | 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------- | ----- | ---- |  | - | ----- | 
|                                                                                                                                                                                                                                                                                                                     |  | 2002        |       | 2001
|                                                                                                                                                                                                                                                                                                                     |  |             |       |     
|                                                                                                                                                                                                                                                                                                                     |  |            
|                                                                                                                                                                                                                                                                                                                     |  | (Dollars in
|                                                                                                                                                                                                                                                                                                                     |  | thousands) 
|Industrial Development Revenue Bonds payable on a
    yearly basis with principal installments from $95 to $605
    through April 2011 and variable interest ranging from 1.18% to
    2.31% during fiscal year 2002.                                                                                                |  | $           | 1,735 |      |  | $ | 2,435 | 
|Commercial loan payable in fixed monthly
    installments of $5 at 8.19% interest maturing May 2004; secured
    with certain machinery and equipment                                                                                                                                                                |  |             | 104   |      |  |   | 154   | 
|Capital expenditure notes payable on a monthly
    basis with principal installments of $58 and interest due
    monthly at the prime rate plus 1% (5.75% at August 31,
    2002); secured by machinery and equipment and cross
    collateralized with revolving line of credit and letter of
    credit facilities |  |             | 1,075 |      |  |   | 2,824 | 
|                                                                                                                                                                                                                                                                                                                     |  |             |       |      |  |   |       | 
|Total                                                                                                                                                                                                                                                                                                                |  |             | 3,914 |      |  |   | 5,413 | 
|Less current maturities                                                                                                                                                                                                                                                                                              |  |             | 2,441 |      |  |   | 1,441 | 
|                                                                                                                                                                                                                                                                                                                     |  |             |       |      |  |   |       | 
|Total long-term debt                                                                                                                                                                                                                                                                                                 |  | $           | 1,473 |      |  | $ | 3,972 | 
|                                                                                                                                                                                                                                                                                                                     |  |             |       |      |  |   |       | 

Principal maturities of long-term debt at
August 31, 2002, as adjusted for the December 13, 2002
amended loan agreement, are as follows (in thousands):

|                        |  |   |       | 
|----------------------- |  | - | ----- | 
|Years ending August 31, |  |   |       | 
|2003                    |  | $ | 2,441 | 
|2004                    |  |   | 788   | 
|2005                    |  |   | 115   | 
|2006                    |  |   | 95    | 
|Thereafter              |  |   | 475   | 
|                        |  |   |       | 
|                        |  | $ | 3,914 | 
|                        |  |   |       | 

The Companys capital expenditure notes,
revolving line of credit and letters of credit are subject to
certain restrictive financial covenants, including but not
limited to, tangible net worth, interest coverage, debt service
coverage, annual loss limitations and the ability to declare or
pay dividends. The Company was not in compliance with the
tangible net worth, interest coverage ratio, debt service
coverage ratio and year to date net loss covenants at
August 31, 2002. The Company was also not in compliance
with the tangible net worth, and year to date net loss covenants
at November 30, 2002. The Company has amended the agreement
with the financial institution, on November 1, 2002 and on
December 13, 2002, to waive the August 31, 2002 and
November 30, 2002 defaults, respectively. The
December 13, 2002, amendment also reset the covenants for
the remainder fiscal 2003. These revised bank covenants reduced
the overall revolving line of credit (note 7) from maximum
amount of $5,000 to $3,000, increased the interest rate by 1%
and required the Company to prepay $1 million of long-term
debt relating to the financing of manufacturing equipment. Based
on current projections, the Company believes that it will meet
the bank covenants going forward and has classified the debt per
the terms of the respective agreements.

We have IDRBs outstanding totaling $1,735. These
bonds were originally issued in April 1996 in connection with
the construction of a new addition to the Companys
manufacturing facility in Victoria, Minnesota, and for
production equipment purchases. In April of each year, these
bonds require annual

35



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

principal payments of $700. The Company has
limited market risk with of the variability of the interest rate
on these bonds. The bonds bear interest at a rate, which varies
weekly, based on comparable tax-exempt issues, and are limited
to a maximum rate of 10%. The interest rate at August 31,
2002 and, 2001 was 1.44% and 2.11%, respectively. Two
irrevocable letters of credit and essentially all of the
Companys property and equipment collateralize the bonds. A
commitment fee is paid annually to the bank at a rate of 4.25%
of the amount of the letters of credit.

The Company also has an agreement with a
financial institution for capital expenditure loans. According
to the terms of the loan, the Company will receive up to $4,456
reimbursement for capital equipment expenditures. At
August 31, 2002, $2,075 was outstanding under the capital
expenditure term loan and unused availability under the loan was
$1,000. Based on the terms of the agreement, the Company is
currently unable to obtain additional advances under the loan
until certain financial covenants are met. Therefore until the
covenants are satisfied the Company must fund future capital
expenditures from its cash balances or obtain other finance
sources. The capital expenditure loan is due and payable in
monthly installments or August 2004 or later, contingent on the
renewal of the bank agreement. If the Company fails to meet the
bank covenants and are not able to obtain a waiver, we may be
required to immediately repay our outstanding balances and find
a new lender, which may cause us to incur additional costs,
including higher interest costs, in connection with such new
lending relationship.

Note 7



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

Effective with the December 13, 2002
amendment, the Company has a revolving commitment with a
financial institution for total borrowings of the lesser of
$3,000 or the borrowing base, as defined in the agreement, with
interest effective December 1, 2002, based on the
Companys option, at 2.75% above the prime rate of interest
or 5.25% above the LIBOR rate. At August 31, 2002 and 2001,
the interest rate was 5.50% and 7.50%, respectively, and balance
outstanding on the revolving commitment was $1,589 and $10,
respectively. The agreement requires the Company to maintain
certain covenants, including but not limited to, tangible net
worth, interest coverage, debt service coverage, annual loss
limitations and the ability to declare or pay dividends. The
Company was not in compliance with the tangible net worth,
interest coverage ratio, debt service coverage ratio and year to
date net loss covenants at August 31, 2002. The Company was
also not in compliance with the tangible net worth, and year to
date net loss covenants at November 30, 2002. The Company
has amended the agreement with the financial institution, which
waives the events of default at August 31, 2002 and
November 30, 2002 and amends the covenants for fiscal 2003.
Based on current projections, the Company believes that it will
meet the bank covenants going forward and has classified the
debt per the terms of the respective agreements.

Note 8



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

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

During the fourth quarter of fiscal 2001, certain
material adverse changes occurred in MSCs business,
including a weakening of the economy and demand for MSCs
products. The Company wrote-off the remaining value of the
investment in MSC and the related license agreement. Circuit
Components Inc,

36



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

(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 call provided the Company with a $750 five-year
interest-bearing note, payable in quarterly installments. This
note is secured by 900 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
year ended August 31, 2002 the Company recognized $75 in
other income and $17 in interest income related to payments
under this note.

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

Note 9



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

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

|                             |         |                |       |      |   |      |      |   |  |   |      |   | 
|---------------------------- | ------- | -------------- | ----- | ---- | - | ---- | ---- | - |  | - | ---- | - | 
|                             |         | 2002           |       | 2001 |   | 2000
|                             |         |                |       |      |   |     
|                             |         |                |       |     
|                             |         | (In thousands) |       |     
|Current:                     |         |                |       |      |   |      |      |   |  |   |      |  
|                             | Federal |                | $     | (459 | ) |      | $    |  |  |   | $    |  | 
|                             | State   |                |       | (58  | ) |      |      |  |  |   |      |  | 
|Deferred                     |         |                | 1,609 |      |   |      | (930 | ) |  |   | (372 | )
|                             |         |                |       |      |   |      |      |   |  |   |      |  
|Income tax expense (benefit) |         | $              | 1,092 |      |   | $    | (930 | ) |  | $ | (372 | )
|                             |         |                |       |      |   |      |      |   |  |   |      |  

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

|                                                  |  |      |       |      |  |      |       |    |  |  |       |   
|------------------------------------------------- |  | ---- | ----- | ---- |  | ---- | ----- | -- |  |  | ----- | --
|                                                  |  | 2002 |       | 2001 |  | 2000
|                                                  |  |      |       |      |  |     
|Federal statutory tax rate                        |  |      | (34.0 | )%   |  |      | (34.0 | )% |  |  | 34.0  | % 
|State income tax rate (net of federal tax effect) |  |      | 6.2   |      |  |      | (1.2  | )  |  |  | (1.9  | ) 
|Non-deductible acquisition costs                  |  |      |      |      |  |      |      |    |  |  | 10.1  |   
|Permanent differences                             |  |      | 3.3   |      |  |      |      |    |  |  |      |   
|Reversal of reserve for contingencies             |  |      | (14.0 | )    |  |      |      |    |  |  |      |   
|Change in federal valuation allowance             |  |      | 77.5  |      |  |      |      |    |  |  |      |   
|Write-off of equity investment                    |  |      |      |      |  |      | 11.0  |    |  |  |      |   
|Other                                             |  |      |      |      |  |      | 1.6   |    |  |  | 1.4   |   
|                                                  |  |      |       |      |  |      |       |    |  |  |       |   
|Effective tax rate                                |  |      | 39.0  | %    |  |      | (22.6 | )% |  |  | (24.4 | )%
|                                                  |  |      |       |      |  |      |       |    |  |  |       |   

37



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##### Table of Contents



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, 2002 and 2001 are as follows:

|                                              |                                  |                |        |       |  |   |       |       | 
|--------------------------------------------- | -------------------------------- | -------------- | ------ | ----- |  | - | ----- | ----- | 
|                                              |                                  | 2002           |        | 2001 
|                                              |                                  |                |        |      
|                                              |                                  |               
|                                              |                                  | (In thousands)
|Deferred tax assets (short-term):             |                                  |                |        |       |  |   |       |      
|                                              | Receivables                      |                | $      | 33    |  |   | $     | 99    | 
|                                              | Inventories                      |                |        | 219   |  |   |       | 200   | 
|                                              | Accrued liabilities              |                |        | 197   |  |   |       | 130   | 
|                                              | Other                            |                |        | 18    |  |   |       |      | 
|                                              |                                  |                |        |       |  |   |       |      
|                                              |                                  |                | 467    |       |  |   | 429   |      
|                                              |                                  |                |        |       |  |   |       |      
|Deferred tax assets (long-term):              |                                  |                |        |       |  |   |       |      
|                                              | Net operating loss carry-forward |                |        | 3,364 |  |   |       | 1,984 | 
|                                              | Capital loss carry-forward       |                |        | 510   |  |   |       | 510   | 
|                                              | AMT credit carry-forward         |                |        |      |  |   |       | 83    | 
|                                              | Other                            |                |        | 18    |  |   |       | 10    | 
|                                              |                                  |                |        |       |  |   |       |      
|Gross deferred tax assets (long-term)         |                                  |                | 3,892  |       |  |   | 2,587 |      
|                                              |                                  |                |        |       |  |   |       |      
|Less: Deferred tax assets valuation allowance |                                  |                | (3,420 | )     |  |   | (510  | )    
|Net deferred tax assets (long-term)           |                                  |                | 472    |       |  |   | 2,077 |      
|                                              |                                  |                |        |       |  |   |       |      
|Deferred tax liabilities (long-term):         |                                  |                |        |       |  |   |       |      
|Property and equipment                        |                                  |                | (851   | )     |  |   | (664  | )    
|Patents                                       |                                  |                | (88    | )     |  |   |      |      
|                                              |                                  |                |        |       |  |   |       |      
|Net deferred tax asset                        |                                  | $              | 0      |       |  | $ | 1,842 |      
|                                              |                                  |                |        |       |  |   |       |      

At August 31, 2002, the Company has net
operating loss carryforwards of $8,270 for federal income tax
purposes and $5,960 for state income tax purposes that may be
offset against future taxable income beginning 2012 though 2022.
A deferred tax asset of $3,364 has been recognized for the
carryforwards. However, no tax benefit has been reported in the
2002 financial statements because of the change in assumptions
in the realization of this benefit in accordance with Financial
Accounting Standards no. 109. In reaching this conclusion, the
Company considered its historical operating losses, particularly
during the fourth quarter of fiscal 2002, and the limited
visibility to forecast future taxable income. Accordingly a
$3,131 tax benefit of the loss carryforwards has been offset by
a $3,131 valuation allowance. The remaining portion of this
deferred tax asset relates to the tax benefit of stock options
of $233, which has also been offset by a $233 valuation
allowance. Any future benefit resulting from the reversal of the
valuation allowance related to the exercise of stock options
will result in an increase in contributed capital. Management
will continue to assess the amount of tax benefit it will
realize from using these carryforwards.

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

38



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Note 10



| |                    
| | -------------------
| | 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 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, 2002, the number of shares
available for grant was 34,025.

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 fiscal 2002, 2001 and 2000, 20,271, 1,639, and 14,431
shares at prices of $5.12, $7.97, and $4.59, respectively, were
purchased under the 1989 Plan in connection with the employee
stock purchase plan. At August 31, 2002, the number of
shares available for grant was 69,951.

Directors Plan.During fiscal year 1999, the
shareholders approved the 1998 Stock Option Plan for
Non-employee Directors. This plan replaced and superceded the
Companys prior Stock Option Plan for Non-employee
Directors. Under the new directors plan, 425,000 shares
are authorized for issuance, with an initial year grant of
55,000 shares and an annual grant thereafter of 10,000 shares to
each non-employee director. These grants are effective on the
day of the annual shareholders meeting upon adjournment at
an exercise price equal to the market price on the date of
grant. The options become exercisable at the earlier of seven
years after the grant date or on the first day the market value
equals or exceeds $25.00. These options expire ten years after
the grant date. Options to purchase 30,000 shares, in the
aggregate, were granted to the three non-employee directors at
$5.95, $13.875 and $10.75 in fiscal 2002, 2001 and 2000,
respectively. At August 31, 2002, 190,000 shares remain
outstanding and 60,000 shares are available for grant.

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

39



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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 options:

|                         |  |             |           |                  |  |   |        | 
|------------------------ |  | ----------- | --------- | ---------------- |  | - | ------ | 
|                         |  |             |           | Weighted Average
|                         |  | Options     |           | Exercise Price  
|                         |  | Outstanding |           | Per Share       
|                         |  |             |           |                 
|Balance, August 31, 1999 |  |             | 611,300   |                  |  | $ | 5.602  | 
|                         |  |             |           |                  |  |   |        | 
|Granted                  |  |             | 481,000   |                  |  |   | 10.886 | 
|Exercised                |  |             | (60,300   | )                |  |   | 6.049  | 
|Cancelled                |  |             | (39,100   | )                |  |   | 7.949  | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 2000 |  |             | 992,900   |                  |  |   | 8.042  | 
|                         |  |             |           |                  |  |   |        | 
|Granted                  |  |             | 421,050   |                  |  |   | 13.881 | 
|Exercised                |  |             | (228,125  | )                |  |   | 5.995  | 
|Cancelled                |  |             | (80,099   | )                |  |   | 10.316 | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 2001 |  |             | 1,105,726 |                  |  |   | 10.523 | 
|                         |  |             |           |                  |  |   |        | 
|Granted                  |  |             | 508,200   |                  |  |   | 6.234  | 
|Exercised                |  |             | (35,025   | )                |  |   | 4.894  | 
|Cancelled                |  |             | (86,376   | )                |  |   | 4.135  | 
|                         |  |             |           |                  |  |   |        | 
|Balance, August 31, 2002 |  |             | 1,492,525 |                  |  | $ | 9.305  | 
|                         |  |             |           |                  |  |   |        | 

The following table summarizes information about
stock options outstanding as of August 31, 2002:

|                         |  |                     |           |                     |  |             |       |           |  |          |     |  |  |  |         |  |  |   |       | 
|------------------------ |  | ------------------- | --------- | ------------------- |  | ----------- | ----- | --------- |  | -------- | --- |  |  |  | ------- |  |  | - | ----- | 
|                         |  |                     |           |                    
|                         |  | Options outstanding |           | Options exercisable
|                         |  |                     |           |                    
|                         |  |                     |           | Weighted            |  |            
|                         |  |                     |           | Weighted            |  | Average     |       |           |  | Weighted
|                         |  |                     |           | Average             |  | Remaining   |       |           |  | Average 
|                         |  | Number of           |           | Exercise            |  | Contractual |       | Number of |  | Exercise
|Range of Exercise Prices |  | Options             |           | Price               |  | Life        |       | Options   |  | Price   
|                         |  |                     |           |                     |  |             |       |           |  |         
|$4.438-5.99.             |  |                     | 530,425   |                     |  | $           | 5.77  |           |  |          | 8.0 |  |  |  | 192,751 |  |  | $ | 5.59  | 
|$6.00-9.99.              |  |                     | 257,350   |                     |  |             | 7.26  |           |  |          | 8.9 |  |  |  | 20,938  |  |  |   | 6.74  | 
|$10.00-11.99.            |  |                     | 273,750   |                     |  |             | 10.75 |           |  |          | 7.4 |  |  |  | 141,563 |  |  |   | 10.75 | 
|$12.00-14.99.            |  |                     | 413,000   |                     |  |             | 13.74 |           |  |          | 8.2 |  |  |  | 76,500  |  |  |   | 13.52 | 
|$15.00-20.375.           |  |                     | 18,000    |                     |  |             | 18.80 |           |  |          | 8.0 |  |  |  | 2,250   |  |  |   | 18.80 | 
|                         |  |                     |           |                     |  |             |       |           |  |          |     |  |  |  |         |  |  |   |       | 
|                         |  |                     | 1,492,525 |                     |  | $           | 9.31  |           |  |          | 8.1 |  |  |  | 434,002 |  |  | $ | 8.79  | 
|                         |  |                     |           |                     |  |             |       |           |  |          |     |  |  |  |         |  |  |   |       | 

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

Accounting for Stock-based Compensation.Had the Company used the
fair-value-based method of accounting for its stock option plans
beginning in fiscal year 1997 and charged compensation cost
against income over the vesting period, net loss for fiscal
years 2002, 2001, and 2000 would have been changed to the
following pro forma amounts:

|                            |  |                       |        |      |  |      |        |   |  |   |        |  
|--------------------------- |  | --------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                            |  | 2002                  |        | 2001 |  | 2000
|                            |  |                       |        |      |  |     
|                            |  |                      
|                            |  | (In thousands, except
|                            |  | per share amounts)   
|Net loss                    |  | $                     | (5,954 | )    |  | $    | (4,566 | ) |  | $ | (1,899 | )
|Net loss per share, diluted |  | $                     | (0.99  | )    |  | $    | (0.94  | ) |  | $ | (0.46  | )

40



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##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The weighted average grant-date fair value of
options granted during fiscal 2002, 2001, and 2000 was $5.82,
$4.29 and $4.48, respectively. The weighted average grant-date
fair value of options was determined separately for each grant
under the Companys various plans by using the fair value
of each option and warrant grant on the date of grant, utilizing
the Black-Scholes option-pricing model and the following key
weighted average assumptions:

|                         |  |                |  |                |  |               
|------------------------ |  | -------------- |  | -------------- |  | --------------
|                         |  | 2002           |  | 2001           |  | 2000          
|                         |  |                |  |                |  |               
|Risk-free interest rates |  | 3.97% to 4.93% |  | 4.6% to 5.9%   |  | 6.00% to 6.70%
|Expected life            |  | 0.5 to 5 years |  | 0.5 to 5 years |  | 0.5 to 8 years
|Expected volatility      |  | 185%           |  | 182%           |  | 62%           
|Expected dividends       |  | None           |  | None           |  | None          

Note 11

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
fiscal years 2002, 2001, and 2000, the Company contributed $45,
$119 and $130, respectively, to the plan.

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

|                                                                                             |                                 |                |     |     |  
|-------------------------------------------------------------------------------------------- | ------------------------------- | -------------- | --- | --- | -
|                                                                                             |                                 | (In thousands)
|Benefit obligation at August 31, 2000.                                                       |                                 | $              | 871 |    
|                                                                                             |                                 |                |     |    
|Fair value of plan assets at August 31, 2000.                                                |                                 | $              | 884 |    
|                                                                                             |                                 |                |     |    
|Funded status at August 31, 2000:                                                            |                                 |                |     |    
|                                                                                             | Unrecognized actuarial gain     |                | $   | (93 | )
|                                                                                             | Unrecognized prior service cost |                |     |    |  
|                                                                                             | Additional liability            |                |     |    |  
|                                                                                             |                                 |                |     |    
|Net amount recognized                                                                        |                                 | $              | (93 | )  
|                                                                                             |                                 |                |     |    
|Amounts recognized in the statement of financial
    position at August 31, 2000 consist of: |                                 |                |     |    
|                                                                                             | Accrued benefit liability       |                | $   | 80  |  
|                                                                                             |                                 |                |     |    
|Weighted-average assumptions as of
    August 31, 2000:                                      |                                 |                |     |    
|                                                                                             | Discount rate                   |                |     | 7.5 | %
|                                                                                             | Expected return on plan assets  |                |     | 7.5 | %
|                                                                                             | Rate of compensation increase   |                |     |    |  

41



---



##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

|                                                                                |                                               |                |     |     |  
|------------------------------------------------------------------------------- | --------------------------------------------- | -------------- | --- | --- | -
|                                                                                |                                               | (In thousands)
|Components of net periodic benefit cost for the
    year ended August 31, 2000: |                                               |                |     |    
|                                                                                | Service cost                                  |                | $   | 138 |  
|                                                                                | Interest cost                                 |                |     | 51  |  
|                                                                                | Expected return on plan assets                |                |     | (53 | )
|                                                                                | Amortization of prior service costs           |                |     | 6   |  
|                                                                                | Termination, settlement and curtailment costs |                |     | 60  |  
|                                                                                |                                               |                |     |    
|Total benefit cost                                                              |                                               | $              | 202 |    
|                                                                                |                                               |                |     |    

Note 12

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 +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 installments shall be made thereafter.
These notes receivable are classified as a reduction to
shareholders equity on the consolidated balance sheet. As
of August 31, 2002 the interest due the Company on these
notes was $104 and is payable November 2, 2002.

Note 13

Commitments

Future commitments under non-cancelable operating
leases, primarily for manufacturing equipment and facilities,
are approximately, $488 in 2003, $402 in 2004, $350 in 2005, and
$253 in 2006 and beyond. Total expense under non-cancelable
operating leases was approximately $649 in 2002, $696 in 2001,
and $533 in 2000.

Note 14

Net Loss Per
Share Computation

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

|                                                          |  |                           |        |      |  |      |        |   |  |   |        |  
|--------------------------------------------------------- |  | ------------------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                          |  | 2002                      |        | 2001 |  | 2000
|                                                          |  |                           |        |      |  |     
|                                                          |  |                          
|                                                          |  | (In thousands,           
|                                                          |  | except per share amounts)
|Basic:                                                    |  |                           |        |      |  |      |        |   |  |   |        |  
|Net loss                                                  |  | $                         | (3,892 | )    |  | $    | (3,193 | ) |  | $ | (1,155 | )
|Net loss per share                                        |  | $                         | (0.65  | )    |  | $    | (0.65  | ) |  | $ | (0.24  | )
|Weighted average number of common shares
    outstanding  |  |                           | 5,922  |      |  |      | 4,881  |   |  |   | 4,726  |  
|                                                          |  |                           |        |      |  |      |        |   |  |   |        |  
|Diluted:                                                  |  |                           |        |      |  |      |        |   |  |   |        |  
|Net loss                                                  |  | $                         | (3,892 | )    |  | $    | (3,193 | ) |  | $ | (1,155 | )
|Loss per share                                            |  | $                         | (0.65  | )    |  | $    | (0.65  | ) |  | $ | (0.24  | )
|Weighted average number of common shares
    outstanding  |  |                           | 5,992  |      |  |      | 4,881  |   |  |   | 4,726  |  
|Assumed conversion of stock options                       |  |                           |       |      |  |      |       |   |  |   |       |  
|                                                          |  |                           |        |      |  |      |        |   |  |   |        |  
|Weighted average common and assumed conversion
    shares |  |                           | 5,992  |      |  |      | 4,881  |   |  |   | 4,726  |  
|                                                          |  |                           |        |      |  |      |        |   |  |   |        |  

42



---



##### Table of Contents



HEI, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Approximately 1,540,000, 1,156,000, and 993,000
stock options and warrants have been excluded from the
calculation of diluted net loss per common share as they are
antidilutive for fiscal 2002, 2001 and 2000, respectively.

Note 15

Private
Placement of Common Stock

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

43



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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, 2002 and 2001, 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, 2002. 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, 2002 and 2001, and the results of their
operations and their cash flows for each of the years in the
three-year period ended August 31 2002, in conformity with
accounting principles generally accepted in the United States of
America.



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

Minneapolis, Minnesota

October 3, 2002, except as to notes 1, 2, 6
and 7


which are as of December 13, 2002


44



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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 October 3, 2002, except as to
notes 1, 2, 6 and 7 which are as of December 13, 2002, we
reported on the consolidated balance sheets of HEI, Inc. and
subsidiaries as of August 31, 2002 and 2001, 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, 2002, as
contained in the annual report on Form 10-K for the fiscal
year ended August 31, 2002. In connection with our audits
of the aforementioned consolidated financial statements, we have
also audited the related financial statement schedule as listed
in the accompanying index. This financial statement schedule is
the responsibility of the Companys management. Our
responsibility is to express an opinion on this financial
statement schedule based on our audits.

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



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

Minneapolis, Minnesota

October 3, 2002, except as to notes 1, 2, 6
and 7


which are as of December 13, 2002


45



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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 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 | )

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



---

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.


46



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##### Table of Contents





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

None.




PART III



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

Information regarding executive officers required
by this Item 10 is set forth in Part I of this Annual
Report on Form 10-K pursuant to Instruction 3 to
Item 401(b) of Regulation S-K. The other information
required by this Item 10 is incorporated herein by
reference to HEIs definitive Proxy Statement for its
Annual Meeting of Shareholders, to be held on January 16,
2003, to be filed with the Securities and Exchange Commission
pursuant to Schedule 14A under the Securities Exchange Act
of 1934, as amended.



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

The information required by this Item 11 is
incorporated herein by reference to HEIs definitive Proxy
Statement for its Annual Meeting of Shareholders, to be held on
January 16, 2003 to be filed with the Securities and
Exchange Commission pursuant to Schedule 14A under the
Securities Exchange Act of 1934, as amended.



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

The following table sets forth certain
information concerning all equity compensation plans previously
approved by shareholders and all equity compensation plans not
previously approved by shareholders as of August 31, 2002.
Share amounts are in thousands.

Equity Compensation Plan Information

|                                                           |  |                     |       |                  |  |                     |       |  |  |  |     | 
|---------------------------------------------------------- |  | ------------------- | ----- | ---------------- |  | ------------------- | ----- |  |  |  | --- | 
|                                                           |  |                     |       |                  |  | Number of Shares   
|                                                           |  |                     |       | Weighted-        |  | Remaining Available
|                                                           |  | Number of Shares to |       | Average Exercise |  | for Future Issuance
|                                                           |  | be Issued Upon      |       | Price of         |  | Under Equity       
|                                                           |  | Exercise of         |       | Outstanding      |  | Compensation Plans 
|                                                           |  | Outstanding         |       | Options,         |  | (Excluding Shares  
|                                                           |  | Options, Warrants   |       | Warrants and     |  | Reflected in the   
|Plan Category                                              |  | and Rights          |       | Rights           |  | First Column)      
|                                                           |  |                     |       |                  |  |                    
|Equity Compensation Plans Approved By Shareholders         |  |                     | 1,540 |                  |  | $                   | 9.266 |  |  |  | 217 | 
|Equity Compensation Plans Not Approved By
    Shareholders |  |                     | N/A   |                  |  |                     | N/A   |  |  |  | N/A | 
|Total                                                      |  |                     | 1,540 |                  |  | $                   | 9.266 |  |  |  | 217 | 

The other information required by this
Item 12 is incorporated herein by reference to HEIs
definitive Proxy Statement for its Annual Meeting of
Shareholders, to be held on January 16, 2003, to be filed
with the Securities and Exchange Commission pursuant to
Schedule 14A under the Securities Exchange Act of 1934, as
amended.



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

The information required by this Item 13 is
incorporated herein by reference to HEIs definitive Proxy
Statement for its Annual Meeting of Shareholders, to be held on
January 16, 2003, to be filed with the Securities and
Exchange Commission pursuant to Schedule 14A under the
Securities Exchange Act of 1934, as amended.

47



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##### Table of Contents





|         |                         
|-------- | ------------------------
|Item 14. | Controls and Procedures.

(a) Evaluation of disclosure controls and
procedures.Based on their evaluation as of a date within
90 days of the filing date of this Annual Report on
Form 10-K, our principal executive officer and principal
financial officer have concluded that our disclosure and
controls procedures (as defined in Rules 13a-14(c) and
15d-14(c) under the Exchange Act) are effective to ensure that
information required to be disclosed by us in reports that we
file or submit under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in SEC
rules and forms.

(b) Changes in internal controls.There were no significant changes in our internal controls
or in other factors that could significantly affect those
controls subsequent to the date of their evaluation, including
any corrective actions with regard to significant deficiencies
and material weaknesses.



|         |                                                                    
|-------- | -------------------------------------------------------------------
|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 20, 2002, HEI filed a Form 8-K reporting under
Item 5-Other Events its financial results for the quarter
ended June 1, 2002.

(c) Exhibits:

| |         |  |  |   |  |                                                                                                                                                                                           |  |       
| | ------- |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------
| | 2.1     |  |  |  |  | Cross Technology, Inc., Agreement and Plan of
    Reorganization                                                                                                                          |  | Note 6
| | 3.1     |  |  |  |  | Amended and Restated Articles of Incorporation                                                                                                                                            |  | Note 1
| | 3.2     |  |  |  |  | Amended and Restated Bylaws                                                                                                                                                               |  | Note 1
| | 10.1a   |  |  |  |  | Loan and Security Agreement with LaSalle Bank,
    N.A. dated July 31, 2000                                                                                                               |  | Note 2
| | 10.1b   |  |  |  |  | First Amendment to Credit Agreement                                                                                                                                                       |  | Note 7
| | 10.1c   |  |  |  |  | Second Amendment to Loan Security Agreement                                                                                                                                               |  | Note 7
| | 10.1d   |  |  |  |  | Third Amendment to Loan Security Agreement                                                                                                                                                |  | Note 7
| | 10.2a   |  |  |  |  | Capital Expenditure Note with LaSalle Bank, N.A.
    dated July 31, 2000                                                                                                                  |  | Note 2
| | 10.2b   |  |  |  |  | Amended and Restated Capital Expenditure Note                                                                                                                                             |  | Note 7
| | 10.2c   |  |  |  |  | Amended and Restated Capital Expenditure Note                                                                                                                                             |  | Note 7
| | 10.3    |  |  |  |  | Reimbursement Agreement by and between HEI, Inc.
    and LaSalle Bank, N.A. dated July 31, 2000                                                                                           |  | Note 2
| | 10.4    |  |  |  |  | Mortgage, Security Agreement, Fixture Financing
    Statement and Assignment of Leases and Rents by HEI, Inc. as
    Mortgagor to LaSalle Bank, N.A. as Mortgagee dated July 31,
    2000 |  | Note 2
| | 10.5a   |  |  |  |  | Patent, Trademark and License Mortgage by HEI,
    Inc. in favor of LaSalle Bank, N.A. dated July 31, 2000                                                                                |  | Note 2
| | 10.5b   |  |  |  |  | Amendment No. 1 to Patent Trademark and
    License Agreement                                                                                                                             |  | Note 7
| | 10.6    |  |  |  |  | Security Agreement with LaSalle Bank, N.A. dated
    July 31, 2000                                                                                                                        |  | Note 2
| | 10.7a   |  |  |  |  | Revolving Note with LaSalle Bank, N.A. dated
    July 31, 2000                                                                                                                            |  | Note 2
| | 10.7b   |  |  |  |  | Amended and Restated Revolving Note                                                                                                                                                       |  | Note 7
| | 10.8    |  |  |  |  | Form of Indemnification Agreement between HEI and
    officers and directors                                                                                                              |  | Note 3
| | *10.9   |  |  |  |  | HEI 1989 Omnibus Stock Compensation Plan adopted
    April 3, 1989, as amended to date                                                                                                    |  | Note 4
| | *10.10 |  |  |  |  | 1991 Stock Option Plan for Non-employee
    Directors, as amended to date                                                                                                                 |  |       
| | *10.11  |  |  |  |  | 1998 Stock Option Plan adopted November 18, 1998                                                                                                                                          |  | Note 5
| | *10.12  |  |  |  |  | 1998 Stock Option Plan for Non-employee Directors
    adopted November 18, 1998                                                                                                           |  | Note 5

48



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##### Table of Contents



| |        |  |  |   |  |                                                                                                                                                   |  |       
| | ------ |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------
| | *10.14 |  |  |  |  | Agreement regarding Employment/Compensation upon
    change in control with Mr. Courtney, dated November 20,
    1998.                            |  | Note 8
| | *10.15 |  |  |  |  | Stock purchase agreement by and among HEI, Inc.
    and the Investors listed on Exhibit A thereto, including
    exhibits, dated August 29, 2001. |  | Note 8
| | 10.16 |  |  |  |  | Sample Promissory Note Used by Certain Officers
    and Directors In Connection with the Exercise of Stock Options.                               |  |       
| | 21    |  |  |  |  | Subsidiaries of the Registrant                                                                                                                    |  |       
| | 23    |  |  |  |  | Consent of KPMG LLP.                                                                                                                              |  |       
| | 99.1  |  |  |  |  | Certifications of Chief Executive Officer and
    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 proxy statement for
    the 2001 annual meeting of shareholders, filled on
    January 23, 2002.                       
|   
|(2) | Filed as an exhibit to this Form 10-KSB for
    the fiscal year ended August 31, 2000.                                                            
|   
|(3) | Filed as an exhibit to Registration Statement on
    Form S-2 (SEC No. 33-37285) filed October 15, 1990,
    and incorporated herein by reference.
|   
|(4) | Filed as an exhibit to Annual Report on
    Form 10-KSB for the year ended August 31, 1996 and
    incorporated herein by reference.              
|   
|(5) | Filed as an exhibit to Annual Report on
    Form 10-KSB for the year ended August 31, 1997 and
    incorporated herein by reference.              
|   
|(6) | Filed as an exhibit to our report on
    Form 8-K, filed on March 21, 2000.                                                                       
|   
|(7) | Filed as an exhibit to Annual Report on
    Form 10-K for the fiscal year ended August 31, 2001.                                                  
|   
|(8) | Filed as an exhibit to our report on
    Form 8-K, filed September 4, 2001.                                                                       



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



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

49



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##### Table of Contents



SCHEDULE II

Valuation and qualifying accounts

|                                 |  |            |     |                           |  |                 |       |               |  |   |       |  |  |   |     | 
|-------------------------------- |  | ---------- | --- | ------------------------- |  | --------------- | ----- | ------------- |  | - | ----- |  |  | - | --- | 
|                                 |  | Balance at |     | Additions Charged         |  |                 |       |              
|                                 |  | Beginning  |     | to Costs and              |  | Deductions from |       | Balance at   
|                                 |  | of Period  |     | Expenses                  |  | Reserve (1)     |       | End of Period
|                                 |  |            |     |                           |  |                 |       |              
|                                 |  |            |     |                           |  |                
|                                 |  |            |     | (In thousands of dollars) |  |                
|Allowance for doubtful accounts: |  |            |     |                           |  |                 |       |               |  |   |       |  |  |   |     | 
|Year ended August 31, 2002       |  | $          | 271 |                           |  | $               | 6     |               |  | $ | 192   |  |  | $ | 85  | 
|Year ended August 31, 2001       |  |            | 215 |                           |  |                 | 1,268 |               |  |   | 1,212 |  |  |   | 271 | 
|Year ended August 31, 2000       |  |            | 140 |                           |  |                 | 75    |               |  |   |      |  |  |   | 215 | 



---



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

50



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##### Table of Contents






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/ ANTHONY J. FANT

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

Date: December 16, 2002

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

|                                               |  |                                                                                           |  |                  
|---------------------------------------------- |  | ----------------------------------------------------------------------------------------- |  | -----------------
|                                               |  |                                                                                           |  | Date             
|                                               |  |                                                                                           |  |                  
|                                              
|/s/ ANTHONY J. FANTAnthony J. Fant             |  | Chairman and Chief Executive Officer                                                      |  | December 16, 2002
|                                              
|/s/ STEVE E. TONDERA, JR.Steve E. Tondera, Jr. |  | Chief Financial Officer, Treasurer, Secretary,
    Vice President of Finance and Director |  | December 16, 2002
|                                              
|/s/ MACK V. TRAYNOR, IIIMack V. Traynor, III   |  | Director                                                                                  |  | December 16, 2002
|                                              
|/s/ TIMOTHY F. FLOEDERTimothy F. Floeder       |  | Director                                                                                  |  | December 16, 2002
|                                              
|/s/ DENNIS J. LEISZDennis J. Leisz             |  | Director                                                                                  |  | December 16, 2002

51



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##### Table of Contents



CERTIFICATIONS

I, Anthony J. Fant, certify that:



|   |                                                                                                                                                                                                                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. | I have reviewed this annual report on
    Form 10-K of HEI, Inc.;                                                                                                                                                                                                                                                                           
|  
|2. | Based on my knowledge, this annual report does
    not contain any untrue statement of a material fact or omit to
    state a material fact necessary to make the statements made, in
    light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|  
|3. | Based on my knowledge, the financial statements,
    and other financial information included in this annual report,
    fairly present in all material respects the financial condition,
    results of operations and cash flows of the registrant as of,
    and for, the periods presented in this annual report;                       
|  
|4. | The registrants other certifying officers
    and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and we have:                                                                                                       



| |    |                                                                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | designed such disclosure controls and procedures
    to ensure that material information relating to the registrant,
    including its consolidated subsidiaries, is made known to us by
    others within those entities, particularly during the period in
    which this annual report is being prepared;
|
| | b) | evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) | presented in this annual report our conclusions
    about the effectiveness of the disclosure controls and
    procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



|   |                                                                                                                                                                                                                                                               
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|5. | The registrants other certifying officers
    and I have disclosed, based on our most recent evaluation, to
    the registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent function):



| |    |                                                                                                                                                                                                                                                                                                                   
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) | any fraud, whether or not material, that involves
    management or other employees who have a significant role in the
    registrants internal controls; and                                                                                                                                                    



|   |                                                                                                                                                                                                                                                                                                                                                                                                               
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|6. | The registrants other certifying officers
    and I have indicated in this annual report whether or not there
    were significant changes in internal controls or in other
    factors that could significantly affect internal controls
    subsequent to the date of our most recent evaluation, including
    any corrective actions with regard to significant deficiencies
    and material weaknesses.



| |                                     
| | ------------------------------------
| | /s/ ANTHONY J. FANT                 
| |                                     
| | Anthony J. Fant                     
| | Chairman and Chief Executive Officer

Date: December 16, 2002

52



---



##### Table of Contents



I, Steve E. Tondera, Jr., certify that:



|   |                                                                                                                                                                                                                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. | I have reviewed this annual report on
    Form 10-K of HEI, Inc.;                                                                                                                                                                                                                                                                           
|  
|2. | Based on my knowledge, this annual report does
    not contain any untrue statement of a material fact or omit to
    state a material fact necessary to make the statements made, in
    light of the circumstances under which such statements were
    made, not misleading with respect to the period covered by this
    annual report;
|  
|3. | Based on my knowledge, the financial statements,
    and other financial information included in this annual report,
    fairly present in all material respects the financial condition,
    results of operations and cash flows of the registrant as of,
    and for, the periods presented in this annual report;                       
|  
|4. | The registrants other certifying officers
    and I are responsible for establishing and maintaining
    disclosure controls and procedures (as defined in Exchange Act
    Rules 13a-14 and 15d-14) for the registrant and we have:                                                                                                       



| |    |                                                                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | designed such disclosure controls and procedures
    to ensure that material information relating to the registrant,
    including its consolidated subsidiaries, is made known to us by
    others within those entities, particularly during the period in
    which this annual report is being prepared;
|
| | b) | evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) | presented in this annual report our conclusions
    about the effectiveness of the disclosure controls and
    procedures based on our evaluation as of the Evaluation Date;                                                                                                                                



|   |                                                                                                                                                                                                                                                               
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|5. | The registrants other certifying officers
    and I have disclosed, based on our most recent evaluation, to
    the registrants auditors and the audit committee of
    registrants board of directors (or persons performing the
    equivalent function):



| |    |                                                                                                                                                                                                                                                                                                                   
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) | all significant deficiencies in the design or
    operation of internal controls which could adversely affect the
    registrants ability to record, process, summarize and
    report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) | any fraud, whether or not material, that involves
    management or other employees who have a significant role in the
    registrants internal controls; and                                                                                                                                                    



|   |                                                                                                                                                                                                                                                                                                                                                                                                               
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|6. | The registrants other certifying officers
    and I have indicated in this annual report whether or not there
    were significant changes in internal controls or in other
    factors that could significantly affect internal controls
    subsequent to the date of our most recent evaluation, including
    any corrective actions with regard to significant deficiencies
    and material weaknesses.



| |                                     
| | ------------------------------------
| | /s/ STEVE E. TONDERA, JR.           
| |                                     
| | Steve E. Tondera, Jr.               
| | Chief Financial Officer, Treasurer, 
| | Vice President Finance and Secretary

Date: December 16, 2002

53



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##### Table of Contents



Exhibit Index

| |         |  |  |   |  |                                                                                                                                                                                           |  |       
| | ------- |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------
| | 2.1     |  |  |  |  | Cross Technology, Inc., Agreement and Plan of
    Reorganization                                                                                                                          |  | Note 6
| | 3.1     |  |  |  |  | Amended and Restated Articles of Incorporation                                                                                                                                            |  | Note 1
| | 3.2     |  |  |  |  | Amended and Restated Bylaws                                                                                                                                                               |  | Note 1
| | 10.1a   |  |  |  |  | Loan and Security Agreement with LaSalle Bank,
    N.A. dated July 31, 2000                                                                                                               |  | Note 2
| | 10.1b   |  |  |  |  | First Amendment to Credit Agreement                                                                                                                                                       |  | Note 7
| | 10.1c   |  |  |  |  | Second Amendment to Loan Security Agreement                                                                                                                                               |  | Note 7
| | 10.1d   |  |  |  |  | Third Amendment to Loan Security Agreement                                                                                                                                                |  | Note 7
| | 10.2a   |  |  |  |  | Capital Expenditure Note with LaSalle Bank, N.A.
    dated July 31, 2000                                                                                                                  |  | Note 2
| | 10.2b   |  |  |  |  | Amended and Restated Capital Expenditure Note                                                                                                                                             |  | Note 7
| | 10.2c   |  |  |  |  | Amended and Restated Capital Expenditure Note                                                                                                                                             |  | Note 7
| | 10.3    |  |  |  |  | Reimbursement Agreement by and between HEI, Inc.
    and LaSalle Bank, N.A. dated July 31, 2000                                                                                           |  | Note 2
| | 10.4    |  |  |  |  | Mortgage, Security Agreement, Fixture Financing
    Statement and Assignment of Leases and Rents by HEI, Inc. as
    Mortgagor to LaSalle Bank, N.A. as Mortgagee dated July 31,
    2000 |  | Note 2
| | 10.5a   |  |  |  |  | Patent, Trademark and License Mortgage by HEI,
    Inc. in favor of LaSalle Bank, N.A. dated July 31, 2000                                                                                |  | Note 2
| | 10.5b   |  |  |  |  | Amendment No. 1 to Patent Trademark and
    License Agreement                                                                                                                             |  | Note 7
| | 10.6    |  |  |  |  | Security Agreement with LaSalle Bank, N.A. dated
    July 31, 2000                                                                                                                        |  | Note 2
| | 10.7a   |  |  |  |  | Revolving Note with LaSalle Bank, N.A. dated
    July 31, 2000                                                                                                                            |  | Note 2
| | 10.7b   |  |  |  |  | Amended and Restated Revolving Note                                                                                                                                                       |  | Note 7
| | 10.8    |  |  |  |  | Form of Indemnification Agreement between HEI and
    officers and directors                                                                                                              |  | Note 3
| | *10.9   |  |  |  |  | HEI 1989 Omnibus Stock Compensation Plan adopted
    April 3, 1989, as amended to date                                                                                                    |  | Note 4
| | *10.10 |  |  |  |  | 1991 Stock Option Plan for Non-employee
    Directors, as amended to date                                                                                                                 |  |       
| | *10.11  |  |  |  |  | 1998 Stock Option Plan adopted November 18, 1998                                                                                                                                          |  | Note 5
| | *10.12  |  |  |  |  | 1998 Stock Option Plan for Non-employee Directors
    adopted November 18, 1998                                                                                                           |  | Note 5
| | *10.14  |  |  |  |  | Agreement regarding Employment/Compensation upon
    change in control with Mr. Courtney, dated November 20,
    1998.                                                                    |  | Note 8
| | *10.15  |  |  |  |  | Stock purchase agreement by and among HEI, Inc.
    and the Investors listed on Exhibit A thereto, including
    exhibits, dated August 29, 2001.                                         |  | Note 8
| | 10.16  |  |  |  |  | Sample Promissory Note Used by Certain Officers
    and Directors In Connection with the Exercise of Stock Options.                                                                       |  |       
| | 21     |  |  |  |  | Subsidiaries of the Registrant                                                                                                                                                            |  |       
| | 23     |  |  |  |  | Consent of KPMG LLP.                                                                                                                                                                      |  |       
| | 99.1   |  |  |  |  | Certifications of Chief Executive Officer and
    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 proxy statement for
    the 2001 annual meeting of shareholders, filled on
    January 23, 2002.                       
|   
|(2) | Filed as an exhibit to this Form 10-KSB for
    the fiscal year ended August 31, 2000.                                                            
|   
|(3) | Filed as an exhibit to Registration Statement on
    Form S-2 (SEC No. 33-37285) filed October 15, 1990,
    and incorporated herein by reference.
|   
|(4) | Filed as an exhibit to Annual Report on
    Form 10-KSB for the year ended August 31, 1996 and
    incorporated herein by reference.              

54



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##### Table of Contents





|    |                                                                                                                                     
|--- | ------------------------------------------------------------------------------------------------------------------------------------
|(5) | Filed as an exhibit to Annual Report on
    Form 10-KSB for the year ended August 31, 1997 and
    incorporated herein by reference.
|   
|(6) | Filed as an exhibit to our report on
    Form 8-K, filed on March 21, 2000.                                                         
|   
|(7) | Filed as an exhibit to Annual Report on
    Form 10-K for the fiscal year ended August 31, 2001.                                    
|   
|(8) | Filed as an exhibit to our report on
    Form 8-K, filed September 4, 2001.                                                         



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



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

55