<PAGE>

                                                                      Exhibit 13


HEI, Inc.
Five Year Summary of Selected Financial Information
---------------------------------------------------
(In thousands, except per share amounts)

<TABLE>
<CAPTION>

--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Years Ended August 31                                  1998         1997         1996         1995           1994
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
<S>                                                   <C>          <C>         <C>           <C>             <C>
Net sales                                             $20,805      $30,962     $20,680       $23,423         $17,295
Cost of sales                                          16,592       24,524      14,957        17,263          12,497
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Gross profit                                            4,213        6,438       5,723         6,160           4,798
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Operating expenses:
  Selling, general and administrative                   2,375        2,277       2,342         2,401           2,094
  Research, development and engineering                   852          843         849           754             679
Proxy/change of control costs                           5,664            -           -             -               -
Gain on sale of product line, net                           -         (215)        (45)            -               -
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Operating income (loss)                                (4,678)       3,533       2,577         3,005           2,025
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------

Income (loss) before income taxes                      (4,098)       3,980       2,833         3,250           2,102
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Income taxes (benefit)                                 (1,471)       1,430         720         1,210             777
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Net income (loss)                                     $(2,627)     $ 2,550     $ 2,113       $ 2,040         $ 1,325
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Net income (loss) per basic share                     $  (.64)     $   .62     $   .54       $   .54         $   .36
Net income (loss) per diluted share                   $  (.64)     $   .60     $   .52       $   .52         $   .34
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Weighted average common shares
 Outstanding
  Basic                                                 4,085        4,135       3,942         3,748           3,665
  Diluted                                               4,085        4,279       4,098         3,899           3,858
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------
Balance sheet:
  Working capital                                     $11,864      $14,784     $10,088       $ 8,380         $ 5,927
  Total assets                                         22,173       24,511      22,414        12,857          10,905
  Long-term debt, less current maturities               3,835        4,537       5,271             -               -
  Shareholders' equity                                 14,341       16,995      13,816        10,982           8,671
--------------------------------------------------- ------------ ----------- ------------- ------------ ---------------

</TABLE>






<PAGE>


To Our Shareholders

Fiscal year 1998 was a year of fundamental transition for your Company. HEI
successfully completed a transition to new leadership and direction. It also
completed a transition from a business strategy that concentrated on building
our financial and technology foundations to a focus on strategic markets,
consistency of growth and expansion of capabilities. We eliminated our heavy
dependence on revenues from the volatile disk drive market--approximately 55% of
net sales in fiscal 1997 -- and built a revenue base founded on more diverse and
stable long-term growth opportunities. We also absorbed a one-time charge of
$5.7 million for the expenses associated with both parties' costs in the
Company's recent proxy contest and the related change of control costs.

1998: Successful Transition
HEI achieved 60% growth in revenues from targeted applications in the hearing,
medical and communications markets during fiscal 1998. This growth demonstrates
HEI's ability to successfully apply and expand our state-of-the-art
ultraminiature microelectronic packaging capabilities in these areas. The
Company reported net income from operations for the past fiscal year, excluding
the one-time costs related to the proxy contest and change of control, of
approximately $.25 per share diluted, almost all from non-disk drive business.

In fiscal 1998, HEI added significant top management expertise with the hiring
of Donald Reynolds as President and Stephen Petersen as Director of
Manufacturing. Mr. Reynolds came to us with 17 years' experience in electronics
engineering, marketing and senior management with BF Goodrich Aerospace. Mr.
Peterson brings over 20 years' experience in high technology engineering and
manufacturing, most recently with the Interconnect Division of Sheldahl, Inc. We
are pleased by their addition to our management team and look forward to their
ongoing contributions to our growth. Eugene Courtney resigned as Chief Executive
Officer, but remains a director of HEI and will also serve the Company in an
advisory role.

1999: Growth and Expansion
In fiscal 1999, with the strengthening of our focus on hearing, medical and
communications markets, we expect to further demonstrate HEI's growth potential
in these markets which have been carefully selected for their current and future
requirements for our core competencies.

In addition, we have begun a process of expanding those competencies to add
applications-specific design expertise and sales coverage. This effort will
provide differentiation in our markets and better position HEI for future growth
and profitability. We believe that the combination of leading edge packaging
knowledge and expanded circuit design expertise will provide value-added
services that more fully serve the needs of our prospects and customers.

As we pursue the strategies set out in fiscal 1998, we intend to expand our
technology base, adding and broadening HEI's capabilities through selective
partnering and/or acquisitions, particularly in the areas of flexible and
laminate substrates. This will enable us to provide optimum packaging
alternatives and serve new applications areas. We will also investigate further
expansion of our manufacturing capacity and capabilities, to provide additional
lower cost assembly services, where such services naturally complement and add
value to our leading edge capabilities in ultraminiature device manufacturing.

We believe that fiscal 1999 will be a year of growth in revenues and expansion
of capabilities and resources. Despite the uncertain economic conditions, we
remain optimistic, hopeful that these factors will not override our growth
prospects for fiscal 1999, particularly the latter half. We believe we have the
dynamic leadership and strategic direction, the identified applications and
customers, and the means and capability to create long-term growth and
expansion.


<PAGE>


New Directions and Opportunities

On August 4, 1998, HEI's shareholders elected a new Board of Directors to 
lead your Company into the 21st century. HEI's strength comes from its 
experienced staff, its leading edge technology and the outstanding customer 
base it serves. Management and the new board are committed to building on 
this foundation, setting aggressive objectives, and seeking new opportunities 
to broaden and expand HEI's prospects.

HEI is well positioned to take advantage of exciting new opportunities in
microelectronics design and manufacturing, particularly in our strategic markets
of hearing and medical instrumentation and communications. We thank you for your
loyalty and confidence in HEI, and assure you of our dedication to growth,
diversity and increased shareholder value. We look forward to a bright future
for the Company and all its stakeholders.

Sincerely,




Anthony J. Fant               Eugene W. Courtney         Donald R. Reynolds
Chairman of the Board         Director                   President
Chief Executive Officer


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 involving 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 secure and satisfy customers; the availability and
cost of materials from HEI's suppliers; adverse competitive developments; change
in or cancellation of customer requirements; the year 2000 issue; 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.




<PAGE>


Management's Discussion and
Analysis of Financial Condition and
Results of Operations

FINANCIAL CONDITION

         The Company's net cash flow used for operating activities for the year
ended August 31, 1998, was $3,043,000. The significant components of this
operating net cash flow were negative cash flow of $1,451,000 from operations
before changes in current operating items, a $1,056,000 increase in accounts
receivable, a $1,089,000 increase in income taxes receivable and a $512,000
increase in other current assets partially offset by a $1,106,000 increase in
accounts payable. The increase in accounts receivable is attributable primarily
to increased sales in the last month of the current fiscal year versus the same
period of last fiscal year. The income tax receivable is a result of the carry
back effect of the pre-tax loss on fiscal year 1998 results. The increase in
other current assets is mainly due to deposits made on equipment that will be
converted to operating lease agreements. The increase in accounts payable is
primarily due to an accrual of invoiced proxy/change of control costs not paid
until September 1998.

         Accounts receivable average days outstanding was 40 days for the year
ended August 31, 1998 compared to 36 days for the same period a year ago.
Inventory turns were 12.0 turns and 10.9 turns for the years ended August 31,
1998 and 1997, respectively.

         The Company decreased short-term investments, primarily commercial
paper, to $7,984,000, down $1,191,000 from a year ago, primarily to pay
proxy/change of control costs. The current ratio at the end of fiscal 1998 was
4.2:1 as compared to 6.7:1 at the end of fiscal 1997. The reduced current ratio
is principally due to decreased cash and cash equivalents and short-term
investments and increased accounts payable partially offset by increased
accounts receivable and other current assets.

         In May 1998, the Company extended the due date of its $3,000,000
revolving line of credit to January 1999 (see Note 5 under Notes to Financial
Statements). As of August 31, 1998, there were no borrowings under the line.

         During fiscal 1998, the Company purchased $1,025,000 of property and
equipment to increase manufacturing capacity to meet anticipated requirements.
These expenditures were funded primarily by internally generated funds and the
remaining proceeds of the Industrial Development Revenue Bonds issued in April
1996. The Company also entered into operating leases for an additional $694,000
of equipment over a three year period.

         During fiscal 1999, the Company intends to expend approximately $2.0
million for manufacturing facility improvements and capital equipment. These
additions will increase manufacturing capacity to meet anticipated requirements
for continued revenue growth. It is expected that these expenditures will be
funded primarily from operations.

RESULTS OF OPERATIONS
<TABLE>
<CAPTION>

SALES BY PRODUCT LINE
------------------------------------------------------------------------------------------------------------
(In thousands)                                             1998                  1997                  1996
------------------------------------------ --------------------- --------------------- ---------------------
<S>                                                     <C>                   <C>                   <C>
Microelectronics                                        $20,805               $30,962               $18,545
Light pens                                                    -                     -                 2,135
------------------------------------------ --------------------- --------------------- ---------------------
Total                                                   $20,805               $30,962               $20,680
------------------------------------------ --------------------- --------------------- ---------------------

</TABLE>


Sales. 1998 vs. 1997: Sales in fiscal 1998 decreased $10,157,000, or 33%, as
compared to fiscal 1997. This decrease reflects the phase out during the last
quarter of fiscal 1997 of volume production of a device for use in high-density
disk drives. In the previous fiscal year, this disk drive program accounted for
55% of total sales. However, sales to the Company's other market areas (hearing
and medical instruments, telecommunications and industrial applications)
collectively increased 60% in fiscal 1998 as compared to sales to such markets
in fiscal 1997. In fiscal 1998, one large multinational customer accounted for
59% of total sales. The business with


<PAGE>


this customer has grown steadily over the last five years, and currently the
Company is producing 21 different devices for this customer for shipment to
multiple locations, both domestic and international. <TABLE> <CAPTION>

PERCENTAGE OF SALES
------------------------------------------------- ------------------- ------------------ -------------------
                                                                1998               1997                1996
------------------------------------------------- ------------------- ------------------ -------------------
<S>                                                             <C>                <C>                 <C>
Sales                                                           100%               100%                100%
Gross profit                                                     20%                21%                 28%
Selling, general and
  administrative                                                 11%                 7%                 11%
Research, development
  and engineering                                                 4%                 3%                  4%
Proxy/change of control costs                                    27%                  -                   -
------------------------------------------------- ------------------- ------------------ -------------------

</TABLE>


         1997 vs. 1996: Sales in fiscal 1997 increased $10,282,000, or 50%, as
compared to fiscal 1996. This increase was primarily due to shipments in the
high-density disk drive business, primarily to one customer. Shipments to this
customer constituted 55% of sales during fiscal year 1997.

         Because the Company's sales to the computer disk drive market were
generally tied to the customers' projected sales and production of the related
product, the Company's sales levels were subject to fluctuations outside the
Company's control. To the extent that sales to any one customer represent a
significant portion of the Company's sales, any change in the level of sales to
that customer can have a significant impact on the Company's total revenues. 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.

         In April 1997, the Company announced that it had received notice from
its then largest current customer to begin phasing out production of a
microelectronic assembly used in high-density disk drives. Phase out of this
program commenced late in the third quarter of fiscal year 1997 and was
completed by the end of the fourth quarter.

Gross Profit. 1998 vs. 1997: The Company's gross profit as a percentage of sales
was 20% in fiscal 1998, as compared to 21% in fiscal 1997. The reduction in
gross profit and gross profit as a percentage of sales was primarily due to the
decrease in sales and the impact of relatively fixed manufacturing support
costs.

         1997 vs. 1996: The Company's gross profit as a percentage of sales was
21% in fiscal 1997, as compared to 28% in fiscal 1996. The reduced gross profit
rate was primarily the result of volume pricing to a customer resulting in lower
gross margin rates for sales on a high-density disk drive program.

Operating Expenses. 1998 vs. 1997: Fiscal 1998 selling, general and
administrative and research, development and engineering expenses increased
$107,000, or 3%, over the previous year. In addition to these costs, the Company
incurred $5,664,000 of one-time expenses related to proxy contest and change of
control costs which resulted from the efforts of Fant Industries Inc. in the
second half of this year to gain control of the Board of Directors. These
expenses included preparation of proxy materials and other information to
shareholders and litigation expenses related to the takeover activity, cash-out
payments made to all stock option holders which were required as a result of the
change of control and reimbursement to Fant Industries Inc. for its expenses as
agreed to by the shareholders. These one-time expenses of $5,664,000 were
entirely a cash outlay with the final amounts paid out in the first quarter of
fiscal 1999.

         1997 vs. 1996: Selling, general and administrative expenses decreased
$65,000, or 3%, in fiscal 1997 from the previous year primarily due to the sale
of the light pen product line at the end of fiscal 1996 and the leveraging
effects of a significantly higher sales level. Research, development and
engineering expenses remained fairly constant in fiscal 1997 versus fiscal 1996.


<PAGE>


         Gain on sale of product line of $215,000 in fiscal 1997 represents the
gain on the sale of the optoelectronic switch assembly business in August 1997.
The $45,000 net gain on sale of product line in fiscal 1996 represents the gain
on the sale of the light pen product line, which was completed in August 1996,
partially offset by costs to close down the light pen product line (see Note 4
of Notes to Financial Statements).

Other, Principally Interest Income. 1998 vs. 1997: Other income increased
$133,000, or 30%, in fiscal 1998 as compared to fiscal 1997 primarily due to
cash received from previously reserved notes receivable.

         1997 vs. 1996: Other income increased $191,000, or 75%, in fiscal 1997
as compared to fiscal 1996 primarily due to increased interest income from
significantly higher short-term investment balances, partially offset by higher
interest expense on the Industrial Development Revenue Bonds.

Net Income (Loss). 1998 vs. 1997: The Company had a net loss of $2,627,000 in
fiscal 1998 compared to net income of $2,550,000 in fiscal 1997. The loss in
fiscal 1998 was a result of decreased revenues and proxy/change of control costs
of $5,664,000. The fiscal 1998 loss also resulted in an income tax benefit of
$1,471,000 and an effective rate of 36%.

         1997 vs. 1996: The Company had net income of $2,550,000 in fiscal 1997
as compared to net income of $2,113,000 in fiscal 1996. Operating income of
$3,533,000 increased $956,000 in fiscal 1997 as compared to fiscal 1996
reflecting the significant 1997 sales increase. The effective tax rate in fiscal
1997 was 36% as compared to 25% in fiscal 1996. The reduced rate in fiscal year
1996 was due to the elimination of a deferred tax asset valuation allowance.

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

         The forward-looking statements included herein are based on current
assumptions that the Company will continue to develop, market, manufacture and
ship products on a timely basis, that competitive conditions within the
Company's markets will not change materially or adversely, that the Company will
continue to identify and satisfy customer needs for products and services, that
the Company will be able to retain and hire key personnel, that its equipment,
process, 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, that the Company does not anticipate a significant financial
impact relating to year 2000 issues, and that there will be no material adverse
change in the Company's operations or business. Assumptions relating to the
foregoing involve judgments that are based on incomplete information and are
subject to many factors that can materially affect results. The Company operates
in a volatile segment of high technology markets and applications that are
subject to rapid change and technical obsolescence.

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

Substantial Fluctuations in Future Operating Results: The Company has
experienced substantial fluctuations in its annual and quarterly operating
results, and such fluctuations are expected to continue in future periods. The
Company's operating results are affected by a number of factors, many of which
are beyond the Company's control. All products manufactured by the Company 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


<PAGE>


materialize to the degree anticipated, if at all. The Company typically incurs
significant start-up costs in the production of a particular product, which
costs are expensed as incurred and for which the Company attempts to seek
reimbursement from the customer. Accordingly, the Company's level of experience
in manufacturing a particular product and its efficiency in minimizing start-up
costs will affect the Company's operating results during the periods in which
production begins and ramp-up occurs. The efficiencies of the Company in
managing inventories and fixed assets, shortages of components or labor, the
degree of automation used in the assembly process, fluctuations in material
costs and the mix of materials, labor, manufacturing, and overhead costs are
also significant factors affecting annual and quarterly operating results. Other
factors contributing to fluctuations in the Company's operating results include
unforeseen design or manufacturing problems, price competition, functional
competition (other means of accomplishing the same or similar packaging end
result), the inability to pass on cost overruns, the timing of expenditures in
anticipation of increased sales, customer product delivery requirements, and the
range of services provided. In addition, the amount and timing of orders placed
by a customer may vary 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
thereof, could adversely affect the Company's annual and quarterly results of
operations.

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

Dependence on Single Industry: During the past several years, the Company has
had significant dependence on a single market. In fiscal 1998, 69% of the
Company's revenues came from sales to hearing instrument manufacturers. In
addition, the Company has made significant sales in the medical products
industry. Each of these industries is characterized by intense competition,
relatively short product life cycles, rapid technological change, significant
fluctuations in product demand, and significant pressure on vendors to reduce or
minimize cost. Although the Company is attempting to reduce its dependence on
any single industry, the Company does not expect this historic dependence to
change dramatically or quickly. Accordingly, the Company will likely be affected
by trends in the industries it serves.

Customer Concentration: The Company's customer base is highly concentrated. In
fiscal 1998, 1997 and 1996, the Company's two largest customers accounted for
73%, 82% and 54%, respectively, of net sales. Although the Company is attempting
to reduce its dependence on a limited number of customers, the Company expects
that sales to a relatively small number of original equipment manufacturers
("OEMs") will continue to account for a substantial portion of net revenues for
the foreseeable future, and the loss of, or a decline in orders from, one of the
Company's key customers would have a material adverse effect on the Company's
financial and operating results.

Competition: The Company operates in a highly competitive industry and competes
against several domestic and foreign providers of similar microelectronics
design and/or manufacturing services. The Company also faces competition from
the internal operations of its current and potential OEM customers, which the
Company believes will continue to evaluate the merits of manufacturing
components internally versus outsourcing, and from offshore contract


<PAGE>


manufacturers, which, because of their lower labor rates and other related
factors, enjoy a comparative advantage over the Company with respect to
high-volume production. The Company expects to encounter future competition from
other electronics manufacturers that currently provide or may begin to provide
contract design and manufacturing services. A number of the Company's
competitors may have substantially greater manufacturing, financial, technical,
marketing, and other resources than does the Company, and may offer a broader
scope and presence of operations on a worldwide basis.

         Significant competitive factors in the microelectronics market include
price, quality, responsiveness, testing capabilities, the ability to manufacture
in very high volumes and proximity to the customers final assembly facilities.
While the Company has competed favorably in the past with respect to these
factors, this is a particularly fast changing market, and there can be no
assurance that the Company will continue to do so in the future. The trends
toward increasingly shorter product cycles and to off-shore production are
expected to result in more intense competition as each new customer program is
generally open to bidding by the Company and its competitors, increasingly
including those with off-shore facilities and capabilities. Further, the Company
is often only one of two or more suppliers on any particular customer
requirement and is therefore subject to continuing competition on existing
programs. In order to remain competitive in any of its markets, the Company must
continually provide timely and technologically advanced design capabilities and
manufacturing services, ensure the quality of its products, and compete
favorably with respect to turnaround and price. If the Company were to fail to
compete favorably with respect to the principal competitive factors in its
markets served, the Company's business and operating results would be adversely
affected.

Component Supply and Sources: Substantially all of the Company's manufacturing
services are provided on a turnkey basis in which the Company, in addition to
providing design, assembly and testing services, is responsible for the
procurement of the components that are assembled by the Company for its
customers. Although the Company attempts to minimize margin erosion as a result
of component price increases, in certain circumstances it is required to bear
some or all of the risk of such price fluctuations, which could adversely affect
the Company's profits. To date, the Company has generally been able to negotiate
contracts that allow it to shift much of the impact of price fluctuations to the
customer; however, there can be no assurance that the Company will be able to do
so in all cases. In addition, in order to assure an adequate supply of certain
key components that have long procurement lead times, such as integrated
circuits, the Company 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 the Company's financial and operating results.

         Some of the assemblies manufactured by the Company 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 the Company's key suppliers could have a material adverse
impact on the financial performance of the Company. From time to time, the
Company's 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 the Company has not experienced sustained periods of shortages of
components in the recent past, there can be no assurance that substantial
component shortages will not occur in the future. Any such shortages could have
a material adverse effect on the Company's operating results.

Variability of Customer Requirements and Customer Financing: 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 and demand for the customers' products. Due in part to these factors,
most of the Company's customers do not commit to firm


<PAGE>


production schedules for more than several weeks in advance of requirements. The
Company's inability to forecast the level of customers' orders with certainty
makes it difficult to schedule production and optimize utilization of
manufacturing capacity. In the past, the Company has been required to increase
staffing and incur other expenses in order to meet the anticipated demands of
its customers. From time to time, anticipated orders from some of the Company's
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 the Company's operating results. On other occasions,
customers have required rapid increases in production that have placed an
excessive burden on the Company's resources. There can be no assurance that the
Company will not experience similar fluctuations in customer demand in the
future. In addition, the Company may carry significant accounts receivable in
connection with providing manufacturing services to its customers. Although the
Company has not encountered significant problems in collecting on such accounts
receivable on a timely basis, if one or more of the Company's principal
customers were to become insolvent, or otherwise fail to pay for the services
and materials provided by the Company, the Company's operating results and
financial condition would be adversely affected.

Rapid Technological Change: The Company's customers compete in markets that are
characterized by rapid technological change and short product life cycles. In
particular, the hearing, medical and telecommunications markets are prone to
rapid product obsolescence by new technologies. The microelectronics industry
could experience future competition from new or emerging technologies that
render existing technology less competitive or obsolete. The inability of the
Company to develop technologies or acquire capability to meet the evolving
market requirements of its customers could have a material adverse effect on the
Company's business, financial condition and results of operations, including the
Company's ability to maintain its revenue base.

Management of Growth: The Company has a recent history of growth, sometimes
followed by significant decreases in revenues as customer demand for the
Company's products decreases. The Company's future operating results will depend
on management's ability to manage periods of both growth and downturn, to be
able to hire, train and retain the appropriate number of qualified employees,
and to forecast revenues and control expenses. Unexpected declines in revenues,
without corresponding and timely reductions in expenses, could have a material
adverse effect on the Company's business, results of operations, or financial
condition.

Hiring and Retention of Employees: The Company's continued growth and success
depend to a significant extent on the continued service of senior management and
other key employees and the hiring of new qualified employees. Competition for
skilled business, product development, technical and other personnel is intense.
There can be no assurance that the Company will be successful in recruiting new
personnel and retaining existing personnel. None of the Company's 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
could have a material adverse effect on the growth of the Company.

Possible Volatility of Stock Price: The market price of the Company's 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 factors such as changes in requirements or demands for the Company's
services, the announcement of new products or product enhancements by the
Company or its competitors, technological innovations by the Company or its
competitors, quarterly variations in the Company's or its competitors' results
of operations, changes in prices of the Company's or its competitors' products
and services, changes in revenue and revenue growth rates of the Company,
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


<PAGE>


sector have experienced wide fluctuations that often have been unrelated to
their operating performance. Such fluctuations may adversely affect the market
price of the Company's Common Stock.

Impact of Year 2000: The Company has considered the impact of Year 2000 on the
computer systems and applications and developed a remediation plan. Conversion
activities are in process and we expect conversion and testing to be completed
by March 1999. Expenditures in 1998 for the Year 2000 project amounted to
approximately $60,000 and the Company expects that completion of the project
will result in additional expenditures of approximately $50,000. The Company is
also assessing the Year 2000 readiness of key material and service providers.

         The Company believes that with modifications to existing systems and
conversions to new systems, the Year 2000 issue will not pose significant
operational problems. However, there can be no assurance that all Year 2000
issues will be identified and resolved in a timely manner, particularly those
issues involving key material and service providers' and other business
affiliates' computer systems outside of the Company's control. If the Company's
remediation plan is not successful, or if these outside systems should fail,
there could be a significant disruption of the Company's ability to transact
business with its customers and suppliers.


<PAGE>
HEI, Inc.
Balance Sheets
--------------
(Dollars in thousands, except per share amounts)

<TABLE>
<CAPTION>
----------------------------------------------------------------------------
As of August 31                                          1998          1997
----------------------------------------------------------------------------
<S>                                                    <C>           <C>
Assets
Current assets:
  Cash and cash equivalents                            $   297       $ 3,458
  Short-term investments                                 7,984         9,175
----------------------------------------------------------------------------
                                                         8,281        12,633
  Accounts receivable, net                               3,434         2,325
  Inventories                                            1,538         1,575
  Income taxes receivable                                1,176            87
  Other current assets                                   1,176           773
----------------------------------------------------------------------------
Total current assets                                    15,605        17,393
----------------------------------------------------------------------------
----------------------------------------------------------------------------
Property and equipment
  Land                                                     216           216
  Building and improvements                              3,897         3,790
  Fixtures and equipment                                 9,018         8,158
  Accumulated depreciation                              (6,859)       (5,558)
----------------------------------------------------------------------------
Net property and equipment                               6,272         6,606
----------------------------------------------------------------------------

Restricted cash                                             --           389
Long-term investments                                      186            --
Deferred financing costs                                   110           123
----------------------------------------------------------------------------
Total assets                                           $22,173       $24,511
----------------------------------------------------------------------------
----------------------------------------------------------------------------

Liabilities and Shareholders' Equity
Current liabilities:
  Current maturities of long-term debt                $   700        $   648
  Accounts payable                                      1,834            728
  Accrued employee related costs                          612            680
  Accrued liabilities                                     595            553
----------------------------------------------------------------------------
Total current liabilities                               3,741          2,609
----------------------------------------------------------------------------
----------------------------------------------------------------------------
Long-term debt, less current maturities                 3,835          4,537
Deferred tax liability                                    256            370
----------------------------------------------------------------------------
Shareholders' equity:
  Undesignated stock; 5,000,000 shares authorized,
    none issued
  Common stock, $.05 par: 10,000,000 shares
    authorized; 4,095,195 and 4,103,176 shares
    issued and outstanding, respectively                  205            205
  Paid-in capital                                       7,491          7,518
  Retained earnings                                     6,645          9,272
----------------------------------------------------------------------------
Total shareholders' equity                             14,341         16,995
----------------------------------------------------------------------------
Total liabilities and shareholders' equity            $22,173        $24,511
----------------------------------------------------------------------------
----------------------------------------------------------------------------
</TABLE>

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



<PAGE>

HEI, Inc.
Statements of Operations
------------------------
(in thousands, except per share amounts)

<TABLE>
<CAPTION>
----------------------------------------------------------------------------
Years Ended August 31                         1998         1997       1996
----------------------------------------------------------------------------
<S>                                         <C>          <C>         <C>
Net sales                                   $20,805      $30,962     $20,680
Cost of sales                                16,592       24,524      14,957
----------------------------------------------------------------------------
Gross profit                                  4,213        6,438       5,723
----------------------------------------------------------------------------
Operating expenses:
  Selling, general and administrative         2,375        2,277       2,342
  Research, development and engineering         852          843         849
Proxy/change of control costs                 5,664           --          --
Gain on sale of product line, net                --         (215)        (45)
----------------------------------------------------------------------------
Operating income (loss)                      (4,678)       3,533       2,577
----------------------------------------------------------------------------
Other, principally interest income              580          447         256
----------------------------------------------------------------------------
Income (loss) before income taxes            (4,098)       3,980       2,833
----------------------------------------------------------------------------
Income tax expense (benefit)                 (1,471)       1,430         720
----------------------------------------------------------------------------
Net income (loss)                           $(2,627)     $ 2,550     $ 2,113
----------------------------------------------------------------------------
Net income (loss) per common share
  Basic                                     $ (0.64)     $  0.62     $  0.54
  Diluted                                   $ (0.64)     $  0.60     $  0.52
----------------------------------------------------------------------------
Weighted average common shares outstanding
  Basic                                       4,085        4,135       3,942
  Diluted                                     4,085        4,279       4,098
----------------------------------------------------------------------------

</TABLE>

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


<PAGE>

HEI, Inc.
Statements of Changes in 
Shareholders' Equity
----------------------
(Dollars in thousands)

<TABLE>
<CAPTION>

-----------------------------------------------------------------------------------------------------------
                                                 Common Stock     Common Stock
                                                       Shares           Amount      Paid-in       Retained
                                                  Outstanding      Outstanding      Capital       Earnings
-----------------------------------------------------------------------------------------------------------
<S>                                               <C>              <C>              <C>           <C>
Balance, August 31, 1995........................   3,791,597           $  190        $6,183        $ 4,609
  Net income....................................        --                --            --           2,113
  Issuance of common shares
    under employee stock purchase
    and option plans............................     238,830               12           636           --
  Tax benefit of nonqualified stock options.....        --                --             73           --
-----------------------------------------------------------------------------------------------------------
Balance, August 31, 1996........................   4,030,427              202         6,892          6,722
  Net income....................................        --                --            --           2,550
  Issuance of common shares
    under employee stock purchase
    and option plans............................     177,049                8           799           --
  Common shares repurchased and retired.........    (104,300)              (5)         (595)          --
  Tax benefit of nonqualified stock options.....        --                --            422           --
-----------------------------------------------------------------------------------------------------------
Balance, August 31, 1997........................   4,103,176              205         7,518          9,272
  Net loss......................................        --                --            --          (2,627)
  Issuance of common shares
    under employee stock purchase
    and option plans............................      26,819                1           159           --
  Common shares repurchased and retired ........     (34,600)              (1)         (186)          --
-----------------------------------------------------------------------------------------------------------
Balance, August 31, 1998                           4,095,195           $  205        $7,491        $ 6,645
-----------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------

</TABLE>

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


<PAGE>


HEI, Inc.
Statements of Cash Flows
------------------------

(In thousands)

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------
Years Ended August 31                                             1998         1997        1996
-----------------------------------------------------------------------------------------------------
<S>                                                            <C>           <C>          <C>
Cash flow provided by operating activities:
  Net income (loss)                                            $ (2,627)     $  2,550     $  2,113
  Depreciation                                                    1,358         1,376          907
  Amortization                                                       60            70           31
  Accounts receivable and inventory allowances                       (1)           59         (222)
  Deferred income tax expense (benefit)                            (242)            8         (198)
  Gain on sale of product line, net                                  --          (215)         (45)
  Other                                                               1            35           51
Change in current operating items:
  Accounts receivable                                            (1,056)        1,701       (1,539)
  Inventories                                                       (15)          (60)         537
  Income taxes                                                   (1,089)         (656)         394
  Other current assets                                             (512)         (133)        (112)
  Accounts payable                                                1,106           256           88
  Accrued employee related costs and accrued liabilities            (26)         (121)         311
-----------------------------------------------------------------------------------------------------
Net cash flow provided by (used for) operating activities        (3,043)        4,869        2,316
-----------------------------------------------------------------------------------------------------
Cash flow used for investing activities:
  Purchases of investments                                      (15,185)      (10,892)      (7,033)
  Maturities of investments                                      16,170         7,205        5,365
  Additions to property and equipment                            (1,025)       (1,605)      (4,621)
  Proceeds on sales of product lines and equipment                  237           494           --
  Decrease (increase) in restricted cash                            389         2,066       (2,455)
-----------------------------------------------------------------------------------------------------
Net cash flow provided by (used by) investing activities            606        (2,732)      (8,744)
-----------------------------------------------------------------------------------------------------
Cash flow provided by financing activities:
  Proceeds from long-term debt                                       --            --        5,625
  Repayment of long-term debt                                      (650)         (440)          --
  Increase in deferred financing costs                              (47)          (54)        (170)
  Issuance of common stock and other                                159           807          648
  Tax benefit of nonqualified stock options                          --           422           73
  Repurchase of common shares                                      (186)         (600)          --
-----------------------------------------------------------------------------------------------------
Net cash flow provided by (used for) financing activities          (724)          135        6,175
-----------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents             (3,161)        2,272         (252)
Cash and cash equivalents, beginning of year                      3,458         1,186        1,438
-----------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year                         $    297      $  3,458      $ 1,186
-----------------------------------------------------------------------------------------------------

Supplemental disclosures of cash flow information:
-----------------------------------------------------------------------------------------------------
Interest paid                                                  $    201      $    218      $    80
Income taxes paid                                                   100         1,656          515
-----------------------------------------------------------------------------------------------------

</TABLE>

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


<PAGE>


Notes to Financial Statements

NOTE 1
--------------------------------------------------------------------------------
Summary of Significant Accounting Policies
HEI, Inc. (the Company) specializes in the design and manufacture of
ultraminiature microelectronic devices and high technology products
incorporating those devices.

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 in accordance with Statement of Financial Accounting Standards
No. 115 (SFAS No. 115).

Inventories. Inventories are stated at the lower of cost or market and include
materials, labor and overhead costs. The first-in, first-out cost method is used
to value inventories.
 
        The allowance for excess or obsolete stock is determined based on the
Company's continuing analysis of inventory levels in excess of current
requirements or considered to be obsolete. The Company has established an
allowance to record such inventories at estimated net realizable value.

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 charged or credited to operations.

Long-Lived Assets. The Company evaluates the recoverability of long-lived assets
in accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed of". This statement requires
long-lived assets and certain identifiable intangibles to be evaluated for
impairment whenever events or changes in circumstances indicate that the
carrying value of an asset may not be recoverable. As of August 31, 1998, the
Company did not consider any of its assets to be impaired.

Income Taxes. Deferred income tax assets and liabilities are recognized for the
expected future tax consequences of events that have been included in the
financial statements or 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.

Accounting for Stock-based Compensation. In October 1995, the Financial
Accounting Standards Board (FASB) issued SFAS No. 123 "Accounting for
Stock-based Compensation", a new standard of accounting and reporting for
stock-based compensation plans. The Company adopted the disclosure provisions in
fiscal 1997. The Company has continued to measure compensation cost, if any, for
its stock option plans using the intrinsic value based method of 


<PAGE>


accounting it has historically used and, therefore, the new standard has no
effect on the Company's operating results.

Revenue Recognition. Revenue is recognized at the time of shipment.

Net Income (Loss) Per Weighted Average Common Share. In February 1997, SFAS No.
128, "Earnings per Share" (EPS) was issued by the FASB. This standard, which the
Company adopted effective with its second quarter of fiscal 1998, requires dual
presentation of basic and diluted EPS on the face of the statement of
operations.
         Basic earnings per share is computed by dividing net income (loss) by
the weighted average number of common shares outstanding. Diluted earnings per
share is computed by dividing net income (loss) by the weighted average number
of common shares outstanding assuming the exercise of dilutive stock options.
The dilutive effect of the stock options is computed using the average market
price of the Company's stock during each period under the treasury stock method.
All prior period earnings per share have been recalculated in accordance with
SFAS No. 128.

Use of Estimates. The preparation of financial statements in conformity with
generally accepted accounting principles 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 expenses during the reporting period.
Actual results could differ from those estimates.


NOTE 2
--------------------------------------------------------------------------------
Proxy/Change of Control Costs

The Company incurred $5,664,000 of one-time expenses related to proxy contest
and change of control costs which resulted from the efforts of Fant Industries
Inc. in the second half of this year to gain control of the Board of Directors.
These expenses included preparation of proxy materials and other information to
shareholders and litigation expenses related to the takeover activity, cash-out
payments made to all stock option holders which were required as a result of the
change of control and reimbursement to Fant Industries Inc. for its expenses as
agreed to by the shareholders. These one-time expenses of $5,664,000 were
entirely a cash outlay with the final amounts paid out in the first quarter of
fiscal 1999.


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:
<TABLE>
<CAPTION>

------------------- ------------------ ----------------- ------------------
                                 1998              1997               1996
------------------- ------------------ ----------------- ------------------
<S>                               <C>               <C>                <C>
Customer A                        59%               27%                38%
Customer B                        14%                 -                  -
Customer C                          -               55%                16%
Customer D                          -                 -                10%
------------------- ------------------ ----------------- ------------------

</TABLE>


         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. Customer C's product program was completed
during the fourth quarter of 


<PAGE>


fiscal 1997. The Company's ten largest customers accounted for approximately 96%
of net sales in fiscal 1998, 95% in fiscal 1997, and 88% in fiscal 1996 and
approximately 96% and 87% of accounts receivable at August 31, 1998 and 1997,
respectively.

         The Company had net sales of $10,407,000, $6,647,000 and $5,924,000 to
Singapore in fiscal 1998, 1997, and 1996, respectively, and $14,970,000 to
Thailand in fiscal 1997. Net export sales were $11,819,000, $22,604,000 and
$7,278,000 in fiscal 1998, 1997 and 1996, respectively. The majority of the
international sales were to multinational companies who instructed HEI to ship
products to their own off-shore assembly facilities.

NOTE 4
--------------------------------------------------------------------------------
Other Financial Statement Data

The following provides additional information concerning selected balance sheet
accounts at August 31, 1998 and 1997:
<TABLE>
<CAPTION>

------------------------------------------- ----------------------- ----------------------
(In thousands)                                             1998                    1997
------------------------------------------- ----------------------- ----------------------
<S>                                                      <C>                     <C>
Accounts receivable, net:
  Trade accounts receivable                              $3,664                  $2,608
  Less allowance for doubtful accounts                     (230)                   (283)
------------------------------------------- ----------------------- ----------------------
                                                         $3,434                  $2,325
------------------------------------------- ----------------------- ----------------------
Inventories:
  Purchased parts                                        $1,590                  $1,557
  Work in process                                           681                     556
  Finished goods                                             76                     220
  Less allowance for excess
     or obsolete stock                                     (809)                   (758)
------------------------------------------- ----------------------- ----------------------
                                                         $1,538                  $1,575
------------------------------------------- ----------------------- ----------------------
Other current assets:
  Deferred tax assets                                    $  688                  $  560
  Deposits on operating leases                              456                       -
  Receivable on sale of product line, net                    12                     114
  Other current assets                                       20                      99
------------------------------------------- ----------------------- ----------------------
                                                         $1,176                  $  773
------------------------------------------- ----------------------- ----------------------
Accrued liabilities:
  Real estate taxes                                      $    90                 $  136
  Other                                                     505                     417
------------------------------------------- ----------------------- ----------------------
                                                         $  595                  $  553
------------------------------------------- ----------------------- ----------------------


</TABLE>


Sale of Product Lines. In August 1997 and 1996, the Company sold its
optoelectronic switch assembly and light pen product lines, respectively.
Through these transactions, the buyers acquired certain assets including
manufacturing equipment and related inventory, product licenses and assumed all
warranties. In connection with these sales, the Company received cash payments
for the assets and an agreement for additional amounts to be paid monthly over
the subsequent two years. At August 31, 1996, as a result of the sale of the
light pen product line, costs associated with the close down of this product
line were accrued and were included in the $45,000 net gain from the sale of
product line. The Company anticipates no substantial effect of the sale of these
product lines on future operating results.

NOTE 5
--------------------------------------------------------------------------------
Financing Arrangements

In April 1996, the Company received proceeds of $5,625,000 from the issuance of
Industrial Development Revenue Bonds. Of these funds, approximately $1,500,000
was used for the 


<PAGE>


construction of the new addition to the Company's manufacturing facility, and 
the remainder was used for equipment purchases. The bonds related to the 
facility expansion require annual principal payments of $90,000 in the first 
year and $95,000 on April 1 of each year thereafter through 2011. The bonds 
related to the purchased equipment require payments over seven years from the 
date of purchase of the equipment through April 1, 2005. In April 1998 and 
1997 the Company repaid $650,000 and $440,000 of the construction and 
equipment bonds. The bonds bear interest at a rate which varies weekly, based 
on comparable tax exempt issues, and is limited to a maximum rate of 10%. The 
interest rate at August 31, 1998 was 3.70%. The bonds are collateralized by 
two irrevocable letters of credit and essentially all property and equipment. 
A commitment fee is paid annually to the bank at a rate of 1% of the letters 
of credit. The letter of credit reimbursement agreement contains certain 
restrictive covenants including limitations on other borrowings and 
maintenance of specified financial levels and ratios for net income, tangible 
net worth, debt to tangible net worth, cash flow and indebtedness. Due to the 
Company's one-time $5,664,000 proxy/change of control costs, the Company was 
in default of certain of these covenants. The Company received waivers for 
its covenant defaults. Restricted cash on the balance sheet represented cash 
advanced under the bonds which was held by the bond trustee in an interest 
bearing account and was released to the Company in fiscal 1998.

         Also in fiscal 1998, the Company extended the due date of its
$3,000,000 revolving line of credit to January 1999. At August 31, 1998 and
1997, there were no borrowings under the line of credit. Any borrowings under
this agreement would be collateralized by accounts receivable. The agreement
contains certain restrictive covenants including limitations on other borrowings
and maintenance of specified financial levels and ratios for net income,
tangible net worth and debt to tangible net worth and cash flow. Due to the
Company's one-time $5,664,000 proxy/change of control costs, the Company was in
default of certain of these covenants. The Company received waivers for its
covenant defaults. The agreement also includes a covenant which limits the sale
of assets not in the ordinary course of business. In accordance with the
agreement, the Company received waivers for the sale of each product line.
Borrowings are limited to the lesser of $3,000,000 or the borrowing base, which
is 80% of eligible accounts receivable. Interest on the borrowings is based, at
the Company's option, on the lender's prime rate of interest or at 2% above the
lender's LIBOR rate.

         Principal maturities of long-term debt at August 31, 1998 are as
follows (in thousands):
<TABLE>
<CAPTION>

        Years ending August 31,
<S>                                                           <C>
        1999                                                     $  700
        2000                                                        700
        2001                                                        700
        2002                                                        700
        2003                                                        700
        Thereafter                                                1,035
     ------------------------------------- -----------------------------
                                                                 $4,535
     ------------------------------------- -----------------------------

</TABLE>



NOTE 6
--------------------------------------------------------------------------------
Income Taxes

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

--------------------------------- ----------------- ----------------- -----------------
(In thousands)                              1998              1997              1996
--------------------------------- ----------------- ----------------- -----------------
<S>                                      <C>                <C>                 <C>
Current:
  Federal                                $(1,234)           $1,279              $829
  State                                        5               143                89
Deferred                                    (242)                8              (198)
--------------------------------- ----------------- ----------------- -----------------
Income tax expense (benefit)             $(1,471)           $1,430              $720
--------------------------------- ----------------- ----------------- -----------------

</TABLE>


<PAGE>


         The components of the deferred tax assets and liabilities at August 31,
1998 and 1997 are as follows:
<TABLE>
<CAPTION>

--------------------------------------------- ----------------------- -----------------------
(In thousands)                                                1998                    1997
--------------------------------------------- ----------------------- -----------------------
<S>                                                          <C>                     <C>  
Deferred tax assets:
  Receivables                                                $ 105                   $ 160
  Inventories                                                  324                     282
  Accrued liabilities                                          151                     118
  Net operating loss carry-forward                             108                       -
--------------------------------------------- ----------------------- -----------------------
--------------------------------------------- ----------------------- -----------------------
                                                             $ 688                   $ 560
--------------------------------------------- ----------------------- -----------------------
Deferred tax liabilities:
  Property and equipment                                     $(238)                  $(263)
  Deferred gain on sales of product lines                      (18)                   (107)
--------------------------------------------- ----------------------- -----------------------
                                                             $(256)                  $(370)
--------------------------------------------- ----------------------- -----------------------

</TABLE>


         In fiscal 1996, the Company eliminated the valuation allowance of
$274,000 for the deferred tax asset related to the allowance established for
excess or obsolete inventories due to the sale and disposal of light pen
inventories during the fourth quarter of fiscal 1996 and the determination that
the deferred tax asset related to the remaining inventory allowance will more
likely than not be recoverable.

         A reconciliation of the statutory federal income tax rate for the years
ended August 31 is as follows:
<TABLE>
<CAPTION>

----------------------------------- ------------------ ------------------- ------------------
                                             1998                1997                1996
----------------------------------- ------------------ ------------------- ------------------
<S>                                           <C>                  <C>                 <C>  
Federal statutory tax rate                    (34.0)%              34.0%               34.0%
State income tax rate
  (net of federal tax effect)                  (3.0)                2.4                 2.7
Reversal of valuation allowance                 -                   -                  (9.7)
Other                                           1.1                 (.5)               (1.6)
----------------------------------- ------------------ ------------------- ------------------
Effective tax rate                            (35.9)%              35.9%               25.4%
----------------------------------- ------------------ ------------------- ------------------

</TABLE>


NOTE 7
--------------------------------------------------------------------------------
Stock Benefit Plans

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.
Generally, the exercise price for options granted is equal to the average
closing market price of the common stock for the five days preceding the date of
grant.

         Under the 1989 Plan, substantially all regular full-time employees are
given the opportunity to designate up to 10% of their annual compensation to be
withheld, through payroll deductions, for the purchase of common stock at 85% of
the lower of (i) the market price at the beginning of the plan year, or (ii) the
market price at the end of the plan year. During fiscal 1998, 1997 and 1996,
11,619, 12,049 and 26,330 shares at prices of $5.79, $5.08 and $3.96,
respectively, were purchased under the 1989 Plan.

         At August 31, 1998, 1997 and 1996, the number of shares available for
grant were 428,062, 179,681 and 214,230, respectively.

Directors' Plan. Under the directors' plan, 400,000 shares are authorized for
issuance, with an annual grant of 10,000 shares to each non-employee director.
These grants are effective on the first business day following the annual
shareholders' meeting at an exercise price equal to the average closing market
price of the common stock for the five days preceding the date of grant. The
options become exercisable one year after the grant date and expire ten years
after the grant 


<PAGE>


date. Options to purchase 40,000 shares were granted each year to the four
non-employee directors at $11.325 per share and $6.00 per share in 1997 and
1996, respectively. Options to purchase 30,000 shares were granted to the three
non-employee directors at $4.925 in 1998. At August 31, 1998, no options for
shares remain outstanding and 130,000 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. In fiscal 1998, all stock options were liquidated under this provision.
The required payments relating to stock options outstanding due to the change of
control liquidation made in fiscal 1998 were approximately $3,700,000 which are
included in proxy/change of control costs in the statement of operations.

Summary of Activity. The following is a summary of all activity involving
options:

<TABLE>
<CAPTION>

---------------------------------- ---------------- ---------------------
                                                    Weighted Average
                                        Options     Exercise Price
                                    Outstanding         Per Share
---------------------------------- ---------------- ---------------------
<S>                                     <C>                    <C>   
Balance, August 31, 1995                692,000                $4.061
Granted                                 110,000                 5.920
Exercised                              (212,500)                2.473
---------------------------------- ---------------- ---------------------
Balance, August 31, 1996                589,500                 4.980
---------------------------------- ---------------- ---------------------
Granted                                  40,000                11.325
Exercised                              (165,000)                4.527
Cancelled                               (17,500)                4.713
---------------------------------- ---------------- ---------------------
Balance, August 31, 1997                447,000                 5.680
---------------------------------- ---------------- ---------------------
Granted                                 575,000                 5.160
Exercised                               (15,000)                5.308
Change of control liquidation          (972,000)                5.397
Cancelled                               (35,000)                5.305
---------------------------------- ---------------- ---------------------
Balance, August 31, 1998                      0                $0.000
---------------------------------- ---------------- ---------------------

</TABLE>


         During fiscal 1998, terms of all outstanding stock options were
modified to extend the expiration to ten years after 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 1996 and charged compensation cost against income over the vesting
period, net income (loss) for fiscal years 1998, 1997 and 1996 would have been
changed to the following pro forma amounts:
<TABLE>
<CAPTION>

--------------------------------------- ------------------- -------------------- ---------------------
                                               1998                1997                  1996
--------------------------------------- ------------------- -------------------- ---------------------
<S>                                        <C>                  <C>                   <C>
Net income (loss)                          $(2,636,000)         $2,384,000            $2,023,000

Net income (loss) per share, diluted         $ (.65)               $ .56                $ .49
--------------------------------------- ------------------- -------------------- ---------------------

</TABLE>


         The weighted average grant-date fair value of options granted during
1998, 1997 and 1996 was $1.22, $5.59 and $2.92, 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
grant on the date of grant, utilizing the Black-Scholes option-pricing model and
the following key weighted average assumptions:
<TABLE>
<CAPTION>

---------------------------------------------- -------------------- ------------------- --------------------
                                                      1998                 1997                1996
---------------------------------------------- -------------------- ------------------- --------------------
<S>                                             <C>                 <C>                 <C>
Risk-free interest rates                         5.00% to 5.50%       6.00% to 6.35%      5.22% to 6.31%





</TABLE>


<PAGE>

<TABLE>
<CAPTION>

---------------------------------------------- -------------------- ------------------- --------------------
                                                      1998                 1997                1996
---------------------------------------------- -------------------- ------------------- --------------------
<S>                                             <C>                 <C>                 <C>

Expected life                                     .5 to 3 years       .5 to 5 years        .5 to 5 years
Expected volatility                                    62%                 62%                  58%
Expected dividends                                    None                 None                None
---------------------------------------------- -------------------- ------------------- --------------------

</TABLE>


NOTE 8
--------------------------------------------------------------------------------
Employee Benefit Plans

The Company has a 401(k) plan covering all eligible employees. Employees can
make voluntary contributions to the plan of up to 20% of their compensation not
to exceed the maximum specified by the Internal Revenue Code. The plan also
provides for a discretionary contribution by the Company. During fiscal years
1998, 1997 and 1996, the Company contributed $93,000, $100,000 and $96,000,
respectively, to the plan.

NOTE 9
--------------------------------------------------------------------------------
Commitments

Future commitments under non-cancelable operating leases, primarily for
manufacturing equipment, are approximately $216,000 in 1999, $198,000 in 2000
and $72,000 in 2001. Total expense under non-cancelable operating leases was
approximately $153,000 in 1998, $66,000 in 1997 and $64,000 in 1996.

NOTE 10
--------------------------------------------------------------------------------
Net Income (Loss) Per Weighted Average Share Computation

The components of net income (loss) per basic and diluted share are as follows:
<TABLE>
<CAPTION>
-------------------------------------------------------- ------------------ ---------------
(In thousands, except per share amounts)                           1998            1997
-------------------------------------------------------- ------------------ ---------------
<S>                                                               <C>               <C> 
Basic:
Net income (loss)                                                 $(2,627)          $2,550
Net income (loss) per share                                       $  (.64)          $  .62

Weighted average number of common shares outstanding                 4,085           4,135
-------------------------------------------------------- ------------------ ---------------

Diluted:
Net income (loss)                                                 $(2,627)          $2,550
Net income (loss) per share                                       $  (.64)          $  .60

Weighted average number of common shares outstanding                 4,085           4,135
 Assumed conversion of stock options                                     -             144
-------------------------------------------------------- ------------------ ---------------
Weighted average common and assumed conversion shares                4,085           4,279
-------------------------------------------------------- ------------------ ---------------

</TABLE>








<PAGE>


Report of Independent Accountants

To the Shareholders of HEI, Inc.:
We have audited the accompanying balance sheet of HEI, Inc. as of August 31,
1998 and the related statement of operations, changes in shareholders' equity,
and cash flows for the year then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audit. The accompanying
financial statements of HEI, Inc. as of and for the years ended August 31, 1997
and 1996 were audited by other auditors whose report, dated September 26, 1997,
expressed an unqualified opinion on those statements.

We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the 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 audit provides a reasonable basis for our opinion.

In our opinion, the 1998 financial statements referred to above present fairly,
in all material respects, the financial position of HEI, Inc. as of August 31,
1998 and the results of its operations and its cash flows for the year then
ended, in conformity with generally accepted accounting principles.




KPMG Peat Marwick LLP
Minneapolis, Minnesota
October 12, 1998










<PAGE>


Statement of Financial Responsibility

The accompanying 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
financial statements have been prepared in accordance with generally accepted
accounting principles 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 independent accountants, as
well as with management, to review accounting, auditing, and financial reporting
matters.

On September 25, 1998, the Company's Board of Directors took action to approve
the engagement of KPMG Peat Marwick LLP (KPMG) as the Company's independent
accountants following the September 3, 1998 resignation of
PricewaterhouseCoopers LLP (PwC), the Company's independent accountants for the
past five years. The report by PwC on the Company's financial statements for
fiscal years ended August 31, 1997 and 1996 did not contain an adverse opinion
or disclaimer of opinion nor were they qualified or modified as to uncertainty,
scope, or accounting principles. During the Company's fiscal years ended August
31, 1997 and 1996, and the period from September 1, 1997 to September 3, 1998,
there were no disagreements with PwC on any matter of accounting principles or
practices, financial statement disclosure, or auditing scope or procedure, that
if not resolved to the satisfaction of PwC would have caused it to make a
reference to such disagreement in its report nor any reportable events as
defined in Item 304(a) (1) (v) of Regulation S-K. Prior to the engagement of
KPMG, neither the Company nor anyone acting on its behalf consulted KPMG on any
matter of accounting principles or the application of such principles to a
particular transaction.

The Company's independent accountants, KPMG, are engaged to audit the financial
statements of the Company and to issue their report thereon. See the
accompanying Report of Independent Accountants.






<PAGE>


Summary of Quarterly Operating Results (unaudited)
(In thousands, except per share amounts)
<TABLE>
<CAPTION>

----------------------------------- -------------- -------------- -------------- --------------

Fiscal Year 1998                            First         Second          Third         Fourth
----------------------------------- -------------- -------------- -------------- --------------
<S>                                        <C>            <C>            <C>            <C>   
Net sales                                  $4,080         $4,632         $6,026         $6,067
Gross profit                                  537            992          1,414          1,270
Proxy/change of control costs                   -              -            274          5,390
Operating income (loss)                     (266)            137            336         (4,885)
Net income (loss)                           (104)            204            347         (3,074)
----------------------------------- -------------- -------------- -------------- --------------
Net income (loss) per share
   Basic                                  $ (.03)         $  .05         $  .08         $ (.75)
   Diluted                                $ (.03)         $  .05         $  .08         $ (.75)
----------------------------------- -------------- -------------- -------------- --------------

Fiscal Year 1997                            First         Second          Third         Fourth
----------------------------------- -------------- -------------- -------------- --------------
Net sales                                  $6,258         $9,197         $9,067         $6,440
Gross profit                                2,383          1,629          1,528            898
Operating income                            1,563            809            744            417
Net income                                  1,010            591            539            410
----------------------------------- -------------- -------------- -------------- --------------
Net income per share
   Basic                                  $   .25        $   .14        $   .13        $   .10
   Diluted                                $   .24        $   .14        $   .13        $   .10
----------------------------------- -------------- -------------- -------------- --------------

</TABLE>

NOTE:
The summation of quarterly net income (loss) per share for 1998 and on a diluted
basis for 1997 does not equate to the calculation for the year since the
quarterly calculations are performed on a discrete basis.

Corporate Information

HEI INC

Board of Directors
Anthony J. Fant, Chairman
Chief Executive Officer
of the Company, President
and Chief Executive Officer
Fant Industries Inc.

Eugene W. Courtney
Business Consultant

Edwin W. Finch, III
President
FHL Capital Corporation

David W. Ortlieb
Independent Management Consultant

Steve E. Tondera, Jr.
Senior Vice President
and Chief Financial Officer
Fant Industries Inc.

Mack V. Traynor, III
President and


<PAGE>


Chief Executive Officer
NEO Networks

Corporate Officers
and Management
Anthony J. Fant
Chief Executive Officer

Donald R. Reynolds
President

Jerald H. Mortenson
Vice President of Finance
and Administration,
Chief Financial Officer
and Treasurer

Dale A. Nordquist
Vice President of Sales
and Marketing

Stephen K. Petersen
Director of Manufacturing

Scott J. Kazle
Director of Research and Development

Wray A. Wentworth
Director of Corporate Quality

General Counsel
Brown & Wood LLP
New York, New York

Independent Accountants
KPMG Peat Marwick LLP
Minneapolis, Minnesota

Stock Transfer Agent
and Registrar
Norwest Bank Minnesota, N.A.
Box 738
161 North Concord Exchange
South St. Paul
Minnesota  55075-0738

Corporate Headquarters
HEI, Inc.
P.O. Box 5000
1495 Steiger Lake Lane
Victoria, Minnesota  55386-5000
(612) 443-2500
E-mail: headqtrs@heii.com
Internet: www.heii.com


<PAGE>


Form 10-KSB A copy of the Company's Annual
Report to the Securities and
Exchange Commission on Form
10-KSB is available without
charge by written or oral request
to:

Shareholder Relations
HEI, Inc.
P.O. Box 5000
Victoria, Minnesota  55386
Phone (612) 443-2500
Facsimile (612) 443-2668

Annual Meeting of Shareholders
The Company's annual meeting of
shareholders will be held on
January 20, 1999 at 3:00 PM at
The Planets (50th floor),
IDS Center, 80 South Eighth Street,
Minneapolis, Minnesota.



Market Price and Related Matters
The Company's common stock is currently traded on The Nasdaq National Market
under the symbol HEII. Below are the high and low closing bid prices for each
quarter of fiscal year 1998 and 1997, as reported by Nasdaq.
<TABLE>
<CAPTION>

1998                                              High               Low
<S>                                          <C>                <C>
First Quarter                                $   5-3/4          $4-11/32
Second Quarter                                   7-3/8             4-1/4
Third Quarter                                    7-1/4             6-1/8
Fourth Quarter                                 6-15/16             4-3/4

1997                                              High               Low
First Quarter                                $   9-1/2         $   6-3/8
Second Quarter                                      12                 8
Third Quarter                                    9-1/4             4-1/4
Fourth Quarter                                       6            4-9/16

</TABLE>


As of August 31, 1998, the Company had approximately 2,500 shareholders of which
approximately 525 are shareholders of record. The Company has not declared cash
dividends.