e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

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FORM 10-Q

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þ		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended November 26, 2005.


o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the transition period from to .

Commission File Number 0-10078

HEI, Inc.

(Exact name of Registrant as Specified in Its Charter)


Minnesota		41-0944876

(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

PO Box 5000, 1495 Steiger Lake Lane, Victoria, MN		55386

(Address of principal executive offices)		(Zip Code)

(952) 443-2500
Registrant’s telephone number, including area code

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.


Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of January 4, 2006, 9,479,567 Common Shares, par value $.05 per share, were outstanding.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

HEI, Inc.

Consolidated Balance Sheets

(In thousands, except per share and share data)


	November 26 ,			August 31,
	2005			2005
	(Unaudited)			(Audited)
ASSETS
Current assets:
Cash and cash equivalents	$	826		$	351
Accounts receivable, net of allowance for doubtful accounts of $157		8,227			9,278
Inventories		7,797			8,044
Security deposit		—			1,350
Other current assets		730			1,136

Total current assets		17,580			20,159

Property and equipment:
Land		216			216
Building and improvements		4,323			4,323
Fixtures and equipment		23,393			23,214
Accumulated depreciation		(21,394	)		(20,864	)

Net property and equipment		6,538			6,889

Developed technology, less accumulated amortization of $383 and $352, respectively		31			62
Security deposit		230			230
Other long-term assets		649			337

Total assets	$	25,028		$	27,677


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Line of credit	$	1,143		$	2,563
Current maturities of long-term debt		500			484
Accounts payable		3,354			4,019
Accrued liabilities		3,729			4,129

Total current liabilities		8,726			11,195

Other long-term liabilities, less current maturities		913			873
Long-term debt, less current maturities		1,771			1,813

Total other long-term liabilities, less current maturities		2,684			2,686

Total liabilities		11,410			13,881

Commitments and contingencies Shareholders’ equity:
Undesignated stock; 1,833,000 shares authorized; none issued		—			—
Convertible preferred stock, $.05 par; 167,000 shares authorized; 32,000 shares issued and outstanding; liquidation preference at $26 per share (total liquidation preference $832)		2			2
Common stock, $.05 par; 13,000,000 shares authorized; 9,479,000 and 9,379,000 shares issued and outstanding		474			469
Paid-in capital		27,148			26,701
Accumulated deficit		(13,799	)		(13,169	)
Notes receivable-related parties-officers and former directors		(207	)		(207	)

Total shareholders’ equity		13,618			13,796

Total liabilities and shareholders’ equity	$	25,028		$	27,677

See accompanying notes to unaudited consolidated financial statements.

HEI, Inc.

Consolidated Statements of Cash Flows (Unaudited)
(In thousands)


	Three Months Ended
	November 26, 2005			November 27, 2004
Cash flow from operating activities:
Net income (loss)	$	(630	)	$	415
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation and amortization		585			645
Loss on disposal of property and equipment		—			15
Stock based compensation expense		116			—
Changes in operating assets and liabilities:
Restricted cash related to deferred litigation		—			481
Accounts receivable		1,051			(1,476	)
Inventories		247			(808	)
Other current assets		406			444
Accounts payable		(665	)		281
Accrued liabilities and other long-term liabilities		(360	)		(795	)

Net cash flow provided by (used in) operating activities		750			(798	)

Cash flow from investing activities:
Additions to property and equipment		(58	)		(338	)
Additions to patents		—			(54	)
Refund of security deposit		1,350			—

Net cash flow provided by (used in) investing activities		1,292			(392	)

Cash flow from financing activities:
Note repayment		—			20
Repayment of long-term debt		(147	)		(103	)
Net borrowings (repayments) on line of credit		(1,420	)		1,377

Net cash flow provided by (used in) financing activities		(1,567	)		1,294

Net increase in cash and cash equivalents		475			104
Cash and cash equivalents, beginning of period		351			200

Cash and cash equivalents, end of period	$	826		$	304

*Supplemental disclosures of cash flow information:*
Interest paid	$	143		$	169
Capital lease obligations related to equipment acquisitions	$	121			—
Issuance of common stock to landlord recorded as long-term asset	$	336			—

See accompanying notes to unaudited consolidated financial statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share and per share data)

(1) Basis of Financial Statement Presentation

The accompanying unaudited interim consolidated financial statements have been prepared by HEI, Inc. pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). These financial statements contain all normal recurring adjustments, which are, in our opinion, necessary for a fair presentation of the financial position, results of operations and cash flows in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. We believe, however, that the disclosures are adequate to make the information presented not misleading. The year-end balance sheet data was derived from audited financial statements but does not include all disclosures required by GAAP. These unaudited interim consolidated financial statements should be read in conjunction with the financial statements and accompanying notes included in our Annual Report on Form 10-K for our fiscal year ended August 31, 2005 (“Fiscal 2005”). Interim results of operations for the three-month period ended November 26, 2005, may not necessarily be indicative of the results to be expected for the full year.

The unaudited interim consolidated financial statements include the accounts of our wholly-owned subsidiary. All significant intercompany transactions and balances have been eliminated in consolidation.

Our quarterly periods end on the Saturday closest to the end of each quarter of our fiscal year ending August 31.

Summary of Significant Accounting Policies

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

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

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

(2) Liquidity

The accompanying unaudited consolidated financial statements have been prepared assuming that the realization of assets and the satisfaction of liabilities will occur in the normal course of business. We incurred a net loss of $630 for the three months ended November 26, 2005 and net income of $355 for the year ended August 31, 2005.

We have historically financed our operations through the public and private sale of equity securities, bank borrowings, operating equipment leases and cash generated by operations.

At November 26, 2005, our sources of liquidity consisted of $826 of cash and cash equivalents and our accounts receivable agreement (“Credit Agreement”) with Beacon Bank of Shorewood, Minnesota, which provides borrowing capacity up to $5.0 million subject to availability based on our accounts receivable. The Credit Agreement is due to expire in September 2006. There was $1,143 outstanding debt under the Credit Agreement at November 26, 2005.

On May 9, 2005, we sold 130,538 shares of our Series A Convertible Preferred Stock which provided net proceeds of $3.2 million to the Company. In addition, on November 23, 2005, we received $1,350 refund of our security deposit on our Boulder facility. These actions enabled us to fund working capital requirements and acquire manufacturing equipment.

Our liquidity, however, is affected by many factors, some of which are based on the normal ongoing operations of our business, the most significant of which include the timing of the collection of receivables, the level of inventories and capital expenditures. In the event cash flows are not sufficient to fund operations at the present level measures can be taken to reduce the expenditure levels including but not limited to reduction of spending for research and development, engineering, elimination of budgeted raises, and reduction of non-strategic employees and the deferral or elimination of capital expenditures. In addition, we believe that other sources of liquidity are available including issuance of the Company’s stock, the expansion of our Credit Agreement and the issuance of long-term debt.

(3) Stock Based Compensation

On December 16, 2004, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards (SFAS) No. 123(R), “Share-Based Payment”, which is a revision of SFAS No. 123 and supersedes APB Opinion No. 25. SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. Pro forma disclosure of the income statement effects of share-based payments is no longer an alternative. SFAS No. 123(R) is effective for all share-based awards granted on or after September 1, 2005. In addition, companies must also recognize compensation expense related to any awards that are not fully vested as of the effective date. Compensation expense for the unvested awards will be measured based on the fair value of the awards previously calculated in developing the pro forma disclosures in accordance with the provisions of SFAS No. 123. We implemented SFAS No. 123(R) on September 1, 2005 using the modified prospective method.

As more fully described in our Annual Report on Form 10-K for the year ended August 31, 2005, we have granted stock options over the years to employees and Directors under various stockholder approved stock option plans. As of November 26, 2005, 1,637,975 stock options are outstanding. The fair value of each option grant was determined as of grant date, utilizing the Black-Scholes option pricing model. Based on these valuations, we recognized compensation expense of $116 ($0.01 per share) in the quarter ended November 26, 2005 related to the amortization of the unvested portion of these options as of the September 1, 2005. The amortization of each option grant will continue over the remainder of the vesting period of each option grant . We expect that the impact on earnings for the remainder of Fiscal 2006 for stock based compensation will be approximately $400 and estimate the impact on future earnings to be approximately $700.

In prior years, we applied the intrinsic-value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for the issuance of stock incentives to employees and directors. No compensation expense related to employees’ and directors’ stock incentives were recognized in the prior year financial statements, as all options granted under stock incentive plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Had we applied the fair value recognition provisions of “SFAS” No. 123, “Accounting for Stock-Based Compensation,” to stock based employee compensation for periods prior to Fiscal 2006, our net income (loss) per share would have increased to the pro forma amounts indicated below:


	November 27, 2004
Net income (loss) as reported	$	415
Add: Stock-based employee compensation included in reported net income (loss), net of related tax effects		—
Deduct: Total stock-based employee compensation income (expense) determined under fair value based method for all awards		(407	)

Net income (loss) pro forma	$	8

Basic and diluted net income (loss) per share as reported	$	0.05
Stock-based compensation expense		(0.05	)

Basic and diluted net income (loss) per share pro forma	$	—

(4) Developed Technology

Amortization expense for developed technology for the three-months ended November 26, 2005, and November 27, 2004, was $31 and $31, respectively. Amortization expense is estimated to be $62 during our fiscal year ending August 31, 2006.

(5) Other Financial Statement Data

The following provides additional information concerning selected consolidated balance sheet accounts at November 26, 2005 and August 31, 2005:


	November 26,		August 31,
	2005		2005
Inventories:
Purchased parts	$	5,415	$	5,881
Work in process		666		590
Finished goods		1,716		1,573

	$	7,797	$	8,044

Accrued liabilities:
Employee related costs	$	1,566	$	1,786
Deferred revenue		92		440
Real estate taxes		165		130
Customers deposits		772		589
Current maturities of long-term liabilities		273		247
Warranty reserve		70		132
Other accrued liabilities		791		805

	$	3,729	$	4,129

Other long-term liabilities:
Remaining lease obligation, less estimated sublease proceeds	$	628	$	552
Unfavorable operating lease, net		558		568

Total		1,186		1,120
Less current maturities		273		247

Total other long-term liabilities	$	913	$	873

(6) Warranty Obligations

Sales of our products are subject to limited warranty guarantees that typically extend for a period of twelve months from the date of manufacture. Warranty terms are included in customer contracts under which we are obligated to repair or replace any components or assemblies deemed defective due to workmanship or materials. We do, however, reserve the right to reject warranty claims where we determine that failure is due to normal wear, customer modifications, improper maintenance, or misuse. Warranty provisions are based on estimated returns and warranty expenses applied to current period revenue and historical warranty incidence over the preceding twelve-month period. Both the experience and the warranty liability are evaluated on an ongoing basis for adequacy. Warranty provisions and claims for the first three months of Fiscal 2006 and 2005 were as follows:


			Warranty			Warranty
	Beginning Balance		Provisions			Claims		Ending Balance
Fiscal 2006	$	132	$	(37	)	$	25	$	70
Fiscal 2005	$	139	$	20		$	19	$	140

(7) Long-Term Debt

Our long-term debt consists of the following:


	November 26		August 31,
	2005		2005
Commerce Bank mortgage payable in monthly installments of principal and interest of $9 based on a twenty-year amortization with a final payment of approximately $1,050 due in November 2009; collateralized by our Victoria facility	$	1,140	$	1,145
Commerce Financial Group, Inc. equipment loan payable in fixed monthly principal and interest installments of $28 through September 2007; collateralized by our Victoria facility and equipment located at our Tempe facility		581		673
Capital lease obligation; payable in installments of $1 through February 2009; collateralized with equipment		23		25
Commercial loans payable in fixed monthly principal installments of $1 through May 2009; collateralized with certain machinery and equipment		21		22
Commercial loans payable in fixed monthly principal installments of $12 through July 2005; collateralized with certain machinery and equipment		0		9
Capital lease obligations; payable in fixed monthly installments of $15 through July 2008; secured with certain machinery and equipment		392		423

Capital lease obligations; payable in fixed monthly installments of $5 through September 2008; secured with certain machinery and equipment		114		0

Total		2,271		2,297
Less current maturities		500		484

Total long-term debt	$	1,771	$	1,813

The Company has two primary long-term debt obligations with Commerce Bank, a Minnesota state banking association, and its affiliate, Commerce Financial Group, Inc., a Minnesota corporation. The first note, with Commerce Bank, in the original principal amount of $1,200 was executed on October 14, 2003. This note is collaterialized by our Victoria, Minnesota facility. The term of the first note is six years. The original interest rate on this note was a nominal rate of 6.50% per annum for the first three years, and thereafter the interest rate will be adjusted on the first date of the fourth loan year to a nominal rate per annum equal to the then Three Year Treasury Base Rate (as defined) plus 3.00%; provided, however, that in no event will the interest rate be less than the Prime Rate plus 1.0% per annum. Monthly payment of principal and interest will be based on a twenty-year amortization with a final payment of approximately $1,050 due on November 1, 2009. The second note, with Commerce Financial Group, Inc., in the original principal amount of $1,150 was executed on October 28, 2003. The second note is secured by our Victoria facility and equipment located at our Tempe facility. The term of the second note is four years. The original interest rate on this note was of 8.975% per year through September 27, 2007. Monthly payments of principal and interest in the amount of $28 are paid over a forty-eight month period beginning on October 28, 2003.

We entered into a waiver and amendments on December 3, 2004 which increased the interest rate to be paid under the Commerce Bank note beginning March 1, 2005, to and including October 31, 2006, from 6.5% to 7.5%, and increased the interest rate to be paid under the Commerce Financial Group, Inc. note beginning March 1, 2005, to and including September 28, 2007, from 8.975% to 9.975%.

The Company is in compliance with all covenants as of November 26, 2005.

During Fiscal 2005, the Company entered into several capital lease agreements to fund the acquisition of machinery and equipment. The total principal amount of these leases is $442 with an average effective interest rate of 16%. These agreements are for three years with reduced payment terms over the life of the lease. At the end of the lease, we have the option to purchase the equipment at an agreed upon value which is generally approximately 20% of the original equipment cost. However, this amount may be reduced to 15% if our equity increases by $4.0 million within 18 months of the date of these leases. In fiscal 2006, the Company entered into a capital lease agreement to fund the acquisition of $121 of equipment. The terms of this lease are approximately the same as the fiscal 2005 capital leases.

(8) Line of Credit

Since early in Fiscal 2003, we have had an accounts receivable agreement (the “Credit Agreement”) with Beacon Bank of Shorewood, Minnesota. The Credit Agreement expires on September 1, 2006. The Credit Agreement provides for a maximum amount of credit of $5,000. The Credit Agreement is an accounts receivable backed facility and is additionally collateralized by inventory, intellectual property and other general intangibles. The Credit Agreement is not subject to any restrictive financial covenants. The balance on the line of credit was $1,143 as of November 26, 2005. The Credit Agreement as amended on July 7, 2005 bears an interest rate of Prime plus 2.75%. There is also an immediate discount of .85% for processing. The effective borrowing rate is approximately 9%. Borrowings are reduced as collections and payments are received into a lock box by the bank. As of November 26, 2005, the Company is in compliance with all covenants of the Credit Agreement.

(9) Deferred Taxes

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The significant components of our deferred tax assets and liabilities consist of timing differences related to allowance for doubtful accounts, depreciation, reserves for excess and obsolete inventory, accrued warranty reserves, and the future benefit associated with Federal and state net operating loss carryforwards. A valuation allowance has been set at approximately $7,450 and $7,195, at November 26, 2005, and August 31, 2005, respectively, because of uncertainties related to the ability to utilize certain Federal and state net loss carryforwards as determined in accordance with GAAP. The valuation allowance is based on estimates of taxable income by jurisdiction and the period over which our deferred tax assets are recoverable.

(10) Net Income (Loss) per Share Computation

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


	Three Months Ended
	November 26, 2005			November 27, 2004
Basic:
Net income (loss)	$	(630	)	$	415
Net income (loss) per share	$	(0.07	)	$	0.05
Weighted average number of common shares outstanding		9,400			8,357
Diluted:
Net income (loss)	$	(630	)	$	415
Net income (loss) per share	$	(0.07	)	$	0.05
Weighted average number of common shares outstanding		9,400			8,357
Assumed conversion of stock options		—			68
Weighted average common and assumed conversion shares		9,400			8,425

Approximately 2,662,000 and 1,850,400 shares of our Common Stock under stock options and warrants have been excluded from the calculation of diluted net income (loss) per common share as they are antidilutive for the three-month periods ended November 26, 2005 and November 27, 2004, respectively.

(11) Notes Receivable-Related Parties-Officers and Former Directors

In Fiscal 2001, the Company recorded notes receivable of $1,266 from certain officers and directors in connection with the exercise of stock options. These notes were amended on July 2002 and provide for full recourse to the individuals, bear interest at Prime with the exception of one individual at Prime plus ¹/2% per annum and have a term of five years with interest only payments to be made annually for the first (2) years and annual principal and interest installments through April 2, 2006. These notes receivable are classified as a reduction to shareholders’ equity on the consolidated balance sheet. As of November 26, 2005, the amounts owed on these notes was $207 and the interest due the Company on these notes was $9. Both amounts are payable April 2, 2006.

(12) Litigation Recoveries

On June 30, 2003, we commenced litigation against Mr. Fant, our former Chief Executive Officer and Chairman, in the State of Minnesota, Hennepin County District Court, Fourth Judicial District. The complaint alleged breach of contract, conversion, breach of fiduciary duty, unjust enrichment and corporate waste resulting from, among other things, Mr. Fant’s default on his promissory note to us and other loans and certain other matters. On August 12, 2003, we obtained a judgment against Mr. Fant on the breach of contract count in the amount of approximately $606. On November 24, 2003, the Court granted an additional judgment to us against Mr. Fant in the amount of approximately $993 on the basis of our conversion, breach of fiduciary duty, unjust enrichment and corporate waste claims. On March 29, 2004, we obtained a third judgment against Mr. Fant relating to our claims for damages for conversion, breach of fiduciary duty, and our legal and special investigation costs in the amount of approximately $656. As of November 26, 2005, the total combined judgment against Mr. Fant was approximately $2,255, excluding interest.

During Fiscal 2004 and 2005, we obtained, through garnishments and through sales of Common Stock previously held by Mr. Fant, approximately $1,842 of recoveries which have served to partially reduce our total judgment against Mr. Fant. In Fiscal 2005 and 2004 we recognized $481 and $1,361 of these recoveries, respectively. Mr. Fant filed for bankruptcy protection on October 14, 2005. The Company will seek to collect additional amounts from Mr. Fant’s Bankruptcy Estate. At this early stage of the bankruptcy proceedings, it is not possible to determine whether collection of additional amounts is possible.

(13) Major Customers

There were two customers where net sales represented over 10% of our revenue for the three months ended November 26, 2005, one customer accounted for 14% and the second customer accounted for 10% of net sales. For the three months ended November 27, 2004, one customer accounted for 16% and a second customer accounted for 12% of net sales.

As of November 26, 2005, two customers represented 12% and 10% of our accounts receivable amounts, respectively.

(14) Geographic Data

Sales to customers by geographic region as a percentage of net sales are as follows:


	Three Months Ended
	November 26, 2005					November 27, 2004
	Dollars		% of Sales			Dollars		% of Sales
United States	$	9,908		72	%	$	10,410		74	%
Canada / Mexico	$	654		5	%	$	1,598		11	%
Europe	$	1,621		12	%	$	678		5	%
Asia-Pacific	$	1,598		11	%	$	1,372		10	%
South America	$	6		0	%	$	13		0	%

Total	$	13,787				$	14,071

(15) Segments

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

Advanced Medical Operations: This segment consists of our Boulder facility that provides design and manufacturing outsourcing of complex electronic and electromechanical medical devices.

Corporate Operations: This includes sales, marketing, and general and administrative expenses that benefit the Company as a whole and are not specifically related to either of the business segments.

Segment information is as follows:


	Three Months Ended November 26, 2005
	Corporate			Microelectronics		Advanced Medical
	Operations			Operations		Operations		Total
Net sales	$	—		$	8,920	$	4,867	$	13,787
Gross profit		—			1,981		743		2,724
Operating expense		2,144			863		249		3,256
Operating income (loss)		(2,144	)		1,118		494		(532	)
Total assets		—			18,111		6,917		25,028
Depreciation and amortization		—			482		103		585
Capital expenditures		—			50		8		58


	Three Months Ended November 27, 2004
Net sales	$	—		$	7,636	$	6,435	$	14,071
Gross profit		—			1,137		1,819		2,956
Operating expense		1,967			379		533		2,879
Operating income (loss)		(1,967	)		758		1,286		77
Total assets		—			17,069		9,238		26,307
Depreciation and amortization		—			564		81		645
Capital expenditures		—			323		15		338

(16) Commitments and Contingencies

We lease a 14,000 square foot production facility in Tempe, Arizona for our high density flexible substrates. The lease extends through July 31, 2010. Base rent is approximately $100,000 per year. We lease one property in Minnesota: a 20,000 square foot facility in Chanhassen, Minnesota, for our RFID business. The Chanhassen facility is leased until October 15, 2007. Base rent is approximately $140,000 per year.

We lease a 152,022 square foot facility in Boulder, Colorado for our AMO. Our base rent is approximately $1.4 million per year. In addition to the base rent we pay all operating costs associated with this building. The annual base rent increases each year by 3%. The Boulder facility is leased until September 2019. Currently, we occupy approximately 100,000 square feet of the facility and 50,000 is unimproved vacant space. In April 2005, we entered into a ten year sublease agreement for approximately 25,000 square feet of unimproved vacant space with a high quality tenant. This is a ten year lease which provides for rental payments and reimbursement of operating costs. Aggregate rental and operating cost payments to be received by the Company (following a 9 month free rent period), will be approximately $0.3 million per year. We are continuing to look for sublease tenants for the remaining 25,000 square feet of vacant space.

Our Boulder lease provided for the refund of $1,350 of our security deposit after completing four consecutive quarters of positive earnings before interest, taxes, depreciation and amortization, as derived from our consolidated financial statements and verified by an independent third party accountant and delivery to our landlord of the greater of 100,000 shares of our common stock or 0.11% of the

outstanding shares of our common stock. In November 2005, we delivered the required documents and a certificate for 100,000 shares of our stock. On November 23, 2005, we received the $1,350 refund. The value of the additional stock consideration issued to our landlord is approximately $336 and will be amortized over the remaining term of our lease.

Through January 4, 2006, we have initiated purchase orders and have arranged for financing for approximately $2.0 million of equipment purchases that will be delivered in the second quarter of Fiscal 2006.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

(In thousands, except share and per share data)

Overview

We provide a comprehensive range of engineering, product design, automation and test, manufacturing, distribution, and fulfillment services and solutions to our customers in the hearing, medical device, medical equipment, communications, computing and industrial equipment industries. We provide these services and solutions on a global basis through integrated facilities in North America. These services and solutions support our customers’ products from initial product development and design through manufacturing to worldwide distribution and aftermarket support. We leverage our various technology platforms and internal manufacturing capacity to provide bundled solutions to the markets served. Our current focus is on managing costs and integration of our business operating units.

The following discussion highlights the significant factors affecting changes in our results of operations and financial condition. This review should be read in conjunction with the Consolidated Financial Statements, Notes to Consolidated Financial Statements, the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the fiscal year ended August 31, 2005 and the risks disclosed in our Annual Report on Form 10-K for the Fiscal year ended August 31, 2005.

Results of Operations

Three Months Ended November 26, 2005 and November 27, 2004:

The following table indicates the dollars and percentages of total revenues represented by the selected items in our unaudited consolidated statements of operations:

Selected Operating Results


	Three Months Ended
	November 26					November 27
	2005					2004
Net sales	$	13,787		100	%	$	14,071	100	%
Cost of sales		11,063		80	%		11,115	79	%

Gross profit		2,724		20	%		2,956	21	%
Operating expenses		3,256		24	%		2,879	20	%

Operating income (loss)		(532	)	(4	%)		77	1	%
Other income (expense)		(98	)	(1	%)		338	2	%


Income (loss) before income taxes		(630	)	(5	%)		415	3	%

Income tax benefit		—		0	%		—	0	%

Net income (loss)	$	(630	)	(5	%)		415	3	%

Net sales by market are as follows:


	Three Months Ended
	November 26 2005		November 27 2004
Medical/Hearing	$	10,222	$	11,294
Communications		2,588		1,574
Industrial		977		1,203

Total Net Sales	$	13,787	$	14,071

Net Sales

Net sales in the first quarter of Fiscal 2005 were $13,787, a decrease of $284, or 2%, from the comparable quarter last year. This slight decrease was the result of vendor supplied part problems at our RFID division and due to product transition driven production shortages at our Tempe facility which manufactures flexible substrates.

Sales in our Microelectronics operations increased approximately 17% to $8.9 million in the quarter ended November 26, 2005 from $7.6 million in the first quarter of last fiscal year. This increase is due primarily to growth in sales to our communications market customers. Our microelectronics operations also benefited from increased sales in the medical / hearing area. These increases were offset by a reduction in sales in the industrial area which was due to a temporary problem with a specific part supplied by a vendor. This problem was corrected early in the second quarter of Fiscal 2006.

Sales in our AMO operations decreased to $4.9 million in the quarter ended November 26, 2005 from $6.4 million in the quarter ended November 27, 2004 or a decrease of 24%. This decrease was all in the medical market and related to a drop in orders for final assembly business that we perform for several customers.

At November 26, 2005, our backlog of orders for revenue was approximately $18.7 million, compared to approximately $20.1 million at August 31, 2005. We expect to ship our backlog as of November 26, 2005 during Fiscal 2006. This decrease in backlog is reflective of a change in the way our customers do business in that they are more unwilling to make commitments too far into the future. The backlog from our AMO includes customer commitments that have longer terms, as compared to our historical customer commitments. Our backlog is not necessarily a firm commitment from our customers and can change, in some cases materially, beyond our control.

Because sales are generally tied to the customers’ projected sales and production of the related product, our sales may be subject to uncontrollable fluctuations. Significant changes in sales to any one customer could have a significant impact on total sales. In addition, production from one customer may conclude while production for a new customer may not have begun or is not yet at full volume.

Gross Profit

Gross profit was $2,724 (20% of net sales) for the three-months ended November 26, 2005 compared to $2,956 (21% of net sales) for the three-months ended November 27, 2004. The decrease of $232 is due to lower sales in the first quarter of fiscal 2006 and due to new customer programs which traditionally begin at lower margin levels.

Our gross margins are heavily impacted by fluctuations in net sales, due to the fixed nature of many of our manufacturing costs, and by the mix of products manufactured in any particular quarter. In addition, the start up of new customer programs could adversely impact our margins as we implement the complex processes involved in the design and manufacture of ultra miniature microelectronic devices. We anticipate that our gross profit margins will remain relatively constant over the near term. We continue to work to improve our process which we believe will enable us to see improved gross profit margins in the future.

Operating Expenses

Selling, general and administrative expenses

Selling, general and administrative expenses increased by $121, or 6%, for the three month-period ended November 26, 2005 as compared to the first quarter of Fiscal 2005. The increase is due primarily to the recognition of $116 of expense related to compensation for stock options as required by SFAS 123R which was adopted in Fiscal 2006. As a percentage of net sales, selling, general and administrative expenses increased to 16% for the three-month period ended November 26, 2005, as compared to 15% for the first quarter last year. This increase is due to a slight decrease in sales and the increased costs discussed above.

Research, development, and engineering expenses

Research, development, and engineering expenses increased $256, or 31%, for the first quarter of Fiscal 2006 as compared to the first quarter of Fiscal 2005. This increase is due to expanded engineering projects designed to improve the overall efficiency and capacity of our manufacturing facilities. It is anticipated that these initiatives will enhance our production capabilities and improve our gross margins in the next six-to-nine months. As a percentage of net sales, research, development, and engineering expenses were 8% for the three-month period ended November 26, 2005 as compared to 6% for the first quarter of Fiscal 2005. The increase of these expenses as a percentage of net sales for the period ended November 26, 2005 is a result of the increased costs as discussed above and the slight decrease in revenue. We expect that our research, development and engineering expenses will remain at approximately the same quarterly levels for the remainder of the year.

Other Income (Expense), Net

Interest expense for the three months ended November 26, 2005 was $127 which included interest income of $40. This compares with interest expense of $169 in the first quarter of fiscal 2005. In the first quarter of Fiscal 2005, other income also included a gain of $481 related to additional cash collections against the outstanding judgments against Mr. Fant, our former CEO.

Income Taxes

We did not record a tax provision in the first quarter of Fiscal 2006 due to the operating loss in the quarter. We did not record any income tax expense in the first quarter of Fiscal 2005 since we have unutilized net operating loss carryforwards from prior years which will be utilized to offset taxes associated with our income in the quarter. We have established a valuation allowance to fully reserve the deferred tax assets because of uncertainties related to our ability to utilize certain federal and state loss carryforwards as measured by GAAP. This allowance is based on estimates of taxable income by jurisdiction during the period over which its deferred tax assets are recoverable. The economic benefits of our net operating loss carryforwards to future years will continue until expired.

FINANCIAL CONDITION AND LIQUIDITY

We have historically financed our operations through the public and private sale of equity securities, bank borrowings, operating equipment leases and cash generated by operations.

At November 26, 2005, our primary sources of liquidity consisted of $826 of cash and cash equivalents and our accounts receivable agreement (“Credit Agreement”) with Beacon Bank of Shorewood, Minnesota, which provides borrowing capacity up to $5.0 million subject to availability based on our accounts receivable. The Credit Agreement is due to expire in September 2006. There was $1,143 outstanding debt under the Credit Agreement at November 26, 2005.

On November 23, 2005 we received $1,350 refund of our security deposit on our Boulder facility. These actions enabled us to fund working capital requirements and acquire manufacturing equipment. In addition, on May 9, 2005, we sold 130,538 shares of our Series A Convertible Preferred Stock which provided net proceeds of $3.2 million to the Company.

During Fiscal 2006, we intend to spend approximately $3.0 million for manufacturing equipment which we expect to expand our manufacturing capacity and our technological capabilities in order to meet the expanding needs of our customers. It is expected that these expenditures will be funded from existing cash and cash equivalents, cash generated from operations, lease financing and available debt financing for the next 12 months. Through January 4, 2006, we have initiated purchase orders and have arranged for financing for approximately $2.0 million of equipment purchases that will be delivered in the second quarter of Fiscal 2006. We will evaluate the necessity and timing for additional capital expenditures for the remainder of Fiscal 2006.

Management believes that existing cash and cash equivalents, current lending capacity and cash generated from operations will supply sufficient cash flow to meet short- and long-term debt obligations, working capital, capital expenditure and operating requirements during the next 12 months.

CRITICAL ACCOUNTING POLICIES

The accompanying consolidated financial statements are based on the selection and application of accounting principles generally accepted in the United States of America (“GAAP”), which require estimates and assumptions about future events that may affect the amounts reported in these financial statements and the accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to the financial statements. We believe that the following accounting policy as well as the policies included in our Annual Report on Form 10-K for our fiscal year ended August 31, 2005, may involve a higher degree of judgment and complexity in their application and represent the critical accounting policies used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results could be materially different from reported results.

Revenue Recognition, Sales Returns and Warranty

Revenue for manufacturing and assembly contracts is generally recognized upon shipment to the customer which represents the point at which the risks and rewards of ownership have been transferred to the customer. We have a limited number of customer arrangements with customers which require that we retain ownership of inventory until it has been received by the customer, until it is accepted by the customer, or in one instance, until the customer places the inventory into production at its facility. There are no additional obligations or other rights of return associated with these agreements. Accordingly, revenue for these arrangements is recognized upon receipt by the customer, upon acceptance by the customer or when the inventory is utilized by the customer in its manufacturing process. Our AMO provides service contracts for some of its products. Billings for services contracts are based on published renewal rates and revenue is recognized on a straight-line basis over the service period.

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

We may establish one or more contractual relationships with one customer that involves multiple deliverables including development, manufacturing and service. Each of these deliverables may be considered a separate unit of accounting and we evaluate if each element has sufficient evidence of fair value to allow separate revenue recognition. If we cannot separately account for the multiple elements in an arrangement, we may be required to account for the arrangement as one unit of accounting with recognition over an extended period of time or upon delivery of all of the contractual elements.

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

Forward-Looking Statements

Some of the information included in this Quarterly Report on Form 10-Q contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “may,” “will,” “expect,” “anticipate,” “believe,” “intend,” “estimate,” “continue,” and similar words. You should read statements that contain these words carefully for the following reasons: such statements discuss our future expectations, such statements contain projections of future earnings or financial condition and such statements state other forward-looking information. Although it is important to communicate our expectations, there may be events in the future that we are not accurately able to predict or over which we have no control. The risk factors included in our Annual Report on Form 10-K for the fiscal year ended August 31, 2005 provide examples of such risks, uncertainties and events that may cause actual results to differ materially from our expectations and the forward-looking statements. Readers are cautioned not to place undue reliance on forward-looking statements, as we undertake no obligation to update these forward-looking statements to reflect ensuing events or circumstances, or subsequent actual results.

Item 3. Qualitative and Quantitative Disclosures About Market Risk

(In thousands, except share and per share amounts)

Market Risk

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

Interest Rate Risk

We are exposed to a floating interest rate risk from our term credit note with Commerce Bank, a Minnesota state banking association and on our credit agreement with Beacon Bank. The Commerce Bank note, in the amount of $1,200, was executed on October 14, 2003 and has a floating interest rate. The term of this note is six years with interest at a nominal rate of 6.50% per annum until October 31, 2006. Thereafter the interest rate will be adjusted to a nominal rate per annum equal to the then Three Year Treasury Base Rate (as defined) plus 3.00%; provided, however, that in no event will the interest rate be less than the Prime Rate plus 1.0% per annum. Monthly payments of principal and interest are based on a twenty-year amortization with a final payment of approximately $1,048 due on November 1, 2009.

Since early in Fiscal 2003, we have had an accounts receivable agreement (the “Credit Agreement”) with Beacon Bank of Shorewood, Minnesota. The Credit Agreement expires on September 1, 2006. The Credit Agreement provides for a maximum amount of credit of $5,000. The Credit Agreement is an accounts receivable backed facility and is additionally collateralized by inventory, intellectual property and other general intangibles. The Credit Agreement is not subject to any restrictive financial covenants. The balance on the line of credit was $1,143 as of November 26, 2005. The Credit Agreement as amended on July 7, 2005 bears an interest rate of Prime plus 2.75%. There is also an immediate discount of .85% for processing. Borrowings are reduced as collections and payments are received into a lock box by the bank. The effective borrowing rate is approximately 9%. As of the November 26, 2005, the Company is in compliance with all covenants of the Credit Agreement.

A change in interest rates is not expected to have a material adverse effect on our near-term financial condition or results of operation as the first note has a fixed rate for its first three years and the second note has a fixed rate for its term.

Item 4. Controls and Procedures

During the course of the audit of the consolidated financial statements for Fiscal 2005, our independent registered public accounting firm, Virchow, Krause & Company, LLP, did not identify any deficiencies in internal controls which were considered to be “material weaknesses” as defined under standards established by the American Institute of Certified Public Accountants.

There were no changes in our system of internal controls during the first quarter of Fiscal 2006.

Our management team, including our Chief Executive Officer and President and Chief Financial Officer, have conducted an evaluation of the effectiveness of disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended as of the end of the period covered by this Form 10-Q. Based on such evaluation, our Chief Executive Officer and President and Chief Financial Officer have concluded that the disclosure controls and procedures did provide reasonable assurance of effectiveness as of the end of such period.

We are currently in the process of reviewing and formalizing our plans and approach to complying with the Securities and Exchange Commission’s rules implementing the internal control reporting requirements included in Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). We expect to dedicate significant resources, including senior management time and effort, and incurring substantial costs in connection with our ongoing Section 404 assessment and compliance. We have initiated the process of documenting our internal controls and considering whether any improvements are necessary for maintaining an effective control environment at our Company. Despite the mobilization of significant resources for our Section 404 assessment, we, however, cannot provide any assurance that we will timely complete the evaluation of our internal controls or that, even if we do complete the evaluation of our internal controls, we do so in time to permit our independent registered public accounting firm to test our controls

and timely complete their attestation procedures of our controls in a manner that will allow us to comply with applicable Securities and Exchange Commission rules and regulations, as recently revised, which call for compliance by the filing deadline for our Annual Report on Form 10-K for Fiscal 2007.

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

PART II — OTHER INFORMATION

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

In November 2005, the Company delivered 100,000 shares of its common stock to the landlord of its Boulder facility to obtain the return of $1,350 of a security deposit. The security deposit release procedure is described in the Company’s Boulder lease which was previously filed as an exhibit to the Company’s SEC reports and as previously described by the Company in its Annual Report on Form 10-K for the year ended August 31, 2005 in the Management Discussion and Analysis of Operations and in the Notes to the Consolidated Financial Statements.

Item 6. Exhibits

a) Exhibits


31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

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

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


	Three Months Ended
	November 26, 2005			November 27, 2004
Net sales	$	13,787		$	14,071
Cost of sales		11,063			11,115

Gross profit		2,724			2,956

Operating expenses:
Selling, general and administrative		2,163			2,042
Research, development and engineering		1,093			837

Total Operating expenses		3,256			2,879

Operating income (loss)		(532	)		77

Other income (expenses):
Interest expense, net		(127	)		(169	)
Litigation recovery		—			481
Other income (expense), net		29			26

Income (loss) before income taxes		(630	)		415
Income taxes		—			—

Net income (loss)	$	(630	)	$	415

Net income (loss) per common share:
Basic	$	(0.07	)	$	0.05
Diluted	$	(0.07	)	$	0.05

Weighted average common shares outstanding:
Basic		9,400			8,357
Diluted		9,400			8,425


	HEI, Inc.
Date: January 10, 2006	/s/ Timothy C. Clayton
	Timothy C. Clayton
	Chief Financial Officer

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Table of Contents	HEI, Inc.

Part I — Financial Information (unaudited)		3
Item 1. Financial Statements		3
Consolidated Balance Sheets		3
Consolidated Statements of Operations		4
Consolidated Statements of Cash Flows		5
Notes to Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		13
Item 3. Quantitative and Qualitative Disclosures About Market Risk		18
Item 4. Controls and Procedures		18
Part II — Other Information		19
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		19
Item 6. Exhibits		19
Signature		20
Certification of CEO Pursuant to Section 302
Certification of CFO Pursuant to Section 302
Certification of CEO Pursuant to Section 906
Certification of CFO Pursuant to Section 906