e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

****

FORM 10-Q

****


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

For the quarterly period ended February 25, 2006.


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 April 7, 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)


	February25,			August 31,
	2006			2005
	(Unaudited)			(Audited)
ASSETS
Current assets:
Cash and cash equivalents	$	160		$	351
Accounts receivable, net of allowance for doubtful accounts of $151 and $157, respectively		7,379			9,278
Inventories		8,142			8,044
Security deposit		—			1,350
Other current assets		802			1,136

Total current assets		16,483			20,159

Property and equipment:
Land		216			216
Building and improvements		4,323			4,323
Fixtures and equipment		23,813			23,214
Accumulated depreciation		(21,853	)		(20,864	)

Net property and equipment		6,499			6,889

Developed technology, less accumulated amortization of $406 and $352, respectively		8			62
Security deposit		322			230
Other long-term assets		657			337

Total assets	$	23,969		$	27,677


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Line of credit	$	1,400		$	2,563
Current maturities of long-term debt		545			484
Accounts payable		3,487			4,019
Accrued liabilities		3,685			4,129

Total current liabilities		9,117			11,195

Other long-term liabilities, less current maturities		919			873
Long-term debt, less current maturities		1,706			1,813

Total other long-term liabilities, less current maturities		2,625			2,686

Total liabilities		11,742			13,881

Commitments and contingencies
Shareholders’ equity:
Undesignated stock; 5,000,000 and 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; 20,000,000 and 13,000,000 shares authorized; 9,479,000 and 9,379,000 shares issued and outstanding		474			469
Paid-in capital		27,305			26,701
Accumulated deficit		(15,487	)		(13,169	)
Notes receivable-related parties-officers and former directors		(67	)		(207	)

Total shareholders’ equity		12,227			13,796

Total liabilities and shareholders’ equity	$	23,969		$	27,677

See accompanying notes to unaudited consolidated financial statements.

HEI, Inc.

Consolidated Statements of Operations (Unaudited)

(In thousands, except per share data)

Three Months Ended

Six Months Ended

February 25, 2006

February 26, 2005

February 25, 2006

February 26, 2005

Net sales

11,718

13,736

25,505

27,808

Cost of sales

9,972

10,869

21,035

21,984

Gross profit

1,746

2,867

4,470

5,824

Operating expenses:

Selling, general and administrative

2,350

2,344

4,513

4,387

Research, development and engineering

984

934

2,077

1,771

Total Operating expenses

3,334

3,278

6,590

6,158

Operating loss

(1,588

)

(411

)

(2,120

)

(334

)

Other income (expenses):

Interest expense, net

(96

)

(180

)

(223

)

(349

)

Litigation recovery

—

481

Other income (expense), net

)

Loss before income taxes

(1,688

)

(537

)

(2,318

)

(122

)

Income taxes

—

Net loss

(1,688

)

(537

)

(2,318

)

(122

)

Net loss per common share:

Basic

(0.18

)

(0.06

)

(0.25

)

(0.01

)

Diluted

(0.18

)

(0.06

)

(0.25

)

(0.01

)

Weighted average common shares outstanding:

Basic

9,480

8,357

9,440

8,357

Diluted

9,480

8,357

9,440

8,357

See accompanying notes to unaudited consolidated financial statements.

HEI, Inc.

Consolidated Statements of Cash Flows (Unaudited)

(In thousands)


	Six Months Ended
	February 25, 2006			February 26 2005
Cash flow from operating activities:
Net loss	$	(2,318	)	$	(122	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		1,206			1,307
Loss on disposal of property and equipment		—			24
Stock based compensation expense		273			—
Changes in operating assets and liabilities:
Restricted cash related to deferred litigation		—			481
Accounts receivable		1,899			(2,046	)
Inventories		(98	)		(1,145	)
Other current assets		474			150
Accounts payable		(532	)		879
Accrued liabilities and other long-term liabilities		(398	)		(845	)

Net cash flow provided by (used in) operating activities		506			(1,317	)

Cash flow from investing activities:
Additions to property and equipment		(527	)		(768	)
Proceeds from sale of assets		8			—
Additions to patents		(2	)		(80	)
Refund of security deposit, net		1,258			—

Net cash flow provided by (used in) investing activities		737			(848	)

Cash flow from financing activities:
Note repayment-related parties-officers and former directors		—			—
Repayment of long-term debt		(271	)		(195	)
Net borrowings (repayments) on line of credit		(1,163	)		2,229

Net cash flow provided by (used in) financing activities		(1,434	)		2,054

Net increase in cash and cash equivalents		(191	)		(131	)
Cash and cash equivalents, beginning of period		351			200

Cash and cash equivalents, end of period	$	160		$	69

*Supplemental disclosures of cash flow information:*
Interest paid	$	239		$	349
Capital lease obligations related to equipment acquisitions	$	225			—
Issuance of common stock to landlord recognized as long-term asset	$	336			—
Reclassification of notes receivable-related parties to other current assets	$	140		$	227

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 and six-month periods ended February 25, 2006, 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 $1,688 for the three months ended February 25, 2006, a net loss of $2,318 for the six months ended February 25, 2006 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 February 25, 2006, our sources of liquidity consisted of $160 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 $1,400 outstanding debt under the Credit Agreement at February 25, 2006.

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. We have entered into additional financing agreements primarily in the form of operating and capital leases for the acquisition of approximately $2.2 million of equipment which will be capitalized upon release of the equipment into production which will occur in the third quarter of Fiscal 2006.

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. For the company, 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 February 25, 2006, 1,621,975 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 $115 and $231 ($.01 and $.02 per share) in the three and six months ended February 25, 2006 related to the amortization of the unvested portion of these options as of 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 $225, and estimate the impact on future earnings to be approximately $400. In addition, during the three months ended February 25, 2006, we modified the terms of 100,000 options to accelerate vesting on any unvested portion of these grants and to extend the exercise period on 25,000 options for 90 days beyond normal terms. The effect of these actions was an additional non-cash expense of $42,000 which was recorded in the quarter ended February 25, 2006.

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 loss per share would have increased to the pro forma amounts indicated below:


	Three- Months Ended			Six Months Ended
	February 26, 2005			February 26, 2005
Net loss as reported	$	(537	)	$	(122	)
Add: Stock-based employee compensation included in reported net loss, net of related tax effects					—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(407	)		(815	)

Net loss pro forma	$	(944	)	$	(937	)

Basic and diluted net loss per share as reported	$	(0.06	)	$	(0.01	)
Stock-based compensation expense		(0.05	)		(0.10	)

Basic and diluted net loss per share pro forma	$	(0.11	)	$	(0.11	)

There were no options granted in the three months ended February 25, 2006 or February 26, 2005. There were 5,000 options granted in the six months ended February 25, 2006 and no options granted in the six months ended February 26, 2005.

During the three month period ended February 25, 2006, the Company granted 73,800 shares of restricted stock to several officers, key employees and directors. These shares vest over four years. The value of the shares at the date of grant was $242 which will be expensed over the vesting period.

(4) Developed Technology

Amortization expense for developed technology for the three-months ended February 25, 2006 and February 26, 2005 was $23 and $31, respectively. Amortization expense for the six-month periods was $54 in Fiscal 2006 and $62 in Fiscal 2005. Amortization expense for developed technology will be $62 for our fiscal year ending August 31, 2006.

(5) Other Financial Statement Data

The following provides additional information concerning selected consolidated balance sheet accounts at February 25, 2006 and August 31, 2005:


	February 25,		August 31,
	2006		2005
Inventories:
Purchased parts	$	5,722	$	5,881
Work in process		559		590
Finished goods		1,861		1,573

	$	8,142	$	8,044

Accrued liabilities:
Employee related costs	$	1,551	$	1,786
Deferred revenue		120		440
Real estate taxes		229		130
Customers deposits		639		589
Current maturities of long-term liabilities		280		247
Warranty reserve		86		132
Other accrued liabilities		780		805

	$	3,685	$	4,129

Other long-term liabilities:
Remaining lease obligation, less estimated sublease proceeds	$	651	$	552
Unfavorable operating lease, net		548		568

Total		1,199		1,120
Less current maturities		280		247

Total other long-term liabilities	$	919	$	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 and six months of Fiscal 2006 and 2005 were as follows:


			Warranty			Warranty
	Beginning Balance		Provisions			Claims		Ending Balance
For the Three Months Ended
February 25, 2006	$	70	$	(24	)	$	10	$	36
February 26, 2005	$	140	$	83		$	63	$	160
For the Six Months Ended
February 25, 2006	$	132	$	(60	)	$	36	$	36
February 26, 2005	$	139	$	103		$	82	$	160

(7) Long-Term Debt

Our long-term debt consists of the following:


	February 25		August 31,
	2006		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	$	1,136	$	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		509		673
Capital lease obligation; payable in installments of $1 through February 2009; collateralized with equipment		22		25
Commercial loans payable in fixed monthly principal installments of $1 through May 2009; collateralized with certain machinery and equipment		20		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 $16 through July 2008; collateralized with certain machinery and equipment		360		423
Capital lease obligations; payable in fixed monthly installments of $4 through September 2008; collateralized with certain machinery and equipment		105		0
Capital lease obligations; payable in fixed monthly installments of $1 through November 2008; collateralized with certain machinery and equipment		20		0
Capital lease obligations; payable in fixed monthly installments of $3 through January 2009; collateralized with certain machinery and equipment		79		0

Total		2,251		2,297
Less current maturities		545		484

Total long-term debt	$	1,706	$	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 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 February 25, 2006.

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 capital lease agreements to fund the acquisition of $2.7 million of equipment. The terms of these leases are approximately the same as

the Fiscal 2005 capital leases. The Company has received and placed into service $225 of equipment financed by these leases. The remainder will be recognized in the third quarter as the equipment is released into production.

(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 $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 $1,400 as of February 25, 2006. 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 10.5% as of March 31, 2006. Borrowings are reduced as collections and payments are received into a lock box by the bank. As of February 25, 2006, 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 $8,100 and $7,195, at February 25, 2006, 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 Loss per Share Computation

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


	Three Months Ended						Six Months Ended
	February 25, 2006			February 26, 2005			February 25, 2006			February 26, 2005
Basic:
Net loss	$	(1,688	)	$	(537	)	$	(2,318	)	$	(122	)
Net loss per share	$	(0.18	)	$	(0.06	)	$	(0.25	)	$	(0.01	)
Weighted average number of common shares outstanding		9,480			8,357			9,440			8,357

Diluted:
Net loss	$	(1,688	)	$	(537	)	$	(2,318	)	$	(122	)
Net loss per share	$	(0.18	)	$	(0.06	)	$	(.25	)	$	(0.01	)
Weighted average number of common shares outstanding		9,480			8,357			9,440			8,357
Assumed conversion of stock options		—			—			—			—
Weighted average common and assumed conversion shares		9,480			8,357			9,440			8,357

Approximately 2,621,000 and 1,830,900 shares of our Common Stock under stock options and warrants have been excluded from the calculation of diluted net loss per common share as they are antidilutive for the three-month and six-month periods ended February 25, 2006 and February 26, 2005, 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 in 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. As of February 25, 2006, 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.

On April 2, 2006, $140 was collected related to these notes and $67.5 owed by Mr. Edwin Finch, a former director, was refinanced to be repaid over the next nine months. The amount of $67.5 is presented as a reduction to stockholders equity. The amounts collected have been reclassified as other receivables included in other current assets as of February 25, 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 February 25, 2006, 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 Bankruptcy Court dismissed Mr. Fant’s petition on December 1, 2005, because he had failed to file all required schedules. The Company continues to seek to collect additional amounts from Mr. Fant. 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 February 25, 2006. One of these customers accounted for 14% and the second customer accounted for 12% of net sales. For the three months ended February 26, 2005, no customers accounted for over 10% of net sales. For the six-month period ended February 25, 2006, two customers accounted for 11% of net sales. There were no customers over 10% of net sales for the six month period ended February 26, 2005.

As of February 25, 2006, two customers represented 14% and 10% of our accounts receivable amounts, respectively. As of August 31, 2005, two customers each represented 11% of our accounts receivable.

(14) Geographic Data

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


	Three Months Ended February 25.										Six Months Ended February 25.
	2006					2005					2006					2005
																		% of
	Dollars		% of Sales			Dollars		% of Sales			Dollars		% of Sales			Dollars		Sales
United States	$	8,426		72	%	$	9,185		67	%	$	18,334		72	%	$	19,595		70	%

Canada / Mexico	$	223		2	%	$	852		6	%	$	877		3	%	$	2,450		9	%

Europe	$	1,315		11	%	$	1,649		12	%	$	2,936		12	%	$	2,327		8	%

Asia-Pacific	$	1,744		15	%	$	1,835		13	%	$	3,342		13	%	$	3,207		12	%

South America	$	10		0	%	$	215		2	%	$	16		0	%	$	229		1	%


Total	$	11,718				$	13,736				$	25,505				$	27,808

(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 February 25, 2006										Six Months Ended February 25, 2006
						Advanced										Advanced
				Microelectronics		Medical								Microelectronics		Medical
	Corporate			Operations		Operations		Total			Corporate			Operations		Operations		Total
Net sales	$	0		$	7,363	$	4,355	$	11,718		$	0		$	16,283	$	9,222	$	25,505
Gross profit		0			1,012		734		1,746			0			2,993		1,477		4,470
Operating Expense		2,322			810		202		3,334			4,466			1,673		451		6,590
Op. income (loss)		(2,322	)		202		532		(1,588	)		(4,466	)		1,320		1,026		(2,120	)
Total assets		0			16,786		7,183		23,969			0			16,786		7,183		23,969
Depr. and amortization		0			525		96		621			0			1,007		199		1,206
Capital expenditures		0			446		23		469			0			496		31		527


	Three Months Ended February 26, 2005										Six Months Ended February 26, 2005
						Advanced										Advanced
				Microelectronics		Medical								Microelectronics		Medical
	Corporate			Operations		Operations		Total			Corporate			Operations		Operations		Total
Net sales	$	0		$	8,401	$	5,335	$	13,736		$	0		$	16,038	$	11,770	$	27,808
Gross profit		0			1,637		1,230		2,867			0			2,775		3,049		5,824
Operating Expense		2,314			483		481		3,278			4,458			1,139		561		6,158
Op. income (loss)		(2,314	)		1,154		749		(411	)		(4,458	)		1,636		2,488		(334	)
Total assets		0			19,579		7,706		27,285			0			19,579		7,706		27,285
Depr. and amortization		0			561		101		662			0			1,106		201		1,307
Capital expenditures		0			387		43		430			0			733		35		768

(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 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 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 25,000 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 March 31, 2006, we have initiated purchase orders for approximately $2.7 million of equipment which will be financed through operating and capital leases. We have received and placed into service $225 of this equipment through February 25, 2006. We expect that the remainder will be released into production and capitalized in the third 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)

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 Item 7 of 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.

Overview

We provide a comprehensive range of engineering, product design, automation and test, manufacturing, distribution, and fulfillment services and solutions to 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 February 25, 2006 and February 26, 2005:

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*						*Six Months Ended*
	February 25, 2006			February 26, 2005			February 25, 2006			February 26, 2005
Net sales	$	11,718		$	13,736		$	25,505		$	27,808
Cost of sales		9,972			10,869			21,035			21,984

Gross profit		1,746			2,867			4,470			5,824

Operating expenses:
Selling, general and administrative		2,350			2,344			4,513			4,387
Research, development and engineering		984			934			2,077			1,771

Operating loss		(1,588	)		(411	)		(2,120	)		(334	)
Other income (expenses):		(100	)		(126	)		(198	)		212

Loss before income taxes		(1,688	)		(537	)		(2,318	)		(122	)
Income tax benefit		—			—			—			—

Net loss	$	(1,688	)	$	(537	)	$	(2,318	)	$	(122	)

Net sales by market are as follows:


	Three Months Ended				Six Months Ended
	February 25 2006		February 26, 2005		February 25, 2006		February 26, 2005
Medical/Hearing	$	9,240	$	10,948	$	19,462	$	22,243
Communications		1,193		1,688		3,781		3,262
Industrial		1,285		1,100		2,262		2,303

Total Net Sales	$	11,718	$	13,736	$	25,505	$	27,808

Net Sales

Net sales in the second quarter of Fiscal 2006 were $11,718, a decrease of $2,018, or 15%, from the comparable quarter last year. For the six months ended February 25, 2006 net sales were $25,505, a decrease of $2,303 from the six month period ended February 26, 2005. The decreases in both the three and six month periods are due to decreases in orders from several customers, limited capacity at our Tempe facility and delays in FDA approvals for our customers which caused certain orders to be delayed.

At our Microelectronics business, revenues dropped to $7.4 million in the quarter ended February 25, 2006 from $8.4 million in the second quarter last year. For the six month period, revenues were $16.3 million in Fiscal 2006 as compared with $16.0 million in Fiscal 2005. The primary reason for this decrease in revenues for the second quarter is the lack of flex substrate components which serve as the building blocks for our microelectronics manufacturing operations. The rapid increase experienced in demand for flex based product exceeded capacity at our Tempe facility and occurred more rapidly than forecasted. We have invested a significant amount of capital into new equipment at Tempe to increase our capacity. We expect increased output in the third quarter over the second quarter and expect a further increase in the fourth quarter. Another contributing factor for our revenue shortfall in Microelectronics business was lower demand from several customers. For the six month period, the decrease in revenues from the second quarter 2006 was offset by an increase in revenues in the first quarter 2006 due to an increase in demand from customers in our communications market.

At our Advanced Medical Operation or AMO, revenues decreased to $4.3 million in the second quarter from $5.3 million in the second quarter last year. For the six month period, revenues dropped to $9.2 million in Fiscal 2006 as compared with $11.8 million in fiscal 2005 or a decrease of 22%. The decrease from last year is due to a drop in both manufacturing business and software testing services called verification and validation services. One customer delayed verification and validation service work from the second quarter to late third and fourth quarter, and one other customer, who had awarded us a manufacturing program, subsequently decided to take the program in-house. In addition, several of our customers have experienced delays in obtaining approvals from regulatory agencies and this has caused a delay in our obtaining orders for assembly business at our AMO facility.

At February 25, 2006, our backlog of orders for revenue was approximately $18.1 million, compared to approximately $20.1 million at August 31, 2005. We expect to ship our backlog as of February 25, 2006 during Fiscal 2006. This decrease in backlog is reflective of a change in the way our customers do business, they are more unwilling to make commitments too far into the future. The backlog from our AMO includes customer commitments with longer shipment schedules, 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 in full production.

Gross Profit

Gross profit was $1,746 (15% of net sales) for the three-months ended February 25, 2006 compared to $2,867 (21% of net sales) for the three-months ended February 26, 2005. The decrease of $1,121 is due to lower sales in the second quarter of fiscal 2006 and due to the fixed costs of our business resulting in lower profit margins at lower revenue levels. For the six month period, gross profit dropped to $4,470 from $5,824 or a 23% decrease. The gross profit margin for the six month period was 17.5% in Fiscal 2006 as compared with 20.9% in Fiscal 2005.

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 increase in the second half of the fiscal year if our revenues increase, as expected. 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 were $2,350 in the second quarter of Fiscal 2006 and $2,344 in the second quarter of Fiscal 2005. For the six month period, selling, general and administrative expenses were $4,513 in Fiscal 2006 versus $4,387 in Fiscal 2005, an increase of $126 or 3%. Selling, general and administrative expenses in Fiscal 2006 include $157 and $273 for the three month and six month periods, respectively, related to the cost of employee and director stock options. This cost was not required to be recognized in prior periods. As a percentage of net sales, selling, general and administrative expenses increased to 20% for the three-month period ended February 25, 2006, as compared to 17% for the second quarter last year. For the six month periods, selling, general and administrative expenses as a percentage of sales were 18% in Fiscal 2006 versus 16% in Fiscal 2005. This increase is due to a decrease in sales and the increased costs discussed above. As a percentage of sales, we expect our Selling, general and administrative expenses to decrease in the second half of fiscal 2006.

Research, development, and engineering expenses

Research, development, and engineering expenses increased $50, or 5%, for the second quarter of Fiscal 2006 compared to the second quarter of Fiscal 2005. For the six month period, research, development and engineering costs increased by $306 from $1,771 in Fiscal 2005 to $2,077 in Fiscal 2006. 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% and 8% for the three-month and six-month periods ended February 25, 2006, respectively, as compared to 7% and 6% for the three-months and six-months ended February 26, 2005, respectively. The increase of these expenses as a percentage of net sales for the period ended February 25, 2006 is a result of the increased costs as discussed above and the 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

Net interest expense for the three months ended February 25, 2006 was $96, compared to $180 in the second quarter of Fiscal 2005. For the six-month periods, interest expense was $223 in Fiscal 2006 and $219 in 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 our former CEO.

Income Taxes

We did not record a tax provision or benefit in Fiscal 2006 or Fiscal 2005 due to our operating loss. 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 potential economic benefits of our net operating loss carryforwards to future years will continue until expired.

FINANCIAL CONDITION AND 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 $1,688 and $2,318 for the three months and six-months ended February 25, 2006, respectively. We generated 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 February 25, 2006, our primary sources of liquidity consisted of $160 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 $1,400 outstanding debt under the Credit Agreement at February 25, 2006.

On November 23, 2005 we received $1,350 refund of our security deposit on our Boulder facility. 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. These actions enabled us to fund working capital requirements and acquire manufacturing equipment.

During Fiscal 2006, we intend to spend approximately $2.8-$3.0 million for manufacturing equipment 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 through capital and operating leases and available debt financing. Through March 31, 2006, we have initiated purchase orders and have arranged for financing for approximately $2.7 million of equipment purchases that were delivered by early third quarter of Fiscal 2006. Approximately $2.5 million of this equipment will be capitalized in the third quarter as the equipment is placed into production. 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.

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 $1,400 as of February 25, 2006. 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 10.5% as of March 31, 2006. As of the February 25, 2006, 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 second 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 will 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 4. Submission of Matters to a Vote of Security Holders

The Company’s Annual Meeting of Shareholders was held on January 12, 2006. Of the 9,479,567 shares of common stock outstanding and entitled to vote at the meeting, 8,544,400 shares were present, either in person or by proxy. The following describes the matters considered by the Company’s shareholders at the Annual Meeting, as well as the results of the votes cast at the Annual Meeting:

1. To elect two (2) directors to hold office for a term of three years ending in 2009.


Name of Nominee	For		Withhold
Timothy F. Floeder		8,062,232		482,168
Mack V. Traynor		8,166,347		378,053

The following directors also continue to serve: George M. Heenan (term expires in 2007), Thomas Leahy (term expires in 2007), Michael J. Evers (term expires in 2008) and Robert Heller (term expires in 2008).

2. To approve an amendment to increase the number of shares authorized for issuance under the Company’s 1998 Stock Option Plan from 1,650,000 to 2,000,000.


For:			2,405,216
Against:			1,518,056
Abstain:			21,550
Broker Non-Vote:			4,599,578

This proposal was approved.

To approve the 2005 HEI, Inc. Employee Stock Purchase Plan.


For:			3,467,836
Against:			452,616
Abstain:			24,370
Broker Non-Vote:			4,599,578

This proposal was approved.

To approve an amendment to the Articles of Incorporation of the Company to increase the number of authorized shares from 15,000,000 to 25,000,000.


For:			7,063,232
Against:			1,461,781
Abstain:			19,387
Broker Non-Vote:			0

This proposal was approved.


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.


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


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.

	a)		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	b)		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	c)		Disclosed in this report any changes in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

	a)		All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	b)		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

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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			15
	Item 3. Quantitative and Qualitative Disclosures About Market Risk			19
	Item 4. Controls and Procedures			20
Part II – Other Information				21
	Item 4. Submission of Matters to a Vote of Security Holders			21
	Item 6. Exhibits			22
	Signature			23
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

1.		I have reviewed this Quarterly Report on Form 10-Q of HEI, Inc.;

2.		Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.		Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have:


		/s/ Mack V. Traynor, III Mack V. Traynor, III Chief Executive Officer and President


		/s/ Timothy C. Clayton Timothy C. Clayton Chief Financial Officer