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 May 27, 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 the 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 July 7, 2006 — 9,504,567 Common Shares, par value $.05 per share, were outstanding.

TABLE OF CONTENTS

Table of Contents HEI, Inc.

 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

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Consolidated Balance Sheets

(In thousands, except per share and share data)

	May 27, 2006			August 31, 2005
	(unaudited)			(audited)
Assets
Current assets:
Cash and cash equivalents	$	169		$	351
Accounts receivable, net of allowance for doubtful accounts of $151 and $157, respectively		8,047			9,278
Inventories		7,822			8,044
Security Deposit		—			1,350
Other current assets		813			1,136
Total current assets		16,851			20,159
Property and equipment:
Land		216			216
Building and improvements		4,350			4,323
Fixtures and equipment		24,906			23,214
Accumulated depreciation		(21,385	)		(20,864	)
Net property and equipment		8,087			6,889
Developed technology, less accumulated amortization of $408 and $352, respectively		6			62
Security deposits		414			230
Other long-term assets		641			337
Total assets	$	25,999		$	27,677
Liabilities and Shareholders’ Equity
Current liabilities:
Line of credit	$	2,420		$	2,563
Current maturities of long-term debt		1,052			484
Accounts payable		4,493			4,019
Accrued liabilities		2,783			4,129
Total current liabilities		10,748			11,195
Other long-term liabilities, less current maturities		972			873
Long-term debt, less current maturities		3,003			1,813
Total other long-term liabilities, less current maturities		3,975			2,686
Total liabilities		14,723			13,881
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; 11,000,000 shares authorized; 9,505,000 and 9,379,000 shares issued and outstanding		475			469
Paid-in capital		27,465			26,701
Accumulated deficit		(16,598	)		(13,169	)
Notes receivable-related parties-former officers and directors		(68	)		(207	)
Total shareholders’ equity		11,276			13,796
Total liabilities and shareholders’ equity	$	25,999		$	27,677

See accompanying notes to unaudited consolidated financial statements.

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HEI, Inc.

Consolidated Statements of Operations (Unaudited)

(In thousands, except per share data)

	Three Months Ended						Nine Months Ended
	May 27, 2006			May 28, 2005			May 27, 2006			May 28, 2005
Net sales	$	13,219		$	13,755		$	38,724		$	41,563
Cost of sales		10,781			11,185			31,816			33,170
Gross profit		2,438			2,570			6,908			8,393
Operating expenses:
Selling, general and administrative		2,247			1,995			6,759			6,381
Research, development and engineering		1,062			690			3,140			2,462
Gain on claim settlement		—			(300	)		—			(300	)
Costs related to investigation		—			—			—			—
Operating income (loss)		(871	)		185			(2,991	)		(150	)
Other income (expenses):
Interest expense and other		(206	)		(148	)		(429	)		(498	)
Litigation recovery		—			—			—			481
Other income (expense), net		(34	)		236			(9	)		318
Income (loss) before income taxes		(1,111	)		273			(3,429	)		151
Income taxes		—			—			—			—
Net income (loss)	$	(1,111	)	$	273		$	(3,429	)	$	151
Deemed dividend on Preferred Stock	$	—		$	1,072		$	—		$	1,072
Net loss attributable to common stock holders	$	(1,111	)	$	(799	)	$	(3,429	)	$	(921	)
Earnings (loss) per common share:
Basic & Diluted:
Net Income (loss)	$	(0.12	)	$	0.03		$	(0.36	)	$	0.02
Deemed dividend on Preferred Stock	$	—		$	(0.13	)	$	—		$	(0.13	)
Net loss attributable to common stock holders	$	(0.12	)	$	(0.10	)	$	(0.36	)	$	(0.11	)
Weighted average common shares outstanding:
Basic		9,491			8,381			9,457			8,365
Diluted		9,491			8,381			9,457			8,365

See accompanying notes to unaudited consolidated financial statements.

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HEI, Inc.

Consolidated Statements of Cash Flows (Unaudited)

(In thousands)

	Nine Months Ended
	May 27, 2006			May 28, 2005
Cash flow from operating activities:
Net income (loss)	$	(3,429	)	$	151
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation and amortization		1,848			1,893
Loss on disposal of property and equipment		33			40
Stock based compensation expense		387			—
Changes in operating assets and liabilities:
Restricted cash related to deferred litigation		—			481
Accounts receivable		1,231			(1,560	)
Inventories		222			(1,528	)
Other current assets		323			261
Other assets		—			(14	)
Accounts payable		474			309
Accrued liabilities and other long-term liabilities		(1,247	)		(283	)
Net cash flow used in operating activities		(158	)		(250	)
Additions to property and equipment		(923	)		(1,519	)
Proceeds from sale of assets		83			—
Additions to patents		(7	)		(80	)
Security Deposit		1,166			—
Net cash flow provided by (used in) investing activities		319			(1,599	)
Cash flow from financing activities:
Proceeds from issuance of stock, net		47			3,280
Note repayment		139			227
Repayment of long-term debt		(386	)		(40	)
Net repayments on line of credit		(143	)		(1,310	)
Net cash flow provided by (used in) financing activities		(343	)		2,157
Net increase (decrease) in cash and cash equivalents		(182	)		308
Cash and cash equivalents, beginning of period		351			200
Cash and cash equivalents, end of period	$	169		$	508
Supplemental disclosures of cash flow information:
Interest paid	$	435		$	498
Deemed dividend on preferred stock	$	—		$	1,072
Capital lease obligations related to property and equipment	$	2,144		$	250
Issuance of common stock to landlord recognized as long-term asset	$	336		$	—

See accompanying notes to unaudited consolidated financial statements.

5

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 nine-month periods ended May 27, 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.

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(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 $1,111 for the three months ended May 27, 2006, a net loss of $3,429 for the nine months ended May 27, 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 May 27, 2006, our sources of liquidity consisted of $169 of cash and cash equivalents, our working capital line of credit (“Line of Credit”) and our accounts receivable agreement (“Credit Agreement”). Our Line of Credit agreement provides a $2.0 million credit facility with Beacon Bank. This facility is secured by a portion of our inventory and our foreign accounts receivable. The facility is guaranteed by the Small Business Administration and is due to expire in September 2006. There was $2.0 million outstanding debt under the Line of Credit at May 27, 2006. The Credit Agreement with Beacon Bank provides borrowing capacity up to $5.0 million subject to availability based on our domestic accounts receivable. The Credit Agreement is due to expire in September 2006. There was $420 outstanding debt under the Credit Agreement at May 27, 2006.

On November 23, 2005, we received $1,350 refund of our security deposit on our Boulder facility. 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. In addition, in Fiscal 2006 we entered into additional financing agreements primarily in the form of capital leases for the acquisition of approximately $2.2 million of equipment. This equipment was received and placed into production in the third quarter of this year and has been capitalized.

Our liquidity is affected by many factors which are inherent in the normal ongoing operations of our business. The most significant of these factors include the timing of the collection of receivables, the level of inventories, the timing and magnitude of our payroll costs, maintenance expenses and capital expenditures. During Fiscal 2006, cash flows from operations have not been sufficient to fund operations at the present level. Measures have been taken to reduce expenses and additional measures are possible to reduce the expenditure levels including but not limited to reduction of spending for development and engineering, elimination of budgeted raises, the reduction of non-strategic or underutilized 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 and the issuance of long-term debt. There can be no assurances, however, that additional funding would be available at acceptable terms.

(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.

7

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 May 27, 2006, 1,371,975 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 $114 and $345 ($.01 and $.04 per share) in the three and nine months ended May 27, 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 $115, and estimate the impact on future earnings to be approximately $400.

In addition, during the nine months ended May 27, 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 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			Nine Months Ended
	May 28, 2005			May 28, 2005
Net loss attributable to common stockholders as reported	$	(799	)	$	(921	)
Add: Stock-based employee compensation included in reported net income, net of related tax effects		—			—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(259	)		(1,074	)
Net loss pro forma	$	(1,058	)	$	(1,995	)
Basic and diluted net loss per share attributable to common stockholders as reported	$	(0.10	)	$	(0.11	)
Stock-based compensation expense		(0.03	)		(0.13	)
Basic and diluted net loss per share pro forma	$	(0.13	)	$	(0.24	)

There were no options granted in the three months ended May 27, 2006. There were 5,000 options granted in the nine months ended May 27, 2006. There were 80,000 options granted during the three and nine months ended May 28, 2005.

8

During the nine month period ended May 27, 2006, the Company granted 79,800 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 $260 which will be expensed over the vesting period. As of May 27, 2006, 58,800 shares of restricted stock remain outstanding.

(4) Developed Technology

Amortization expense for developed technology for the three months ended May 27, 2006 and May 28, 2005 was $2 and $31, respectively. Amortization expense for the nine-month periods was $56 in Fiscal 2006 and $92 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 May 27, 2006 and August 31, 2005:

	May 27,		August 31,
	2006		2005
Inventories:
Purchased parts	$	5,735	$	5,881
Work in process		520		590
Finished goods		1,567		1,573
	$	7,822	$	8,044
Accrued Liabilities:
Employee related costs	$	1,338	$	1786
Deferred revenue		—		440
Real estate taxes		42		130
Customer deposits		191		589
Current maturities of long-term liabilities		125		247
Warranty reserve		62		132
Other accrued liabilities		1,025		805
	$	2,783	$	4,129
Other long-term liabilities:
Remaining lease obligation, less estimated sublease proceeds	$	559	$	552
Unfavorable operating lease, net		538		568
Total	$	1,097	$	1,120
Less current maturities		125		247
Total other long-term liabilities	$	972	$	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 nine months of Fiscal 2006 and 2005 were as follows:

9

			Warranty			Warranty
	Beginning Balance		Provisions			Claims		Ending Balance
For the Three Months Ended
May 27, 2006	$	36	$	(22	)	$	2	$	12
May 28, 2005	$	160	$	90		$	27	$	223
For the Nine Months Ended
May 27, 2006	$	132	$	(82	)	$	38	$	12
May 28, 2005	$	139	$	174		$	90	$	223

(7) Long-Term Debt

Our long-term debt consists of the following:

	May 27		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	$	1,129	$	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		460		673
Capital lease obligation; payable in installments of $1 through February 2009; collateralized with equipment		20		25
Commercial loans payable in fixed monthly principal installments of $1 through May 2009; collateralized with certain machinery and equipment		19		22
Capital lease obligations; payable in fixed monthly installments of $16 through July 2008; collateralized with certain machinery and equipment		326		423
Capital lease obligations; payable in fixed monthly installments of $4 through September 2008; collateralized with certain machinery and equipment		96		0
Capital lease obligations; payable in fixed monthly installments of $1 through November 2008; collateralized with certain machinery and equipment		19		0
Capital lease obligations; payable in fixed monthly installments of $3 through January 2009; collateralized with certain machinery and equipment		74		0
Capital lease obligations; payable in fixed monthly installments of $1 through February 2009; collateralized with certain machinery and equipment		24		0
Capital lease obligations; payable in fixed monthly installments of $2 through March 2009; collateralized with certain machinery and equipment		51		0
Capital lease obligations; payable in fixed monthly installments of $21 through November 2009 with final payment of $140; collateralized with certain machinery and equipment;		875		0
Capital lease obligations; payable in fixed monthly installments of $9 through March 2009 with final payment of $47; collateralized with certain machinery and equipment		296		0
Capital lease obligations; payable in fixed monthly installments of $2 through May 2009 with final payment of $8; collateralized with certain machinery and equipment		53		0
Capital lease obligations; payable in fixed monthly installments of $6 through February 2010 with final payment $41; collateralized with certain machinery and equipment		257		0
Capital lease obligations; payable in fixed monthly installments of $10 through July 2009 with final payment of $57; collateralized with certain machinery and equipment		356		0
Commercial loans payable paid in full during Fiscal 2006		0		9
Total		4,055		2,297
Less current maturities		1,052		484
Total long-term debt	$	3,003	$	1,813

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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 collateralized 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 was not in compliance with the debt service coverage ratio requirement of these two agreements as of May 27, 2006. On June 21, 2006, we entered into a Waiver and Amendment dated effective May 27, 2006 (the “Commerce Bank Amendment”) to waive and amend certain provisions of The Commerce Bank Term Loan Agreement dated October 14, 2003, as amended by the Waiver and Amendment dated as of November 30, 2004, the Waiver and Amendment dated as of December 29, 2004 and the Promissory Note dated October 14, 2003. The Commerce Bank Amendment, among other things: (i) waived the Company’s compliance with the Debt Service Coverage Ratio covenant in the Commerce Bank Loan Agreement for the period up to the Company’s reporting period ending August 31, 2006 and (ii) amended the Commerce Bank Loan Agreement to re-establish the $100 Payment Reserve Account. Also on June 21, 2006, the Company entered into a Waiver and Amendment (the “Commerce Financial Group Amendment”) to waive and amend certain provisions of The Commerce Financial Group Term Loan Agreement dated October 28, 2003, as amended by the Waiver and Amendment dated as of November 30, 2004, the Waiver and Amendment dated as of December 29, 2004 and the Promissory Note dated October 28, 2003. The Commerce Financial Group Amendment, among other things: (i) waived the Company’s compliance with the Debt Service Coverage Ratio covenant in the Commerce Financial Group Loan Agreement for the period up to the Company’s reporting period ending August 31, 2006 and (ii) amended the Commerce Financial Group Loan Agreement to re-establish the $25 payment reserve account.

During Fiscal 2006, the Company entered into several capital lease agreements to fund the acquisition of machinery and equipment, primarily at our Tempe facility. The majorities of these leases were entered into with Commerce Financial Group and are secured by the equipment being leased and a secured interest in our Victoria building. The total principal amount of these leases is $2.1 million with an average effective interest rate of 12.7%. These agreements are for three to five years with reduced payments in the last year of the lease. At the end of the lease we have the option to purchase the equipment for $1.

Also on June 21, 2006, the Company entered into a Waiver (the “Waiver”) to waive and amend certain provisions of its Master Equipment Lease No. 0512231 (the “Master Lease”) dated as of December 23, 2005 with Commerce Leasing Corporation (the “Lessor”), a division of Commerce Financial Group, Inc.; those lease commitments by the Lessor for the benefit of the Company dated as of December 5, 2005, December 8, 2005, February 23, 2006 and February 24, 2006 (collectively, the “Commitments”); and those supplements (the “Supplements”) to the Master Lease in favor of the Lessor (the Master Lease, Commitments and Supplements are collectively the “Lease”). The Waiver, among other things: (i) waived the Company’s compliance with the Debt Service Coverage Ratio covenant in the Lease for the period up to the Company’s reporting period ending August 31, 2006 and (ii) amended the Lease to increase by 2% the implied economic interest rate for each Supplement under the Master Lease and to adjust the monthly rental payments for the Supplements accordingly until the Company is in compliance with the covenants in the Lease.

11

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.

(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 $420 as of May 27, 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 11% as of May 27, 2006. Borrowings are reduced as collections and payments are received into a lock box by the bank. As of May 27, 2006, the Company is in compliance with all covenants of the Credit Agreement.

In March 2006, the Company entered into a supplemental $2.0 million revolving line of credit with Beacon Bank that is secured by a portion of our inventory and our foreign accounts receivable and guaranteed by the Small Business Administration (the “Line of Credit”). The Line of Credit expires on September 1, 2006. Borrowings under the Line of Credit bear an interest rate of Prime plus 2.75% and a processing fee of .65%. The effective borrowing rate as of May 27, 2006 was approximately 11%. As of May 27, 2006, the balance outstanding on the Line of Credit was $2.0 million. The Company is in compliance with all covenants of the Line of Credit.

(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 $8,500 and $7,195, at May 27, 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.

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(10) Net Income (Loss) per Share Computation

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

	Three Months Ended						Nine Months Ended
	May 27, 2006			May 28, 2005			May 27, 2006			May 28, 2005
Basic:
Net income (loss)	$	(1,111	)	$	273		$	(3,429	)	$	151
Net loss attributable to common stockholders	$	(1,111	)	$	(799	)	$	(3,429	)	$	(921	)
Net income (loss) per share	$	(0.12	)	$	0.03		$	(0.36	)	$	0.02
Net loss attributable to common stockholders per share	$	(0.12	)	$	(0.10	)	$	(0.36	)	$	(0.11	)
Weighted average number of common shares outstanding		9,491			8,381			9,457			8,365
Diluted:
Net income (loss)	$	(1,111	)	$	273		$	(3,429	)	$	151
Net loss attributable to common stockholders	$	(1,111	)	$	(799	)	$	(3,429	)	$	(921	)
Net income (loss) per share	$	(0.12	)	$	0.03		$	(0.36	)	$	0.02
Net loss attributable to common stockholders per share	$	(0.12	)	$	(0.10	)	$	(0.36	)	$	(0.11	)
Weighted average number of common shares outstanding		9,491			8,381			9,457			8,365
Assumed conversion of preferred stock		—			—			—			—
Assumed conversion of stock options		—			—			—			—
Weighted average common and assumed conversion shares		9,491			8,381			9,457			8,365

Approximately 2,372,000 and 2,367,000 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 and nine-month periods ended May 27, 2006 and May 28, 2005, respectively.

(11) Notes Receivable Related Parties — Officers and Former Directors and Transactions with Former CEO

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.

On April 2, 2006, $140 was collected related to these notes and $68 owed by Mr. Edwin Finch, a former director, was refinanced to be repaid over the next nine months. The amount of $68 is presented as a reduction to stockholders equity at May 27, 2006.

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(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 May 27, 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

Net sales from one customer represented 18% of our revenue for the three months ended May 27, 2006. For the nine months ended May 27, 2006, two customers accounted for 13% and 10% of net sales, respectively. There were no customers over 10% of net sales for the three and nine months ended May 28, 2005.

As of May 27, 2006, one customer represented 21% of our accounts receivable. 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 May 27								Nine Months Ended May 27
	2006				2005				2006				2005
			% of				% of				% of				% of
	Dollars		Sales		Dollars		Sales		Dollars		Sales		Dollars		Sales
United States	$	9,333		71%	$	9,344		68%	$	27,667		71%	$	28,939		70%
Canada / Mexico		278		2%		799		6%		1,155		3%		3,249		8%
Europe		1,166		9%		1,673		12%		4,102		11%		4,000		10%
Asia-Pacific		2,431		18%		1,928		14%		5,773		15%		5,135		12%
South America		11		0%		11		0%		27		0%		240		0%
Total	$	13,219			$	13,755			$	38,724			$	41,563

(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.

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

Segment information is as follows:

	Three Months Ended May 27, 2006											Nine Months Ended May 27, 2006
						Advanced											Advanced
				Microelectronics		Medical									Microelectronics		Medical
	Corporate			Operations		Operations			Total			Corporate			Operations		Operations		Total
Net sales	$	0		$	9,049	$	4,170		$	13,219		$	0		$	25,332	$	13,392	$	38,724
Gross profit		0			2,317		121			2,438			0			5,310		1,598		6,908
Operating Expense		2,204			954		151			3,309			6,670			2,627		602		9,899
Op income (loss)		(2,204	)		1,363		(30	)		(871	)		(6,670	)		2,683		996		(2,991	)
Total assets		0			19,952		6,047			25,999			0			19,952		6,047		25,999
Depr. and amortization		0			572		70			642			0			1,579		269		1,848
Capital expenditures		0			102		294			396			0			598		325		923

	Three Months Ended May 28, 2005									Nine Months Ended May 28, 2005
						Advanced									Advanced
				Microelectronics		Medical							Microelectronics		Medical
	Corporate			Operations		Operations		Total		Corporate			Operations		Operations		Total
Net sales	$	0		$	8,150	$	5,605	$	13,755	$	0		$	24,188	$	17,375	$	41,563
Gross profit		0			1,356		1,214		2,570		0			4,130		4,263		8,393
Operating Expense		1,980			292		113		2,385		6,438			1,431		674		8,543
Op income (loss)		(1,980	)		1,064		1,101		185		(6,438	)		2,699		3,589		(150	)
Total assets		0			19,379		8,070		27,449		0			19,379		8,070		27,449
Depr. and amortization		0			484		102		586		0			1,590		303		1,893
Capital expenditures		0			741		10		751		0			1,554		45		1,599

(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.

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(17) Gain on claim settlement

During the third quarter of Fiscal 2005, we entered into a settlement agreement related to an outstanding claim against the seller of the AMO operations that we acquired in January 2003. The net effect of this settlement, after offsetting legal and other related costs was a gain of $300. All the cash related to this settlement was received in the third quarter of Fiscal 2005.

(18) Deemed Dividend on Preferred Stock

The preferred stock issued by the Company in May 2005 contained an embedded beneficial conversion feature. We have recorded a deemed dividend on preferred stock in our financial statements for the quarterly period ended May 28, 2005. This non-cash dividend is to reflect the implied economic value to the preferred stockholders of being able to convert their shares into common stock at a price which is in excess of the fair value of the preferred stock. In order to determine the dividend value, we allocated the proceeds of the offering between preferred stock and the common stock warrants that were issued as part of the offering based on their relative fair values. The fair value allocated to the warrants of $850 was recorded as equity. The fair value allocated to the preferred stock of $2,550 together with the original conversion terms were used to calculate the value of the deemed dividend on the preferred stock of $1,072 at the date of issuance of the preferred stock. This amount has been charged to accumulated deficit with the offsetting credit to additional paid-in-capital. We have treated the deemed dividend on preferred stock as a reconciling item on the statement of operations to adjust our reported net income (loss) to “net income (loss) available to common stockholders.”

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, increasing sales and increasing capacity at our Tempe flex operation.

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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 May 27, 2006 and May 28, 2005:

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

	Three Months Ended									Nine month ended
	May 27,					May 28,				May 27,					May 28,
	2006					2005				2006					2005
Net sales	$	13,219		100	%	$	13,755	100	%	$	38,724		100	%	$	41,563		100	%
Cost of sales		10,781		82	%		11,185	81	%		31,816		82	%		33,170		80	%
Gross profit		2,438		18	%		2,570	19	%		6,908		18	%		8,393		20	%
Operating expenses		3,309		24	%		2,385	18	%		9,899		26	%		8,543		21	%
Operating loss		(871	)	(6	)%		185	1	%		(2,991	)	(8	)%		(150	)	(1	)%
Other income (expense)		(240	)	(2	)%		88	1	%		(438	)	(1	)%		301		1	%
Net income (loss)	$	(1,111	)	(8	)%	$	273	2	%	$	(3,429	)	(9	)%	$	151		0	%

	Three Months Ended				Nine Months Ended
	May 27, 2006		May 28, 2005		May 27, 2006		May 28, 2005
Medical/Hearing	$	10,778	$	11,234	$	30,240	$	33,477
Communications		1,435		1,224		5,216		4,486
Industrial		1,006		1,297		3,268		3,600
Total Net Sales	$	13,219	$	13,755	$	38,724	$	41,563

Net Sales

Net sales in the third quarter of Fiscal 2006 were $13,219, a decrease of $536, or 4%, from the comparable quarter last year. For the nine months ended May 27, 2006 net sales were $38,724, a decrease of $2,839 from the nine month period ended May 28, 2005. The decrease in the three month period is primarily due to a decrease in design and development business at our AMO business unit which was the result of the termination of one program for one customer. This decrease offset an increase in production of flex substrates at our Tempe facility.

At our Microelectronics business, revenues increased to $9.0 million in the quarter ended May 27, 2006 from $8.2 million in the third quarter last year or an increase of nearly 10%. The primary reason for this increase in the quarter over the last fiscal year is the increased production and output of flex substrates at our Tempe facility. This increase is due to the addition of equipment at this facility in the third quarter.

For the nine month period, revenues were $25.3 million in Fiscal 2006 as compared with $24.2 million in Fiscal 2005. The primary reason for this increase in revenues is the increase in flex capacity in the third quarter which enabled the Company to sell more flex based products.

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At our Advanced Medical Operation or AMO, revenues decreased to $4.2 million in the third quarter from $5.6 million in the third quarter last year. For the nine month period, revenues dropped to $13.4 million in Fiscal 2006 as compared with $17.4 million in fiscal 2005 or a decrease of 23%. The decrease from last year is due to a drop in both manufacturing business and engineering services called design and development and verification and validation services. The termination of one design and development contract with one customer contributed to a significant portion of the decrease in both the third quarter and the nine month period. In addition, one customer delayed verification and validation service work from the second quarter to fourth quarter, and one other customer, who had awarded us a manufacturing program, subsequently decided to take the program in-house. We also had several of our customers experience delays in obtaining approvals from regulatory agencies and this has caused a delay in our obtaining orders for assembly business at our AMO facility. The Company has been actively working to replace this revenue and have obtained new business opportunities with new and long standing customers which should approximate $2.3 million of new business over the next two quarters. We expect to see about $1.0 million of this revenue in the fourth quarter of Fiscal 2006.

At May 27, 2006, our backlog of orders for revenue was in excess of $15 million, compared to approximately $20 million at August 31, 2005. We expect to ship our backlog as of May 27, 2006 during Fiscal 2006 and Fiscal 2007. 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 $2,438 (18% of net sales) for the three-months ended May 27, 2006 compared to $2,570 (19% of net sales) for the three months ended May 28, 2005. The decrease of $132 is due to lower sales in the third quarter of fiscal 2006 and due to the reduction in engineering services revenue at our AMO business unit which is generally at a higher gross margin. For the nine month period, gross profit dropped to $6,908 from $8,393 or a 18% decrease. The gross profit margin for the nine month period was 18% in Fiscal 2006 as compared with 20% 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 and services 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 fourth quarter of the fiscal year as our revenues increase and the mix of the revenue returns to more normal levels at our AMO operation. 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 $2,247 in the third quarter of Fiscal 2006 and $1,995 in the third quarter of Fiscal 2005. For the nine month period, selling, general and administrative expenses were $6,759 in Fiscal 2006 versus $6,381 in Fiscal 2005, an increase of $378 or 6%. Selling, general and administrative expenses in Fiscal 2006 include $114 and $387 for the three month and nine month periods, respectively, related to the cost of employee and director stock options and restricted stock grants. This cost was not required to be recognized in prior periods. As a percentage of net sales, selling, general and administrative expenses increased to 17% for the three-month period ended May 27, 2006, as compared to 15% for the third quarter last year. For the nine month periods, selling, general and administrative expenses as a percentage of sales were 17% in Fiscal 2006 versus 15% in Fiscal 2005. This increase is due to a decrease in sales and the increased costs discussed above related to stock based compensation. As a percentage of sales, we expect our selling, general and administrative expenses to decrease as a percentage of sales in the fourth quarter of fiscal 2006.

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Research, development, and engineering expenses

Research, development, and engineering expenses increased $372, or 54%, for the third quarter of Fiscal 2006 compared to the third quarter of Fiscal 2005. For the nine month period, research, development and engineering costs increased by $678 from $2,462 in Fiscal 2005 to $3,140 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 future. In addition, incremental engineering costs were incurred in Fiscal 2006 related to obtaining and qualifying a second source of flex substrates so as to meet customer demand in this area. As a percentage of net sales, research, development, and engineering expenses were 8% and 8% for the three-month and nine-month periods ended May 27, 2006, respectively, as compared to 5% and 6% for the three-months and nine-months ended May 28, 2005, respectively. The increase of these expenses as a percentage of net sales for the period ended May 27, 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.

Gain on claim settlement

During the third quarter of Fiscal 2005, we entered into a settlement agreement related to an outstanding claim against the seller of the AMO operations that we acquired in January 2003. The net effect of this settlement, after offsetting legal and other related costs, was a gain of $300. All the cash related to this settlement was received in the third quarter of Fiscal 2005.

Other Income (Expense), Net

Net interest expense for the three months ended May 27, 2006 was $206 compared to $148 in the third quarter of Fiscal 2005. For the nine-month periods, interest expense was $429 in Fiscal 2006 and $498 in Fiscal 2005. Interest expense increased for the three month period due to higher net borrowing levels related to incremental debt on the equipment added to our Tempe facility and higher borrowing on our credit facilities.

For the three months ended May 28, 2005, other income included a gain on recoveries on a previously written off note receivable of approximately $236. 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.

Deemed Dividend on Preferred Stock

The preferred stock that was issued in the third quarter of Fiscal 2005 contained an embedded beneficial conversion feature which required that we record a deemed dividend on preferred stock in our financial statements for the quarterly period ended May 28, 2005. This non-cash dividend is to reflect the implied economic value to the preferred stockholders of being able to convert their shares into common stock at a price which is in excess of the fair value of the preferred stock. In order to determine the dividend value, we allocated the proceeds of the offering between preferred stock and the common stock warrants that were issued as part of the offering based on their relative fair values. The fair value allocated to the warrants of $850 was recorded as equity. The fair value allocated to the preferred stock of $2,550 together with the original conversion terms were used to calculate the value of the deemed dividend on the preferred stock of $1,072 at the date of issuance of the preferred stock. This amount has been charged to accumulated deficit with the offsetting credit to additional paid-in-capital. The deemed dividend on preferred stock is a reconciling item on the statement of operations to adjust reported net income (loss) to “net income (loss) available to common stockholders.”

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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 $1,111 and $3,429 for the three months and nine-months ended May 27, 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 May 27, 2006, our sources of liquidity consisted of $169 of cash and cash equivalents, our working capital line of credit (“Line of Credit”) and our accounts receivable agreement (“Credit Agreement”). Our Line of Credit agreement provides a $2.0 million credit facility with Beacon Bank. This facility is secured by a portion of our inventory and our foreign accounts receivable. The facility is guaranteed by the Small Business Administration and is due to expire in September 2006. There was $2.0 million outstanding debt under the Line of Credit at May 27, 2006. The Credit Agreement with Beacon Bank 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 $420 outstanding debt under the Credit Agreement at May 27, 2006.

On November 23, 2005, we received $1,350 refund of our security deposit on our Boulder facility. 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. In addition, in Fiscal 2006 we entered into additional financing agreements primarily in the form of capital leases for the acquisition of approximately $2.1 million of equipment. This equipment was received and placed into production in the third quarter of this year and has been capitalized.

Our liquidity is affected by many factors which are inherent in the normal ongoing operations of our business. The most significant of these factors include the timing of the collection of receivables, the level of inventories, the timing and magnitude of our payroll costs, maintenance expenses and capital expenditures. During Fiscal 2006, cash flows from operations have not been sufficient to fund operations at the present level. Measures have been taken to reduce expenses and additional measures are possible to reduce the expenditure levels including but not limited to reduction of spending for development and engineering, elimination of budgeted raises, the reduction of non-strategic or underutilized 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 and the issuance of long-term debt. There can be no assurances, however, that additional funding would be available at acceptable terms.

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. Virtually all of the equipment has been purchased as of May 27, 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 should supply sufficient cash flow to meet short- and long-term debt obligations, working capital and operating requirements during the next 12 months based on current revenue expectations. Supplemental financing arrangements will need to be identified to fund additional capital expenditures or in the event that operations do not return to a profitable level in the near term.

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On June 21, 2006, HEI, Inc. (the “Company”) entered into a Waiver and Amendment dated effective May 27, 2006 (the “Commerce Bank Amendment”) to waive and amend certain provisions of The Commerce Bank Term Loan Agreement dated October 14, 2003, as amended by the Waiver and Amendment dated as of November 30, 2004, the Waiver and Amendment dated as of December 29, 2004 and the Promissory Note dated October 14, 2003. The Commerce Bank Amendment, among other things: (i) waived the Company’s compliance with the Debt Service Coverage Ratio covenant in the Commerce Bank Loan Agreement for the period up to the Company’s reporting period ending August 31, 2006 and (ii) amended the Commerce Bank Loan Agreement to re-establish the $100 Payment Reserve Account. Also on June 21, 2006, the Company entered into a Waiver and Amendment (the “Commerce Financial Group Amendment”) to waive and amend certain provisions of The Commerce Financial Group Term Loan Agreement dated October 28, 2003, as amended by the Waiver and Amendment dated as of November 30, 2004, the Waiver and Amendment dated as of December 29, 2004 and the Promissory Note dated October 28, 2003. The Commerce Financial Group Amendment, among other things: (i) waived the Company’s compliance with the Debt Service Coverage Ratio covenant in the Commerce Financial Group Loan Agreement for the period up to the Company’s reporting period ending August 31, 2006 and (ii) amended the Commerce Financial Group Loan Agreement to re-establish the $25 payment reserve account.

Also on June 21, 2006, the Company entered into a Waiver (the “Waiver”) to waive and amend certain provisions of its Master Equipment Lease No. 0512231 (the “Master Lease”) dated as of December 23, 2005 with Commerce Leasing Corporation (the “Lessor”), a division of Commerce Financial Group, Inc.; those lease commitments by the Lessor for the benefit of the Company dated as of December 5, 2005, December 8, 2005, February 23, 2006 and February 24, 2006 (collectively, the “Commitments”); and those supplements (the “Supplements”) to the Master Lease in favor of the Lessor (the Master Lease, Commitments and Supplements are collectively the “Lease”). The Waiver, among other things: (i) waived the Company’s compliance with the Debt Service Coverage Ratio covenant in the Lease for the period up to the Company’s reporting period ending August 31, 2006 and (ii) amended the Lease to increase by 2% the implied economic interest rate for each Supplement under the Master Lease and to adjust the monthly rental payments for the Supplements accordingly until the Company is in compliance with the covenants in the Lease.

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.

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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 $420 as of May 27, 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 11% as of May 27, 2006. As of the May 27, 2006, the Company is in compliance with all covenants of the Credit Agreement.

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Our Line of Credit agreement with Beacon Bank provides a $2.0 million credit facility with Beacon Bank. This facility is secured by a portion of our inventory and our foreign accounts receivable. The facility is guaranteed by the Small Business Administration and is due to expire in September 2006. The interest on the Line of Credit is Prime plus 2.75% plus a processing fee of         .65%. The effective rate as of May 27, 2006 is approximately 11%. There was $2.0 million outstanding debt under the Line of Credit at May 27, 2006. The Company is in compliance with all covenants of the Line of Credit.

A change in interest rates is not expected to have a material adverse effect on our near-term financial condition or results of operation.

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 third 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 2008.

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.

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PART II — OTHER INFORMATION

Item 6. Exhibits

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.

SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized

	HEI, Inc.
Date: July 11, 2006	/s/ Timothy C. Clayton
	Timothy C. Clayton
	Chief Financial Officer

Exhibit Index

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.

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