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SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 0-10078

HEI, Inc.

Issuer’s telephone number, including area code:

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

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

Common Stock, Par Value $.05 Per Share

(Title of Class)

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

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

          Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).     Yes o          No þ

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

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

DOCUMENTS INCORPORATED BY REFERENCE

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

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FORWARD-LOOKING STATEMENTS

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

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

PART I

Item 1.     Description of Business

(a) Business Development

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

(b) Business of the Company

	•	Microelectronics — Our microelectronics division designs and manufactures ultraminiature microelectronic devices and high technology products incorporating these devices. These custom microelectronic devices typically consist of placing or assembling one or more integrated circuits (IC) commonly referred to as “chips,” and other passive electrical components onto a ceramic or organic substrate. The microelectronic assembly typically embodies the primary functions of the end products of our customers, such as hearing aids, defibrillators and communication components. For example, in hearing aids the microelectronic assemblies we design and make are contained within a shell and connected to a microphone, receiver and battery. We may procure the microphone, receiver and battery from outside vendors and assemble all of the components into further assemblies for some customers, and we may sell only the microelectronic assembly to others. Our custom-built microelectronics are employed in the hearing, medical, telecommunications and ultraminiature radio frequency markets.

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

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

	•	RFID/ Access — Through our subsidiary, Cross, we manufacture wireless smart cards and other ultra-miniature radio frequency (RF) applications. Ultraminiature electronic modules are connected to an RF coil, creating an assembly. This assembly is contained within a smart card or wireless card (about the same size as a credit card) that is used for financial, security access and identification or tacking applications.
	•	High Density Interconnect — Our Tempe, Arizona location manufactures and designs high density, high quality flex circuits and high-performance laminate-based substrates. We further process significant portions of the substrates produced at this location into custom-built microelectronics at our facility in Minnesota. The high density interconnect location serves the hearing, medical and communications markets.

      Manufacturing Process: We manufacture our products by fabricating a substrate and placing IC’s and passive electrical components onto that substrate. Substrates are made of multi-layer ceramic or laminate materials. The process of placing components onto the substrate is automated using sophisticated equipment that picks an IC from a wafer or waffle pack and places it onto a substrate with very high precision. Many of the components require wire bonding to electrically connect them to the substrate. We then electrically test the microelectronic assemblies to ensure required performance.

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

      We currently have annual agreements with our two largest customers, Sonic Innovations, Inc. and Siemens, Inc., along with several other customers. These agreements typically include basic understandings that relate to estimated needs of the customer as well as range of prices for the products for the current year. These agreements generally are cancelable by either party for any reason upon advanced notice given within a relatively short time period (eight to twelve weeks), and, upon such cancellation, the customer is liable only for any residual inventory purchased in accordance with the agreement. Although these annual agreements do not commit our customers to order specific quantities of products they set the sale price and are useful as they enable us to forecast our customer’s orders for the upcoming year.

      Actual orders from our customers with whom we have annual agreements are made through customer supplied Purchase Orders (PO), and the contractual basis for the relationship is set forth in the PO. The PO specifies quantities, price, product lead times, material and quality requirements, and other general business terms and conditions.

      For customers with lower demand requirements we commonly use their PO only to plan production and procure materials. These programs are subject to our standard terms and conditions including cancellation clauses, whereby either party may cancel such PO for any reason upon advanced notice given within a relatively short time period.

      Component Supply Operations: For all application specific or custom material, we try to match the quantities and terms related to the supply of such product of the customer and all major vendors. Although we prefer to have long-term agreements with our vendors, we do not currently have any long-term agreements with vendors in place. Typically, there are many sources of raw material supplies available nationally and internationally; however, many raw materials we use are customer specified and may only be available from customer specified vendors or supplied by the customer itself. The ICs that we assemble onto circuit boards

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      Proprietary Technology: We use proprietary technology and proprietary processes to incorporate such technology into many of our products. We protect this technology through patents, proprietary information agreements with our customers and vendors, and non-disclosure agreements with many of our employees. Additionally, we will apply for new patents whenever appropriate. We hold four microelectronic process and design patents, which expire on dates ranging from 2018 through 2021. Our two most significant patents are the High Density Stacked Circuit Module and the Interconnection Device. The High Density Stacked Circuit Module is a method of stacking two or more ICs and then electrically interconnecting them. This approach allows us to use the thickness of the circuit to add capabilities rather than increase the width and length. The result is a more compact device than can be attained using conventional methods. The primary application is in our hearing market, where smaller circuits make it possible to fit more people with hearing aides and makes the hearing aid less obtrusive. Our latest design patent, the Interconnection Device, allows for the cost effective use of high-speed millimeter wave integrated circuits by placing them into surface mount packages. These surface mount packages allow our customers to cost effectively incorporate those packages into their products, and also permits a rapid increase to high volume manufacturing, using standard high volume assembly equipment.

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

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

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

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

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

      We believe that diversification between our key markets is important. Our goals are to have no one market account for 40% or more of our net sales, no one customer greater than 25% of net sales and no one program exceeding 10% of net sales. Likewise we seek to operate our business to avoid risking concentrations in our business with one customer or program. Our plans to achieve our goals include increasing our product offerings, customer base and programs to increase revenue, which will result in more diversification.

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

      Competition: In each of our product lines, we face significant competition, including customers’ who may produce the same or similar products themselves. Our competitive advantage starts with knowledge of the market requirements and our investment in technology to meet those demands. We obtain new business by first identifying customer needs and designing and engineering our products to meet those needs in an ultraminiature and cost effective way. We then design products to application specific requirements of the customer and then manufacture those electronic assemblies with a high degree of automation to ensure quality and low cost. Finally, we compete on the basis of full service to obtain new and repeat orders. Application specific requirements typically include: very small size, low power, high performance and low cost. We are a full-service supplier and partner with our customers, providing full “turn-key” capability.

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

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

Item 2.     Description of Property

      We own a 48,000 square foot facility for administration and microelectronics production in Victoria, Minnesota, a suburb of Minneapolis, which was originally built in August 1981. The facility was expanded during fiscal year 1996 from the original 25,000 square feet with an addition of 23,000 square feet to increase production capacity. The addition was financed through the issuance of Industrial Development Revenue Bonds (IDRBs) with the City of Victoria on the property and certain equipment. The IDRBs are further collateralized by letters of credit from LaSalle Business Credit, Inc. We mortgaged the property to secure the credit facility with LaSalle Business Credit, Inc.

      We lease a 14,000 square foot facility in Tempe, Arizona for our high density interconnects business. We lease a 20,000 square foot facility in Chanhassen, Minnesota, for part of our RFID business and a 3,100 square foot facility in Eden Prairie, Minnesota used for corporate offices. The Tempe and Chanhassen facilities are leased until July 2005 and October 2007, respectively and the Eden Prairie location is leased until March 2005.

Item 3.     Legal Proceedings

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

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

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

     Executive Officers

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

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

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

      Stephen K. Petersen joined us in March 1998 as Director of Manufacturing. He was appointed Vice President of Operations in September 2000 and as Chief Operating Officer in October 2002. Before joining us, he was employed with Sheldahl, a manufacturer of electronic materials and derivatives, in a variety of positions ranging from Engineer to Plant Manager and most recently as the Operations Manager. Mr. Petersen was responsible for production and manufacturing engineering.

      Simon F. Hawksworth joined us in September 2002 as Vice President of Sales and Marketing. Prior to this appointment he was Vice President of Sales and Marketing at InnovaComm Technologies, Inc, a microelectronics manufacturing company and a spin-off of Maxtek, a wholly owned subsidiary of Tektronix. Mr. Hawksworth served Maxtek in a variety of positions from Business Development Manager through Director and Vice President of Sales and Marketing. His former role focused on winning new business requiring high frequency electronics packaging solutions.

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PART II

Item 5.     Market for Common Equity and Related Stockholder Matters

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

      As of December 12, 2002, we had 310 shareholders of record. We have not paid any dividends on our common stock since our initial public offering on March 24, 1981. We expect that for the foreseeable future we will follow a policy of retaining earnings in order to finance the continued development of our future business. Payment of dividends is within the discretion of our board of directors and will depend upon, among other things, our earnings, capital requirements and operating and financial condition. In addition, the terms of our loan agreement with our bank requires advance approval to pay dividends.

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Item 6.     Selected Financial Data

HEI, INC. AND SUBSIDIARIES

FIVE-YEAR SUMMARY OF SELECTED FINANCIAL INFORMATION

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General

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

Workforce Reductions

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

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

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

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

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

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

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

CRITICAL ACCOUNTING POLICIES

      Our consolidated financial statements are based on the selection and application of accounting principles generally accepted in the United States, which require us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and any such differences may be material to the financial statements. We believe that the following accounting policies may involve a higher degree of judgment and complexity in their application and represent the critical accounting policies used in the preparation of our financial statements. If different assumptions or conditions were to prevail, the results could be materially different from our reported results.

Revenue recognition, Sales Returns and Warranty

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

      We record provisions against net sales for estimated product returns. These estimates are based on factors that include, but are not limited to, historical sales returns, analyses of credit memo activities, current economic trends and changes in our customers’ demand. We also record estimated provisions for warranty claims based on historical trends and known warranty claims. Should our actual product returns exceed our estimated allowances, additional reductions to our revenue would result. As of August 31,2002 and 2001 we had an aggregate amount of $200 and $50, respectively, in our warranty and product return reserves.

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Allowance for Uncollectible Accounts

      We estimate the collectibility of our trade receivables and notes receivable which requires considerable amount of judgment in assessing the realization of these receivables including the current credit-worthiness of each customer and related aging of the past due balances. In order to assess the collectibility of these receivables, we perform ongoing credit evaluations of our customers’ financial condition. Through these evaluations, we may become aware of a situation where a customer may not be able to meet its financial obligations due to a deterioration of its financial viability, credit ratings or bankruptcy. The reserve requirements are based on the best facts available to us and reevaluated and adjusted as additional information is received. Significant increases in reserves have been recorded in recent periods and may occur in the future due to evolving market conditions. We are not able to predict changes in the financial condition of our customers, and if circumstances related to our customers deteriorate, our estimates of the recoverability of our receivables could be materially affected and we may be required to record additional allowances. Alternatively, if we provide more allowances than we need, we may reverse a portion of such provisions in future periods based on changes in estimate from our actual collection experience. As of August 31, 2002 and 2001 we had $85 and $271, respectively, in our accounts receivable allowance.

Inventories

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

Valuation of Deferred Taxes

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

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

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Results of Operations

Percentage of Net Sales

Sales

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

      We continue to experience fluctuations in demand for our hearing products and expect this to continue into the first half of fiscal 2003. The communications and RFID markets remain soft as our customers are awaiting market acceptance of new products and increased demand for existing products. As the demand for these products increases, we are positioned for an increase in sales in these markets. In addition, we are experiencing continued interest in our proprietary products which have received design approval for numerous applications with increasing low volume production. We continue to work on new designs, qualification testing and continue to receive prototype orders from numerous customers. At August 31, 2002, our backlog of orders for revenue in fiscal 2003 was approximately $5,400 compared to approximately $11,000 and $22,450 at August 31, 2001 and 2000 respectively. We expect to ship our backlog as of August 31, 2002 during fiscal 2003. This decrease in backlog is mainly due to two factors; first, net sales are down overall from the weak economic conditions in our markets and secondly, from customers being reluctant to issue long-term purchase orders based on lack of visibility for future demand and fluctuations in over all market conditions. The Company’s backlog at December 13, 2002 was $6,298.

      Because our sales are generally tied to the customers’ projected sales and production of the related product, our sales levels are subject to fluctuations beyond our control. To the extent that sales to any one customer represent a significant portion of our sales, any change in the sales levels to that customer can have a significant impact on the our total sales. In addition, production for one customer may conclude while production for a new customer has not yet begun or is not yet at full volume. These factors may result in significant fluctuations in sales from quarter to quarter.

      Sales to hearing/medical customers for fiscal 2002 decreased by $5,798, or 21% compared to fiscal 2001. This decrease in demand comparing fiscal 2002 to 2001 is a result of the general economic slowdown impacting the hearing contract manufacturing markets. Also, during the latter part of fiscal 2002 one of our customer’s internal manufacturing capabilities increased, negatively impacting revenue by approximately $1,450 in the fourth quarter fiscal 2002. In fiscal 2003 we expect the impact from this customer will be a further reduction in annual net sales by $4,200. We have received increased orders from customers in the

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

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

      Sales to the communications and industrial (non Mexico) products market decreased $2,338, or 37% in fiscal 2002, as compared to fiscal 2001. Sales increased in fiscal 2001 of $224 or 2% as compared to fiscal 2000. This decrease comparing fiscal 2002 to 2001 is largely a result of the current weakness in the telecommunications markets. We are experiencing increased activity in this market with numerous low volume purchase orders. In September 2002 we realigned our sales emphasis to narrowly focus our efforts to key niche customers to obtain the best margin revenue while improving the efficiencies in developing new business.

Gross Profit

      Our gross profit as a percentage of sales was 18.1% in fiscal 2002, as compared to 17.8% in fiscal 2001 and 17.0% in fiscal 2000. While our gross margin percentages are heavily impacted by revenue, due to the fixed nature of many of our manufacturing costs, we were able to improve gross margins in fiscal 2002 from fiscal 2001 despite a 36% decrease in net sales. This improvement is due to reduction of 35 direct labor and manufacturing employees in fiscal 2002 (resulting in a savings of $649 in direct labor and $77 in administrative salary costs), improved manufacturing yields (from 94.4% in fiscal 2002 to 92.7% in 2001), reduced scrap expense (from 3.8% in fiscal 2002 to 4.5% in 2001, calculated as a percentage of gross sales) and from the closure of the Mexico division, which generated negative gross margins of $624 during fiscal 2001. In future periods, we expect gross margins to be impacted in a similar manner as revenues increase and decrease. In addition, when, and if, market acceptance of our proprietary broadband communications products occurs, we expect gross margins to increase, as these products are expected to have higher gross margin than we have historically experienced. Our gross profit as a percentage of sales was 17.8% in fiscal 2001, as compared to 17.0% in fiscal 2000. The increase in gross profit as a percentage of sales was primarily due to start-up costs in the prior year for the high density interconnect division, which were offset by higher operating losses for the Mexico division, which was closed in the third quarter of fiscal 2001.

Operating Expenses

      Operating expenses in total were 28% of net sales in fiscal 2002, compared to 22% and 20% in fiscal 2001 and 2000, respectively. Operating expenses in 2002 decreased $2,081 when compared to fiscal 2001. Fiscal 2001 also reflected an increase of $1,377 when compared to fiscal 2000. Selling, general and administrative expenses decreased by $471 when compared to fiscal 2001 mainly due to the closure of the Mexico operations and our constant attention to other cost containment measures, including reduction of employees, travel and other operational costs. These reductions were offset by increases in professional fees and insurance costs totaling $196. The reduction of 11 employees during fiscal 2002, resulted in decreased selling, general and administrative expenses of $178 during fiscal 2002. These overall decreasing expenses are a result of our

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      Research, development, and engineering expenses increased $83 in fiscal 2002, when compared to fiscal 2001 and increased $752 when compared to fiscal year 2000. These increases are a result of our commitment to maintain our design capabilities to support future programs and continue the development and enhancement of our proprietary products and manufacturing processes. Comparing fiscal 2001 to 2000 costs increased in fiscal 2001 by $669, or 38%, compared to fiscal 2000. The increase is a result of an emphasis on new product development, especially in the broadband communications market, as well as new process and product development in all focus markets

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

Other Income (Expense), Net

      Other expense of $106 in fiscal 2002 is $626 less than our other expenses in fiscal 2001 which reflects an increase of $21 when compared to fiscal 2000. Net interest expense for fiscal 2002 decreased by $158 from fiscal 2001 as a result of the lower average debt in fiscal 2002 of approximately $2,000, and higher average cash balances of approximately $4,000, along with average interest rates of approximately 2% lower during the current-year period compared to the prior-year period. The lower average debt and higher average cash balances are the result of the net offering proceeds of $6,222 received in August 2001. Other expense, net for fiscal 2001 of $732 includes a non-cash charge of $161 ($106 net of tax) related to costs associated with the abandoned Colorado MEDtech transaction. Comparing fiscal 2001 to 2000 other expense in fiscal 2001 of $732 increased $647 as compared to fiscal 2000, primarily due to higher interest expense, as a result of decreased average cash balances and increased short and long-term debt throughout fiscal 2001, partially offset by interest on loans receivable. In the fourth quarter of fiscal 2001, we wrote off our equity investment in Micro Substrates Corporation (MSC). Including this write-off, expenses incurred related to MSC for fiscal 2001 were $1,450.

Income Tax Expense (Benefit)

      Management performs an analysis of the realization of the deferred tax asset each fiscal quarter. During the fourth quarter of fiscal 2002, we determined that a valuation allowance of $3,420 should be established for all of our deferred tax assets due to the softness in our markets, the results of operations for the fourth quarter, and uncertainties about visibility to customer order rates, and a general economic recovery. For fiscal 2002 we recognized tax expense of $1,092 compared to a tax benefit of $930 and $372 in fiscal 2001 and 2000 respectively. Comparing fiscal 2002 to 2001 the primary difference in the tax expense between the periods is the establishment of a $3,420 deferred tax allowance of which $3,188 was included in income tax expense. An aggregate of $233 of tax valuation allowance was reflected as an adjustment to additional paid-in capital as it represents the tax asset benefit from stock option exercises that are included in our net operating loss carryforwards. Management will monitor this deferred tax asset going forward. At the end of fiscal 2002, we had net operating loss carryforwards expiring at various dates ranging from 2013 through 2022. Even though this valuation allowance has been established, we still retain all the economic benefits of the net operating loss in future years. Comparing fiscal 2001 to 2000, the income tax benefit of $930 in fiscal 2001 increased over fiscal 2000 by $558. The increase is a result of the larger loss before income taxes in the current year. The effective tax rate of 22.6% in fiscal 2001 is lower than the federal and state statutory tax rate due to the loss on the MSC investment, which created a capital loss. The realization of the capital loss will not occur until we generate capital gains. During fiscal 2001, the Company concluded it was more likely than not that such

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Net Income (Loss)

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

Financial Condition

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

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

      Our net cash flow provided by financing activities was $325, $3,782 and $4,255 for fiscal 2002, 2001 and 2000, respectively. Cash generated from issuance of common stock was $275, $6,336 and $506 for fiscal year 2002, 2001 and 2000 respectively. During fiscal 2001 the company completed a private placement of common stock that generated $6,200 in net proceeds. Other issuance of common stock during the past three fiscal years were from the exercise of stock options. The majority of other year-to-year changes relate to the borrowings and repayment under the revolving line of credit and term debt.

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

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

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

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

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

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

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

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

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

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

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

RISK FACTORS (In thousands except per share amounts)

      This Annual Report on Form 10-K contains forward-looking statements that are based on our current expectations and involve a number of risks and uncertainties. Factors that may materially affect revenues, expenses and operating results include, without limitation, adverse business or market conditions, our ability to secure and satisfy customers, the availability and cost of materials from suppliers, adverse competitive developments, and change in or cancellation of customer requirements.

      The forward-looking statements included herein are based on current assumptions that we will continue to develop, market, manufacture and ship products on a timely basis, that competitive conditions within our markets will not change materially or adversely, that we will continue to identify and satisfy customer needs for products and services, that we will be able to retain and hire key personnel, that our equipment, processes, capabilities and resources will remain competitive and compatible with the current state of technology, that risks due to shifts in customer demand will be minimized, and that there will be no material adverse change in our operations or business. Assumptions relating to the foregoing involve judgments that are based on incomplete information and are subject to many factors that can materially affect results. We operate in a volatile segment of high technology markets and applications that are subject to rapid change and technical obsolescence.

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

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

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

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

      See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition.”

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

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

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

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

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

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

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

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

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

	•	We may not be able to negotiate or finance the acquisition successfully.
	•	The integration of acquired businesses, products or technologies into our existing business may fail.
	•	We may issue equity securities, incur debt, assume contingent liabilities or have amortization expenses and write-downs of acquired assets which could cause our earnings per share to decline.

      If our customers are unable to gain market acceptance for the products that we develop or manufacture for them, we may lose revenue. We design and manufacture components for other companies. We also sell proprietary products that contain components to other companies and end-user customers. For products we manufacture (manufactured for others or those we sell directly), our success is dependent on the acceptance of those products in their markets. We have no control over the products or marketing of products that we sell to our customers. Market acceptance may depend on a variety of factors, including educating the target market regarding the use of a new procedure. Market acceptance and market share are also affected by the timing of market introduction of competitive products. Some of our customers, especially emerging growth companies, have limited or no experience in marketing their products and may be unable to establish effective sales and marketing and distribution channels to rapidly and successfully commercialize their products. If our customers are unable to gain any significant market acceptance for the products we develop or manufacture for them, our business will be adversely affected.

      If we fail to comply with environmental laws and regulations we may be fined and prohibited from manufacturing products. As a small generator of hazardous substances, we are subject to local governmental regulations relating to the storage, discharge, handling, emission, generation, manufacture and disposal of toxic or other hazardous substances, such as waste oil, acetone and alcohol that are used in very small

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      Future quarterly and annual operating results may fluctuate substantially due to a number of factors, many of which are beyond our control, which may cause our stock price to decline. We have experienced substantial fluctuations in our annual and quarterly operating results, and such fluctuations may continue in future periods. Our operating results are affected by a number of factors, many of which are beyond our control, including the following:

	•	we may manufacture products that are custom designed and assembled for a specific customer’s requirement in anticipation of the receipt of volume production orders from that customer, which may not always materialize to the degree anticipated, if at all;
	•	we may incur significant start-up costs in the production of a particular product, which costs are expensed as incurred and for which we attempt to seek reimbursement from the customer;
	•	we may experience fluctuations and inefficiencies in managing inventories, fixed assets, components and labor, in the degree of automation used in the assembly process, in the costs of materials, and the mix of materials, labor, manufacturing, and overhead costs;
	•	we may experience unforeseen design or manufacturing problems, price competition or functional competition (other means of accomplishing the same or similar packaging end result);
	•	we may be unable to pass on cost overruns;
	•	we may not have control over the timing of expenditures in anticipation of increased sales, customer product delivery requirements and the range of services provided; and
	•	we may experience variance in the amount and timing of orders placed by a customer due to a number of factors, including inventory balancing, changes in manufacturing strategy, and variation in product demand attributable to, among other things, product life cycles, competitive factors, and general economic conditions.

      Any one of these factors, or a combination of one or more factors, could adversely affect our annual and quarterly operating results, which in turn may cause our stock price to decline.

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

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

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

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      A number of our competitors may have substantially greater manufacturing, financial, technical, marketing, and other resources than we have, and may offer a broader scope and presence of operations on a worldwide basis. Significant competitive factors in the microelectronics market include price, quality, design capabilities, responsiveness, testing capabilities, the ability to manufacture in very high volumes and proximity to the customers final assembly facilities. While we have competed favorably in the past with respect to these factors, this is a particularly fast changing market, and there can be no assurance that we will continue to do so in the future.

      We are often one of two or more suppliers on any particular customer requirement and are, therefore, subject to continuing competition on existing programs. In order to remain competitive in any of our markets, we must continually provide timely and technologically advanced design capabilities and manufacturing services, ensure the quality of our products, and compete favorably with respect to turnaround and price. If we fail to compete favorably with respect to the principal competitive factors in the markets we serve, we may lose business and our operating results may be reduced.

      Fluctuations in the price and supply of components used to manufacture our products may reduce our profits. Substantially all of our manufacturing services are provided on a turnkey basis in which we, in addition to providing design, assembly and testing services, are responsible for the procurement of the components that are assembled by us for our customers. Although we attempt to minimize margin erosion as a result of component price increases, in certain circumstances we are required to bear some or all of the risk of such price fluctuations, which could adversely affect our profits. To date, we have generally been able to negotiate contracts that allow us to shift much of the impact of price fluctuations to the customer; however, there can be no assurance that we will be able to do so in all cases.

      In order to assure an adequate supply of certain key components that have long procurement lead times, such as integrated circuits, we occasionally must order such components prior to receiving formal customer purchase orders for the assemblies that require such components. Failure to accurately anticipate the volume or timing of customer orders can result in component shortages or excess component inventory, which in either case could adversely affect our operating results and financial condition.

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

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

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

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      Our business success may be adversely affected by our ability to hire and retain employees. Our continued growth and success depend to a significant extent on the continued service of senior management and other key employees and the hiring of new qualified employees. We rely upon the acquisition and retention of employees with extensive technological experience. Competition for skilled business, product development, technical and other personnel is intense. There can be no assurance that we will be successful in recruiting new personnel and retaining existing personnel. None of our employees are subject to a long-term employment agreement, although several key employees are subject to non-competition agreements. The loss of one or more key employees may materially adversely affect our growth. We do not currently have employment contracts with any of our employees.

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

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

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

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

      We have issued numerous options to acquire our common stock that could have a dilutive effect on our common stock. As of December 12, 2002, we had options outstanding to acquire 1,492,525 shares of our common stock, exercisable at prices ranging from $4.438 to $20.375 per share, with a weighted average exercise price of approximately $9.305 per share. During the terms of these options, the holders will have the opportunity to profit from either an increase in the market price of our common stock with resulting dilution to the holders of shares who purchased shares for a price higher than the respective exercise or conversion price. In addition, the increase in the outstanding shares of our common stock as a result of the exercise or conversion of these options could result in a significant decrease in the percentage ownership of our common stock by the purchasers of our common stock.

      The market price of our common stock may be reduced by future sales of our common stock in the public market. Sales of substantial amounts of common stock in the public market that are not currently freely tradable, or even the potential for such sales, could have an adverse effect on the market price for shares of our

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	•	approximately 993,693 shares beneficially owned by our executive officers and directors of our outstanding common stock; and
	•	approximately 1,540,025 shares issuable to option and warrant holders.

      Unless the shares of our outstanding common stock owned by our executive officers and directors are further registered under the securities laws, they may not be resold except in compliance with Rule 144 promulgated by the SEC, or some other exemption from registration. Rule 144 does not prohibit the sale of these shares but does place conditions on their resale that must be complied with before they can be resold.

      Our Amended and Restated Articles of Incorporation contain provisions that could discourage or prevent a potential takeover, even if such transaction would be beneficial to our shareholders. Our Amended and Restated Articles of Incorporation authorize our Board of Directors to issue up to 10,000,000 shares of common stock and 5,000,000 shares of undesignated stock, the terms of which may be determined at the time of issuance by the Board of Directors, without further action by our shareholders. Undesignated stock authorized by the Board of Directors may include voting rights, preferences as to dividends and liquidation, conversion and redemptive rights and sinking fund provisions that could affect the rights of the holders of our common stock and reduce the value of our common stock. The issuance of preferred stock could also prevent a potential takeover because the terms of any issued preferred stock may require the approval of the holders of the outstanding shares of preferred stock in order to consummate a merger, reorganization, and sale of substantially all of our assets or other extraordinary corporate transaction.

      Our Amended and Restated Articles of Incorporation provide for a classified Board of Directors with staggered, three-year terms. Our Amended and Restated Articles of Incorporation also require the affirmative vote of a supermajority (80%) of the voting power for the following matters:

	•	To approve the merger or consolidation of HEI or any subsidiary with or into any person that directly or indirectly beneficially owns, or owned at any time in the preceding twelve months, five percent or more of the outstanding shares of our stock entitled to vote in elections of directors (a Related Person);
	•	To authorize the sale of substantially all of our assets to a Related Person;
	•	To authorize the issuance of any of our voting securities in exchange or payment for the securities or assets of any Related Person, if such authorization is otherwise required by law or any agreement;
	•	To adopt any plan for the dissolution of HEI; or
	•	To adopt any amendment, change or repeal of certain articles of the Amended and Restated Articles of Incorporation, including the articles that establish the authority of the Board of Directors, the supermajority voting requirements and the classified Board of Directors.

      These provisions may have the effect of deterring a potential takeover or delaying changes in control or our management.

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

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

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	•	Incur additional restrictions on our ability to borrow additional funds.

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

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

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

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Item 8.     Financial Statements

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

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HEI, INC.

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

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HEI, INC.

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

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HEI, INC.

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

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HEI, INC.