HEI (HEII)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number: 0-10078

 

 

 

 

HEI, Inc.

(Exact name of registrant as specified in its Charter)

 

 

Registrant’s telephone number, including area code:

(952) 443-2500

 

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

 

 

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

None

 

Indicate by a check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act of 1933.  Yes o     No þ

 

Indicate by a check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not 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 or any amendment to this Form 10-K.  þ

 

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

 

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

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates as of the last business day of the registrant’s most recently completed second fiscal quarter (March 3, 2007) was approximately $10.1 million.

 

As of November 28, 2007, 9,542,887 of the registrant’s common shares, par value $.05 per share, were outstanding.

 

 

TABLE OF CONTENTS

 

 

Documents Incorporated By Reference

 

Certain information required by Part III is omitted from this Annual Report on Form 10-K because the Registrant will file a definitive Proxy Statement relating to its 2008 Annual Meeting of Shareholders pursuant to Schedule 14A (the “Proxy Statement”) not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and certain information included therein is incorporated herein by reference as indicated below.

FORWARD-LOOKING STATEMENTS

 

Some of the information included in this Annual Report on Form 10-K 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 may discuss our future expectations, such statements contain projections of future earnings or financial condition and such statements may 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 1A of this Annual Report on Form 10-K 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.

 

GENERAL INFORMATION

 

HEI, Inc. and its subsidiaries are referred to in this Annual Report on Form 10-K as “HEI,” the “Company,” “us,” “we” or “our,” unless the context indicates otherwise.

 

During fiscal year 2006, the Company changed its fiscal year end to a 52 or 53 week period ending on the Saturday closest to August 31. Fiscal year 2007 ended September 1, 2007, fiscal year 2006 ended on September 2, 2006, and fiscal year 2005 ended on August 31, 2005, and are identified herein as Fiscal 2007, Fiscal 2006 and Fiscal 2005, respectively.

 

PART I

 

 

Divestiture

 

The Company sold substantially all the assets and liabilities of its Radio Frequency Identification (“RFID”) business unit for $3 million in cash effective August 31, 2007. This business unit was part of the Microelectronics Operations as further described below. The divestiture, which occurred at the end of Fiscal 2007, is treated as a discontinued operation of the Company. All results of operations and assets and liabilities of RFID for all periods presented have been restated and classified as discontinued operations. All references to the business are based on results of operations from continuing operations. The sale of RFID, completed at the end of Fiscal 2007, resulted in a pre-tax gain of approximately $1.7 million reported in the Company’s Fiscal 2007 results. Cash proceeds from the sale were used to reduce borrowing under the Company’s existing credit facility.

 

Business of the Issuer

 

We operate two business segments that provide a comprehensive suite of services from design and development, testing to transitional manufacturing and full service contract manufacturing.

 

Our Microelectronics segment, which has operations in Victoria, Minnesota and Tempe, Arizona, offers:

 

 

Our Advanced Medical Operation (“AMO”) segment, with operations in Boulder, Colorado, offers:

 

 

Segment data for each of the last three fiscal years is disclosed in the financial statements included in Item 8 of this report.

 

Microelectronics Operations

 

In our Victoria, Minnesota facility, we design microelectronic components that are integrated into medical or telecommunications devices. Typically these microelectronic circuits consist of assembling one or more integrated circuits (ICs) or chips and some passive electronic components onto a substrate. These microelectronic assemblies are typically integrated into our customers’ end products such as implantable defibrillators, cochlear implants, insulin pumps or network switching systems. For example, in the case of an insulin pump, the microelectronic assemblies start with a complex flexible substrate provided by our Tempe, Arizona facility. Then our Victoria, Minnesota facility builds up a circuit onto the flexible substrate attaching active and passive electronic components. We ship this sub-assembly to our customers who further assemble the insulin pump into a shell with an LED, battery and insulin vile as a finished device. Our Victoria and Tempe facilities have been ISO 9000:2000 compliant since August 2003.

 

Certain proprietary technology employed in our Victoria facility allows us to manufacture miniature chip packages that are specially designed to hold and protect high frequency chips for broadband communications. This package, with the enclosed chip, may then be easily and inexpensively attached to a 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. We manufacture our products by fabricating a substrate and placing integrated circuits 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 reliability.

 

Our Tempe facility designs and manufactures high quality, high density flexible and rigid-flex substrates. We utilize specialized tooling strategies, advanced procedures and a highly trained team to minimize circuit handling to obtain consistent processing parameters throughout the manufacturing process. Tempe supplies a portion of the substrates used in the microelectronics circuits built in our Victoria facility including defibrillator and insulin pump component manufacturing. In addition, the Tempe facility sells flexible substrates directly to customers for implantable and non-implantable medical devices as well as optical communications circuit applications. We continue to leverage market interest in designing microelectronics with flexible substrates to grow HEI’s total business.

 

Advanced Medical Operations

 

Our Boulder, Colorado facility provides Electronics Manufacturing Services in four key areas relating to our Advanced Medical Operations. For large medical device original equipment manufacturers (OEMs) and emerging medical device companies, we provide design and development services, software validation and verification services and value added services including fulfillment, distribution and end of life services. Our design and development projects generally include project concept definition, development of specifications for product features and functions, product engineering specifications, instrument design, development, prototype production and testing and development of test specifications and procedures. We also perform verification and validation test for software used in medical device applications. HEI maintains a technical staff of engineers with backgrounds in electrical, mechanical, software and manufacturing disciplines. The manufacturing group manages a production line that utilizes a combination of lean flow and six sigma manufacturing techniques. This group currently manufactures electro mechanical designs for medical diagnostic and therapeutic hardware and medical imaging subsystems. We are a registered device manufacturer with the Food and Drug Administration (the “FDA”) and are required to meet the FDA’s Quality System Regulation (“QSR”) standards. Manufacturing projects include pre-production and commercialization services, turnkey manufacturing of FDA Class I, Class II and Class III devices and system test services. In addition, our Boulder facility provides logistical support distributing devices directly to the OEMs’ customers. Finally, HEI provides service support to medical imaging and therapeutic medical device customers, ranging from receipt and decontamination of field returns to troubleshooting, repair or shipping new products, to managing the documentation required by the FDA.

 

Customers:  We sell our products through our employed sales staff located at our Victoria, Tempe and Boulder facilities. The Victoria and Tempe sales staff work often together as the flexible and rigid flex substrates produced by our Tempe facility are utilized on a number of products produced by our Victoria operation. In addition to direct sales contact, we utilize trade shows to promote our name and our products and services.

 

We currently have agreements with GE Healthcare, Johnson & Johnson Ethicon Gynacare Division and Johnson & Johnson Biosense Webster Division. In addition, we have annual agreements with 8 of our top 20 customers. These agreements typically include basic understandings that relate to estimated volume requirements, as well as a range of prices for the coming 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 as well as work in progress. 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 assist us in forecasting 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 (“POs”). POs specify quantity, price, product lead times, material and quality requirements and other general business terms and conditions.

 

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. Typically, there are many sources of raw material supplies available nationally and internationally; however, many raw materials we use are customer specified and we are required to use customer specified vendors, or the customer supplies materials to us. The ICs that we assemble onto circuit boards are an example of a raw material that is commonly customer specified and available from specified vendors or supplied by the customer.

 

Proprietary Technology:  We use proprietary technology and proprietary processes to incorporate such technology into many of our customer’s products. We protect this technology through patents, proprietary information agreements with our customers and vendors and non-disclosure agreements with substantially all of our employees. We have approximately 13 different inventions across the spectrum of our activities, which consist of 7 issued patents and 6 pending patents. We pursue new patentable technologies whenever practicable and have extended many of these filings in international venues. Our two most recent granted US patents are “High Frequency Interconnection For Circuits” and “Hearing-Aid Assembly Using Folded Flex Circuits”. The High Frequency Interconnection patent describes a radio frequency microcircuit package and interconnection device which minimizes impedance mismatch between circuit elements. The hearing-aid patent saves space and reduces the cost of manufacturing hearing aids. We bring value to our customers, in part, by leveraging our publicly disclosed technology as well as our internally protected trade secrets and know-how to provide solutions and enhancements to our customer’s products. These capabilities include the application of multiple manufacturing technologies from both product performance and product manufacturability perspectives, manufacturing processes, such as lean-flow, that reduce overall production cost, and systems and methodologies that streamline development resulting in robust product designs that fulfill the stringent requirements of the FDA. Our proprietary technology and patents are incorporated into our daily production and design efforts which allow us to maintain our competitiveness in the marketplace and allows us to differentiate ourselves with our customers when compared to competitors that do not have such proprietary technologies.

 

Government Regulations:  Certain end products of our customers that we manufacture in our facilities are subject to federal governmental regulations (such as FDA regulations). The Boulder facility is a registered device manufacturer with the FDA. The Medical Device Amendments of 1976 to the Food, Drug and Cosmetic Act (the “FDC Act”), and regulations issued or proposed under the FDC Act, including the Safe Medical Devices Act of 1990, provide for regulation by the FDA of the marketing, design, manufacturing, labeling, packaging and distribution of medical devices. These regulations apply to products that are outsourced to us for manufacture, which include many of our customers’ products, but not to our imaging and power generation components. The FDC Act and the regulations include requirements that manufacturers of medical products and devices register with, and furnish lists of products and devices manufactured by them, to the FDA. The FDA regulates many of our customers’ products, and requires certain clearances or approvals before new medical devices can be marketed. As a prerequisite to any introduction of a new device into the medical marketplace, our customers must obtain necessary product clearances or approvals from the FDA or other regulatory agencies. In addition, products intended for use in foreign countries must comply with similar requirements and be certified for sale in those countries.

 

The FDA’s QSR for medical devices sets forth requirements for the design and manufacturing processes that require the maintenance of certain records and provide for unscheduled inspections of our Boulder facility. The FDA reviewed our procedures and records during routine general inspections with the latest review in Fiscal 2007.

 

We are not directly subject to any governmental regulations or industry standards at our Victoria and Tempe facilities. However, we are subject to certain industry standards in connection with our ISO 9000:2000 certification. Our products and manufacturing processes at such facilities 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. All facilities are subject to local environmental regulations.

 

Over 90 countries have adopted the ISO 9000 series of quality management and quality assurance standards. ISO standards require that a quality system be used to guide work to assure quality and to produce quality products

and services. These elements include management responsibility, design control, training, process control and servicing. ISO 9001 is the quality systems standard used by companies providing design, development, manufacturing, installation and servicing. The quality systems for our AMO segment are ISO 13485 certified, and our Victoria and Tempe facilities achieved ISO 9000:2000 certification in August 2003.

 

There are no material costs or expenses associated with our compliance with federal, state and local environmental laws other than quality control costs associated with compliance. 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 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 the percentage of our net sales to major customers that accounted for more than 10% of total net sales in our fiscal years ended September 1, 2007, September 2, 2006 and August 31, 2005.

 

 

Animas, a subsidiary of Johnson & Johnson, is a customer for our Hearing/Medical market at the Victoria operation; Cochlear is a customer of our Tempe operation and is part of our Hearing/Medical market; and GE Medical Systems, a subsidiary of General Electric Company, is a customer of our Advanced Medical Operations. See Note 15 to our Consolidated Financial Statements — Major Customer, Concentration of Credit Risk and Geographic Data — for financial information about net sales from external customers attributed to specific geographic areas.

 

The following table illustrates the approximate percentage of our net sales by markets served.

 

 

At September 1, 2007, our backlog was approximately $15.1 million compared to approximately $14.9 million and approximately $20.1 million at September 2, 2006 and August 31, 2005, respectively. We expect to ship our backlog as of September 1, 2007 during Fiscal 2008. Our backlog is not necessarily a firm commitment from our customers and can change, in some cases materially, beyond our control.

 

Competition:  In each of our product lines, we face significant competition, including customers who may produce the same or similar products themselves. We believe that our competitive advantage starts with knowledge of the market requirements and our investment in technology to meet those demands. We use proprietary technology and proprietary processes to create unique solutions for our customers’ product development and manufacturing requirements. We believe that customers engage us because they view us to be on the leading edge in designing and manufacturing products that, in turn, help them to deliver better products faster and more cost effectively than they could do themselves. We also compete on the basis of full service to obtain new and repeat orders. We are a full-service supplier and partner with our customers, often providing full “turn-key” capability.

 

Engineering, Research and Development:  The amount that we spent on company-sponsored engineering, research and development activities aggregated approximately $2.3 million, $4.0 million and $3.2 million for our fiscal years ended September 1, 2007, September 2, 2006 and August 31, 2005, respectively.

Employees:  On September 1, 2007, we employed 250 full-time persons, 2 part-time and an equivalent of 18 full-time employees on a contract basis.

 

Geographical Information:  Our geographical data for each of the last three fiscal years are disclosed in the financial statements included in Item 8 of this report.

 

Website and Available Information:  Our website is located at www.heii.com. Information on this website does not constitute part of this Annual Report on Form 10-K.

 

We make available, free of charge, our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 as soon as reasonably practicable after such forms are filed with or furnished to the SEC. Copies of these documents are available through a link on our website or upon written request to our Chief Executive Officer at P.O. Box 5000, 1495 Steiger Lake Lane, Victoria, Minnesota, 55386.

 

Item 1A.  Risk Factors.

 

Our business faces significant risks. The risks described below are not the only risks we face. Additional risks and uncertainties not presently known to us or that we currently believe are immaterial also may impair our business operations. If any of the events or circumstances described in the following risks occurs, our business, operating results or financial condition could be materially adversely affected. The following risk factors should be read in conjunction with the other information and risks set forth in this report.

 

We have a history of losses.  For the Fiscal 2007, we had a gross profit of $1.7 million generated from net sales of $38.4 million with which to cover sales, marketing, research, development and general administrative costs. Our sales, marketing, research, development and general administrative costs have historically been a significant percentage of our net sales, due partly to the expenses of developing leads and the relatively long period required to convert leads into sales associated with selling products in the medical and telecommunications markets. For Fiscal 2007, our operating expenses were $8.0 million and exceeded our gross profit by $6.4 million. For Fiscal 2006, our operating expenses were $12.4 million and exceeded our gross profit by $4.6 million. For Fiscal 2005, our operating expenses were $11.2 million and exceeded our gross profit by $450,000. Total net loss for Fiscal 2007 was $5.7 million compared to a net loss in Fiscal 2006 of $6.1 million and a $355,000 net income for Fiscal 2005. Although we expect our operating losses as a percentage of net sales to decline and reach break-even during Fiscal 2008, we may not achieve profitability.

 

We may need to raise additional capital if we do not quickly become profitable.  Based on our line of credit availability of $3.7 million at September 1, 2007 and our expectation that we will generate positive cash from operations in Fiscal 2008, we anticipate having sufficient cash resources for at least the next twelve months. The business environment may not be conducive to raising additional debt or equity financing. If we borrow additional money, we may incur significant additional interest charges or other restrictive or onerous provisions, which could harm our operating results. Holders of debt may also have rights, preferences or privileges senior to those of existing holders of our common stock. If we raise additional equity, the terms of such financing may dilute the ownership interests of current investors and cause our stock price to fall significantly. We may not be able to secure financing upon acceptable terms at all. If we cannot raise funds on acceptable terms, we may not be able to develop or enhance our products or customer base, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, which could seriously harm our business, operating results, and financial condition.

 

We rely on a guarantee from our Chairman in connection with our line of credit facility.  Our line of credit facility is backed in part by personal collateral of our Chairman of the Board of Directors. This collateral was essential in securing the underlying line of credit and is essential to the current availability under this credit facility. If this guarantee is no longer available to the Company, the entire line of credit is at risk of being terminated and the outstanding balance due in full. If this were to occur, the Company may not be able to repay the outstanding balance.

 

The price of our stock has been volatile and we could be delisted from the NADSAQ Capital Market.  Our common stock price has been and may continue to be volatile, and there is a risk we could be delisted from the NASDAQ Capital Market. The market price of our common stock has been and may continue to be subject to significant fluctuation as a result of variations in our quarterly operating results and volatility in the financial

markets. On September 10, 2007, the Company received a notice from The NASDAQ Stock Market (“NASDAQ”) stating that the Company is not in compliance with the requirements for continued inclusion under NASDAQ Marketplace Rule 4310(c)(4), due to the fact that the closing bid price of the Company’s common stock has not exceeded $1.00 for a consecutive 30 day period. NASDAQ stated in its notice that, in accordance with the NASDAQ Marketplace Rules, the Company will be provided 180 calendar days, or until March 10, 2008, to regain compliance. If our stock is delisted from the NASDAQ Capital Market, an investor could find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, our common stock. Additionally, our stock may be subject to “penny stock” regulations if it is delisted from the NASDAQ Capital Market. If our common stock were subject to “penny stock” regulations, which apply to certain equity securities not traded on the NASDAQ Capital Market which have market price of less that $1.00 per share, subject to limited exceptions, additional disclosure would be required by broker-dealers in connection with any trades involving such stock.

 

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

 

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 negatively affect our results of operations.  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 operating results. To date, we have generally been able to negotiate contracts that allow us to adjust our prices on a periodic basis (typically quarterly, semi-annually, or annually); 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.

 

Single source components and component shortages.  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 negatively affect 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, many of our customers do not commit to firm production schedules more than several months 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 has 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 be unable to realize net sales from our backlog.  We compute our backlog from purchase orders received from our customers and from other contractual agreements. Our customer purchase orders and contracts typically preserve the customer’s right to cancel with appropriate notice. As such, even though we may have contractual agreements or purchase orders for future shipments, there is no guarantee that this backlog will be realized in net sales.

 

Future quarterly and annual operating results may fluctuate substantially due to a number of factors, many of which are beyond our control and could 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 similarly packaged end result); we may be unable to pass on cost overruns; we may not be able to gain the benefits expected out of lean-flow manufacturing at our Victoria facility; we may not have control over the timing of expenditures, 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 may fail to adequately adjust our expenses to predicted net sales in any given period or we may experience significant fluctuations in quarterly net sales because the sales cycle for our products and services is lengthy and unpredictable.  While our sales cycle varies from customer to customer, it historically 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 prospective customer’s budgetary constraints and internal acceptance reviews, over which we have little or no control. As a result of this variability, combined with the fact that many of our expenses are fixed, we may fail to adequately adjust our expenses to predicted net sales in any given period or we may experience significant fluctuations in quarterly net sales.

We may have a significant accounts receivable write-off as 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 inventory in connection with providing manufacturing services to our customers. If one or more of our principal customers were to become insolvent, or otherwise fail to pay for the services and materials provided by us, our operating results and financial condition would be adversely affected.

 

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. Some of our employees are subject to employment agreements that can be terminated upon providing 30 days advance, written notice by either party. The majority of our employees, including our Chief Executive Officer, are employees at will. The loss of one or more key employees may materially adversely affect our growth.

 

We operate in a regulated industry, and our products and revenue are subject to regulatory risk.  We are subject to a variety of regulatory agency requirements in the United States and foreign countries relating to many of the products that we develop and manufacture. The process of obtaining and maintaining required regulatory approvals and otherwise remaining in regulatory compliance can be lengthy, expensive and uncertain.

 

The FDA inspects manufacturers of certain types of devices before providing a clearance to manufacture and sell such devices, and the failure to pass such an inspection could result in delay in moving ahead with a product or project. We are required to comply with the FDA’s QSR for the development and manufacture of medical products. In addition, in order for devices we design or manufacture to be exported and for us and our customers to be qualified to use the “CE” mark in the European Union, we maintain ISO 9001/EN 46001 certification which, like the QSR, subjects our operations to periodic surveillance audits. To ensure compliance with various regulatory and quality requirements, we expend significant time, resources and effort in the areas of training, production and quality assurance. If we fail to comply with regulatory or quality regulations or other FDA or applicable legal requirements, the governing agencies can issue warning letters, impose government sanctions and levy serious penalties.

 

Noncompliance or regulatory action could have a negative impact on our business, including the increased cost of coming into compliance, and an adverse effect on the willingness of customers and prospective customers to do business with us. Such noncompliance, as well as any increased cost of compliance, could have a material adverse effect on our business, results of operations and financial condition.

 

If our customers do not promptly obtain regulatory approval for their products, our projects and net sales may be adversely affected.  The FDA regulates many of our customers’ products, and requires certain clearances or approvals before new medical devices can be marketed. As a prerequisite to any introduction of a new device into the medical marketplace, our customers must obtain necessary product clearances or approvals from the FDA or other regulatory agencies. This can be a slow and uncertain process, and there can be no assurance that such clearances or approvals will be obtained on a timely basis, if at all. In addition, products intended for use in foreign countries must comply with similar requirements and be certified for sale in those countries. A customer’s failure to comply with the FDA’s requirements can result in the delay or denial of approval to proceed with the product. Delays in obtaining regulatory approval are frequent and, in turn, can result in delaying or canceling customer orders. There can be no assurance that our customers will obtain or be able to maintain all required clearances or approvals for domestic or exported products on a timely basis, if at all. The delays and potential product cancellations inherent in the regulatory approval and ongoing regulatory compliance of products we develop or manufacture may have a material adverse effect on our projects and revenue, as well as our business, reputation, results of operations and financial condition.

 

Failure to comply with our debt covenants may require us to immediately repay our outstanding balances and/or may affect our ability to borrow funds in the future, either of which may adversely affect our future operating results.  At various times over the past five years, we have not been in compliance with our debt covenants. These defaults have had the effect of, among other things, increasing the cost of our financing.

Failure to meet our debt covenants in the future may require us to: further increase borrowing rates; incur amendment fees; incur additional restrictions on our ability to borrow additional funds; immediately repay our outstanding balances; find a new lender, which may cause us to incur costs in connection with such new lending relationship; and reduce the number of potential alterative lenders.

 

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

 

We may fail to have enough liquidity to operate our business because we may not adequately adjust our expenses to actual revenue in any given period, which may dramatically and negatively impact our cash flow.  Our basis for determining our ability to fund our operations depends on our ability to accurately estimate our revenue streams and our ability to accurately predict our related expenditures. Furthermore, our borrowing base is tied to eligible accounts receivable and inventory balances. As a result, we may fail to adequately adjust our expenses to actual revenue in any given period or we may experience significant fluctuations in quarterly revenue, either of which may dramatically and negatively affect our cash flow.

 

If the components that we design and manufacture are the subject of product recalls or a product liability claim, our business may be damaged, we may incur significant legal fees and our results of operations and financial condition may be adversely affected.  Certain of the components we design or manufacture are used in medical devices, several of which may be used in life-sustaining or life-supporting roles. The tolerance for error in the design, manufacture or use of these components and 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, improper use of the product or other reasons, the product may need to be recalled, possibly at our expense. Further, 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, results of operations and financial condition.

 

The manufacture and sale of the medical devices involves the risk of product liability claims. Although we generally obtain indemnification from our customers for components that we manufacture to the customers’ specifications and we maintain product liability insurance, there can be no assurance that the indemnities will be honored or the coverage of our insurance policies will be adequate. Further, we generally provide a warranty and indemnify our customers for failure of a product to conform to specifications and against defects in materials and workmanship. Product liability insurance is expensive and in the future may not be available on acceptable terms, in sufficient amounts, or at all. A successful product liability claim in excess of our insurance coverage or any material claim for which insurance coverage was denied or limited and for which indemnification was not available could have a material adverse effect on our business, results of operations and financial condition.

 

The loss of a key customer may reduce our operating results and financial condition.  The loss of a key customer could adversely effect our operating results and financial condition. In Fiscal 2007, two customers accounted for 14% and 11% of our net sales and the same customers accounted for 10% and 15%, respectively, of our net sales for Fiscal 2006, and 10% and 6%, respectively, for Fiscal 2005. Also in Fiscal 2005, one additional customer accounted for 13% of net sales. No other customer was over 10% of net sales in Fiscal 2007, Fiscal 2006 or Fiscal 2005. Although our objective is to reduce the concentration of sales to any customers, we expect that sales to a relatively small number of customers will continue to account for a substantial portion of net sales 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 to maintain a focused yet diverse market and customer mix. New customers and programs can have a significant ramp up effort associated with getting the product ready for delivery. The efforts associated with managing a more diversified customer base and projects could prove to be more difficult than previously thought and could result in loss of customers and net sales.

 

If we are unable to develop new products and services our net sales 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 net sales.  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; and our limited experience in specific market segments in marketing our products and services.

 

Our business may suffer 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, infringement could be a persistent problem. In addition, the laws of some foreign countries do not protect our intellectual property rights to the same extent that the laws of the United States protect our intellectual property rights. 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 sales and 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 manufacturing methods, processes or technologies.

 

Third-party intellectual property infringement claims may be costly and may prevent the future sale of our customer’s products.  Substantial litigation and threats of litigation regarding intellectual property rights exist in our industry. Third parties may claim that our customer’s products or our manufacturing methods, processes or technologies infringe upon their intellectual property rights. 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, assist in removing the infringing customer’s products from the marketplace or expend substantial amounts in order to modify the customer’s products so that they no longer infringe on the third party’s rights.

 

We may pursue future significant corporate transactions, such as acquisitions, divestitures or investments that may adversely affect our financial position or cause our net sales to decline or loss per share to increase.  In the future, we may pursue significant corporate transactions, such as acquisitions, divestitures or investments in businesses, products and technologies that could focus, complement or expand our business. Such transactions, though, involve certain risks such as: we may not be able to negotiate acceptable terms with respect to an acquisition, divestiture or investment, or finance an acquisition or investment successfully; a divestiture could reduce consolidated sales volumes and any economies associated with a larger enterprise; the integration of acquired businesses, products or technologies into our existing business may fail; and we may issue equity securities, incur debt, assume contingent liabilities, accept credit risk or have amortization expenses and write-downs of acquired assets which could cause our results of operations to suffer.

 

If our customers are unable to gain market acceptance for the products that we develop or manufacture for them, we may lose net sales.  We design and manufacture components for other companies. For products we manufacture, our success is dependent on the acceptance of those products in their markets. Market acceptance may depend on a variety of factors, including educating the target market regarding the use of a new product or 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 quantities to manufacture our products. While we are currently in compliance with applicable regulations, 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.

 

We are dependent on a single market, and adverse trends in that market may reduce our revenues.  During the past several years, we have been significantly dependent on a single market. In Fiscal 2007, Fiscal 2006 and Fiscal 2005, 85%, 84% and 87%, respectively, of our net sales came from the medical/hearing market. This market is characterized by intense competition, 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 market trends to the extent that they reduce our revenues. In particular, if manufacturers in the medical/hearing market 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. 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.

 

Our orders are subject to cancellation and cancellation can disrupt our business.  In certain circumstances, our customers are permitted to cancel their orders, change production quantities, delay production and terminate their contracts and any such event or series of events may adversely affect our gross margins and operating results. We, as a medical/hearing device development and manufacturing service provider, must provide product output that matches the needs of our customers, which can change from time to time. We generally do not obtain long-term commitments from our customers and we continue to experience reduced lead times in customer orders. In certain situations, cancellations, reductions in quantities, delays or terminations by a significant customer could adversely affect our operating results. Such cancellations, reductions or delays have occurred and may continue to occur in response to slowdowns in our customers’ businesses or for other reasons. In addition, we make significant decisions, including determining the levels of business that we will seek and accept, production schedules, parts procurement commitments, and personnel needs based on our estimates of customer requirements. Because many of our costs and operating expenses are relatively fixed, a reduction in customer demand or a termination of a contract by a customer could adversely affect our gross margins and operating results.

 

Inventory management is critical to maximizing our cash flow.  Inventory risk and production delay may adversely affect our financial performance. Most of our contract manufacturing services are provided on a turnkey basis, where we purchase some or all of the materials required for product assembling and manufacturing. We bear varying amounts of inventory risk in providing services in this manner. In manufacturing operations, we need to order parts and supplies based on customer forecasts, which may be for a larger quantity of product than is included in the firm orders ultimately received from those customers and this cost may limit our available funds for other purposes. While many of our customer agreements include provisions that require customers to reimburse us for excess inventory which we specifically order to meet their forecasts, we may not actually be reimbursed or be able to collect on these obligations. In that case, we could have excess inventory and/or cancellation or return charges from our suppliers. Our medical/hearing device manufacturing customers continue to experience fluctuating demand for their products, and in response they may ask us to reduce or delay production. If we delay production, our financial performance may be adversely affected.

 

If government or insurance company reimbursements for our customers’ products change, our products, revenues and profitability may be adversely affected.  Governmental and insurance industry efforts to reform the healthcare industry and reduce healthcare spending have affected, and will continue to affect, the market for medical devices. There have been several instances of changes in governmental or commercial insurance reimbursement policies that have significantly impacted the markets for certain types of products or services or that have had an impact on entire industries, such as recent policies affecting payment for nursing home and home care services. Adverse governmental regulation relating to our components or our customers’ products that might arise from future legislative, administrative or insurance industry policy cannot be predicted and the ultimate effect on private insurer and governmental healthcare reimbursement is unknown. Government and commercial insurance

companies are increasingly vigorous in their attempts to contain healthcare costs by limiting both coverage and the level of reimbursement for new therapeutic products even if approved for marketing by the FDA. If government and commercial payers do not provide adequate coverage and reimbursement levels for uses of our customers’ products, the market acceptance of these products and our revenues and profitability would be adversely affected.

 

We have customers located in foreign countries and our unfamiliarity of the laws and business practices of such foreign countries could cause us to incur increased costs.  We currently have customers located in foreign countries and anticipate additional customers located outside the United States. Our lack of knowledge and understanding of the laws of, and the customary business practices in, foreign counties could cause us to incur increased costs in connection with disputes over contracts, environmental laws, collection of accounts receivable, holding excess and obsolete inventory, duties and other import and export fees, product warranty exposure and unanticipated changes in governmental regimes.

 

We have excess space available for sublease at our Colorado facility and may not be able to find qualified sublease tenants.  Our lease agreement at our Colorado facility allows for us to sublease out any excess space, subject to the approval of our landlord. We currently have a tenant for a portion of the facility and are actively looking for additional sublease tenants to sublease up to 55,000 square feet of vacant space or space that could be made available through changes in the current layout of the operation. Our ability to find additional sublease tenants will have an impact on the operating performance of that division if we cannot provide an offset to our base rent and facility operating costs.

 

Our Amended and Restated Articles of Incorporation and our Amended and Restated Bylaws, as amended, 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 September 1, 2007, we had options outstanding to acquire 883,000 shares of our common stock, exercisable at prices ranging from $1.28 to $20.38 per share, with a weighted average exercise price of $5.64 per share. During the terms of these options, the holders will have the opportunity to profit from 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.

 

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 common stock and could impair the ability of purchasers of our common stock to recoup their investment or make a profit. As of September 1, 2007, these shares consist of:

 

 

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 Securities and Exchange Commission, or 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.

 

The trading dynamics of our common stock makes it subject to large fluctuations in the per share value.  Our common stock is a micro-stock that is thinly traded on The NASDAQ Capital Market. In some cases, our common stock may not trade during any given day. Small changes in the demand for shares of our common stock can have a material impact, both negatively and positively, in the trading share price of our stock. In addition, the Company’s common stock could become delisted from the NASDAQ Capital Market which could further impact the per share value and trading volumes of our common stock.

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 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 or 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 us or any subsidiary with or into any person that directly or indirectly beneficially owns, or owned at any time in the preceding 12 months, five percent or more of the outstanding shares of our stock entitled to vote in elections of directors, referred to as 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 us; and 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.

 

If we are not able to establish an effective control environment in Fiscal 2008, we will not comply with Section 404 of the Sarbanes-Oxley Act relating to internal controls over financial reporting.  Section 404 of the Sarbanes-Oxley Act requires that we attest as to the effectiveness of our internal controls over financial reporting beginning with our Annual Report on Form 10-K for our fiscal year ending August 30, 2008, referred to as Fiscal 2008. Under applicable SEC rules and regulations, management may not conclude that a company’s internal control over financial reporting is effective if there are one or more material weaknesses in the company’s internal control over financial reporting. We have initiated the process of documenting our internal control process and our evaluation of those controls. We cannot provide any assurance that we will timely complete the evaluation of our internal controls, including implementation of the necessary improvements to our internal controls, or that even if we do complete this evaluation and make such improvements, we will do so in time to permit us to test our controls and complete our attestation procedures in a manner that will allow us to comply with the applicable SEC rules and regulations relating to internal controls over financial reporting by the filing deadline for our Annual Report on Form 10-K for Fiscal 2008.

 

The market price of our shares may experience significant price and volume fluctuations for reasons over which we have little control.  The trading price of our common stock has been, and is likely to continue to be volatile. The closing price of our common stock as reported on The NASDAQ Capital Market has ranged from a high of $4.53 to a low of $0.65 over the past two years. Our stock price could be subject to wide fluctuations in response to a variety of factors, including, but not limited to, the risks relating to an investment in our stock described above and the following: new products or services offered by us or our competitors; actual or anticipated variations in quarterly operating results; announcements of significant acquisitions, strategic partnerships, joint ventures, capital commitments or divestitures by us or our competitors; issuances of debt or equity securities; changes in requirements or demands for our services; 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 financial or earnings estimates by market analysts; speculation in the press or analyst community; general market conditions or market conditions specific to particular industries; and other events or factors, many of which are beyond our control.

 

In addition, the stock market in general, and The NASDAQ Capital Market and companies in our industry, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the

operating performance of these companies. Broad market and industry factors may negatively affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against such companies. This type of litigation, if instituted, could result in substantial costs and a diversion of management’s attention and resources, which would harm our business.

 

 

None.

 

 

We own an approximately 48,000 square foot facility for administration and microelectronics production in Victoria, Minnesota, a suburb of Minneapolis, which was originally built in 1981. The facility serves as collateral for a number of our financings.

 

We lease an approximately 13,000 square foot production facility in Tempe, Arizona for our high density flexible substrates. The lease extends through July 31, 2010. Base rent is approximately $100,000 per year. We lease another approximately 4,000 square foot mixed office and warehouse space facility in Tempe Arizona that is used for office and storage space in support of the Tempe operation. The second Tempe lease termination date coincides with the lease termination date on the other space in Tempe — July 31, 2010. The base rent on the second Tempe lease is approximately $32,000 per year.

 

We lease an approximately 152,000 square foot facility in Boulder, Colorado for our AMO segment operations. Our base rent is approximately $1,486,000 for Fiscal 2008. 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 76,000 square feet of the facility and approximately 55,000 is vacant. In April 2005, we entered into a ten year sublease agreement for approximately 21,000 square feet 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 payable of approximately $281,000 per year commenced in November 2006. We are continuing to look for sublease tenants for the remaining 55,000 square feet of vacant space.

 

We consider our current facilities adequate for our current needs and believe that suitable additional space would be available if necessary.

 

 

During Fiscal 2003, we commenced litigation against Mr. Fant, our former Chief Executive Officer and Chairman. 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. During Fiscal 2003 and 2004, we obtained judgments against Mr. Fant totaling approximately $2,255,000, excluding interest. During Fiscal 2004 and 2005, we obtained, through garnishments and through sales of common stock previously held by Mr. Fant, approximately $1,842,000 of recoveries. In Fiscal 2005 and 2004, we recognized $481,000 and $1,361,000 of these recoveries, respectively.

 

During Fiscal 2006 and 2007, the Company continued to seek to collect additional amounts from Mr. Fant and other parties relating to the litigation. In March 2007, the Company received a final settlement of $275,000 before deducting accumulated legal fees of approximately $50,000, which is included in other income in the consolidated statements of operations for Fiscal 2007. Following the receipt of the settlement, the Company ceased all further action in this matter.

 

 

There were no matters submitted to a vote of shareholders during the fourth quarter of Fiscal 2007.

 

PART II

 

 

Our common stock is currently traded on the NASDAQ Capital Market under the symbol HEII. Below are the high and low sales prices for each quarter of our fiscal years ending September 1, 2007 and September 2, 2006, for our common stock. Effective December 28, 2006, the Company’s securities were transferred to the NASDAQ Capital Market. Prior to that time, the Company’s securities were listed on the NASDAQ Global Market.

 

 

 

As of November 1, 2007, we had 282 direct shareholders of record of our common stock based on data obtained from our transfer agent.

 

Possible Delisting of our Common Stock from the NASDAQ Capital Market

 

On September 10, 2007, the Company received a notice from The NASDAQ Stock Market (“NASDAQ”) stating that the Company is not in compliance with the requirements for continued inclusion under NASDAQ Marketplace Rule 4310(c)(4), due to the fact that the closing bid price of the Company’s common stock has not exceeded $1.00 for a consecutive 30 day period. NASDAQ stated in its notice that, in accordance with the NASDAQ Marketplace Rules, the Company will be provided 180 calendar days, or until March 10, 2008, to regain compliance.

 

Dividends

 

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 our continued development. 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 term loan agreements provide that we cannot, without our lender’s prior written consent, pay any dividend or make any distribution of assets to our shareholders or affiliates.

 

Repurchase of Equity Securities

 

The Company did not repurchase any of its equity securities during Fiscal 2007.

Shareholder Return Performance Presentation

 

The following line graph compares the cumulative total shareholder return on the Common Stock to the cumulative total return of the Russell 2000 (RUT) and the PHGILA SemiConductor (SOXX) Index for the last five years. Returns are based on a $100 investment on September 1, 2001, and are calculated assuming reinvestment of dividends during the period presented. The Company has not paid any dividends.

 

Total Return to Shareholders

 

 

 

Equity Compensation Plan Information

 

The following table sets forth certain information about the Company’s common stock that may be issued upon the exercise of options, warrants and rights under all of the existing equity compensation plans as of September 1, 2007.

 

 

 

Set forth below is selected financial data on a historical basis for the Company and its consolidated subsidiaries for the fiscal years ended September 1, 2007, September 2, 2006, and August 31, 2005, 2004 and 2003. During Fiscal 2006, the Company changed its fiscal year end to a 52 or 53 week period ending on the Saturday closest to August 31. Fiscal year 2007 ended on September 1, 2007 and fiscal year 2006 ended on September 2, 2006. These results may not be indicative of future results. This information should be read in conjunction with the consolidated financial statements and notes to consolidated financial statements appearing in Part II, Item 8 of this Annual Report on Form 10-K. Results for Fiscal 2006, Fiscal 2005, Fiscal 2004 and Fiscal 2003 have been restated to present comparable results for the RFID discontinued operations as if that divestiture had taken place in each of those respective fiscal years.

 

 

 

 

 

 

CRITICAL ACCOUNTING POLICIES

 

The accompanying consolidated financial statements are based on the selection and application of United States generally accepted accounting principles (“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 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 reported results.

 

Revenue recognition, sales returns and warranty

 

Revenue for manufacturing and assembly is recognized upon shipment to the customer which represents the point at which the risks and rewards of ownership have been transferred to the customer. Previously, we had a limited number of arrangements with customers which required that we retain ownership of inventory until it was received by the customer or until it was accepted by the customer. There were no additional obligations or other rights of return associated with these agreements. Accordingly, revenue for these arrangements was recognized upon receipt by the customer or upon acceptance by the customer.

 

Our Advanced Medical Operations development contracts are typically discrete time and materials projects that generally do not involve separately priced 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 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.

 

Allowance for Doubtful Accounts Estimation

 

We estimate the collectability of trade receivables and note receivables, which requires a 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 collectability 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 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. 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 for uncollectible accounts. Alternatively, if we provide more allowances than we need, we may reverse a portion of such provisions in future periods based on changes in estimates from our actual collection experience.

 

Inventories

 

Inventories are stated at the lower of cost or market and include materials, labor, and overhead costs. Cost is determined using the first-in-first-out method (FIFO). The majority of the inventory is purchased based on contractual forecasts and customer purchase orders, and in these cases, excess or obsolete inventory may be the customers’ responsibility. Even though contractual arrangements may be in place, we are still required to assess the utilization of inventory. In assessing the ultimate realization of inventories, judgments as to future demand requirements are made and compared to the current or committed inventory levels and contractual inventory holding requirements. Reserve requirements generally increase as projected demand requirements decrease due to market conditions, technological and product life cycle changes as well as longer than previously expected usage periods. It is possible that significant charges to record inventory at the lower of cost or market may occur in the future if there is a further decline in market conditions.

 

Long-lived Assets

 

Considerable management judgment is necessary in estimating future cash flows and other factors affecting the valuation of long-lived assets, including intangible assets, including the operating and macroeconomic factors that may affect them. The Company uses historical financial information, internal plans and projections and industry information in making such estimates. The Company did not recognize any impairment charges for our long-lived assets, including intangible assets, during fiscal 2007, 2006 or 2005. Although the Company has not generated positive cash flows in certain prior years, management believes that based on cost reduction actions and estimated revenue growth and margin improvement initiatives, that the Company will have cash flows from these long-lived assets in the future. While the Company currently believes the expected cash flows from these long-lived assets, including intangible assets, exceeds the carrying amount, materially different assumptions regarding future performance and discount rates could result in future impairment losses. In particular, if the Company no longer believes it will achieve its long-term projected sales or operating expenses, the Company may conclude in connection with any future impairment tests that the estimated fair value of its long-lived assets, including intangible assets, are less than the book value and recognize an impairment charge. Such impairment would adversely affect the Company’s earnings.

 

Valuation of Deferred Taxes

 

Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. We record a current provision for income taxes based on amounts payable or refundable. Deferred tax assets and liabilities are recognized for the future tax consequences of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. The overall change in deferred tax assets and liabilities for the period measures the deferred tax expense or benefit for the period. We recognize a valuation allowance for deferred tax assets when it is more likely than not that deferred assets are not recoverable.

At September 1, 2007 and September 2, 2006, we had valuation allowances of approximately $12,103,000 and $9,821,000, respectively, because of uncertainties related to the ability to utilize certain Federal and state net loss carryforwards due to our historical losses and net tax operating loss carryforward position. The valuation allowance is based on estimates of taxable income by jurisdiction and the period over which our deferred tax assets are recoverable.

 

RESULTS OF OPERATIONS

 

Percentage of Net Sales

 

 

The following table illustrates the approximate percentage of our net sales by market served.

 

 

Net Sales

 

Net sales for Fiscal 2007 were $38,384,000, a decrease of $10,677,000, or 22%, from net sales of $49,061,000 in Fiscal 2006. Net sales for our Microelectronic operations were $22.7 million in Fiscal 2007 as compared to $31.2 million in Fiscal 2006 or a decrease of $8.5 million or 27%. Sales at our AMO operations were $15.7 million compared to $17.9 million in Fiscal 2006 or a decrease of $2.2 million or 12%. The decrease was a result of several factors. The largest decrease came from our Microelectronics segment, which experienced a reduction in legacy business resulting from a series of consolidations in the telecommunications industry and off-shore outsourcing by one of our medical products customers during the current year. Net sales at our flexible substrate business were also lower in Fiscal 2007 due to a reduction in orders from our primary external customer that reduced orders to consume excess inventories of our product. Volumes at our Tempe facility increased subsequent to the end of Fiscal 2007 as our primary external customer increased orders and we increased the amount of interplant orders from our Victoria operation. Also on a year over year basis, our AMO segment experienced a reduction in design and development contracts.

 

During Fiscal 2007, the sales staff and business development efforts were expanding in all of our segments in an effort to replace legacy business. The success of these efforts cannot be predicted at this time, but management believes that these efforts will produce expanded sales opportunities in the future and will contribute to future revenues at all of our segments.

 

At September 1, 2007, our backlog of orders for sales was estimated at approximately $15.1 million compared to approximately $14.9 million and $20.1 million at September 2, 2006 and August 31, 2005, respectively. We expect to ship our backlog during the first and second quarters of Fiscal 2008. Our backlog is not necessarily a firm commitment from our customers and can change, in some cases materially, beyond our control.

Net sales for Fiscal 2006 were $49,061,000, a decrease of $3,581,000, or 7%, from net sales of $52,642,000 in Fiscal 2005. Our Microelectronic operations achieved sales of $31.2 million in Fiscal 2006 as compared to $29.3 million in Fiscal 2005 or an increase of $1.9 million or 6%. Sales at our AMO operations decreased from $23.2 million in Fiscal 2005 to $17.9 million in Fiscal 2006 or a $5.3 million or 23% decrease. At the Microelectronics segment, the primary reason for the increase was the increased production and output of flexible substrate materials at our Tempe facility which was facilitated by the addition of equipment during the fiscal year. At our AMO operations, the decrease was primarily driven by a decrease in design and development business which was a result of the termination of one program for one customer and the loss of contract software development projects with two other customers.

 

Net sales to medical/hearing customers represented 85%, 84% and 87% of total net sales for Fiscal 2007, Fiscal 2006 and Fiscal 2005, respectively. The consistency in this market are indicative of the acceptance of the customer’s products in this market and the expected strength of this market as companies continue to use companies like HEI as contract manufacturers. The decrease in Fiscal 2006 was a result of the shift to more communications products as existing customers increased their sales volumes resulting from further market acceptance of their products.

 

Net sales to the communications market were 13%, 14% and 11% of net sales for Fiscal 2007, 2006 and 2005, respectively. The increase in Fiscal 2006 over Fiscal 2005 was the result of targeted marketing efforts initiated in prior years to focus on niche customers in these markets. Sales efforts to these customers resulted in incremental revenues in Fiscal 2006 and we benefited from a general expansion of the global communications markets.

 

When taking into account the sale of the Company’s RFID business unit that is presented as a discontinued operation, the net sales to the Industrial markets was consistent at 2% for Fiscal 2007, Fiscal 2006 and Fiscal 2005.

 

Because our sales are generally tied to the customers’ projected sales and production of their products, 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 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 and year over year.

 

Gross Profit

 

Our gross profit as a percentage of net sales was 4% for Fiscal 2007 as compared to 16% in Fiscal 2006 and 20% in Fiscal 2005. The decline in gross profit was affected by several factors.

 

The reduction in percentage of net sales was a result of lower sales volumes, which did not contribute as much to cover fixed operating costs. In addition, the decline in gross margin in the current fiscal year compared to the prior fiscal year was a result of a lower volume of higher margin design, development, verification, and validation contracts at the AMO segment. In addition, our prior year’s levels of fixed overhead costs were structured in anticipation of significantly higher sales volumes than were actually achieved. Cost reductions were made in the later part of Fiscal 2006 and again throughout Fiscal 2007, but did not have a material impact on the margins for Fiscal 2007 as sales reduced at a faster rate than we were able to reduce fixed and variable costs. The Company believes that it has adjusted its costs to be consistent with current sales volumes with gross profit as a percent of net sales expected for Fiscal 2008.

 

The decline in gross margin in Fiscal 2006 compared to Fiscal 2005 was a result of a shift in sales mix at our AMO segment which resulted in a higher percentage of lower margin manufacturing revenues compared to higher margin design and development and verification and validation contracts. In addition, our fixed overhead costs were structured at higher levels in anticipation of significantly higher sales volumes than were actually achieved. Cost reductions were made in the later part of Fiscal 2006, but not in time to show a material impact on the gross margins. During Fiscal 2006, the Company changed its estimates for the calculation of inventory carrying costs relating to the computation of overhead associated with its inventory categories. Specifically, the Company believes that its prior estimates, which included significant allocations of quality control costs in the computations, were no longer representative of the costs associated with its current inventory make up. The change in estimate was further

supported by the change in the Company’s product mix and resulting inventory make up, expanding regulatory and compliance nature of the Company’s quality control function and the shift to a business unit configuration for the Company compared to a previously corporate-centralized configuration for our operations. The Company believes that this change in estimate is more representative of our changing inventory make up during the last fiscal year. The change in estimate resulted in a $1 million reduction in inventory carrying costs as of September 2, 2006 and adversely impacted our gross margin in Fiscal 2006 by approximately $1 million.

 

Our gross margins are heavily impacted by fluctuations in net sales, due to the fixed nature of many of our manufacturing costs, and by the mix of products manufactured in any particular quarter. In addition, the start up of new customer programs could adversely impact our margins as we implement the complex processes involved in the design and manufacture of ultra miniature microelectronic devices. We anticipate that our gross profit margins will start to improve in Fiscal 2008. 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

 

Selling, general and administrative expenses in total were $5.6 million or 15% of net sales for Fiscal 2007 compared to $8.4 million or 17% of net sales in Fiscal 2006 and $8.3 million or 16% of net sales in Fiscal 2005. The decrease in actual dollars of net sales is reflective of the focus on cost reductions implemented throughout Fiscal 2007. We are focused on reducing all of our fixed costs to be more in line with current revenue levels, while expanding the sales and business development activities in all of our segments. Specific cost reductions came in the areas of payroll and payroll related expenses through the reduction in staff in all segments and corporate departments (at September 1, 2007 we had 268 full-time equivalent employees compared to 441 full-time equivalent employees at September 2, 2006), reduction in stock related expenses ($185,000 for Fiscal 2007 compared to $503,000 in Fiscal 2006), elimination of image consulting expenses and a tightening of travel and entertainment expenses. Fiscal 2006 selling, general and administrative costs were higher as a percentage and in actual dollars as a result of expanded expenses in anticipation of significantly higher sales volumes in all of our segments. The increased sales volumes were not achieved and expenses were not adjusted in time to compensate for the change in estimated revenues and profitability. The expenses were not adjusted down until late in the fiscal year. In addition, in Fiscal 2006, we recorded a non-cash expense of approximately $503,000 relating to charges for stock based compensation under SFAS 123(R), “Share-Based Payment” that is now required to be recorded in the financial statements when in the prior year, the expense was disclosed only in the footnotes to the financial statements.

 

Research, development, and engineering expenses

 

Research, development, and engineering expenses were $2.3 million or 6% of net sales compared to $4.0 million or 8% of net sales for Fiscal 2006 and $3.2 million or 6% of net sales for Fiscal 2005. The decrease in actual dollars is reflective of the change in the engineering structure that focuses more heavily on supporting the contract manufacturing nature of our business segments instead of a focus on separable research and development. General cost reductions were also made in the first three quarters of Fiscal 2007 as part of the Company’s overall cost reduction efforts. In Fiscal 2006 compared to Fiscal 2005, the increases reflect additional engineering activities to improve manufacturing processes and design and development work associated with new customer programs. For Fiscal 2008, we expect that research, development and engineering costs will be more fully absorbed into the manufacturing and sales functions as we continue to realign our engineering activities to provide the support needed to meet our customer and internal needs.

 

Gain on Settlement

 

During 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 $300,000. All the cash related to this settlement was received in Fiscal 2005.

Interest Expense

 

Interest expense for Fiscal 2007 was $1.3 million as compared to $776,000 for Fiscal 2006 as compared with $667,000 in Fiscal 2005. The increase reflects the interest expense on the capital leases entered into by the Company during Fiscal 2006 and the increased borrowing under the Company’s line of credit and note from a related party, which were at higher levels and rates compared to the prior year period. During the third quarter of Fiscal 2007, the Company finalized a debt refinancing arrangement and repaid its prior line of credit and repaid the note from a related party. This refinancing reduced the interest rate payable on a substantial portion of the Company’s variable debt. The increase in interest expense in Fiscal 2006 compared to Fiscal 2005 was due to added borrowing relating to capital leases initiated in Fiscal 2006 and additional borrowing under the revolving credit agreements as a result of operating losses sustained during Fiscal 2006.

 

Income Tax Expense (Benefit)

 

We did not record a tax provision in Fiscal 2007, Fiscal 2006 or Fiscal 2005 since we have unutilized net operating loss carryforwards from prior years which will be utilized to offset taxes associated with income in future years. 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. The economic benefits of our net operating loss carryforwards to future years will continue until expired.

 

At the end of Fiscal 2007, we had net operating loss carryforwards of approximately $30.1 million, expiring at various dates ranging from 2012 through 2027. Though valuation allowances have been established, we still retain all the economic benefits of the net operating loss in future years.

 

Deemed Dividend on Preferred Stock

 

The deemed dividend on preferred stock was recorded in Fiscal 2005 and resulted from the sale of our preferred stock. On May 9, 2005, we completed the sale of 130,538 shares of our Series A Convertible Preferred Stock. Each share of the Preferred Stock is immediately convertible into ten shares of common stock. Because the Preferred Stock was issued at a discount to the market price on the date of issue and because it is immediately convertible into common stock, we were required to record a deemed dividend on preferred stock in our financial statements for the year ended August 31, 2005. This non-cash dividend is to reflect the implied economic value to the preferred shareholders of being able to convert their shares into common stock at a discounted price. 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 $850,000 was recorded as equity. The fair value allocated to the preferred stock of $2,550,000 together with the original conversion terms were used to calculate the value of the deemed dividend on the preferred stock of $1,072,000 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 shareholders.”

 

FINANCIAL CONDITION

 

Our net cash flow provided by operating activities was $1,298,000 for Fiscal 2007 compared to net cash flow used in operating activities of $2,648,000 and $2,956,000 for Fiscal 2006 and Fiscal 2005, respectively. The net loss sustained in Fiscal 2007 of $5,657,000 was offset by reductions in accounts receivable due to a reduction in sales, but also an improvement in days outstanding, and a reduction in inventory as part of our effort to reduce inventories as well as a reduction in the capitalization of inventory overhead. The use of cash in operations in Fiscal 2006 was driven by the $6,057,000 net loss sustained by the Company during Fiscal 2006. Reductions in accruals in the normal course of business also impacted our net cash flow used in operations. In Fiscal 2005, the primary factors affecting net cash flow used in operations was an increase of $2,544,000 of accounts receivable and an increase of $1,257,000 of inventory. Also in Fiscal 2005, we paid down accounts payable and accrued liabilities during the year which required the use of cash and caused us to increase the use of our line of credit. We generated a net loss of $5,657,000 in Fiscal 2007 as compared to a net loss of $6,057,000 in Fiscal 2006 as compared with net income of

$355,000 in Fiscal 2005. The net loss in Fiscal 2007 was reduced by a gain of $1.7 million on discontinued operations that resulted from the sale of our RFID business unit at the close of Fiscal 2007.

 

Our net cash flow provided by (used in) investing activities was $2,693,000, $149,000 and ($1,249,000) for Fiscal 2007, Fiscal 2006 and Fiscal 2005, respectively. We spent $461,000, $977,000 and $1,404,000 on capital expenditures and patent costs in Fiscal 2007, Fiscal 2006 and Fiscal 2005, respectively. Spending on capital expenditures was funded through the use of debt and capital leases. The capital expenditures relate to facility improvements and purchases of manufacturing equipment to enhance our production capabilities, capacity and quality control systems. In Fiscal 2007, we received net proceeds from the sale of our RFID business unit which improved the Company’s cash flow by approximately $3,000,000. In Fiscal 2006, we had a refund of a security deposit from our facility at our AMO segment which provided approximately $1,000,000 in additional cash flow to the Company.

 

Our net cash flow used in financing activities in Fiscal 2007 was ($4,488,000) and was primarily related to the net repayments against our line of credit and repayments of our long-term debt. The net repayments against our line of credit were made possible by the cash proceeds of $3 million from the sale of our RFID business at the close of Fiscal 2007. Our net cash flow from financing activities in Fiscal 2006 was $2,822,000 and was primarily related to net borrowing under our line of credit of $3,385,000 which was used to offset operating losses. We also repaid $749,000 in long-term debt during Fiscal 2006. In addition to these financing activities, we also utilized $2,314,000 in non-cash capital lease financing to acquire equipment. Our net cash flow from financing activities in Fiscal 2005 was $4,356,000 and was primarily related to cash proceeds from the issuance of Series A Convertible Preferred Stock during the year. This offering generated net proceeds of $3,162,000 for the Company. We also generated cash through additional borrowings on our line of credit of $1,253,000 and by the repayments on notes from officers and former directors of $228,000. During Fiscal 2005, we repaid $381,000 on our long-term debt. In addition to these financing activities, we also utilized non-cash capital lease financing to acquire $442,000 of equipment.

 

The result of these activities was a decrease in cash of $497,000 in Fiscal 2007 as compared to an increase in cash of $323,000 in Fiscal 2006 as compared with an increase in cash of $151,000 in Fiscal 2005. At the end of Fiscal 2007, our cash balance was $177,000.

 

Accounts receivable average days outstanding were 42 days at September 1, 2007 compared to 64 days at September 2, 2006 and compared to 55 at August 31, 2005. Inventory turns were 11.3, 5.9 and 6.0 for Fiscal 2007, Fiscal 2006 and Fiscal 2005, respectively. The inventory turns for Fiscal 2007 and Fiscal 2006 were impacted by the change in estimate for inventory overhead capitalization costs during these years which reduced the comparable inventory balances.

 

The Company’s current ratio at the end of Fiscal 2007 was 1.6:1 as compared to 1.3:1 and 1.9:1 at the end of Fiscal 2006 and Fiscal 2005, respectively. The increase in Fiscal 2007 was a result of a complete change of the makeup of both current assets and current liabilities from the prior fiscal year. Accounts receivable were lower due to lower sales, but also faster collection of balances due. Inventories were also reduced to improve cash flow and as a result of further reductions in inventory overhead capitalization due to our changing corporate support structures. At the same time, current liabilities were reduced due to a refinancing of our debt that resulted in long-term liability classification of our line of credit compared to the prior year’s current liability classification and a reduction in accounts payable due to lower revenue levels and a reduction in accrued liabilities due to reduced expense structures. The decrease in Fiscal 2006 compared to Fiscal 2005 was due to additional borrowings under the line of credit and a reduction in security deposit that was refunded to the Company during Fiscal 2006 and reduction in inventory carrying costs which resulted from a change in estimate of the inventory overhead calculations as of September 2, 2006. As of September 1, 2007, our current liabilities included $848,000 in current maturities of long-term debt and we had long-term debt of $4,350,000 which included $2,115,000 under our revolving line of credit and shareholders equity of $3,360,000. The previous revolving line of credit was categorized as a current liability for the calculation of the current ratio.

TERM-DEBT

 

Long-term debt

 

During our fiscal years ended September 1, 2007, September 2, 2006 and August 31, 2005, we have undertaken a number of activities to restructure our term-debt. The following is a summary of those transactions:

 

The Company had two separate loans in the original aggregate amount of $2,350,000 under Term Loan Agreements with Commerce Bank, a Minnesota state banking association, and its affiliate, Commerce Financial Group, Inc., a Minnesota corporation. The first loan, with Commerce Bank, in the amount of $1,200,000 was executed on October 14, 2003. This loan is secured by our Victoria, Minnesota facility. The term of the first loan is six years with a nominal interest rate of 6.50% per year for the first three years. The rate was adjusted per the original agreement on November 1, 2006 to 9.25% per year. Monthly payment of principal and interest is based on a twenty-year amortization with a final payment of approximately $1,039,000 due on November 1, 2009. The second loan, with Commerce Financial Group, Inc., in the amount of $1,150,000 was executed on October 28, 2003. The second loan was secured by our Victoria facility and certain equipment located at our Tempe facility. The second loan was due October 27, 2007, but the loan was paid off early through the use of the proceeds from the Wells Fargo Business Credit revolving line of credit and term loan facilities that were entered into on May 15, 2007. There was no outstanding balance under the second loan as of September 1, 2007.

 

The Company has not been in compliance with the debt service coverage ratios required by these two agreements beginning with the quarter ended May 27, 2006. The Company has received waivers for any violations of its debt covenants with Commerce Bank and Commerce Financial Group, Inc. through September 1, 2007.

 

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 at September 1, 2007 is $133,000 with an average effective interest rate of 16%. These agreements are for three years and 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.

 

During Fiscal 2006, the Company entered into several capital lease agreements to fund the acquisition of machinery and equipment, primarily at our Tempe facility. Most 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 at September 1, 2007 is $1,508,000 with an average effective interest rate of 12.5%. These agreements are for 36 to 45 months 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 or at an agreed upon value which is generally not less than 15% nor greater than 20% of the original equipment cost.

 

On May 15, 2007, the Company entered into a three year $8.0 million revolving credit facility pursuant to a Credit and Security Agreement with Wells Fargo Business Credit, and a three year $340,000 term loan. Borrowings under these facilities were used to repay the $5 million loan to the Company by Thomas F. Leahy, the Company’s Chairman of the Board, to repay certain obligations of the Company and for general operating purposes. Mr. Leahy guaranteed the financing package in an amount not to exceed $4 million and provided collateral to secure the guarantee in the amount of $4 million. In return for the guarantee and collateral pledge, he is paid a guarantee fee in the amount of $8,000 per month by the Company. The revolving credit facilities are secured by accounts receivable and inventories and a third mortgage position on the Company’s Victoria, Minnesota production facility. The term loan is secured by a first priority security interest in all non-leased assets at the Company’s Tempe, Arizona production facility. The revolving line of credit advance rates are based on outstanding balances of both domestic and foreign accounts receivable and certain inventory balances. The interest rate on the revolving line of credit advances is 2% over prime and the term loan interest rate is 2.25% over prime, except upon an event of default. The prime rate was 8.25% at September 1, 2007. The term loan has a 60 month amortization period with monthly payments beginning June 1, 2007 with the balance due and payable in full on May 15, 2010. The revolving credit facilities are due on May 15, 2010. The credit facilities require a minimum interest charge of $150,000 per year and there is an unused line fee of 0.25% under the revolving credit facility.

These credit facilities with Wells Fargo Business Credit (“Wells”) contain customary affirmative and negative covenants. The financial covenants include a limitation on capital expenditures, a maximum/minimum cumulative net loss/net income position through February 2008 and a minimum debt service coverage ratio beginning with the Company’s fiscal year 2008. The creation of indebtedness outside the credit facility, creation of liens, making of certain investments, sale of assets, and incurrence of debt are all either limited or require prior approval from Wells under those facilities. These credit facilities also contain customary events of default such as nonpayment, bankruptcy, and change in the Company’s Chairman of the Board, which if they occur may constitute an event of default. In November 2007, Wells waived all previous covenant violations for Fiscal 2007 and agreed to work with the Company to establish new covenant levels for the future. Based upon the discussions with Wells regarding the proposed new covenant levels, the Company believes it will be able to meet the new financial covenants in Fiscal 2008, once established.

 

Short-term debt

 

Since early in Fiscal 2003, we had an accounts receivable agreement (the “Credit Agreement”) with Beacon Bank of Shorewood, Minnesota. The initial term of the Credit Agreement expired September 1, 2006 and was automatically extended to March 1, 2007. The Credit Agreement provided for a maximum amount of credit $5,000,000 and was an accounts receivable backed facility and was additionally secured by inventory, intellectual property and other general intangibles. The Credit Agreement was not subject to any restrictive financial covenants. The balance on the line of credit was $3,948,000 and $2,563,000 as of September 2, 2006 and August 31, 2005, respectively. The Credit Agreement as amended on July 7, 2005 bore an interest rate of Prime plus 2.75%. There was also an immediate discount of .85% for processing. The Credit Agreement was paid off in full in May 2007.

 

On November 3, 2006, Thomas F. Leahy, the Chairman of the Board of Directors of the Company, loaned the Company $5,000,000 dollars (the “Secured Loan”). The Company’s obligations under the Secured Loan were evidenced by a promissory note (the “Note”) and a security agreement. The Note had an original principal amount of $5,000,000, and required the Company to pay monthly installments of interest, and a maturity of November 2, 2007. Unpaid principal due under the Note bears interest at the rate of fifteen percent (15%) per annum, commencing on November 3, 2006 with such interest rate increasing by one percent (1%) each calendar month, beginning January 1, 2007, up to a maximum of twenty percent (20%) per annum. The Company used $2,200,000 of the proceeds of the Secured Loan to satisfy the Company’s obligations under the Credit Agreement with Beacon Bank. The remainder of the proceeds were available for general working capital needs. The Secured Loan was paid off in full on May 15, 2007. During the period of time that this related party Note was outstanding, the Company paid Mr. Leahy a total of $451,000 in interest payments.

 

In April 2006, the Company entered into a $2,000,000 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, which had a balance of $2,000,000 outstanding, expired on April 18, 2007 and was paid off in April and May 2007.

FISCAL 2007 LIQUIDITY

 

We generated a net loss in Fiscal 2007 of $5,657,000, a net loss in Fiscal 2006 of $6,057,000 and net income in Fiscal 2005 of $355,000. Net sales declined in each of Fiscal 2007 and Fiscal 2006 as compared to Fiscal 2005. The Company experienced an increase in sales in Fiscal 2005 compared to Fiscal 2004 and anticipated the sales increase to continue during Fiscal 2006. As a result, our costs were structured to support the higher level of anticipated sales including selling, general and administrative costs and research, development and engineering costs. The higher sales levels were not achieved during Fiscal 2006 or Fiscal 2007 and cost reductions were not implemented until late in Fiscal 2006 and throughout Fiscal 2007. These cost reductions had little to no impact in reducing the operating loss during Fiscal 2006 and the severance costs and inventory adjustments negatively impacted results during Fiscal 2007. In addition, during Fiscal 2007, a change in the sales mix at our AMO segment reduced the overall gross margin contribution on the sales that were achieved at that segment. During Fiscal 2006, the operating losses were funded in part by the refund of the security deposit on our AMO facility in the amount of $1.35 million (net of additional security deposits on other debt of $320,000). The operating losses sustained during Fiscal 2007 have been funded through borrowing under our various line of credit facilities and the Company has excess borrowing capacity under its current line of credit facility to fund the operation through its turnaround efforts over the next several quarters.

 

On May 15, 2007, the Company entered into a three year $8.0 million revolving credit facility pursuant to a Credit and Security Agreement with Wells Fargo Business Credit, and a three year $340,000 term loan. Borrowings under these facilities were used to repay the $5 million loan to the Company by Thomas F. Leahy, the Company’s Chairman of the Board, to repay certain obligations of the Company and for general operating purposes. Mr. Leahy guaranteed the financing package in an amount not to exceed $4 million and provided collateral to secure the guarantee in the amount of $4 million. In return, he is paid a guarantee fee in the amount of $8,000 per month by the Company in consideration for the guarantee and collateral pledge. The revolving credit facilities are secured by accounts receivable and inventories and a third mortgage position on the Company’s Victoria, Minnesota production facility. The term loan is secured by a first priority security interest in all non-leased assets at the Company’s Tempe, Arizona production facility. The revolving line of credit advance rates are based on outstanding balances of both domestic and foreign accounts receivable and certain inventory balances. The interest rate on the revolving line of credit advances is 2% over prime and the term loan interest rate is 2.25% over prime, except upon an event of default. The current prime rate is 7.50%. The term loan has a 60 month amortization period with monthly payments that began June 1, 2007 with the balance due and payable in full on May 15, 2010. The credit facilities require a minimum interest charge of $150,000 per year and there is an unused line fee of 0.25% under the revolving credit facility with a term date of May 15, 2010.

 

These credit facilities with Wells Fargo Business Credit (“Wells”) contain customary affirmative and negative covenants. The financial covenants include a limitation on capital expenditures, a maximum/minimum cumulative net loss/net income position through February 2008 and a minimum debt service coverage ratio beginning with the Company’s fiscal year 2008. The creation of indebtedness outside the credit facility, creation of liens, making of certain investments, sale of assets, and incurrence of debt are all either limited or require prior approval from Wells under those facilities. These credit facilities also contain customary events of default such as nonpayment, bankruptcy, and change in the Company’s Chairman of the Board, which if they occur may constitute an event of default. In November 2007, Wells waived all previous covenant violations for Fiscal 2007 and agreed to work with the Company to establish new covenant levels for the future. Based upon the discussions with Wells regarding the proposed new covenant levels, the Company believes it will be able to meet the new financial covenants in Fiscal 2008, once established.

 

On August 31, 2007, the Company sold its RFID business unit for $3 million cash, resulting in a pre-tax gain of approximately $1.5 million reported in the Company’s Fiscal 2007 results. Cash proceeds from the sale were used to reduce borrowing under the Company’s existing credit facility as of September 1, 2007.

 

As a result of these events, at September 1, 2007 our sources of liquidity consisted of $177,000 of cash, offset by $191,000 in checks in excess of bank balances, and had available borrowing capacity of approximately $3,700,000 under our revolving credit facility. Our liquidity, however, is affected by many factors, some of which

are based on the normal ongoing operations of our business, the most significant of which include the timing of the collection of receivables, the level of inventories and capital expenditures.

 

Beginning in mid-Fiscal 2006, the Company focused efforts on changing its cost structures and operating structures in an effort to reduce costs and strengthen the operational performance of each of segment. The most significant change was to shift from a centralized management of our segments to setting up a general manager for each of our operations. Some additional cost reductions were further undertaken at our Victoria facility towards the end of Fiscal 2006. The impacts of these changes along with the reduction of overall sales levels were not adequate to move the Company to a level of profitability by the end of the Fiscal 2006 and negatively impacted the first quarter of Fiscal 2007. Further cost reductions were undertaken during Fiscal 2007 to better align costs with current revenue levels. These reductions also had a negative impact on Fiscal 2007 due in part to severance obligations in certain instances and inventory adjustments.

 

Beginning in Fiscal 2007, the Company hired a new Chief Executive Officer, who was hired as the Company’s Chief Financial Officer in June 2006. He continues to fulfill that dual role and his efforts are targeted on cost structures and operational improvements. Additional cost reductions have already been initiated in addition to operational improvement initiatives at each of our segments. Revised operating budgets have been established to allow us to focus our efforts on our operating activity and expenses and to improve gross margins and minimize costs. Initiatives include or included:

 

 

During Fiscal 2007, we limited spending for manufacturing equipment. All expenditures were made on an as needed basis and future capital expenditures of approximately $1 million have been budgeted as part of the strategic planning and budgeting process for Fiscal 2008 as we assessed our needs to expand our manufacturing capacity and our technological capabilities in order to meet the expanding needs of our customers. It is expected that these expenditures will be funded from existing cash, cash generated from operations, lease financing and available debt financing.

 

In the event future cash flows and borrowing capacities are not sufficient to fund operations at the present level, additional measures will be taken including efforts to further reduce expenditure levels that may include reduction of spending for research and development and engineering, elimination of budgeted raises, reduction of non-strategic employees and the deferral or elimination of capital expenditures. In addition, we believe that other sources of liquidity are available which may include issuance of the Company’s stock, the expansion of our credit facilities and the issuance of long-term debt.

 

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

 

Off Balance Sheet Arrangements

 

We do not have any off balance sheet arrangements.

Contractual Obligations

 

Our contractual cash obligations at September 1, 2007, excluding any potential sublease income, are summarized in the following table. Long-term debt obligation does not include any potential interest to be paid on the revolving line of credit facility:

 

 

New Accounting Pronouncements

 

The FASB has published FASB Interpretation (FIN) No. 48 (FIN No. 48), Accounting for Uncertainty in Income Taxes, to address the noncomparability in reporting tax assets and liabilities resulting from a lack of specific guidance in FASB Statement of Financial Accounting Standards (SFAS) No. 109 (SFAS No. 109), Accounting for Income Taxes, on the uncertainty in income taxes recognized in an enterprise’s financial statements. Specifically, FIN No. 48 prescribes (a) a consistent recognition threshold and (b) a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides related guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 will apply to fiscal years beginning after December 15, 2006, our Fiscal 2008. The Company does not expect the adoption of FIN No. 48 to have a material effect on its consolidated financial statements.

 

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin 108, “Considering the Effects on Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” (“SAB 108”). SAB 108 requires registrants to quantify errors using both the income statement method (i.e. iron curtain method) and the rollover method and requires adjustment if either method indicates a material error. If a correction in the current year relating to prior year errors is material to the current year, then the prior year financial information needs to be corrected. A correction to the prior year results that are not material to those years, would not require a “restatement process” where prior financials would be amended. SAB 108 was effective for our Fiscal 2007 and did not have a material effect on our financial position, results of operations or cash flows.

 

 

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 revolving credit facility and term loan with Wells Fargo Business Credit. The Commerce Bank note, in the amount of $1,200,000, 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 adjusts 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. The rate was adjusted per the original agreement on November 1, 2006 to 9.25% per year.

 

On May 15, 2007, the Company entered into a three year $8.0 million revolving credit facility pursuant to a Credit and Security Agreement with Wells Fargo Business Credit, and a three year $340,000 term loan. The interest

rate on the revolving line of credit advances is 2% over prime and the term loan interest rate is 2.25% over prime, except upon an event of default. The current prime rate is 7.50%. The credit facilities require a minimum interest charge of $150,000 per year and there is an unused line fee of 0.25% under the revolving credit facility with a term date of May 15, 2010.

 

Changes in interest rates for the Commerce Bank tern credit note and Wells credit facility and term loan are not expected to have a material adverse effect on our near-term financial condition or results of operation. Our financing arrangements, which include our lease financings, do not fluctuate with the movement of general interest rates.

 

In April 2006, the Company entered into a supplemental $2,000,000 revolving line of credit with Beacon Bank that expired in April 2007. Borrowings under the Line of Credit bore an interest rate of Prime plus 2.75% and a processing fee of .65%. The Line of Credit was paid off in full in May 2007.

 

Prior to May 2007, the Company was a party to a credit agreement with Beacon Bank that provided for a maximum amount of credit of $5,000,000. The Credit Agreement as amended on July 7, 2005 bore an interest rate of Prime plus 2.75%. There was also an immediate discount of .85% for processing. The Beacon Bank Credit Agreement was paid off in full in May 2007.

 

On November 3, 2006, Thomas F. Leahy, the Chairman of the Board of Directors of the Company, loaned the Company $5,000,000 dollars (the “Secured Loan”). The Company’s obligations under the Secured Loan were evidenced by a promissory note (the “Note”) and a security agreement. The Note had an original principal amount of $5,000,000, and required the Company to pay monthly installments of interest, and a maturity of November 2, 2007. Unpaid principal due under the Note bore interest at the rate of fifteen percent (15%) per annum, commencing on November 3, 2006 with such interest rate increasing by one percent (1%) each calendar month, beginning January 1, 2007, up to a maximum of twenty percent (20%) per annum. The Secured Loan was paid off in full in May 2007.

 

 

Our financial statements as of September 1, 2007 and September 2, 2006, and for each of the years ended September 1, 2007, September 2, 2006 and August 31, 2005, together with the Reports of our Independent Registered Public Accounting Firm, are included in this Annual Report on Form 10-K on the pages indicated below.

 

HEI, INC.

 

CONSOLIDATED BALANCE SHEETS

 

 

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

HEI, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

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

HEI, INC.

 

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

 

 

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

HEI, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Supplemental disclosures of non-cash financing and investing activities:

 

In Fiscal 2006, capital lease obligations related to property and equipment were $2,314 and issuance of common stock to landlord recognized as long-term asset was $336.

 

In Fiscal 2005, 98,538 shares of Convertible Preferred Stock were converted into 985,000 shares of common stock and capital lease obligations related to property and equipment were $442.

 

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

HEI, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1

 

Overview

 

HEI, Inc. and subsidiaries are referred to herein as “HEI,” the “Company,” “us,” “we” or “our,” unless the context indicates otherwise. We provide a comprehensive range of engineering, product design, automation and test, manufacturing, distribution, and fulfillment services and solutions to our customers in the hearing, medical device, medical equipment, communications, computing and industrial equipment markets. We provide these services and solutions on a global basis through three 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.

 

Fiscal Year

 

During fiscal year 2006, the Company changed its fiscal year end to a 52 or 53 week period ending on the Saturday closest to August 31. Fiscal year 2007 ended September 1, 2007, fiscal year 2006 ended on September 2, 2006, and fiscal year 2005 ended on August 31, 2005, and are identified herein as Fiscal 2007, Fiscal 2006 and Fiscal 2005, respectively.

 

Discontinued operations

 

The Company sold substantially all of the assets and liabilities of its RFID business effective August 31, 2007. The divestiture, which occurred at the end of Fiscal 2007, is treated as a discontinued operation for the Company. All results of operations and assets and liabilities of RFID for all periods presented have been restated and classified as discontinued operations. All references to the business are based on results of operations from continuing operations.

 

Summary of Significant Accounting Policies

 

Principles of Consolidation.  The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant inter-company transactions and balances have been eliminated in consolidation.

 

Revenue Recognition.  Revenue for manufacturing and assembly is recognized upon shipment to the customer which represents the point at which the risks and rewards of ownership have been transferred to the customer. Previously, we had a limited number of arrangements with customers which required that we retain ownership of inventory until it was received by the customer or until it was accepted by the customer. There were no additional obligations or other rights of return associated with these agreements. Accordingly, revenue for these arrangements was recognized upon receipt by the customer or upon acceptance by the customer.

 

Our Advanced Medical Operations development contracts are typically discrete time and materials projects that generally do not involve separately priced 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 if the term of the arrangement is short-term or using the percentage of completion method for longer-term contracts.

 

Cash Equivalents.  The Company considers its investments in all highly liquid debt instruments with original maturities of three months or less at date of purchase to be cash equivalents. The Company deposits its cash in high credit quality financial institutions. The balances, at times, may exceed Federal insured limits.

 

HEI, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Accounts Receivable.  The Company reviews customers’ credit history before extending unsecured credit and establishes an allowance for uncollectible accounts based upon factors surrounding the credit risk of specific customers and other information. Credit risk on accounts receivable is minimized as a result of the diverse nature of the Company’s customer base. Invoices are generally due 30 days after presentation. Accounts receivable over 30 days are considered past due. The Company does not accrue interest on past due accounts receivable. Receivables are written off only after all collection attempts have failed and are based on individual credit evaluation and specific circumstances of the customer. Accounts receivable are shown net of an allowance for uncollectible accounts of $106,000 and $113,000 at September 1, 2007 and September 2, 2006, respectively. During Fiscal 2007 and Fiscal 2006, the Company reduced the allowance for uncollectible accounts by $18,000 and $33,000, respectively. Accounts receivable over 90 days past due, including discontinued operations accounts receivable over 90 days past due, were $66,000 and $464,000 at September 1, 2007 and September 2, 2006, respectively.

 

Inventories.  Inventories are stated at the lower of cost or market and include materials, labor, and overhead costs. Cost is determined using the first-in, first-out method (FIFO). The majority of the inventory is purchased based upon contractual forecasts and customer purchase orders, in which case excess or obsolete inventory is generally the customers’ responsibility.

 

Property and Equipment.  Property and equipment are stated at cost. Depreciation and amortization are provided on the straight-line method over the estimated useful lives of the property and equipment. The approximate useful lives of building and improvements are 10-39 years and fixtures and equipment are 3-10 years. Depreciation and amortization expense on property and equipment for both continuing and discontinued operations was $1,831,000, $2,320,000 and $2,233,000 for the fiscal years ended September 1, 2007, September 2, 2006 and August 31, 2005, respectively.

 

Maintenance and repairs are charged to expense as incurred. Major improvements and tooling costs are capitalized and depreciated using the straight-line method over their estimated useful lives. The cost and accumulated depreciation of property and equipment retired or otherwise disposed of is removed from the related accounts, and any resulting gain or loss is credited or charged to operations.

 

Patents.  External costs associated with patents are capitalized and amortized over 84 months or the remaining life of the patent, whichever is shorter. Amortization expense related to patents was $88,000, $88,000 and $72,000 for Fiscal 2007, 2006 and 2005, respectively. Amortization expense is expected to approximate $63,000, $46,000, $33,000, $15,000 and $4,000 in each of the next five fiscal years, respectively. The book value of the patents are as follows:

 

 

Impairment of Notes Receivable.  The Company routinely performs an analysis as to the probability that a receivable is collectible. A note receivable is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the note receivable agreement including scheduled interest payments. At September 1, 2007, the Company had written off the remaining balance of a note receivable from a former director as uncollectible. No other notes receivable are recorded on the books of the Company at September 1, 2007.

 

HEI, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Valuation of Long-Lived Assets

 

We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying amount may not be recoverable, in accordance with FASB SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An asset or asset group is considered impaired if its carrying amount exceeds the undiscounted future net cash flow the asset or asset group is expected to generate. If an asset or asset group is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair value. If estimated fair value is less than the book value, the asset is written down to the estimated fair value and an impairment loss is recognized.

 

If we determine that the carrying amount of long-lived assets, including intangible assets, may not be recoverable, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model or another valuation technique. Net intangible assets and long-lived assets amounted to $6.1 million as of September 1, 2007.

 

Considerable management judgment is necessary in estimating future cash flows and other factors affecting the valuation of long-lived assets, including intangible assets, including the operating and macroeconomic factors that may affect them. We use historical financial information, internal plans and projections and industry information in making such estimates.

 

We did not recognize any impairment charges for our long-lived assets, including intangible assets, during fiscal 2007, 2006 or 2005. While we currently believe the expected cashflows from these long-lived assets, including intangible assets, exceeds the carrying amount, materially different assumptions regarding future performance and discount rates could result in future impairment losses. In particular, if we no longer believe we will achieve our long-term projected sales or operating expenses, we may conclude in connection with any future impairment tests that the estimated fair value of our long-lived assets, including intangible assets, are less than the book value and recognize an impairment charge. Such impairment would adversely affect our earnings.

 

Research, Development and Engineering.  The Company expenses all research, development and engineering costs as incurred.

 

Shipping and Handling.  The Company includes shipping and handling revenue in net sales and shipping and handling costs in cost of sales.

 

Advertising.  Advertising costs are charged to expense as incurred. Advertising costs were $95,000, $511,000 and $187,000 for the years ended September 1, 2007, September 2, 2006 and August 31, 2005, respectively, and are included in selling, general and administrative expense.

 

Income Taxes.  Deferred income tax assets and liabilities are recognized for the expected future tax consequences of events that have been included in the financial statements or income tax returns. Deferred income tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities using currently enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts more likely than not to be realized. Income tax expense (benefit) is the tax payable (receivable) for the period and the change during the period in deferred income tax assets and liabilities.