##### 



Exhibit 13.1 Letter from the CEO (PHOTO)
    
    To Our Shareholders
 To
our Shareholders Fiscal 2005 was another good year for
CHAD Therapeutics. Revenue increased for
the fourth consecutive year, and net income
rose to an eight-year high. We met all of
our primary product development objectives,
including the release of our newest device,
the
LOTUSTM electronic oxygen
conserver, and in May of 2005 we completed
the initial round of independent clinical
trials of our new therapeutic product for
sleep apnea. Our progress in fiscal 2005
set the stage for continued success in the
rapidly changing competitive environment in
the home oxygen market, and positioned CHAD
to take advantage of new growth
opportunities in the sleep disorder market. One key to our strategic growth plan
is continued expansion of our oxygen
conserver product lines. The success of our
conservers in domestic and international
markets has restored CHADs traditional
leadership in this important market
segment, and we continued to build on that
platform. The SAGE Oxygen Therapeutic
Device, which we launched in fiscal 2004,
is the first in a planned line of
therapeutic oxygen devices, and it
performed well for us in fiscal 2005. The
recent introduction of the LOTUS Electronic
Oxygen Conserver represents another product
innovation at CHAD that we believe will
contribute to our growth. These devices,
along with CHADs OXYMATIC®400
Series electronic conservers and CYPRESS
OXYPneumatic®conservers,
provide the industrys widest range of
cost-effective choices for homecare
providers to satisfy individual patient
requirements and preferences for ambulatory
oxygen products. We also experienced substantial growth in sales of our TOTAL O2® home oxygen filling system. Recent
changes in home oxygen reimbursement are
encouraging homecare providers to evaluate
their monthly operating costs more
carefully and to seek more cost-effective
ways to service their home oxygen patients.
CHADs proprietary TOTAL O2
system was designed specifically to
reduce these costs while improving the quality of
patient care. We remain convinced that the
TOTAL O2 system can
become a major contributor to CHADs
growth, and that our new marketing
initiatives have put us on the right track
to build awareness and demand. Financial Results For the fiscal year ended March 31,
2005, revenue increased 13% to $24,287,000
from $21,541,000 for fiscal 2004. Research
and development spending increased to
$1,473,000 for fiscal 2005 from $1,292,000
for fiscal 2004 to support our various
product development initiatives, with all
funding provided from internally generated
sources. Earnings before income taxes
increased 33% to $1,327,000 from $1,001,000
for fiscal 2004. Net earnings for fiscal
2005 rose 81% to $1,811,000, or $0.17 per
diluted share. This compares to net
earnings for fiscal 2004 of $1,001,000, or
$0.10 per diluted share. At March 31, 2005, the Company had
approximately $1,846,000 in California net
operating loss carryforwards available to
offset future income taxes payable. Based
on earnings performance and future earnings
projections, the Company released the
valuation allowance that had been placed on
its deferred tax assets, resulting in a net
income tax benefit of $484,000 for fiscal
2005. The effective combined Federal and
California income tax rate in fiscal 2006
and future years is currently expected to
be approximately 40%. CHADs balance sheet remains well
positioned to sustain our growth. Working
capital at March 31, 2005, was $10.4
million versus $9.2 million at March 31,
2004, and shareholders equity was $13
million versus $11.2 million at March 31,
2004. The company has no debt. The Year In Review As we discussed in last years annual
report, the Medicare Improvement and
Modernization Act signed into law in
December 2003 has increased pressure on
home care providers to reduce the
costs of providing home oxygen services.
This has created both positive and negative
trends for CHAD. Sales of oxygen conservers
to domestic customers increased by only 5%
in fiscal 2005 compared to fiscal 2004,
reflecting increased pricing pressure in
the domestic market as well as lower sales
of conservers to a large customer. On the positive side, TOTAL O2
sales increased 64% in
fiscal 2005 compared to fiscal 2004. The
very same competitive pressures that
restrained the growth of our domestic
conserver business in fiscal 1




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##### 



To Our Shareholders 2005 are working to expand the market
opportunity for our TOTAL O2® home oxygen
filling system. By producing unlimited oxygen
just like a standard oxygen concentrator,
while simultaneously allowing patients to
easily and safely refill their portable oxygen
cylinders at home, this device can
significantly reduce monthly operating costs
while at the same time improving patient care. We have been approached by several major
distributors regarding our TOTAL O2 system. These new
distribution opportunities have the potential to
significantly expand TOTAL O2  sales and may also have a
positive impact on our conserver sales.
We hope that we will be able to convert these
opportunities into formal distribution
agreements during fiscal 2006. We are also encouraged that the
international conserver market is now emerging
as an important growth opportunity for CHAD.
Sales of our conservers to international
customers, which accounted for 6% of sales in
fiscal 2005, increased 51% in fiscal 2005
compared to fiscal 2004. The international
conserver market is in a much earlier stage of
development than the domestic market, and we
are taking advantage of this opportunity by
offering the industrys broadest conserver
product line and by modifying certain of our
conservers to meet specific foreign market
requirements. As a result, based on current
trends and orders
received to date, we expect another
significant increase in international sales in
fiscal 2006. LOTUS Electronic Oxygen Conserver In October 2004 we received clearance
from the FDA to market CHADs new LOTUS
Electronic Oxygen Conserver. The latest
addition to CHADs extensive line of oxygen
conserving devices, the new LOTUS conserver
combines innovative new features with the
proven technologies in the Companys OXYMATIC
400 Series conservers. The LOTUS conserver offers several
significant enhancements to our popular
OXYMATIC 400 Series platform. Sleek and
lightweight at less than a pound, our new
device will be offered with or without a
breath-sensing alarm and will incorporate
additional liter flow settings and an audible
and visual low battery alarm. Two AA-size
batteries will provide power for up to four
months of normal usage. An optional
rechargeable battery pack is also available
for both versions. These advanced
features demonstrate yet again CHADs
commitment to offering homecare providers and
their patients the widest array of home oxygen
choices to suit individual needs, preferences
and disease conditions. Sleep Products Update The initial independent clinical trial of
our first potential product for the sleep
disorder market recently was completed at a
university sleep clinic. The trial confirmed
that our sleep apnea therapeutic device
incorporating our proprietary sensor
technology achieved a significant reduction in
the air pressure needed to treat sleep apnea
patients, in addition to potentially providing
other therapeutic benefits. We believe this is
why all of the patients tested preferred our
device to the standard device that was used
for comparative purposes in the clinical
trial. This may translate into improved
compliance by patients who use our device,
which is a significant factor in sleep apnea
therapy. We expect to make a decision this
summer regarding our distribution options for
our sleep apnea products. Outlook For Growth An unusually large number of factors
affect the outlook for fiscal 2006. These
include the wide range of outcomes that could
result from the distribution options
we are pursuing for our TOTAL O2system and our sleep
apnea products, the emerging
opportunities for our conserver products in
international markets, continued uncertainty
with respect to the domestic conserver market,
and our expectation of a significantly higher
tax rate beginning this year. On balance, we
expect CHAD to report higher revenue and
earnings before income taxes in fiscal 2006
than in fiscal 2005. We are encouraged by our progress and
excited by our opportunities for growth. We
appreciate the commitment of every member of
CHADs team, whose hard work, dedication and
professionalism make our success possible. We
also thank our shareholders for their
continued support. We look forward to an
exciting year for CHAD Therapeutics. -s- Earl L. Yager
Earl L. Yager
Chief Executive Officer 2




---



##### 



Selected Financial Data Selected Financial Data Years Ended March 31,2005
    
    
    2004
    
    
    2003
    
    
    2002
    
    
    2001Net sales
    
    $
    24,287,000
    
    
    $
    21,541,000
    
    
    $
    19,541,000
    
    
    $
    19,006,000
    
    
    $
    12,400,000Interest income, net
    
    
    39,000
    
    
    
    22,000
    
    
    
    20,000
    
    
    
    50,000
    
    
    
    87,000Net earnings (loss)
    
    
    1,811,000
    
    
    
    1,001,000
    
    
    
    (433,000
    )
    
    
    1,157,000
    
    
    
    (3,011,000
    )Basic earnings (loss) per share
    
    
    .18
    
    
    
    .10
    
    
    
    (.04
    )
    
    
    .12
    
    
    
    (.30
    )Diluted earnings (loss) per share
    
    
    .17
    
    
    
    .10
    
    
    
    (.04
    )
    
    
    .11
    
    
    
    (.30
    )Net working capital
    
    
    10,393,000
    
    
    
    9,175,000
    
    
    
    8,224,000
    
    
    
    7,497,000
    
    
    
    5,847,000Total assets
    
    
    15,790,000
    
    
    
    13,043,000
    
    
    
    12,105,000
    
    
    
    12,323,000
    
    
    
    10,788,000Shareholders equity
    
    
    13,024,000
    
    
    
    11,153,000
    
    
    
    10,100,000
    
    
    
    10,373,000
    
    
    
    9,211,000
 No cash dividends have been declared or paid during the periods presented. 3




---



##### 



Balance Sheets March 31,2005
    
    
    2004AssetsCurrent assets:Cash
    
    $
    177,000
    
    
    $
    2,708,000Accounts receivable, less allowance for doubtful
accounts of $39,000 and $68,000 in 2005 and
2004, respectively
    
    
    3,745,000
    
    
    
    2,911,000Inventories, net (Note 2)
    
    
    8,512,000
    
    
    
    4,989,000Prepaid expenses
    
    
    264,000
    
    
    
    233,000Deferred income taxes (Note 3)
    
    
    461,000
    
    
    
    224,000Total current assets
    
    
    13,159,000
    
    
    
    11,065,000Property and equipment, at cost:Office equipment and furniture
    
    
    1,854,000
    
    
    
    1,809,000Machinery and equipment
    
    
    957,000
    
    
    
    877,000Tooling
    
    
    1,441,000
    
    
    
    1,283,000Leasehold improvements
    
    
    1,888,000
    
    
    
    1,820,0006,140,000
    
    
    
    5,789,000Less accumulated depreciation and amortization
    
    
    4,949,000
    
    
    
    4,571,000Net property and equipment
    
    
    1,191,000
    
    
    
    1,218,00Intangible assets, net (Note 4)
    
    
    802,000
    
    
    
    729,000Deferred income taxes (Note 3)
    
    
    568,000
    
    
    
    Other assets
    
    
    70,000
    
    
    
    31,000$
    15,790,000
    
    
    $
    13,043,000Liabilities and Shareholders EquityCurrent liabilities:Accounts payable
    
    $
    1,196,000
    
    
    $
    502,000Accrued expenses (Note 7)
    
    
    1,370,000
    
    
    
    1,185,000Income taxes payable (Note 3)
    
    
    200,000
    
    
    
    203,000Total current liabilities
    
    
    2,766,000
    
    
    
    1,890,000Commitments (Note 8)Shareholders equity (Note 5):Common shares, $0.01 par valueAuthorized 40,000,000 shares;10,134,000 and 10,096,000 shares issued
and outstanding
    
    
    13,369,000
    
    
    
    13,309,000Accumulated deficit
    
    
    (345,000
    )
    
    
    (2,156,000
    )Net shareholders equity
    
    
    13,024,000
    
    
    
    11,153,000$
    15,790,000
    
    
    $
    13,043,000
 See accompanying notes to financial statements. 4




---



##### 



Statements of Operations Years Ended March 31,2005
    
    
    2004
    
    
    2003Net sales
    
    $
    24,287,000
    
    
    $
    21,541,000
    
    
    $
    19,541,000Cost of sales
    
    
    14,581,000
    
    
    
    12,846,000
    
    
    
    12,292,000Gross profit
    
    
    9,706,000
    
    
    
    8,695,000
    
    
    
    7,249,000Costs and expenses:Selling, general and administrative
    
    
    6,947,000
    
    
    
    6,436,000
    
    
    
    6,708,000Research and development
    
    
    1,473,000
    
    
    
    1,292,000
    
    
    
    989,000Total costs and expenses
    
    
    8,420,000
    
    
    
    7,728,000
    
    
    
    7.697,000Operating income (loss)
    
    
    1,286,000
    
    
    
    967,000
    
    
    
    (448,000
    )Interest income, net
    
    
    39,000
    
    
    
    22,000
    
    
    
    20,000Other income
    
    
    2,000
    
    
    
    12,000
    
    
    
    Earnings (loss) before income taxes
    
    
    1,327,000
    
    
    
    1,001,000
    
    
    
    (428,000
    )Income tax expense (benefit) (Note 3)
    
    
    (484,000
    )
    
    
    
    
    
    
    5,000Net earnings (loss)
    
    $
    1,811,000
    
    
    $
    1,001,000
    
    
    $
    (433,000
    )Basic earnings (loss) per share
    
    $
    .18
    
    
    $
    .10
    
    
    $
    (.04
    )Diluted earnings (loss) per share
    
    $
    .17
    
    
    $
    .10
    
    
    $
    (.04
    )Weighted shares outstanding:Basic
    
    
    10,122,000
    
    
    
    10,084,000
    
    
    
    10,071,000Diluted
    
    
    10,625,000
    
    
    
    10,362,000
    
    
    
    10,071,000
 See accompanying notes to financial statements. 5




---



##### 



Statements of Shareholders Equity For the years ended March 31, 2005,
2004, and 2003 Common Shares (Note 5)
    
    
    AccumulatedShares
    
    
    Amount
    
    
    DeficitBalance at March 31, 2002
    
    
    10,059,000
    
    
    $
    13,097,000
    
    
    $
    (2,724,000
    )Exercise of stock options
    
    
    17,000
    
    
    
    20,000
    
    
    
    Stock options granted as part of
technology acquisition
    
    
    
    
    
    
    140,000
    
    
    
    Net loss
    
    
    
    
    
    
    
    
    
    
    (433,000
    )Balance at March 31, 2003
    
    
    10,076,000
    
    
    
    13,257,000
    
    
    
    (3,157,000
    )Exercise of stock options
    
    
    20,000
    
    
    
    26,000
    
    
    
    Stock options granted as part of
technology acquisition
    
    
    
    
    
    
    23,000
    
    
    
    Tax benefit from exercise of
non-qualified stock options
    
    
    
    
    
    
    3,000
    
    
    
    Net earnings
    
    
    
    
    
    
    
    
    
    
    1,001,000Balance at March 31, 2004
    
    
    10,096,000
    
    
    
    13,309,000
    
    
    
    (2,156,000
    )Exercise of stock options
    
    
    38,000
    
    
    
    60,000
    
    
    
    Net earnings
    
    
    
    
    
    
    
    
    
    
    1,811,000Balance at March 31, 2005
    
    
    10,134,000
    
    
    $
    13,369,000
    
    
    $
    (345,000
    )
 See accompanying notes to financial statements. 6




---



##### 



Statements of Cash Flows Years Ended March 31,2005
    
    
    2004
    
    
    2003Cash flows from operating activities:Net earnings (loss)
    
    $
    1,811,000
    
    

    $
    1,001,000
    
    
    $
    (433,000
    )Adjustments to reconcile net earnings (loss)
to net cash provided by (used in) operating activities:Depreciation and amortization
    
    
    417,000
    
    
    
    450,000
    
    
    
    768,000Loss on write down of intangible asset
    
    
    
    
    
    
    
    
    
    
    934,000Loss on asset disposition
    
    
    
    
    
    
    57,000
    
    
    
    Tax benefit attributable to stock options
    
    
    
    
    
    
    3,000
    
    
    
    Changes in assets and liabilities:Decrease (increase) in accounts receivable
    
    
    (834,000
    )
    
    
    (394,000
    )
    
    
    (184,000
    )Decrease (increase) in inventories
    
    
    (3,523,000
    )
    
    
    522,000
    
    
    
    (227,000
    )Decrease (increase) in income taxes refundable
    
    
    
    
    
    
    4,000
    
    
    
    991,000Decrease (increase) in prepaid expenses
    
    
    (31,000
    )
    
    
    368,000
    
    
    
    (286,000
    )Decrease (increase) in other assets
    
    
    (39,000
    )
    
    
    47,000
    
    
    
    (41,000
    )Decrease (increase) in deferred income taxes
    
    
    (805,000
    )
    
    
    (224,000
    )
    
    
    Increase (decrease) in accounts payable
    
    
    694,000
    
    
    
    (239,000
    )
    
    
    (36,000
    )Increase (decrease) in accrued expenses
    
    
    185,000
    
    
    
    (78,000
    )
    
    
    94,000Increase (decrease) in income taxes payable
    
    
    (3,000
    )
    
    
    202,000
    
    
    
    (3,000
    )Net cash provided by (used in) operating activities
    
    
    (2,128,000
    )
    
    
    1,719,000
    
    
    
    1,577,000Cash flows from investing activities:Additions to other assets
    
    
    (112,000
    )
    
    
    (146,000
    )
    
    
    (278,000
    )Capital expenditures
    
    
    (351,000
    )
    
    
    (487,000
    )
    
    
    (243,000
    )Net cash used in investing activities
    
    
    (463,000
    )
    
    
    (633,000
    )
    
    
    (521,000
    )Cash flows from financing activities:Exercise of stock options
    
    
    60,000
    
    
    
    26,000
    
    
    
    20,000Net cash provided by financing activities
    
    
    60,000
    
    
    
    26,000
    
    
    
    20,000Net increase (decrease) in cash
    
    
    (2,531,000
    )
    
    
    1,112,000
    
    
    
    1,076,000Cash beginning of year
    
    
    2,708,000
    
    
    
    1,596,000
    
    
    
    520,000Cash end of year
    
    $
    177,000
    
    
    $
    2,708,000
    
    
    $
    1,596,000Supplemental disclosure of cash flow information:Cash paid during the year for:Interest
    
    $
    
    
    
    $
    
    
    
    $
    2,000Income taxes
    
    
    325,000
    
    
    
    13,000
    
    
    
    15,000
 See accompanying notes to financial statements. 7




---



##### 



Notes to Financial Statements (1) Summary of Significant Accounting Policies The Company CHAD Therapeutics, Inc. (the Company) is in
the business of developing, producing and
marketing respiratory care devices designed to
improve the efficiency of oxygen delivery systems
for home health care and hospital treatment of
patients suffering from pulmonary diseases. Fair Value of Financial Instruments The carrying amounts of financial
instruments approximate fair value as of March
31, 2005 and 2004. The carrying amounts related
to cash, accounts receivable, other current
assets, and accounts payable approximate fair
value due to the relatively short maturity of
such instruments. Inventories Inventories are valued at lower of cost or
market. Cost is determined based on standard cost
which approximates the first-in, first-out
method. Property and Equipment Property and equipment are stated at cost.
Depreciation of property and equipment is
provided using the straight-line method based on
the estimated useful lives of the related assets
as follows: Office Equipment and Furniture
    
    5-10 YearsMachinery and Equipment
    
    5-10 YearsTooling
    
    4 Years
 Amortization of leasehold improvements is over
the life of the related lease or asset, whichever
is shorter. Use of Estimates Management of the Company has made a number
of estimates and assumptions relating to the
reporting of assets and liabilities and the
disclosure of contingent assets and liabilities
at the balance sheet date and the reporting of
revenues and expenses during the periods to
prepare these financial statements in conformity
with accounting principles generally accepted in
the United States of America. Actual results
could differ from those estimates. Significant estimates include the allowance for
doubtful accounts, inventory valuation, deferred
income tax asset valuation allowances, and the
estimated future operating cash flows from the
Companys long-lived assets, including its
intangible assets. Considerable management
judgment is necessary to estimate future
operating cash flows as future cash flows are
impacted by competitive and other factors that
are generally out of managements control.
Accordingly, actual results could vary
significantly from managements estimates. Impairment of Long-Lived Assets The Company reviews its long-lived assets
for impairment whenever events or changes in
circumstances indicate that the carrying amount
of an asset may not be recoverable.
Recoverability of assets to be held
and used is measured by a comparison of the
carrying amount of an asset to undiscounted
future net cash flows expected to be generated by
the asset. If such assets are considered to be
impaired, the impairment to be recognized is
measured by the amount by which the carrying
amount of the assets exceeds the fair value of
the assets. Revenue Recognition Revenue from product sales is recognized
upon shipment of merchandise. Products are
shipped FOB shipping point and title, to the
products transfers to the purchaser upon
shipment. Shipping charges billed to customers
are included in net sales. Allowances for
customer returns have not been established, as
historical experience has been minor. Costs paid
to shipping companies are recorded as a cost of
sales. Comprehensive Income (Loss) The Company did not have components of
other comprehensive income during the periods
ended March 31, 2005, 2004, and 2003. As a
result, comprehensive income (loss) is the same
as net earnings (loss) for the periods ended
March 31, 2005, 2004, and 2003. Royalty Expense The Company charges royalties incurred on
product licenses to costs of sales. Earnings (Loss) Per Common Share Following is a calculation of basic and
diluted earnings (loss) per common share for the
years ended March 31, 2005, 2004, and 2003,
respectively: 2005
    
    
    2004
    
    
    2003Basic earnings (loss) per share
Numerator  net earnings (loss)
    
    $
    1,811,000
    
    
    $
    1,001,000
    
    
    $
    (433,000
    )Denominator  weighted common
shares outstanding
    
    
    10,122,000
    
    
    
    10,084,000
    
    
    
    10,071,000Basic earnings (loss) per share
    
    $
    .18
    
    
    $
    .10
    
    
    $
    (.04
    )Diluted earnings (loss) per shareNumerator  net earnings (loss)
    
    $
    1,811,000
    
    
    $
    1,001,000
    
    
    $
    (433,000
    )Denominator  weighted common
shares outstanding
    
    
    10,122,000
    
    
    
    10,084,000
    
    
    
    10,071,000Common stock equivalents
    
    
    503,000
    
    
    
    278,000
    
    
    
    10,625,000
    
    
    
    10,362,000
    
    
    
    10,071,000Diluted earnings (loss) per share
    
    $
    .17
    
    
    $
    .10
    
    
    $
    (.04
    )
 Options to purchase 128,000, 379,000, and
1,089,000 shares of common stock at prices
ranging from $5.00 to $12.54, $3.14 to $12.54,
and from $0.50 to $12.54 per share were not
included in the computation of diluted earnings
per share in 2005, 2004, and 2003, respectively,
because their inclusion would be anti-dilutive. Income Taxes Income taxes are accounted for under the
asset and liability method. Deferred tax assets
and liabilities are recognized for the future tax
consequences attributable to differences between
the financial statement carrying amounts of
existing assets and liabilities and their
respective tax basis and net operating loss and
tax credit carryforwards. In assessing whether
there is a need for a valuation allowance on
deferred tax assets, we determine whether it is
more 8




---



##### 



Notes to Financial Statements likely than not that we will recognize tax
benefits associated with deferred tax assets. In
making this determination, we consider future
taxable income and tax planning strategies that
are both prudent and feasible. 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 income in the period
that includes the enactment date. Major Customer One national chain customer accounted for
36%, 27%, and 24% of net sales during 2005, 2004,
and 2003, respectively. Another national chain
customer accounted for 11%, 14%, and 11% of net
sales during 2005, 2004, and 2003, respectively.
The Companys customers are affected by Medicare
reimbursement policy as approximately 80% of home
oxygen patients are covered by Medicare and other
government programs. Concentration of Credit Risk At times the Company maintains balances of
cash that exceed $100,000 per account, the maximum
insured by the Federal Deposit Insurance
Corporation. The Companys right to the cash is
subject to the risk that the financial institution
will not pay when the cash is requested. The
potential loss is the amount in any one account
over $100,000. At March 31, 2005, the amount at
risk was approximately $77,000. At March 31, 2005, the outstanding accounts
receivable balance from one customer was 26% of
gross accounts receivable and from a second
customer was 23% of gross accounts receivable. No
individual customer accounted for ten (10) percent
or more of accounts receivable at March 31, 2004. Stock Option Plan The Company accounts for its stock option
plan in accordance with the provisions of
Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and
related interpretations. The Company has also
adopted the pro forma disclosure provisions of
Statement of Financial Accounting Standards (SFAS)
No. 123, Accounting for Stock-Based Compensation,
which permits entities to provide pro forma net
income and pro forma net earnings per share
disclosures as if the fair-value-based method
defined in SFAS No. 123 had been applied. The Company applies Accounting Principles Board
Opinion No. 25 in accounting for the Plan, and no
compensation expense has been recognized for its
stock options in the accompanying financial
statements. The following table illustrates the
effect on net earnings (loss) and earnings (loss)
per share if the Company had applied the fair
value recognition provision of FASB Statement No.
123, Accounting for Stock-Based Compensation, to
stock-based employee compensation: Year Ended March 31,2005
    
    
    2004
    
    
    2003Net earnings (loss), as reported
    
    $
    1,811,000
    
    
    $
    1,001,000
    
    
    $
    (433,000
    )Deduct: Total stock-based
employee compensation expense
determined under fair value-based method for all awards,
net of related tax effects
    
    
    (108,000
    )
    
    
    (81,000
    )
    
    
    (147,000
    )Pro forma net earnings (loss)
    
    
    1,703,000
    
    
    
    920,000
    
    
    
    (580,000
    )Earnings (loss) per share:Basic  as reported
    
    
    .18
    
    
    
    .10
    
    
    
    (.04
    )Basic  pro forma
    
    
    .17
    
    
    
    .09
    
    
    
    (.05
    )Diluted  as reported
    
    
    .17
    
    
    
    .10
    
    
    
    (.04
    )Diluted  pro forma
    
    
    .16
    
    
    
    .09
    
    
    
    (.05
    )
 The weighted average fair value of options
granted during 2005, 2004, and 2003 is estimated
at $3.71, $2.69, and $1.74, respectively. The
disclosure of compensation cost under this
pronouncement may not be representative of the
effects on net earnings (loss) for future years.
The fair value of options granted during each
period was estimated using the Black-Scholes
option pricing model with the following
assumptions: 2005
    
    
    2004
    
    
    2003Risk-free interest rate
    
    
    3.3
    %
    
    
    3.9
    %
    
    
    5.9
    %Forfeiture rate
    
    
    2.0
    %
    
    
    2.0
    %
    
    
    2.0
    %Dividend yield
    
    
    .0
    
    
    
    .0
    
    
    
    .0Volatility
    
    
    98
    %
    
    
    82
    %
    
    
    86
    %Expected life (years)
    
    
    10.0
    
    
    
    10.0
    
    
    
    5.0
 Segment Information The Company operates in one segment, the respiratory care market. Reclassifications The Company reclassified royalty expense of
$552,000, $776,000, and $1,102,000 from selling,
general and administrative expenses to costs of
sales for fiscal years ended 2005, 2004, and 2003,
respectively. (2) Inventories At March 31, 2005 and 2004, inventories consisted of the following: 2005
    
    
    2004Finished goods
    
    $
    2,767,000
    
    
    $
    1,223,000Work in process
    
    
    1,790,000
    
    
    
    1,062,000Raw materials
and supplies
    
    
    4,063,000
    
    
    
    2,806,000Inventory reserve
    
    
    (108,000
    )
    
    
    (162,000
    )$
    8,512,000
    
    
    $
    4,989,000
 9




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##### 



Notes to Financial Statements (3) Income Taxes Income tax expense (benefit) for fiscal 2005, 2004, and 2003 consisted of the following: 2005
    
    
    2004
    
    
    2003Current:Federal
    
    $
    307,000
    
    
    $
    204,000
    
    
    $
    3,000State
    
    
    15,000
    
    
    
    16,000
    
    
    
    2,000322,000
    
    
    
    220,000
    
    
    
    5,000Deferred:Federal
    
    
    (466,000
    )
    
    
    (204,000
    )
    
    
    State
    
    
    (340,000
    )
    
    
    (16,000
    )
    
    
    (806,000
    )
    
    
    (220,000
    )
    
    
    Total
    
    $
    (484,000
    )
    
    $
    
    
    
    $
    5,000
 A reconciliation of the difference between the
Companys income tax expense (benefit) and the
statutory income tax for the years ended March
31, 2005, 2004, and 2003, respectively, is as
follows: 2005
    
    
    2004
    
    
    2003Statutory tax
expense (benefit)
    
    $
    451,000
    
    
    $
    341,000
    
    
    $
    (145,000
    )State income tax, net
    
    
    72,000
    
    
    
    
    
    
    
    (22,000
    )Valuation allowance
    
    
    (1,004,000
    )
    
    
    (383,000
    )
    
    
    157,000Warranty and other
    
    
    (3,000
    )
    
    
    42,000
    
    
    
    15,000$
    (484,000
    )
    
    $
    
    
    
    $
    5,000
 The tax effects of temporary differences that
give rise to significant portions of the deferred
tax assets at March 31, 2005 and 2004 are
presented as follows: 2005
    
    
    2004Bad debt reserves
    
    $
    17,000
    
    
    $
    29,000Accrued expenses
    
    
    283,000
    
    
    
    286,000Inventories
    
    
    88,000
    
    
    
    70,000Depreciation and amortization
    
    
    258,000
    
    
    
    391,000Intangible assets
    
    
    346,000
    
    
    
    373,000Net operating loss
    
    
    149,000
    
    
    
    226,000Other
    
    
    
    
    
    
    5,000Total deferred tax assets
    
    
    1,141,000
    
    
    
    1,380,000Deferred tax liabilities:State taxes
    
    
    (112,000
    )
    
    
    (152,000
    )Subtotal
    
    
    1,029,000
    
    
    
    1,228,000Valuation allowance
    
    
    
    
    
    
    (1,004,000
    )Net deferred tax assets
    
    $
    1,029,000
    
    
    $
    224,000
 In assessing the realizability of deferred tax
assets, management considers whether it is more
likely than not that some portion or all of the
deferred tax assets will be realized. At March
31, 2005, based on earnings performance and
projections, the Company determined it was more
likely than not that all of the deferred tax
assets would be realized, and accordingly,
released the remaining allowance on its deferred
tax assets, which resulted in a $484,000 net tax
benefit for the year ended March 31, 2005. The
Company has California net operating loss
carryforwards of $1,846,000. The State of
California suspended the utilization of net
operating loss carryforwards during tax years
starting in 2002 and 2003. As a result, the
Company was unable to use its California net
operating loss carryforwards until the tax year
beginning April 1, 2004. The California net
operating losses expire in 2008. (4) Intangible Assets Intangible assets include amounts paid for
licenses on new and existing products. License
fees are being amortized using the straight-line method over the life of the related patents.
Accumulated amortization on the license fees
amounted to $39,000 and $17,000 at March 31, 2005
and 2004, respectively. Annual amortization on
intangible assets currently in service will be
$39,000 for each of the next five years. During
2003, the Company wrote off a license fee asset
that had a net book value of $934,000 in
accordance with the provisions of FASB Statement
No. 144, Accounting for the Impairment of
Long-Lived Assets and Long-Lived Assets to be
Disposed Of.Net intangible assets were $802,000
and $729,000 at March 31, 2005 and 2004,
respectively. (5) Shareholders Equity The Company has an equity incentive plan
(the Plan) for key employees as defined under
Section 422(A) of the Internal Revenue Code. The
Plan provides that 750,000 common shares be
reserved for issuance under the Plan, which
expires on September 8, 2014. In addition, the
Plan provides that non-qualified options can be
granted to directors and independent contractors
of the Company. Transactions involving the equity
plan and the 1994 stock option plan, which
expired in 2004, are summarized as follows: WeightedAverageOption
    
    
    PriceShares
    
    
    Per ShareIncentive options:Outstanding  March 31, 2002
    
    
    882,000
    
    
    $
    3.25Cancelled
    
    
    (120,000
    )
    
    
    9.32Granted
    
    
    77,000
    
    
    
    2.49Exercised
    
    
    (17,000
    )
    
    
    1.18Expired
    
    
    (33,000
    )
    
    
    1.85Outstanding  March 31, 2003
    
    
    789,000
    
    
    
    2.37Cancelled
    
    
    (16,000
    )
    
    
    3.44Granted
    
    
    15,000
    
    
    
    2.80Exercised
    
    
    (9,000
    )
    

    
    .78Outstanding  March 31, 2004
    
    
    779,000
    
    
    
    2.37Cancelled
    
    
    (13,000
    )
    
    
    2.51Exercised
    
    
    (17,000
    )
    
    
    1.02Expired
    
    
    (83,000
    )
    
    
    8.19Outstanding  March 31, 2005
    
    
    666,000
    
    
    $
    1.98Exercisable  March 31, 2005
    
    
    594,000
    
    
    $
    1.88Non-qualified options:Outstanding  March 31, 2002
    
    
    190,000
    
    
    $
    7.50Cancelled
    
    
    (10,000
    )
    
    
    8.90Granted
    
    
    120,000
    
    
    
    2.27Outstanding  March 31, 2003
    
    
    300,000
    
    
    
    5.37Cancelled
    
    
    (42,000
    )
    
    
    8.20Granted
    
    
    75,000
    
    
    
    2.04Exercised
    
    
    (11,000
    )
    
    
    1.58Outstanding  March 31, 2004
    
    
    322,000
    
    
    
    4.30Cancelled
    
    
    (41,000
    )
    
    
    8.33Granted
    
    
    55,000
    
    
    
    3.71Exercised
    
    
    (21,000
    )
    
    
    2.07Expired
    
    
    (6,000
    )
    
    
    5.18Outstanding  March 31, 2005
    
    
    309,000
    
    
    $
    3.83Exercisable  March 31, 2005
    
    
    182,000
    
    
    $
    1.98
 10




---



##### 



Notes to Financial Statements At March 31, 2005, information regarding
outstanding options is summarized as follows: Range of Exercise Prices$
    50-6.69
    
    
    $
    7.63-12.54Number outstanding
    
    
    894,000
    
    
    
    81,000Weighted average
remaining life (yrs.)
    
    
    5.9
    
    
    
    1.3Weighted average
exercise price
    
    $
    1.78
    
    
    $
    11.22Number exercisable
    
    
    776,000
    
    
    
    81,000Weighted average
exercise price
    
    $
    1.90
    
    
    $
    11.22
 Incentive and non-qualified options were granted at
prices not less than 100% of market value at dates
of grant. Options under the Plan become exercisable
on the anniversary of the grant date on a pro rata
basis over a defined period and expire ten (10)
years after the date of grant. To the extent the
Company derives a tax benefit from options
exercised by employees, such benefit is credited to
Common Shares. (6) Employee Benefit Plan In December 1992, the Company adopted a
defined contribution profit sharing plan, including
features under Section 401(k) of the Internal
Revenue Code. The purpose of the plan is to provide
an incentive for employees to make regular savings
for their retirement. Company contributions to the
profit sharing plan are discretionary and are
determined by the Board of Directors. There have
been no contributions since 2002. (7) Accrued Expenses Accrued expenses consist of the following: 2005
    
    
    2004Accrued royalties
    
    $
    347,000
    
    
    $
    374,000Deferred rent
    
    
    48,000
    
    
    
    24,000Accrued vacation
    
    
    182,000
    
    
    
    181,000Warranty reserve
    
    
    109,000
    
    
    
    103,000Payroll and incentive
compensation
    
    
    215,000
    
    
    
    172,000Customer deposits
    
    
    132,000
    
    
    
    120,000Other
    
    
    337,000
    
    
    
    211,000$
    1,370,000
    
    
    $
    1,185,000
 (8) Commitments The Company is currently leasing its
administrative and plant facilities and certain
office equipment under noncancelable operating
leases which expire through June 2008. The Companys minimum annual rental commitments
under these leases are as follows: 2006
    
    $
    427,0002007
    
    
    441,0002008
    
    
    454,0002009
    
    
    113,000Thereafter
    
    
    0TOTAL:
    
    $
    1,435,000
 Rent expense amounted to $577,000, $552,000, and
$469,000 for the years ended March 31, 2005, 2004,
and 2003, respectively. The Company has minimum annual royalty requirements
pursuant to the terms of license agreements related
to certain products in the amount of $515,000.
Annual royalty expense on all products amounted to
$552,000, $776,000, and $1,102,000 for the years
ended March 31, 2005, 2004, and 2003, respectively.
License agreements with minimum annual royalty
requirements are in place through fiscal year 2012. The Company is involved in certain legal actions
resulting from the ordinary course of business. The
Company believes the ultimate outcome of the legal
actions will not have a material adverse impact on
the Companys financial statements as a whole. (9) Geographic Information The Company has one reportable operating segment as defined in Note
1. Geographic information regarding the Companys
net sales is as follows: 2005
    
    
    2004
    
    
    2003United States
    
    $
    22,912,000
    
    
    $
    20,498,000
    
    
    $
    18,639,000Canada
    
    
    306,000
    
    
    
    303,000
    
    
    
    307,000Japan
    
    
    405,000
    
    
    
    238,000
    
    
    
    207,000All other countries
    
    
    664,000
    
    
    
    458,000
    
    
    
    342,000$
    24,287,000
    
    
    $
    21,541,000
    
    
    $
    19,541,000
 All long-lived assets are located in the United States. Sales of OXYMATIC® and CYPRESS
conservers accounted for 73%, 77%, and 74% of the
Companys net sales for the years ended March 31,
2005, 2004, and 2003, respectively. (10) Valuation and Qualifying Accounts and Reserves The following is the Companys schedule of
activity in the valuation and qualifying accounts
and reserves for the years ended March 31, 2005,
2004, and 2003: Balance at
    
    
    Charged to
    
    
    
    
    
    
    BalanceBeginning
    
    
    Costs and
    
    
    
    
    
    
    at Endof Year
    
    
    Expenses
    
    
    Deductions
    
    
    of YearAllowance for
doubtful accounts:2003
    
    $
    76,000
    
    
    
    97,000
    
    
    
    61,000
    
    
    $
    112,0002004
    
    
    112,000
    
    
    
    7,000
    
    
    
    51,000
    
    
    
    68,0002005
    
    $
    68,000
    
    
    
    
    
    
    
    29,000
    
    
    $
    39,000Warranty reserve:2003
    
    $
    161,000
    
    
    
    15,000
    
    
    
    36,000
    
    
    $
    140,0002004
    
    
    140,000
    
    
    
    22,000
    
    
    
    59,000
    
    
    
    103,0002005
    
    $
    103,000
    
    
    
    57,000
    
    
    
    51,000
    
    
    $
    109,000
 11




---



##### 



Notes to Financial Statements (11) Quarterly Financial Data (Unaudited) The following table presents summarized,
unaudited, quarterly financial data for 2005 and
2004: DilutedGross
    
    
    Net
    
    
    EarningsRevenue
    
    
    Profit
    
    
    Earnings
    
    
    Per Share2005First quarter
    
    $
    6,099,000
    
    
    $
    2,420,000
    
    
    $
    262,000
    
    
    $
    0.02Second quarter
    
    
    6,309,000
    
    
    
    2,613,000
    
    
    
    455,000
    
    
    
    0.04Third quarter
    
    
    6,444,000
    
    
    
    2,703,000
    
    
    
    505,000
    
    
    
    0.05Fourth quarter
    
    
    5,435,000
    
    
    
    1,970,000
    
    
    
    589,000
    
    
    
    0.06Year
    
    $
    24,287,000
    
    
    $
    9,706,000
    
    
    $
    1,811,000
    
    
    $
    0.172004First quarter
    
    $
    5,669,000
    
    
    $
    2,246,000
    
    
    $
    224,000
    
    
    $
    .02Second quarter
    
    
    5,284,000
    
    
    
    2,116,000
    
    
    
    150,000
    
    
    
    .02Third quarter
    
    
    5,237,000
    
    
    
    2,220,000
    
    
    
    418,000
    
    
    
    .04Fourth quarter
    
    
    5,351,000
    
    
    
    2,113,000
    
    
    
    209,000
    
    
    
    .02Year
    
    $
    21,541,000
    
    
    $
    8,695,000
    
    
    $
    1,001,000
    
    
    $
    .10
 (12) Accounting Standards. In November 2004 the Financial Accounting Standards
Board issued Statement of Financial Accounting
Standard (SFAS) No. 151 (Inventory Costs), an
amendment of ARB No. 43, Chapter 4. The statement
clarifies accounting for abnormal amounts of idle
facility expense, freight, handling costs and
spoilage and requires those items to be expensed
when incurred. SFAS 151 is applicable to inventory
costs incurred during fiscal years beginning after
June 15, 2005. The Company has not yet determined
if the adoption of this standard will have a
significant impact on its financial statements. In December 2004, the Financial Accounting Standard
Board issued Statement of Financial Accounting
Standard (SFAS) No. 123R (Share-Based Payment).
SFAS 123R requires the Company to recognize
compensation expense based on the fair value of
equity instruments awarded to employees. We
currently plan to adopt SFAS 123R on April 1, 2006,
and the Company does not anticipate a significant
impact to its financial statements. 12




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##### 



Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders CHAD Therapeutics, Inc. We have audited the accompanying balance sheets of CHAD Therapeutics, Inc.
as of March 31, 2005 and 2004 and the related statements of operations,
shareholders equity and cash flows for each of the years in the three-year
period ended March 31, 2005. These financial statements are the responsibility
of the Companys management. Our responsibility is to express an opinion on
these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Companys
internal control over financial reporting. Accordingly, we express no such
opinion. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of CHAD Therapeutics, Inc. as of
March 31, 2005 and 2004 and the results of its operations and its cash flows
for each of the years in the three-year period ended March 31, 2005, in
conformity with accounting principles generally accepted in the United States
of America. (KPMG LLP)
Los Angeles, California
April 29, 2005 13




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##### 



Managements Discussion and Analysis of Financial Condition and Results of
Operation Overview The Company develops, assembles and markets medical
devices that furnish supplementary oxygen to home health
care patients. The Company was a pioneer in developing
oxygen conserving devices that enhance the quality of
life for patients by increasing their mobility and, at
the same time, lower operating costs by achieving
significant savings in the amount of oxygen actually
required to properly oxygenate patients. The market for
oxygen conserving devices has been, and continues to be,
significantly affected by increased competition,
consolidation among home oxygen dealers and revisions
(and proposed revisions) in governmental reimbursement
policies. All of these factors, as described more fully
below, have contributed to a more competitive market for
the Companys products, as devices that were less
expensive but which provided lower oxygen savings (or,
in some cases, did not truly provide ambulatory oxygen)
have achieved some level of success. The current procedures for reimbursement by Medicare for
home oxygen services provide a prospective flat-fee
monthly payment based solely on the patients prescribed
oxygen requirement. Under this system, inexpensive
concentrators have grown in popularity because of low
cost and less frequent servicing requirements. At the
same time, oxygen conserving devices, such as the
Companys products, have also grown in popularity due to
their ability to extend the life of oxygen supplies and
reduce service calls by home care providers, thereby
providing improved mobility for the patient and cost
savings for home care providers. In addition, other changes in the health care delivery
system, including the increase in the acceptance and
utilization of managed care, have stimulated a
significant consolidation among home care providers.
Major national and regional home medical equipment
chains have continued to expand their distribution
networks through the acquisition of independent home
care providers in strategic areas. Margins on sales to
national chains are generally lower due to quantity
pricing, and management anticipates continued downward
pressure on its average selling price. Four major
national chains accounted for approximately 53%, 49%,
and 47% of the Companys net sales, for the years ended
March 31, 2005, 2004, and 2003, respectively. One chain
accounted for 36%, 27%, and 24% of sales in the years
ended March 31, 2005, 2004, and 2003, respectively, and
one other chain accounted for 11%, 14%, and 11% of sales
in the years ended March 31, 2005, 2004, and 2003,
respectively. The Company believes that price competition and
continuing industry consolidation will continue to
affect the marketplace for the foreseeable future. To
address the competitive nature of the oxygen conserver
marketplace, the Company has developed and introduced a
number of new products in this area in recent years.
The first of these, the OXYMATIC
®401
conserver, received 501(k) clearance from the Food And
Drug Administration in June 2000, and shipments of the
new product began in July 2000. The second, the
OXYMATIC 411 conserver, was cleared in December 2000
and shipments began in January 2001. The third, the
OXYMATIC 401A and 411A conservers, received clearance
in March 2001 with shipments beginning that month. The
SEQUOIA OXYMATIC 300 series conservers began shipping
in December 2001, and the Company began shipment of
CYPRESS
OXYPneumatic®conserver in July
2002. The Company received clearance from the FDA to
market its newest oxygen conserving device, the
LOTUS Electronic Oxygen Conserver, in October 2004.
The LOTUS conserver weighs less than a pound and will
be offered with or without a breath-sensing alarm. It
also offers additional liter flow settings and an
extended battery life of up to four months of normal
usage on two AA-size batteries. Management believes the
features and improvements in these products have
enabled the Company to regain some of the market share
lost in the conserver market prior to 2001 and
reestablish the Company as a leader in the conserver
market. In May of 2004 the Company received clearance from the
FDA to market its new SAGE Oxygen Therapeutic Device.
The SAGE device is the first in a planned family of
oxygen therapeutic devices that use the Companys
proprietary technologies to sense a patients movements
and automatically adjust the rate of oxygen delivery to
reduce the risk of desaturation as activity increases.
This device combines the industrys first truly dynamic
delivery technology with the proven oxygen sensor
technology in the OXYMATIC 400 series
conservers. As a result, the new SAGE Oxygen Therapeutic
Device addresses the common problem of oxygen
desaturation, which causes a patient to feel weak and
out of breath when activity increases, while it still
maximizes patient ambulatory capability. This new device
underscores the Companys dedication to providing home
care suppliers and their patients with the widest range
of home oxygen choices to suit individual needs,
preferences and disease conditions. The Company began
selling the SAGE device nationwide in October 2004. No
estimate can currently be made regarding the level of
success the Company may achieve with this line of
products or when the additional therapeutic devices
based on this advanced new platform that are now in
development may be introduced to the market. 14




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##### 



Managements Discussion and Analysis of Financial Condition and Results of Operation In 1998 the Company introduced the TOTAL
O2® Delivery System, which
provides stationary oxygen for patients at home,
portable oxygen, including an oxygen conserving device
for ambulatory use, and a safe and efficient mechanism
for filling portable oxygen cylinders in the home. This
provides home care providers with a means to reduce
their monthly cost of servicing patients, while at the
same time providing a higher quality of service by
maximizing ambulatory capability. The Company received
clearance in November 1997 from the Food and Drug
Administration to sell this product. Initial sales were
adversely affected by several factors, including the
overall home oxygen market climate and home care
providers reluctance to invest in the higher cost of
the TOTAL O2 Delivery System to achieve the
lower monthly operating costs. Recent changes in home
oxygen reimbursement appear to be causing home care
providers to examine their operating costs more
carefully and this is improving the marketing climate
for the TOTAL O2 system. During the past three years, the Company has
recovered substantial market share in the conserver
market and is using that platform to spearhead its
growth strategy for the future, which includes the
following:  
    
    Development of additional oxygen conserver models,
such as the LOTUS Electronic Oxygen conserver
introduced in October 2004, that diversify the
product line in order to offer customers a wide
range of oxygen conservation choices;  
    
    A continued promotional and educational
campaign with respect to the benefits of the
TOTAL O2 system; and  
    
    An effort to expand the Companys product lines
and improve existing products through the
investment in and development of new technologies,
such as proprietary sensor technology and control
software
licensed in January of 2003 and the introduction of
the SAGE Oxygen Therapeutic Device in May 2004. These
new technologies will provide the Company with an
opportunity to expand its oxygen delivery product
lines and potentially enter the high-growth sleep
disorder market. While the turnaround measures of the past four years
have had a positive impact, and management believes the
current growth strategy should continue to enhance the
Companys competitive position and future operating
performance, no assurances can be given that these
objectives will be achieved. Management of the Company
will continually monitor the success of these efforts
and will attempt to remain flexible in order to adjust
to possible future changes in the market for respiratory
care devices. For information that may affect the
outcome of forward-looking statements in this Overview
regarding the Companys business strategy and its
introduction of new products, see Outlook: Issues and
Risks  New Products, Consolidation of Home Care
Industry, Competition, Rapid Technological Change, and
Potential Changes in the Administration of Health Care,
beginning on page 16 of this Report. Results of Operations Sales for the years ended March 31, 2005 and 2004
increased by $2,746,000 (12.7%) and $2,000,000 (10.2%),
respectively, as compared to prior years. The primary
driver of the Companys increase in sales has been the
significant growth in sales of its conservers, largely
as a result of the introduction of the OXYMATIC 400
series conservers and CYPRESS OXYPneumatic conservers.
Management believes that the performance features of
these conservers have enabled the Company to recapture
significant market share. Unit sales of conservers for
the year ended March 31, 2005, increased 34% over the
prior year, while the increase in revenues from
conserver sales was 7%. This resulted from price
reductions, the impact of national chain contract
pricing (see above), and the generally lower pricing for
pneumatic conservers in the marketplace. Sales to foreign distributors represented 6% and 5% of
total sales for the years ended March 31, 2005 and
2004. Management expects an increase in sales to
foreign distributors during the upcoming twelve months,
however, quarter-to-quarter sales may fluctuate
depending on the timing of shipments. All foreign sales
are denominated in US dollars. Cost of sales as a percent of net sales increased from
56.2% to 60.0% for the year ended March 31, 2005, as
compared to the prior year period. This was a result of
downward price pressures in the marketplace, increased
chain sales, and a change in the product mix, as the
TOTAL O2system has a lower gross profit margin
than conservers. We currently expect continued downward
price pressure for the foreseeable future. Cost of sales
as a percent of net sales decreased from 57.3% to 56.1%
for the year ended March 31, 2004, as compared to the
prior year primarily due to cost efficiencies gained
from increased sales. Selling, general and administrative expenditures
decreased from 33.5% to 28.6% and from 40.0% to 33.5%
of net sales for years ended March 31, 2005 and 2004,
respectively, as compared to the prior year periods.
The Companys cost reduction efforts over the past two
years have helped align staffing and operating expenses
more closely with current sales expectations but were
offset, to some extent, by commissions paid to the
companys field sales force of manufacturers
representatives. Research and development expenses
increased by $181,000 and $303,000 for the years 15




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##### 



Managements Discussion and Analysis of Financial Condition and Results of
Operation ended March 31, 2005 and 2004, respectively, as
compared to the prior years. Currently, management
expects research and development expenditures to total
approximately $1,512,000 in the fiscal year ending March
31, 2006, on projects to enhance and expand the
Companys product line. At March 31, 2005, the Company had fully utilized its
net operating loss carrybacks and federal net operating
loss carryforwards and had approximately $1,846,000 in
California net operating loss carryforwards. In December
2002 California enacted legislation that suspends the
utilization of net operating loss carryforwards during
tax years starting 2002 and 2003 effective retroactively
back to January 1, 2002. As a result, the Company was
unable to use its California net operating loss
carryforwards until the tax year beginning April 1,
2004. Financial Condition At March 31, 2005, the Company had cash totaling
$177,000 or 1.1% of total assets as compared to
$2,708,000 or 20.8% at March 31, 2004. Net working
capital increased from $9,175,000 at March 31, 2004, to
$10,393,000 at March 31, 2005. Net accounts receivable
increased $834,000 during the year ended March 31, 2005,
due to the increase in sales. Future increases or
decreases in accounts receivable will generally coincide
with sales volume fluctuations and the timing of
shipments to foreign customers. During the same period,
inventories increased $3,523,000, while cash decreased
by $2,531,000. These changes resulted in large part from
a significant inventory build in the latter part of
fiscal 2005 to fill certain customer orders and
anticipated customer orders. Certain of these orders did
not materialize or were deferred. However, there is an
active market for the products involved, and the company
believes the inventory will be sold in due course. The
Company attempts to maintain sufficient inventories to
meet its customer needs as orders are received and new
products are introduced. Thus, future inventory and
related accounts payable levels will be
impacted by the ability of the Company to maintain its
safety stock levels. If safety stock levels drop below
target amounts, then inventories in subsequent periods
will increase more rapidly as inventory balances are
replenished. The Company depends upon its cash flow from operations
to meet its capital requirements. Management believes
cash balances and funds derived from operations should
be adequate to meet the Companys near- and long-term
cash requirements given the recent recovery of market
share of oxygen conservers. Cash derived from
operations will depend on the ability of the Company to
maintain profitable operations and the timing of
increases in receivables and inventories. If profitable
operations do not continue, the Company may need to
seek other sources of working capital. While the
Company has no established lines of credit or other
arrangements in place to obtain working capital,
management believes the Company would be able to secure
a line of credit from a bank should that be deemed
necessary. The Company currently has no debt; however,
no assurance can be given that if and when needed other
sources of working capital will be available. The
Company expects capital expenditures during the next
twelve months to be approximately $800,000. The following table aggregates all of the Companys
material contractual obligations as of March 31, 2005: Payments Due By PeriodContractual
    
    
    
    
    
    Less than 1
    
    
    1-3
    
    
    3-5
    
    
    After 5Cash Obligations
    
    Total
    
    
    Year
    
    
    Years
    
    
    Years
    
    
    YearsOperating lease obligations
    
    $
    1,435,000
    
    
    $
    427,000
    
    
    $
    1,008,000
    
    
    
    
    
    
    
    Minimum royalty obligations
    
    $
    3,285,000
    
    
    $
    515,000
    
    
    $
    1,590,000
    
    
    $
    1,090,000
    
    
    $
    90,000
 Operating lease commitments consist primarily of
a real property lease for our corporate office as
well as minor equipment leases. Payments for these
lease commitments are provided for by cash flows
generated from operations. Please see Note 8 to the
financial statements. The Company does not have any debt and is not subject to
any covenants or contractual restrictions limiting its
operations. The Company has not adopted any programs
that provide for post-employment retirement benefits,
however, it has on occasion provided such benefits to
individual employees. The Company does not have any off
balance sheet arrangements with any special purpose
entities or any other parties, does not enter into any
transactions in derivatives and has no material
transactions with any related parties. Significant Accounting Policies The preparation of financial statements in conformity
with accounting principles generally accepted in the
United States of America requires management to make
estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the
financial statements and the reported amounts of
revenues and expenses during the reporting period.
Actual results could differ significantly from those
estimates under different assumptions and conditions.
Management believes that the following discussion
addresses the accounting policies and estimates that are
most important in the portrayal of the Companys
financial condition and results. 16




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##### 



Managements Discussion and Analysis of Financial Condition and Results of Operation Allowance for doubtful accounts  the Company
provides a reserve against receivables for estimated
losses that may result from our customers inability to
pay. The amount of the reserve is based on an analysis
of known uncollectible accounts, aged receivables,
historical losses, and credit-worthiness. Amounts later
determined and specifically identified to be
uncollectible are charged or written off against this
reserve. The likelihood of material losses is dependent
on general economic conditions and numerous factors that
affect individual accounts. Inventories  the Company provides a reserve against
inventories for excess and slow moving items. The amount
of the reserve is based on an analysis of the inventory
turnover for individual items in inventory. The
likelihood of material write-downs is dependent on
customer demand and competitor product offerings. Intangible and long-lived assets  The Company assesses
whether or not there has been an impairment of
intangible and long-lived assets in evaluating the
carrying value of these assets. Assets are considered
impaired if the carrying value is not recoverable over
the useful life of the asset. If an asset is considered
impaired, the amount by which the carrying value exceeds
the fair value of the asset is written off. The
likelihood of a material change in the Companys
reported results is dependent on each assets ability to
continue to generate income, loss of legal ownership or
title to an asset and the impact of significant negative
industry or economic trends. Deferred income taxes  the Company provides a
valuation allowance to reduce deferred tax assets to
the amount expected to be realized. The likelihood of a
material change in the expected realization of these
assets depends on the Companys ability to generate
future taxable income. Outlook: Issues & Risks This report contains forward-looking statements which
reflect the Companys current views with respect to
future events and financial performance. These
forward-looking statements are subject to certain risks
and uncertainties, which may cause actual operating
results to differ materially from currently anticipated
results. Among the factors that could cause actual
results to differ materially are the following: Dependence Upon a Single Product Line Although the Company currently markets a number of
products, these products comprise a single product
line for patients requiring supplementary oxygen. The
Companys future performance is thus dependent upon
developments


affecting this segment of the health care market and
the Companys ability to remain competitive within
this market sector. New Products The Companys future growth in the near term will
depend in significant part upon its ability to
successfully introduce new products. In recent years
the Company has introduced the OXYMATIC 400 series, the
SEQUOIA and CYPRESS OXYPneumatic conservers, and the
TOTAL O2 Delivery System and in May 2004
introduced the SAGE Oxygen Therapeutic Device; the
Company is currently developing additional new
products. The success of the Companys products will
depend upon the health care communitys perception of
such products capabilities, clinical efficacy and
benefit to patients, as well as obtaining timely
regulatory approval for new products. In addition,
prospective sales will be impacted by the degree of
acceptance achieved among home care providers and
patients requiring supplementary oxygen. As with any
product, the Companys ability to successfully promote
new products cannot be determined at this time. Consolidation of Home Care Industry -
Dependence on Key Customers The home health care industry is undergoing significant
consolidation. As a result, the market for the Companys
products is increasingly influenced by major national
chains. Four major national chains accounted for 53% of
the Companys net sales during the year ended March 31,
2005, up from 49% in the prior year. One customer
accounted for 36% of our sales in the year
ended March 31, 2005, up from 27% in the prior year.
Future sales may be increasingly dependent upon a
limited number of customers, which may result in
continuing downward pressure on our average selling
price due to quantity pricing. Moreover, our dependence
on a limited number of significant customers increases
the risk that our financial performance will be
adversely affected if one or more of these customers
reduces their purchases of our products or terminates
their relationship with the Company. Competition CHADs success in the early 1990s has drawn competition
to vie for a share of the home oxygen market. These new
competitors include both small and very large companies.
While the Company believes the quality of its products
and its established reputation will continue to be a
competitive advantage, some competitors have
successfully introduced lower priced products that do
not provide oxygen conserving 17




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##### 



Managements Discussion and Analysis of Financial Condition and Results of
Operation capabilities comparable to the Companys products.
Most of these competitors have greater capital
resources than the Company. No assurance can be given
that increased competition in the home oxygen market
will not have an adverse affect on the Companys
operations. Rapid Technological Change The health care industry is characterized by rapid
technological change. The Companys products may become
obsolete as a result of new developments. The Companys
ability to remain competitive will depend to a large
extent upon its ability to anticipate and stay abreast
of new technological developments related to oxygen
therapy. The Company has limited internal research and
development capabilities. Historically, the Company has
contracted with outside parties to develop new products.
Some of the Companys competitors have substantially
greater funds and facilities to pursue research and
development of new products and technologies for oxygen
therapy. Potential Changes in Administration of Health Care A number of bills proposing to regulate, control or
alter the method of financing health care costs have
been discussed and certain such bills have been
introduced in Congress, including various proposals for
competitive bidding, and various state legislatures.
Because of the uncertain state of health care proposals,
it is not meaningful at this time to predict the effect
on the Company if any of these proposals is enacted. Approximately 80% of home oxygen patients are covered
by Medicare and other government programs. Federal law
has altered the payment rates available to providers of
Medicare services in various ways during the last
several years. In November of 2003, Congress enacted
the Medicare Improvement and Modernization
Act, which is resulting in changes and reductions in
home oxygen reimbursement over the next several years.
These changes in reimbursement will cause increased
downward pressure on the average selling price of the
Companys products. Protection of Intellectual Property Rights The Company pursues a policy of protecting its
intellectual property rights through a combination of
patents, trademarks, trade secret laws and
confidentiality agreements. The Company considers the
protection of its proprietary rights and the
patentability of its products to be significant to the
success of the Company. To the extent that the products
to be marketed by the Company do not receive patent
protection, competitors may be able to manufacture and
market substantially similar products. Such competition
or claims that the Companys products infringe the
patent rights of others could have an adverse impact
upon the Companys business. Product Liability The nature of the Companys business subjects it to
potential legal actions asserting that the Company is
liable for damages for product liability claims.
Although the Company maintains product liability
insurance in an amount which it believes to be customary
in the industry, there is no assurance that this
insurance will be sufficient to cover the cost of
defense or judgments which might be entered against the
Company. The type and frequency of these claims could
have an adverse impact on the Companys results of
operations and financial position. Availability and Reliability of Third Party Component Products The Company tests and packages most of its products in
its own facility and manufactures some products
internally. Some other manufacturing processes are
conducted by other firms. The Company expects to
continue using outside firms for certain manufacturing
processes for the foreseeable future and is thus
dependent on the reliability and quality of parts
supplied by these firms. From time to time, the Company
has experienced problems with the reliability of
components produced by third party suppliers. The
Companys agreements with its suppliers are terminable
at will or by notice. The Company believes that other
suppliers would be available in the event of termination
of these arrangements. No assurance can be given,
however, that the Company will not suffer a material
disruption in the supply of parts required for its
products. Accounting Standards In November 2004 the Financial Accounting Standards
Board issued Statement of Financial Accounting Standard
(SFAS) No. 151 (Inventory Costs), an amendment of
ARB No. 43, Chapter 4. The statement clarifies
accounting for abnormal amounts of idle facility
expense, freight, handling costs and spoilage and
requires those items to be expensed when incurred. SFAS
151 is applicable to inventory costs incurred during
fiscal years beginning after June 15, 2005. The Company
has not yet determined if the adoption of this standard
will have a significant impact on its financial
statements. 18




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##### 



Managements Discussion and Analysis of Financial Condition and Results of Operation In December 2004 the Financial Accounting Standard
Board issued Statement of Financial Accounting Standard
(SFAS) No. 123R (Share-Based Payment). SFAS 123R
requires the Company to recognize compensation expense
based on the fair value of equity instruments awarded to
employees. We will adopt SFAS 123R on April 1, 2006, and
the Company does not anticipate a significant impact to
its financial statements. Additional Risk Factors Additional factors, which might affect the Companys
performance, may be listed from time to time in the
reports filed by the Company with the Securities and
Exchange Commission. 19




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##### 



Corporate Data  OfficersTHOMAS E. JONES
ChairmanEARL L. YAGER
Chief Executive Officer and PresidentALFONSO DEL TORO
Vice President, ManufacturingTRACY A. KERN
Chief Financial OfficerERIKA LASKEY
Vice President, Sales and MarketingKEVIN McCULLOH
Vice President, EngineeringPAULA OCONNOR
Corporate SecretaryOSCAR J. SANCHEZ
Vice President,
Business DevelopmentDirectorsTHOMAS E. JONES
Chairman
CHAD Therapeutics, Inc.EARL L. YAGER
President and Chief
Executive
Officer 
CHAD Therapeutics, Inc.JOHN C. BOYD
RetiredJAMES M. BROPHY
Hospital ExecutiveKATHLEEN M. GRIGGS
Financial ConsultantEDWARD ANTHONYOPPENHEIMER, M.D.
Associate Clinical
Professor of Medicine
UCLA School of MedicinePHILIP T. WOLFSTEIN
International Trade ConsultantCorporate DataCORPORATE HEADQUARTERS
21622 Plummer Street

Chatsworth, CA 91311
(818)882-0883LEGAL COUNSEL
Morrison & Foerster, LLPAUDITORS
KPMG LLP
Los Angeles, CaliforniaTRANSFER AGENT AND REGISTRAR
American Stock Transfer Company
40 Wall Street
New York, NY 10005 Common Stock Price Range Beginning August 3, 1993, the Companys common shares
were traded on the American Stock Exchange Emerging Company
Marketplace and on June 6, 1994, the Companys shares moved
to the primary list of the American Stock Exchange with the
symbol CTU. The following table sets forth, for the periods
indicated, the high and low closing prices as furnished by
the American Stock Exchange. Quarter Ended
    
    High
    
    
    LowJune 30, 2003
    
    
    1.67
    
    
    
    1.67September 30, 2003
    
    
    2.13
    
    
    
    2.05December 31, 2003
    
    
    2.40
    
    
    
    2.21March 31, 2004
    
    
    3.70
    
    
    
    3.45June 30, 2004
    
    
    4.39
    
    
    
    4.12September 30, 2004
    
    
    4.40
    
    
    
    4.26December 31, 2004
    
    
    5.50
    
    
    
    5.35March 31, 2005
    
    
    3.70
    
    
    
    3.10
 As of June 12, 2005, there were approximately 257
shareholders of record and approximately 2,500 beneficial
owners of the Companys common stock. No cash dividends have
been paid on the common stock. SEC Form 10-K A copy of the Companys annual report to the
Securities and Exchange Commission on Form 10-K is available
without charge upon written request to: Chief Financial Officer 
CHAD
Therapeutics, Inc.
21622 Plummer Street
Chatsworth, CA 91311 20