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SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q Quarterly Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934 [X]   For Quarterly Period Ended: September 30, 2004 Or [  ]   Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934 Commission file number: 1-12214 CHAD THERAPEUTICS, INC. 
  California
    
    95-3792700(State of other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 21622 Plummer Street, Chatsworth, CA 91311 
 (818) 882-0883 
    (Former name, former address and former fiscal year, if changed since last report.) 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.  Indicate by check whether the registrant is an accelerated filer (as defined in
Rule 12b-2 of the Exchange Act.)  As of September 30, 2004, the registrant had 10,122,000 shares of its common
stock outstanding.




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TABLE OF CONTENTS  Condensed Balance SheetsCondensed Statements of OperationsCondensed Statements of OperationsCondensed Statement of Shareholders EquityCondensed Statements of Cash FlowsItem 2. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3. Quantitative and Qualitative Disclosures about Market RisksItem 4. Controls and ProceduresPart II Other InformationItem 1. Legal ProceedingsItem 2. Changes in Securities, Use of Proceeds and Issuer Purchase of Equity SecuritiesItem 3. Defaults Upon Senior SecuritiesItem 4. Submission of Matters to a Vote of Security HoldersItem 5. Other InformationItem 6. Exhibits and Reports on Form 8-KINDEX TO EXHIBITSExhibit 31.1Exhibit 31.2Exhibit 32    Table of Contents  
 CHAD THERAPEUTICS, INC.
Condensed Balance Sheets
September 30, 2004 and March 31, 2004
(Unaudited) September 30,
    
    March 31,2004
    
    2004ASSETSCurrent Assets:Cash
    
    $
    3,007,000
    
    
    $
    2,708,000Accounts receivable, less allowance for
doubtful accounts of $59,000 at
September 30, 2004 and $68,000 at
March 31, 2004
    
    
    3,458,000
    
    
    
    2,911,000Inventories, net (Note 2)
    
    
    5,362,000
    
    
    
    4,989,000Prepaid Expenses
    
    
    382,000
    
    
    
    233,000Deferred income taxes
    
    
    434,000
    
    
    
    224,000Total current assets
    
    
    12,643,000
    
    
    
    11,065,000Property and equipment, at cost
    
    
    5,881,000
    
    
    
    5,789,000Less accumulated depreciation
    
    
    4,749,000
    
    
    
    4,571,000Net property and equipment
    
    
    1,132,000
    
    
    
    1,218,000Intangible assets, net
    
    
    710,000
    
    
    
    729,000Other assets, net
    
    
    54,000
    
    
    
    31,000Total assets
    
    $
    14,539,000
    
    
    $
    13,043,000LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,252,000
    
    
    $
    502,000Accrued expenses
    
    
    1,151,000
    
    
    
    1,185,000Income taxes payable
    
    
    228,000
    
    
    
    203,000Total current liabilities
    
    
    2,631,000
    
    
    
    1,890,000Shareholders equity:Common shares, $.01 par value, authorized
40,000,000 shares; 10,122,000 and 10,096,000
shares issued and outstanding
    
    
    13,347,000
    
    
    
    13,309,000Accumulated deficit
    
    
    (1,439,000
    )
    
    
    (2,156,000
    )Total shareholders equity
    
    
    11,908,000
    
    
    
    11,153,000Total liabilities and shareholders equity
    
    $
    14,539,000
    
    
    $
    13,043,000
 See accompanying notes to condensed financial statements.




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CHAD THERAPEUTICS, INC.
Condensed Statements of Operations
For the three months ended September 30, 2004 and 2003
(Unaudited) Three Months EndedSeptember 30,2004
    
    2003Net Sales
    
    $
    6,309,000
    
    
    $
    5,284,000Cost of Sales
    
    
    3,696,000
    
    
    
    3,190,000Gross profit
    
    
    2,613,000
    
    
    
    2,094,000Costs and expenses:Selling, general and administrative
    
    
    1,712,000
    
    
    
    1,596,000Research and development
    
    
    417,000
    
    
    
    345,000Total costs and expenses
    
    
    2,129,000
    
    
    
    1,941,000Operating income
    
    
    484,000
    
    
    
    153,000Other Income
    
    
    6,000
    
    
    
    4,000Earnings before income taxes
    
    
    490,000
    
    
    
    157,000Income tax expense
    
    
    35,000
    
    
    
    7,000Net earnings
    
    $
    455,000
    
    
    $
    150,000Basic earnings per share
    
    $
    0.04
    
    
    $
    0.02Diluted earnings per share
    
    $
    0.04
    
    
    $
    0.02Weighted shares outstanding:Basic
    
    
    10,122,000
    
    
    
    10,076,000Diluted
    
    
    10,598,000
    
    
    
    10,313,000
 See accompanying notes to condensed financial statements.




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CHAD THERAPEUTICS, INC.
Condensed Statements of Operations
For the six months ended September 30, 2004 and 2003
(Unaudited) Six Months EndedSeptember 30,2004
    
    2003Net Sales
    
    $
    12,408,000
    
    
    $
    10,953,000Cost of Sales
    
    
    7,375,000
    
    
    
    6,591,000Gross profit
    
    
    5,033,000
    
    
    
    4,362,000Costs and expenses:Selling, general and administrative
    
    
    3,448,000
    
    
    
    3,311,000Research and development
    
    
    827,000
    
    
    
    668,000Total costs and expenses
    
    
    4,275,000
    
    
    
    3,979,000Operating income
    
    
    758,000
    
    
    
    383,000Other Income  interest income, net
    
    
    14,000
    
    
    
    9,000Earnings before income taxes
    
    
    772,000
    
    
    
    392,000Income tax expense
    
    
    55,000
    
    
    
    18,000Net earnings
    
    $
    717,000
    
    
    $
    374,000Basic earnings per share
    
    $
    0.07
    
    
    $
    0.04Diluted earnings per share
    
    $
    0.07
    
    
    $
    0.04Weighted shares outstanding:Basic
    
    
    10,116,000
    
    
    
    10,076,000Diluted
    
    
    10,609,000
    
    
    
    10,297,000
 See accompanying notes to the condensed financial statements.




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CHAD THERAPEUTICS, INC.
Condensed Statement of Shareholders Equity
For the six months ended September 30, 2004
(Unaudited) Common Shares
    
    AccumulatedShares
    
    Amount
    
    DeficitBalance as of March 31, 2004
    
    
    10,096,000
    
    
    $
    13,309,000
    
    
    $
    (2,156,000
    )Exercise of stock options
    
    
    26,000
    
    
    
    38,000
    
    
    
    Net earnings
    
    
    
    
    
    
    
    
    
    
    717,000Balance at September 30, 2004
    
    
    10,122,000
    
    
    $
    13,347,000
    
    
    $
    (1,439,000
    )
 See accompanying notes to consolidated financial statements.




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CHAD THERAPEUTICS, INC.
Condensed Statements of Cash Flows
For the six months ended September 30, 2004 and 2003
(Unaudited) Six Months EndedSeptember 30,2004
    
    2003Cash flows from operating activities:Net earnings
    
    $
    717,000
    
    
    $
    374,000Adjustments to reconcile net earnings to net cash
provided by (used in) operating activities:Depreciation and amortization of property and
equipment
    
    
    178,000
    
    
    
    254,000Amortization of intangibles
    
    
    19,000
    
    
    
    Changes in assets and liabilities:Decrease (increase) in accounts receivable
    
    
    (547,000
    )
    
    
    (243,000
    )Decrease (increase) in inventories
    
    
    (373,000
    )
    
    
    (483,000
    )Decrease (increase) in prepaid expenses
    
    
    (149,000
    )
    
    
    173,000Decrease (increase) in other assets
    
    
    (23,000
    )
    
    
    (3,000
    )Decrease (increase) in deferred income tax
    
    
    (210,000
    )
    
    
    Increase (decrease) in accounts payable
    
    
    750,000
    
    
    
    (144,000
    )Increase (decrease) in accrued expenses
    
    
    (34,000
    )
    
    
    (287,000
    )Increase (decrease) in income taxes payable
    
    
    25,000
    
    
    
    15,000Net cash provided by (used in) operating activities
    
    
    353,000
    
    
    
    (344,000
    )Cash flows from investing activities:Capital expenditures
    
    
    (92,000
    )
    
    
    (171,000
    )Net cash used in investing activities
    
    
    (92,000
    )
    
    
    (171,000
    )Cash flows from financing activities:Exercise of stock options
    
    
    38,000
    
    
    
    2,000Net cash provided by financing activities
    
    
    38,000
    
    
    
    2,000Net increase (decrease) in cash
    
    
    299,000
    
    
    
    (513,000
    )Cash beginning of period
    
    
    2,708,000
    
    
    
    1,596,000Cash end of period
    
    $
    3,007,000
    
    
    $
    1,083,000
 See accompanying notes to condensed financial statements.




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##### Table of Contents



1.
    
    Interim ReportingCHAD 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.In the opinion of management, all adjustments necessary, which are of a
normal and recurring nature, for a fair presentation of the results for the
interim periods presented have been made. The results for the three and six
month periods ended September 30, 2004, are not necessarily indicative of the
results expected for the year ended March 31, 2005. The interim statements
are condensed and do not include some of the information necessary for a more
complete understanding of the financial data. Accordingly, your attention is
directed to the footnote disclosures found in the March 31, 2004, Annual
Report and particularly to Note 1 which includes a summary of significant
accounting policies.2.
    
    InventoriesInventories in 2004 are summarized as follows: September 30
    
    March 31Finished goods
    
    $
    1,463,000
    
    
    $
    1,223,000Work-in-process
    
    
    1,411,000
    
    
    
    1,062,000Raw materials
    
    
    2,488,000
    
    
    
    2,704,000$
    5,362,000
    
    
    $
    4,989,000




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3.
    
    Earnings Per Common ShareFollowing is a reconciliation of the numerators and denominators used in the
calculation of basic and diluted earnings per common share: Three Months Ended September 30,
    
    Six Months Ended September 30,2004
    
    2003
    
    2004
    
    2003Basic earnings per share:Numerator-net earnings
    
    $
    455,000
    
    
    $
    150,000
    
    
    $
    717,000
    
    
    $
    374,000Denominator-weighted average
common shares outstanding
    
    
    10,122,000
    
    
    
    10,076,000
    
    
    
    10,116,000
    
    
    
    10,076,000Basic earnings per share
    
    $
    0.04
    
    
    $
    0.02
    
    
    $
    0.07
    
    
    $
    0.04Diluted earnings per share:Numerator-net earnings
    
    $
    455,000
    
    
    $
    150,000
    
    
    $
    717,000
    
    
    $
    374,000Denominator:Weighted average common shares
outstanding
    
    
    10,122,000
    
    
    
    10,076,000
    
    
    
    10,116,000
    
    
    
    10,076,000Diluted effect of common
stock options
    
    
    476,000
    
    
    
    237,000
    
    
    
    493,000
    
    
    
    221,00010,598,000
    
    
    
    10,313,000
    
    
    
    10,609,000
    
    
    
    10,297,000Diluted earnings per share
    
    $
    0.04
    
    
    $
    0.02
    
    
    $
    0.07
    
    
    $
    0.04
  Options to purchase 225,000 shares of common stock at prices ranging from
$5.00 to $12.54 per share and 572,000 shares of common stock at prices
ranging from $2.03 to $13.47 were not included in the computation of diluted
earnings per share for the three and six month periods ended September 30,
2004 and 2003, respectively, because their effect would have been
anti-dilutive.4.
    
    Income Tax ExpenseAt September 30, 2004, the Companys net deferred tax assets are partially
offset by a valuation allowance. The Company will continue to assess the
valuation allowance and to the extent it is determined that such allowance is
no longer required, the tax benefit of the remaining net deferred tax assets
will be recognized in the future. The Company has California net operating
loss carryforwards of $2,013,000, against which a full valuation allowance
has been recorded. California has suspended the utilization of net operating
loss carryforwards during tax years starting in 2002 and 2003. As a result,
the company has been unable to use its California net operating loss
carryforwards until the tax year that began April 1, 2004. The California
net operating losses expire in 2006.




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5.
    
    Geographic InformationThe Company has one reportable operating segment. Geographic information
regarding the Companys sales is as follows: Three Months Ended
    
    Six Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003United States
    
    $
    5,840,000
    
    
    $
    5,078,000
    
    
    $
    11,653,000
    
    
    $
    10,494,000Canada
    
    
    67,000
    
    
    
    51,000
    
    
    
    156,000
    
    
    
    146,000Germany
    
    
    5,000
    
    
    
    4,000
    
    
    
    5,000
    
    
    
    45,000Japan
    
    
    120,000
    
    
    
    17,000
    
    
    
    183,000
    
    
    
    55,000All other countries
    
    
    276,000
    
    
    
    134,000
    
    
    
    411,000
    
    
    
    213,000$
    6,308,000
    
    
    $
    5,284,000
    
    
    $
    12,408,000
    
    
    $
    10,953,000
  All long-lived assets are located in the United States.Sales of OXYMATIC® and CYPRESS OXYPneumatic® conservers accounted for 77% of
the Companys sales for the three month periods ended September 30, 2004 and
2003, and 73% and 66% for the six month periods ended September 30, 2004 and
2003, respectively.6.
    
    Stock Option PlanThe 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 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 and earnings 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:




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Three Months Ended
    
    Six Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net earnings, as reported
    
    $
    455,000
    
    
    $
    150,000
    
    
    $
    717,000
    
    
    $
    374,000Deduct: Total stock based employee
compensation expense determined under
fair value-based method for all awards, net
of related tax effects
    
    
    29,000
    
    
    
    30,000
    
    
    
    58,000
    
    
    
    59,000Pro forma net income
    
    $
    426,000
    
    
    $
    120,000
    
    
    $
    659,000

    
    
    $
    315,000Earnings per share:Basic  as reported
    
    $
    0.04
    
    
    $
    0.02
    
    
    $
    0.07
    
    
    $
    0.04Basic  pro forma
    
    
    0.04
    
    
    
    0.01
    
    
    
    0.07
    
    
    
    0.03Diluted  as reported
    
    
    0.04
    
    
    
    0.02
    
    
    
    0.07
    
    
    
    0.04Diluted  proforma
    
    
    0.04
    
    
    
    0.01
    
    
    
    0.06
    
    
    
    0.03
  7.
    
    ReclassificationsCertain reclassifications have been made to the prior years balances to
conform to the presentation for the three and six months ended September 30,
2004.8.
    
    Major CustomersFour major national chains accounted for 55% and 49% of the Companys net
sales for the six month periods ended September 30, 2004 and 2003,
respectively. One chain accounted for 34% and 26% of sales for the six
month periods ended September 30, 2004 and 2003, respectively, and one
other chain accounted for 14% and 15% of sales for the six month periods
ended September 30, 2004 and 2003, respectively.




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Overview CHAD Therapeutics, Inc. (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 dealers, thereby
providing improved mobility for the patient and cost savings for dealers. 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 oxygen dealers. Major national and
regional home medical equipment chains have continued to expand their
distribution networks through the acquisition of independent dealers 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 55% and 49% of the Companys net sales, for the six month periods
ended September 30, 2004 and 2003, respectively. One chain accounted for 34%
and 26% of sales for the six month periods ended September 30, 2004 and 2003,
respectively, and one other chain accounted for 14% and 15% of sales for the
six month periods ended September 30, 2004 and 2003, respectively. The Company believes that price competition, continuing industry consolidation
and competitive products with features not found in the Companys products
prior to the introduction of the OM-400 and CYPRESS OXYPneumatic® series
conservers discussed below adversely affected sales during the three years
ending March 31, 2001. To combat the erosion in sales of the oxygen conserver
product line, the Company developed and introduced several new products in this
area. 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




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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 with plans to begin
shipment of the new device in January 2005. The LOTUS Electronic Oxygen
Conserver weighs less than a pound and will be offered with or without a
breath-sensing alarm. It will also offer 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 improves 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 has received purchase orders that will consume its SAGE production
capability through January 2005. 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 that are now in development and which are
based on this advanced new platform may be introduced to the market. For
information that may affect the forward-looking statements made in this
paragraph about products under development, see Outlook: Issues and Risks  New
Products,  Manufacture of SAGE Oxygen Therapeutic Device. 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 dealers
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 of the TOTAL O2 system
were adversely affected by several factors, including the overall home oxygen
market climate as well as start-up manufacturing and related supplier quality
issues. The Company has taken a number of steps to resolve the manufacturing
and supplier issues and now believes the success of this product will be
dependent on the healthcare communitys acceptance of this technology and
willingness to substitute a higher capital acquisition cost for lower operating
costs. While the Company will continue its efforts to promote this product,
based on sales levels through March of 2003, the Company wrote off the
unamortized license fees related to the TOTAL O2 system in March 2003.




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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 range of oxygen
conservation choices;  
    
    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 should
provide the Company with an opportunity to expand its oxygen delivery
product lines and potentially enter the high-growth sleep disorder
market.  
    
    A continued promotional and education campaign with respect to the
benefits of the TOTAL O2 system, coupled with an ongoing emphasis on
improving the performance of component suppliers. While the turnaround measures of the past three 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 three and six month periods ended September 30, 2004 increased by
$1,024,000 (19.4%) and $1,455,000 (13.3%) respectively, as compared to the same
periods in the prior year. The primary driver of the Companys increase in
sales has been the significant growth in sales of its conservers and
therapeutic devices, largely as a result of the introduction of the OXYMATIC
400 series and the CYPRESS OXYPneumatic conservers, as well as the SAGE Oxygen
Therapeutic Device. Management believes that the performance features of these
conservers and therapeutic devices have enabled the Company to recapture
significant market share. Domestic unit sales of conservers and therapeutic
devices for the three and six month period ended September 30, 2004, increased
49% and 44%, respectively over the prior year, while the increase in domestic
revenues from conserver sales was 17% and 10%, respectively. 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. As noted above, management expects continued downward pressure on
its average selling price.




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Sales to foreign distributors represented 7.6% and 4.0% of total sales for the
three month period ended September 30, 2004 and 2003, respectively and 6.3% and
4.3% for the six month period ended September 30, 2004 and 2003 respectively.
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, with the exception of
Canada, are denominated in US dollars. Sales in Canada represent less than 2%
of total sales. Cost of sales as a percent of net sales decreased from 60.4% to 58.6% for the
three month period ended September 30, 2004 and from 60.2% to 59.4% for the six
month period ended September 30, 2004, as compared to the same periods in the
prior year. This was a result of overhead efficiencies achieved due to
production increases related to the increase in sales. Selling, general and administrative expenditures decreased from 30.2% to 27.1%
and from 30.2% to 27.8% of net sales for the three and six month periods ended
September 30, 2004, respectively as compared to the same periods in the prior
year. 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 $72,000 for the three month period ended
September 30, 2004 and $159,000 for the six month period ended September 30,
2004 , as compared to the same period in the prior year. Currently, management
expects research and development expenditures to total approximately $1,570,000
in the fiscal year ending March 31, 2005, on projects to enhance and expand the
Companys product line. During fiscal year 2004, the Company spent $1,292,000
on research and development. On July 31, 2002, a national chain accounting for less than 10% of sales in
fiscal 2003 filed a Plan of Reorganization under Chapter 11 of the United
States Bankruptcy Code (the Plan). The Plan provided for full repayment to
the Company, and the Bankruptcy Court has approved the Plan. Payments to the
unsecured creditors commenced on July 1, 2003. No assurance can be given that
all of the payments will be made as proposed under the Plan. As of September
30, 2004, this chain was indebted to the Company for approximately $48,000. At September 30, 2004, the Companys net deferred tax assets are partially
offset by a valuation allowance. The Company will continue to assess the
valuation allowance and to the extent it is determined that such allowance is
no longer required, the tax benefit of the remaining net deferred tax assets
will be recognized in the future. The Company has California net operating
loss carryforwards of $2,013,000, against which a partial valuation allowance
has been recorded. California has suspended the utilization of net operating
loss carryforwards during tax years starting in 2002 and 2003. As a result,
the company has been unable to use its California net operating loss
carryforwards until the tax year which began April 1, 2004. The California net
operating losses expire in 2006. Financial Condition At September 30, 2004, the Company had cash totaling $3,007,000 or 20.7% of
total assets, as compared to $2,708,000 (20.8% of total assets) at March 31,
2004. Net working capital increased from $9,175,000 at March 31, 2004 to
$10,012,000 at




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September 30, 2004. Net accounts receivable increased $547,000 during the six
months ended September 30, 2004, due to the increase in sales. For information
regarding the reorganization proceedings of one of our customers, please see
the discussion in Results of Operations. 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 $373,000. The Company attempts to maintain sufficient
inventories to meet its customer needs as orders are received. 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. Currently,
inventory balances are generally near safety stock levels. 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 Companys recent operating performance. 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. The Company has no established lines of
credit or other arrangements in place to obtain working capital and no
assurance can be given that if and when needed other sources of working capital
would be available. The Company expects capital expenditures during the next
twelve months to be approximately $1,250,000. The following table aggregates all of the Companys material contractual
obligations as of September 30, 2004: Payments Due by PeriodLess than 1
    
    1  3
    
    3-5
    
    After 5Total
    
    Year
    
    Years
    
    Years
    
    YearsContractualCash ObligationsOperating lease
obligations
    
    
    1,625,000
    
    
    
    414,000
    
    
    
    1,211,000
    
    
    
    
    
    
    
    
 Operating lease commitments consist primarily of a real property lease for the
Companys 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 in the 2004 Annual
Report. 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.




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Critical 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. 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 The 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




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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, CYPRESS
OXYPneumatic, and LOTUS 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 oxygen dealers
and patients requiring supplementary oxygen. As with any product, the
Companys ability to successfully promote new products cannot be determined at
this time. Manufacture of SAGE Oxygen Therapeutic Device In May 2004, CHAD received clearance for the FDA to market the SAGE Oxygen
Therapeutic Device. Customer response to this new product has been positive,
and the Company has received purchase orders that will consume its SAGE product
capability through January 2005. As the Company ramps its production
capabilities to meet demand for the SAGE device, it may encounter difficulties
in securing components, scaling production facilities or other aspects of
managing growth in manufacturing operations. Unexpected problems or costs
could adversely affect the Companys gross profit margins or its ability to
meet customer demand on a timely basis. Failure to meet customer demand on a
timely basis could result in lost orders or could harm the Companys
reputation. Consolidation of Home Care Industry 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, 2004 and for 55% of net
sales for the six months ended September 30, 2004. Future sales may be
increasingly dependent upon a limited number of customers, which may reduce our
average selling price due to quantity pricing. For information regarding the reorganization proceedings of one of our
customers, please see the discussion in Results of Operations. Competition The Companys success in the early 1990s 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 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.




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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 proposals to regulate, control or alter the method of financing
health care costs have been discussed and certain such bills have been
introduced in Congress, and various state legislatures. Because of the
uncertain state and widely varying terms 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 will cause 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 or trademark 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 its products in its own facility. Some of its
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




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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 Accounting standards promulgated by the Financial Accounting Standards Board
change periodically. Changes in such standards may have an impact on the
Companys future financial position. In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51. This
Interpretation addresses the consolidation by business enterprises of variable
interest entities as defined in the Interpretation. The Interpretation
generally applies immediately to variable interests in variable interest
entities created after January 31, 2003 and to variable interests in variable
interest entities obtained after January 31, 2003. The application of this
Interpretation did not have a material effect on the Companys financial
statements. In December 2003, the FASB revised FIN 46 to exempt certain
entities from its requirements and to clarify certain issues arising during the
implementation of FIN 46. The adoption of this revised interpretation did not
have any impact on our financial statements. In May 2003, the Financial Accounting Standards Board issued Statement No. 150,
Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity (SFAS No. 150). The statement establishes standards for
how an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. It requires that an issuer
classify a financial instrument that is within its scope as a liability (or an
asset in some circumstances). It is effective for financial instruments entered
into or modified after May 31, 2003, and otherwise is effective at the
beginning of the first interim period beginning after June 15, 2003. We adopted
this standard effective July 1, 2003, and it did not have a material effect on
the Companys 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. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risks The Company has no significant exposure to market risk sensitive instruments or
contracts. 
 Item 4. Controls and Procedures The Company has evaluated the effectiveness of the design and operation of its
disclosure controls and procedures as of September 30, 2004 (the Evaluation
Date). Such evaluation was conducted under the supervision and with the
participation of the




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Companys Chief Executive Officer (CEO) and its Chief Financial Officer
(CFO). Based upon such evaluation, the Companys CEO and CFO have concluded
that, as of the Evaluation Date, the Companys disclosure controls and
procedures were effective. There have been no significant changes in the
Companys internal control over financial reporting that occurred during the
Companys most recent fiscal quarter that have materially affected, or are
reasonably likely to materially affect, the Companys internal control over
financial reporting. 
 Part II
Other Information 
 Item 1. Legal Proceedings None. 
 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchase of Equity Securities None. 
 Item 3. Defaults Upon Senior Securities Not applicable. 
 Item 4. Submission of Matters to a Vote of Security Holders We held our 2004 Annual Meeting of Shareholders as further discussed
below:  (a)
    
    Our 2004 Annual Meeting of Shareholders was held on September
9, 2004 in Woodland Hills, California.(b)
    
    Proxies for the Annual Meeting were solicited pursuant to
Regulation 14 under the Securities Exchange Act of 1934, as amended,
there was no solicitation in opposition to the managements nominees
as listed in the proxy statement, and all of such nominees were
elected.(c)
    
    At the Annual Meeting, the following matters were considered
and voted upon:  (i)
    
    The election of seven directors to our board of
directors. Our board of directors currently consists of
seven persons. Only four positions on our board of directors
were to be elected at our Annual Meeting. At the Annual
Meeting, our shareholders elected each of the following
director nominees as directors, to serve on our board of
directors until the Annual Meeting of Shareholders of 2006 or
until their successors are duly elected and qualified. The
vote for each director was as follows:(ii) Name
    
    For
    
    Against
    
    WithheldThomas E. Jones
    
    
    8,955,048
    
    
    
    835,024John C. Boyd
    
    
    8,690,509
    
    
    
    1,099,563Earl L. Yager
    
    
    8,955,764
    
    
    
    834,304Edward A. Oppenheimer
    
    
    8,954,294
    
    
    
    835,778




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(iii)
    
    To approve the 2004 Equity Incentive Plan. At
the Annual Meeting, our shareholders approved this proposal
by the votes indicated below: SharesFor
    
    
    4,478,275Against
    
    
    1,124,834Abstain
    
    
    261,823
  (iv)
    
    To ratify the appointment of KPMG LLP as our
independent auditors for the fiscal year ending March 31,
2005. At the Annual Meeting, our shareholders approved this
proposal by the votes indicated below: SharesFor
    
    
    9,338,565Against
    
    
    443,792Abstain
    
    
    7,715
  (d)
    
    Not applicable. 
 Item 5. Other Information None. 
 Item 6. Exhibits and Reports on Form 8-K (a) 31.1 Certification pursuant to Section 302 of Sarbanes-Oxley for CEO (b) 31.2 Certification pursuant to Section 302 of Sarbanes-Oxley for CFO (c) 32 Certification pursuant to 18 U.S.C Section 1350 Reports on Form 8-K: None




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Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. CHAD THERAPEUTICS, Inc.(Registrant)Date 9/15/04
    /s/ Earl L. YagerEarl L. YagerPresident and Chief Executive Officer Date 09/15/04
    /s/ Tracy A. KernTracy A. KernChief Financial Officer




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INDEX TO EXHIBITS Exhibit No.
    
    Description of Exhibits31.1
    
    Certification pursuant to Section 302 of Sarbanes-Oxley for CEO31.2
    
    Certification pursuant to Section 302 of Sarbanes-Oxley for CFO32
    
    Certification pursuant to 18 U.S.C Section 1350