Chad Therapeutics (CTU) 10-K 2006 FY Annual report

Exhibit 13.1

Selected Financial Data

Selected Financial Data

	Years Ended March 31,
	2006			2005		2004		2003			2002
Net sales	$	22,354,000		$	24,287,000	$	21,541,000	$	19,541,000		$	19,006,000
Interest income, net		20,000			39,000		22,000		20,000			50,000
Net earnings (loss)		(673,000	)		1,811,000		1,001,000		(433,000	)		1,157,000
Basic earnings (loss) per share		(.07	)		.18		.10		(.04	)		.12
Diluted earnings (loss) per share		(.07	)		.17		.10		(.04	)		.11
Net working capital		9,806,000			10,393,000		9,175,000		8,224,000			7,497,000
Total assets		14,356,000			15,790,000		13,043,000		12,105,000			12,323,000
Shareholders’ equity		12,395,000			13,024,000		11,153,000		10,100,000			10,373,000

No cash dividends have been declared or paid during the periods presented.

1

Balance Sheets

	March 31,
	2006			2005
Assets
Current assets:
Cash	$	935,000		$	177,000
Accounts receivable, less allowance for doubtful accounts of $52,000 and $39,000 in 2006 and 2005, respectively		3,220,000			3,745,000
Income taxes refundable		383,000			–––
Inventories (Note 2)		6,381,000			8,512,000
Prepaid expenses and other assets		178,000			264,000
Deferred income taxes (Note 3)		666,000			461,000
Total current assets		11,763,000			13,159,000
Property and equipment, at cost:
Office equipment and furniture		1,761,000			1,854,000
Machinery and equipment		954,000			957,000
Tooling		1,489,000			1,441,000
Leasehold improvements		1,897,000			1,888,000
		6,101,000			6,140,000
Less accumulated depreciation and amortization		5,151,000			4,949,000
Net property and equipment		950,000			1,191,000
Intangible assets, net (Note 4)		972,000			802,000
Deferred income taxes (Note 3)		600,000			568,000
Other assets		71,000			70,000
	$	14,356,000		$	15,790,000
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	522,000		$	1,196,000
Accrued expenses (Note 7)		1,435,000			1,370,000
Income taxes payable (Note 3)		–––			200,000
Total current liabilities		1,957,000			2,766,000
Other liabilities		4,000			–––
Commitments (Note 8)
Shareholders’ equity (Note 5):
Common shares, $0.01 par value
Authorized 40,000,000 shares; 10,158,000 and 10,134,000 shares issued and outstanding		13,413,000			13,369,000
Accumulated deficit		(1,018,000	)		(345,000	)
Shareholders’ equity		12,395,000			13,024,000
	$	14,356,000		$	15,790,000

See accompanying notes to financial statements.

2

Statement of Operations

	Years Ended March 31,
	2006			2005			2004
Net sales	$	22,354,000		$	24,287,000		$	21,541,000
Cost of sales		15,113,000			14,581,000			12,846,000
Gross profit		7,241,000			9,706,000			8,695,000
Costs and expenses:
Selling, general and administrative		6,788,000			6,947,000			6,436,000
Research and development		1,574,000			1,473,000			1,292,000
Total costs and expenses		8,362,000			8,420,000			7,728,000
Operating income (loss)		(1,121,000	)		1,286,000			967,000
Interest income, net		20,000			39,000			22,000
Other income (expense)		(3,000	)		2,000			12,000
Earnings (loss) before income taxes		(1,104,000	)		1,327,000			1,001,000
Income tax expense (benefit) (Note 3)		(431,000	)		(484,000	)		—
Net earnings (loss)	$	(673,000	)	$	1,811,000		$	1,001,000
Basic earnings (loss) per share	$	(.07	)	$	.18		$	.10
Diluted earnings (loss) per share	$	(.07	)	$	.17		$	.10
Weighted shares outstanding:
Basic		10,146,000			10,122,000			10,084,000
Diluted		10,146,000			10,625,000			10,362,000

See accompanying notes to financial statements.

3

Statements of Shareholders’ Equity

For the years ended March 31, 2006,
2005, and 2004

	Common Shares				Accumulated
	Shares		Amount		Deficit
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		—		—		1,001,000
Balance at March 31, 2004		10,096,000		13,309,000		(2,156,000	)
Exercise of stock options		38,000		60,000		—
Net earnings		—		—		1,811,000
Balance at March 31, 2005		10,134,000		13,369,000		(345,000	)
Exercise of stock options		24,000		29,000		––
Tax benefit from exercise of non-qualified stock options		––		15,000		––
Net loss		––		—		(673,000	)
Balance at March 31, 2006		10,158,000	$	13,413,000	$	(1,018,000	)

See accompanying notes to financial statements.

4

Statements of Cash Flows

	Years Ended March 31,
	2006			2005			2004
Cash flows from operating activities:
Net earnings (loss)	$	(673,000	)	$	1,811,000		$	1,001,000
Adjustments to reconcile net earnings (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization of property and equipment		418,000			378,000			448,000
Amortization of intangibles		40,000			39,000			2,000
Provision for losses on receivables		13,000			(31,000	)		(74,000	)
Loss on asset disposition		12,000			—			57,000
Tax benefit attributable to stock options		15,000			—			3,000
Decrease (increase) in deferred income taxes		(237,000	)		(805,000	)		(224,000	)
Changes in assets and liabilities:
Decrease (increase) in accounts receivable		512,000			(803,000	)		(320,000	)
Decrease (increase) in inventories		2,131,000			(3,523,000	)		522,000
Decrease (increase) in income taxes refundable		(383,000	)		—			4,000
Decrease (increase) in prepaid expenses		86,000			(31,000	)		368,000
Decrease (increase) in other assets		(1,000	)		(39,000	)		47,000
Increase (decrease) in accounts payable		(681,000	)		694,000			(239,000	)
Increase (decrease) in accrued expenses		65,000			185,000			(78,000	)
Increase (decrease) in income taxes payable		(200,000	)		(3,000	)		202,000
Net cash provided by (used in) operating activities		1,117,000			(2,128,000	)		1,719,000
Cash flows from investing activities:
Additions to intangible assets		(210,000	)		(112,000	)		(146,000	)
Capital expenditures		(175,000	)		(351,000	)		(487,000	)
Net cash used in investing activities		(385,000	)		(463,000	)		(633,000	)
Cash flows from financing activities:
Exercise of stock options		29,000			60,000			26,000
Other liabilities		(3,000	)		––			––
Net cash provided by financing activities		26,000			60,000			26,000
Net increase (decrease) in cash		758,000			(2,531,000	)		1,112,000
Cash beginning of year		177,000			2,708,000			1,596,000
Cash end of year	$	935,000			177,000		$	2,708,000
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes		348,000			325,000			13,000
Acquisition of capital assets through capital lease	$	14,000		$	––		$	––

See accompanying notes to financial statements.

5

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, 2006 and 2005. 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 Years
Machinery and Equipment	3-10 Years
Tooling	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 other than its net earnings (loss) during the periods ended March 31, 2006, 2005, and 2004. As a result, comprehensive income (loss) is the same as net earnings (loss) for the periods ended March 31, 2006, 2005, and 2004.

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, 2006, 2005, and 2004, respectively:

	2006			2005		2004
Basic earnings (loss) per share
Numerator — net earnings (loss)	$	(673,000	)	$	1,811,000	$	1,001,000
Denominator — weighted common shares outstanding		10,146,000			10,122,000		10,084,000
Basic earnings (loss) per share	$	(.07	)	$	.18	$	.10
Diluted earnings (loss) per share
Numerator — net earnings (loss)	$	(673,000	)	$	1,811,000	$	1,001,000
Denominator — weighted common shares outstanding		10,146,000			10,122,000		10,084,000
Diluted potential common shares		–––			503,000		278,000
		10,146,000			10,625,000		10,362,000
Diluted earnings (loss) per share	$	(.07	)	$	.17	$	.10

Options to purchase 945,000, 128,000, and 379,000 shares of common stock at prices ranging from $.50 to $11.50, $5.00 to $12.54, and from $3.14 to $12.54 per share were not included in the computation of diluted earnings per share in 2006, 2005, and 2004, respectively, because their inclusion would have been 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 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.

6

Notes to Financial Statements

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

	2006			2005			2004
Customer A**		36.0	%		35.8	%		26.5	%
Customer B**		*			10.8	%		14.5	%
Customer C		11.0	%		*			*

*	Indicates sales less than 10% of the Company’s net sales.
**	Indicates national chain customer.

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, 2006, the amount at risk was approximately $835,000.

At March 31, 2006 and 2005, significant accounts receivable balances were as follows:

	2006			2005
Customer A**		25.4	%		26.0	%
Customer B		21.6	%		*
Customer C		*			22.6	%

*	Indicates accounts receivable balance less than 10% of gross accounts receivable.
**	Indicates national chain customer.

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 earnings (loss) and pro forma net earnings (loss) 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 as 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,
	2006			2005			2004
Net earnings (loss), as reported	$	(673,000	)	$	1,811,000		$	1,001,000
Deduct: Total stock-based employee compensation expense determined under fair-value- based method for all awards, net of related tax effects		(128,000	)		(108,000	)		(81,000	)
Pro forma net earnings (loss)	$	(801,000	)	$	1,703,000		$	920,000
Earnings (loss) per share:
Basic — as reported	$	(.07	)	$	.18		$	.10
Basic — pro forma		(.08	)		.17			.09
Diluted — as reported		(.07	)		.17			.10
Diluted — pro forma	$	(.08	)	$	.16		$	.09

The weighted average fair value of options granted during 2006, 2005, and 2004 is estimated at $3.41, $3.71, and $2.69, 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:

	2006			2005			2004
Risk-free interest rate		4.3	%		3.3	%		3.9	%
Forfeiture rate		4.0	%		4.0	%		4.0	%
Dividend yield		.0			.0			.0
Volatility		79.0	%		78.0	%		82.0	%
Expected life (years)		8.0			8.0			8.0

Segment Information

The Company operates in one segment, the respiratory care market.

Reclassifications

The Company reclassified royalty expense of $542,000, $552,000, and $776,000 from selling, general, and administrative expenses to costs of sales for fiscal years ended 2006, 2005, and 2004, respectively.

The Company also added provisions for losses on receivables and amortization of intangibles to its statements of condensed cash flows.

(2) Inventories

At March 31, 2006 and 2005, inventories consisted of the following:

	2006		2005
Finished goods	$	1,706,000	$	2,767,000
Work in process		1,234,000		1,790,000
Raw materials and supplies		3,441,000		3,955,000
	$	6,381,000	$	8,512,000

7

Notes to Financial Statements

(3) Income Taxes

Income tax expense (benefit) for fiscal 2006, 2005, and 2004 consisted of the following:

	2006			2005			2004
Current:
Federal	$	(217,000	)	$	307,000		$	204,000
State		7,000			15,000			16,000
		(210,000	)		322,000			220,000
Deferred:
Federal		(149,000	)		(466,000	)		(204,000	)
State		(72,000	)		(340,000	)		(16,000	)
		(221,000	)		(806,000	)		(220,000	)
Total	$	(431,000	)	$	(484,000	)	$	—

A reconciliation of the difference between the Company’s income tax expense (benefit) and the statutory income tax for the years ended March 31, 2006, 2005, and 2004, respectively, is as follows:

	2006			2005			2004
Statutory tax expense (benefit)	$	(375,000	)	$	451,000		$	341,000
State income tax, net		(51,000	)		72,000			—
Valuation allowance		9,000			(1,004,000	)		(383,000	)
Warranty and other		(14,000	)		(3,000	)		42,000
	$	(431,000	)	$	(484,000	)	$	—

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets at March 31, 2006 and 2005 are presented as follows:

	2006			2005
Bad debt reserves	$	21,000		$	15,000
Accrued expenses		263,000			265,000
Inventories		344,000			83,000
Depreciation and amortization		241,000			237,000
Intangible assets		261,000			325,000
Net operating loss		147,000			99,000
Other		2,000			5,000
Total deferred tax assets		1,279,000			1,029,000
Deferred tax liabilities:
Valuation allowance		(13,000	)		—
Net deferred tax assets	$	1,266,000		$	1,029,000

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 $2,424,000. As of March 31, 2006, the Company has approximately $606,000 in California net operating losses expiring in 2007. Based on current earnings performance and projections, a valuation allowance of $13,000 has been placed on the portion of the California net operating loss expiring in 2007.

(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 $96,000 and $56,000 at March 31, 2006 and 2005, respectively. Annual amortization on intangible assets currently in service will be $42,000 for each of the next five years. Intangible assets were $972,000 and $802,000, and amortization expense was $40,000 and $39,000 at March 31, 2006 and 2005, 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:

	��
					Weighted
					Average
		Option			Price
		Shares			Per Share
Incentive options:
Outstanding — March 31, 2003			789,000		$	2.37
Cancelled			(16,000	)		3.44
Granted			15,000			2.80
Exercised			(9,000	)		.78
Outstanding — March 31, 2004			779,000			2.37
Cancelled			(13,000	)		2.51
Exercised			(17,000	)		1.02
Expired			(83,000	)		8.19
Outstanding — March 31, 2005			666,000			1.98
Cancelled			(7,000	)		3.33
Granted			40,000			3.41
Exercised			(24,000	)		1.16
Outstanding — March 31, 2006			675,000		$	2.10
Exercisable — March 31, 2006			635,000		$	2.03
Non-qualified options:
Outstanding — March 31, 2003			300,000			5.37
Cancelled			(42,000	)		8.20
Granted			75,000			2.04
Exercised			(11,000	)		1.58
Outstanding — March 31, 2004			322,000			4.30
Cancelled			(41,000	)		8.33
Granted			55,000			3.71
Exercised			(21,000	)		2.07
Expired			(6,000	)		5.18
Outstanding — March 31, 2005			309,000			3.83
Expired			(39,000	)		11.88
Outstanding — March 31, 2006			270,000		$	9.56
Exercisable — March 31, 2006			267,000		$	2.70

8

Notes to Financial Statements

At March 31, 2006, information regarding outstanding options is summarized as follows:

	Range of Exercise Prices
	$.50-6.69		$7.62-12.54
Number outstanding		929,000		16,000
Weighted average remaining life (yrs.)		5.2		1.5
Weighted average exercise price	$	2.10	$	9.56
Number exercisable		887,000		15,000
Weighted average exercise price	$	2.10	$	9.56

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:

	2006		2005
Accrued royalties	$	267,000	$	347,000
Accrued vacation		205,000		182,000
Warranty reserve		139,000		109,000
Payroll and incentive compensation		86,000		215,000
Accrued inventory in transit		175,000		––
Customer deposits		152,000		132,000
Accrued extended warranty		95,000		90,000
Other		316,000		295,000
	$	1,435,000	$	1,370,000

(8) Commitments

In December 2005, the Company entered into a $1 million revolving line of credit agreement that expires in December 2006. Advances under the line of credit bear interest at the bank’s prime rate (7.75% at March 31, 2006) and are secured by inventories and accounts receivable. Under the terms of the credit agreement, the Company is required to maintain a specific working capital, net worth, profitability levels, and other specific ratios. In addition, the agreement prohibits the payment of cash dividends and contains certain restrictions on the Company’s ability to borrow money or purchase assets or interests in other entities without prior written consent of the bank. At March 31, 2006, the Company was not in compliance with certain of the covenants related to profitability and is currently renegotiating changes to the line of credit. There were no borrowings under the line of credit at March 31, 2006.

The Company is currently leasing its administrative and plant facilities and certain office equipment under noncancelable operating leases which expire through June 2008. Rent expense amounted to $570,000, $577,000, and $552,000 for the years ended March 31, 2006, 2005, and 2004, 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 $542,000, $552,000, and $776,000 for the years ended March 31, 2006, 2005, and 2004, respectively. License agreements with minimum annual royalty requirements are in place through fiscal year 2012.

Employee obligations consist of an employment agreement (the “Employment Agreement“) with Thomas E. Jones, Chairman of the Board of Directors. The Employment Agreement does not have a specific term and provides for a base salary of $160,000 per year, which is subject to annual review of the Board of Directors. The Employment Agreement may be terminated at any time by the Company, with our without cause, and may be terminated by Mr. Jones upon 90 days’ notice. If Mr. Jones resigns or is terminated for cause (as defined in the Employment Agreement), he is entitled to receive only his base salary and accrued vacation through the effective date of his resignation or termination. If Mr. Jones is terminated without cause, he is entitled to receive a severance benefit in accordance with the company’s Severance and Change of Control Plan, or if not applicable, a severance benefit equal to 200% of his salary and incentive bonus for the prior fiscal year. In estimating its contractual obligation, the company has assumed that Mr. Jones will voluntarily retire at the end of the year he turns 65 and that no severance benefit will be payable. This date may not represent the actual date the company’s payment obligations under the Employment Agreement are extinguished.

In the second quarter of fiscal year 2006, the Company entered into a capital lease agreement for certain plant equipment totaling $14,000, with annual lease payments of $7,000, a fixed interest rate of 7%, and a purchase option at lease end in August 2007. Amortization of plant equipment under capital leases will be included in depreciation expense.

The following table aggregates all of the Company’s material contractual obligations as of March 31, 2006:

	Operating		Minimum				Capital
	Lease		Royalty		Employee		Lease
	Obligation		Obligation		Obligations		Obligations
2007	$	441,000	$	523,000	$	160,000	$	7,000
2008		454,000		530,000		160,000		4,000
2009		113,000		530,000		160,000		–––
2010		–––		530,000		–––		–––
2011		–––		530,000		–––		–––
Thereafter	$	–––	$	427,000	$	–––	$	–––

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

Notes to Financial Statements

(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:

	2006		2005		2004
United States	$	17,996,000	$	22,912,000	$	20,498,000
Canada		193,000		306,000		303,000
Japan		506,000		405,000		238,000
Europe		3,337,000		418,000		278,000
All other countries		322,000		246,000		224,000
	$	22,354,000	$	24,287,000	$	21,541,000

All long-lived assets are located in the United States.

Sales of OXYMATIC^®and CYPRESS conservers accounted for 70%, 73%, and 77% of the Company’s net sales for the years ended March 31, 2006, 2005, and 2004, 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, 2006, 2005, and 2004:

	Balance at		Charged to				Balance
	Beginning		Costs and				at End
	of Year		Expenses		Deductions		of Year
Allowance for doubtful accounts:
2004	$	112,000		7,000		51,000	$	68,000
2005		68,000		—		29,000		39,000
2006	$	39,000		28,000		15,000	$	52,000
Warranty reserve:
2004	$	140,000		22,000		59,000	$	103,000
2005		103,000		57,000		51,000		109,000
2006	$	109,000		64,000		34,000	$	139,000

(11) Quarterly Financial Data (Unaudited)

The following table presents summarized, unaudited, quarterly financial data for 2006 and 2005:

								Diluted
								Earnings
			Gross		Net			(Loss)
	Revenue		Profit		Earnings			Per Share
2006
First quarter	$	5,895,000	$	2,101,000	$	(42,000	)	$	.00
Second quarter		5,375,000		1,781,000		(210,000	)		(.02	)
Third quarter		5,907,000		2,101,000		39,000			.00
Fourth quarter		5,177,000		1,258,000		(460,000	)		(.05	)
Year	$	22,354,000	$	7,241,000	$	(673,000	)	$	(.07	)
2005
First quarter	$	6,099,000	$	2,420,000	$	262,000		$	0.02
Second quarter		6,309,000		2,613,000		455,000			0.04
Third quarter		6,444,000		2,703,000		505,000			0.05
Fourth quarter		5,435,000		1,970,000		589,000			0.06
Year	$	24,287,000	$	9,706,000	$	1,811,000		$	0.17

(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.

10

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, 2006 and 2005, and the related statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended March 31, 2006. 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, 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, 2006 and 2005, and the results of its operations and its cash flows for each of the years in the three-year period ended March 31, 2006, in conformity with accounting principles generally accepted in the United States of America.

Los Angeles,California
May 5, 2006

11

Managements’ 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 are less expensive but which provide 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. Beginning January 1, 2006, the reimbursement procedures have been modified to provide that title for the equipment being used by a patient transfers to the patient after 36 months. 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. However, the uncertainties created by the new reimbursement procedures have adversely affected the market for our products by causing many home health care dealers to delay product purchases as they seek to assess the impact of the new procedures.

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 43%, 53%, and 49% of the Company’s net sales, for the years ended March 31, 2006, 2005, and 2004, respectively. One chain accounted for 36%, 36%, and 27% of sales in the years ended March 31, 2006, 2005, and 2004, respectively, and one other chain accounted for 11% and 14% of sales in the years ended March 31, 2005 and 2004, respectively. The Company also had one significant non-chain customer that accounted for 11.0% of sales in the year ended March 31, 2006.

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 510(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 is 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. Notwithstanding the advances requested by the foregoing products, recent changes in home oxygen reimbursements have created an environment where the cost of a product is a significantly greater factor in its success than any therapeutic benefit to the patient. No estimate can currently be made regarding the level of success the Company may achieve with its current line of products or when the additional therapeutic devices now in development based on the SAGE platform may be introduced to the market.

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 gives home care providers 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 four 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;

12

Managements’ Discussion and Analysis of Financial
Condition and Results of Operation

• 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.

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. In November 2005, the Company announced that it was considering various strategic options for its future. The process of evaluating those options continues. Management believes that the uncertainties inherent in this process have adversely affected the Company’s results of operations during the past several months. 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 17 of this Report.

Results of Operations

Net sales for the years ended March 31, 2006 and 2005 decreased by $1,933,000 (8.0%) and increased $2,746,000 (12.7%), respectively, as compared to the same periods in the prior year. The primary reasons for the decrease in sales for the year ended March 31, 2006, as compared to the previous year have been the price reduction on conservers and reduced sales to a large customer. Unit sales of conservers and therapeutic devices for the year ended March 31, 2006, remained consistent with the prior year showing a 1% increase, while the decrease in revenues from conserver and therapeutic device sales was 11.3% for the same period. The increase in sales for the year ended March 31, 2005, as compared to the previous year was primarily driven by the significant growth in sales of the Company’s conservers, largely as a result of the introduction of the OXYMATIC 400 series conservers and the CYPRESS OXYPneumatic conservers. Unit sales of conservers and therapeutic devices for the year ended March 31, 2005, increased 37.7% over the prior year, while the increase in revenues from conserver and therapeutic device sales was 7.0%. Decreased per-unit- conserver revenues over the past two years are due to 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. In addition, future operating results may be increasingly dependent upon purchase decisions of a limited number of large customers.

Sales to foreign distributors represented 19.5% and 5.8% of total sales for the years ended March 31, 2006 and 2005, respectively. Management believes there may be substantial growth opportunities for the Company’s products in a number of foreign markets and currently 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 60.0% to 67.6% and from 56.2% to 60.0% for the years ended March 31, 2006 and 2005, respectively. This was partially a result of the downward price pressures in the market place, increased sales to chain customers and those with quantity pricing arrangements, and a change in the product mix, as the TOTAL O₂ system has a lower gross profit margin than conservers. We currently expect continued downward price pressure for the foreseeable future. In accordance with the Company’s policy to provide a reserve against excess or slow-moving inventory, in March 2006 the Company established a $739, 000 reserve against certain slow-moving inventories related to its SAGE Oxygen Therapeutic Device. In the latter part of fiscal 2005, the Company had a significant inventory build up to fill certain customer orders and anticipated customer orders. Certain of these orders did not materialize. Prior to the application of the reserve, the book value of the SAGE inventory was approximately $1,484,000. Based on the rate of sales for this inventory during the past twelve months, the Company concluded that a reserve was appropriate. Sales of the SAGE inventory continue, and the Company intends to continue to market and support the SAGE Oxygen Therapeutic Device in the future.

Selling, general, and administrative expenditures increased from 28.6% to 30.4% of net sales for the year ended March 31, 2006 as compared to the same period in the prior year primarily due to the decrease in domestic sales. Selling, general, and administrative expenditures decreased from 33.5% to 28.6% of net sales for the year ended March 31, 2005, as compared to the same period in the prior year. The Company’s ongoing cost reduction efforts have helped align staffing and operating expenses more closely with current sales expectations, but were offset, to some extent, by growth in the Company’s sales force. Research and development expenses increased by $101,000 and $181,000 for the years ended March 31, 2006 and 2005, respectively, as compared to the prior years. Currently, management expects research and development expenditures to total approximately $1,500,000 in the fiscal year ending March 31, 2007, on projects to enhance and expand the Company’s product line.

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. Based on current earnings performance and projections, a valuation allowance of $13,000 has been placed on the portion of the California net operating loss expiring in 2007. The Company has total California net operating loss carryforwards of $2,424,000 of which $606,000 expires in 2007, $488,000 in 2006, and the remaining balance expires in 2013.

Financial Condition

At March 31, 2006, the Company had cash totaling $935,000 or 6.6% of total assets as compared to $177,000 or 1.1% at March 31, 2005. The increase in the Company’s cash balance is due to a large payment against an accounts receivable balance in existence at March 31, 2005 received early in fiscal year 2006, as well as the utilization of inventory balances on hand. Net working capital decreased from $10,393,000 at March 31, 2005, to $9,806,000 at March 31, 2006. Net accounts receivable decreased $525,000 during the year ended March 31, 2006, due to the decrease 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 decreased $2,131,000, while cash increased by $758,000. These changes resulted in large part from a significant inventory build up in the latter part of fiscal 2005 to fill certain customer orders and

13

Managements’ Discussion and Analysis of Financial
Condition and Results of Operation

anticipated customer orders of the SAGE device. Certain of these orders did not materialize or were deferred. In March 2006, the Company established a $739,000 reserve against slow-moving inventories related to the build up and utilized inventories on hand during the year. 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 primarily upon its cash flow from operations to meet its capital requirements. Historically, the Company’s cash flow from operations has fluctuated significantly, primarily as a result of changes in inventory, accounts receivable, and accounts payable. 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.

Historically, the Company has financed its inventory requirements out of cash flow, and it has not sought to finance its accounts receivable. In December 2005, the Company entered into a $1 million line of credit agreement. The line of credit was established in order to fund anticipated capital expenditures. As of March 31, 2006, there were no borrowings under the line of credit. Advances under the line of credit bear interest at the bank’s prime rate (7.75% at March 31, 2006) and are secured by inventories and accounts receivable. Under the terms of the credit agreement, the Company is required to maintain a specific working capital, net worth, profitability levels, and other specific ratios. In addition, if advances were outstanding, the agreement would prohibit the payment of cash dividends and contains certain restrictions on the Company ability to borrow money or purchase assets or interests in other entities without prior written consent of the bank. At March 31, 2006, the Company was not in compliance with certain of the covenants related to profitability and is currently negotiating changes to the line of credit agreement. The Company expects capital expenditures during the next twelve months to be approximately $525,000 and believe that cash balance and funds derived from operations will be adequate to meet the Company’s near-term cash requirements.

The following table aggregates all of the Company’s material contractual obligations as of March 31, 2006:

	Payments Due By Period
Contractual			Less than 1		1-3		3-5		After 5
Cash Obligations	Total		Year		Years		Years		Years
Operating lease obligations	$	1,008,000	$	441,000	$	567,000		—		—
Minimum royalty obligations	$	3,070,000	$	523,000	$	1,590,000	$	882,000	$	75,000
Employee obligations	$	480,000	$	160,000	$	320,000		—		—
Capital lease obligations	$	11,000	$	7,000	$	4,000		—		—

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.

Employee obligations consist of an employment agreement (the “Employment Agreement”) with Thomas E. Jones Chairman of the Board of Directors. The Employment Agreement does not have a specific term and provides for a base salary of $160,000 per year, which is subject to annual review of the Board of Directors. The Employment Agreement may be terminated at any time by the Company, with or without cause, and may be terminated by Mr. Jones upon 90-days’ notice. If Mr. Jones resigns or is terminated for cause (as defined in the Employment Agreement), he is entitled to receive only his base salary and accrued vacation through the effective date of his resignation or termination. If Mr.Jones is terminated without cause, he is entitled to receive a severance benefit in accordance with the Company’s Severance and Change of Control Plan, or if not applicable, a severance benefit equal to 200% of his salary and incentive bonus for the prior fiscal year. In estimating its contractual obligation, the Company has assumed that Mr. Jones will voluntarily retire at the end of the year he turns 65 and that no severance benefit will be payable. This date may not represent the actual date the Company’s payment obligations under the Employment Agreement are extinguished.

The Company does not have any outstanding debt and is not subject to any covenants or contractual restrictions limiting its operations with the exception of those required by its line of credit agreement indicated above. 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.

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

14

Managements’ Discussion and Analysis of Financial
Condition and Results of Operation

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, LOTUS 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 43% of the Company’s net sales during the year ended March 31, 2006, down from 53% in the prior year. One customer accounted for 36% of our sales in the year ended March 31, 2006 and 2005. 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 reduce their purchases of our products or terminate 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 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. In February 2006, reimbursement procedures were again modified, resulting in ownership of equipment being transferred to the patient after 36 months. These changes in reimbursement will cause increased downward pressure on the average selling price of the Company’s products.

15

Managements’ Discussion and Analysis of Financial
Condition and Results of Operation

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.

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.

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.

16

CORPORATE DATA

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		Low
June 30, 2004		4.39		4.12
September 30, 2004		4.40		4.26
December 31, 2004		5.50		5.35
March 31, 2005		3.70		3.10
June 30, 2005		3.87		3.62
September 30, 2005		3.81		3.71
December 31, 2005		3.60		3.36
March 31, 2006		2.90		2.50

As of June 12, 2006, there were approximately 223 shareholders of record and approximately 2,000 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

Officers

THOMAS E. JONES
Chairman

EARL L. YAGER
Chief Executive Officer and President

ALFONSO DEL TORO
Vice President, Manufacturing

TRACY A. KERN
Chief Financial Officer

ERIKA LASKEY
Vice President, Sales and Marketing

KEVIN McCULLOH
Vice President, Engineering

PAULA O’CONNOR
Corporate Secretary

SAMUEL PATTON
Vice President, Quality Assurance
and Regulatory Affairs

OSCAR J. SANCHEZ
Vice President, Business
Development

Directors
THOMAS E. JONES
Chairman
CHAD Therapeutics, Inc.

EARL L. YAGER
President and Chief Executive Officer
CHAD Therapeutics, Inc.

JOHN C. BOYD
Retired

JAMES M. BROPHY
Hospital Executive

KATHLEEN M. GRIGGS
Financial Consultant

PHILIP T. WOLFSTEIN
International Trade Consultant

Corporate Data
CORPORATE HEADQUARTERS
21622 Plummer Street
Chatsworth, CA 91311
(818) 882-0883

LEGAL COUNSEL
Morrison & Foerster, LLP

AUDITORS
KPMG LLP
Los Angeles, California

TRANSFER AGENT AND REGISTRAR
American Stock Transfer Company
40 Wall Street
New York, NY 10005