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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)


þ		Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended March 31, 2006


o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from to

Commission file number 1-12214

CHAD Therapeutics, Inc.

(Exact name of registrant as specified in its charter)


California		95-3792700
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

21622 Plummer Street, Chatsworth, CA (Address of principal executive offices)		91311 (Zip Code)

Registrant’s telephone number, including area code: (818) 882-0883

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


		Name of each exchange

Title of each class		on which registered

Common Shares, $.01 par value		American Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None.

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

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

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

Indicate by check mark if disclosures of delinquent filers pursuant to Item 405 of Regulation SK (229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2).

Large accelerated filer o Accelerated filer o Non-accelerated filer þ

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

As of March 31, 2006, the last business day of the registrant’s most recently completed fiscal year, the approximate aggregate market value of voting and non-voting common stock held by non-affiliates of the registrant was $21,788,000 (based upon the last closing price for shares of the registrant’s common stock as reported by the American Stock Exchange as of that date). Shares of common stock held by each officer, director, and holder of 10% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

There were approximately 10,169,000 shares of common stock outstanding as of June 26, 2006.

Portions of the Registrant’s Annual Report to Shareholders for the year ended March 31, 2006, (“Annual Report”) are incorporated into Part II as set forth herein and only such portions of the Annual Report as are specifically incorporated by reference are thereby made a part of this Annual Report on Form 10-K.

TABLE OF CONTENTS


PART I
	Item 1. Business
	Item 1A. Risk Factors
	Item 1B.Unresolved Staff Comments
	Item 2.Properties
	Item 3.Legal Proceedings
	Item 4.Submission of Matters to a Vote of Security Holders
PART II
	Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
	Item 6.Selected Financial Data
	Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 7a.Quantitative and Qualitative Disclosures about Market Risk
	Item 8.Financial Statements and Supplementary Data
	Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
	Item 9A.Controls and Procedures
	Item 9B.Other Information
PART III
	Item 10.Directors and Executive Officers of the Registrant
	Item 11. Executive Compensation
	Item 12. Security Ownership of Certain Beneficial Owners and Management
	Item 13. Certain Relationships and Related Transactions
	Item 14. Principal Accountant Fees and Services
PART IV
	Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
SIGNATURES
Exhibit Index
Exhibit 13.1
Exhibit 23.1
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2
Exhibit 99.12

PART I

Item 1. Business

CHAD Therapeutics, Inc. (“CHAD” or the “Company”) was organized in August 1982 to develop, produce, and market respiratory care devices designed to improve the efficiency of oxygen delivery systems for both home and hospital treatment of patients who require supplemental oxygen. The Company introduced its first respiratory care device in the market in June of 1983 and has introduced additional respiratory care devices in subsequent years.

Pulmonary Disease and Oxygen Therapy

The Company was organized to pursue the development and marketing of devices that improve the efficiency of systems used to administer oxygen to patients requiring supplemental oxygen. These are primarily patients suffering from chronic obstructive pulmonary diseases.

Chronic obstructive pulmonary diseases (COPD) are progressive, debilitating conditions that affect millions of Americans, severely limiting their activities and shortening their lives. Such conditions, which include chronic bronchitis, emphysema, and severe asthma, decrease the capacity of the lungs to oxygenate the blood. To make up for this deficiency, it is common medical practice to administer supplemental oxygen (usually on a 24 hours per day basis) in an amount sufficient to increase blood oxygenation to near normal levels.

According to the National Heart, Lung and Blood Institute of the National Institutes of Health (NIH), COPD represents the fourth leading cause of death in the United States and is predicted to be the third largest cause of death by 2020.

The American Lung Association reported that in 2003 there were 10.7 million Americans suffering from COPD. This report also notes that in 2004 the annual cost to the nation for COPD in health care and indirect costs was estimated to be $37.2 billion.

Although precise data are not available, various individual and institutional sources and reports estimate that there are more than one (1) million home care patients receiving supplementary administration of oxygen. Medicare, which accounts for about 60% of home oxygen dealers’ revenues, spent approximately $1.8 billion in 2002 for home oxygen, according to a report by the Centers for Medicare and Medicaid Services Office of Actuary. This represented a 13% increase over the previous year, according to the report.

Chronic obstructive pulmonary diseases are also prevalent in other countries, particularly in some European nations and the Far East, where the incidence is higher than in the United States. We believe the potential international market for home oxygen is expected to grow to 150% of the U.S. market over the next five to ten years.

The primary oxygen supply options for home patients are concentrators that concentrate oxygen from the ambient air (85-90%), reservoirs containing liquid oxygen (10-15%), and cylinders containing compressed gaseous oxygen (less than one percent (1%)).

Standard oxygen delivery systems are characteristically inefficient, permitting over 67% of the oxygen supply delivered to the patient to be wasted, primarily because the oxygen is administered steadily to the patient, even while he is exhaling. Since the normal breathing cycle consists of an exhalation period that is approximately twice as long as the inhalation period, at least two-thirds (2/3) of

the oxygen from this continuous flow system is wasted. Furthermore, it is generally accepted that the oxygen breathed in during the first one-third (1/3) of the inhalation period provides most of the oxygenation benefit to the patient.

Currently Medicare provides a prospective flat-fee monthly payment for home oxygen services based solely on the patient’s prescribed oxygen requirement and disregards modality, the type of system in use. In accordance with the federal budget reconciliation bill approved by the Senate in February 2006, title to oxygen equipment transfers to the beneficiary after 36 months. Consequently, with the incentive to operate efficiently, inexpensive concentrators have grown in popularity because of their low cost and less frequent servicing requirements. At the same time, interest in oxygen conserving devices, which can extend the life of oxygen supplies and reduce service calls by dealers, has heightened. There is also a separate fixed allowance from Medicare for patients who need to be mobile and therefore require portable oxygen systems.

In November 2003 Congress enacted the Medicare Improvement and Modernization Act, which had and will continue to impact reimbursement for home oxygen over the next several years. The new legislation will result in continued pressure on home care providers to reduce the cost of providing home oxygen services.

While these cost pressures have intensified, mobility has increased in importance as the treatment of pulmonary patients has moved away from hospitals and into home care. Also, the American Lung Association has advised that, to reduce and control symptoms, pulmonary patients should live a healthy lifestyle that includes exercise. Maintaining quality of life and compliance with prescribed exercise programs require that the patient be as mobile as possible and thus increase the demand for portable oxygen equipment.

CHAD’s Products

Since its inception, the Company has recognized the need for more efficient oxygen delivery systems and has pursued the development and marketing of devices that are designed to conserve oxygen. The benefits of such improvements include substantial cost savings for the home care provider, as well as increased mobility for ambulatory patients who require portable oxygen supplies. These devices extend the life of oxygen supplies and make possible more compact and longer lasting portable systems, thereby improving the quality of life for home oxygen patients.

OXYMIZER^{^®} and OXYMIZER Pendant Oxygen-Conserving Devices. In June 1983 the Company began marketing its first product, the OXYMIZER disposable oxygen-conserving device, a unique, patented, disposable device developed to provide up to four-to-one (4:1) savings of oxygen as compared to continuous flow when used with any oxygen supply source.

The OXYMIZER device contains a collapsible reservoir that captures incoming oxygen delivered during expiration and prevents its waste. The oxygen captured in this reservoir is then inhaled by the patient during the first instant of his next inspiration. Thus the OXYMIZER device both conserves oxygen and provides the patient with an extra rich supply of oxygen at the beginning of the inhalation period when it can be most effectively utilized.

Extensive clinical testing and trials over the past 22 years have repeatedly demonstrated that patients using the OXYMIZER device are able to achieve equivalent blood oxygenation levels while using significantly less oxygen. There have been more than 32 clinical evaluations from institutions worldwide that have confirmed the efficacy and oxygen savings of the OXYMIZER devices.

The greater efficiency provided by these devices over standard oxygen delivery systems also permits home health care patients to achieve greater mobility by enabling them to use smaller portable cylinders or by obtaining two (2) to four (4) times the life from standard sized portable cylinders.

For home oxygen dealers, the disposable OXYMIZER devices afford the cost advantages of oxygen conservation without capital investment in expensive equipment. In addition, the OXYMIZER devices can be utilized to achieve higher flow setting equivalencies for standard oxygen concentrators.

In hospitals, the OXYMIZER devices are used for maintenance of certain patients requiring higher flow levels of oxygen without having to resort to uncomfortable oxygen masks.

The Company is pursuing a marketing strategy that emphasizes the cost savings, efficiencies, and level of patient comfort associated with the use of the OXYMIZER devices. See “Marketing” and “Competition.”

The OXYMIZER Pendant device is similar to the OXYMIZER device except that its reservoir is located in a “pendant” that hangs over the patient’s chest rather than under the nose. The OXYMIZER Pendant has a more traditional appearance than the OXYMIZER. The Company began marketing the OXYMIZER Pendant in August 1984.

OXYMATIC^{^®} Electronic Oxygen Conservers. The Company began marketing the OXYMATIC conserver in March 1986. This product is a small electronic device designed for use with portable oxygen systems. The OXYMATIC conserver electronically senses the optimal moment in the breathing cycle for delivery of oxygen and at that moment, releases a very brief pulse of oxygen to the patient. The OXYMATIC conserver concentrates the administration of oxygen during the first one-third (1/3) of the inhalation phase, when oxygen is most efficiently utilized. There have been at least 12 controlled clinical trials and studies of patient groups using the OXYMATIC conserver, all of which have confirmed its efficacy and efficiency.

In July 2000 the Company introduced the first of the OXYMATIC 400 series of conservers. Additional models were added to this line in January and March of 2001. This new line of conservers was designed to capitalize on the proven reliability and efficiency of the Company’s previous models. In addition, features and options were added to create state-of-the-art conservers that would give home care providers a wide choice of products to service their patients’ individual needs and preferences. These new conservers include a built-in regulator and expanded flow rates that provide average savings of five-to-one (5:1) over continuous flow oxygen.

In November 2001 the Company introduced the SEQUOIA OXYMATIC line of conservers. These conservers utilize the same electronic features as the OXYMATIC 400 series conservers but do not contain a built-in regulator.

LOTUS Electronic Oxygen Conserver. The Company received clearance from the Food and Drug Administration (FDA) to market the LOTUS Electronic Oxygen Conserver in October 2004 and began shipment of the device in November 2005. The LOTUS weighs less than one (1) 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 (4) months of normal usage on two (2) AA-size batteries.

CYPRESS OXYPneumatic^{^®} Conservers. In July 2002 the Company began marketing the CYPRESS pneumatic conserver, which allowed the Company to compete in the pneumatic segment of the conserver market for the first time. This device incorporates no electronic parts, thus eliminating the need for batteries. It is lightweight, small and allows the use of a standard, single-lumen cannula, unlike

many other pneumatic conservers that require special cannulas. The CYPRESS conserver provides flow rates from one (1) to six (6) liters per minute and oxygen savings greater than three-to-one (3:1) over continuous flow oxygen.

Sales of OXYMATIC electronic and CYPRESS OXYPneumatic conservers accounted for approximately 70%, 73%, and 77% of the Company’s sales in 2006, 2005, and 2004, respectively.

The OXYMATIC electronic and CYPRESS pneumatic conservers extend the length of time the contents of the cylinders will last over continuous flow oxygen. They provide ambulatory patients with greater mobility and less weight. The Company believes these systems offer a superior alternative to commonly used liquid oxygen systems for mobile patients and are more cost effective for home care dealers to supply.

SAGEOxygen Therapeutic Device. In May 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. The SAGE device combines the industry’s first truly dynamic, patented delivery technology with the proven oxygen sensor technology in the Company’s OXYMATIC 400 series conserver. As a result, the device addresses the common problem of oxygen desaturation, which causes a patient to feel weak and out of breath when activity increases, yet it still maximizes patient ambulatory capability.

OXYCOIL^{^®} Coiled Oxygen Tubing. In January 1986 the Company began marketing the OXYCOIL coiled oxygen tubing, a device which replaces the standard supply tubing for the OXYMIZER devices, the OXYMATIC conservers or conventional nasal cannulas. The OXYCOIL tubing is a convenience and a safety device that can be used with any oxygen system to help keep the supply tubing out of the patient’s way, thus minimizing the tripping and tangling problems associated with standard supply tubing.

TOTAL O₂^{^®} Delivery System. In January 1998 the Company began marketing the TOTAL O₂Delivery System. This system provides stationary oxygen for patients at home, portable oxygen including an oxygen conserving device for ambulation, and a safe and efficient mechanism for filling portable oxygen cylinders. The TOTAL O₂Delivery System was designed to provide home care dealers with a more cost effective means to provide home oxygen services while at the same time providing the patients with a higher quality of service. This can be accomplished as the home care dealer will no longer be required to make regular monthly service calls to deliver full portable cylinders, and the patient will no longer be dependent on the dealer for those deliveries to obtain full cylinders.

Initial sales of the TOTAL O₂ system 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 system to achieve the lower monthly operating costs it affords. Recent changes in home oxygen reimbursement appears to be causing home care providers to examine their operating costs more carefully, which should have a positive impact on sales of the TOTAL O₂system. No assurances can currently be given regarding the level of success the Company may achieve with the TOTAL O₂ system. See Outlook: Issues & Risks — New Product in the Company’s Annual Report to Shareholders.

The technology for each of the devices described above has been licensed from the inventors thereof, with the exception of the CYPRESS OXYPneumatic and Lotus conservers, which belongs to the Company. The Company has acquired exclusive licenses to manufacture and market the OXYMIZER devices, the OXYMATIC conservers, the SAGE device, the OXYCOIL tubing, and the TOTAL O₂ system. See “Licensing and Related Agreements.”

Sales of the TOTAL O₂ system accounted for approximately 10.7%, 9.6%, and 5.6% of the Company’s sales in 2006, 2005, and 2004, respectively.

Other Products. The Company also offers a variety of ancillary products that support the principal oxygen conserving products. These include oxygen cylinders of various sizes and compositions, regulators, cannulas and connecting tubing, and assorted carrying bags. In addition, with a field sales force of manufacturer’s representatives and direct sales representatives covering the entire United States (see “Marketing”), the Company will utilize this team as part of a strategy to market and sell additional products that are targeted for the Company’s current customer base, the home care provider.

Products Under Development

It is the Company’s objective to continuously improve and add to its oxygen conserving and related products. During the fiscal years ended March 31, 2004 and 2003, the Company entered into contracts with outside vendors to develop products in the home oxygen market and sleep disorder market. Development efforts continue on these products, some of which have begun pre-clinical testing. No assurance can be given that any products developed pursuant to these contracts will be successfully marketed or that the Company will ever derive significant revenues or earnings from the sale of such products.

Research and Development

For the year ended March 31, 2006, the Company expended approximately $1,574,000 on research and development and has expended approximately $10,666,000 since its inception in August of 1982. The Company operates in an industry that is subject to rapid technological change, and its ability to compete successfully depends upon, among other things, its ability to stay abreast or ahead of new technological developments. Accordingly, the Company expects to expend increasing amounts for the development or acquisition of new products or the improvement of existing products. In the next fiscal year the Company expects to spend approximately $1,500,000 on several projects. The Company conducts research and development internally and also utilizes the services of outside firms and consultants for its research and development activities.

Licensing and Related Agreements

The Company has entered into license agreements (the “Inventor’s License Agreements”) with Brian L. Tiep, M.D., Robert E. Phillips, and Ben A. Otsap, the inventors of the OXYMIZER device (the “Inventors”), with respect to that device and each of the additional oxygen conserving devices developed by them.

Pursuant to the Inventor’s License Agreements, the Inventors grant to the Company an exclusive license (with the right to grant sublicenses) to manufacture, use, and sell such device. Through September 2003, the Inventor’s License Agreements provided that the Company pay royalties to the Inventors on the net proceeds of sales of the device covered by the agreement at the rate of six percent (6%) on amounts up to ten (10) million dollars and three percent (3%) on amounts of ten (10) million dollars or more. The Inventor’s License Agreements also provided that the Company pays minimum advance royalties for each license year in the amount of $10,000. The advance payments are to be applied toward royalties payable for the corresponding license year. As of September 2003, no further royalty payments are due. The Company is obligated to prosecute and defend, at its own expense, any infringement suits related to manufacture or sale of each device covered by any such agreement.

Each Inventor’s License Agreement continues until the expiration of the last to expire of any patent covering the related device or, if no patent is issued, for 17 years. The Inventors may terminate the Inventor’s License Agreements at an earlier date if the Company is in arrears for 60 days on any royalty payment or if the Company defaults in performing any other term of the agreement and fails to cure such default within 60 days.

The Company has also entered into a license agreement (the “Carleton License Agreement”) with the Life Support Division of Carleton (formerly Litton Life Support) for the TOTAL O₂ Delivery System. Pursuant to the Carleton License Agreement, the Licensor grants to the Company an exclusive license (with the right to grant sublicenses) to manufacture, use, and sell such device in the health care market. The Carleton License Agreement provides that the Company pay royalties to the Licensor on the net proceeds of sales of the device covered by the agreement at the rate of seven percent (7%) and requires minimum annual royalties of $100,000, $300,000, and $500,000 in 1999, 2000, and subsequent years, respectively. The Carleton License Agreement continues until the expiration of the last to expire of any patent covering the related device or until the Company ceases use of the licensed technology. The Licensors may terminate the Carleton License Agreement at an earlier date if the Company is in arrears for 30 days on any royalty payment or if the Company defaults in performing any other material obligation of the agreement and fails to cure such default within 30 days.

The Company has also entered into a license agreement (the “Phillips and Otsap License Agreement”) with Robert E. Phillips and Ben A. Otsap for the SAGE Oxygen Therapeutic Device. Pursuant to the Phillips and Otsap Agreement, the Licensor grants to the Company an exclusive license (with the right to grant sublicenses) to manufacture, use, and sell such devices in the health care market. The Phillips and Otsap License Agreement provides that the Company pay royalties to the Licensor on the net proceeds of sales of the device covered by the agreement at the rate of three percent (3%) for unit sales up to 1,499 units, four percent (4%) for unit sales from 1,500 to 1,999 units per month, five percent (5%) for unit sales from 2,000 to 2,499 units per month and six percent (6%) for unit sales of 2,500 or more per month. The agreement also requires minimum annual royalties of $15,000 in the first year after FDA clearance is received to market the product and $30,000 per annum thereafter. The Phillips and Otsap License Agreement continues until the expiration of the last to expire of any patent covering the related devise or until the Company ceases use of the licensed technology. The Licensors may terminate the Phillips and Otsap License Agreement at an earlier date if the Company is in arrears for six (6) days on any royalty payment or if the Company defaults in performing any other material obligation of the agreement and fails to cure such default within 30 days.

Manufacturing and Sources of Supply

The Company tests and packages its products in its own facility and performs some manufacturing operations on certain products. Some manufacturing processes are conducted by other firms, and the Company expects to continue using outside firms for certain manufacturing processes for the foreseeable future. All outside manufacturing is conducted under the supervision and control of the Company and with tooling provided by the Company.

Pursuant to a written agreement, the Company purchases finished units of the OXYMIZER devices from a supplier in Hong Kong. The Company believes that other injection molding facilities would be available in the event of a termination of this arrangement.

Production of the OXYMATIC 300 series, 2400, and 400 series conservers, the LOTUS, the CYPRESS pneumatic conservers, and the SAGE Oxygen Therapeutic Device are being handled internally with only a portion of the electronic assembly for electronic conservers being subcontracted outside the Company. The Company is currently subcontracting with two (2) electronic assembly facilities and believes that other facilities would be available in the event of an interruption of supply from the existing facilities.

Production of the TOTAL O₂ system is being handled internally with a number of subassemblies being subcontracted outside the Company. The Company believes that there are alternate sources of supply for these subassemblies, including internal manufacturing as production quantities increase.

The Company is not aware of any shortages of materials necessary for the manufacture of its products. The Company provides customers the right to return merchandise for credit and requires payment within a time frame consistent with industry standards. The Company provides warranties for certain of its products based on industry standards and accrues for the estimated expenses associated with those warranties based on the best information available, primarily historical claims experience.

The Company has received ISO 13485 certification for its manufacturing facility based on criterion developed by the International Organization for Standardization, a quality standards organization with headquarters in Geneva, Switzerland. The Company has also received authorization for the same facility under the European Union’s Medical Devices directive, to affix the “CE Mark” to the Company’s products marketed throughout the world. The primary component of the certification process was an audit of the facility’s quality systems conducted by an independent agency authorized to perform conformity assessments under ISO guidelines and the Medical Devices Directive.

Marketing

The Company’s products are designed to reduce the cost of health care while maintaining or enhancing the therapeutic benefits to the patient and improving the user’s quality of life. The Company’s marketing efforts have focused primarily on providing home oxygen suppliers with products that they can utilize to increase their revenues and provide a better quality of care at less cost.

Home care dealers have reportedly increased their revenues by assembling small portable systems incorporating the Company’s OXYMATIC electronic conserver or CYPRESS pneumatic conserver as a vehicle to attract new and additional patients to their business. The Company believes these lightweight, long-lasting, portable systems have both high professional and patient acceptance that allows the supplier promoting these products to attract new and additional customers.

A large portion of home oxygen patients is covered by Medicare or other government programs. Since June 1989 home oxygen suppliers have been reimbursed on a fixed, monthly-fee basis by Medicare. The monthly reimbursement amount does not vary with either the type of oxygen delivery equipment provided or the amount of oxygen supplied. Since monthly, per-patient revenues are fixed, home oxygen suppliers can only increase their per-patient profitability by reducing costs. The Company’s oxygen conserving products and TOTAL O₂ Delivery System allow these suppliers to decrease their costs while providing their patients with improved therapeutic benefits and quality of life.

While the home respiratory care dealer remains the primary focus of the Company’s marketing efforts, this focus has been augmented by a major effort to increase professional awareness. Promotional programs target respiratory care physicians, nurses, and therapists.

The Company markets its products directly to home oxygen suppliers throughout the U.S. The Company currently has a Vice President of Sales & Marketing, two (2) Regional Vice Presidents of Sales, a Director of Strategic Sales and Marketing, a manager of sales administration, an art and media manager, a marketing manager, a customer relations manager, and five (5) in-house sales and customer service representatives who are in regular and frequent proactive telephone sales contact with customers and potential customers. In addition, the Company has a field sales force of direct sales representatives and independent manufacturer’s sales representatives to handle direct selling to customers. This field sales force is currently comprised of six (6) direct sales representatives and 21 manufacturer’s sales representatives with coverage throughout the United States. The Company also utilizes direct mail, trade

show attendance, trade advertising, and a web site to promote the benefits of its products to home care dealers. Additionally, the Company actively seeks to increase professional awareness of its products through professional advertising and participation in professional meetings.

Home oxygen therapy markets outside the United States are, in most cases, at a much earlier stage of development. In many countries, these patients are cared for in institutional settings. As the trend develops to move patients into home care, opportunities for the Company’s products should increase. Sales of conservers in Europe, Canada, and Japan have become an important part of the Company’s business. Based on industry market research projections, the Company expects the international market to increase to 150% of the U.S. potential over the next five (5) to ten (10) years.

The Company has entered into exclusive distributorship agreements in Germany, Japan, Australia, and several other countries. The Company also has non-exclusive distributors in many other countries.

Sales outside of the United States subject the Company to certain risks, including those involving political and economic factors, interruption of shipments of products, currency fluctuations and devaluations, and governmental restrictions and regulations.

Customers, Backlog and Orders

The Company presently has an active list of over 4,000 dealer and hospital customers. Based upon information developed from various lists the Company believes that there are approximately 7,000 to 8,000 home oxygen dealers and 3,000 general hospitals in the United States that are potential customers or customer sources for the Company. Of these 7,000 to 8,000 home care providers, approximately 48% are represented by three (3) major national chain accounts. One (1) national chain customer accounted for 36%, 36%, and 27% of net sales during 2006, 2005, and 2004, respectively, and one (1) other chain accounted for 11% and 14% of sales in 2005 and 2004, respectively. One non-chain customer accounted for 11% of sales in 2006.

Financial Information Relating to Foreign and
Domestic Operations and Export Sales
(in 000’s)


	2006		2005		2004

Sales
United States	$	17,996	$	22,912	$	20,498
Canada		193		306		303
Japan		506		405		238
Europe		3,337		418		278
All other countries		322		246		224

Total	$	22,354	$	24,287	$	21,541

All identifiable assets are located in the United States.

At March 31, 2006, the Company had no backlog of orders for any of its products. The Company presently endeavors to maintain sufficient inventory to ship all of its products immediately upon receipt of orders. The Company believes that maintaining such levels of inventory is necessary to meet the requirements of its customers.

Competition

Competition in the Company’s market has increasingly focused upon pricing, rather than product features. The Company is aware of several demand-valve, electronically controlled devices currently being marketed. Of these devices, those that have been the principal competitors of the OXYMATIC conserver in the past were targeted primarily to a specific segment of the market — liquid oxygen usage. Several companies, including Caire Inc. and Puritan Bennett, market small (3.4 to 5.5 pounds) portable liquid oxygen systems incorporating simple oxygen conserving devices that double the useful life of these systems. Some of these companies have substantially greater marketing and financial resources than the Company. However, these units are more expensive than systems utilizing the OXYMATIC conservers and still require the supplier to make frequent and costly oxygen deliveries. The Company does not know the levels of sales achieved by the companies marketing these systems.

Several of these competitors are now marketing conservers in direct competition with the Company’s OXYMATIC electronic and CYPRESS pneumatic conservers. Some of these conservers provide only two-to-one (2:1) to three-to-one (3:1) savings ratios compared to continuous flow. As a result, these units, while weighing about the same as the OXYMATIC conserver, provide only one-third (1/3) or one-half (1/2) as much ambulation time. In addition, the Company is aware of two (2) companies marketing oxygen conserving devices that claim similar oxygen savings ratios as the OXYMATIC conserver. The Company believes that some of these competitors have been able to offer their oxygen conservers as part of a bundle of products with perceived pricing advantages over the Company’s products. The Company does not know the level of sales achieved by these companies.

There are several other types of portable oxygen systems which compete with the Company’s OXYMATIC conservers but do not utilize oxygen conserving devices. Aluminum and steel oxygen cylinders with continuous flow regulators are utilized by some oxygen suppliers as portable systems. Although they do provide users with some portability, their size and bulk limit their use by patients who need or want to be truly ambulatory. The most commonly used of these cylinders is approximately three (3) feet high, weighs over 20 pounds, and provides an average patient with less than five (5) hours of oxygen. These systems are enjoying some level of success due to their lower unit-price advantage. The OXYMATIC electronic and CYPRESS pneumatic conservers allow the use of smaller, lighter cylinders and thus provides greater mobility.

Until the availability of portable systems utilizing the OXYMATIC conservers and the previously cited changes in Medicare oxygen reimbursement, liquid oxygen was the modality of choice for truly mobile users. Portable liquid oxygen systems that weigh 3.4 to 10 (ten) pounds, provide an average patient with six (6) to eight (8) hours of oxygen, compared to the smallest OXYLITE system which weighs 4.5 pounds and provides an average patient with 7.3 hours of oxygen. These systems are more costly than systems utilizing the OXYMATIC conservers and require frequent and expensive (often weekly) deliveries of bulk liquid oxygen to the patient’s home. In addition, the patient must remain within range of the base unit for refilling, unlike with the systems utilizing the OXYMATIC conservers with which a patient can take as many cylinders as needed to provide the amount of time necessary to be away from the base unit.

The Company is aware of one (1) combination oxygen concentrator and refilling station being marketed in competition with the TOTAL O₂ system. This system is larger and heavier and does not contain some of the integrated features found in the TOTAL O₂ system. In addition, another competitor has recently introduced a refilling station that also competes with the TOTAL O₂ system. These competitors have substantially greater financial and marketing resources than the Company and have used these resources to aggressively market their products. The Company does not know the level of sales achieved for these systems by the competition.

Patents and Trademarks

The Company regards the products that it develops or licenses and its manufacturing processes as proprietary and relies on a combination of patents, trademarks, trade secret laws, and confidentiality agreements to protect its rights in its products. U.S. patents have been issued covering the original OXYMATIC conserver, the Lotus conserver, the CYPRESS OXYPneumatic conserver, the TOTAL O₂ Delivery System, and the SAGE Oxygen Therapeutic Device. A number of foreign patent applications pertaining to the Company’s activities have also been issued.

The Company pursues a policy of obtaining patents for appropriate inventions related to products marketed or manufactured by the Company. The Company considers the patentability of products developed for it 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 could have an adverse impact upon the Company’s business.

There can be no assurance that patents, domestic or foreign, will be obtained with respect to the Company’s products, or that, if issued, they will provide substantial protection or be of commercial benefit to the Company. In addition, the patent laws of foreign countries may differ from those of the United States as to the patentability of the Company’s products and processes and, accordingly, the degree of protection afforded by foreign patents may be more or less than in the United States.

In the United States, although a patent has a statutory presumption of validity, the issuance of a patent is not conclusive as to such validity or as to the enforceable scope of its claims therein. The validity and enforceability of a patent can be attacked by litigation after its issuance by the U.S. Patent and Trademark Office. If the outcome of such litigation is adverse to the owner of the patent in that the patent is held to be invalid, other parties may then use the invention covered by the patent. Accordingly, there can be no assurance that patents with respect to the Company’s products, if issued, will afford protection against competitors with similar products, nor can there be any assurance that the patents will not be infringed upon or designed around by others.

Through patent searches, contacts in the industry, and representations and indemnities received from licensors and development partners, the Company seeks to ensure that its products do not infringe on the intellectual property rights claimed by others. However, interpretation of the scope and validity of existing patent rights may differ, and no assurance can be given that the Company products will in all cases not infringe on the rights of others. Moreover, any dispute regarding potential infringement may require substantial management and financial resources to defend.

The Company has obtained U.S. registration for the trademarks “OXYMIZER,” “OXYMATIC,” “LOTUS,” “OXYPneumatic,” “CHAD,” “OXYCOIL,” and “TOTAL O_2.” A series of foreign applications to register the trademark “OXYMIZER” in a number of countries of commercial interest to the Company have been filed.

Governmental Regulation

The commercialization of the OXYMIZER, OXYMATIC, LOTUS, CYPRESS, TOTAL O_2,and SAGE devices is subject to the Federal Food, Drug and Cosmetic Act (the “Food and Drug Act”) and to regulations issued thereunder. The Company anticipates that commercialization of other devices that it intends to market will also be subject to the Food and Drug Act. The Food and Drug Act is administered by the FDA, which has authority to regulate the marketing, manufacturing, labeling, packaging, and distribution of products subject to the Food and Drug Act. In addition, there are requirements under other federal laws and under state, local, and foreign statutes that may apply to the manufacture and marketing of the Company’s products. The Medical Device Amendments of 1976 to the Food and Drug

Act (the “Amendments”) and the Safe Medical Device Act of 1990 significantly extended the authority of the FDA to regulate the commercialization of medical devices. The Amendments established three (3) classifications of medical devices: Class I, Class II, and Class III. With respect to all three (3) classes, the general provisions of the Food and Drug Act prohibit adulteration and misbranding. A medical device may be adulterated if the device is or could be adversely affected by its methods of manufacture, storage, or packaging. A medical device may be misbranded if its labeling is false or misleading or if its labeling does not contain specific information required by law applicable to such type of device. In addition, failure to register a medical device covered under the Food and Drug Act will render it misbranded under the Food and Drug Act.

All manufacturers of medical devices must register with the FDA and list all medical devices produced by them. This listing must be updated annually. In addition, prior to commercial distribution of additional devices, the manufacturer must file with the FDA and receive approval prior to the commencement of such commercial distribution, a notice setting forth certain information about the device, including the classification into which the manufacturer believes it falls.

Class I devices are subject only to the general controls concerning adulteration, misbranding, good manufacturing practices, record keeping, and reporting requirements. Class II devices must, in addition, comply with performance standards as promulgated by the FDA.

The Company has registered with the Bureau of Medical Devices of the FDA as a Medical Device Establishment and with the Department of Health Services of the State of California as a Medical Device Manufacturer. In addition, the Company has developed procedures to comply with FDA standards concerning good manufacturing practices, record keeping, and reporting and is ISO 134850 certified.

The Company has been granted permission by the FDA to market the OXYMIZER and the OXYMIZER Pendant as Class I devices. Permission has been granted to market the OXYMATIC, the CYPRESS OXYPneumatic, the LOTUS Electronic Oxygen conserver, the OXYCOIL, the TOTAL O₂ Delivery System, and the SAGE Oxygen Therapeutic Device as Class II devices.

Employees

As of June 27, 2006, CHAD had 115 full-time employees and two (2) part-time employees with 57 of the Company’s employees engaged in manufacturing and the remaining are engaged in marketing, sales, administration, and management. None of the Company’s employees is represented by unions, and the Company believes its employee relations are satisfactory. The Company will employ additional personnel in all phases of its activities as required by the growth in its activities. The number of additional personnel will be dependent on sales levels of individual products.

Item 1A. Risk Factors.

Because of the following risk factors, past performance may not be indicative of our future operating results. Forward-looking statements in this report reflect the Company’s current views and expectations. However, such forward looking statements are subject to the risks and uncertainties described herein which may cause future operating results to differ materially from currently anticipated results.

Our future results depend upon our ability to successfully introduce new products.

We operate in a market which is subject to continuing technological change. In order to stay abreast of new technological developments, we must continually improve our products. Moreover, there

is significant price pressure on our primary product line, oxygen conservers. As a result, in order to mitigate the price pressure on our conservers, we must introduce innovative new products and we are seeking to expand our product offerings.

There are a number of significant risks involved with new product introductions. Problems encountered in the design and development of new products or in obtaining regulatory clearances to market the products may impair our ability to timely introduce any new product. Competitors may leapfrog our development efforts, particularly if our development efforts are delayed.

The commercial success of any new products we do introduce will depend upon the health care community’s perception of such product’s capabilities, clinical efficacy and benefit to patients. In addition, prospective sales will be impacted by the degree of acceptance achieved among home care providers and patients requiring supplementary oxygen. Our prospective customers may be reluctant to try unproven products which we introduce. Our ability to successfully introduce new products in a new market sector such as the sleep disorder market will also be complicated by our lack of experience in this market. Thus, the success of any new products we may introduce is unpredictable and our future results may suffer if we are unable to successfully introduce new products.

Our operating results, profitability and operating margins have been adversely affected by price pressure on our principal products.

During the past several years, there has been significant price pressure on oxygen conservers and therapeutic devices. Thus, though our unit sales of conservers and therapeutic devices in fiscal 2006 was roughly the same as in fiscal 2005, revenues from the sales of such products declined by 11.3%. This trend is magnified by the continuing consolidation of the home care industry as national chains typically negotiate for quantity discounts. We expect continuing price pressure on our principal products for the foreseeable future.

We are highly dependent upon a limited number of large customers, which may increase the volatility of our future operating results.

The home health care industry is undergoing significant consolidation. As a result, the market for our products is increasingly influenced by major national chains. Four major national chains accounted for 43% of our sales for the year ended March 31, 2006, down from 53% in the prior year. One customer accounted for 36% of sales in both fiscal 2006 and 2005. One non-chain customer accounted for 11% of sales for the year ended March 31, 2006. Future sales may be increasingly dependent upon a limited number of customers which increases the risk that our financial performance may be adversely affected if one or more of these customers reduces their purchases of our products or terminates its relationship with us. During the past two years, a significant decline in orders from one national chain contributed to our decline in revenues.

We are dependent upon a single product line, which increases our vulnerability to adverse developments affecting the market for supplementary oxygen.

Although we market a range of products, all of our current products are designed for patients requiring supplementary oxygen. Unlike some of our competitors, we are not a diversified provider of home health care products. As a result, our future performance is dependent upon developments affecting this narrow segment of the health care market. Adverse regulatory or economic developments affecting the market for supplementary oxygen will have a significant impact on our performance.

Changes and prospective changes in the administration of health care may disrupt the market for our products, resulting in decreased profitability.

Approximately 80% of home health care patients are covered by Medicare and other government programs. Federal law has altered the payment rates available to providers of Medicare services. The Medicare Improvement and Modernization Act of 2003 has resulted in several years of reductions in reimbursement for home oxygen. In February 2006, reimbursement procedures were modified again, with a new requirement that ownership of home oxygen equipment be transferred to the patient after 36 months. New proposals related to reimbursement for home health care are routinely introduced in Congress.

As a result, we expect changes in reimbursement policies to continue to exert downward pressure on the average selling price of our products. Moreover, the uncertainty resulting from constant change in reimbursement policies has had a deleterious affect upon our market, causing many home care providers to delay or cut back their product purchase plans as they seek to evaluate the impact of the new policies.

We operate in a highly competitive environment which has contributed to our reduced operating margins.

Our success in the early 1990s drew a significant number of competitors into the home oxygen market. Some of these competitors have substantially greater marketing and financial resources compared with those of the Company. While we believe that our product features and reputation for quality will continue to be competitive advantages, we note that our market is increasingly dominated by price competition. Some of our competitors have successfully introduced lower priced products that do not provide oxygen conserving capabilities comparable to our products. We expect competition to remain keen, with continuing emphasis on price competition for oxygen conservers and therapeutic devices.

If we are unable to stay abreast of continuing technological change, our products may become obsolete, resulting in a decline in sales and profitability,

The home health care industry is characterized by rapid technological change. Our products may become obsolete if we do not stay abreast of such changes and introduce new and improved products. We have limited internal research and development capabilities. Historically, we have contracted with outside parties to develop new products. Some of our competitors have substantially greater funds and facilities to pursue development of new products and technologies. If we are unable to maintain our technological edge, our product sales will likely decline, as will our profitability.

Failure to protect our intellectual property rights could result in a loss of market share.

The success of our business is dependent to a significant extent upon our ability to develop, acquire and protect proprietary technologies related to the delivery of supplementary oxygen. We pursue a policy of protecting our intellectual property rights through a combination of patents, trademarks, license agreements, confidentiality agreements and protection of trade secrets. To the extent that our products do not receive patent protection, competitors may be able to market substantially similar products, thereby eroding our market share. Moreover, claims that our products infringe upon the intellectual property rights of any third party could impair our ability to sell certain products or could require us to pay a license fee, thereby increasing our costs.

Our profitability would be adversely affected if we incur uninsured losses due to product liability claims.

The nature of our business subjects us to potential legal actions asserting that we are liable for personal injury or property loss due to alleged defects in our products. Although we maintain product liability insurance in an amount which we believe to be customary for our size, there can be no assurance that the insurance will prove sufficient to cover the costs of defense or and adverse judgments entered

against the Company. To date, we have not experienced any significant losses due to product liability claims. However, given the use of our products by infirm patients, there is a continuing risk that such claims will be asserted against us.

Our dependence upon third party suppliers exposes us to the risk that our ability to deliver products may be adversely affected if the suppliers fail to deliver quality components on a timely basis.

While we perform most of our manufacturing internally, some of our products depend upon components or processes provided by independent companies. We expect to continue to use outside firms for various processes for the foreseeable future. From time to time, we have experienced problems with the reliability of components produced by third party suppliers. We do not have any long term supply contracts that are not readily terminable and we believe there are alternative sources of supply with respect to all the components we acquire from third parties. Nonetheless, any reliability or quality problem encountered with a supplier could disrupt our manufacturing process, thereby delaying our ability to timely deliver product and potentially harming our reputation with our customers.

Item 1B. Unresolved Staff Comments.

None.

Item 2. Properties.

The Company’s offices and manufacturing facilities are situated in premises located in Chatsworth, California, and consist of approximately 55,500 square feet, at a monthly rental fee of $34,000 pursuant to a lease expiring in June 2008. Management believes this facility should adequately handle the Company’s needs for the foreseeable future. The Company does not own any real property and does not anticipate acquiring any in the foreseeable future.

Item 3. Legal Proceedings.

The Company becomes involved in legal proceedings in the ordinary course of business. The Company maintains product liability insurance in an amount it deems customary in the industry for protection of the Company against potential product liability claims. Although the Company believes its product liability insurance is sufficient and no pending legal proceeding poses a material threat, no assurance can be given that pending or future proceedings will not have a material impact on the Company’s financial condition or results of operations.

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

Not applicable.

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

The information required herein is hereby incorporated by reference to the information contained under the caption “Corporate Data” in the Company’s Annual Report.

Item 6. Selected Financial Data.

The information required herein is hereby incorporated by reference to the information contained under the caption “Selected Financial Data” in the Company’s Annual Report.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The information required herein is hereby incorporated by reference to the information contained under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report.

Item 7a. Quantitative and Qualitative Disclosures about Market Risk.

The Company has no significant exposure to market risk sensitive instruments or contracts.

Item 8. Financial Statements and Supplementary Data.

The information required herein is hereby incorporated by reference to the Financial Statements and the Notes thereto contained in the Company’s Annual Report.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

None.

Item 9A. Controls and Procedures.

(a) Evaluation of Disclosure Controls and Procedures. An evaluation as of the end of the period covered by this report was carried out under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and Rule 15d – 15 (e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective to ensure that we record, process, summarize, and report information required to be disclosed by us in our reports filed under the Securities Exchange Act within the time periods specified by the Securities and Exchange Commission’s rules and forms.

(b) Changes in Internal Control Over Financial Reporting. There have not been any changes in the Company’s internal control over financial reporting during our fourth (4th) fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting

Item 9B. Other Information.

None

PART III

Item 10. Directors and Executive Officers of the Registrant.

The Directors in Class I and Class II have supplied the following information pertaining to their age and principal occupation or employment during the past five (5) years:


Name	Age	Position	Director Since

Class I
Philip T. Wolfstein (1) (2) (3)	55	Director	1994
James M. Brophy (1) (2) (3)	56	Director	2000
Kathleen M. Griggs (1) (3) (4)	51	Director	2003

Class II
Thomas E. Jones	62	Chairman and Director	1997
John C. Boyd (2) (3)	73	Director	1986
Earl L. Yager	60	Chief Executive Officer, President and Director	1988


(1)		Member of Audit Committee

(2)		Member of Compensation Committee

(3)		Member of Corporate Governance Committee

(4)		Audit Committee Expert

Class I Directors

Philip T. Wolfstein has been a director of the Company since October 1994. As of April 2005, Mr. Wolfstein is an International Trade consultant. From July 2004 to 2005, Mr. Wolfstein was Executive Vice President of Sales, Marketing and Business Development for Bay World, Ltd. and, from June 2001 to 2004, was Managing Director, Southern California, for PM Global Food LLC. From 1976 to 2001, he was President and a Director of Wolfstein International, Inc., an international trading company. Mr. Wolfstein served on the Executive Committee of the United States Meat Export Federation (USMEF) from 1998 to 2004 and held all Board positions from Representative to Chairman from November 1997 to 2003. He is also a member of the USMEF’s exporter committee and remains actively engaged in eliminating trade barriers for U.S. products.

James M. Brophy has been a director of the Company since September 2000. Mr. Brophy is a hospital executive and from 2003 to 2005 he was the Senior Vice President of Truman Medical Centers. From 2001 to 2002, Mr. Brophy was the President of Missouri Baptist Medical Center. In 2000, Mr. Brophy was the Deputy Executive Director of Truman Medical Centers and from 1992 to 1999, Mr. Brophy was President of Saint Luke’s Northland and St. Luke’s Hospitals. Mr. Brophy has served in the health care field as a senior executive and administrator since 1974. Mr. Brophy is currently a Fellow of the American College of Healthcare Executives and is a past member of the Board of Directors of HealthNet, Premier Alliance Insurance Company, and the Illinois Hospital Association.

Kathleen M. Griggs has served as a director of the Company since September 2003. Ms. Griggs is currently a financial consultant and served as the Executive Vice President and Chief Financial Officer of SonicWALL, Inc., a publicly held Internet security system manufacturer from July 2003 to October 2004. Ms. Griggs served as Executive Vice President and Chief Financial Officer of QAD Inc., a publicly held provider of enterprise resource planning software, from March of 2000 to July of 2003. From 1999 to 2000, Ms. Griggs served as the chief financial officer of Adept Technology, a publicly held automation software and hardware manufacturer in San Jose, California. From 1997 to 1999, she served as CFO for Borland Software Corporation, a publicly held software company. Prior to that, she was

employed in several positions in accounting and financial management. Ms. Griggs has served as the Chief Financial Officer of publicly held companies for a total of eight (8) years and the Corporate Governance Committee has determined she has the expertise to serve as Chairman of the Audit Committee. Ms. Griggs received a Bachelor of Science degree in Business Administration from the University of Redlands and a Master of Business Administration degree from the University of Southern California in Los Angeles.

Class II Directors

Thomas E. Jones was elected Chairman effective January 1, 2003, and was Chief Executive Officer of the Company from April 1, 1998 to March 31, 2004, and a director since October 1997. From 1996 to 1997, Mr. Jones was an independent consultant to numerous companies in the health care field, including the Company from March 1997. From 1973 to 1996, Mr. Jones was employed by Nellcor Puritan Bennett Corporation and its predecessor, Puritan Bennett, Inc., a major manufacturer of respiratory products where Mr. Jones served in a number of positions leading up to Senior Vice President and General Manager of home care business from 1989 to 1996. Mr. Jones was a director of the Compressed Gas Association for 16 years, including a one-year term as Chairman, and was a director of the International Oxygen Manufacturers Association for eight (8) years. Mr. Jones is currently a member of the Engineering Advisory Board at the University of Kansas.

John C. Boyd has been a director of the Company since May 1986. Prior to his retirement in 1994, Mr. Boyd was General Manager of Dunaway Equipment Co., Inc., a company specializing in the sale and service of equipment in the logging industry. From 1982 to 1991, Mr. Boyd was President of Beaty Leasing & Rental, an automobile leasing and rental firm which he founded. From 1969 to 1982, he served as Personnel Director and Manager of Marketing Administration for Riker Laboratories, Inc., a major manufacturer and distributor of pharmaceuticals and health care products.

Earl L. Yager has served as a director of the Company since July 1988. Mr. Yager was appointed Chief Executive Officer effective April 1, 2004, and has served as the President of the Company since January 2003. Mr. Yager has also served as the Company’s Chief Operating Officer from September 2000 to April 2004, Executive Vice President from April 1999 to September 2000, Senior Vice President from April 1995 to September 2000, and as Chief Financial Officer from May 1983 to April 2004. Mr. Yager has been a certified public accountant since 1970 and is a member of the American Institute of Certified Public Accountants.

Board Compensation

Each non-employee director is entitled to receive his expenses and a fee of $1,000 for each Board meeting attended and $100 for each committee meeting attended unless the committee meeting occurs on the same day as the Board meeting, in which event, each non-employee director receives only the fee for attending a Board meeting. In addition, each non-employee director receives a quarterly retainer in the amount of $2,500, and the Audit Committee chairman receives a quarterly retainer in the amount of $3,250. Non-employee directors may receive equity grants upon their election to the Board and receive annual, restricted stock grants for common shares having a value of $20,000 on the date of the grant. Directors who are also employees do not receive separate compensation for services as directors.

Section 16 Beneficial Ownership Reporting

Under the Federal securities laws, the Company’s directors, its executive officers and any persons holding more than ten (10) percent of the Company’s common stock are required to report their ownership of the Company’s common stock and any changes in that ownership to the Securities and Exchange Commission on Form 3, for an initial report of securities ownership, and on Forms 4 or 5, for

reports of changes in security ownership. Such directors, executive officers and ten (10) percent shareholders are also required by Securities and Exchange Commission rules to furnish the Company with copies of all Section 16(a) forms they file. Specific due dates for these reports have been established and the Company is required to report in this Proxy Statement any failure to file by these dates during the most recent fiscal year or prior fiscal years. Based on the written representations of its directors and executive officers and its ten (10) percent shareholders and copies of the reports that they have furnished to the Company, the Company believes that the Company’s directors and executive officers and ten (10) percent shareholders timely filed all reports required under Section 16(a) in fiscal 2006.

Code of Ethics

We have adopted a Code of Business Conduct and Ethics that applies to our employees (including our principal executive officer, chief financial officer and controller). A copy of our Code of Business Conduct and Ethics can be found under the “Investor Relations” section of our website at www.chadtherapeutics.com. The information on our website is not incorporated by reference in this Form 10-K. We may post amendments to, or waivers of, the provisions of the Code of Business Conduct and Ethics, if any, made with respect to any of our directors and executive officers on that website.

Executive Officers

The executive officers of the Company are:


Name	Age		Position

Thomas E. Jones		62	Chairman
Earl L. Yager		60	President and Chief Executive Officer
Alfonso Del Toro		48	Vice President, Manufacturing
Tracy A. Kern		38	Chief Financial Officer
Erika Laskey		40	Vice President, Sales and Marketing
Kevin McCulloh		45	Vice President, Engineering
Paula O’Connor		53	Secretary
Samuel Patton		45	Vice President, Quality Assurance and Regulatory Affairs
Oscar J. Sanchez		64	Vice President, Business Development

Alfonso Del Toro was appointed Vice President, Manufacturing of the Company in January 1998. Mr. Del Toro was the Company’s Manufacturing Manager from January 1997 to December 1997. From 1993 to 1996, Mr. Del Toro was Manufacturing Manager for VIA Medical Corp. From 1986 to 1993, Mr. Del Toro was employed by Nellcor, Inc., a major manufacturer of respiratory products where he served in several positions leading up to Senior Principal Manufacturing Engineer.

Tracy Kern was appointed Chief Financial Officer in April 2004. Ms. Kern was Cost Accounting Manager from January 2003 to March 2004. From 1997 to 2002, Ms. Kern was employed by KPMG LLP, where she held a number of positions leading up to the position of Audit Manager. Ms. Kern is a certified public accountant.

Erika Laskey was appointed Vice President, Sales and Marketing of the Company in April 2002. Ms. Laskey was Director of Sales and Marketing from January 2001 to March 2002. From 1992 to 2000, Ms. Laskey was employed by Mallinckrodt, Inc. (formerly Nellcor Puritan-Bennett) where she held a number of sales positions leading up to the position of Global Account Business Manager.

Kevin McCulloh was appointed Vice President, Engineering of the Company in March 2000. Mr. McCulloh was Engineering Manager from March 1999 to February 2000, and was Manufacturing

Engineer from July 1998, when he joined the Company, to March 1999. From 1982 to 1998, Mr. McCulloh was employed by Litton Life Support where he had broad based experience in product design and development leading up to the position of Senior Design Engineer.

Paula O’Connor was appointed Secretary in September 2004. Ms. O’Connor has been Executive Assistant to the Chairman and the Chief Executive Officer of the Company since June 1998.

Samuel Patton was appointed Vice President, Quality Assurance and Regulatory Affairs in April 2005. Mr. Patton was an independent consultant in the quality systems area for the health care field from January 2004 to March 2005. From 2000 to 2003 Mr. Patton was employed by Medtronic, Inc. as Director of Cardiac Rhythm Management Global Quality Systems.

Oscar J. Sanchez was appointed Vice President, Business Development of the Company in March 2000. Mr. Sanchez served as the Company’s Vice President of Engineering and Development from September 1996 to February 2000, Vice President of Manufacturing from April 1993 to August 1996, and Manufacturing Manager from April 1983 to April 1993. Prior to these assignments with the Company, Mr. Sanchez occupied various positions of responsibility in Engineering and Management both inside and outside the U.S., the most recent as Director of Manufacturing for Riker Laboratories in Mexico City. Mr. Sanchez has been an active member of the Society of Manufacturing Engineers for 20 years where he served two (2) terms as elected Chairman of the Los Angeles Chapter.

For the biographies of Messrs. Jones and Yager, see Directors.

Item 11. Executive Compensation.


							Long-Term
							Compensation Awards
	Annual Compensation						Securities		All Other
			Salary		Bonus		Underlying		Compensation
Name and					(1)		Options		(2)
Principal Position	Year		($)		($)		(#)		($)

Thomas E. Jones		2006		160,000		––		––		7,550
Chairman		2005		160,000		24,000		––		3,450
		2004		160,000		––		––		10,583

Earl L. Yager		2006		240,000		––		––		3,000
President and Chief		2005		235,500		24,975		––		7,500
Executive Officer		2004		222,000		––		––		7,000

Alfonso Del Toro		2006		142,200		––		––		7,052
Vice President,		2005		138,000		12,420		––		6,500
Manufacturing		2004		138,000		8,694		––		6,098

Erika Laskey		2006		169,200		27,554		––		6,991
Vice President,		2005		163,560		33,000		––		6,500
Sales and Marketing		2004		166,290		32,246		––		5,953

Kevin McCulloh		2006		148,800		––		––		7,135
Vice President,		2005		138,000		16,560		––		6,500
Engineering		2004		138,000		8,694		––		6,098


(1)		Annual bonus amounts are earned and accrued during the fiscal years indicated and paid within 30 days subsequent to the end of the fiscal year indicated.

(2)		These amounts consist of contributions by the Company in 2006, 2005, and 2004 to the CHAD Therapeutics, Inc. Employee Savings and Retirement Plan.

Option Grants for the Year Ended March 31, 2006:

Potential Realized Value at

% of Total

Assumed Annual Rates of

Options Granted

Exercise

Stock Price Appreciation

Options

to Employees

Price ($) Per

Expiration

for Option Term

Name

Granted

During 2006

Date

10%

NONE

Aggregated Option Exercises in Last Fiscal and Option Values at March 31, 2006:

Number of Securities

Acquired

Underlying Unexercised

Value of Unexercised In-

Options at March 31, 2006

The-Money Options at

Exercise

Value

Exercisable/

March 31, 2006 Exercisable/

Name

(#)

Realized

Unexercisable

Thomas E. Jones

-0-

128,000/––––

$210,000/––––

Earl L. Yager

-0-

88,000/––––

150,000/––––

Alfonso Del Toro

-0-

40,000/––––

73,000/––––

Erika Laskey

-0-

31,000/9,000

62,000/––––

Kevin McCulloh

-0-

41,000/––––

23,000/16,000

Compensation Committee Interlocks and Insider Participation

None of the members of the Compensation Committee are, or formerly were, officers or employees of the Company or had any relationship requiring disclosure under Item 404 of Regulation S-K. Furthermore, none of the executive officers of the Company served as a member of the Board of Directors, Compensation Committee or committee performing equivalent functions of any other public company.

Employment Agreement

Effective April 1, 1998, the Company and Thomas E. Jones entered into an employment agreement, which was amended on January 1, 2003, pursuant to which the Company employs Mr. Jones as Chairman of the Board of Directors (the “Employment Agreement”). The Employment Agreement, as amended, provides a base salary of $160,000 per year, which amount is subject to annual review by the Board of Directors. In addition, Mr. Jones is eligible to receive a bonus in an amount to be determined by the Board of Directors. Mr. Jones is entitled to participate in all stock option, severance and benefit plans adopted by the Company. The Employment Agreement does not have a specific term. 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 after March 31, 2000, he is entitled to receive a severance benefit in accordance with the Company’s Severance and Change of Control Plan (the “Plan”) or, if such Plan is not applicable, a severance benefit equal to 200% of his salary and incentive bonus for the prior fiscal year. A description of the Plan is set forth below.

Severance and Change of Control Plan

The Company has adopted a Severance and Change of Control Plan pursuant to which nine (9) of the Company’s officers have entered into Severance and Change of Control Agreements with the Company (the “Severance Agreements”). The Severance Agreements provide that the executive officer is entitled to a lump sum severance benefit equal to 200% of his aggregate compensation for the prior calendar year (the amounts vary for other officers) if the officer is terminated without cause (as defined in the Severance Agreements) and not offered a comparable position within 60 days or if the executive suffers a change in duties, in either case, within 24 months of a Change of Control or Ownership Change of the Company (as defined in the Severance Agreements). If any payment due a named executive officer pursuant to the Severance Agreements would be deemed an excess parachute payment under Section 280G of the Internal Revenue Code, then the Company may reduce such payment to the extent necessary to avoid all taxes and penalties under Section 280G. Separately, the Company provided for accelerated vesting of all outstanding options upon a Change of Control or Ownership Change of the Company.

A change in duties is defined in the Severance Agreements to include, among other things, an involuntary reduction in authority, any reduction in annual salary, a reduction of 10% or more in aggregate compensation or re-location to a site more than 50 miles from the executive’s principal place of employment.

A Change of Control or Ownership Change shall be deemed to have occurred if (i) as a result of a tender offer or sale of stock any person acquires 20% or more of the Company’s Common Stock, (ii) the Company merges into another corporation or, as a result of a merger, shareholders of the Company own less than 70% of the voting stock of the surviving entity, (iii) more than one third (1/3) of the Company’s directors are replaced during any 12-month period by directors who were not endorsed by a majority of the Board, (iv) the Company is dissolved or sells substantially all of its assets, or (v) any other event occurs which the Board of Directors deems to constitute an Ownership Change.

Equity Compensation Plan Information

The following table provides information as of March 31, 2006, with respect to the shares of our common stock that may be issued under our existing equity compensation plans.

Number of Securities

Number of Securities to

Weighted-Average

Remaining Available for

be Issued Upon

Exercise Price of

Future Issuance Under

Exercise of

Outstanding

Equity Compensation Plans

Outstanding Options,

Options, Warrants,

[Excluding Securities

Plan Category

Warrants, and Rights

and Rights

Reflected in Column (a)]

(a)

(b)

(c)

1994 Stock Option Plan

940,000

$2.16

-0-

2004

Equity Compensation Plan

45,000

$3.47

705,000

Total

985,000

705,000

REPORT OF THE COMPENSATION COMMITTEE

The information contained in this report is not to be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor is such information to be incorporated by reference into any future filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent the Company specifically incorporates it by reference.

All members of the Compensation Committee are independent, non-employee directors. The Compensation Committee is responsible for reviewing the Company’s compensation policies and making recommendations to the Board with respect to executive compensation.

The Company’s compensation policies are designed to:

	•		Attract and retain well-qualified executives who are willing to work in a small, growing company;

	•		Create a performance-oriented environment which recognizes both annual and long-term results;

	•		Strengthen the identification of executive officers with shareholder interests; and

	•		Reward long-term commitment to the Company.

Compensation of the Company’s executive officers is composed primarily of salary, bonuses and stock options.

1. Salaries — Salaries for executive officers are established with a view toward maintaining the Company’s competitive ability to retain well-qualified executive officers. The Compensation Committee reviews the Report on Executive Compensation In the Medical Equipment and Supply Industry (the “Report on Executive Compensation”) as reported by Top Five Data Services in establishing salaries for its executive officers. The Report on Executive Compensation reports on the execution compensation of 300 U.S.-based, publicly traded companies in the medical equipment and supply industry. The Compensation Committee generally seeks to fix executive salaries at or near the midpoint for positions of comparable responsibility pursuant to the Report on Executive Compensation. In addition, the Compensation Committee reviews executive pay in relation to competitive salaries in the Southern California area. Salaries are reviewed annually by the Compensation Committee, which consults with the Chief Executive Officer on the appropriate salary levels for each of the executive officers. Salary levels are generally increased as executives assume new or expanded responsibilities.

2. Bonuses — The Company has an incentive bonus plan with fixed performance standards. Bonuses are payable yearly, based upon the extent to which the specified performance standards have been satisfied. Thirty percent of the target amount is based on the achievement of sales, forty percent is based on earnings before income taxes, and thirty percent is based on individual job performance objectives. In addition, the Vice President of Sales and Marketing receives incentive compensation based on achievement of tiered sales goals. Please refer to the Summary Compensation Table for bonuses paid for the year ended March 31, 2006.

3. Equity Grants — Equity Grants are intended to strengthen the identification of executive officers with the interests of the Company’s shareholders. Equity grants are used by the Compensation Committee as a form of long-term incentive compensation and not as remuneration for the past year’s services. Equity grants are also issued to a broad range of employees for the purpose of strengthening the relationship between the employees and the Company. The Compensation Committee makes equity grants and fixes their terms subject to the provisions of the Company’s equity compensation plan adopted on September 9, 2004. There are no fixed performance criteria that govern the equity grants. The Compensation Committee’s standards for determining the number of equity grants are subjective. The Compensation Committee confers with the Chief Executive Officer regarding the contribution which each executive officer made to the Company’s performance during previous years and likely future

contributions in order to determine if equity grants should be made and, if so, the appropriate amount to be granted. The Compensation Committee generally makes grants as a reward for sustained superior performance reflected in the Company’s operating results as well as to reward long-term commitment to the Company. Equity grants are generally structured to provide executives with an incentive to continue with the Company. In this regard, consideration is given to the number of equity grants and options held by an officer, the exercise price and vesting dates. All grants are issued at a price not less than the fair market value of the stock on the date of the grant, generally vest over a period of two (2) to five (5) years, and only attain a value if the price of the stock increases.

Basis for Compensation of the CEO

During the fiscal year ending March 31, 2006, Earl L. Yager received total annual compensation of $240,000. The factors considered in establishing the base salary, bonus, and equity grants for Mr. Yager were the same as described above in the description of our compensation policies. The Committee also notes the following: Mr. Yager’s base salary in 2006 reflected an increase of approximately 5% over his base salary for 2005. This increase was approved in order to maintain Mr. Yager’s base salary at the approximate mid-point for CEOs of comparably sized medical equipment manufacturers as set forth in the Report on Executive Compensation. No bonus was paid to Mr. Yager for the 2006 fiscal year. In addition to the sales and earnings before income taxes applicable to all persons eligible for an incentive bonus, the personal objectives for Mr. Yager in fiscal 2006 included maintaining shareholder value and overseeing certain product development projects and sales and marketing objectives. No equity grants were made to Mr. Yager during the year ended March 31, 2006, notwithstanding the Committee’s view that Mr. Yager achieved significant success during the year in positioning the Company for future opportunities. However, the Committee noted that Mr. Yager has a significant equity stake in the Company, as he currently owns 88,107 options and 269,131 shares (2.7%) of the Company’s common shares.

Compliance with Internal Revenue Code Section 162(m)

Section 162(m) of the Internal Revenue Code disallows a tax deduction to publicly held companies for compensation paid to certain of their executive officers, to the extent that compensation, whether payable in cash or stock, exceeds $1 million per covered officer in any fiscal year. The limitation applies only to compensation that is not considered to be performance-based. Non-performance-based compensation paid to the Company’s executive officers for the 2005 fiscal year did not exceed the $1 million limit per officer, and the Committee does not anticipate that any non-performance-based compensation payable in cash to the executive officers for the 2006 fiscal year will exceed that limit. Accordingly, the Committee has decided not to take any action at this time to limit or restructure the elements of cash compensation payable to the Company’s executive officers but will reconsider this decision should the individual cash compensation of any executive officer ever approach the $1 million level. The Company’s Stock Option Plan has been structured so that any compensation deemed paid by the Company in connection with the exercise of option grants made under that plan with an exercise price equal to the fair market value of the option shares on the grant date will qualify as performance-based compensation that will not be subject to the $1 million limitation on deductibility.

Submitted by the Compensation Committee
John C. Boyd (Chairman)
Philip T. Wolfstein
James M. Brophy

Item 12. Security Ownership of Certain Beneficial Owners and Management.

The following table sets forth as of May 30, 2006, the ownership of the Common Shares by those persons known by the Company to own beneficially five percent (5%) or more of such shares, by each

director who owns any such shares, and by all officers and directors of the Company as a group:


Name and Address (1)	Amount (2)		Percent Owned

Thomas E. Jones		328,573		3.2	%
Earl L. Yager		269,131		2.7	%
John C. Boyd		188,129		1.9	%
Philip T. Wolfstein		185,497		1.8	%
James M. Brophy		53,579		0.5	%
Kathleen M. Griggs		27,905		0.3	%
All Officers & Directors as a group (11 people)		1,398,569		13.8	%
Kevin Kimberlin (3)		836,560		8.2	%

(1)		The address of each director is 21622 Plummer Street, Chatsworth, CA 91311.

(2)		Includes shares subject to options which are currently exercisable or which become exercisable within sixty (60) days: Thomas E. Jones — 127,779 shares, John C. Boyd — 62,485 shares, Philip T. Wolfstein — 68,665 shares, James M. Brophy — 43,174 shares, Kathleen M. Griggs — 15,000 shares, Earl L. Yager — 88,107 shares, all Officers and Directors as a group — 558,210 shares.

(3)		Mr. Kimberlin’s address is c/o Spencer Trask, 535 Madison Avenue, New York, NY 10022.

Item 13. Certain Relationships and Related Transactions.

None.

Item 14. Principal Accountant Fees and Services.

Accountant Fees and Services

During the fiscal years ended March 31, 2006 and 2005, KPMG LLP provided various audit, audit-related and non-audit services to us as follows:


Fee Category	Fiscal 2006 Fees		Fiscal 2005 Fees
Audit Fees — Aggregate fees billed for professional services rendered for the audit of our 2006 and 2005 fiscal year annual financial statements and review of financial statements included in our quarterly reports on Form 10-Q or services that are normally provided in connection with statutory and regulatory filings or engagements for the 2006 and 2005 fiscal years	$	154,000	$	145,150

Audit-Related Fees — Aggregate fees billed for assurance and related services that are reasonably related to the performance of the audit or review of our financial statements which are not reported under “Audit Fees” above		—		—

Tax Fees — Aggregate fees billed for tax compliance and tax planning		21,500		17,750

All Other Fees — Aggregate fees billed for products and services provided other than as described in the preceding three (3) categories		—		—



Total Fees	$	175,500	$	162,900

Our Audit Committee has considered whether provision of the above services other than audit services is compatible with maintaining the independent accountant’s independence and has determined that such services have not adversely affected KPMG LLP’s independence.

Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Accountants

The Audit Committee’s policy is to pre-approve all audit and permissible non-audit services provided by the independent accountants. These services may include audit services, audit-related services, tax services, and other services. Pre-approval is generally provided for up to one (1) year and any pre-approval is detailed as to the particular service or category of services and is generally subject to a specific budget. The independent accountants and management are required to periodically report to the Audit Committee regarding the extent of services provided by the independent accountants in accordance with this pre-approval and the fees for the services performed to date. The Audit Committee may also pre-approve particular services on a case-by-case basis.

Since the May 6, 2003, effective date of the Securities and Exchange Commission rules stating that an auditor is not independent of an audit client if the services it provides to the client are not appropriately approved, each new engagement of KPMG LLP was approved in advance by the Audit Committee, and none of those engagements made use of the de minimus exception to pre-approval contained in the SEC’s rules.

AUDIT COMMITTEE REPORT

The following is the report of the Audit Committee of the Board of Directors of the Company. The information contained in this report shall not be deemed to be “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent that the Company specifically incorporates it by reference in such filing.

On behalf of the Board of Directors, the Audit Committee monitors the Company’s financial reporting processes and internal controls, as well as the Company’s relationship with its independent accountants and the performance of such accountants. All of the members of the Audit Committee are independent directors, and the Chairman of the Audit Committee has been determined to have the expertise to serve as chairman by the Corporate Governance Committee. The Board of Directors has adopted a charter for the Audit Committee, which can be accessed under the Investor Relations section on CHAD’s website.

Management has the primary responsibility for preparation of the Company’s financial reports, the Company’s financial reporting systems, and its internal controls. The Audit Committee is not intended to supersede in any respect management’s responsibilities in this regard. Management has represented to the Audit Committee that the Company’s financial statements were prepared in accordance with generally accepted accounting principles, and the Audit Committee has reviewed and discussed such financial statements with management and with the Company’s independent accountants. The Audit Committee has also discussed with the independent accountants their evaluation of the Company’s financial reporting systems and internal controls, their plan of audit for fiscal 2006, the application of new accounting principles to the Company’s financial statements, and other matters required to be communicated to the Committee by the independent accountants pursuant to standards established by the American Institute of Certified Public Accountants.

The Audit Committee has received from the independent accountants a letter addressing matters which might bear on the independence of the accountants as required by Independence Standards Board Standard No. 1. The Audit Committee has discussed independence issues with the accountants and has reviewed their fees and scope of services rendered to the Company. The Audit Committee has discussed the performance of the independent accountants with the Company’s management.

In reliance on the foregoing, the Audit Committee has recommended to the Board of Directors the inclusion of the audited financial statements in the Company’s Annual Report on Form 10-K for the year ended March 31, 2006.

Submitted by the Audit Committee of the Board of Directors,
Kathleen M. Griggs, Chairman
James M. Brophy
Philip T. Wolfstein

PART IV

Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

(a) (1) Financial Statements.

Included in Part II of this Report:

Report of Independent Registered Public Accounting Firm

Balance Sheets — March 31, 2006 and 2005

Statements of Operations — Years ended March 31, 2006, 2005, and 2004.

Statements of Shareholders’ Equity — Years ended March 31, 2006, 2005, and 2004.

Statements of Cash Flows — Years ended March 31, 2006, 2005, and 2004.

Notes to Financial Statements.

(a) (2) Financial Statement Schedules.

See Notes to Financial Statements.

(3) Exhibits.

3.1 Articles of Incorporation of the Registrant, as amended*****

3.2 Bylaws of the Registrant, as amended*

10.5 Pulser System License Agreement, as amended, with Robert E. Phillips, Brian L. Tiep, M.D., and Ben A. Otsap. (The Pulser System is now called the OXYMATIC.)*

10.20 OXYCOIL tubing License Agreement with Mary Smart (licensed under the name Respi-Coil).***

10.23 Summary plan description for CHAD Therapeutics, Inc. Employee Savings and Retirement Plan****

10.24 1994 Stock Option Plan******

10.25 Lease on real property at 21622 Plummer Street, Chatsworth, California******

10.26 TOTAL O₂ Delivery System License Agreement, as amended, with the Carleton Life Support Division of Litton Industries, Inc.*******

10.27 2004 Equity Incentive Plan************

13.1 Annual Report to Shareholders for the year ended March 31, 2006

23.1 Consent of Independent Registered Public Accounting Firm

31.1 Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.1 Letter from the FDA authorizing the Company to market the OXYMIZER oxygen conserving device as a Class I device*

99.2 Letter from the FDA authorizing the Company to market the OXYMIZER Pendant oxygen conserving device as a Class I device**

99.3 Letter from the FDA authorizing the Company to market the OXYMATIC electronic oxygen conserver as a Class II device***

99.4 Letter from the FDA authorizing the Company to market the OXYCOIL coiled oxygen tubing as a Class II device***

99.5 Letter from the FDA authorizing the Company to market the TOTAL O₂ Delivery System as a Class II device*******

99.6 Letter from the FDA authorizing the Company to market the OXYMATIC 411 conserver as a Class II device********

99.7 Letter from the FDA authorizing the Company to market the OXYMATIC 401A and 411A conservers as Class II devices********

99.8 Letter from the FDA authorizing the Company to market the TOTAL O₂ Post Valve Cylinders*********

99.9 Letter from the FDA authorizing the Company to market the CYPRESS OXYPneumatic conserver**********

99.10 Letter from the FDA authorizing the Company to market the SAGE Oxygen Therapeutic Device***********

99.11 Letter from the FDA authorizing the Company to market the LOTUS Electronic Oxygen Conserver*************

99.12 Press release dated June 29, 2006.


*		Previously filed as an Exhibit to the Registrant’s Registration Statement on Form S-18, File No. 2-83926.

**		Previously filed as an Exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 1984.

***		Previously filed as an Exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 1986.

****		Previously filed as an Exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 1993.

*****		Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 1994.


******		Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 1996.

*******		Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 1998.

********		Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 2001.

*********		Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 2002.

**********		Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 2003.

***********		Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 2004.

************		Previously filed as Appendix A of the Registrant’s Proxy Statement for the 2004 Annual Shareholders’ Meeting.

*************		Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the year ended March 31, 2005.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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, in the City of Los Angeles, State of California, on the 29th day of June, 2006.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.


Signature	Title	Date

/s/ Thomas E. Jones Thomas E. Jones	Chairman of the Board of Directors	June 29, 2006

/s/ Earl L. Yager Earl L. Yager	Chief Executive Officer, President, and Director (Principal Executive Officer)	June 29, 2006

/s/ Tracy A. Kern Tracy A. Kern	Chief Financial Officer (Principal Financial and Accounting Officer)	June 29, 2006

/s/ Kathleen M. Griggs Kathleen M. Griggs	Director	June 29, 2006

/s/ John C. Boyd John C. Boyd	Director	June 29, 2006

/s/ Philip T. Wolfstein Philip T. Wolfstein	Director	June 29, 2006

/s/ James M. Brophy James M. Brophy	Director	June 29, 2006

Exhibit Index


Exhibit No.		Document
13.1		Annual Report to Shareholders for the year ended March 31, 2006

23.1		Consent of Independent Accountant

31.1		Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.12		Press release dated June 29, 2006

EX-13.1 2 v21773exv13w1.htm EXHIBIT 13.1 exv13w1

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.

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.

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.

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.

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.

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.

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

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

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.

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.


		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

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;

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

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

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.

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

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.

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

EX-23.1 3 v21773exv23w1.htm EXHIBIT 23.1 exv23w1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors
Chad Therapeutics, Inc.:

We consent to the incorporation by reference in the registration statement (No. 33-93734) on Form S-8 of Chad Therapeutics, Inc. of our report dated May 5, 2006, with respect to the 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, which report appears in the March 31, 2006 annual report on Form 10-K of Chad Therapeutics, Inc.

/s/ KPMG LLP

Los Angeles, California
June 28, 2006

EX-31.1 4 v21773exv31w1.htm EXHIBIT 31.1 exv31w1

Exhibit 31.1

CERTIFICATION PURSUANT TO SECTION 302 OF SARBANES-OXLEY ACT OF 2002

I, Earl L. Yager, as Chief Executive Officer of CHAD Therapeutics, Inc. (the “Company”), hereby certify that:

(1)		I have reviewed this annual report on Form 10-K of CHAD Therapeutics, Inc.;

(2)		Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

(3)		Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

(4)		The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e) and 15(d)-15(e) for the registrant and have:

	(a)		designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	(b)		paragraph omitted;

	(c)		evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by the report based on such evaluation; and

	(d)		disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and

(5)

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

	(a)		all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	(b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.



Date: June 29, 2006	/s/ Earl L. Yager
	Earl L. Yager
	Chief Executive Officer of CHAD Therapeutics, Inc.

EX-31.2 5 v21773exv31w2.htm EXHIBIT 31.2 exv31w2

Exhibit 31.2

CERTIFICATION PURSUANT TO SECTION 302 OF SARBANES-OXLEY ACT OF 2002

I, Tracy A. Kern, as Chief Financial Officer of CHAD Therapeutics, Inc. (the “Company”), hereby certify that:

(6)		I have reviewed this annual report on Form 10-K of CHAD Therapeutics, Inc.;

(7)		Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

(8)		Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

(9)		The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e) and 15(d)-15(e) for the registrant and have:

	(a)		designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	(b)		paragraph omitted;

	(c)		evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by the report based on such evaluation; and

	(d)		disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect the registrant’s internal control over financial reporting; and

(10)

	(a)		all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	(b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.



Date: June 29, 2006	/s/ Tracy A. Kern
	Tracy A. Kern
	Chief Financial Officer of CHAD Therapeutics, Inc.

EX-32.1 6 v21773exv32w1.htm EXHIBIT 32.1 exv32w1

Exhibit 32.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Earl L. Yager, Chief Executive Officer of CHAD Therapeutics, Inc. (the “Company”), certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge:

(1) the Annual Report of the Company on Form 10-K for the fiscal year ended March 31, 2006, as filed with the Securities and Exchange Commission (the “Report”), fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

This Certification has not been, and shall not be deemed, “filed” with the Securities and Exchange Commission.


/s/ Earl L. Yager Earl L. Yager
Chief Executive Officer
June 29, 2006

EX-32.2 7 v21773exv32w2.htm EXHIBIT 32.2 exv32w2

Exhibit 32.2

CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Tracy A. Kern, Chief Financial Officer of CHAD Therapeutics, Inc. (the “Company”), certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge:

(2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

This Certification has not been, and shall not be deemed, “filed” with the Securities and Exchange Commission.


/s/ Tracy A. Kern Tracy A. Kern
Chief Financial Officer
June 29, 2006

EX-99.12 8 v21773exv99w12.htm EXHIBIT 99.12 exv99w12

Exhibit 99.12


THERAPEUTICS Innovative Respiratory Solutions	FOR IMMEDIATE RELEASE	21622 Plummer Street Chatsworth, CA 91311 Toll Free: 800.423.8870 Phone: 818.882.0883 Main Fax: 818.882.1809

Company Contact:		Investor Contact:
Earl L. Yager		Neil Berkman Associates
President and CEO		(310) 826 — 5051
www.CHADtherapeutics.com		info@BerkmanAssociates.com

CHAD Therapeutics Reports
Fourth Quarter and Fiscal 2006 Financial Results and
Provides Update on Evaluation of Strategic Opportunities

CHATSWORTH, California, June 29, 2006 . . . CHAD Therapeutics, Inc. (ASE:CTU) today reported financial results for the fourth quarter and fiscal 2006, and provided an update on the Company’s evaluation of strategic alternatives to maximize shareholder value.

Fourth Quarter and Fiscal 2006 Results

For the three months ended March 31, 2006, revenue declined to $5,177,000 from $5,435,000 for the fourth quarter of fiscal 2005. The net loss for the fourth quarter of fiscal 2006 was $460,000, or $0.05 per diluted share, which included an inventory reserve of $739,000 reflected in cost of goods sold for the Company’s SAGE Oxygen Therapeutic Device, whose sales have not met expectations. For the fourth quarter of fiscal 2005, net earnings were $589,000, or $0.06 per diluted share.

For the twelve months ended March 31, 2006, revenue declined to $22,354,000 from $24,287,000 for fiscal 2005. The net loss for fiscal 2006 was $673,000, or $0.07 per diluted share, which included the inventory reserve mentioned above. This compares to net earnings for fiscal 2005 of $1,811,000, or $0.17 per diluted share.

Revenue from sales of oxygen conservers and therapeutic devices declined 11% for fiscal 2006 compared to fiscal 2005, reflecting a 29% decline in sales to domestic customers and a 331% increase in international sales. The decline in domestic sales was primarily due to pricing pressure and the reduction in sales to a major customer reported previously. Sales of CHAD’s proprietary TOTAL O₂^® home oxygen filing system increased 3% for fiscal 2006 compared to fiscal 2005.

President and CEO Earl Yager said, “Effective January 1, 2006, Medicare reimbursement procedures were modified to provide that title for equipment used by an oxygen patient transfers to the patient after 36 months. This new policy has intensified pressure on homecare providers to reduce operating and equipment costs. Over time, we believe this will stimulate demand for CHAD’s TOTAL O₂ home oxygen filling system, which is a cost-effective solution to the changing economics of the home oxygen market. However, the immediate impact among our customers has been a ‘wait and see’ approach until important questions are answered regarding equipment repair and the provision of oxygen to patients after the transfer of title. We have taken appropriate steps to adjust our operating model and inventory posture in light of these developments. We also are continuing our efforts to expand our product offerings, and are pleased by our progress in the development of proprietary diagnostic and therapeutic products for the sleep disorder market.”

Working capital was approximately $9.8 million at March 31, 2006, including cash and cash equivalents of $935,000 versus $177,000 at March 31, 2005. Yager noted that the Company’s cash position has increased further during the first quarter of the new fiscal year. CHAD has no debt.

CHAD, OXYMATIC, OXYMIZER, OXYLITE, and TOTAL O₂ are Registered Trademarks of Chad Therapeutics, Inc.
ISO 13485 Certified Company
WWW.CHADTHERAPEUTICS.COM

(more)

CHAD Therapeutics Reports Fourth Quarter and Fiscal 2006 Financial Results
June 29, 2006
Page Two

Update on Evaluation of Strategic Opportunities

As previously reported, CHAD is in discussions with several parties concerning the distribution of both the Company’s TOTAL O₂ home oxygen filling system and the products it is developing for the sleep disorder market. During the course of these discussions, the Board of Directors decided to broaden the scope of its consideration of various strategic alternatives for the Company, and engaged an investment banking firm to assist the Board in evaluating strategic opportunities to maximize value for CHAD’s shareholders.

“While we cannot assure shareholders that we will be successful in these efforts, and no final determination will be made until all of our alternatives have been carefully analyzed in concert with our investment banker, we are pleased to report that this process is nearing its conclusion. We will report publicly as soon as new information is available,” Yager said.

About CHAD Therapeutics

CHAD Therapeutics, Inc. 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. For more information, visit www.CHADtherapeutics.com.

Safe Harbor Statements under the Private Securities Litigation Reform Act of 1995.

The foregoing statements regarding prospects for future earnings and revenues, future sales trends and the introduction of products under development are forward-looking statements that involve certain risks and uncertainties. A number of important factors could cause actual results to differ materially from those contemplated by such forward-looking statements. These include the potential loss of one of our major customers upon whom we depend for a material portion of our business, increased competition and continuing downward pressure on prices for certain of our products, the potential introduction of new products with perceived competitive advantages over the Company’s products, changes or proposed changes in health care reimbursement which affect home care providers, the terms of any distribution agreement which may be negotiated with respect to our TOTAL O2 system or our sleep products, and CHAD’s ability to anticipate and respond to technological and economic changes in the home oxygen market. Moreover, the success of the Company’s products and products under development will depend on their efficacy, reliability and the health care community’s perception of the products’ capabilities and benefits, the degree of acceptance the products achieve among homecare providers and, with respect to products under development, obtaining timely regulatory approval. Additional factors that could cause actual results to differ materially from those contemplated in this press release can be found in the Company’s annual and quarterly reports filed with the Securities and Exchange Commission under the caption “Outlook: Issues and Risks.”

(tables attached)

CHAD THERAPEUTICS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)


	Twelve Months Ended						Three Months Ended
	March 31,						March 31,
	2006			2005			2006			2005
Net sales	$	22,354,000		$	24,287,000		$	5,177,000		$	5,435,000
Cost of sales		15,113,000			14,581,000			3,919,000			3,465,000

Gross profit		7,241,000			9,706,000			1,258,000			1,970,000

Selling, general and administrative		6,788,000			6,947,000			1,687,000			1,641,000
Research and development		1,574,000			1,473,000			372,000			266,000

Total costs and expenses		8,362,000			8,420,000			2,059,000			1,907,000


Operating income (loss)		(1,121,000	)		1,286,000			(801,000	)		63,000

Other income, net		17,000			41,000			(6,000	)		13,000


Earnings (loss) before income taxes		(1,104,000	)		1,327,000			(807,000	)		76,000

Income tax (benefit)		(431,000	)		(484,000	)		(347,000	)		(513,000	)


Net earnings (loss)	$	(673,000	)	$	1,811,000		$	(460,000	)	$	589,000


Earnings (loss) per share:
Basic	$	(0.07	)	$	0.18		$	(0.05	)	$	0.06
Diluted	$	(0.07	)	$	0.17		$	(0.05	)	$	0.06


Weighted shares outstanding:
Basic		10,146,000			10,122,000			10,158,000			10,131,000
Diluted		10,146,000			10,625,000			10,158,000			10,636,000

CHAD THERAPEUTICS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)


	March 31,
	2006			2005
Assets
Current assets:
Cash	$	935,000		$	177,000
Accounts receivable, net		3,220,000			3,745,000
Income taxes refundable		383,000			—
Inventories, net		6,381,000			8,512,000
Prepaid expenses and other assets		178,000			264,000
Deferred income taxes		666,000			461,000


Total current assets		11,763,000			13,159,000


Property, plant and equipment, net		950,000			1,191,000
Intangible assets, net		972,000			802,000
Deferred income taxes		600,000			568,000
Other assets		71,000			70,000


Total Assets	$	14,356,000		$	15,790,000


Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	522,000		$	1,196,000
Accrued expenses		1,435,000			1,370,000
Income taxes payable		—			200,000


Total current liabilities		1,957,000			2,766,000

Other long-term liabilities		4,000			—


Total liabilities		1,786,000			2,766,000


Shareholders’ equity:
Common shares, $.01 par value, authorized 40,000,000 shares, 10,158,000 and 10,134,000 issued and outstanding		13,413,000			13,369,000
Accumulated deficit		(1,018,000	)		(345,000	)


Shareholders’ equity		12,395,000			13,024,000


Total Liabilities and Shareholders’ Equity	$	14,356,000		$	15,790,000

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CHAD THERAPEUTICS, INC.

/s/ Earl L. Yager

Earl L. Yager, Chief Executive Officer