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TABLE OF CONTENTS

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PART I

Item 1.   BUSINESS

General

        CNS, Inc. (the “Company”) is in the business of developing and marketing consumer health care products, including Breathe Right® nasal strips, Breath Right Snore Relief™ throat spray, Breathe Right Vapor Shot!™ personal vaporizer and FiberChoice® chewable fiber tablets. The Company focuses on products that address important consumer needs within the aging well/self care market, including better breathing and digestive health.

        The Company’s principal product, the Breathe Right nasal strip, improves breathing by reducing nasal airflow resistance. Nasal strips provide temporary relief from nasal congestion, reduce snoring and reduce breathing difficulties due to a deviated nasal septum. Breathe Right nasal strips, and the entire Breathe Right product line, provide “drug free” solutions to these consumer conditions.

        The Company further extended the Breathe Right brand in fiscal 2003 by launching Breathe Right Snore Relief throat spray. Snore Relief spray works by lubricating and soothing dry throats, while a natural astringent firms loose throat tissue to reduce the vibrations that cause snoring. Breathe Right nasal strips are also an effective snoring treatment. Nasal strips work by opening nasal passages and thereby reducing mouth breathing that leads to snoring. These two product lines provide a portfolio of solutions for snoring.

        In fiscal 2004, the Company launched Breathe Right Vapor Shot!™ personal vaporizer. Vapor Shot! is a drug-free convenient personal vaporizer designed to relieve day-time congestion related to colds, flu and allergies. This product builds on the existing line of Breathe Right mentholated vapor strips, which are primarily used to relieve night-time congestion.

        The Company introduced its FiberChoice® chewable fiber tablets in March, 2000. The FiberChoice product is a chewable fiber tablet that offers consumers an effective, convenient and good-tasting way to supplement their daily intake of dietary fiber.

        In addition to expanding the Breathe Right® and FiberChoice brands and introducing other new products, the Company is exploring possibilities for acquiring or licensing new consumer health care products that have established consumer brands, particularly those that complement the Company’s drug-free, better breathing and digestive health platforms. The Company is also considering opportunities for licensing new products and technologies.

        On January 23, 2002, the Company implemented a fiscal year-end change from December 31 of each year to March 31 of each year. The change in its fiscal year-end aligns the Company’s financial reporting period with its business and customer-planning cycle. The Company believes this change provides a clearer picture of the Company’s financial results by including an entire cold/flu season within the same fiscal year.

Management

        The Company’s management structure is organized into strategic business teams to expand the Breathe Right and Fiber-Choice brands and to develop and launch new products: Breathe Right Brand Team; FiberChoice Team; International Team and New Business Development Team. The Company believes that its team focus and organization model enables the Company to more effectively implement its business strategies.

        Breathe Right Brand Team.   The Company’s Breathe Right Brand Team is responsible for the strategic development and management of the Breathe Right nasal strip and other products that carry the Breathe Right brand name. Breathe Right nasal strip products currently represent the cornerstone of the Company’s business. The Company intends to exploit new markets and opportunities that it believes exist for its current nasal strip products and plans to commercialize potential new Breathe Right branded products.

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        FiberChoice Team.   The FiberChoice Team is responsible for the strategic development and management of the FiberChoice fiber supplement business including new product development related to the “digestive health” product platform. The Company introduced FiberChoice® chewable fiber tablets in March, 2000.

        International Team.   The International Team is responsible for developing and managing the Company’s overseas markets and its relationships with international distributors and representatives. The Company began shipping Breathe Right® nasal strips to new distributor partners in Europe, Australia and Japan during 2000. The international team is focused on continued development of nasal strips in existing country markets, as well as the future introduction of selected Breathe Right new products within international markets, and further geographic expansion over time into new country markets that present meaningful opportunities.

        New Business Development Team.   The New Business Development Team is focused on the expansion of the Company’s product base through the development, acquisition or licensing of promising consumer health care products. The New Business Development Team is responsible for identifying and evaluating potential new products, inventions and other business prospects that will enable the Company to achieve its long-term growth and profit objectives, including opportunities for the acquisition of established product lines and brands that may become the basis for a third brand platform.

Products

        Breathe Right Nasal Strips.   The Breathe Right nasal strip is a nonprescription, single-use disposable device that improves breathing by opening the nasal passages. The Company has 510(k) clearance from the United States Food and Drug Administration (“FDA”) to market the Breathe Right nasal strip for improvement of nasal breathing, temporary relief of nasal congestion, elimination or reduction of snoring and temporary relief of breathing difficulties due to a deviated nasal septum. See Item 1, “Government Regulation.” Breathe Right nasal strips come in tan, clear, mentholated and stars-for-kids varieties.

        The Breathe Right nasal strip includes two embedded plastic strips. When folded down onto the sides of the nose, the Breathe Right nasal strip lifts the side walls of the nose outward to open the nasal passages. The product improves nasal breathing upon application and does not include any drugs, thereby avoiding any medicinal side effects. The Breathe Right nasal strip is offered in three sizes (kids, small/medium and large) to accommodate the range of nose sizes. The Breathe Right nasal strip is packaged for the consumer market in various quantities ranging between 8 to 38 strips per box. The Company believes that the Breathe Right nasal strips are priced competitively compared to medicinal decongestants with retail prices ranging between $3.99 and $14.99 per box.

        The Company expanded the Breathe Right nasal strip line with the introduction of Breathe Right nasal strips with mentholated vapors and Breathe Right nasal strip for kids in 2000. The mentholated vapor strip uses traditional Breathe Right strip technology but contains a soothing mentholated aroma for additional relief. The Company believes that its mentholated vapor strip product has increased the Company’s customer base for nasal strip products by more clearly communicating that Breathe Right nasal strips can reduce nasal congestion. In fiscal 2004, the Company will increase advertising and promotion of its clear nasal strip, as a good solution for consumers with dry or sensitive skin types.

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        Other Breathe Right Brand Products.   Breathe Right Snore Relief™ throat spray is a drug-free product that addresses a different cause of snoring than nasal strips by lubricating and soothing dry throats while a natural astringent firms loose tissues to reduce the vibrations that produce snoring. This product leverages the Company’s existing position in the better breathing/snoring product category and complements existing Breathe Right® product offerings. Breathe Right VaporShot! personal vaporizer works by dropping an effervescent tablet into hot water in the customized VaporShot! cup which delivers an intense shot of mentholated vapors that instantly provides soothing comfort for your nose. This product leverages the Company’s line of Breathe Right mentholated vapor strips for colds. Breathe Right saline nasal spray is a non-habit forming, drug-free product that restores moisture to comfort and soothe dry, irritated nasal passages due to colds, allergies, dry air (low humidity), air pollution and the overuse of nasal decongestants.

        FiberChoice® Chewable Fiber Tablets.   FiberChoice is an orange-flavored, chewable tablet that offers consumers an effective, convenient, good-tasting way to supplement their daily intake of dietary fiber. Two tablets contain four grams of fiber and provide more than twice the amount of fiber per dose versus other convenient fiber supplements. The active ingredient in FiberChoice tablets is inulin, a natural fiber source. Inulin is also a prebiotic that helps promote the growth of healthy intestinal tract bacteria. FiberChoice tablets can be taken without water and have been clinically proven to be as effective as powder alternatives. The product is available in both regular and sugar-free varieties and is packaged in 90-count and 36-count bottles and 10-count tubes.

Markets

        Breathe Right Brand Product Line.   The Breathe Right brand of products includes Breathe Right nasal strip, Breathe Right Snore Relief throat spray, Breathe Right Vapor Shot! personal vaporizer and Breathe Right saline nasal spray. The Company intends to continue expanding the Breathe Right brand with the introduction of additional products within the better breathing product category.

        Air impedance in the nose accounts for approximately one-half of the total airway resistance involved in the respiratory system. If the effort to breathe through the nose during sleep is excessive, the person will resort to mouth breathing, promoting snoring, dry mouth, sore throat and mini-awakenings which disrupt sleep. In addition, nasal breathing difficulties during sleep are often caused by nasal congestion found in people who have a common cold, allergies and sinusitis and by those who experience nasal obstruction due to a deviated nasal septum. The Company believes that people with chronic conditions such as snoring or allergies or with structural nasal problems such as deviated septa are more predisposed to use Breathe Right products on a regular or daily basis, while seasonal sufferers are likely to use Breathe Right products as needed especially during the cold/flu season. Consumers suffering from these conditions are currently the primary users of the Company’s Breathe Right products and are the main targets of its advertising.

        The Company’s marketing efforts capitalize on the benefits of Breathe Right® products to consumers in various, and often overlapping, consumer market segments:

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        FiberChoice® Chewable Fiber Tablets.   Approximately 10 million U.S. households annually purchase bulk fiber products, primarily to promote regularity and improve digestive health. The bulk fiber category represents approximately $340 million in U.S. retail sales. The Company believes this is an attractive product category due to the aging of the baby-boomer generation. As people age, they frequently develop digestive problems. People over 55 years old are three times more likely to purchase a bulk fiber supplement than those younger than 55. Baby boomers are generally more active and demanding than their parents. These consumers search for solutions that do not hamper their active lifestyles. Additionally, most Americans only get 10-15 grams of fiber a day, while dietary experts recommend 25-30 grams daily. Two FiberChoice tablets provide four grams of fiber per dose and can be taken with or without water. The Company believes that its FiberChoice chewable fiber tablet represents a solution as an effective, convenient and good-tasting alternative for supplementing dietary fiber intake.

Growth Strategies

        Marketing Campaigns for Breathe Right® Nasal Strips.   The Company’s marketing efforts for Breathe Right products are directed to different consumer markets — the nasal congestion market and the snoring market. The Company has primarily used television advertising to market its products. The Company’s advertising focuses on the Breathe Right brand benefits of providing instant, drug-free relief from nasal congestion and snoring. The Company also uses product promotion programs, such as sampling, coupons and public relations activities to encourage product trial and repeat purchases. Marketing communications are generally designed to promote trial of Breathe Right brand products by increasing consumer awareness of the benefits of each product.

        Marketing efforts for Breathe Right nasal strips as an aid in the prevention of snoring have also included direct mail sampling and sampling through direct response television. In both programs, self-identified snorers were sent a sample of Breathe Right nasal strips along with a brochure explaining the causes of snoring and how the Company’s Breathe Right products can alleviate the condition.

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        In fiscal year 2005, the Company intends to build its Breathe Right brand by focusing its marketing efforts on the relaunch of clear nasal strips and on building additional awareness and trial of Breathe Right VaporShot! and mentholated vapor nasal strips.

        Marketing Campaigns for FiberChoice® Chewable Fiber Tablets.   The Company’s marketing efforts for FiberChoice tablets are directed toward all consumers who do not get the recommended amount of fiber in their diet. In 2002, the Company tested a new advertisement in four markets that simply states that busy people usually do not get the fiber they need from their diets and that FiberChoice tablets offer at least twice as much fiber per dose than any other convenient fiber supplement. During fiscal 2003, the Company expanded its successful four-market advertising test to thirteen markets. The Company broadened the FiberChoice brand marketing efforts to 68% of the United States in fiscal 2004 with strong results.

        Increasing Product Trial and Frequency of Product Usage.   The Company uses a combination of advertising, sampling, promotions, public relations and celebrity endorsements to increase consumer awareness and to encourage consumer trial and repeat purchases of its products.

        Developing New Products.   The Company believes that the Breathe Right and FiberChoice brand names are two of the Company’s most valuable assets and intends to leverage these assets by future introduction of new products.

        The Company is focused on the future expansion of its product lines through the acquisition and development of unique consumer health care products and technologies that have good market potential, particularly those that complement the Company’s drug-free, better breathing platform or digestive health platform. The Company routinely evaluates the merit of product concepts and acquisition opportunities and, from time to time, may acquire or license the rights to products which it believes could successfully be sold through the Company’s established distribution channels.

        Most, if not all, of the Company’s current products are regulated to varying degrees by the FDA and other regulatory bodies. See Item 1, “Government Regulation.” Products that the Company may acquire or develop in the future could also be subject to a variety of regulatory requirements. Some products will require extensive clinical studies and regulatory approvals prior to marketing and sale. There can be no assurance that any required regulatory approvals will be obtained or that the Company will market or sell any of these products.

        Developing Domestic Distribution.   Breathe Right® and FiberChoice products are sold to mass merchandise stores, drug stores, grocery stores, warehouse clubs, military base stores and on-line retailers in the United States. The Company sells its products through a direct sales force that concentrates on serving certain key retail accounts as well as through sales representatives referred to in the industry as brokers.

        Breathe Right nasal strips are typically positioned in the cough, cold and allergy sections of stores because they provide benefits similar to those obtained with other decongestant products. Breathe Right saline nasal spray is also usually positioned in the same section of the store as Breathe Right nasal strips since the products are typically used by those suffering from congestion, allergies and colds. Breathe Right Snore Relief throat spray and Breathe Right Vapor Shot! personal vaporizer are also usually positioned in the cold/flu section of stores, adjacent to Breathe Right nasal strips. FiberChoice chewable tablets are positioned in the bulk fiber and laxative sections of stores.

        The Company’s retail customers include national chains of mass merchants, drug stores and grocery stores such as Wal-Mart, Kmart, Target, Eckerd, Walgreens, RiteAid, CVS, Kroger and Albertson’s and warehouse clubs such as Sam’s Club and Costco, as well as regional and independent stores in the retail channels. In fiscal 2004, Wal-Mart accounted for approximately 26% of sales. The loss of this customer or any other large retailer would require the Company to replace the lost sales through other retail outlets and could disrupt distribution of the Company’s products or result in a loss of revenue.

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        Expanding Company Presence in International Markets.   The Company believes that there is significant market potential for its products outside the United States. The Company devotes significant resources to the development of its international business. The Company is considering additional distributors and representatives for distribution of its nasal strip products in additional international markets. The Company believes that the network that it has established for the international distribution of Breathe Right nasal strips will also enable the Company to build its international marketing and distribution capacity for other products. The Company is currently testing FiberChoice in selected international markets.

        From August of 1995 through September of 1999, The 3M Company (“3M”) was the exclusive distributor of the Company’s Breathe Right nasal strip products outside the United States and Canada. The contractual relationship with 3M produced lower than anticipated results in international markets. The Company believed that international markets required an increased level of focus, advertising and promotion to reach their potential. On September 30, 1999, the Company and 3M agreed to terminate the existing distribution agreement in a manner that enabled the Company to take a direct and immediate role in the sale, marketing and distribution of its nasal strip products in international markets. As part of the agreement, 3M also agreed not to sell any nasal dilator devices for a period of two years, which period ended on June 30, 2002.

        In 2000, the Company established a broad-ranging international distribution system for the Breathe Right nasal strip business that consists of both sales representatives and reselling distributors. The Company has established relationships with distributors in Canada, Australia, Japan, Hong Kong and major markets in Europe. The Company is also pursuing additional distribution opportunities. Sales are supervised by the Company from its Minnesota headquarters and by CNS International, Inc., a wholly-owned domestic subsidiary with one business manager in Europe. The business manager supervises and coordinates the activities of the distributors and sales representatives in Europe. Distributors are appointed largely on an exclusive basis, with territories consisting of one or more countries, and it is expected that this pattern will continue. The Company retains control over the packaging and advertising in all territories. Most shipments are made in bulk, either to reselling distributors who package for the local market, or to warehouse facilities abroad, where final packaging is arranged by the Company directly before shipment to retailers.

Manufacturing and Operations

        The Company currently subcontracts with multiple manufacturers to produce its products. The Company does no in-house product production. Each of the manufacturers makes Breathe Right and FiberChoice products to the Company’s specifications using materials specified by the Company. The contract manufacturers have all entered into confidentiality agreements with the Company to protect the Company’s intellectual property rights. Company quality control and operations personnel regularly inspect the contract manufacturers to observe processes and procedures in an attempt to ensure compliance with FDA Good Manufacturing Practice Standards. Finished goods are also inspected to ensure that they meet quality requirements. The Company works closely with its material vendors and contract manufacturers to reduce scrap and waste, improve efficiency and improve yields to reduce the manufacturing costs of the product. The Company has received certification that it has established and maintains a quality system which meets the requirements of ISO 9001:2000/EN 46001.

        To ensure consistent quality and supply, the Company has multi-year contracts with manufacturers that purchase most of the major components for the Breathe Right nasal strips directly from 3M. In 2001, the Company entered into a multi-year contract with 3M that provides for consistent supply, adherence to specifications and pricing. Although similar materials are currently available from other suppliers, the Company has historically utilized 3M components in its products. Although the Company believes that this relationship will not be disrupted or terminated, the inability to obtain sufficient quantities of these components or the need to develop alternative sources in a timely and cost-effective manner could adversely affect the Company’s operations until new sources of these components become available.

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Competition

        Breathe Right Nasal Strips.   The market for decongestant products is highly competitive. The Company’s competition in the consumer market for decongestant products and other cold, allergy and sinus relief products consists primarily of pharmaceutical products sold over the counter, other nasal sprays and external nasal dilators, while competition in the snoring remedies market also consists primarily of nasal dilators, throat sprays, herbs, supplements and homeopathic remedies.

        Although the Company is currently the leading manufacturer of external nasal dilation products, Schering Plough Corp. entered the market in September, 1998 with an external nasal dilation device. Schering Plough Corp. recently sold its nasal strip business to Aso Corp., a subsidiary of Aso International of Japan. In May 2003, Aso Corp. announced it was acquiring the marketing, sales and distribution of Schering Plough’s nasal strip device effective June 3, 2003. Other companies have also entered the nasal dilation market with private label products.

        Many of the Company’s competitors have significantly greater financial and operating resources than the Company. The Company has developed and implemented marketing strategies aimed at minimizing the impact of competitive products. As a result of these strategies and other steps taken by the Company, the Breathe Right nasal strip has maintained approximately 90% of the nasal dilator market despite the entry of other competitors into the market place.

        The Company believes the patents owned and licensed by the Company on the Breathe Right nasal strip will limit the ability of others to introduce competitive external nasal dilator products similar to the Breathe Right nasal strip in the United States and most major international markets. The Company intends to aggressively enforce its patent rights covering the Breathe Right nasal strip and has engaged in litigation to protect its patent rights.

        There can be no assurance that potential competitors will not be able to develop nasal dilation products which circumvent the Company’s patents. In addition, external nasal dilator products compete in broader consumer markets with many alternative decongestant and sinus relief products and snoring remedies in the United States and international markets.

        FiberChoice® Chewable Fiber Tablet.   The market for dietary fiber supplements is highly competitive and dominated by large companies with greater resources and better established brand recognition than the Company. Competitors included Metamucil® manufactured by Proctor and Gamble, Citrucel® manufactured by GlaxoSmithKline and FiberCon® manufactured by Wyeth. The Company believes that its FiberChoice chewable fiber tablet is a unique product with significant market potential that offers consumers an effective, convenient and good-tasting alternative to existing products with more fiber per dose than any other convenient fiber supplement. The technology of the FiberChoice chewable fiber tablet is currently protected by one issued U.S. patent with other U.S. and international patents pending.

Government Regulation

        As a manufacturer and marketer of medical devices, the Company is subject to regulation by, among other governmental entities, the FDA and the corresponding agencies of the states and foreign countries in which the Company sells its products. The Company must comply with a variety of regulations, including the FDA’s Good Manufacturing Practice regulations, and is subject to periodic inspections by the FDA and applicable state and foreign agencies. If the FDA believes that its regulations have not been fulfilled, it may implement extensive enforcement powers, including the ability to ban products from the market, prohibit the operation of manufacturing facilities and effect recalls of products from customer locations. The Company believes that it is currently in compliance with applicable FDA regulations.

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        FDA regulations classify medical devices into three categories that determine the degree of regulatory control to which the manufacturer of the device is subject. In general, Class I devices involve compliance with labeling and record keeping requirements and are subject to other general controls. Class II devices are subject to performance standards in addition to general controls. Class III devices are those devices, usually invasive, for which pre-market approval (as distinct from pre-market notification) is required before commercial marketing to assure product safety and effectiveness. Nasal dilators, such as the Company’s Breathe Right strips, have been classified by the FDA as Class I devices.

        Before a new medical device can be introduced into the market, the manufacturer generally must obtain FDA clearance through either a 510(k) pre-market notification or a pre-market approval application (“PMA”). A 510(k) clearance will be granted if the submitted data establish that the proposed device is “substantially equivalent” to a legally marketed Class I or II medical device, or to a Class III medical device for which the FDA has not called for PMAs. The PMA process can be expensive, uncertain and lengthy, frequently requiring from one to several years from the date the PMA is accepted. In addition to requiring clearance for new products, FDA rules may require a filing and waiting period prior to marketing modifications of existing products. The Company has received 510(k) pre-market notification approvals to market the Breathe Right nasal strip as a device that can (i) temporarily relieve the symptoms of nasal congestion and stuffy nose, (ii) eliminate or reduce snoring, (iii) improve nasal breathing by reducing nasal airflow resistance, and (iv) temporarily relieve breathing difficulties due to a deviated nasal septum.

        The Company’s FiberChoice product is considered to be a dietary supplement and is regulated under the Federal Food, Drug, and Cosmetic Act as amended by the Dietary Supplement Health and Education Act “DSHEA” of 1994, and under the Fair Packaging and Labeling Act. There is generally no requirement that a company obtain a license or approval from FDA before marketing dietary supplements in the United States. The FDA is currently developing regulations for certain provisions of the DSHEA that may affect the regulation of the Company’s FiberChoice product line. However, at this time, the impact of any proposed regulation on the Company or its products is not certain.

        Sales of the Company’s products outside the United States are subject to regulatory requirements that vary widely from country to country. The Company has selected a third party to act as an “Authorized Representative” in the European Union. The Company believes that it has the necessary documentation to support affixing the “CE” mark, an international symbol of quality and compliance with applicable European medical device directives, to the Company’s Breathe Right® nasal strips in Europe. Regulatory approvals have also been obtained for the Breathe Right nasal strip in Australia and additional approvals in other jurisdictions will be sought by the Company as needed for all of its products.

        No assurance can be given that the FDA or state or foreign regulatory agencies will give on a timely basis, if at all, the requisite approvals or clearances for additional applications for the Breathe Right nasal strip or for any of the Company’s other products. Moreover, after clearance is given, the Company is required to advise the FDA and these other regulatory agencies of modifications to its products. These agencies have the power to withdraw the clearance or require the Company to change the device or its manufacturing process or labeling, to supply additional proof of its safety and effectiveness or to recall, repair, replace or refund the cost of the medical device if it is shown to be hazardous or defective. The process of obtaining clearance to market products is costly and time-consuming and can delay the marketing and sale of the Company’s products. Furthermore, federal, state and foreign regulations regarding the manufacture and sale of medical devices and other products are subject to future change. The Company cannot predict what impact, if any, such changes might have on its business.

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        The Company is also subject to substantial federal, state and local regulation regarding occupational health and safety, environmental protection, hazardous substance control, waste management and disposal, among others.

Patents, Trademarks and Proprietary Rights

        The Company has registered trademarks, owns several patents and pending patent applications, and has a number of patents through licenses which are used in connection with its business. Some of these patents and licenses cover significant product formulations, methods and designs for the Company’s current and possible future products. The Company believes its trademarks are important as protection for the Company’s image in the marketplace. The Company’s success is and will continue to be dependent upon the existence of and ability to protect its patents, trademarks and those under its licenses and the Company intends to take such steps as are necessary to protect its intellectual property rights.

        There can be no assurance that the Company’s technology and proprietary rights will not be challenged on the grounds that its products infringe on patents, copyrights or other proprietary information owned or claimed by others, or that others will not successfully utilize part or all of the Company’s technology without compensation to the Company. Nor can there be any assurance that others will not attempt to challenge the validity or enforceability of the Company’s patents and licensed patents on the basis of prior art or introduce competitive products. In addition to seeking patent protection for its products, the Company also intends to protect its proprietary technologies and proprietary information as trade secrets.

        The Company entered into license agreements pursuant to which the Company acquired from the licensors the exclusive worldwide rights to manufacture and sell the Breathe Right nasal strip in its various versions and the FiberChoice® chewable fiber tablet. Specifically, the Company has the exclusive right pursuant to those license agreements to manufacture, sell and otherwise practice any invention claimed in the licensors’ patents issued in any country, including those that issue on pending applications. The Company is obligated to pay royalties to the licensors based on sales of the products typically including certain minimum royalty amounts in order to maintain its exclusivity.

        The original licensor of the Breathe Right nasal strip has filed patent applications with the U.S. Patent and Trademark Office seeking patent protection for different aspects of the Breathe Right nasal strip technology. Seven of these patent applications have resulted in issued patents in the United States, including one with claims that cover the single-body construction of the Breathe Right® nasal strip. The licensor of the Breathe Right nasal strip also has one patent application which is currently pending. In addition, that licensor has obtained patent protection on the Breathe Right nasal strip in several foreign countries and has various applications pending which seek further patent protection in these and a number of additional countries. The later licensor of the Breathe Right mentholated vapor strip has filed several patent applications with the U.S. Patent and Trademark Office as well as international patent offices resulting in both issued and pending applications. The Company, in addition to the patents and patent applications pending in the U.S. mentioned above, has filed corresponding patent applications seeking protection in several foreign countries to protect certain rights to nasal dilation technology that it acquired.

        The licensor of the FiberChoice® chewable fiber tablet has one issued U.S. Patent and other issued and pending international patents seeking patent protection for different aspects of this product.

        Although the Company believes that its owned and licensed patents on nasal strips will limit the ability of others to introduce competitive external nasal dilator products in the United States, there can be no assurance that the patents on the Breathe Right nasal strip, or any additional patents on this or other products that may be issued in the future, if any, will effectively foreclose the development of competitive products or that the Company will have sufficient resources to pursue enforcement of any patents issued. The Company does, however, intend to aggressively enforce the patents covering nasal strips and its other products. In order to enforce any patents issued covering nasal strips, including the Breathe Right nasal strip, or any of its other products, the Company may have to engage in litigation which may result in substantial cost to the Company and counterclaims against the Company. Any adverse outcome of such litigation could have a negative impact on the Company’s business.

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        The Company has engaged in litigation to enforce its patent rights relating to the Breathe Right nasal strip. In 1999, the Company brought a suit in federal district court to enforce one of the licensed nasal strip patents containing the broadest claims and providing the most comprehensive protection. In the course of this suit, the defendant requested reexamination in the U.S. Patent and Trademark Office (the “Patent Office”) of the Company’s primary licensed patent. On September 29, 2000, the Patent Office issued an Office Action in Reexamination and rejected certain of the claims. Other claims that were not subject to reexamination remain in effect. The Company has joined the licensor in the exercise of its right to contest the action of the Patent Office and has provided reasons that it believes establish that the claims should not have been rejected. The Company and its licensor are also seeking to amend certain claims to provide the Company with additional protection under the patent. The final outcome of the reexamination by the Patent Office is therefore uncertain. Although an adverse ruling from the Patent Office would narrow the protection available for nasal dilators and limit the breadth of the Company’s patent protection, the Company believes that its current portfolio of both pending patent applications and newly issued patents will enable it to maintain significant patent protection for its nasal strip products.

        On February 18, 2004, the Company, together with Creative Integration & Design, Inc., sued Silver Eagle Labs, Inc. in the United States District Court for the District of Minnesota for infringement of two nasal dilator patents owned by Creative Integration & Design, Inc. and exclusively licensed to the Company. The matter, which will now proceed to trial, is in the discovery stage. See “Item 3. Legal Proceedings.”

        The Company has registered its Breathe Right and FiberChoice trademarks in the United States and in several foreign countries and is seeking further registration of those trademarks and other trademarks.

Employees

        At June 11, 2004, the Company had 54 full-time employees and 3 part-time employees, of whom 15 were engaged in operations, 21 in general administration, and 21 in marketing and sales. There are no unions representing Company employees. Relations with its employees are believed to be positive and there are no pending or threatened labor employment disputes or work interruptions.

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EXECUTIVE OFFICERS OF THE COMPANY

        The following table sets forth the names and ages of the Company’s current Executive Officers together with all positions and offices held with the Company by such executive officers. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting of Stockholders and until their successors have been elected and have qualified.

        Daniel E. Cohen has served as the Company’s Chairman of the Board since 1993 and has served as a director of the Company since its formation in 1982. Mr. Cohen also served as the Company’s Chief Executive Officer from 1989 to June 2001 and as Treasurer from 1982 to March 1999. Mr. Cohen, a founder of the Company, is a medical doctor and board-certified neurologist.

        Marti Morfitt has served as the Company’s President and Chief Executive Officer since June 2001 and its President and Chief Operating Officer from March 1998 to June 2001. Ms. Morfitt has served as a director of the Company since 1998. From September 1982 to February 1998, Ms. Morfitt served in a series of positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving from May 1997 to February 1998 as Vice-President, Meals, and from February 1994 to May 1997 as Vice-President, Green Giant Brands. She also serves as a director of Graco, Inc., a Minneapolis-based manufacturer of fluid handling systems.

        Samuel Reinkensmeyer has served as the Company’s Chief Financial Officer since October 14, 2003. From March 2000 until joining the Company, Mr. Reinkensmeyer was employed by ValueVision Media Inc., a television and Internet retailer which owns and operates ShopNBC and ShopNBC.com serving most recently as its Senior Vice President of Finance and Investor Relations. From August 1988 to February 2000, he served in various financial positions at The Pillsbury Company, most recently as Finance Director, Pillsbury North America. Previously, Mr. Reinkensmeyer worked for Citicorp and PriceWaterhouse.

        John J. Keppeler has served as the Company’s Vice President of Worldwide Sales since August of 1999 and has served as the Company’s Vice President of Sales from 1998 to 1999. From November of 1986 to June of 1998, Mr. Keppeler served in a series of sales and customer marketing positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving as Director of Category & Customer Development for the Green Giant and Progresso Business.

        Linda Kollofski has served as the Company’s Vice President of Domestic Marketing since February of 2004 and as Vice President of New Business Development from November of 2002 to January of 2004. Prior to joining the Company in 2002, Ms. Kollofski was principal of Linda K. Consulting, Inc. from October of 1994 to October of 2002. Ms. Kollofski provided marketing expertise to various Pillsbury brands including Haagen-Daz, Totino’s and Green Giant as well as to Telex Communications, Hazeldon Foundation publishing business and the Company’s FiberChoice brand. Previously, Ms. Kollofski served in senior marketing and new business development positions with the Hazeldon Foundation, Dow Brands, Pillsbury and Munsingwear.

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        Larry R. Muma has served as the Company’s Vice President of Operations since January of 2001. From May of 2000 to December of 2000, Mr. Muma served as Director of Supply Chain for Novartis, Inc., a worldwide manufacturer and distributor of health care and pharmaceutical products. From February of 1992 to April of 2000, Mr. Muma served in various operations positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, serving from February 1994 to April of 1999 as Vice President of Operations for Pillsbury North America and most recently from April of 1999 to April of 2000 as Vice President of Operations Frozen Division.

        Carol J. Watzke has served as the Company’s Vice President of Consumer Strategy since July of 1998. Prior to joining the Company, Ms. Watzke served in a series of positions of increasing responsibility since 1974 with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving as Consumer Insights Director from May of 1997 to July of 1998 and as Market Research Director, Green Giant Brands, from 1994 to 1997.

Item 2.   PROPERTIES

        The Company leases approximately 73,000 square feet of office and warehouse space in Eden Prairie, Minnesota. The lease expires in November of 2010 and contains a renewal option. Monthly payments on the lease are $61,766.

Item 3.   LEGAL PROCEEDINGS

        On February 18, 2004, the Company, together with Creative Integration & Design, Inc., sued Silver Eagle Labs, Inc. in the United States District Court for the District of Minnesota for infringement of two nasal dilator patents owned by Creative Integration & Design, Inc. and exclusively licensed to the Company.  The suit seeks injunctive relief, damages, enhanced damages for willful infringement, attorneys’ fees and costs.  Silver Eagle has counterclaimed for a declaration that the asserted patents are invalid and not infringed and asks for its attorneys’ fees and costs.  CNS quickly sought a preliminary injunction forbidding Silver Eagle from making, using or selling or offering the infringing dilator for sale, which the Court denied.  The matter, which will now proceed to trial, is in the discovery stage.

        Additionally, from time to time, the Company may become a party to litigation and subject to claims incident to the ordinary course of business.

Item 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

      None.

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PART II

Item 5.   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

        The Company’s Common Stock has been traded on The Nasdaq Stock Market under the symbol “CNXS” since April 8, 1994. The following table sets forth the high and low last sale prices of the Company’s Common Stock for the period indicated which cover the Company’s fiscal years ending March 31, 2004 and 2003.

        On June 4, 2004, the last sale price of the Common Stock was $10.20 per share.

Shareholders

        As of June 4, 2004, there were approximately 600 owners of record of the Company’s Common Stock.

Dividends

        The Company paid three quarterly dividends of $.04 per share of Common Stock during fiscal 2004. No dividends were paid during fiscal 2003. The payment of future dividends, if any, will be at the discretion of the Board of Directors and will depend upon, among other things, future earnings, capital requirements, restrictions in future financing agreements, the general financial condition of the Company and general business considerations.

Information Regarding Equity Compensation Plans

        The following table sets forth information regarding the Company’s equity compensation plans in effect as of March 31, 2004. Each of the Company’s equity compensation plans is an “employee benefit plan” as defined by Rule 405 of Regulation C of the Securities Act of 1933.

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Securities Authorized for Issuance under Equity Compensation Plans

        The equity compensation plans approved by CNS, Inc. shareholders are the 2000 Amended Stock Option Plan, the 1994 Amended Stock Plan, the 1990 Stock Plan and the 1987 Employee Incentive Stock Option Plan. No shares remain available for future awards under any of the 1990 or 1987 Plans.

        The Company also maintains a 1989 Employee Stock Purchase Plan, participation in which is available to substantially all of the Company’s employees. Participating employees may purchase the Company’s common stock at the end of each participation period at a purchase price equal to 85% of the lower of the fair market value of the stock at the beginning or end of the participation period. The six-month participation period runs from January 1 to June 30 and from July 1 to December 31 each year. Employees may contribute up to 10% of their base compensation to the plan subject to certain IRS limits on stock purchases through the plan. This plan has been approved by the Company’s shareholders.

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Item 6.   SELECTED FINANCIAL DATA

        The following selected financial data should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto together with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” all of which are included elsewhere in this Report. The Consolidated Statements of Operations and Balance Sheet data presented below as of and for the Years Ended December 31, 1999 through March 31, 2004 have been derived from the Company’s Consolidated Financial Statements included elsewhere in this Report or previously filed with the Securities and Exchange Commission on Form 10-K, which have been audited by KPMG LLP, independent certified public accountants.

FINANCIAL HIGHLIGHTS
(In thousands, except per share amounts)

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Item 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The following discussion of the financial condition and results of operations should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto appearing elsewhere in this Annual Report. In this discussion, our fiscal years ended March 31, 2004 and 2003 and December 31, 2001 are referred to as fiscal year 2004, 2003 and 2001, respectively.

History

        The Company was founded in 1982. From 1987 until 1995, the Company designed, manufactured and marketed computer-based diagnostic devices for sleep disorders. In 1995, the Company divested itself of the assets related to its sleep disorders business to focus on the Breathe Right® nasal strip.

        The Company obtained the exclusive license to manufacture and sell the Breathe Right nasal strip in 1992 and received FDA clearance in October 1993 to market the Breathe Right nasal strip as a product that improves nasal breathing. The Company has also received FDA clearance to market the Breathe Right nasal strip for the reduction or elimination of snoring, for the temporary relief of nasal congestion and for the temporary relief of breathing difficulties due to a deviated nasal septum.

        In August 1995, the Company signed an exclusive international distribution agreement with the 3M Company (“3M”) to market Breathe Right nasal strips outside the U.S. and Canada. On September 30, 1999, the Company and 3M amended the distribution agreement in a manner that enabled the Company to regain control of the marketing, sales and distribution of Breathe Right nasal strips in international markets. In exchange for the one-time contract termination fee, the international distribution agreement with 3M terminated on June 30, 2000. During 2000, the Company established an international distribution network that consists of both sales representatives and reselling distributors and reintroduced nasal strips in Europe, Japan and Australia.

        In July 1996, U.S. Utility Patents were issued covering the basic invention of the Breathe Right nasal strip and additional elements incorporated in the product. During 1997, the Company became aware of a foreign reference to a nasal dilator, not commercially available. During 2000, the U.S. Patent and Trademark Office (“Patent Office”) reexamined the Company’s primary licensed patent and rejected certain claims. Other claims that were not subject to reexamination remain in effect. The Company has joined its licensor in the exercise of its right to contest the action of the Patent Office. The Company and its licensor have amended and are also seeking to further amend certain claims to provide the Company with additional protection under the patent. The final outcome of the reexamination is uncertain. Although an adverse ruling could narrow the range of protection available for nasal dilators and limit the breadth of the Company’s patent protection, the Company believes that its current portfolio of both pending patent applications and issued patents will enable it to maintain significant patent protection for its nasal strip products.

        Beginning in 1998, the Company strengthened its management team to add consumer packaged goods and new products experience. The Company also formed teams to focus on individual product lines. The Company completed positioning research work to expand the Breathe Right® brand and developed a road map for new product development. During 1999 and 2000, the Company invested aggressively in marketing, selling and product development expenses to build the Breathe Right brand and launch additional products.

        In 2000, the Company expanded its domestic Breathe Right product line to include nasal strips for colds with mentholated vapors that are sized for the entire family and nasal strips for children that are available in multiple colors. Breathe Right nasal strips for colds with mentholated vapors were introduced in selected overseas markets in 2001.

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        During 2000, the Company launched FiberChoice® chewable fiber tablets. The tablets are positioned in the bulk fiber category and give the Company an entry into the digestive health products market. FiberChoice chewable fiber tablets can be taken without water and have been clinically proven to be as effective as powder alternatives.

        In 2001, the Company streamlined and realigned the Company’s resources to better match its strategic goals and to focus on building its core product lines. The Company recorded a special charge related to costs associated with this plan. Approximately 25% of the workforce, from throughout the organization, was eliminated. The cost savings relating to this plan were realized beginning in July of 2001.

        In 2002, the Company changed its fiscal year-end from December 31 to March 31. The change in its fiscal year end aligns the Company’s financial reporting with its business and customer planning cycle. The Company believes this change provides a clearer picture of the Company’s financial results by including an entire cold/flu season within the same fiscal year. The first period to be reported in 2002 was a three-month stub period ending March 31, 2002.

        In fiscal 2003, the Company continued to expand its Breathe Right product line by launching Breathe Right Snore Relief^TM throat spray. Snore Relief spray lubricates and soothes dry throats, while a natural astringent firms loose tissue to reduce the vibrations that cause snoring. Breathe Right strips open nasal passages and reduce the mouth breathing that leads to snoring. These two products provide a portfolio of solutions for snoring.

        Breathe Right VaporShot! personal vaporizer was introduced during fiscal 2004. This product builds on the Company’s existing line of Breathe Right mentholated vapor strips for colds. Breathe Right VaporShot! personal vaporizer is a styrofoam cup with a fitted, vapor concentrating lid. It works by dropping an effervescent tablet into hot water in the VaporShot! cup which then delivers an intense shot of mentholated vapors that instantly provides soothing comfort for your nose. This product leverages the Company’s existing position in the better breathing product category and complements existing Breathe Right product offerings.

Growth Strategy and Financial Focus

        CNS designs and markets consumer health care products, including Breathe Right nasal strips, Breathe Right Snore Relief throat spray, Breathe Right Vapor Shot! Personal vaporizer and FiberChoice chewable fiber tablets. The Company’s products address consumer needs within the “better breathing” and “digestive health” segments of the consumer healthcare products market.

        For the year ended March 31, 2004, a breakdown of the Company’s net sales is as follows:

        The Company’s core competency is consumer marketing and sales within the mass merchandise, drug, and food channels of retail distribution. The Company considers its product lines to be unique and differentiated relative to competing products. CNS generates strong consumer demand for its products through substantial investments in advertising and promotional campaigns, which stimulate brand and product awareness, as well as consumer trial and repeat purchases.

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        The Company’s financial focus is to achieve sustainable long-term growth in revenues, operating profit and operating cash flow.

        Revenue.   CNS is concentrating its revenue growth efforts in three areas. The first priority is the growth of the high margin Breathe Right brand, both domestically and internationally, in order to leverage the Company’s most valuable brand equity. The second priority for revenue growth is the continued development of the “digestive health” platform, anchored by the successful FiberChoice brand. The final growth priority is the acquisition or internal development of a third brand platform that will further leverage the Company’s existing core competencies in the United States market.

        Operating Profit.   During the past three fiscal years, the Company has increased its operating profit at a rate which exceeds the growth rate of net sales. This has been achieved primarily through a combination of targeting growth in higher margin products, by lowering product cost of goods sold, and improving the efficiency of the Company’s advertising and promotion campaigns. The Company intends to continue its focus on improving operating profit margins over the long term.

        Operating Cash Flow.   The Company is also focused on growing its operating cash flow primarily through sustainable growth in revenue and net income, as well as continued focus on maintaining an efficient level of working capital. The Company’s operating model is to contract with third parties to manufacture its products, thereby avoiding the capital investment associated with manufacturing plants and equipment, and also retaining flexibility to partner with industry-leading manufacturers who can supply the Company’s various product lines. The Company also focuses on maintaining an efficient level of working capital by closely managing days sales outstanding of accounts receivable, inventory levels and payment terms with suppliers.

Accounting Policies

        In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management must make judgments, estimates and decisions which impact the reported amounts and the related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, management applies judgment based on its understanding and analysis of the relevant circumstances. Note 1 to the consolidated financial statements provides a summary of the significant accounting policies followed in the preparation of the financial statements.

        The Company’s critical accounting policies include the following:

        Revenue Recognition, Sales Returns and Other Allowances, and Allowance for Doubtful Accounts.   Revenue from sales is recognized when all of the following criteria have been met: a valid customer order with a fixed price has been received; title and risk of loss transfer to the customer; there is no further significant obligation to assist in the resale of the product; and collectibility is reasonably assured. Revenue is reduced for provisions for trade promotions, estimated sales returns, certain promotional costs and other allowances in the same period as the related sales are recorded. Management must make estimates of potential future product returns and other allowances related to current period revenue. Management analyzes historical returns, current trends, and changes in customer and consumer demand when evaluating the adequacy of the sales returns and other allowances. The Company has established a reserve of $1.3 million for future sales returns and other allowances as of March 31, 2004. Similarly, management must make estimates of the uncollectability of accounts receivables. Management specifically analyzes customer account balances, historical bad debts, current economic trends and changes in the timing of customer payments. The balance of accounts receivable was $11.4 million, net of the allowance for doubtful accounts of $380,000 as of March 31, 2004.

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        Inventory Valuation.   Inventory is valued at the lower of cost, determined on a first-in, first-out basis (FIFO), or market. The Company analyzes the cost and the market value of inventory items and establishes the appropriate valuation reserves. The Company has established a reserve for excess or obsolete inventory of $551,000 as of March 31, 2004. Management believes that the inventory valuation results in carrying inventory at the lower of cost or market.

        Accounting for Income Taxes.   As part of the process of preparing financial statements, the Company is required to estimate income taxes, both state and federal. This process involves management estimating the actual current tax exposure together with assessing temporary differences resulting from different treatment for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. Management must then assess the likelihood that deferred tax assets will be utilized to offset future taxable income during the periods in which these temporary differences are deductible. Based on the level of historical taxable income and projections of future taxable income for the periods, in which the deferred tax assets are deductible, management believes that it is more likely than not the Company will realize the benefits of these deductible differences. Accordingly, the Company eliminated the valuation allowance of $9.1 million related to the net deferred tax assets as of March 31, 2002.

        Trade and Consumer Promotions.   Management judgment is involved in recognizing the amount and timing of trade and consumer promotion activities. Management regularly reviews current period and prior period promotional liabilities and assesses customers’ and consumers’ participation and performance levels related to various promotional activities. The vast majority of year end liabilities associated with these activities are resolved within the following fiscal year and therefore, do not require highly uncertain long-term estimates. The Company has established a liability for trade and consumer promotions of $1.6 million as of March 31, 2004.

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Operating Results

        On January 23, 2002, the Company changed its fiscal year-end from December 31 to March 31. The first period to be reported in 2002 was a three-month stub period ended March 31, 2002. The change in fiscal year-end aligns the Company’s financial reporting period with its business and customer-planning cycle. The Company believes this change provides a clearer picture of the Company’s financial results by including an entire cold/flu season within the same fiscal year.

        The tables below set forth certain selected financial information of the Company and the percentage of net sales represented by certain items included in the Company’s statements of operations for the periods indicated. For fiscal 2001, certain amounts have been reclassified to conform to the current period’s presentation. These reclassifications had no impact on the operating net (loss) or net income. Amounts are in thousands, except per share amounts.

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Operating results shown as a percent of net sales:

Net sales

        The following is a breakdown of net sales by brand and geographic area:

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        Net sales for fiscal 2004 of $87.0 million increased 10.0% over fiscal 2003 sales of $79.1 million and an increase of 14.1% compared to fiscal 2001 sales. Domestic sales of Breathe Right® branded products grew to $64.1 million, representing an increase of 10.8 % over fiscal 2003 and 19.2% over fiscal 2001. The growth in the Breathe Right brand was the result of successful promotions of the Company’s nasal strip product line, as well as the launch of Breathe Right Snore Relief throat spray in fiscal 2003 and Breathe Right Vapor Shot! personal vaporizer in fiscal 2004. Domestic FiberChoice® sales for fiscal 2004 grew to $9.3 million, representing an increase of 31.1% over fiscal 2003 and 45.8% over fiscal 2001. Growth in domestic FiberChoice sales resulted from increased advertising and promotional campaigns, supporting the “fiber for health” consumer positioning.

        International sales decreased to $13.0 million dollars, down 6.1% versus fiscal 2003 and down 19.0% versus fiscal 2001. This decrease resulted primarily from lower shipments to the Company’s distributor in Japan, caused by high distributor inventory levels in that market. The Company expects to further lower distributor inventory levels in Japan during fiscal 2005 and thereby better align future shipments with consumer demand. As a result, the Company expects its net sales to its Japan distributor to decline in fiscal 2005; however, sales growth is expected in subsequent years.

        During fiscal 2004, CNS decided to exit its line of Flair equine products which are included in “other” on the net sales breakdown, shown on the prior page. The Company has terminated its agreements with its distributor of Flair products and the licensor of technology related to this business, effective April 30, 2004. Net sales of Flair products totaled $375,000 for fiscal 2004 and $268,000 for fiscal 2003.

Gross profit rate

        The Company’s gross margin rate is dependent on a number of factors and may fluctuate from quarter to quarter as well as year to year. These factors include the mix of products sold, the level at which promotional programs are executed, and the cost of materials and manufacturing. Gross margins continued to improve in fiscal 2004 to 69.1% compared to 67.1% and 63.7% in fiscal 2003 and 2001 respectively. The improving gross margin rates in 2004 and 2003 resulted primarily from lower product cost and increasing efficiency in procuring and distributing the Company’s product lines.

Advertising and promotion expense

        Advertising and promotion expenses were $33.1 million for fiscal 2004 compared to $30.9 million and $34.3 million for fiscal 2003 and fiscal 2001, respectively. For fiscal 2004, advertising and promotional expenses as a percentage of net sales of 38.0% continued to decrease compared to 39.1% and 45.0% for fiscal 2003 and fiscal 2001, respectively. This reduction is the result of economies of scale driven by growth of the Company’s product lines, as well as continuing efforts to develop more efficient and effective methods of stimulating consumer demand.

Selling, general and administrative expense

        Selling, general and administrative expenses were $14.2 million for 2004 compared to $12.5 million for 2003 and $14.6 million for 2001. Selling, general and administrative expense declined in fiscal 2003 as a result of the reduction and realignment of the Company’s workforce to better match its strategic direction and to focus on building the core Breathe Right and FiberChoice product lines. Selling, general and administrative expense increased in fiscal 2004 due to severance and recruitment costs associated with several changes on the Company’s management team.

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Special charges

        The Company recorded a special charge of $930,000 in 2001 for the costs of implementing the Company’s corporate restructuring plan to streamline and realign the Company’s resources. The charge was primarily for severance benefits. As of March 31, 2004, the Company made all of the payments relating to this plan and therefore the balance of the accrued liability was $0.

Investment income

        Investment income was $725,000 for 2004 compared to $839,000 and $1.3 million for 2003 and 2001, respectively. The benefit of higher levels of marketable securities was more than offset by a decrease in market interest rates and a shift in the investment portfolio to lower yield, tax exempt securities, resulting in lower levels of investment income. The following table compares the average bond equivalent yield of various marketable securities held by the Company as of March 31, 2004 and March 31, 2003 (dollar amounts in thousands):

        The average remaining days to effective maturity of the Company’s portfolio of marketable securities has decreased to 403 days as of March 31, 2004 compared to 417 days as of March 31, 2003.

Income tax expense (benefit)

        Income tax expense was $4.9 million for 2004 compared to $4.0 million and $0 for 2003 and 2001, respectively. The effective tax rate for 2004 was 36.6% compared to an effective tax rate in 2003 of 37.8%. The reduction in the effective tax rate is the result of utilizing foreign export incentives and a change in investment strategy from taxable corporate and U.S. Government obligations to tax exempt municipal obligations. Refer to the following effective tax rate reconciliation table:

        The Company did not recognize an income tax expense in 2001. Income before tax was offset by changes in deferred tax assets, including utilization of net operating loss and credit carryforwards for which a full valuation allowance had been previously established.

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        The Company recognized a tax benefit of $9.1 million during the three month period ending March 31, 2002 as a result of reinstating net deferred tax assets, including the benefit of net operating loss carryforwards. Management believed at this time, based on the level of historical taxable income and projections of future taxable income for the periods in which the deferred tax assets were deductible, that it was more likely than not the Company would realize the benefits of the deductible differences. As of March 31, 2004, the Company has a deferred tax asset of $158,000 relating to state net operating loss and credit carryforwards.

Operating and Net Income

        Increases in sales, as well as improved gross margin rates and efficiencies in advertising and promotions, have provided significant improvement in operating income as well as net income. Operating income for fiscal 2004 was $12.7 million, up 32.3% compared to fiscal 2003 operating income of $9.6 million and up strongly from a net operating loss of $1.2 million for fiscal 2001. Diluted net income per share increased from $.01 in fiscal 2001, to $.46 per share for fiscal 2003 and $.59 per share for fiscal 2004.

Seasonality

        The Company has experienced in the past, and expects that it will continue to experience in the future, quarterly fluctuations in both domestic and international sales and earnings. These fluctuations are due in part to advertising levels and seasonality of sales, as well as increases and decreases in purchases by distributors and retailers in anticipation of future demand by consumers. The Company believes that significant portions of Breathe Right® product line are used for the temporary relief of nasal congestion and congestion-related snoring. Sales of nasal congestion remedies are higher during the fall and winter seasons, corresponding with the Company’s third and fourth quarters.

Liquidity and Capital Resources

        At March 31, 2004, the Company had cash, cash equivalents and marketable securities of $49.4 million, an increase of 18.8% or $7.8 million from $41.6 million as of March 31, 2003. The Company has no long term debt. The Company believes that its existing funds will be sufficient to support its planned operations for the foreseeable future.

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        Operating Activities.   The Company generated cash from operating activities of $8.6 million during fiscal 2004 compared to $19.2 million during fiscal 2003. For fiscal 2001, the Company used cash in operating activities of $2.8 million. The improvement in net income from $81,000 in fiscal 2001 to $6.5 million and $8.5 million in fiscal 2003 and 2004, respectively, contributed significantly to the improvement in cash flow. During fiscal years 2004 and 2003, the Company utilized deferred tax assets of $2.5 million and $3.5 million, respectively, having a positive impact on cash flow. For fiscal 2004, cash flow from operating activities was reduced by an increase in inventory of $866,000 and an increase in prepaid expenses and other current assets of $1.8 million. The increase in inventory was caused by higher finished goods inventory levels associated with the early end to the fiscal 2004 cold/flu season. The increase in prepaid expenses resulted primarily from overpayments of the Company’s estimated income tax liability. In fiscal 2003, the Company recorded a significant increase in accounts payable and accrued expenses of $6.1 million, resulting from trade promotions and advertising campaigns that were executed in the latter part of fiscal 2003 and not paid until fiscal 2004.

        Investing Activities.   Purchases of marketable securities exceeded sales and maturities by $15.6 million and $5.9 million in 2004 and 2003, respectively. For 2004, marketable securities purchased consisted primarily of U.S. Government obligations and tax exempt municipal securities.

        The Company purchased $478,000 and $60,000 of property and equipment in 2004 and 2003, respectively, primarily associated with upgrading its network of personal computers and software. The Company purchased $310,000; $510,000 and $357,000 of product rights during the 2004, 2003 and 2001, respectively.

        Financing Activities.   The Company paid cash dividends during 2004 of $1.6 million. No dividends had been paid during prior periods. In making the decision to initiate a cash dividend, the Company’s Board of Directors considered, among other things, the recent revisions to the U.S. income tax code that provides for favorable tax treatment of corporate dividends.

        The Company purchased 458,000 shares of its common stock for $2.8 million in 2003 and purchased 202,000 shares for $1.0 million in 2001. The Company did not repurchase any shares of its common stock in 2004. These treasury shares will be used to meet the Company’s obligations under its employee stock purchase plan and stock option plans, and for possible future acquisitions. The Company is authorized to repurchase an additional 531,000 shares as of March 31, 2004.

        The Company received $1.8 million in 2004 and $949,000 in 2003 from the exercise of stock options and issuance of stock under the employee stock purchase plan.

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        Significant Agreements and Lease Obligations. The Company has entered into certain agreements and operating leases in order to secure product rights and office space. The following is a summary of significant agreements and lease obligations (in thousands):

        The Company has agreements that exclusively license intellectual property rights for certain products. Royalties due under these agreements are based on various percentages of net sales of related product lines. The licensing agreements are valid for the lives of the related patents, however, they may be terminated earlier under certain conditions. Total minimum royalties are not determinable since royalties continue for the life of current and potential future patents related to the licensed intellectual property.

        The Company has entered into operating leases for office space and office equipment. Leases expire at various dates beginning in 2007 through 2010. Management is not aware of any significant agreements or obligations that would have a material negative impact upon the Company’s short-term or long-term liquidity.

Recent Accounting Pronouncements

        In November 2002, the Emerging Issues Task Force finalized its tentative consensus on EITF Issue 00-21, “Revenue Arrangements with Multiple Deliverables”, which provides guidance on the timing of revenue recognition for sales undertakings to deliver more than one product or service. The Company will adopt EITF 00-21 on transactions beginning fiscal 2005, as required. The Company does not anticipate that the adoption of this pronouncement will have a material impact on the Company’s consolidated financial statements.

        In December 2003, the Financial Accounting Standards Board (“FASB”) published a revision to FASB Interpretation 46 (“FIN 46”) to clarify some of the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities”, and to exempt certain entities from its requirements. The FASB issued, FIN 46, an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to improve financial reporting of special purpose and other entities. In accordance with FIN 46, business enterprises that represent the primary beneficiary of another entity by retaining a controlling financial interest in that entity’s assets, liabilities and results of operating activities must consolidate the entity in its financial statements. Prior to the issuance of FIN 46, consolidation generally occurred when an enterprise controlled another entity through voting interests. As of March 31, 2004, the Company is not involved in any variable interest entities.

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Forward-Looking Statements

        Certain statements contained in this Annual Report and other written and oral statements made from time to time by the Company do not relate strictly to historical or current facts but provide current expectations or forecasts of future events. As such, they are considered “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties that could cause actual results to differ materially from those presently anticipated or projected. Such forward-looking statements can be identified by the use of terminology such as “may,”“will,” “expect,” “plan,” “intend,”“anticipate,” “estimate,” or “continue” or similar words or expressions. It is not possible to foresee or identify all factors affecting the Company’s forward-looking statements and investors therefore should not consider any list of factors to be an exhaustive statement of all risks, uncertainties or potentially inaccurate assumptions. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to, the following factors: (i) the Company’s revenue and profitability is reliant on sales of Breathe Right® nasal strips; (ii) the Company currently has a seasonal pattern of sales that is typically higher in the third and fourth quarters of each fiscal year due to increased nasal strip usage during the cold/flu season and its revenues and earnings may be impacted by the severity of such season; (iii) the Company’s success and future growth will depend significantly on its ability to effectively market Breathe Right nasal strips and upon its ability to develop and achieve markets for additional products; (iv) the Company’s competitive position will, to some extent, be dependent on the enforceability and comprehensiveness of the patents on its Breathe Right nasal strip technology which have been, and in the future may be, the subject of litigation and could be narrowed as a result of the outcome of the reexamination of one such patent by the United States Patent and Trademark Office; (v) the Company has faced and will continue to face challenges in successfully developing and introducing new products; (vi) the Company operates in competitive markets where recent and potential entrants into the nasal dilator segment pose competitive challenges; (vii) the Company is dependent upon contract manufacturers for the production of substantially all of its products; and (viii) the Company currently purchases most of its nasal strip products from different contract manufacturers that obtain the raw materials from a single supplier.

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Item 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        The Company’s market risk exposure is primarily interest rate risk related to its cash and cash equivalents and investments in marketable securities. The Company has an investment policy which limits the types of securities in which it may invest as well as the length of maturities. No investment may exceed 36 months in maturity and the weighted average life of the portfolio may not exceed 18 months. The average life of the investment portfolio as of March 31, 2004 was 403 days.

        The table below provides information about the Company’s cash and cash equivalents and marketable securities as of March 31, 2004:

Item 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

        The Consolidated Balance Sheets of the Company as of March 31, 2004 and 2003, and the related Consolidated Statements of Operations, Stockholders’ Equity and Comprehensive Income (Loss), and Cash Flows for each of the years ended March 31, 2004 and 2003 and December 31, 2001 and for the three months ended March 31, 2002 and 2001 (unaudited), the Notes to the Consolidated Financial Statements and the Report of Independent Registered Public Accounting Firm, are listed under Item 15 of this 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.

        The Company’s Chief Executive Officer, Marti Morfitt, and Chief Financial Officer, Samuel E. Reinkensmeyer, have evaluated the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based upon that review, they have concluded that these controls and procedures are effective in ensuring that material information related to the Company is made known to them by others within the Company.

(b)   Changes in Internal Control Over Financial Reporting.

        There have been no significant changes in internal control over financial reporting that occurred during the fourth fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the registrant’s internal control over financial reporting.

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PART III

Item 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Directors

        The following sets forth certain information with respect to the Company’s directors:

        Daniel E. Cohen, 51, has served as the Company’s Chairman of the Board since 1993 and has served as a director of the Company since its formation in 1982. Mr. Cohen also served as the Company’s Chief Executive Officer from 1989 to June 2001 and as Treasurer from 1982 to March 1999. Mr. Cohen, a founder of the Company, is a medical doctor and board-certified neurologist.

        Patrick Delaney, 61, has served as a director of the Company since 1983 and as the Company’s Secretary since 1995. A practicing attorney since 1967, Mr. Delaney retired as a partner in the Minneapolis-based law firm of Lindquist & Vennum P.L.L.P., counsel to the Company in December 2002. Mr. Delaney is a professional writer and serves on the board of a number of privately-held companies. In addition, he is a director of Community First Bankshares, Inc., a publicly-held multi-bank holding company.

        R. Hunt Greene, 53, has served as a director of the Company since 1985. Mr. Greene has been an investment banker for over twenty years. He is presently Managing Director and Member of Greene Holcomb & Fisher LLC (“GH&F”), a Minneapolis investment banking firm that was formed in 1995. GH&F has provided the Company with certain financial advisory and investment banking services from time to time since 1996.

        Andrew J. Greenshields, 66, has served as a director of the Company since 1986. Mr. Greenshields has been President of Pathfinder Ventures, Inc., Minneapolis, Minnesota, since 1980. He is also a general partner of Pathfinder Venture Capital Fund III and a general partner of Spell Capital Partners, LP, both of which are Minneapolis-based financial limited partnerships. Mr. Greenshields is also a director of Aetrium, Inc., a manufacturer of semi-conductor handling equipment.

        H. Robert Hawthorne, 59, has served as a director of the Company since 1999. Mr. Hawthorne was Chief Executive Officer of Ocean Spray Cranberries, Inc., a Boston-based food and beverage company, from February 2000 to November 2002. From 1997 to 1999, Mr. Hawthorne served as a director, President and Chief Executive Officer of Select Comfort Corporation, a Minneapolis-based company that manufactures air beds and sleep related products. From 1986 to 1997, Mr. Hawthorne served in a series of positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving from February 1992 to December 1997 as President of The Pillsbury Brands Group, a subsidiary of The Pillsbury Company.

        Marti Morfitt, 46, has served as the Company’s President and Chief Executive Officer since June 2001 and its President and Chief Operating Officer from March 1998 to June 2001. Ms. Morfitt has served as a director of the Company since 1998. From September 1982 to February 1998, Ms. Morfitt served in a series of positions of increasing responsibility with The Pillsbury Company, a Minneapolis-based manufacturer and distributor of food products, most recently serving from May 1997 to February 1998 as Vice-President, Meals, and from February 1994 to May 1997 as Vice-President, Green Giant Brands. She also serves as a director of Graco, Inc., a Minneapolis-based manufacturer of fluid handling systems.

        Richard W. Perkins, 73, has been a director of the Company since 1993. Mr. Perkins has been President, Chief Executive Officer and a director of Perkins Capital Management, Inc., a Minneapolis-based investment management company, since 1985. He is also a general partner of Spell Capital Partners, LP, a Minneapolis-based venture capital limited partnership. He is also a director of the following publicly-held companies: Synovis Life Technologies, Inc., a manufacturer of medical products; PW Eagle, Inc., a manufacturer of plastic pipe; Lifecore Biomedical, Inc., a medical device company; Nortech Systems, Inc., a contract manufacturer for the electronics industry; Vital Images, Inc., a medical diagnostic software company; Teledigital, Inc., a provider of software to the cellular phone industry; and Two Way TV (U.S.), Inc., a provider of software to the television game industry.

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        Morris J. Siegel, 54, has served as a director of the Company since April 18, 2003. Mr. Siegel is the founder and retired chairman of Celestial Seasonings, Inc., a manufacturer and marketer of specialty herb teas. In 2000, Celestial Seasonings merged with The Hain Food Group, a natural, specialty, organic and snack food company. Mr. Siegel then served as vice chairman of the merged company, The Hain Celestial Group, Inc. and was Chief Executive Officer of Celestial Seasonings until September 2002. In 1987, Mr. Siegel founded Earth Wise, Inc., a marketer of environmentally friendly cleaning products and recycled trash bags. Mr. Siegel currently serves as a director of Whole Foods Market, Inc., a North American natural foods grocer. Mr. Siegel is also a director Annie’s HomeGrown Foods, Inc., which manufactures, markets and sells premium all natural and organic foods, and is a subsidiary of Solera Capital LLC.

        Karen T. Beckwith, 43, has served as a director of the Company since October 1, 2003. Since January 2003, Ms. Beckwith has served as the President and Chief Executive Officer of Gelco Information Network, a leading provider of expense and trade management solutions. From 1999 to January 2003, Ms. Beckwith served in various executive positions of Gelco Information Network, most recently as its Chief Financial Officer. Prior to that, she held a number of finance positions at Ceridian Corporation from 1995 to 1999, including Senior Vice President of Finance and Business Development and Integration.

_________________

        Certain other information required under this Item with respect to directors is contained in the Section “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s Proxy Statement for the Annual Meeting of Stockholders to be held on August 25, 2004 (the “2004 Proxy Statement”), a definitive copy of which will be filed with the Commission within 120 days of the close of the last fiscal year, and is incorporated herein by reference.

Executive Officers

        Information concerning executive officers is set forth in the Section entitled “Executive Officers of the Company” in Part I of this Form 10-K pursuant to Instruction 3 to paragraph (b) of Item 401 of Regulation S-K.

Item 11.   EXECUTIVE COMPENSATION

        Information required under this item is contained in the section entitled “Executive Compensation” in the Company’s 2004 Proxy Statement and is incorporated herein by reference.

Item 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

        Information required under this item is contained in the section entitled “Security Ownership of Principal Stockholders and Management” in the Company’s 2004 Proxy Statement and is incorporated herein by reference.

Item 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        Information required under this item is contained in the section entitled “Certain Relationships and Related Transactions” in the Company’s 2004 Proxy Statement and is incorporated herein by reference.

Item 14.   PRINCIPAL ACCOUNTANT FEES AND SERVICES

        Information required under this item is contained in the section entitled “Relationship with Independent Accountants” in the Company’s 2004 Proxy Statement and is incorporated herein by reference.

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PART IV

Item 15.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)       Documents filed as part of this Report:

(b)       Reports on Form 8-K.

           During the fourth quarter covered by this report, the Company filed Current Reports on Form 8-K (a) dated January 22, 2004 reporting under Items 5 a quarterly dividend and attaching at Item 7 a related press release and (b) dated March 8, 2004 reporting under Items 5, 9 and 7 a press release announcing revised guidance for the fourth quarter ending March 31, 2004 and its product plans for fiscal year 2005 and attaching certain remarks of Marti Morfitt, the Company’s Chief Executive Officer, made at a March 8, 2004 telephone conference.

           During the fourth quarter covered by this report, the Company also furnished a Current Report on Form 8-K dated January 22, 2004 reporting under Items 7 and 12 a press release disclosing material non-public information regarding its results of operations for the quarter ended December 31, 2003.

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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.

        Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed by the following persons on June 11, 2004 on behalf of the Registrant in the capacities indicated.

(Power of Attorney and Signatures)

        Each person whose signature appears below constitutes and appoints DANIEL E. COHEN and MARTI MORFITT as his or her true and lawful attorneys-in-fact and agents, each acting alone, with the full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, each acting alone, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all said attorneys-in-fact and agents, each acting alone, or his or her substitute or substitutes, may lawfully do or cause to be done by virtue thereof.

/s/   Marti Morfitt

/s/   Samuel Reinkensmeyer

/s/   Karen T. Beckwith

/s/   Daniel E. Cohen

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/s/   Patrick Delaney

/s/   H. Robert Hawthorne

/s/   R. Hunt Greene

/s/   Andrew J. Greenshields

/s/   Richard W. Perkins

/s/   Morris J. Siegel

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CNS, INC.
EXHIBIT INDEX

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_________________
  *Indicates Compensatory Agreement

**Certain portions of this Exhibit have been deleted and filed separately with the Commission pursuant to a request for confidential treatment under Rule 24b-2. Spaces corresponding to the deleted portions are represented by brackets with asterisks.

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
CNS, Inc.:

We have audited the accompanying consolidated balance sheets of CNS, Inc. and subsidiaries as of March 31, 2004 and 2003 and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for the years ended March 31, 2004 and 2003 and December 31, 2001 and the three months ended March 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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 examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CNS, Inc. and subsidiaries as of March 31, 2004 and 2003 and the results of their operations and their cash flows for the years ended March 31, 2004 and 2003 and December 31, 2001 and the three months ended March 31, 2002 in conformity with U.S. generally accepted accounting principles.

/s/   KPMG LLP

Minneapolis, Minnesota
April 26, 2004

F-1

CNS, INC.
Consolidated Statements of Operations
(in thousands, except per share amounts)

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

F-2

CNS, INC.
Consolidated Balance Sheets
(in thousands, except per share amounts)

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

F-3

CNS, INC.
Consolidated Statements of Cash Flows
(in thousands)