##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 þ
    
    Quarterly Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934
 For Quarterly Period Ended: September 30, 2007
 Or
 o
    
    Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
 Commission file number: 1-12214
 CHAD THERAPEUTICS, INC.
  California
    
    95-3792700(State of other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 (Address of principal executive offices) (Zip Code)
 (Registrants telephone number, including area code)
    þ o
 o o þ
 o þ




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TABLE OF CONTENTS  Item 2. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3. Quantitative and Qualitative Disclosures about Market RisksItem 4. Controls and ProceduresPart IIItem 1. Legal ProceedingsItem 1A. Risk FactorsItem 2. Unregistered Sales of Equity Securities and Use of ProceedsItem 3. Defaults Upon Senior SecuritiesItem 4. Submission of Matters to a Vote of Security HoldersItem 5. Other InformationItem 6. ExhibitsSIGNATUREINDEX TO EXHIBITSEXHIBIT 10.33EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32EXHIBIT 99.1    Table of Contents  
 September 30,
    
    
    March 31,2007
    
    
    2007ASSETSCurrent assets:Cash
    
    $
    387,000
    
    
    $
    375,000Accounts receivable, less allowance for
doubtful accounts of $25,000 at
September 30, 2007, and $38,000 at
March 31, 2007
    
    
    1,775,000
    
    
    
    2,376,000Income taxes refundable
    
    
    2,000
    
    
    
    291,000Inventories (Note 5)
    
    
    5,785,000
    
    
    
    6,557,000Prepaid expenses and other assets
    
    
    434,000
    
    
    
    321,000Total current assets
    
    
    8,383,000
    
    
    
    9,920,000Property and equipment, at cost
    
    
    6,272,000
    
    
    
    6,186,000Less accumulated depreciation
    
    
    5,653,000
    
    
    
    5,501,000Net property and equipment
    
    
    619,000
    
    
    
    685,000Intangible assets, net
    
    
    1,068,000
    
    
    
    1,107,000Other assets
    
    
    301,000
    
    
    
    36,000Total assets
    
    $
    10,371,000
    
    
    $
    11,748,000LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    858,000
    
    
    $
    1,282,000Accrued expenses
    
    
    1,163,000
    
    
    
    1,372,000Revolving line of credit
    
    
    1,094,000
    
    
    
    Current portion of long-term debt
    
    
    292,000
    
    
    
    Total current liabilities
    
    
    3,407,000
    
    
    
    2,654,000Long-term debt
    
    
    458,000
    
    
    
    Total liabilities
    
    
    3,865,000
    
    
    
    2,654,000Shareholders equity:Common shares, $.01 par value, authorized
40,000,000 shares; 10,180,000 and 10,180,000
shares issued and outstanding
    
    
    13,581,000
    
    
    
    13,526,000Accumulated deficit
    
    
    (7,075,000
    )
    
    
    (4,432,000
    )Total shareholders equity
    
    
    6,506,000
    
    
    
    9,094,000Total liabilities and shareholders equity
    
    $
    10,371,000
    
    
    $
    11,748,000




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Three Months EndedSeptember 30,2007
    
    
    2006Net sales
    
    $
    3,206,000
    
    
    $
    4,983,000Cost of sales
    
    
    2,607,000
    
    
    
    3,366,000Gross profit
    
    
    599,000
    
    
    
    1,617,000Costs and expenses:Selling, general, and administrative
    
    
    1,408,000
    
    
    
    1,682,000Research and development
    
    
    391,000
    
    
    
    322,000Total costs and expenses
    
    
    1,799,000
    
    
    
    2,004,000Operating loss
    
    
    (1,200,000
    )
    
    
    (387,000
    )Interest expense
    
    
    153,000
    
    
    
    Other income
    
    
    
    
    
    
    (16,000
    )Loss before income taxes
    
    
    (1,353,000
    )
    
    
    (371,000
    )Income tax expense (benefit)
    
    
    
    
    
    
    (64,000
    )Net loss
    
    $
    (1,353,000
    )
    
    $
    (307,000
    )Basic loss per share
    
    $
    (0.13
    )
    
    $
    (0.03
    )Diluted loss per share
    
    $
    (0.13
    )
    
    $
    (0.03
    )Weighted shares outstanding:Basic
    
    
    10,180,000
    
    
    
    10,169,000Diluted
    
    
    10,180,000
    
    
    
    10,169,000




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Six Months EndedSeptember 30,2007
    
    
    2006Net sales
    
    $
    7,179,000
    
    
    $
    10,459,000Cost of sales
    
    
    5,785,000
    
    
    
    7,028,000Gross profit
    
    
    1,394,000
    
    
    
    3,431,000Costs and expenses:Selling, general, and administrative
    
    
    2,957,000
    
    
    
    3,384,000Research and development
    
    
    853,000
    
    
    
    657,000Total costs and expenses
    
    
    3,810,000
    
    
    
    4,041,000Operating loss
    
    
    (2,416,000
    )
    
    
    (610,000
    )Interest expense
    
    
    175,000
    
    
    
    Other (income) expense
    
    
    48,000
    
    
    
    (39,000
    )Loss before income taxes
    
    
    (2,639,000
    )
    
    
    (571,000
    )Income tax expense (benefit)
    
    
    4,000
    
    
    
    (148,000
    )Net loss
    
    $
    (2,643,000
    )
    
    $
    (423,000
    )Basic loss per share
    
    $
    (0.26
    )
    
    $
    (0.04
    )Diluted loss per share
    
    $
    (0.26
    )
    
    $
    (0.04
    )Weighted shares outstanding:Basic
    
    
    10,180,000
    
    
    
    10,169,000Diluted
    
    
    10,180,000
    
    
    
    10,169,000




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Common Shares
    
    
    AccumulatedShares
    
    
    Amount
    
    
    DeficitBalance as of March 31, 2007
    
    
    10,180,000
    
    
    
    13,526,000
    
    
    $
    (4,432,000
    )Stock-based compensation  options
    
    
    
    
    
    
    6,000
    
    
    
    Warrants
    
    
    
    
    
    
    49,000Net loss
    
    
    
    
    
    
    
    
    
    
    (2,643,000
    )Balance at September 30, 2007
    
    
    10,180,000
    
    
    
    13,581,000
    
    
    $
    (7,075,000
    )




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Six Months EndedSeptember 30,2007
    
    
    2006Cash flows from operating activities:Net loss
    
    $
    (2,643,000
    )
    
    $
    (423,000
    )Adjustments to reconcile net loss to net cash
(used in) provided by operating activities:Depreciation and amortization of property and equipment
    
    
    152,000
    
    
    
    194,000Amortization of intangibles
    
    
    21,000
    
    
    
    21,000Loss on impairment of intangible assets
    
    
    48,000
    
    
    
    Amortization of deferred financing fees
    
    
    25,000
    
    
    
    Provision for losses on receivables
    
    
    (13,000
    )
    
    
    20,000Decrease (increase) in deferred income taxes
    
    
    
    
    
    
    16,000Stock-based compensation
    
    
    6,000
    
    
    
    60,000Warrant costs
    
    
    49,000
    
    
    
    Changes in assets and liabilities:Decrease (increase) in accounts receivable
    
    
    614,000
    
    
    
    632,000Decrease (increase) in inventories
    
    
    772,000
    
    
    
    78,000Decrease (increase) in income taxes refundable
    
    
    289,000
    
    
    
    201,000Decrease (increase) in prepaid expenses and other assets
    
    
    (403,000
    )
    
    
    59,000Increase (decrease) in accounts payable
    
    
    (424,000
    )
    
    
    401,000Increase (decrease) in accrued expenses
    
    
    (209,000
    )
    
    
    (229,000
    )Net cash (used in) provided by operating activities
    
    
    (1,716,000
    )
    
    
    1,030,000Cash flows from investing activities:Additions to intangible assets
    
    
    (30,000
    )
    
    
    (122,000
    )Capital expenditures
    
    
    (86,000
    )
    
    
    (62,000
    )Net cash (used in) provided by investing activities
    
    
    (116,000
    )
    
    
    (184,000
    )Cash flows from financing activities:Borrowings under revolving line of credit
    
    
    1,094,000
    
    
    
    Borrowings under long term debt
    
    
    750,000
    
    
    
    Other long-term liabilities
    
    
    
    
    
    
    (4,000
    )Net cash (used in) provided by financing activities
    
    
    1,844,000
    
    
    
    (4,000
    )Net increase in cash
    
    
    12,000
    
    
    
    842,000Cash beginning of period
    
    
    375,000
    
    
    
    935,000Cash end of period
    
    $
    387,000
    
    
    $
    1,777,000Supplemental disclosure of cash flow information:Cash paid during the year for:Interest
    
    $
    124,000




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CHAD THERAPEUTICS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(Unaudited)
 1.
    
    Basis of Presentation and Going ConcernCHAD Therapeutics, Inc. (the Company) is in the business of developing, producing, and
marketing respiratory care devices designed to improve the efficiency of oxygen delivery systems
for home health care and hospital treatment of patients suffering from pulmonary diseases.In the opinion of management, all adjustments necessary, which are of a normal and recurring
nature, for a fair presentation of the results for the interim periods presented, have been
made. The results for the three and six-month periods ended September 30, 2007, are not
necessarily indicative of the results expected for the year ended March 31, 2008. The interim
statements are condensed and do not include some of the information necessary for a more
complete understanding of the financial data. Accordingly, your attention is directed to the
footnote disclosures found in the March 31, 2007, Annual Report and particularly to Note 1 which
includes a summary of significant accounting policies.The Companys financial statements have been prepared and presented on a basis assuming it will
continue as a going concern. However, the Companys prospects must be considered in light of
substantial risks. The Company has experienced net losses since its fiscal year ended March 31,
2006 and as of September 30, 2007, it had an accumulated deficit of approximately $7,075,000.
For the six months ended September 30, 2007, the Company had a net loss of $2,643,000 and
utilized approximately $1,716,000 of cash in operating activities. The Company expects
operating losses to continue through its foreseeable future. At the filing date, the Company
had utilized substantially all of the financing available through its revolving line of credit
and its term note. These factors, among others, indicate that the Company is in need of
additional financing or a strategic arrangement in order to continue operations. These factors
could raise doubts about the Companys ability to continue as a going concern.In order to address this situation, on November 16, 2007, the Company entered into a definitive
agreement, subject to shareholder approval, to sell to Inovo, Inc. (the Buyer) substantially
all of the assets of the Company related to the oxygen conserver business including accounts
receivable, inventory, and certain equipment and intellectual property (the Asset Sale)
pursuant to an Asset Purchase Agreement (the APA). Pursuant to the APA, the Buyer would
assume certain liabilities and obligations related to the Companys oxygen conserver business.
If the Asset Sale is approved, the Company will no longer develop and sell oxygen conserver
products. The Company will retain the assets related to its TOTAL O2 and in-home transfilling
business as well as products in development for the sleep disorder market. The Companys future
efforts will focus on the sleep disorder market and the Company will seek to realize appropriate
value for its sleep business as well as its TOTAL O2 and transfilling assets.




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The selling price for the Assets is $5,250,000, subject to adjustment for changes in working
capital between the execution date of the APA and closing date (the Selling Price). The
selling price may not exceed $5,500,000. There is no limit on a potential downward adjustment
of the selling price based on a reduction in the Companys working capital.The Asset Sale is subject to certain closing conditions including approval by the Companys
shareholders. If the Asset Sale is approved and closes during the first calendar quarter of
2008, then the Company anticipates it will have sufficient working capital in place for the next
12 months to continue operations. If the Asset Sale is not approved by the shareholders or is
not completed during the first calendar quarter of 2008, then the Company would require
additional capital resources which may only be available pursuant to terms and conditions that
would result in significant cost to the Company and significant dilution of the shareholders
interest in the Company and its assets. Moreover, such additional financing may not be
available at all, in which event the Company would need to consider other alternatives,
including an orderly liquidation of its assets, curtailment of its current operations and
seeking protection under the federal bankruptcy laws. The financial statements do not include
any adjustments that might be required for the outcome of this uncertainty.2.
    
    Revenue RecognitionRevenue from product sales is recognized upon shipment of merchandise when title and risk of
loss transfers to the customer and the earnings process is complete. Products are shipped FOB
shipping point and title to the products transfers to the purchaser upon shipment. Under a
sales-type lease agreement, revenue is recognized at the time of the shipment with interest
income recognized over the life of the lease. Shipping charges billed to customers are
included in net sales. Allowances for customer returns have not been established, as
historically customer return experience has been minor. Costs paid to shipping companies are
recorded as a cost of sales.3.
    
    Major Customers
 Three Months Ended
    
    Six Months EndedSeptember 30,
    
    September 30,2007
    
    2006
    
    2007
    
    2006Customer A**
    
    
    34.4
    %
    
    
    39.5
    %
    
    
    41.8
    %
    
    
    38.0
    %Customer B
    
    
    *
    
    
    
    10.5
    %
    
    
    *
    
    
    
    11.7
    %
 
 *
    
    Indicates sales less than 10% of the Companys net sales**
    
    Indicates national chain customer The Companys customers are affected by Medicare reimbursement policy as approximately 80%
of home oxygen patients are covered by Medicare and other government programs.4.
    
    Concentration of Credit RiskAt times the Company maintains balances of cash that exceed $100,000 per financial institution,
the maximum insured by the Federal Deposit Insurance Corporation.
Further, the Company maintains a portion of its cash funds in an interest bearing,




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uninsured
account. The Companys right to the cash is subject to the risk that the financial institution
will not pay when cash is requested. The potential loss is the amount in any one financial
institution over $100,000 and/or all funds in the interest bearing account. At September 30,
2007, the amount at risk was approximately $287,000.The significant outstanding accounts receivable balances in 2007 were as follows:
 September 30
    
    March 31Customer A**
    
    
    22.0
    %
    
    
    41.0
    %Customer B**
    
    
    13.2
    %
    
    
    *
 
 *
    
    Indicates receivables balance less than 10% of the Companys net accounts receivable balance.**
    
    Indicates national chain customer. 5.
    
    InventoriesInventories in 2007 are summarized as follows:
 September 30
    
    
    March 31Finished goods
    
    $
    1,642,000
    
    
    $
    1,841,000Work-in-process
    
    
    1,771,000
    
    
    
    2,240,000Raw materials
    
    
    2,372,000
    
    
    
    2,476,000$
    5,785,000
    
    
    $
    6,557,000
 6.
    
    Long-Term Debt and Revolving Line of CreditLong-term debt in 2007 consists of the following:
 September 30
    
    
    March 31Obligations under capital lease, payable in monthly
installments through September 2007
    
    $
    
    
    
    $
    4,000Long-term note
    
    
    750,000
    
    
    
    750,000
    
    
    
    4,000Less current portion
    
    
    292,000
    
    
    
    4,000Total long-term debt
    
    $
    458,000
    
    
    $
    
 In March 2007, the Company entered into a one-year factoring arrangement that provided for the
sale of up to $1,500,000 of the Companys accounts receivable. Assignments under the agreement
incurred interest at the banks prime rate plus two percent (2%) to three percent (3%)
depending on the total accounts receivable balance. The Company had a minimum monthly interest
payment of $6,000
beginning April 2007. The Company voluntarily terminated the factoring agreement on July 30,
2007.




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On July 30, 2007, the Company entered into a financing transaction with Calliope Capital
Corporation , a Delaware corporation (the Investor) pursuant to which the Company issued to
the Investor a $750,000 convertible term note (Convertible Note) and a $2,750,000 revolving
credit line (Credit Line), all secured by the Companys assets. The Convertible Note is
payable in equal installments over 36 months beginning in November 2007 and maturing in July
2010 and bears interest at prime plus 2%, and the Credit Line bears interest at prime plus
1.5%. A portion of the financing was used to pay all outstanding obligations on the Companys
factoring arrangement. At the Investors option, the Convertible Note may be converted into
shares of the Companys common stock any time during the term of the note at a conversion price
of $1.18. The closing price of the Companys common stock on the issue date of the Convertible
Note was $1.00 per share. In addition, warrants to purchase up to 976,744 shares of the
Companys common stock were issued to the Investor with an exercise price of $1.24 per share.
The Investor was granted registration rights with respect to the shares underlying the
warrants. The warrants include a lock-up feature for a period of 12 months after any warrants
are exercised (see note 12.)At November 16, 2007, the Company had utilized substantially all of its availability on its
financing arrangements based on the lenders calculation of the Companys borrowing base. The
Company is in negotiations with its lender to obtain additional availability through its
revolving line of credit.For the six months ended September 30, 2007, amortization of deferred financing fees was
$25,000. There were no deferred financing fees in fiscal year 2006.7.
    
    Subsequent EventOn November 16, 2007, the Company entered into a definitive agreement, subject to shareholder
approval, to sell to Inovo, Inc. (the Buyer) substantially all of the assets of the Company
related to the oxygen conserver business including accounts receivable, inventory, and certain
equipment and intellectual property (the Asset Sale) pursuant to an Asset Purchase Agreement
(the APA). Pursuant to the APA, the Buyer would assume certain liabilities and obligations
related to the Companys oxygen conserver business. If the Asset Sale is approved, the Company
will no longer develop and sell oxygen conserver products. If the Asset Sale is approved, the
Company will focus its efforts on the development of products for the sleep disorder market and
will seek to realize appropriate value for such products as well as its TOTAL O2 and in-home
transfilling products.The selling price for the oxygen conserver assets is $5,250,000 in cash, subject to adjustment
for changes in working capital between the execution date of the APA and closing date (the
Selling Price). The Selling Price may not exceed $5,500,000. There is no limit on the
possible downward adjustment of the Selling Price based upon a decline in the Companys working
capital between November 16, 2007 and the closing date of the Asset Sale.If the shareholders approve the Asset Sale, the Company will no longer obtain revenues from
sales of CHAD oxygen conserving devices. Such revenues were




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approximately 92% and 94% and 90%
and 91% of the Companys revenues for the three and six-month periods ended September 30, 2007,
and 2006, respectively. The remaining revenues were derived from the sale of the Companys
TOTAL O2 and in-home transfilling products. If the Asset Sale is approved, the Company will
pursue a strategy intended to obtain fair value for its remaining assets. This strategy would
include a focus on the development and introduction of diagnostic and therapeutic products for
the sleep disorder market over the next twelve months. The first of these products is currently
undergoing testing and 510(k) clearance. The channels for sales of the sleep products are not
currently established, and the Company faces competitors with substantially greater resources
who are already entrenched in these markets.
 8.
    
    Leasing ArrangementsIn the second quarter of fiscal year 2006, the Company entered into a capital lease agreement
for certain plant equipment totaling $14,000, with annual lease payments of $7,000, a fixed
interest rate of 7% and a purchase option at lease end in August 2007. The Company completed
the capital lease obligation in September 2007 and exercised the bargain purchase option at
that time. Amortization of plant equipment under capital leases is included in depreciation
expense.9.
    
    Loss Per Common ShareFollowing is a reconciliation of the numerators and denominators used in the calculation of
basic and diluted loss per common share:
 Three Months Ended
    
    
    Six Months EndedSeptember 30,
    
    
    September 30,2007
    
    
    2006
    
    
    2007
    
    
    2006Basic loss per share:Numerator-net loss
    
    $
    (1,353,000
    )
    
    $
    (307,000
    )
    
    $
    (2,643,000
    )
    
    $
    (423,000
    )Denominator-weighted average
common shares outstanding
    
    
    10,180,000
    
    
    
    10,169,000
    
    
    
    10,180,000
    
    
    
    10,169,000Basic earnings loss per share
    
    $
    (0.13
    )
    
    $
    (0.03
    )
    
    $
    (0.26
    )
    
    $
    (0.04
    )Diluted loss per share:Numerator-net loss
    
    $
    (1,353,000
    )
    
    $
    (307,000
    )
    
    $
    (2,643,000
    )
    
    $
    (423,000
    )Denominator-weighted average
common shares outstanding
    
    
    10,180,000
    
    
    
    10,169,000
    
    
    
    10,180,000
    
    
    
    10,169,000Diluted effect of common stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,180,000
    
    
    
    10,169,000
    
    
    
    10,180,000
    
    
    
    10,169,000Diluted earnings (loss) per share
    
    $
    (0.13
    )
    
    $
    (0.03
    )
    
    $
    (0.26
    )
    
    $
    (0.04
    )
 Options to purchase 891,000 shares of common stock at prices ranging from $0.50 to $7.62 per
share and 935,000 shares of common stock at prices ranging from $0.50 to $11.50 were not
included in the computation of diluted earnings per share for the three
and six-month periods ended September 30, 2007 and 2006, respectively, because their effect
would have been anti-dilutive.10.
    
    Income Tax Expense




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Based on managements earnings projections for the fiscal year ended 2008, the Company has
forecasted an effective tax rate of 35 percent. As of March 31, 2007, the Company has Federal
net operating loss carryforwards of $1,407,000 expiring in 2027 and California net operating
loss carryforwards of $3,422,000 expiring in 2010 through 2017. In assessing the realizability
of deferred tax assets, management considered whether it is more likely than not that some
portion or all of the deferred tax assets will not be realized. At September 30, 2007, the
Companys deferred tax assets are fully offset by a valuation allowance.11.
    
    Geographic InformationThe Company has one reportable operating segment. Geographic information regarding the
Companys net sales is as follows:
 Three Months Ended
    
    
    Six Months EndedSeptember 30,
    
    
    September 30,2007
    
    
    2006
    
    
    2007
    
    
    2006United States
    
    $
    2,579,000
    
    
    $
    3,788,000
    
    
    $
    6,158,000
    
    
    $
    8,142,000Canada
    
    
    33,000
    
    
    
    33,000
    
    
    
    68,000
    
    
    
    87,000Japan
    
    
    68,000
    
    
    
    69,000
    
    
    
    126,000
    
    
    
    194,000Europe
    
    
    323,000
    
    
    
    1,004,000
    
    
    
    465,000
    
    
    
    1,858,000Indonesia
    
    
    145,000
    
    
    
    18,000
    
    
    
    176,000
    
    
    
    20,000All other countries
    
    
    58,000
    
    
    
    71,000
    
    
    
    186,000
    
    
    
    158,000$
    3,206,000
    
    
    $
    4,983,000
    
    
    $
    7,179,000
    
    
    $
    10,459,000
 All long-lived assets are located in the United States.Sales of OXYMATIC®, LOTUS and CYPRESS OXYPneumatic® conservers and SAGE Therapeutic devices
accounted for 63.2% and 73.4% of the Companys sales for the three-month periods ended September
30, 2007 and 2006, respectively and 67.0% and 71.5% of the Companys sales for the six-month
periods ended September 30, 2007 and 2006 respectively.12.
    
    Stock Option PlanOn April 1, 2006, the Company adopted Statement of Financial Accounting Standards 123R,
Share-Based Payment, which revised SFAS 123, Accounting for Stock-Based Compensation. The
Company adopted FAS 123R using the modified prospective transition method. Previously, the
Company had followed APB 25, accounting for employee stock options at intrinsic value.
Accordingly, during the three and six-month periods ended September 30, 2007 and 2006, the
Company recorded stock-based compensation expense for awards granted prior to, but not yet
vested, as of April 1, 2006, as if the fair value method required for pro forma disclosure under
FAS 123 were in effect for expense recognition purposes, adjusted
for estimated forfeitures. For stock-based awards granted after April 1, 2006, the Company will
recognize compensation expense based on the estimated grant date fair value method using the
Black-Scholes valuation model. For these awards, the Company will recognize compensation
expense using a straight-line method. As FAS 123R requires that stock based compensation
expense be based on awards that are




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ultimately expected to vest, stock-based compensation for the three and six-month periods ended
September 30, 2007 and 2006, has been reduced for estimated forfeitures. For the six-month
period ended September 30, 2007, stock-based compensation expense of $6,000 was recorded to
selling, general, and administrative expenses, all of which was due to FAS 123R option expense.
For the six-month period ended September 30, 2006, stock-based compensation expense of $60,000
was recorded to selling, general, and administrative expenses. Of the $60,000 in stock-based
compensation recorded for the six-month period ended September 30, 2006, $20,000 related to FAS
123R option expense with the remaining $40,000 related to restricted stock issued to directors
that vested April 1, 2006. Due to the prospective adoption of SFAS No. 123R, results for prior
period have not been restated.The Company has an equity incentive plan (the Plan) for key employees as defined under Section
422(A) of the Internal Revenue Code. The Plan provides that 750,000 common shares be reserved
for issuance under the Plan, which expires on September 8, 2014, of which approximately 720,000
were available for future grant at September 30, 2007. In addition, the Plan provides that
non-qualified options can be granted to directors and independent contractors of the Company.
Stock options are granted with an exercise price equal to the market value of a share of the
Companys stock on the date of the grant. Historically, grants to non-employee directors have
vested over two years, while the majority of grants to employees have vested over two to five
years of continuous service.The fair value of each stock option award is estimated on the date of the grant using the
Black-Scholes option valuation model. Expected volatility is based on the historical volatility
of the Companys stock. No expected dividend yield is used since the Company has not
historically declared or paid dividends and no dividends are expected in the foreseeable future.
The risk-free interest rate is based on the U.S. treasury yield curve on the grant date for the
expected term of the option. The Company did not grant any stock options during the six months
ended September 30, 2007 and 2006, respectively. A summary of stock option activity as of and
for the six-months ended September 30, 2007, is presented below:
 RemainingExercise
    
    ContractualPrice Per
    
    TermShares
    
    Share
    
    (in years)Outstanding at March 31, 2007
    
    
    904,000
    
    
    $
    2.09Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited or expired
    
    
    13,000
    
    
    
    3.81Outstanding at September 30, 2007
    
    
    891,000
    
    
    $
    2.07
    
    
    
    3.8As of September 30, 2007:Exercisable
    
    
    879,000
    
    
    $
    2.11
    
    
    
    3.8Vested and expected to vest
    
    
    888,000
    
    
    $
    2.11
    
    
    
    3.8




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No options were granted or exercised during the six months ended September 30, 2007 or 2006.The aggregate intrinsic value is calculated as the difference between the exercise price of the
underlying awards and the quoted price of the Companys common stock at September 30, 2007 for
the options that were in-the-money September 30, 2007. As of September 30, 2007, there was
approximately $4,000 of unrecognized compensation cost related to unvested stock-based
compensation arrangements granted under the Plan. That cost is expected to be recognized over a
weighted-average period of 6 months.13.
    
    WarrantsIn connection with the Convertible Note financing transaction that the Company entered into in
July 2007, the Company issued warrants to purchase up to 976,744 of the Companys common stock
at an exercise price of $1.24 per share. The closing price of the Companys common stock on
the issue date of the warrants was $1.00 per share. The fair value of the warrants was
approximately $588,000 and was determined using a Black Scholes pricing model. These warrants
expire ten years from the date of issue and have a lock-up period of 12 months after any
warrants are exercised. The warrants will be amortized over the 36 month life of the
Convertible Note.For the six months ended September 30, 2007, amortization of the warrants was $49,000. There
was no warrant amortization in fiscal year 2006.14.
    
    CommitmentsThe Company is currently leasing its administrative and plant facilities and certain office
equipment under noncancelable operating leases that expire through June 2008.The Company has minimum annual royalty requirements pursuant to the terms of license agreements
related to certain products in the amount of $530,000. License agreements with minimum annual
royalty requirements are in place through fiscal year 2016.Employee obligations consist of an employment agreement (the Employment Agreement) with
Thomas E. Jones, Chairman of the Board of Directors. The Employment Agreement does not have a
specific term and provides for a base salary of $160,000 per year, which is subject to annual
review by the Board of Directors. The Employment Agreement may be terminated at any time by
the Company, with or without cause, and may be terminated by Mr. Jones upon 90 days notice.
If Mr. Jones resigns or is terminated for cause (as defined in the Employment Agreement), he is
entitled to receive only his base salary and accrued vacation through the effective date of his
resignation or termination. If Mr. Jones is terminated without cause, he is entitled to
receive a severance benefit in accordance with the Companys Severance and Change of Control
Plan, or if not applicable, a severance benefit equal to 200% of his salary and incentive bonus
for the prior fiscal year. In estimating its




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contractual obligation, the Company has assumed
that Mr. Jones will voluntarily retire at the end of the year he turns 65 and that no severance
benefit will be payable. This date may not represent the actual date the Companys payment
obligations under the Employment Agreement are extinguished.The Company is involved in certain legal actions from the ordinary course of business. The
Company believes the ultimate outcome of the legal actions will not have a material adverse
impact on the Companys financial statements as a whole.15.
    
    Use of EstimatesThe preparation of financial statements in conformity with accounting principles generally
accepted in the United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets, liabilities, revenues, and expenses, and the
disclosure of contingent assets and liabilities at the date of the financial statements.
Actual results may differ from those estimates.16.
    
    Accounting StandardsIn June 2006, the Financial Accounting Standards Board ratified EITF Issue No. 06-3, How Taxes
Collected from Customers and Remitted to Governmental Authorities Should be Presented in the
Income Statement. The EITF provides guidance on the proper presentation of tax assessed by a
governmental authority that is directly imposed on a revenue-producing transaction between a
seller and a customer and requires disclosure of the Companys accounting policy decision. The
consensus becomes effective for periods beginning after December 15, 2006. The implementation
of this interpretation did not have a significant impact on the Companys financial statements.In June 2006, the Financial Accounting Standards Board issued Interpretation No. 48,
Accounting for Uncertainty in Income Taxes. Interpretation No. 48 prescribes a recognition
threshold and measurement attribute for financial statement recognition and measurement of a
tax position taken, or expected to be taken, in a tax return. The Interpretation also provides
guidance on derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. This Interpretation is effective for fiscal years
beginning after December 15, 2006. The implementation of this interpretation did not have a
significant impact on the Companys financial statements.In September 2006, the Financial Accounting Standards Board issued Staff Accounting Bulletin
No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in
Current Year Financial Statements. SAB 108 requires registrants to quantify misstatements
using both the balance sheet and income-statement approaches and to evaluate whether either
approach results in quantifying an error that is material in light of relevant quantitative and
qualitative factors. The requirements are effective for annual financial statements covering
the first fiscal year ending after November 16, 2006. The implementation of this interpretation
did not have a significant impact on the Companys financial statements.




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In September 2006, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standard (SFAS) No. 157 Fair Value Measurement. SFAS 157 establishes a single
authoritative definition of fair value, sets out a framework for measuring fair value, and
requires additional disclosures about fair-value measurements. SFAS 157 applies only to
fair-value measurements that are already required or permitted by other accounting standards.
The Statement is effective for
fair-value measures already required or permitted by other standards for financial statements
issued for fiscal years beginning after November 15, 2007, and interim periods within those
fiscal years. The Company is evaluating the impact of this interpretation and does not
anticipate a significant impact to its financial statements upon implementation.In September 2006, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standard (SFAS) No. 158 Employers Accounting for Defined Benefit Pension and
Other Post-retirement Plans. SFAS 158 requires employers to recognize on their balance sheets
the funded status of pension and other post-retirement benefit plans as of September 30, 2007,
for the calendar-year public companies. SFAS 158 will also require fiscal-year-end
measurements of plan assets and benefit obligations, eliminating the use of earlier measurement
dates currently permissible. The Company does not have a defined benefit pension plan, nor
does it have any other post-retirement plans. The implementation of this interpretation did not
have a significant impact on the Companys financial statements.In February 2007, the FASB issued SFAS No. 159, The Fair Value Option of Financial Assets and
Financial Liabilities. SFAS No. 159 permits companies to choose to measure certain financial
instruments and certain other items at fair value. The standard requires that unrealized gains
and losses on items for which the fair value option has been elected by reported in earnings.
SFAS No. 159 is effective as of the beginning of the entitys first fiscal year that begins
after November 15, 2007. The Company is currently evaluating the impact that SFAS No. 159 will
have on its financial statements.




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Payments Due by PeriodContractual
    
    
    
    
    
    Less than 1
    
    1  3
    
    3-5
    
    After 5Obligations
    
    Total
    
    Year
    
    Years
    
    Years
    
    YearsOperating lease
obligations
    
    $
    356,000
    
    
    $
    347,000
    
    
    $
    9,000
    
    
    
    
    
    
    
    Minimum royalty obligations
    
    $
    1,782,000
    
    
    $
    530,000
    
    
    $
    1,132,000
    
    
    $
    90,000
    
    
    $
    30,000Employee obligations
    
    $
    200,000
    
    
    $
    160,000
    
    
    $
    40,000
    
    
    
    
    
    
    
    Convertible Note
    
    $
    750,000
    
    
    $
    250,000
    
    
    $
    250,000
    
    
    $
    250,000
    
    
    
    




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(a)
    
    The Companys 2007 Annual Meeting of Shareholders was held on October 24,
2007 in Chatsworth, California.(b)
    
    Proxies for the meeting were solicited pursuant to Regulation 14A under the
Securities Exchange Act of 1934, as amended, there was no solicitation in opposition
to the managements nominees as listed in the proxy statement, and all such nominees
were elected.(c)
    
    At the Annual Meeting, the following matters were considered and voted upon:
 (i)
    
    The election of three directors to the Companys board of
directors, which currently consists of six persons. Only three positions on
the Companys board of directors were to be elected at the Annual Meeting. At
the Annual Meeting, the Companys shareholders elected each of the following
director nominees as directors, to serve on the Companys board of directors
until the 2008 Annual Meeting of Shareholders or until their successors are
duly elected and qualified. The vote of each director was as follows:
 Name
    
    For
    
    Against
    
    WithheldKathleen M. Griggs
    
    
    8,758,953
    
    
    
    0
    
    
    
    333,530James Brophy
    
    
    8,756,403
    
    
    
    0
    
    
    
    336,080Philip T. Wolfstein
    
    
    8,758,953
    
    
    
    0
    
    
    
    331,980
 (ii)
    
    To ratify the appointment of Rose, Snyder & Jacobs as the
Companys independent auditors for the fiscal year ended March 31, 2008. At
the Annual Meeting, the Companys shareholders approved this proposal by the
votes indicated below:
 SharesFor
    
    
    8,932,298Against
    
    
    33,293Abstain
    
    
    126,892
 (ii)
    
    None
 
  Asset Purchase Agreement
    Additional Information and Where to Find It




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(1)
 (2)
 (3)
 (4)
 (4)
 (5)
 (6)
 (7)
 (7)
 (7)
 (7)
 (7)
      
 (1)
    
    Previously filed as an Exhibit to the Registrants Registration
Statement on Form S-18, File No. 2-83926.(2)
    
    Previously filed as an Exhibit to the Registrants Annual Report on Form
10-K for the year ended March 31, 1986.(3)
    
    Previously filed as an Exhibit to the Registrants Annual Report on Form
10-K for the year ended March 31, 1993.(4)
    
    Previously filed as an exhibit to the Registrants Annual Report on Form
10-K for the year ended March 31, 1996.(5)
    
    Previously filed as an exhibit to the Registrants Annual Report on Form
10-K for the year ended March 31, 1998.(6)
    
    Previously filed as Appendix A of the Registrants Proxy Statement for the
2004 Annual Shareholders Meeting.(7)
    
    Previously filed as an Exhibit to the Registrants Form 8-K dated August 3,
2007.*
    
    The information in Exhibit 32 shall not be deemed filed for purposes of Section 18 of the
Securities Exchange Act of 1934, as amended (the Exchange Act) or otherwise subject to the liabilities of that section, nor shall they be deemed incorporated by reference in
any filing under the Securities Act of 1933, as amended, or the Exchange Act (including this
quarterly report), unless CHAD Therapeutics specifically incorporates the foregoing information
into those documents by reference.




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CHAD THERAPEUTICS, Inc.(Registrant)
 Date  11/19/2007
    /s/ Earl L. YagerEarl L. YagerPresident and Chief Executive Officer Date  11/19/2007
    /s/ Tracy A. KernTracy A. KernChief Financial Officer




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Exhibit No.
    
    Description of Exhibits10.33
    
    Asset Purchase Agreement dated November 16, 200731.1
    
    Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002 for CEO31.2
    
    Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002 for CFO32*
    
    Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of
Sarbanes-Oxley Act of 200299.1
    
    Press release dated November 9, 2007
 
 *
    
    The information in Exhibit 32 shall not be deemed filed for purposes of Section 18 of the
Securities Exchange Act of 1934, as amended (the Exchange Act) or otherwise subject to the
liabilities of that section, nor shall they be deemed incorporated by reference in any filing under
the Securities Act of 1933, as amended, or the Exchange Act (including this quarterly report),
unless CHAD Therapeutics specifically incorporates the foregoing information into those documents
by reference.