##### Table of Contents



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: June 30, 2006
 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
(State of other jurisdiction of
incorporation or organization)
    
    95-3792700
(I.R.S. Employer
Identification No.)
 21622 Plummer Street, Chatsworth, CA
    
    91311(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 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 31.1EXHIBIT 31.2EXHIBIT 32EX-99.1    Table of Contents  
 June 30,
    
    
    March 31,2006
    
    
    2006ASSETSCurrent assets:Cash
    
    $
    1,704,000
    
    
    $
    935,000Accounts receivable, less allowance for
doubtful accounts of $43,000 at
June 30, 2006, and $52,000 at
March 31, 2006
    
    
    3,184,000
    
    
    
    3,220,000Income taxes refundable
    
    
    290,000
    
    
    
    383,000Inventories (Note 5)
    
    
    6,257,000
    
    
    
    6,381,000Prepaid expenses and other assets
    
    
    159,000
    
    
    
    178,000Deferred income taxes
    
    
    662,000
    
    
    
    666,000Total current assets
    
    
    12,256,000
    
    
    
    11,763,000Property and equipment, at cost
    
    
    6,150,000
    
    
    
    6,101,000Less accumulated depreciation
    
    
    5,249,000
    
    
    
    5,151,000Net property and equipment
    
    
    901,000
    
    
    
    950,000Intangible assets, net
    
    
    1,038,000
    
    
    
    972,000Deferred income taxes
    
    
    613,000
    
    
    
    600,000Other assets
    
    
    55,000
    
    
    
    71,000Total assets
    
    $
    14,863,000
    
    
    $
    14,356,000LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,009,000
    
    
    $
    522,000Accrued expenses
    
    
    1,523,000
    
    
    
    1,435,000Total current liabilities
    
    
    2,532,000
    
    
    
    1,957,000Other long-term liabilities
    
    
    2,000
    
    
    
    4,000Total liabilities
    
    
    2,534,000
    
    
    
    1,961,000Shareholders equity:Common shares, $.01 par value, authorized
40,000,000 shares; 10,169,000 and 10,158,000
shares issued and outstanding
    
    
    13,463,000
    
    
    
    13,413,000Accumulated deficit
    
    
    (1,134,000
    )
    
    
    (1,018,000
    )Total shareholders equity
    
    
    12,329,000
    
    
    
    12,395,000Total liabilities and shareholders equity
    
    $
    14,863,000
    
    
    $
    14,356,000




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Three Months EndedJune 30,2006
    
    
    2005Net sales
    
    $
    5,476,000
    
    
    $
    5,895,000Cost of sales
    
    
    3,662,000
    
    
    
    3,794,000Gross profit
    
    
    1,814,000
    
    
    
    2,101,000Costs and expenses:Selling, general, and administrative
    
    
    1,702,000
    
    
    
    1,844,000Research and development
    
    
    335,000
    
    
    
    332,000Total costs and expenses
    
    
    2,037,000
    
    
    
    2,176,000Operating loss
    
    
    (223,000
    )
    
    
    (75,000
    )Other income
    
    
    23,000
    
    
    
    6,000Loss before income taxes
    
    
    (200,000
    )
    
    
    (69,000
    )Income tax benefit
    
    
    (84,000
    )
    
    
    (27,000
    )Net loss
    
    $
    (116,000
    )
    
    $
    (42,000
    )Basic earnings (loss) per share
    
    $
    (0.01
    )
    
    $
    0.00Diluted earnings (loss) per share
    
    $
    (0.01
    )
    
    $
    0.00Weighted shares outstanding:Basic
    
    
    10,169,000
    
    
    
    10,134,000Diluted
    
    
    10,169,000
    
    
    
    10,134,000




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Common Shares
    
    
    AccumulatedShares
    
    
    Amount
    
    
    DeficitBalance as of March 31, 2006
    
    
    10,158,000
    
    
    $
    13,413,000
    
    
    $
    (1,018,000
    )Stock-based compensation
    
    
    
    
    
    
    10,000
    
    
    
    Restricted stock
    
    
    11,000
    
    
    
    40,000
    
    
    
    Net loss
    
    
    
    
    
    
    
    
    
    
    (116,000
    )Balance at June 30, 2006
    
    
    10,169,000
    
    
    
    13,463,000
    
    
    $
    (1,134,000
    )
 See accompanying notes to condensed financial statements.




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Three Months EndedJune 30,2006
    
    
    2005Cash flows from operating activities:Net loss
    
    $
    (116,000
    )
    
    $
    (42,000
    )Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:Depreciation and amortization of property and equipment
    
    
    98,000
    
    
    
    108,000Amortization of intangibles
    
    
    11,000
    
    
    
    10,000Provision for losses on receivables
    
    
    
    
    
    
    3,000Decrease (increase) in deferred income taxes
    
    
    (9,000
    )
    
    
    (27,000
    )Stock-based compensation
    
    
    20,000
    
    
    
    Changes in assets and liabilities:Decrease (increase) in accounts receivable
    
    
    36,000
    
    
    
    441,000Decrease (increase) in inventories
    
    
    124,000
    
    
    
    365,000Decrease (increase) in income taxes refundable
    
    
    93,000
    
    
    
    119,000Decrease (increase) in prepaid expenses and other assets
    
    
    35,000
    
    
    
    3,000Increase (decrease) in accounts payable
    
    
    487,000
    
    
    
    (421,000
    )Increase (decrease) in accrued expenses
    
    
    118,000
    
    
    
    51,000Increase (decrease) in income taxes payable
    
    
    
    
    
    
    (188,000
    )Net cash provided by operating activities
    
    
    897,000
    
    
    
    422,000Cash flows from investing activities:Additions to intangible assets
    
    
    (77,000
    )
    
    
    (45,000
    )Capital expenditures
    
    
    (49,000
    )
    
    
    (83,000
    )Net cash used in investing activities
    
    
    (126,000
    )
    
    
    (128,000
    )Cash flows from financing activities:Other long-term liabilities
    
    
    (2,000
    )
    
    
    Net cash used in financing activities
    
    
    (2,000
    )
    
    
    Net increase in cash
    
    
    769,000
    
    
    
    294,000Cash beginning of period
    
    
    935,000
    
    
    
    177,000Cash end of period$
    1,704,000
    
    
    $
    471,000




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CHAD THERAPEUTICS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(Unaudited)
 1.
    
    Interim ReportingCHAD Therapeutics, Inc. (the Company) is in the business of developing, producing, and
marketing respiratory care devices designed to improve the efficiency of oxygen delivery systems
for home health care and hospital treatment of patients suffering from pulmonary diseases.In the opinion of management, all adjustments necessary, which are of a normal and recurring
nature, for a fair presentation of the results for the interim periods presented, have been
made. The results for the three-month period ended June 30, 2006, are not necessarily
indicative of the results expected for the year ended March 31, 2007. 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, 2006, Annual Report and particularly to Note 1 which includes
a summary of significant accounting policies.2.
    
    Revenue RecognitionThe Company recognizes revenue when title and risk of loss transfers to the customer and the
earnings process is complete. Under a sales-type lease agreement, revenue is recognized at the
time of shipment with interest income recognized over the life of the lease. The Company
records all shipping fees billed to customers as revenue, and related costs as costs of good
sold, when incurred.3.
    
    Major Customers
 Three Months EndedJune 30,2006
    
    
    2005Customer A**
    
    
    36.6
    %
    
    
    36.5
    %Customer B
    
    
    12.8
    %
    
    
    *
 
 *
    
    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 account, the maximum
insured by the Federal Deposit Insurance Corporation. The Companys right to the cash is
subject to the risk that the financial institution will not pay when cash is requested. The
potential loss is the amount in any one account over $100,000. At June 30, 2006, the amount at
risk was approximately $1,604,000.




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June 30
    
    
    March 31Customer A**
    
    
    28.1
    %
    
    
    25.4
    %Customer B
    
    
    21.8
    %
    
    
    21.6
    %
 
 **
    
    Indicates national chain customer. 5.
    
    InventoriesInventories in 2006 are summarized as follows:
 June 30
    
    
    March 31Finished goods
    
    $
    1,694,000
    
    
    $
    1,706,000Work-in-process
    
    
    1,626,000
    
    
    
    1,234,000Raw materials
    
    
    2,937,000
    
    
    
    3,441,000$
    6,257,000
    
    
    $
    6,381,000
 6.
    
    Line of CreditIn December 2005, the Company entered into a $1 million revolving line of credit agreement
that expires in December 2006. Advances under the line of credit bear interest at the banks
prime rate (8.25% at June 30, 2006) and are secured by inventories and accounts receivable.
Under the terms of the credit agreement, the Company is required to maintain a specific working
capital, net worth, profitability levels, and other specific ratios. In addition, the
agreement prohibits the payment of cash dividends and contains certain restrictions on the
Companys ability to borrow money or purchase assets or interests in other entities without
prior written consent of the bank. At June 30, 2006, the Company was not in compliance with
certain of the covenants related to profitability and is currently renegotiating changes to the
line of credit. There were no borrowings under the line of credit at June 30, 2006.7.
    
    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 current portion of
$7,000 and the long-term portion of $2,000 is included in accounts payable and other long-term
liabilities, respectively. Amortization of plant equipment under capital leases is included in depreciation
expense.




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8.
    
    Earnings (Loss) Per Common ShareFollowing is a reconciliation of the numerators and denominators used in the calculation of
basic and diluted earnings (loss) per common share:
 Three Months EndedJune 30,2006
    
    
    2005Basic earnings (loss) per share:Numerator-net earnings (loss)
    
    $
    (116,000
    )
    
    $
    (42,000
    )Denominator-weighted average
common shares outstanding
    
    
    10,169,000
    
    
    
    10,134,000Basic earnings (loss) per share
    
    $
    (0.01
    )
    
    $
    0.00Diluted earnings (loss) per share:Numerator-net earnings (loss)
    
    $
    (116,000
    )
    
    $
    (42,000
    )Denominator-weighted average
common shares outstanding
    
    
    10,169,000
    
    
    
    10,134,000Diluted effect of common
stock options
    
    
    
    
    
    
    10,169,000
    
    
    
    10,134,000Diluted earnings (loss) per share
    
    $
    (0.01
    )
    
    $
    0.00
 Options to purchase 941,000 shares of common stock at prices ranging from $0.50 to $11.50
per share and 975,000 shares of common stock at prices ranging from $0.50 to $12.54 were not
included in the computation of diluted earnings per share for the three month periods ended June
30, 2006 and 2005, respectively, because their effect would have been anti-dilutive.9.
    
    Income Tax ExpenseBased on managements earnings projections for the fiscal year ended 2007, the Company has
forecasted an effective tax rate of 42 percent. The Company has California net operating loss
carryforwards of $2,364,000 of which $606,000 expires in 2007 and the remaining balance expires
in 2013.




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10.
    
    Geographic InformationThe Company has one reportable operating segment. Geographic information regarding the
Companys net sales is as follows:
 Three Months EndedJune 30,2006
    
    
    2005United States
    
    $
    4,354,000
    
    
    $
    5,121,000Canada
    
    
    54,000
    
    
    
    56,000Japan
    
    
    126,000
    
    
    
    188,000Europe
    
    
    854,000
    
    
    
    466,000All other countries
    
    
    88,000
    
    
    
    64,000$
    5,476,000
    
    
    $
    5,895,000
 All long-lived assets are located in the United States.Sales of OXYMATIC®, LOTUS and CYPRESS OXYPneumatic® conservers and SAGE Therapeutic devices
accounted for 70% of the Companys sales for the three-month periods ended June 30, 2006 and
2005.11.
    
    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-month period ended June 30, 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 ultimately expected to vest, stock-based
compensation for the three-month period ended June 30, 2006 has been reduced for estimated
forfeitures. For the three-month period ended June 30, 2006 stock-based compensation expense of
$10,000 was recorded to selling, general, and administrative expenses. 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 705,000
are available were available for future grant at June 30, 2006. 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




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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. In fiscal year 2006, 40,000 options were issued with vesting periods less
than one year. All options granted to date have ten-year contractual terms from the date of the
grant.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 three
months ended June 30, 2006. The following weighted-average assumptions were used in calculating
the fair value of stock options granted during the three months ended June 30, 2005 using the
Black-Scholes option valuation model:
 Expected life (in years)
    
    
    8.0Expected volatility factor
    
    
    79.0
    %Risk free interest rate
    
    
    4.3
    %Dividend yield
    
    
    0.0Forfeiture rate
    
    
    4.0
    %
  RemainingExercise
    
    
    Contractual
    
    
    AggregatePrice Per
    
    
    Term
    
    
    Intrinsic ValueShares
    
    
    Share
    
    
    (in years)
    
    
    (in thousands)Outstanding at March 31, 2006
    
    
    945,000
    
    
    $
    2.22Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited or expired
    
    
    4,000
    
    
    
    3.41Outstanding at June 30, 2006
    
    
    941,000
    
    
    $
    2.21
    
    
    
    4.8
    
    
    $
    As of June 30, 2006:Exercisable
    
    
    899,000
    
    
    $
    2.22
    
    
    
    4.8
    
    
    $
    Vested and expected to vest
    
    
    925,000
    
    
    $
    2.25
    
    
    
    4.8
    
    
    $
    




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Three MonthsEndedJune 30, 2005Net loss, as reported
    
    $
    (42,000
    )Deduct: Total stock-based employee
compensation expense determined under
fair value-based method for all awards, net
of related tax effects
    
    
    21,000Pro forma net loss
    
    $
    (63,000
    )Earnings (loss) per share:Basic  as reported
    
    $
    0.00Basic  proforma
    
    
    (0.01
    )Diluted  as reported
    
    
    0.00Diluted  proforma
    
    $
    (0.01
    )
 12.
    
    ReclassificationsCertain reclassifications have been made to the fiscal year 2006 financial data to conform with
the 2007 presentation. The Company added provisions for losses on receivables as an adjustment
to reconcile net earnings (loss) to net cash provided by operating activities to its condensed
statements of cash flows.13.
    
    Use of EstimatesThe preparation of financial statements in conformity with U.S. generally accepted accounting
principles 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.14.
    
    Accounting StandardsIn November 2004, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard (SFAS) No. 151 (Inventory Costs), an amendment of ARB No. 43,
Chapter 4. The statement clarifies accounting for abnormal amounts of the idle facility
expense, freight, handling costs, and spoilage and requires those items to be expensed when
incurred. SFAS 151 is applicable to inventory costs incurred during fiscal years beginning
after June 15, 2005. The Company adopted SFAS No. 151 on April 1, 2006, and the Company did
not incur a significant impact to its financial statements.In December 2004, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standard (SFAS) No. 123R (Share-Based Payment). SFAS 123R requires the Company
to recognize compensation expense based on the fair




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value of equity instruments awarded to employees. The Company adopted SFAS 123R on April 1,
2006, and the Company did not incur a significant impact to its financial statements.In 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 Company is
evaluating the impact of this interpretation and does not anticipate a significant impact to
its financial statements upon implementation.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 Company is evaluating the impact of this interpretation
and does not anticipate a significant impact to its financial statements upon implementation.




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®




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®
  
    
    Development of additional oxygen conserver models, such as the
LOTUS Electronic Oxygen Conserver with a view to diversifying the
product line in order to offer customers a range of oxygen
conservation choices;
    
    An effort to expand the Companys product lines and improve
existing products through the investment in and development of new
technologies, such as proprietary sensor technology and control
software licensed in January of 2003 and the introduction of the
SAGE Oxygen Therapeutic Device in May 2004. These new
technologies should provide the Company with an opportunity to
expand its oxygen delivery product lines and potentially enter the
high-growth sleep disorder market; and
    
    A continued promotional and educational campaign with respect to
the benefits of the TOTAL O2 system.




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Payments Due by PeriodLess than 1
    
    
    1  3
    
    
    3-5
    
    
    After 5Total
    
    
    Year
    
    
    Years
    
    
    Years
    
    
    YearsContractualCash ObligationsOperating lease
obligations
    
    $
    888,000
    
    
    $
    435,000
    
    
    $
    453,000
    
    
    
    
    
    
    
    Minimum royalty
obligations
    
    $
    2,937,000
    
    
    $
    523,000
    
    
    $
    1,590,000
    
    
    $
    757,000
    
    
    $
    67,000Employee obligations
    
    $
    440,000
    
    
    $
    160,000
    
    
    $
    280,000
    
    
    
    
    
    
    
    Capital lease
obligations
    
    $
    9,000
    
    
    $
    7,000
    
    
    $
    2,000
    
    
    
    
    
    
    
    




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Additional Risk Factors




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(a) 31.1
    
    Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002 for CEO(b) 31.2
    
    Certification pursuant to Section 302 of Sarbanes-Oxley Act of 2002 for CFO(c) 32*
    
    Certification pursuant to 18 U.S.C Section 1350, as adopted pursuant to Section 906 of
Sarbanes-Oxley Act of 2002(d) 99.1
    
    Press release dated August 11, 2006
 
 *
    
    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  08/14/2006
    /s/ Earl L. YagerEarl L. YagerPresident and Chief Executive Officer Date  08/14/2006
    /s/ Tracy A. KernTracy A. KernChief Financial Officer




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Exhibit No.
    
    Description of Exhibits31.1
    
    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 August 11, 2006
 
 *
    
    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.