##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 Quarterly Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934
 þ
    
    For Quarterly Period Ended: December 31, 2005
 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.)
 21622 Plummer Street, Chatsworth, CA 91311
 (818) 882-0883
 
   þ o
  o o o
 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 32.1Exhibit 99.1    Table of Contents  
 December 31,
    
    
    March 31,2005
    
    
    2005ASSETSCurrent assets:Cash
    
    $
    820,000
    
    
    $
    177,000Accounts receivable, less allowance for
doubtful accounts of $40,000 at
December 31, 2005, and $39,000 at
March 31, 2005
    
    
    3,202,000
    
    
    
    3,745,000Income taxes refundable
    
    
    402,000
    
    
    
    Inventories, net (Note 5)
    
    
    7,356,000
    
    
    
    8,512,000Prepaid expenses and other assets
    
    
    184,000
    
    
    
    264,000Deferred income taxes
    
    
    501,000
    
    
    
    461,000Total current assets
    
    
    12,465,000
    
    
    
    13,159,000Property and equipment, at cost
    
    
    6,316,000
    
    
    
    6,140,000Less accumulated depreciation
    
    
    5,260,000
    
    
    
    4,949,000Net property and equipment
    
    
    1,056,000
    
    
    
    1,191,000Intangible assets, net
    
    
    877,000
    
    
    
    802,000Deferred income taxes
    
    
    376,000
    
    
    
    568,000Other assets
    
    
    74,000
    
    
    
    70,000Total assets
    
    $
    14,848,000
    
    
    $
    15,790,000LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    862,000
    
    
    $
    1,196,000Accrued expenses
    
    
    1,142,000
    
    
    
    1,370,000Income taxes payable
    
    
    
    
    
    
    200,000Total current liabilities
    
    
    2,004,000
    
    
    
    2,766,000Other long-term liabilities
    
    
    5,000
    
    
    
    Total liabilities
    
    
    2,009,000
    
    
    
    2,766,000Shareholders equity:Common shares, $.01 par value, authorized
40,000,000 shares; 10,158,000 and 10,134,000
shares issued and outstanding
    
    
    13,397,000
    
    
    
    13,369,000Accumulated deficit
    
    
    (558,000
    )
    
    
    (345,000
    )Total shareholders equity
    
    
    12,839,000
    
    
    
    13,024,000Total liabilities and shareholders equity
    
    $
    14,848,000
    
    
    $
    15,790,000




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Three Months EndedDecember 31,2005
    
    
    2004Net sales
    
    $
    5,907,000
    
    
    $
    6,444,000Cost of sales
    
    
    3,806,000
    
    
    
    3,741,000Gross profit
    
    
    2,101,000
    
    
    
    2,703,000Costs and expenses:Selling, general, and administrative
    
    
    1,558,000
    
    
    
    1,858,000Research and development
    
    
    435,000
    
    
    
    380,000Total costs and expenses
    
    
    1,993,000
    
    
    
    2,238,000Operating income
    
    
    108,000
    
    
    
    465,000Other income
    
    
    4,000
    
    
    
    14,000Earnings before income taxes
    
    
    112,000
    
    
    
    479,000Income tax expense (benefit)
    
    
    73,000
    
    
    
    (26,000
    )Net earnings
    
    $
    39,000
    
    
    $
    505,000Basic earnings per share
    
    $
    0.00
    
    
    $
    0.05Diluted earnings per share
    
    $
    0.00
    
    
    $
    0.05Weighted shares outstanding:Basic
    
    
    10,151,000
    
    
    
    10,124,000Diluted
    
    
    10,569,000
    
    
    
    10,647,000




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Nine Months EndedDecember 31,2005
    
    
    2004Net sales
    
    $
    17,177,000
    
    
    $
    18,852,000Cost of sales
    
    
    11,194,000
    
    
    
    11,116,000Gross profit
    
    
    5,983,000
    
    
    
    7,736,000Costs and expenses:Selling, general, and administrative
    
    
    5,101,000
    
    
    
    5,306,000Research and development
    
    
    1,202,000
    
    
    
    1,207,000Total costs and expenses
    
    
    6,303,000
    
    
    
    6,513,000Operating income (loss)
    
    
    (320,000
    )
    
    
    1,223,000Other income
    
    
    23,000
    
    
    
    28,000Earnings (loss) before income taxes
    
    
    (297,000
    )
    
    
    1,251,000Income tax expense (benefit)
    
    
    (84,000
    )
    
    
    29,000Net earnings (loss)
    
    $
    (213,000
    )
    
    $
    1,222,000Basic earnings (loss) per share
    
    $
    (0.02
    )
    
    $
    0.12Diluted earnings (loss) per share
    
    $
    (0.02
    )
    
    $
    0.12Weighted shares outstanding:Basic
    
    
    10,142,000
    
    
    
    10,119,000Diluted
    
    
    10,142,000
    
    
    
    10,622,000




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Common Shares
    
    
    AccumulatedShares
    
    
    Amount
    
    
    DeficitBalance as of March 31, 2005
    
    
    10,134,000
    
    
    $
    13,369,000
    
    
    $
    (345,000
    )Exercise of stock options
    
    
    24,000
    
    
    
    28,000
    
    
    
    Net loss
    
    
    
    
    
    
    
    
    
    
    (213,000
    )Balance at December 31, 2005
    
    
    10,158,000
    
    
    
    13,397,000
    
    
    $
    (558,000
    )




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Nine Months EndedDecember 31,2005
    
    
    2004Cash flows from operating activities:Net earnings (loss)
    
    $
    (213,000
    )
    
    $
    1,222,000Adjustments to reconcile net earnings (loss) to net cash
provided by (used in) operating activities:Depreciation and amortization of property and equipment
    
    
    311,000
    
    
    
    274,000Amortization of intangibles
    
    
    29,000
    
    
    
    29,000Provision for losses on receivables
    
    
    1,000
    
    
    
    Changes in assets and liabilities:Decrease (increase) in accounts receivable
    
    
    542,000
    
    
    
    (717,000
    )Decrease (increase) in inventories
    
    
    1,156,000
    
    
    
    (2,368,000
    )Decrease (increase) in income taxes refundable
    
    
    (402,000
    )
    
    
    Decrease (increase) in prepaid expenses and other assets
    
    
    76,000
    
    
    
    (172,000
    )Decrease (increase) in deferred income taxes
    
    
    152,000
    
    
    
    (467,000
    )Increase (decrease) in accounts payable
    
    
    (341,000
    )
    
    
    1,337,000Increase (decrease) in accrued expenses
    
    
    (228,000
    )
    
    
    105,000Increase (decrease) in income taxes payable
    
    
    (200,000
    )
    
    
    215,000Net cash
provided by (used in) operating activities
    
    
    883,000
    
    
    
    (542,000
    )Cash flows from investing activities:Additions to intangible assets
    
    
    (104,000
    )
    
    
    Capital expenditures
    
    
    (162,000
    )
    
    
    (196,000
    )Net cash used in investing activities
    
    
    (266,000
    )
    
    
    (196,000
    )Cash flows from financing activities:Exercise of stock options
    
    
    28,000
    
    
    
    51,000Principal payments on capital lease
    
    
    (2,000
    )
    
    
    Net cash provided by financing activities
    
    
    26,000
    
    
    
    51,000Net increase (decrease) in cash
    
    
    643,000
    
    
    
    (687,000
    )Cash beginning of period
    
    
    177,000
    
    
    
    2,708,000Cash end of period$
    820,000
    
    
    $
    2,021,000Supplemental disclosure of cash flow information:Acquisition of capital assets through capital lease
    
    $
    14,000
    
    
    $
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CHAD THERAPEUTICS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(Unaudited)
 1.
    
    Interim Reporting

CHAD Therapeutics, Inc. (the Company) is in the business of developing, producing, and
marketing respiratory care devices designed to improve the efficiency of oxygen delivery systems
for home health care and hospital treatment of patients suffering from pulmonary diseases.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 nine-month periods ended December 31, 2005, are not
necessarily indicative of the results expected for the year ended March 31, 2006. 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, 2005, Annual Report and particularly to Note 1 which
includes a summary of significant accounting policies.2.
    
    Revenue Recognition

The 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 Ended
    
    Nine Months EndedDecember 31,
    
    December 31,2005
    
    2004
    
    2005
    
    2004Customer A**
    
    
    32.6
    %
    
    
    34.3
    %
    
    
    35.9
    %
    
    
    34.4
    %Customer B**
    
    

    
    *
    
    
    10.5
    %
    
    

    
    *
    
    
    13.4
    %Customer C
    
    
    13.7
    %
    
    
    
    *

    
    
    10.1
    %
    
    

    
    *
 
 *
    
    Indicates sales less than 10% of the Companys net sales**
    
    Indicates national chain customer
  4.
    
    Concentration of Credit Risk

At times the Company maintains balances of cash that exceed $100,000 per account, the maximum
insured by the Federal Deposit Insurance Corporation. The Companys right to the cash is
subject to the risk that the financial institution will not pay when cash is requested. The
potential loss is the amount in any one account over $100,000. At December 31, 2005, the
amount at risk was approximately $720,000.




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December 31
    
    March 31Customer A**
    
    
    21.3
    %
    
    
    26.0
    %Customer B
    
    
    17.0
    %
    
    

    
    *Customer C**
    
    

    
    *
    
    
    22.6
    %Customer D
    
    
    16.7
    %
    
    

    
    *
 
 *
    
    Indicates accounts receivable balance less than 10% of gross accounts
receivable.**
    
    Indicates national chain customer.
 5.
    
    Inventories

Inventories in 2005 are summarized as follows:
 December 31
    
    
    March 31Finished goods
    
    $
    1,722,000
    
    
    $
    2,767,000Work-in-process
    
    
    1,828,000
    
    
    
    1,790,000Raw materials
    
    
    3,938,000
    
    
    
    4,063,000Inventory reserve
    
    
    (132,000
    )
    
    
    (108,000
    )$
    7,356,000
    
    
    $
    8,512,000
 6.
    
    Line of Credit

In December 2005, the Company entered into a $1 million revolving line of credit agreement
that expires in December 2006. Advances under the line of credit bear interest at the banks
prime rate (7.25% at December 31, 2005) 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. There were no borrowings under the line of credit at
December 31, 2005.7.
    
    Leasing Arrangements

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




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8.
    
    Earnings (Loss) Per Common Share

Following is a reconciliation of the numerators and denominators used in the calculation of
basic and diluted earnings (loss) per common share:
 Three Months Ended
    
    
    Nine Months EndedDecember 31,
    
    
    December 31,2005
    
    
    2004
    
    
    2005
    
    
    2004Basic earnings (loss) per share:Numerator-net earnings (loss)
    
    $
    39,000
    
    
    $
    505,000
    
    
    $
    (213,000
    )
    
    $
    1,222,000Denominator-weighted average
common shares outstanding
    
    
    10,151,000
    
    
    
    10,124,000
    
    
    
    10,142,000
    
    
    
    10,119,000Basic earnings (loss) per share
    
    $
    0.00
    
    
    $
    0.05
    
    
    $
    (0.02
    )
    
    $
    0.12Diluted earnings (loss) per share:Numerator-net earnings (loss)
    
    $
    39,000
    
    
    $
    505,000
    
    
    $
    (213,000
    )
    
    $
    1,222,000Denominator:Weighted average common shares
outstanding
    
    
    10,151,000
    
    
    
    10,124,000
    
    
    
    10,142,000
    
    
    
    10,119,000Diluted effect of common
stock options
    
    
    418,000
    
    
    
    523,000
    
    
    
    
    
    
    
    503,00010,569,000
    
    
    
    10,647,000
    
    
    
    10,142,000
    
    
    
    10,622,000Diluted earnings (loss) per share
    
    $
    0.00
    
    
    $
    0.05
    
    
    $
    (0.02
    )
    
    $
    0.12
  9.
    
    Income Tax Expense

Based on managements revised earnings projections for the fiscal year ended 2006, the Company
has forecasted an effective tax rate of 28 percent. The Company has California net operating
loss carryforwards of $1,936,000 of which $606,000 expires in 2007 and the remaining balance
expires in 2013. California suspended the utilization of net operating loss carryforwards
during tax years starting in 2002 and 2003. As a result, the Company had been unable to use its
California net operating loss carryforwards until the tax year that began April 1, 2004.




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10.
    
    Geographic Information

The Company has one reportable operating segment. Geographic information regarding the
Companys net sales is as follows:
 Three Months Ended
    
    
    Nine Months EndedDecember 31,
    
    
    December 31,2005
    
    
    2004
    
    
    2005
    
    
    2004United States
    
    $
    4,242,000
    
    
    $
    6,115,000
    
    
    $
    13,898,000
    
    
    $
    17,768,000Canada
    
    
    47,000
    
    
    
    82,000
    
    
    
    145,000
    
    
    
    238,000Japan
    
    
    134,000
    
    
    
    127,000
    
    
    
    397,000
    
    
    
    330,000Europe
    
    
    1,424,000
    
    
    
    71,000
    
    
    
    2,549,000
    
    
    
    257,000All other countries
    
    
    60,000
    
    
    
    49,000
    
    
    
    188,000
    
    
    
    259,000$
    5,907,000
    
    
    $
    6,444,000
    
    
    $
    17,177,000
    
    
    $
    18,852,000
  ® ®
 11.
    
    Stock Option Plan

The company accounts for its stock option plan in accordance with the provisions of Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations. The Company has also adopted the pro forma disclosure provisions of Statement
of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, which
permits entities to provide pro forma net income and pro forma net earnings per share
disclosures as if the fair-value-based method defined in SFAS 123 had been applied.The Company applies Accounting Principles Board Opinion No. 25 in accounting for the Plan, and
no compensation expense has been recognized for its stock options in the accompanying financial
statements. The following table illustrates the effect on net earnings and earnings per share
if the Company had applied the fair value recognition provision of FASB Statement No.123,
Accounting for Stock Based Compensation, to stock-based employee compensation:




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Three Months Ended
    
    
    Nine Months EndedDecember 31,
    
    
    December 31,2005
    
    
    2004
    
    
    2005
    
    
    2004Net earnings (loss), as reported
    
    $
    39,000
    
    
    $
    505,000
    
    
    $
    (213,000
    )
    
    $
    1,222,000Deduct: Total stock-based employee
compensation expense determined under
fair value-based method for all awards, net
of related tax effects
    
    
    32,000
    
    
    
    27,000
    
    
    
    97,000
    
    
    
    82,000Pro forma net income (loss)
    
    $
    7,000
    
    
    $
    478,000
    
    
    $
    (310,000
    )
    
    $
    1,140,000Earnings (loss) per share:Basic  as reported
    
    $
    0.00
    
    
    $
    0.05
    
    
    $
    (0.02
    )
    
    $
    0.12Basic  pro forma
    
    
    0.00
    
    
    
    0.05
    
    
    
    (0.03
    )
    
    
    0.11Diluted  as reported
    
    
    0.00
    
    
    
    0.05
    
    
    
    (0.02
    )
    
    
    0.12Diluted  proforma
    
    $
    0.00
    
    
    $
    0.04
    
    
    $
    (0.03
    )
    
    $
    0.11
  Fiscal Year2006
    
    2005Risk-free interest rate
    
    
    4.3
    %
    
    
    3.3
    %Forfeiture rate
    
    
    2.0
    %
    
    
    2.0
    %Dividend Yield
    
    
    .0
    
    
    
    .0Volatility
    
    
    78
    %
    
    
    98
    %Expected Life (years)
    
    
    10
    
    
    
    10
 12.
    
    Reclassifications

Certain reclassifications have been made to the fiscal year 2005 financial data to conform with
the 2006 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.




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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 PeriodContractual
    
    
    
    
    
    Less than 1
    
    1  3
    
    3  5
    
    After 5Cash Obligations
    
    Total
    
    Year
    
    Years
    
    Years
    
    YearsOperating lease
obligations
    
    $
    1,116,000
    
    
    $
    438,000
    
    
    $
    678,000
    
    
    
    
    
    
    
    Minimum royalty
obligations
    
    $
    3,190,000
    
    
    $
    530,000
    
    
    $
    1,590,000
    
    
    $
    965,000
    
    
    $
    105,000Employee obligations
    
    $
    560,000
    
    
    $
    160,000
    
    
    $
    400,000
    
    
    
    
    
    
    
    Capital lease
obligations
    
    $
    12,000
    
    
    $
    7,000
    
    
    $
    5,000
    
    
    
    
    
    
    
    




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Table of Contents            
    Table of Contents




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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 February 14, 2006.




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CHAD THERAPEUTICS, Inc.
(Registrant)Date  02/14/2006
    /s/ Earl L. YagerEarl L. YagerPresident and Chief Executive OfficerDate  02/14/2006
    /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 February 14, 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.