##### 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: September 30, 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
 (Address of principal executive offices)     (Zip Code)
 (818) 882-0883
 (Registrants
telephone number, including area code)
 
   þ o
 o þ
 o þ




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##### Table of Contents



September 30,
    
    
    March 31,2005
    
    
    2005ASSETSCurrent assets:Cash
    
    $
    434,000
    
    
    $
    177,000Accounts receivable, less allowance for
doubtful accounts of $50,000 at
September 30, 2005, and $39,000 at
March 31, 2005
    
    
    3,013,000
    
    
    
    3,745,000Inventories, net (Note 4)
    
    
    8,118,000
    
    
    
    8,512,000Prepaid expenses and other assets
    
    
    472,000
    
    
    
    264,000Deferred income taxes
    
    
    518,000
    
    
    
    461,000Total current assets
    
    
    12,555,000
    
    
    
    13,159,000Property and equipment, at cost
    
    
    6,287,000
    
    
    
    6,140,000Less accumulated depreciation
    
    
    5,163,000
    
    
    
    4,949,000Net property and equipment
    
    
    1,124,000
    
    
    
    1,191,000Intangible assets, net
    
    
    863,000
    
    
    
    802,000Deferred income taxes
    
    
    568,000
    
    
    
    568,000Other assets
    
    
    65,000
    
    
    
    70,000Total assets
    
    $
    15,175,000
    
    
    $
    15,790,000LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,210,000
    
    
    $
    1,196,000Accrued expenses
    
    
    1,176,000
    
    
    
    1,370,000Income taxes payable
    
    
    
    
    
    
    200,000Total current liabilities
    
    
    2,386,000
    
    
    
    2,766,000Capital lease obligation, net of current portion
    
    
    7,000
    
    
    
    Total liabilities
    
    
    2,393,000
    
    
    
    2,766,000Shareholders equity:Common shares, $.01 par value, authorized
40,000,000 shares; 10,144,000 and 10,134,000
shares issued and outstanding
    
    
    13,379,000
    
    
    
    13,369,000Accumulated deficit
    
    
    (597,000
    )
    
    
    (345,000
    )Total shareholders equity
    
    
    12,782,000
    
    
    
    13,024,000Total liabilities and shareholders equity
    
    $
    15,175,000
    
    
    $
    15,790,000




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Three Months EndedSeptember 30,2005
    
    
    2004Net sales
    
    $
    5,375,000
    
    
    $
    6,309,000Cost of sales
    
    
    3,594,000
    
    
    
    3,696,000Gross profit
    
    
    1,781,000
    
    
    
    2,613,000Costs and expenses:Selling, general, and administrative
    
    
    1,699,000
    
    
    
    1,712,000Research and development
    
    
    435,000
    
    
    
    417,000Total costs and expenses
    
    
    2,134,000
    
    
    
    2,129,000Operating income (loss)
    
    
    (353,000
    )
    
    
    484,000Other income
    
    
    13,000
    
    
    
    6,000Earnings (loss) before income taxes
    
    
    (340,000
    )
    
    
    490,000Income tax expense (benefit)
    
    
    (130,000
    )
    
    
    35,000Net earnings (loss)
    
    $
    (210,000
    )
    
    $
    455,000Basic earnings (loss) per share
    
    $
    (0.02
    )
    
    $
    0.04Diluted earnings (loss) per share
    
    $
    (0.02
    )
    
    $
    0.04Weighted shares outstanding:Basic
    
    
    10,141,000
    
    
    
    10,122,000Diluted
    
    
    10,141,000
    
    
    
    10,598,000




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Six Months EndedSeptember 30,2005
    
    
    2004Net sales
    
    $
    11,270,000
    
    
    $
    12,408,000Cost of sales
    
    
    7,388,000
    
    
    
    7,375,000Gross profit
    
    
    3,882,000
    
    
    
    5,033,000Costs and expenses:Selling, general, and administrative
    
    
    3,543,000
    
    
    
    3,448,000Research and development
    
    
    767,000
    
    
    
    827,000Total costs and expenses
    
    
    4,310,000
    
    
    
    4,275,000Operating income (loss)
    
    
    (428,000
    )
    
    
    758,000Other income
    
    
    19,000
    
    
    
    14,000Earnings (loss) before income taxes
    
    
    (409,000
    )
    
    
    772,000Income tax expense (benefit)
    
    
    (157,000
    )
    
    
    55,000Net earnings (loss)
    
    $
    (252,000
    )
    
    $
    717,000Basic earnings (loss) per share
    
    $
    (0.02
    )
    
    $
    0.07Diluted earnings (loss) per share
    
    $
    (0.02
    )
    
    $
    0.07Weighted shares outstanding:Basic
    
    
    10,137,000
    
    
    
    10,116,000Diluted
    
    
    10,137,000
    
    
    
    10,609,000




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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
    
    
    10,000
    
    
    
    10,000
    
    
    
    Net loss
    
    
    
    
    
    
    
    
    
    
    (252,000
    )Balance at September 30, 2005
    
    
    10,144,000
    
    
    
    13,379,000
    
    
    $
    (597,000
    )




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Six Months EndedSeptember 30,2005
    
    
    2004Cash flows from operating activities:Net earnings (loss)
    
    $
    (252,000
    )
    
    $
    717,000Adjustments to reconcile net earnings to net cash
provided by operating activities:Depreciation and amortization of property and equipment
    
    
    214,000
    
    
    
    178,000Amortization of intangibles
    
    
    20,000
    
    
    
    19,000Provision for losses on receivables
    
    
    21,000
    
    
    
    7,000Changes in assets and liabilities:Decrease (increase) in accounts receivable
    
    
    711,000
    
    
    
    (554,000
    )Decrease (increase) in inventories
    
    
    394,000
    
    
    
    (373,000
    )Decrease (increase) in prepaid expenses and other assets
    
    
    (203,000
    )
    
    
    (172,000
    )Decrease (increase) in deferred income tax
    
    
    (57,000
    )
    
    
    (210,000
    )Increase (decrease) in accounts payable
    
    
    7,000
    
    
    
    750,000Increase (decrease) in accrued expenses
    
    
    (194,000
    )
    
    
    (34,000
    )Increase (decrease) in income taxes payable
    
    
    (200,000
    )
    
    
    25,000Net cash provided by operating activities
    
    
    461,000
    
    
    
    353,000Cash flows from investing activities:Additions to other assets
    
    
    (81,000
    )
    
    
    Capital expenditures
    
    
    (133,000
    )
    
    
    (92,000
    )Net cash used in investing activities
    
    
    (214,000
    )
    
    
    (92,000
    )Cash flows from financing activities:Exercise of stock options
    
    
    10,000
    
    
    
    38,000Net cash provided by financing activities
    
    
    10,000
    
    
    
    38,000Net increase in cash
    
    
    257,000
    
    
    
    299,000Cash beginning of period
    
    
    177,000
    
    
    
    2,708,000Cash end of period
    
    $
    434,000
    
    
    $
    3,007,000Supplemental 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 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 and six-month periods ended September 30, 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 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 Ended
    
    Six Months EndedSeptember 30,
    
    September 30,2005
    
    2004
    
    2005
    
    2004Customer A**
    
    
    38.8
    %
    
    
    37.3
    %
    
    
    37.6
    %
    
    
    34.5
    %Customer B**
    
    
    *
    
    
    
    13.7
    %
    
    
    *
    
    
    
    14.9
    %Customer C
    
    
    10.1
    %
    
    
    *
    
    
    
    *
    
    
    
    *
 
 *
    
    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 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 September 30, 2005, the
amount at risk was approximately $334,000.




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The significant outstanding accounts receivable balances in 2005 were as follows:
 September 30
    
    March 31Customer A
    
    
    29.0
    %
    
    
    26.0
    %Customer B
    
    
    17.8
    %
    
    
    *Customer C
    
    
    *
    
    
    
    22.6
    %
 
 *
    
    Indicates accounts receivable balance less than 10% of gross accounts receivable. 5.
    
    InventoriesInventories in 2005 are summarized as follows:
 September 30
    
    
    March 31Finished goods
    
    $
    2,095,000
    
    
    $
    2,767,000Work-in-process
    
    
    1,935,000
    
    
    
    1,790,000Raw materials
    
    
    4,203,000
    
    
    
    4,063,000Inventory reserve
    
    
    (115,000
    )
    
    
    (108,000
    )$
    8,118,000
    
    
    $
    8,512,000
 6.
    
    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 6% 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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7.
    
    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 Ended
    
    
    Six Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Basic earnings (loss) per share:Numeratornet earnings (loss)
    
    $
    (210,000
    )
    
    $
    455,000
    
    
    $
    (252,000
    )
    
    $
    717,000Denominatorweighted average
common shares outstanding
    
    
    10,141,000
    
    
    
    10,122,000
    
    
    
    10,137,000
    
    
    
    10,116,000Basic earnings (loss) per share
    
    $
    (0.02
    )
    
    $
    0.04
    
    
    $
    (0.02
    )
    
    $
    0.07Diluted earnings (loss) per share:Numeratornet earnings (loss)
    
    $
    (210,000
    )
    
    $
    455,000
    
    
    $
    (252,000
    )
    
    $
    717,000Denominator:Weighted average common shares
outstanding
    
    
    10,141,000
    
    
    
    10,122,000
    
    
    
    10,137,000
    
    
    
    10,116,000Diluted effect of common
stock options
    
    
    
    
    
    
    476,000
    
    
    
    
    
    
    
    493,00010,141,000
    
    
    
    10,598,000
    
    
    
    10,137,000
    
    
    
    10,609,000Diluted earnings (loss) per share
    
    $
    (0.02
    )
    
    $
    0.04
    
    
    $
    (0.02
    )
    
    $
    0.07
 Options to purchase 1,003,000 shares of common stock at prices ranging from $0.50 to $12.54
per share and 225,000 shares of common stock at prices ranging from $5.00 to $12.54 were not
included in the computation of diluted earnings per share for the three and six-month periods
ended September 30, 2005 and 2004, respectively, because their effect would have been
anti-dilutive.8.
    
    Income Tax ExpenseBased on managements earnings projections for the fiscal year ended 2006, the Company has
established an effective tax rate of 40 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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9.
    
    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 30,2005
    
    
    2004
    
    
    2005
    
    
    2004United States
    
    $
    4,547,000
    
    
    $
    5,840,000
    
    
    $
    9,656,000
    
    
    $
    11,653,000Canada
    
    
    40,000
    
    
    
    67,000
    
    
    
    96,000
    
    
    
    156,000Japan
    
    
    72,000
    
    
    
    120,000
    
    
    
    260,000
    
    
    
    183,000Europe
    
    
    633,000
    
    
    
    20,000
    
    
    
    1,105,000
    
    
    
    32,000All other countries
    
    
    83,000
    
    
    
    262,000
    
    
    
    153,000
    
    
    
    384,000$
    5,375,000
    
    
    $
    6,309,000
    
    
    $
    11,270,000
    
    
    $
    12,408,000
 All long-lived assets are located in the United States.Sales of OXYMATIC® and CYPRESS OXYPneumatic® conservers accounted for 71% and 77% of the
Companys sales for the three-month periods ended September 30, 2005 and 2004, respectively, and
69% and 77% for the six-month periods ended September 30, 2005 and 2004, respectively.10.
    
    Stock Option PlanThe 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
    
    
    Six Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net earnings (loss), as reported
    
    $
    (210,000
    )
    
    $
    455,000
    
    
    $
    (252,000
    )
    
    $
    717,000Deduct: Total stock-based employee
compensation expense determined under
fair value-based method for all awards, net
of related tax effects
    
    
    35,000
    
    
    
    29,000
    
    
    
    70,000
    
    
    
    58,000Pro forma net income (loss)
    
    $
    (245,000
    )
    
    $
    426,000
    
    
    $
    (322,000
    )
    
    $
    659,000Earnings (loss) per share:Basic  as reported
    
    $
    (0.02
    )
    
    $
    0.04
    
    
    $
    (0.03
    )
    
    $
    0.07Basic  pro forma
    
    
    (0.02
    )
    
    
    0.04
    
    
    
    (0.03
    )
    
    
    0.07Diluted  as reported
    
    
    (0.02
    )
    
    
    0.04
    
    
    
    (0.03
    )
    
    
    0.07Diluted  proforma
    
    $
    (0.02
    )
    
    $
    0.04
    
    
    $
    (0.03
    )
    
    $
    0.06
 The fair value of options granted during each period was estimated using the Black-Scholes
option pricing model with the following assumptions:
 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
 11.
    
    ReclassificationsCertain reclassifications have been made to the fiscal year 2005 financial data to conform with
the 2006 presentation.




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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 32Exhibit 99.1    Table of Contents




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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
    
    $
    1,224,000
    
    
    $
    435,000
    
    
    $
    789,000
    
    
    
    
    
    
    
    Minimum royalty
obligations
    
    $
    3,285,000
    
    
    $
    530,000
    
    
    $
    1,590,000
    
    
    $
    1,090,000
    
    
    $
    75,000Employee obligations
    
    $
    600,000
    
    
    $
    160,000
    
    
    $
    440,000
    
    
    
    
    
    
    
    Capital lease
bligations
    
    $
    14,000
    
    
    $
    7,000
    
    
    $
    7,000
    
    
    
    
    
    
    
    




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Additional Risk Factors
  
   
   
 
 
   
   
   
   (a)
    
    The Companys 2005 Annual Meeting of Shareholders was held on September 16,
2005 in Woodland Hills, California.




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(b)
    
    Proxies for the Annual Meeting were solicited pursuant to Regulation 14 under
the Securities Exchange Act of 1934, as amended, here was no solicitation in opposition
to the managements nominees as listed in the proxy statement, and all of such nominees
were elected.(c)
    
    At the Annual Meeting, the following matters were considered and voted upon:
 (i)
    
    The election of four directors to the Companys board of
directors, which currently consists of seven persons. Only four 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
Annual Meeting of Shareholders of 2006 or until their successors are duly
elected and qualified. The vote for each director was as follows:
  Name
    
    For
    
    Against
    
    WithheldPhilip T. Wolfstein
    
    
    9,561,187
    
    
    
    196,266James M. Brophy
    
    
    9,702,939
    
    
    
    54,514Kathleen M. Griggs
    
    
    9,586,621
    
    
    
    170,813
 (iii)
    
    To ratify the appointment of KPMG LLP as the Companys
independent auditors for the fiscal year ended March 31, 2006. At the Annual
meeting, the Companys shareholders approved this proposal by the votes
indicated below:
 SharesFor
    
    
    9,737,404Against
    
    
    11,158Abstain
    
    
    8,891
 (d)
    
    None




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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




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CHAD THERAPEUTICS, Inc.(Registrant)Date 11/14/2005
    
    /s/ Earl L. YagerEarl L. YagerPresident and Chief Executive OfficerDate 11/14/2005
    
    /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