Chad Therapeutics 10K/A 2007 Annual report (amended) | CTU Filing

EXHIBIT 13.1

Selected Financial Data


*Selected Financial Data*	Years Ended March 31,
	2007			2006			2005		2004		2003

Net sales	$	18,981,000		$	22,354,000		$	24,287,000	$	21,541,000	$	19,541,000
Interest income, net		57,000			20,000			39,000		22,000		20,000
Net earnings (loss)		(3,414,000	)		(673,000	)		1,811,000		1,001,000		(433,000	)
Basic earnings (loss) per share		(.34	)		(.07	)		.18		.10		(.04	)
Diluted earnings (loss) per share		(.34	)		(.07	)		.17		.10		(.04	)
Net working capital		7,266,000			9,806,000			10,393,000		9,175,000		8,224,000
Total assets		11,748,000			14,356,000			15,790,000		13,043,000		12,105,000
Shareholders’ equity		9,094,000			12,395,000			13,024,000		11,153,000		10,100,000

No cash dividends have been declared or paid during the periods presented.

Balance Sheets


	March 31,
	2007			2006
Assets
Current assets:
Cash	$	375,000		$	935,000
Accounts receivable, less allowance for doubtful accounts of $38,000 and $52,000 in 2007 and 2006, respectively		2,376,000			3,220,000
Income taxes refundable		291,000			383,000
Inventories (Note 2)		6,557,000			6,381,000
Prepaid expenses and other assets		321,000			178,000
Deferred income taxes (Note 3)		—			666,000

Total current assets		9,920,000			11,763,000

Property and equipment, at cost:
Office equipment and furniture		1,787,000			1,761,000
Machinery and equipment		969,000			954,000
Tooling		1,531,000			1,489,000
Leasehold improvements		1,899,000			1,897,000

		6,186,000			6,101,000
Less accumulated depreciation and amortization		5,501,000			5,151,000

Net property and equipment		685,000			950,000

Intangible assets, net (Note 4)		1,107,000			972,000
Deferred income taxes (Note 3)		—			600,000
Other assets		36,000			71,000

	$	11,748,000		$	14,356,000


Liabilities and Shareholders’ Equity

Current liabilities:
Accounts payable	$	1,282,000		$	522,000
Accrued expenses (Note 7)		1,372,000			1,435,000

Total current liabilities		2,654,000			1,957,000

Other liabilities		—			4,000
Commitments (Note 8)

Shareholders’ equity (Note 5):
Common shares, $0.01 par value Authorized 40,000,000 shares; 10,180,000 and 10,158,000 shares issued and outstanding		13,526,000			13,413,000
Accumulated deficit		(4,432,000	)		(1,018,000	)

Shareholders’ equity		9,094,000			12,395,000

	$	11,748,000		$	14,356,000

See accompanying notes to financial statements.

Statement of Operations


	Years Ended March 31,
	2007			2006			2005
Net sales	$	18,981,000		$	22,354,000		$	24,287,000
Cost of sales		13,677,000			15,113,000			14,581,000

Gross profit		5,304,000			7,241,000			9,706,000
Costs and expenses:
Selling, general and administrative		6,323,000			6,788,000			6,947,000
Research and development		1.466,000			1,574,000			1,473,000

Total costs and expenses		7,789,000			8,362,000			8,420,000

Operating income (loss)		(2,485,000	)		(1,121,000	)		1,286,000
Interest income, net		57,000			20,000			39,000
Other income (expense)		6,000			(3,000	)		2,000

Earnings (loss) before income taxes		(2,422,000	)		(1,104,000	)		1,327,000
Income tax expense (benefit) (Note 3)		992,000			(431,000	)		(484,000	)

Net earnings (loss)	$	(3,414,000	)	$	(673,000	)	$	1,811,000

Basic earnings (loss) per share	$	(.34	)	$	(.07	)	$	.18


Diluted earnings (loss) per share	$	(.34	)	$	(.07	)	$	.17


Weighted shares outstanding:
Basic		10,170,000			10,146,000			10,122,000
Diluted		10,170,000			10,146,000			10,625,000

See accompanying notes to financial statements.

Statements of Shareholders’ Equity

For the years ended March 31, 2007,
2006, and 2005


	Common Shares				Accumulated
	Shares		Amount		Deficit

Balance at March 31, 2004		10,096,000	$	13,309,000	$	(2,156,000	)

Exercise of stock options		38,000		60,000		—

Net earnings		—		—		1,811,000


Balance at March 31, 2005		10,134,000		13,369,000		(345,000	)

Exercise of stock options		24,000		29,000		—

Tax benefit from exercise of non-qualified stock options		—		15,000		—

Net loss		—		—		(673,000	)


Balance at March 31, 2006		10,158,000		13,413,000		(1,018,000	)

Stock based compensation — options		—		33,000		—

Stock based compensation — restricted stock		22,000		80,000		—

Net loss		—		—		(3,414,000	)


Balance at 3/31/07		10,180,000	$	13,526,000	$	(4,432,000	)

See accompanying notes to financial statements.

Statements of Cash Flows


	Years Ended March 31,
	2007			2006			2005
Cash flows from operating activities:
Net earnings (loss)	$	(3,414,000	)	$	(673,000	)	$	1,811,000
Adjustments to reconcile net earnings (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization of property and equipment		350,000			418,000			378,000
Amortization of intangibles		42,000			40,000			39,000
Provision for losses on receivables		(14,000	)		13,000			(31,000	)
Loss on asset disposition		—			12,000			—
Tax benefit attributable to stock options		—			15,000			—
Decrease (increase) in deferred income taxes		1,266,000			(237,000	)		(805,000	)
Stock based compensation		113,000			—			—
Changes in assets and liabilities:
Decrease (increase) in accounts receivable		858,000			512,000			(803,000	)
Decrease (increase) in inventories		(176,000	)		2,131,000			(3,523,000	)
Decrease (increase) in income taxes refundable		92,000			(383,000	)		—
Decrease (increase) in prepaid expenses and other assets		(108,000	)		85,000			(70,000	)
Increase (decrease) in accounts payable		767,000			(681,000	)		694,000
Increase (decrease) in accrued expenses		(63,000	)		65,000			185,000
Increase (decrease) in income taxes payable					(200,000	)		(3,000	)

Net cash provided by (used in) operating activities		(287,000	)		1,117,000			(2,128,000	)


Cash flows from investing activities:
Additions to intangible assets		(177,000	)		(210,000	)		(112,000	)
Capital expenditures		(85,000	)		(175,000	)		(351,000	)

Net cash used in investing activities		(262,000	)		(385,000	)		(463,000	)


Cash flows from financing activities:
Exercise of stock options		—			29,000			60,000
Other liabilities		(11,000	)		(3,000	)		—

Net cash provided by financing activities		(11,000	)		26,000			60,000


Net increase (decrease) in cash		(560,000	)		758,000			(2,531,000	)

Cash beginning of year		935,000			177,000			2,708,000

Cash end of year	$	375,000		$	935,000			177,000


Supplemental disclosure of cash flow information:
Cash paid during the year for:
Income taxes	$	—		$	348,000		$	325,000
Acquisition of capital assets through capital lease	$	—		$	14,000		$	—

See accompanying notes to financial statements.

Notes to Financial Statements

(1) Summary of Significant Accounting Policies

The Company

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.

Fair Value of Financial Instruments

The carrying amounts of financial instruments approximate fair value as of March 31, 2007 and 2006. The carrying amounts related to cash, accounts receivable, other current assets, and accounts payable approximate fair value due to the relatively short maturity of such instruments.

Inventories

Inventories are valued at lower of cost or market. Cost is determined based on standard cost which approximates the first-in, first-out method.

Property and Equipment

Property and equipment are stated at cost. Depreciation of property and equipment is provided using the straight-line method based on the estimated useful lives of the related assets as follows:


Office Equipment and Furniture		5-10 Years
Machinery and Equipment		3-10 Years
Tooling		4 Years

Amortization of leasehold improvements is over the life of the related lease or asset, whichever is shorter.

Use of Estimates

Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities at the balance sheet date and the reporting of revenues and expenses during the periods to prepare these financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ from those estimates.

Significant estimates include the allowance for doubtful accounts, inventory valuation, deferred income tax asset valuation allowances, and the estimated future operating cash flows from the Company’s long-lived assets, including its intangible assets. Considerable management judgment is necessary to estimate future operating cash flows as future cash flows are impacted by competitive and other factors that are generally out of management’s control. Accordingly, actual results could vary significantly from management’s estimates.

Valuation of Accounts Receivable

The Company makes judgements as to the collectibility of accounts receivable based on historical trends and future expectations. Management estimates an allowance for doubtful accounts, which represents the collectability of accounts receivable. This allowance adjusts gross accounts receivable downward to its estimated net realizable value. To determine the allowance for doubtful accounts, management reviews specific customer risk and the Company’s accounts receivable aging.

Impairment of Long-Lived Assets

The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

Revenue Recognition

Revenue 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 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.

Comprehensive Income (Loss)

The Company did not have components of other comprehensive income other than its net earnings (loss) during the periods ended March 31, 2007, 2006, and 2005. As a result, comprehensive income (loss) is the same as net earnings (loss) for the periods ended March 31, 2007, 2006, and 2005.

Royalty Expense

The Company charges royalties incurred on product licenses to costs of sales.

Earnings (Loss) Per Common Share

Following is a calculation of basic and diluted earnings (loss) per common share for the years ended March 31, 2007, 2006, and 2005, respectively:


	2007			2006			2005
Basic earnings (loss) per share Numerator — net earnings (loss)	$	(3,414,000	)	$	(673,000	)	$	1,811,000
Denominator — weighted common shares outstanding		10,170,000			10,146,000			10,122,000

Basic earnings (loss) per share	$	(.34	)	$	(.07	)	$	.18

Diluted earnings (loss) per share Numerator — net earnings (loss)	$	(3,414,000	)	$	(673,000	)	$	1,811,000
Denominator — weighted common shares outstanding		10,170,000			10,146,000			10,122,000
Diluted potential common shares		—			—			503,000

		10,170,000			10,146,000			10,625,000

Diluted earnings (loss) per share	$	(.34	)	$	(.07	)	$	.17

Options to purchase 904,000, 945,000, and 128,000 shares of common stock at prices ranging from $.50 to $11.50 and from $5.00 to $12.54 per share were not included in the computation of diluted earnings per share in 2007, 2006, and 2005, respectively, because their inclusion would have been anti-dilutive.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and net operating loss and tax credit carryforwards. In assessing whether there is a need for a valuation allowance on deferred tax assets, we determine whether

Notes to Financial Statements

it is more likely than not that we will recognize tax benefits associated with deferred tax assets. In making this determination, we consider future taxable income and tax planning strategies that are both prudent and feasible. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Major Customer


	2007			2006			2005
Customer A**		41.3	%		36.0	%		35.8	%
Customer B**		*			*			10.8	%
Customer C		*			11.0	%		*


*		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.

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 the cash is requested. The potential loss is the amount in any one account over $100,000 and/or all funds in the interest bearing account. At March 31, 2007, the amount at risk was approximately $275,000.

At March 31, 2007 and 2006, significant accounts receivable balances were as follows:


	2007			2006
Customer A**		41.0	%		25.4	%
Customer B		*			21.6	%
Customer C**		12.6	%		*


*		Indicates accounts receivable balance less than 10% of gross accounts receivable.

**		Indicates national chain customer.

Stock Option Plan

On 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 Accounting Principles Board Opinion No. 25, accounting for stock issues to employees, and accounting for employee stock options at intrinsic value. Accordingly, during the year ended March 31, 2007, 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 year ended March 31, 2007, has been reduced for estimated forfeitures. For the year ended March 31, 2007, stock-based compensation expense of $113,000 was recorded to selling, general, and administrative expenses. Of the $113,000 in stock-based compensation, $33,000 related to FAS 123R option expense with the remaining $80,000 related to restricted stock issued to directors that vested April 1, 2006 and March 31, 2007. 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 March 31, 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. 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 year ended March 31, 2007. The following weighted-average assumptions were used in calculating the fair value of stock options granted during the year ended March 31, 2006, using the Black-Scholes option valuation model:


Expected life (in years)	8.0
Expected volatility factor	79.0	%
Risk free interest rate	4.3	%
Dividend yield	0.0
Forfeiture rate	4.0	%

A summary of stock option activity as of and for the year ended March 31, 2007, is presented below:


					Remaining
			Exercise		Contractual
			Price Per		Term
	Shares		Share		(in years)

Outstanding at March 31, 2006		945,000	$	2.22
Granted		—		—
Exercised		—		—
Forfeited or expired		41,000		4.99

Outstanding at March 31, 2007		904,000	$	2.09		4.06


As of March 31, 2007
Exercisable		892,000	$	2.13		4.1
Vested and expected to vest		902,000	$	2.14		4.1

The Company granted 25,000 options at $3.45 per share on July 28, 2005, and 15,000 options at $3.35 per share on August 2, 2005. The options were granted at the market price on the day of grant, and fully vested six months subsequent to the grant date. In addition, there were 26,000 options exercised at prices ranging from $.50 to $3.75 in the year ended March 31, 2006. No options were granted or exercised during fiscal year 2007.

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 March 31, 2007, for the options that were in-the- money at March 31, 2007. As of March 31, 2007, there was approximately $10,000 of unrecognized compensation cost related to unvested stock-based

Notes to Financial Statements

compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 9 months. Prior to the adoption of FAS 123R, the Company provided the disclosures required under FAS 123, as amended by FAS No. 148, “Accounting for Stock- Based Compensation — Transitions and Disclosures.” Employee stock-based compensation expense recognized under FAS 123R was not reflected in our results of operations for the year ended March 31, 2006, as all options were granted with an exercise price equal to the market value of the underlying common stock on the date of the grant. The pro forma information for the years ended March 31, 2006 and 2005, is as follows:


	Year Ended March 31,
	2006			2005
Net earnings (loss), as reported	$	(673,000	)	$	1,811,000
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all awards, net of related tax effects		(128,000	)		(108,000	)

Pro forma net earnings (loss)	$	(801,000	)	$	1,703,000


Earnings (loss) per share:
Basic — as reported	$	(.07	)	$	.18
Basic — pro forma		(.08	)		.17
Diluted — as reported		(.07	)		.17
Diluted — pro forma	$	(.08	)	$	.16

Segment Information

The Company operates in one segment, the respiratory care market.

Reclassifications

The Company added provisions for losses on receivables and amortization of
intangibles to its statements of condensed cash flows.

(2) Inventories

At March 31, 2007 and 2006, inventories consisted of the following:


	2007		2006
Finished goods	$	1,841,000	$	1,706,000
Work in process		2,240,000		1,234,000
Raw materials and supplies		2,476,000		3,441,000

	$	6,557,000	$	6,381,000

(3) Income Taxes

Income tax expense (benefit) for fiscal 2007, 2006, and 2005 consisted of the
following:


	2007			2006			2005
Current:
Federal	$	(282,000	)	$	(217,000	)	$	307,000
State		8,000			7,000			15,000

		(274,000	)		(210,000	)		322,000

Deferred:
Federal		837,000			(149,000	)		(466,000	)
State		429,000			(72,000	)		(340,000	)

		1,266,000			(221,000	)		(806,000	)

Total	$	992,000		$	(431,000	)	$	(484,000	)

A reconciliation of the difference between the Company’s income tax expense (benefit) and the statutory income tax for the years ended March 31, 2007, 2006, and 2005, respectively, is as follows:


	2007			2006			2005
Statutory tax expense (benefit)	$	(825,000	)	$	(375,000	)	$	451,000
State income tax, net		(57,000	)		(51,000	)		72,000
Valuation allowance		1,858,000			9,000			(1,004,000	)
Warranty and other		16,000			(14,000	)		(3,000	)

	$	992,000		$	(431,000	)	$	(484,000	)

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets at March 31, 2007 and 2006 are presented as follows:


	2007			2006
Bad debt reserves	$	15,000		$	21,000
Accrued expenses		286,000			263,000
Inventories		426,000			344,000
Depreciation and amortization		245,000			241,000
Intangible assets		191,000			261,000
Net operating loss		860,000			147,000
Other		23,000			2,000

Total deferred tax assets		2,046,000			1,279,000
Deferred tax liabilities:
Valuation allowance		(2,046,000	)		(13,000	)

Net deferred tax assets	$	—		$	1,266,000

The Company has Federal net operating loss carryforwards of $1,459,000 expiring in 2027 and California net operating loss carryforwards of $3,442,000 expiring in 2013. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. At March 31, 2007, the Company’s deferred tax assets are fully offset by a valuation allowance. The Company will carryback Federal net operating losses of $894,000 to prior years, which will generate $281,000 in refundable federal income tax payments.

(4) Intangible Assets

Intangible assets include amounts paid for licenses on new and existing products. License fees are being amortized using the straight-line method over the life of the related patents. Accumulated amortization on the license fees amounted to $138,000 and $96,000 at March 31, 2007 and 2006, respectively. Annual amortization on intangible assets currently in service will be $42,000 for each of the next five years. Intangible assets were $1,107,000 and $972,000, and amortization expense was $42,000 and $40,000 at March 31, 2007 and 2006, respectively.

(5) Shareholders’ Equity

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. In addition, the Plan provides that non-qualified options can be granted to directors and independent contractors of the Company. Transactions involving the equity plan and the 1994 stock option plan, which expired in 2004, are summarized as follows:

Notes to Financial Statements


				Weighted
				Average
	Option			Price
	Shares			Per Share
Incentive options:

Outstanding — March 31, 2004		779,000			2.37
Cancelled		(13,000	)		2.51
Exercised		(17,000	)		1.02
Expired		(83,000	)		8.19


Outstanding — March 31, 2005		666,000			1.98
Cancelled		(7,000	)		3.33
Granted		40,000			3.41
Exercised		(24,000	)		1.16


Outstanding — March 31, 2006		675,000			2.10

Cancelled		(28,000	)		3.42

Outstanding — March 31, 2007		647,000		$	2.02


Exercisable — March 31, 2007		635,000		$	2.01


Non-qualified options:

Outstanding — March 31, 2004		322,000			4.30
Cancelled		(41,000	)		8.33
Granted		55,000			3.71
Exercised		(21,000	)		2.07
Expired		(6,000	)		5.18


Outstanding — March 31, 2005		309,000			3.83
Expired		(39,000	)		11.88


Outstanding — March 31, 2006		270,000			9.56
Cancelled		(5,000	)		3.90
Expired		(8,000	)		11.50

Outstanding — March 31, 2007		257,000			2.26

Exercisable — March 31, 2007		249,000		$	2.26

At March 31, 2007, information regarding outstanding options is summarized as follows:


	Range of Exercise Prices
	$.50-6.69		$7.62-12.54

Number outstanding		896,000		8,000
Weighted average remaining life (yrs.)		4.1		1.0
Weighted average exercise price	$	2.01	$	7.62
Number exercisable		884,000		8,000
Weighted average exercise price	$	2.08	$	7.62

Incentive and non-qualified options were granted at prices not less than 100% of market value at dates of grant. Options under the Plan become exercisable on the anniversary of the grant date on a pro rata basis over a defined period and expire ten (10) years after the date of grant. To the extent the Company derives a tax benefit from options exercised by employees, such benefit is credited to Common Shares.

(6) Employee Benefit Plan

In December 1992, the Company adopted a defined contribution profit sharing plan, including features under Section 401(k) of the Internal Revenue Code. The purpose of the plan is to provide an incentive for employees to make regular savings for their retirement. Company contributions to the profit sharing plan are discretionary and are determined by the Board of Directors. There have been no contributions since 2002.

(7) Accrued Expenses

Accrued expenses consist of the following:


	2007		2006
Accrued royalties	$	301,000	$	267,000
Accrued vacation		216,000		205,000
Warranty reserve		163,000		139,000
Payroll and incentive compensation		102,000		86,000
Accrued inventory in transit		200,000		175,000
Customer deposits		103,000		152,000
Accrued extended warranty		91,000		95,000
Other		196,000		316,000

	$	1,372,000	$	1,435,000

(8) Commitments

The Company is currently leasing its administrative and plant facilities and certain office equipment under noncancelable operating leases which expire through June 2008. Rent expense amounted to $571,000, $570,000, and $577,000 for the years ended March 31, 2007, 2006, and 2005, respectively. The Company is also responsible for common area maintenance costs, including taxes, insurance, and other maintenance costs.

The Company has minimum annual royalty requirements pursuant to the terms of license agreements related to certain products in the amount of $515,000. Annual royalty expense on all products amounted to $559,000, $542,000 and $552,000 for the years ended March 31, 2007, 2006, and 2005, respectively. 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 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.

In March 2007, the Company entered into a one-year factoring arrangement which provides for the sale of certain of the Company’s accounts receivable up to $1,500,000. Assignments under the agreement bear interest at the bank’s prime rate plus 2% to 3% depending on the total accounts receivable balance assigned. The Company has a minimum monthly interest payment of $6,000 beginning in April 2007.

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 September 2007. Amortization of plant equipment under capital leases will be included in depreciation expense.

The following table aggregates all of the Company’s material contractual obligations as of March 31, 2007:

Notes to Financial Statements


	Operating Lease		Minimum Royalty				Capital Lease
	Obligation		Obligation		Employee Obligations		Obligations		Factoring Agreement
2008	$	459,000	$	530,000	$	160,000	$	4,000	$	72,000
2009		118,000		530,000		200,000		—		—
2010		2,000		530,000		—		—		—
2011		—		447,000		—		—		—
2012		—		30,000		—		—		—
Thereafter	$	—	$	105,000	$	—	$	—	$	—

The Company is involved in certain legal actions resulting 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.

(9) Geographic Information

The Company has one reportable operating segment as defined in Note 1. Geographic information regarding the Company’s net sales is as follows:


	2007		2006		2005

United States	$	15,795,000	$	17,996,000	$	22,912,000
Canada		174,000		193,000		306,000
Japan		346,000		506,000		405,000
Europe		2,054,000		3,337,000		418,000
Indonesia		271,000		42,000		20,000
All other countries		341,000		280,000		226,000

	$	18,981,000	$	22,354,000	$	24,287,000

All long-lived assets are located in the United States.

Sales of OXYMATIC^{^®}and CYPRESS conservers accounted for 69%, 70% and 73% of the Company’s net sales for the years ended March 31, 2007, 2006, and 2005, respectively.

(10) Valuation and Qualifying Accounts and Reserves

The following is the Company’s schedule of activity in the valuation and qualifying accounts and reserves for the years ended March 31, 2007, 2006, and 2005:


	Balance at		Charged to Costs				Balance at End of
	Beginning of Year		and Expenses		Deductions		Year
Allowance for doubtful accounts:
2005	$	68,000		—		29,000	$	39,000
2006		39,000		28,000		15,000		52,000
2007	$	52,000		27,000		41,000	$	38,000

Warranty reserve:
2005	$	103,000		57,000		51,000	$	109,000
2006		109,000		64,000		34,000		139,000
2007	$	139,000		46,000		22,000	$	163,000

(11) Quarterly Financial Data (Unaudited)

The following table presents summarized, unaudited, quarterly financial data for 2007 and 2006:


								Diluted
								Earnings
			Gross		Net			Loss
	Revenue		Profit		Loss			Per Share
2007
First quarter	$	5,476,000	$	1,814,000	$	(116,000	)	$	(.01	)
Second quarter		4,983,000		1,617,000		(307,000	)		(.03	)
Third quarter		4,307,000		1,059,000		(435,000	)		(.04	)
Fourth quarter		4,215,000		814,000		(2,556,000	)		(.26	)

Year	$	18,981,000	$	5,304,000	$	(3.414.000	)	$	(.34	)


2006
First quarter	$	5,895,000	$	2,101,000	$	(42,000	)	$	.00
Second quarter		5,375,000		1,781,000		(210,000	)		(.02	)
Third quarter		5,907,000		2,101,000		39,000			.00
Fourth quarter		5,177,000		1,258,000		(460,000	)		(.05	)

Year	$	22,354,000	$	7,241,000	$	(673,000	)	$	(.07	)

(12) Accounting Standards.

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.

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 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 Statement of Financial Accounting Standard (“SFAS”) No. 157 “Share-Based Payment.” 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 Account 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 December 31, 2006, for 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 and therefore does not anticipate a significant impact to its financial statements upon implementation.

Audit Report

The Board of Directors
and Shareholders
CHAD Therapeutics, Inc.

We have audited the accompanying balance sheet of CHAD Therapeutics, Inc. as of March 31, 2007, and the related statement of operations, stockholders’ equity, and cash flows for the year ended March 31, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CHAD Therapeutics, Inc. as of March 31, 2007, and the results of its operations and its cash flows for the year ended March 31, 2007, in conformity with accounting principles generally accepted in the United States of America.

/s/ Rose, Snyder & Jacobs

A Corporation of Certified Public Accountants

Encino, California

May 25, 2007

Report of Independent Registered Public Accounting Firm

The Board of Directors
and Shareholders
CHAD Therapeutics, Inc.

We have audited the accompanying balance sheet of CHAD Therapeutics, Inc. as of March 31, 2006, and the related statements of operations, shareholders’ equity, and cash flows for each of the years in the two-year period ended March 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CHAD Therapeutics, Inc. as of March 31, 2006, and the results of its operations and its cash flows for each of the years in the two-year period ended March 31, 2006, in conformity with accounting principles generally accepted in the United States of America.

KPMG LLP
Los Angeles, California
May 5, 2006

Management’s Discussion and Analysis of Financial
Condition and Results of Operation

Overview

The Company develops, assembles and markets medical devices that furnish supplementary oxygen to home health care patients. The Company was a pioneer in developing oxygen conserving devices that enhance the quality of life for patients by increasing their mobility and, at the same time, lowering operating costs by achieving significant savings in the amount of oxygen actually required to properly oxygenate patients. The market for oxygen conserving devices has been, and continues to be, significantly affected by increased competition, consolidation among home oxygen providers, and revisions (and proposed revisions) in governmental reimbursement policies. All of these factors, as described more fully below, have contributed to a more difficult market for the Company’s products.

The procedures for reimbursement by Medicare for home oxygen services provide a prospective flat-fee monthly payment based solely on the patient’s prescribed oxygen requirement. Beginning January 1, 2006, the reimbursement procedures have been modified to provide that title for the equipment being used by a patient transfers to the patient after 36 months. Under this system, inexpensive concentrators have grown in popularity because of low cost and less frequent servicing requirements. At the same time, oxygen conserving devices, such as the Company’s products, have also grown in popularity due to their ability to extend the life of oxygen supplies and reduce service calls by home care providers, thereby providing improved mobility for the patient and cost savings for home care providers. However, the uncertainties created by the new reimbursement procedures have adversely affected the market for our products by causing many home health care providers to delay product purchases as they seek to assess the impact of the new procedures and revisions.

On January 1, 2007, new rates that include a new reimbursement category for transfilling systems, like the Company’s TOTAL O₂^® Delivery System, became effective. These new rates may have a positive impact on the market for these types of devices. However, in 2003 Congress enacted the Medicare Improvement and Modernization Act, which mandates that the monthly fees that homecare providers receive for servicing oxygen patients will be subject to competitive bidding. The current schedule is that this process wil first be implemented in ten major markets on April 1, 2008. Continuing concern among home care providers about the potential impact of these changes in reimbursement may affect demand for the Company’s products.

In addition, other changes in the health care delivery system, including the increase in the acceptance and utilization of managed care, have stimulated a significant consolidation among home care providers. Major national and regional home medical equipment chains have continued to expand their distribution networks through the acquisition of independent home care providers in strategic areas. Margins on sales to national chains are generally lower due to quantity pricing, and the Company is experiencing continued downward pressure on its average selling price. Four major national chains accounted for approximately 49%, 43%, and 53% of the Company’s net sales, for the years ended March 31, 2007, 2006, and 2005, respectively. One chain accounted for 41%, 36%,and 36% of sales in the years ended March 31, 2007, 2006, and 2005, respectively, and one other chain accounted for 11% of sales in the year ended March 31, 2005. The Company also had one significant non-chain customer that accounted for 11.0% of sales in the year ended March 31, 2006.

The Company believes that price competition and continuing industry consolidation will continue to affect the marketplace for the foreseeable future. To address the competitive and unpredictable nature of the oxygen conserver marketplace, the Company is pursuing the following strategy:

•

Development of additional oxygen conservers with a view to diversifying our product line in order to offer customers a range of oxygen conservation choices.

Over the past several years, the Company has introduced several additional models of electronic conservers, pneumatic conservers, and the SAGE Oxygen Therapeutic Device. These products expand the breadth of the Company’s product line and offer additional features to enhance their competitiveness in the marketplace. For example, the SAGE device senses a patient’s movements

Management’s Discussion and Analysis of Financial
Condition and Results of Operation

and automatically adjusts the rate of oxygen delivery in order to reduce the risk of desaturation as activity increases.

•

An effort to expand the Company’s product offerings in order to reduce its dependence upon the oxygen conserver sector.

The Company has invested in the development of diagnostic and therapeutic devices for the high-growth sleep disorder market. The first of these products are currently undergoing testing and finalization of product design. While reports to date have been encouraging, the Company cannot predict at this time when it will commercially introduce such products, nor can it estimate the level of success it might achieve in selling products for the sleep market. In addition to the sleep products, the Company is considering other opportunities which might expand the product lines it offers for the home health care market.

•

A continued promotional and educational campaign with respect to the benefits of the TOTAL O₂ system.

The Company believes that the changing reimbursement environment should benefit the home transfill systems because of the opportunity for significant cost savings presented by such systems. While the TOTAL O₂ system was first introduced in 1998, sales were adversely affected by several factors, including home care providers’ reluctance to invest in the higher cost of the TOTAL O₂ Delivery System to achieve lower monthly operating costs. Continuing pressure on reimbursement rates and the establishment of a separate reimbursement category for trans-fill systems may represent an emerging opportunity to promote the benefits of the TOTAL O₂ system.

•

Continuing efforts to reduce manufacturing costs.

Recognizing the likelihood of continued pricing pressure for supplemental oxygen equipment, the Company is continuing its efforts to reduce its manufacturing costs. These efforts include implementation of internal practices intended to lower such costs, as well as out-sourcing the production of certain components and processes.

While management believes the current growth strategy should enhance the Company’s competitive position and future operating performance, continuing price pressure on our conservers and concerns about reimbursement changes have depressed operating results for the last two fiscal years. In addition, the Company’s increased dependence on a limited number of large customers has increased the volatility of our operating results. Management of the Company will continually monitor these trends and will attempt to remain flexible in order to adjust to possible future changes in the market for respiratory care devices. For information that may affect the outcome of forward-looking statements in this Overview regarding the Company’s business strategy and its introduction of new products, see Outlook: Issues and Risks beginning on page 18 of this report.

Results of Operations

Net sales for the years ended March 31, 2007 and 2006 decreased by $3,373,000 (15.1%) and $1,933,000 (8.0%), respectively, as compared to the same periods in the prior yeasr. The primary reasons for the decrease in sales for the years ended March 31, 2007 and 2006, respectively as compared to the previous years have been a reduction in sales volume, and the price reductions on conservers, as well as decreases in TOTAL O₂ system sales and a decrease in sales to foreign distributors. Worldwide unit sales of conservers and therapeutic devices for the years ended March 31, 2007 and 2006 decreased 10.0% and increased .8% respectively, while the decrease in worldwide revenues from conserver and therapeutic device sales was 16.9% and 11.3% for the same periods. Domestic conserver and therapeutic device unit sales decreased 2.6% and 13.6%, while international conserver and therapeutic device unit sales decreased 40.1% and increased 203.7% for the years ended March 31, 2007 and 2006 respectively. Decreased per-unit conserver revenues over the past two years are due to price reductions, the impact of national chain contract pricing, and the changing product mix, as pneumatic conservers are generally priced lower than electronic conservers. As noted above, the Company is experiencing continued downward pressure on its average selling price. In addition, future operating results may be increasingly dependent upon purchase decisions of a limited number of large customers.

Management’s Discussion and Analysis of Financial
Condition and Results of Operation

Revenues from TOTAL O2 system sales decreased 25.5% for the year ended March 31, 2007, and increased 2.8% for the year ended March 31, 2006 as compared to the same periods in the prior years. The Company believes that the January 2, 2006, modification of reimbursement procedures that provides for the title of equipment being used by a patient to transfer to the patient after 36 months, and concern over the implementation of competitive bidding and its potential impact on reimbursements negatively impacted sales of TOTAL O2 during the year ended March 31, 2007. The new reimbursement category created by CMS for transfilling systems that went into effect on January 1, 2007, may have a positive impact on the market for transfilling systems, such as the TOTAL O2 system, once the impact of the implementation of competitive bidding becomes settled.

Sales to foreign distributors represented 16.8% and 19.5% of net sales the years ended March 31, 2007 and 2006, respectively. Foreign sales declined by 26.9% for the year ended March 31, 2007 after showing a 208.4% increase for the year ended March 31, 2006 as compared to the respective prior year periods. The decrease for the year ended March 31, 2007 was driven by a 40.6% decrease in conserver sales compared to the prior year. The year ended March 31, 2006 saw a 331.2% increase in conserver sales to foreign distributors over the previous year. Management believes the spike in conserver sales to foreign distributors in the 2006 fiscal year resulted in large part from certain foreign customers ramping up their inventory of conservers in order to comply with regulatory requirements. Notwithstanding the current year decline, management believes there may be substantial growth opportunities for the Company’s products in a number of foreign markets, and currently expects an increase in sales to foreign distributors during the upcoming twelve months. However, quarter-to-quarter sales may fluctuate depending on the timing of shipments. All foreign sales are denominated in US dollars.

Cost of sales as a percent of net sales increased from 67.6% to 72.12% and from 60.0% to 67.6% for the years ended March 31, 2007 and 2006, respectively. This was partially a result of the downward price pressures in the market place, as well as increased sales to chain customers and those with quantity pricing arrangements. We currently expect continued downward price pressure for the foreseeable future. In accordance with the Company’s policy to provide a reserve against excess or slow-moving inventory, in March 2006 the Company established a $739,000 reserve against certain slow-moving inventories related to its SAGE Oxygen Therapeutic Device. In the latter part of fiscal 2005, the Company had a significant inventory build up to fill certain customer orders and anticipated customer orders. Certain of these orders did not materialize. Prior to the application of the reserve, the book value of the SAGE inventory was approximately $1,484,000. In March of 2007 the Company increased its reserve for slow-moving inventory by $185,000 as a result of the impact of current market conditions on sales of the SAGE device as well as the impact of the introduction of the new OMNI-5 and OMNI-2 oxygen transfilling systems. Sales of the SAGE inventory continue, and the Company intends to continue to market and support the SAGE Oxygen Therapeutic Device in the future.

Selling, general, and administrative expenditures increased from 30.4% to 33.3% and from 28.6% to 30.4% of net sales for the year ended March 31, 2007 and 2006, respectively, as compared to the same period in the prior year primarily due to the decrease in sales. While the Company’s ongoing cost reduction efforts have helped align staffing and operating expenses more closely with current sales expectations, and have decreased actual selling, general, and administrative expenditures, decreases in sales revenues have resulted in selling, general and administrative costs increasing as a percentage of net sales. Research and development expenses decreased by $108,000 and increased $101,000 for the years ended March 31, 2007 and 2006, respectively, as compared to the prior years. Currently, management expects research and development expenditures to total approximately $1,754,000 in the fiscal year ending March 31, 2008, on projects to enhance and expand the Company’s product line.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized.

Management’s Discussion and Analysis of Financial
Condition and Results of Operation

Based on current earnings performance and projections, a full valuation allowance $2,046,000 has been placed on the Company’s deferred tax assets. The Company has Federal net operating loss carryforwards of $1,459,000 expiring in 2027 and California net operating loss carryforwards of $3,442,000 expiring in 2013.

Financial Condition

At March 31, 2007, the Company had cash totaling $375,000 or 3.2% of total assets as compared to $935,000 or 6.6% at March 31, 2006. The decrease in the Company’s cash balance is due to the overall decrease in the Company’s sales. Net working capital decreased from $9,806,000 at March 31, 2006, to $7,266,000 at March 31, 2007. Net accounts receivable decreased $844,000 during the year ended March 31, 2007, also due to the decrease in sales. Future increases or decreases in accounts receivable will generally coincide with sales volume fluctuations and the timing of shipments to foreign customers. During the same period, inventories increased $176,000, while cash decreased by $560,000. In March 2006, the Company established a $739,000 reserve against slow-moving inventories related to the SAGE device inventory. The Company experienced a significant inventory build up in the latter part of fiscal 2005 to fill certain customer orders and anticipated customer orders of the SAGE device. Certain of these orders did not materialize. The Company attempts to maintain sufficient inventories to meet its customer needs as orders are received and new products are introduced. Thus, future inventory and related accounts payable levels will be impacted by the ability of the Company to maintain its safety stock levels. If safety stock levels drop below target amounts, then inventories in subsequent periods will increase more rapidly as inventory balances are replenished.

Historically, the Company has depended primarily upon its cash flow from operations to finance its inventory and operating expenses and to meet its capital requirements. The Company’s efforts to expand its product line and enter the sleep disorder market may require significant cash resources for product development, manufacturing, and marketing. If the Company does not increase its capital resources, it may be required to delay development of products for the sleep disorder market and its growth may be constrained by other measures taken to conserve cash. During the next twelve months, the Company intends to seek outside financing arrangements in order to facilitate its ability to fund anticipated capital expenditures, support its development of the sleep products, and enhance its working capital resources. Financing may be obtained through the sale of equity or debt securities, through the establishment of credit arrangements or through some combination of the foregoing. The Company does not have in place of any arrangements to raise additional funds through the sale of securities and it is not possible at this time to determine the terms upon which securities might be sold, or if the Company can raise any funds from prospective investors. In March 2007, the Company entered into a one-year factoring arrangement which provides for the sale of certain of the Company’s accounts receivable up to $1,500,000. Assignments under the agreement bear interest at the bank’s prime rate plus 2% to 3% depending on the total accounts receivable balance assigned. The Company has a minimum monthly interest payment of $6,000 beginning in April 2007. The Company expects capital expenditures during the next twelve months to be approximately $100,000.

The following table aggregates all of the Company’s material contractual obligations as of March 31, 2007:

Payments Due By Period



Contractual			Less than 1		1-3		3-5		After 5
Cash Obligations	Total		Year		Years		Years		Years

Operating lease obligations	$	579,000	$	459,000	$	120,000		—		—
Minimum royalty obligations	$	2,172,000	$	530,000	$	1,507,000	$	90,000	$	45,000
Employee obligations	$	360,000	$	160,000	$	200,000		—		—
Capital lease obligations	$	4,000	$	4,000		—		—		—
Factoring agreement	$	72,000	$	72,000		—		—		—

Operating lease commitments consist primarily of a real property lease for the Company’s corporate office, as well as minor equipment leases. Payments for these lease

Management’s Discussion and Analysis of Financial
Condition and Results of Operation

commitments are provided for by cash flows generated from operations. Please see Note 8 to the financial statements.

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 of 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 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 does not have any outstanding debt and is not subject to any covenants or contractual restrictions limiting its operations with the exception of those required by its line of credit agreement indicated above. The Company has not adopted any programs that provide for post-employment retirement benefits; however, it has on occasion provided such benefits to individual employees. The Company does not have any off-balance sheet arrangements with any special purpose entities or any other parties, does not enter into any transactions in derivatives, and has no material transactions with any related parties.

Significant Accounting Policies

The 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 and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates under different assumptions and conditions. Management believes that the following discussion addresses the accounting policies and estimates that are most important in the portrayal of the Company’s financial condition and results.

Allowance for doubtful accounts — the Company provides a reserve against receivables for estimated losses that may result from our customers’ inability to pay. The amount of the reserve is based on an analysis of known uncollectible accounts, aged receivables, historical losses, and credit-worthiness. Amounts later determined and specifically identified to be uncollectible are charged or written off against this reserve. The likelihood of material losses is dependent on general economic conditions and numerous factors that affect individual accounts.

Inventories — the Company provides a reserve against inventories for excess and slow-moving items. The amount of the reserve is based on an analysis of the inventory turnover for individual items in inventory. The likelihood of material write-downs is dependent on customer demand and competitor product offerings.

Intangible and long-lived assets — The Company assesses whether or not there has been an impairment of intangible and long-lived assets in evaluating the carrying value of these assets. Assets are considered impaired if the carrying value is not recoverable over the useful life of the asset. If an asset is considered impaired, the amount by which the carrying value exceeds the fair value of the asset is written off. The likelihood of a material change in the Company’s reported results is dependent on each asset’s ability to continue to generate income, loss of legal ownership or title to an asset, and the impact of significant negative industry or economic trends.

Deferred income taxes — the Company provides a valuation allowance to reduce deferred tax assets to the amount

Management’s Discussion and Analysis of Financial
Condition and Results of Operation

expected to be realized. The likelihood of a material change in the expected realization of these assets depends on the Company’s ability to generate future taxable income.

Outlook: Issues & Risks

This report contains forward-looking statements which reflect the Company’s current views with respect to future events and financial performance. These forwardlooking statements are subject to certain risks and uncertainties, which may cause actual operating results to differ materially from currently anticipated results.

Factors that could cause actual results to differ materially include but may not be limited to the following:

•		Our future results depend upon our ability to successfully introduce new products.

•		Our operating results, profitability and operating margins have been adversely affected by price pressure on our principal products.

•		We are highly dependent upon a limited number of large customers, which may increase the volatility of our future operating results.

•		We are dependent upon a single product line, which increases our vulnerability to adverse developments affecting the market for supplementary oxygen.

•		Changes and prospective changes in the administration of health care may disrupt the market for our products, resulting in decreased profitability.

•		We operate in a highly competitive environment which has contributed to our reduced operating margins.

•		If we are unable to stay abreast of continuing technological change, our products may become obsolete, resulting in a decline in sales and profitability.

•		Failure to protect our intellectual property rights could result in a loss of market share.

•		Our profitability would be adversely affected if we incur uninsured losses due to product liability claims.

•		Our dependence upon third party suppliers exposes us to the risk that our ability to deliver products may be adversely affected if the suppliers fail to deliver quality components on a timely basis.

Risk factors are disclosed in the Company’s Annual Report and Form 10K under the title Item 1A. Risk Factors. You may obtain a copy of the Company’s Form 10K at the SEC website http://www.sec.gov or at the Company’s website www.chadtherapeutics.com or by contacting the Company at the address listed on the final page of this report.

Accounting Standards

Management’s Discussion and Analysis of Financial
Condition and Results of Operation

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 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 Statement of Financial Accounting Standard (“SFAS”) No. 158 “Employer’s Account 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 December 31, 2006, 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 and therefore does not anticipate a significant impact to its financial statements upon implementation.

Corporate Data

Officers

THOMAS E. JONES
Chairman

EARL L. YAGER
Chief Executive Officer and President

ALFONSO DEL TORO
Vice President, Manufacturing

TRACY A. KERN
Chief Financial Officer

ERIKA LASKEY
Sr. Vice President, Sales and Marketing

KEVIN McCULLOH
Sr. Vice President, Engineering &
Product Development

PAULA O’CONNOR
Corporate Secretary

SAMUEL PATTON
Vice President, Quality Assurance and Regulatory Affairs

OSCAR J. SANCHEZ
Vice President, Business Development

Directors

THOMAS E. JONES
Chairman
CHAD Therapeutics, Inc.

EARL L. YAGER
President and Chief Executive Officer
CHAD Therapeutics, Inc.

JOHN C. BOYD
Retired

JAMES M. BROPHY
Hospital Executive

KATHLEEN M. GRIGGS
Financial Consultant

PHILIP T. WOLFSTEIN
International Trade Consultant

Corporate Data

CORPORATE HEADQUARTERS
21622 Plummer Street
Chatsworth, CA 91311
(818) 882-0883

LEGAL COUNSEL
Morrison & Foerster, LLP

AUDITORS
Rose, Snyder & Jacobs
Encino, California

TRANSFER AGENT AND REGISTRAR
American Stock Transfer Company
40 Wall Street
New York, NY 10005

Common Stock Price Range

Beginning August 3, 1993, the Company’s common shares were traded on the American Stock Exchange Emerging Company Marketplace and on June 6, 1994, the Company’s shares moved to the primary list of the American Stock Exchange with the symbol CTU. The following table sets forth, for the periods indicated, the high and low closing prices as furnished by the American Stock Exchange.


Quarter Ended	High		Low

June 30, 2005		3.87		3.62
September 30, 2005		3.81		3.71
December 31, 2005		3.60		3.36
March 31, 2006		2.90		2.50
June 30, 2006		3.05		2.41
September 30, 2006		2.85		1.46
December 31, 2006		3.06		1.86
March 31, 2007		2.42		1.42

As of June 12, 2007, there were approximately 217 shareholders of record and approximately 2,000 beneficial owners of the Company’s common stock. No cash dividends have been paid on the common stock.

SEC Form 10-K

A copy of the Company’s annual report to the Securities and Exchange Commission on Form 10-K is available without charge upon written request to:

Chief Financial Officer
CHAD Therapeutics, Inc.
21622 Plummer Street
Chatsworth, CA 91311

Chad Therapeutics (CTU) Inactive 10-K/A2007 FY Annual report (amended)