e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2007


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 001-31783

RAE SYSTEMS INC.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		77-0280662 (I.R.S. Employer Identification No.)

3775 North First Street San Jose, California (Address of principal executive offices)		95134 (Zip Code)

408-952-8200
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer o Accelerated filer þ Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.



	Class			Outstanding at July 30, 2007
	Common stock, $0.001 par value per share			59,250,674 shares

PART I. Financial Information

Item 1. Financial Statements

RAE Systems Inc.
Condensed Consolidated Balance Sheets
(unaudited)


	June 30,			December 31,
	2007			2006

Assets

Current Assets:
Cash and cash equivalents	$	10,434,000		$	18,119,000
Short-term investments		—			3,248,000
Trade notes receivable		1,649,000			1,977,000
Accounts receivable, net of allowance for doubtful accounts of $1,400,000 and $843,000, respectively		18,536,000			16,966,000
Accounts receivable from affiliate		206,000			154,000
Inventory		16,533,000			15,382,000
Prepaid expenses and other current assets		4,100,000			2,530,000
Income taxes receivable		772,000			968,000
Deferred tax assets, current		994,000			935,000

Total Current Assets		53,224,000			60,279,000


Property and equipment, net		15,635,000			15,120,000
Acquisition in-progress		—			820,000
Intangible assets, net		5,445,000			5,304,000
Goodwill		4,520,000			3,760,000
Investment in unconsolidated affiliate		346,000			420,000
Deferred tax assets, non-current		3,401,000			3,402,000
Other assets		1,690,000			648,000

Total Assets	$	84,261,000		$	89,753,000


Liabilities, Minority Interest in Consolidated Entities and Shareholders’ Equity

Current Liabilities:
Accounts payable	$	6,528,000		$	7,187,000
Accounts payable to affiliate		217,000			360,000
Account payable to Fushun shareholders		1,774,000			3,926,000
Bank line of credit		2,024,000			—
Accrued liabilities		7,936,000			8,793,000
Notes payable to related parties, current		657,000			822,000
Income taxes payable		—			520,000
Deferred revenue, current portion		1,972,000			2,030,000

Total Current Liabilities		21,108,000			23,638,000

Deferred revenue, net of current portion		613,000			736,000
Deferred tax liabilities, non-current		446,000			438,000
Other long-term liabilities		1,337,000			1,045,000
Notes payable to related parties, non-current		3,074,000			3,222,000

Total Liabilities		26,578,000			29,079,000


Commitments and Contingencies (Note 5)

Minority Interest in Consolidated Entities		4,553,000			4,495,000

Shareholders’ Equity:
Common stock, $0.001 par value; 200,000,000 shares authorized; 59,306,887 and 59,274,596 shares issued and outstanding, respectively		59,000			59,000
Additional paid-in capital		59,942,000			58,828,000
Accumulated other comprehensive income		2,005,000			1,245,000
Accumulated deficit		(8,876,000	)		(3,953,000	)

Total Shareholders’ Equity		53,130,000			56,179,000

Total Liabilities, Minority Interest in Consolidated Entities and Shareholders’ Equity	$	84,261,000		$	89,753,000

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.
Condensed Consolidated Statements of Operations
(unaudited)


	Three Months Ended June 30,						Six Months Ended June 30,
	2007			2006			2007			2006

Net Sales	$	20,093,000		$	15,901,000		$	38,080,000		$	28,327,000
Cost of Sales		10,077,000			7,439,000			18,903,000			13,155,000

Gross Profit		10,016,000			8,462,000			19,177,000			15,172,000

Operating Expenses:
Sales and marketing		6,328,000			4,420,000			11,681,000			8,491,000
Research and development		1,893,000			1,453,000			3,665,000			2,726,000
General and administrative		4,053,000			3,033,000			9,239,000			6,002,000
Adjustment to lease abandonment accrual		16,000			—			(596,000	)		—

Total Operating Expenses		12,290,000			8,906,000			23,989,000			17,219,000

Operating Loss		(2,274,000	)		(444,000	)		(4,812,000	)		(2,047,000	)

Other Income/(Expense):
Interest income		55,000			260,000			119,000			434,000
Interest expense		(84,000	)		(65,000	)		(153,000	)		(86,000	)
Other, net		70,000			138,000			85,000			166,000
Equity in loss of unconsolidated affiliate		(57,000	)		(117,000	)		(75,000	)		(181,000	)

Total Other Income/(Expense)		(16,000	)		216,000			(24,000	)		333,000

Loss Before Income Taxes and Minority Interest		(2,290,000	)		(228,000	)		(4,836,000	)		(1,714,000	)
Income tax benefit/(expense)		(184,000	)		305,000			23,000			484,000

Profit/(Loss) Before Minority Interest		(2,474,000	)		77,000			(4,813,000	)		(1,230,000	)
Minority interest in (income)/loss of consolidated subsidiaries		18,000			(131,000	)		39,000			145,000

Net Loss	$	(2,456,000	)	$	(54,000	)	$	(4,774,000	)	$	(1,085,000	)


Basic Loss Per Common Share	$	(0.04	)	$	(0.00	)	$	(0.08	)	$	(0.02	)


Diluted Loss Per Common Share	$	(0.04	)	$	(0.00	)	$	(0.08	)	$	(0.02	)

Weighted average common shares outstanding — Basic		58,769,349			58,112,766			58,763,539			58,007,469
Stock options and warrants		—			—			—			—

Weighted average common shares outstanding — Diluted		58,769,349			58,112,766			58,763,539			58,007,469

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.
Condensed Consolidated Statements of Cash Flows
(unaudited)


	Six Months Ended
	June 30,
	2007			2006

Cash Flows From Operating Activities:
Net loss	$	(4,774,000	)	$	(1,085,000	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		1,779,000			1,387,000
Loss on disposal of fixed assets		—			115,000
Stock compensation expense		1,043,000			699,000
Equity in loss of unconsolidated affiliate		75,000			181,000
Minority interest in loss of consolidated subsidiary		(39,000	)		(145,000	)
Deferred income taxes		(51,000	)		7,000
Adjustment to lease abandonment accrual		(596,000	)		—
Amortization of discount on notes payable to related parties		114,000			77,000
Changes in operating assets and liabilities:
Accounts receivable		(310,000	)		(706,000	)
Accounts receivable from affiliate		(51,000	)		(50,000	)
Trade notes receivable		371,000			196,000
Inventories		(1,270,000	)		(2,357,000	)
Prepaid expenses and other current assets		(1,108,000	)		(870,000	)
Other assets		(1,038,000	)		146,000
Accounts payable		(784,000	)		2,408,000
Accounts payable to affiliate		(148,000	)		73,000
Accounts payable to Fushun shareholders		(2,152,000	)		—
Accrued liabilities		(360,000	)		(736,000	)
Income taxes		(245,000	)		(1,315,000	)
Deferred revenue		(215,000	)		22,000
Other liabilities		(56,000	)		(185,000	)

Net Cash Used In Operating Activities		(9,815,000	)		(2,138,000	)


Cash Flows From Investing Activities:
Purchases of investments		—			(12,616,000	)
Proceeds from sales and maturities of investments		3,247,000			11,383,000
Business acquisitions, net of cash acquired		(1,715,000	)		4,252,000
Acquisition of property and equipment		(1,135,000	)		(1,362,000	)

Net Cash Provided By Investing Activities		397,000			1,657,000


Cash Flows From Financing Activities:
Proceeds from the exercise of stock options and warrants		73,000			282,000
Borrowings from bank line of credit		2,024,000			—
Payments on notes payable to related parties		(453,000	)		—

Net Cash Provided By Financing Activities		1,644,000			282,000

Effect of Exchange Rate Changes on Cash and Cash Equivalents		89,000			84,000

Net Decrease In Cash and Cash Equivalents		(7,685,000	)		(115,000	)
Cash and Cash Equivalents, beginning of period		18,119,000			13,524,000

Cash and Cash Equivalents, end of period	$	10,434,000		$	13,409,000

Notes to Condensed Consolidated Financial Statements
(Unaudited)

Note 1. Summary of Significant Accounting Policies

Basis of Presentation

The financial information presented in this Form 10-Q is not audited and is not necessarily indicative of the future consolidated financial position, results of operations or cash flows of RAE Systems Inc. (the “Company” or “RAE Systems”). The unaudited financial statements contained in this Form 10-Q have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position at the date of the interim balance sheets, results of operations and its cash flows for the stated periods, in conformity with the accounting principles generally accepted in the United States of America. The consolidated balances at December 31, 2006 were derived from the audited financial statements included in the Company’s Annual Report (“Annual Report”) on Form 10-K for the year ended December 31, 2006. The financial statements included in this report should be read in conjunction with the audited financial statements for the year ended December 31, 2006 included in the Annual Report.

Principles of Consolidation

The consolidated financial statements include the accounts of RAE Systems and its subsidiaries. The ownership of other interest holders of consolidated subsidiaries is reflected as minority interest. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results may differ materially from these estimates and assumptions.

Investments

The Company’s investments have been classified as available-for-sale, and therefore, are carried at fair market value. Available-for-sale securities are stated at fair market value based upon quoted market prices of the securities. Unrealized gains and losses on such securities are reported as a separate component of stockholder’s equity. Realized gains and losses on available-for-sale securities are included in interest income.

Revenue Recognition

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, the Company has experienced an insignificant amount of sales returns. The Company generally recognizes revenue upon shipment to its distributors in accordance with standard contract terms that pass title of all goods upon delivery to a common carrier (Free on board, “FOB” factory) and provides for sales returns under standard product warranty provisions. For non-standard contract terms where title to goods pass upon delivery to the customer (FOB destination), revenue is recognized after the Company has established proof of delivery. Revenues related to services performed under the Company’s extended warranty program are recognized as earned based upon contract terms, generally ratably over the term of service. The Company records project

installation work in Asia using the percentage-of-completion method. Net sales also include amounts billed to customers for shipping and handling. The Company’s shipping costs are included in cost of sales.

Share-Based Payments

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (R), Share-Based Payment, (“SFAS 123 (R)”) which requires companies to recognize in their statement of operations all share-based payments, including grants of stock options, based on their grant date fair value and requires the fair value of each option outstanding to be adjusted to reflect only those shares outstanding that are actually expected to vest. The Company’s implementation of SFAS 123(R) used the modified-prospective transition method where the compensation cost related to each unvested option outstanding as of January 1, 2006, was recalculated and any necessary adjustments were reflected in the first quarter of adoption. The Company estimates the fair value of each share-based payment on the date of grant using the Black-Scholes-Merton valuation method.

The impact on the Company’s results of operations of recording stock-based compensation by function for the three and six, month period ended June 30, 2007 and 2006 was as follows:


	Three months ended June 30,				Six months ended June 30,
	2007		2006		2007		2006
Cost of sales	$	25,000	$	4,000	$	45,000	$	4,000
Research and development		95,000		55,000		172,000		70,000
Sales and marketing		97,000		82,000		195,000		103,000
General and administrative		335,000		217,000		630,000		526,000

Total	$	552,000	$	358,000	$	1,042,000	$	703,000

The fair value of the Company’s stock options granted to employees for the three and six months ended June 30, 2007 and the three and six months ended June 30, 2006, were estimated using the following weighted-average assumptions:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2007			2006			2007			2006
Volatility		65.0	%		78.0	%		65.0	%		78.0	%
Expected dividend		0.0	%		0.0	%		0.0	%		0.0	%
Risk-free interest rate		4.6-5.0	%		5.1	%		4.6-5.0	%		4.8-5.1	%
Expected term in years		5.5			6.1			5.5			6.1
Weighted-average fair value	$	1.71		$	2.67		$	1.71		$	2.67

Stock Option Plans

On June 14, 2007, the stockholders of RAE Systems approved the Company’s 2007 Equity Incentive Plan (the “2007 Plan”) at the annual meeting of the stockholders. The 2007 Plan replaces the Company’s existing 2002 Stock Option Plan (the “2002 Plan”). A total of 4,000,000 shares of the Company’s common stock are authorized for issuance under the 2007 Plan. The maximum number of shares that may be issued under the 2007 Plan will be increased from time to time by shares subject to options granted under the 2002 Plan that expire or are terminated and by shares acquired under the 2002 Plan that are forfeited or repurchased by the Company for the option holder’s purchase price. However, no more than 1,500,000 additional shares may be authorized for issuance under the 2007 Plan as a result of these adjustments.

As of June 30, 2007, the Company has reserved 235,870 shares of common stock for issuance under its 1993 Stock Option Plan and 3,367,883 shares of common stock for issuance under the 2002 Stock Option Plan and 90,000 shares under

the 2007 Plan. As of June 30, 2007, 3,910,000 shares of common stock remain available for future grants under the 2007 Plan.

Earnings Per Common Share

Basic earnings per common share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per common share reflects the potential dilution of common stock equivalents such as options and warrants, to the extent the impact is dilutive. Anti-dilutive shares excluded from diluted earnings per common share calculation for three and six month periods ended June 30, 2007 were 6,292,110 and 5,543,868, respectively. Anti-dilutive shares excluded from diluted earnings per common share calculation for three and six month periods ended June 30, 2006 were 3,042,524 and 2,850,177, respectively.

Segment Reporting

The Company’s operating divisions consist of entities geographically based in the Americas, Asia and Europe. All such operating divisions have similar economic characteristics, as defined by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, and accordingly, the Company operated as one reportable segment during the six months ended June 30, 2007 and 2006.

Variable Interest Entities

S.A.R.L RAE France (“RAE France”) was identified by management as a variable interest entity. The Company is the primary beneficiary through its ownership of RAE Europe ApS. RAE France distributes and sells RAE products exclusively in France. RAE France had total sales of $375,000 and $329,000 in the quarter ended June 30, 2007 and 2006, respectively, and total sales of $801,000 and $684,000 in the six months ended June 30, 2007 and 2006, respectively. The Company has consolidated RAE France since December 2004.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157 (“SFAS 157”), “Fair Value Measurements.” SFAS 157 defines fair value to measure assets and liabilities, establishes a framework for measuring fair value, and requires additional disclosures about the use of fair value. SFAS 157 is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. SFAS 157 does not expand or require any new fair value measures. SFAS 157 is effective for the Company’s fiscal year beginning January 1, 2008. The Company is currently evaluating the impact that the adoption of FAS 157 will have on its financial position or results of operations.

In February 2007, the FASB issued SFAS No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115.” SFAS 159 expands the use of fair value accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, a company may elect to use fair value to measure eligible items at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Eligible items include, but are not limited to, accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees, issued debt and firm commitments. If elected, SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing whether fair value accounting is appropriate for any of its eligible items and is in process of estimating the impact, if any, on its results of operations or financial position.

Note 2. Composition of Certain Financial Statement Items

Short-term investments


	June 30,		December 31,
	2007		2006
Certificates of deposit	$	—	$	1,050,000
U.S. government agencies		—		2,198,000

	$	—	$	3,248,000

Inventory


	June 30,		December 31,
	2007		2006
Raw materials	$	4,720,000	$	4,675,000
Work-in-progress		1,193,000		1,858,000
Finished goods		10,620,000		8,849,000

	$	16,533,000	$	15,382,000

Prepaid expenses and other current assets


	June 30,		December 31,
	2007		2006
Supplier advances and deposits	$	2,210,000	$	1,671,000
Prepaid insurance		507,000		430,000
Other current assets		1,383,000		429,000

	$	4,100,000	$	2,530,000

Property and equipment, net


	June 30,		December 31,
	2007		2006
Building and building improvements	$	8,971,000	$	8,150,000
Land		3,220,000		3,220,000
Equipment		4,219,000		4,043,000
Computer equipment		4,039,000		3,498,000
Automobiles		1,228,000		1,126,000
Furniture and fixtures		742,000		550,000
Construction in progress		217,000		53,000

	$	22,636,000	$	20,640,000

Less: accumulated depreciation	$	7,001,000	$	5,520,000

	$	15,635,000	$	15,120,000

Intangible assets, net


	June 30, 2007							December 31, 2006
	Gross		Accumulated			Net Carrying		Gross Carrying		Accumulated			Net Carrying
	Carrying Amount		Amortization			Amount		Amount		Amortization			Amount
Customer list	$	3,752,000	$	(1,119,000	)	$	2,633,000	$	3,059,000	$	(676,000	)	$	2,383,000
Patent and technology		2,009,000		(524,000	)		1,485,000		1,966,000		(381,000	)		1,585,000
Trade name		1,810,000		(555,000	)		1,255,000		1,661,000		(401,000	)		1,260,000
Trade secret		79,000		(7,000	)		72,000		79,000		(3,000	)		76,000

Total Intangible Assets	$	7,650,000	$	(2,205,000	)	$	5,445,000	$	6,765,000	$	(1,461,000	)	$	5,304,000

Amortization expenses associated with intangible assets was $703,000 and $237,000 for the three months ended June 30, 2007 and 2006, respectively. Future amortization expense related to the net carrying amount of intangible assets at June 30, 2007 is estimated to be $629,000 for the remainder of fiscal 2007, $1,231,000 in fiscal 2008, $1,049,000 in fiscal 2009, $886,000 in fiscal 2010, $728,000 in fiscal 2011, $921,000 in fiscal 2012 and fiscal years subsequent of fiscal 2012.

Accrued liabilities


	June 30,		December 31,
	2007		2006
Compensation and related benefits	$	2,439,000	$	2,233,000
Accrued commissions		2,026,000		1,815,000
Accrued professional fees		921,000		1,066,000
Other		2,550,000		3,679,000

Total	$	7,936,000	$	8,793,000

Note 3. Income Tax

The effective tax rate for the six months ended June 30, 2007 was 0.5% of pretax loss, compared to 28% of pretax loss for the same period in 2006. We calculated our interim income tax provisions based on the estimated annual effective tax rate for the Company. However, as required by FASB Interpretation 18, “Accounting for Income Taxes in Interim Periods” (“FIN 18”), the impact of items of tax expense (or benefit) that do not relate to “ordinary income” in the current year generally should be accounted for discretely in the period in which it occurs and be excluded from the effective tax rate calculation. As a result, the Company reported certain discrete tax expenses for the quarter, including a net expense of $25,000 for the accrual of interest applicable to uncertain tax positions through the period ended June 30, 2007.

The effective tax rate is highly dependent upon the geographic distribution of our worldwide earnings or loss, tax regulations in each geographic region, the availability of tax credits and carry-forwards, and the effectiveness of our tax planning strategies. We regularly monitor the assumptions used in estimating our annual effective tax rate and adjust our estimates accordingly. If actual results differ from our estimates, future income tax expense could be materially affected.

Each quarter we assess the likelihood that we will be able to recover our deferred tax assets in each of the jurisdictions where we operate. We consider all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. As a result of our analysis of all available evidence, we concluded that it is more likely than not that our net deferred tax assets will be realized, with the exception of the RAE Systems (Asia) Limited net operating losses which continue to carry a full valuation allowance. We continue to monitor the realization of deferred taxes on a quarterly basis, and will release or establish valuation allowances in future periods as deemed appropriate by management based on all available evidence.

We adopted the provisions of FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109”, on January 1, 2007. In accordance with the adoption of FIN 48, we recognized a charge of approximately $146,000 to the January 1, 2007 retained earnings balance. As of the June 30, 2007, the Company had gross unrecognized tax benefits of $1,013,000, accrued interest expense related to the unrecognized tax benefits of $60,000, and related penalties of $6,000. Accrued interest and penalties related to uncertain tax positions are recognized on a discrete basis as a component of tax expense.

If the Company is able to eventually recognize these uncertain tax positions, $1,013,000 of the unrecognized benefit would reduce the effective tax rate. The Company anticipates a $242,000 increase to the uncertain tax positions applicable to 2007 foreign tax exposures related to transfer pricing, and this amount has been included as a component of the Company’s 2007 effective tax rate.

We conduct business globally and, as a result, the Company or one or more of our subsidiaries files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions and, in the normal course of business, we are subject to examination by taxing authorities in each of these jurisdictions. Due to completed examinations, we are no longer subject to U.S. federal income tax examinations for years before 2005. The statute of limitation in the various other foreign jurisdictions within which the Company operates varies from 3 to 7 years and no material change is expected to our unrecorded tax benefits in the next year as a result of expiring limitations periods.

The tax authority in Denmark has completed their audit of the Company’s subsidiary in Denmark for the fiscal year ended December 31, 2004. No adjustments were proposed. We are not currently under audit in any other tax jurisdiction.

Note 4. Comprehensive Income/(Loss)

Total comprehensive income/(loss) consisted of the following:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2007			2006			2007			2006
Net loss	$	(2,456,000	)	$	(54,000	)	$	(4,774,000	)	$	(1,085,000	)
Other comprehensive income:
Foreign currency translation adjustments		455,000			101,000			759,000			261,000
Change in unrealized loss on investments, after tax		—			(13,000	)		1,000			(13,000	)

Total comprehensive income/(loss)	$	(2,001,000	)	$	34,000		$	(4,014,000	)	$	(837,000	)

The components of accumulated other comprehensive income were as follows:


	June 30,		December 31,
	2007		2006
Foreign currency translation adjustments	$	2,005,000	$	1,246,000
Unrealized loss on investments, after tax		—		(1,000	)

Accumulated other comprehensive income	$	2,005,000	$	1,245,000

Note 5. Commitments and Contingencies

Legal proceedings

Polimaster Ltd. v. RAE Systems Inc., United States District Court for the Northern District of California, Case No. 05-CV-01887-JF

Polimaster Ltd. (“Polimaster”) filed a complaint against the Company on May 9, 2005, in the United States District Court for the Northern District of California in a case styled Polimaster Ltd. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that the Company breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending arbitration by the parties.

A ten day arbitration proceeding was completed on March 16, 2007 under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. In an interim award, dated July 5, 2007, the arbitrator ruled that Polimaster failed to prove its claims and was not entitled to any relief, that the Company had proven its counterclaims and is awarded damages of approximately $2.4 million; and that the Company was entitled to file an application for attorney’s fees and costs, which it did on July 20, 2007. The interim award was unsealed pursuant to a stipulation and order dated July 24, 2007. Further determinations regarding the Company’s application for attorney’s fees and costs will be included in a final award, which will also incorporate the contents of the interim award. Although the Company has been awarded damages, and may also be awarded attorney’s fees and costs, at this time, the

Company is unable to determine whether it will be able to collect on any such awards due to uncertainty regarding Polimaster’s financial condition and other factors.

From time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

Operating leases

The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the quarters ended June 30, 2007 and 2006 was $292,000 and $169,000, respectively. Total rent expense for the six months ended June 30, 2007 and 2006 was $511,000 and $353,000, respectively. Future minimum lease payments for each of the next five years, from 2007 (the remaining six months) through 2011 and thereafter, excluding the Sunnyvale, California abandoned building lease, are $522,000, $762,000, $531,000, $386,000, $356,000 and $818,000, respectively.

In December 2004, the Company purchased its current corporate headquarters in San Jose, California. The lease related to the Company’s previous headquarters in Sunnyvale, California was charged off as a loss on abandonment of lease during the second quarter of 2005. The total loss on abandonment of the lease was approximately $2.0 million. During the six months of 2007, based upon broker estimates of changes in real estate market conditions and other factors, it was considered more likely than not that the Company will be able to sublease the facility. The Company revised the estimated loss on abandonment of the lease and reduced operating expense by $596,000. As of June 30, 2007, future discounted lease payments related to the Sunnyvale building are included in accrued liabilities totaling $295,000 and other long-term liabilities totaling $467,000. Future minimum lease payments relating to the Sunnyvale lease for each of the next three years, from 2007 (the remaining six months) through 2009, are $118,000, $315,000 and $303,000, respectively.

Purchase obligations

The Company has agreements with suppliers and other parties to purchase inventories and other goods and services. The Company estimates its non-cancelable obligations under these agreements to be approximately $6,966,000. All non-cancelable obligations related to inventories are expected to be delivered within the next 12 months. The Company periodically reviews the carrying value of its inventories and non-cancelable purchase commitments by evaluating material usage requirements and forecasts and estimates of inventory obsolescence, excess quantities and any expected losses on purchase commitments. The Company may record charges to adjust inventory values due to excess, obsolete and slow-moving inventory or due to a lower-of-cost or market analysis considering such factors as the impact of changes in technology, estimates of future sales volumes and market value estimates. There was no loss accrued related to current purchase obligations. However, any additional future write-down of inventories or loss accrued on inventory purchase commitments, if any, due to market conditions, may negatively affect gross margins in future periods.

Guarantees

The Company is permitted under Delaware law, and in accordance with its Bylaws, to indemnify its officers and directors for certain events or occurrences, subject to certain limits, while the officer or director is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that limits its exposure and enables it to recover a portion of any future amounts paid. As a result of our insurance policy coverage, the Company believes the fair value of these indemnification agreements is minimal.

In the Company’s sales agreements, the Company typically agrees to indemnify its customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date, the Company has not paid any amounts to settle claims or defend lawsuits.

Note 6. Warranty Reserves

The Company sells the majority of its products with a 12 to 24 month repair or replacement warranty from the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The following is a summary of the changes in these liabilities during the three and six month periods ended June 30, 2007 and 2006:


	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2007			2006			2007			2006
Provision for products sold during period	$	16,000		$	78,000		$	97,000		$	115,000
Adjustment of prior period provision		(89,000	)		(16,000	)		(136,000	)		—
Claims paid during the period		—			(87,000	)		(2,000	)		(151,000	)
Foreign currency translation effects		2,000			—			4,000			—

Net increase/(decrease) in liabilities	$	(71,000	)	$	(25,000	)	$	(37,000	)	$	(36,000	)

Balance, beginning of period	$	587,000		$	366,000		$	553,000		$	377,000

Balance, end of period	$	516,000		$	341,000		$	516,000		$	341,000

Note 7. Revolving Credit Agreement

On March 14, 2007, the Company signed a one year $15.0 million revolving credit agreement, which is available to help fund future growth and expansion. The agreement provides for borrowings up to $7.0 million based on a blanket security interest in the Company’s assets. An additional $8.0 million of borrowings will be available based on a percentage of qualifying assets. The Company is required to comply with certain bank specific reporting requirements whenever borrowings against the line of credit exceed $3.0 million, in addition to the on-going requirement to submit quarterly financial statements. The Company is in full compliance with all of the borrowing requirements, including certain financial covenants, and as such, has the full line available. As of June 30, 2007, there was approximately $2.0 million outstanding under the line of credit agreement.

Note 8. Related Party Transactions

In conjunction with the original and subsequent additional investment in RAE KLH (Beijing) Co., Ltd (“RAE Beijing”), unsecured notes payable were established for the previous RAE Beijing shareholders as part of the purchase price agreement in May 2004 and July 2006. As of June 30, 2007 and December 31, 2006, $657,000 and $822,000, respectively, were included in the current portion of notes payable to related parties and $3,074,000 and $3,222,000, respectively, were included in long-term notes payable to related parties. Included in the current portion of notes payable is a sum of $216,000 due on and paid as of June 30, 2007. In addition, the future payment requirements for each of the next five years, from 2007 (the remaining six months) through 2011 and thereafter, are $401,000, $242,000, $1,761,000, $967,000 and $940,000, respectively.

The notes issued in conjunction with the original RAE Beijing purchase in May 2004 were non-interest bearing and were recorded at net present value using a discount rate of 5.5%. In conjunction with the additional investment in RAE Beijing in July 2006, 11 million shares of preferred stock were issued to four shareholders of RAE Beijing. In accordance with SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”, these preferred shares were classified as liabilities as they are mandatorily redeemable and were recorded as long-term notes payable to related parties. These preferred shares bear a dividend yield rate of 3% per annum, and were discounted using a market interest rate of 6.48%.

The Company has a 40% ownership interest in Renex Technologies Ltd. (“Renex”), a Hong Kong company, and is accounting for its investment in the entity using the equity method of accounting. Accordingly, the Company has recorded $57,000 and $117,000 of equity in loss in unconsolidated affiliate in the second quarters of 2007 and 2006, respectively, and $75,000 and $181,000 in the first six months of 2007 and 2006, respectively. Additionally, the Company pays a 7.5% royalty to Renex for using certain modems developed by Renex. The Company made royalty payments totaling $35,000 to Renex during the first six months of 2007 and 2006. During the first six months of 2007 and 2006, the Company also purchased $497,000 and $191,000, respectively, of inventory items from Renex and sold $155,000 and $48,000 of inventory items to Renex, respectively. The Company also paid $50,000 to Renex relating to a research project in the first half of 2007. Accounts receivable due from Renex at June 30, 2007 and December 31, 2006 were $206,000 and $154,000, respectively. Accounts payable due to Renex at June 30, 2007 and December 31, 2006 were $217,000 and $360,000, respectively.

The Company’s Director of Information Systems, Lien Chen, is the wife of our Chief Executive Officer, Robert Chen. Ms. Chen was paid a salary of $26,000 for the quarters ended June 30, 2007 and 2006, and $52,000 for the six months ended June 30, 2007 and 2006. Ms. Chen also receives standard employee benefits offered to all other full-time employees located in the United States. Ms. Chen does not report directly to Robert Chen and accordingly, compensation decisions regarding Ms. Chen are performed in the same manner as other United States employees.

Note 9. Business Combinations

On January 3, 2007, RAE Systems (Asia) Ltd. entered into an agreement to purchase intellectual property from Tianjin Securay Technology Ltd. Co. (“Securay”) for Renminbi 12 million (approximately $1.5 million). This transaction, together with purchase agreements entered in 2006, completed our purchase of Securay. Including transactions entered into during 2006, total purchase price was $2.0 million cash. Assets purchased in 2006 amounting to $820,000 were recorded to acquisition in progress at December 31, 2006. The acquisition constitutes a business combination in accordance with criteria defined in Emerging Issues Task Force 98-3 “Determining Whether a Non-monetary Transaction Involves Receipt of Productive Assets or of a Business”. The Company is in the process of completing the valuation of certain intangible assets and, accordingly, the purchase price allocation is subject to refinement. The following table allocates the purchase price to the preliminary fair values of assets acquired and liabilities assumed:


	Amount
Current assets	$	180,000
Property & equipment		287,000
Intangible assets		914,000
Goodwill		646,000

Purchase price	$	2,027,000

The following table presents details of the purchased intangible assets:


			Weighted Average
	Amount		Useful Life (Years)
Trade name	$	141,000		7
Technology		32,000		5
Customer list		741,000		7

Total	$	914,000

Goodwill of $646,000 recorded in conjunction with Securay purchase is not deductible for income tax purpose. The purchase of Securay has been deemed by management to be an immaterial business combination and therefore no pro forma information is included.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. In some cases, readers can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue.” These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from those stated herein. Although management believes that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance, or achievements. For further information, refer to the sections entitled “Risk Factors” in “Part II Item 1A” of this Form 10-Q. The following discussion should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Form 10-Q.

Overview

We are a leading global developer and manufacturer of rapidly-deployable, multi-sensor chemical and radiation detection monitors and networks for industrial applications and homeland security. Founded in 1991 to develop technologies for the detection and early warning of hazardous materials, today we offer a full line of portable single-sensor chemical and radiation detection products. The market for our products has evolved from being strictly focused on environmental and industrial monitoring to now encompassing public safety and the threat of terrorism. In conjunction with two important transactions in 2006, our acquisition of Aegison Corporation and the formation of RAE Coal Mine Safety Instruments (RAE Fushun) Co., Ltd., a joint venture with the Liaoning Coal Industry Group Co., Ltd., of China, we expect to expand our market presence to include mobile digital video security in the United States and the broader energy exploration and refining safety equipment market, including the coal mine safety equipment market in China.

Recent Developments

During 2007, RAE Fushun began operations and is contributing to the growth of our China operations. The Chinese Government has begun closing smaller unsafe coal mining operations and is expected to close up to 10,000 smaller and unsafe mines by the end of 2007. The government plans to consolidate the remaining mines into larger mining operations through a program dedicated to improving mine safety. As we gain visibility into this program, we believe RAE Fushun is well positioned with its customer base and RAE Systems’ access to international technology to capitalize on upcoming projects to modernize China’s coal mine infrastructure and operating safety.

Operations in EMEA (Europe, Middle East, Africa, and Australia) experienced improved sales growth in the second quarter, particularly in the Middle East. Through our office in Dubai, we provide gas detection equipment to support oil production in the Middle East, Africa, and Central Asia. Improved sales growth was also experienced in Australia for continued expansion of homeland security applications, and in Hong Kong which serves the market for gas detection in the fast growing Pearl Delta region of southern China.

In the Americas, we continued to strengthen our relationship with our channel partners. We established master distributor relationships in Canada to address the growing energy and homeland security sectors. Through these relationships we provide in-country technical support, product deliveries, and warranty service. We also established a direct sales organization in the US to address larger government and military programs, such as the Civil Support Teams and National First Responder Training centers.

In June, we successfully launched the MiniRAE 3000 and ppbRAE 3000, our third generation photoionization detectors at the American Industrial Hygiene Association’s annual conference in Philadelphia, PA. Both products set a new standard for PID performance in the industry, extending RAE Systems’ leadership position in the detection of volatile organic compounds (VOCs) for use in environmental, industrial safety and emergency response applications.

During the second quarter, we received an interim award in our arbitration with Polimaster. The arbitrator ruled that Polimaster failed to prove its claims and was not entitled to relief, RAE Systems had proven its counter claims and was to be awarded damages of approximately $2.4 million. The arbitrator further ruled that we may file an application for attorney’s fees and costs. In July 2007, we filed an application for attorneys’ fees.

Critical Accounting Policies and Significant Management Judgments

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, we evaluate these estimates, including, but not limited to, those

related to our allowance for doubtful accounts, valuation of goodwill and other intangible assets, inventory valuation, valuation of deferred tax assets, warranty reserves and stock-based compensation expense. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments or estimates used in the preparation of our condensed consolidated financial statements.

Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, we have experienced an insignificant amount of sales returns. We generally recognize revenue upon shipment to our distributors in accordance with standard contract terms that pass title of all goods upon delivery to a common carrier (FOB factory) and provide for sales returns under standard product warranty provisions. For non-standard contract terms where title to goods passes upon delivery to the customer (FOB destination), revenue is recognized after we have established proof of delivery. Revenues related to services performed under our extended warranty program are recognized as earned based upon contract terms, generally ratably over the term of service. We record project installation work in Asia using the percentage-of-completion method. Net sales also include amounts billed to customers for shipping and handling. Our shipping costs are included in cost of sales.

Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

We grant credit to our customers after undertaking an investigation of credit risk for all significant amounts. An allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. We generally do not require collateral for sales on credit. While management uses the best information available in making our determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there was a deterioration of a major customer’s credit-worthiness or if actual defaults were higher than what have been experienced historically, additional allowances would be required.

Trade notes receivables are presented to us from some of our customers in China as a payment against the outstanding trade receivables. These notes receivables are bank guarantee promissory notes which are non-interest bearing and generally mature within six months.

Inventory

Inventory is stated at the lower of cost, using the first-in, first-out method, or market. We are exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in the market, competitive pressures in products and prices, and the availability of key components from our suppliers. We have established inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for our products and market conditions. When recorded, reserves are intended to reduce the carrying value of the inventory to its net realizable value. If actual demand for specified products deteriorates, or market conditions are less favorable than those projected, additional reserves may be required.

Warranty Reserve

We sell the majority of our products with a 12 to 24 month repair or replacement warranty from the date of shipment. We provide an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The estimated future warranty obligations are affected by the warranty periods, sales volumes, product failure rates, material usage, labor and replacement costs incurred in correcting a product failure. If actual product failure rates, material usage, labor or replacement costs differ from our estimates, revisions to the estimated warranty obligations would be required. The warranty reserve represents the best estimate of the amount necessary to settle future and existing claims on

products sold as of the balance sheet date. We periodically assess the adequacy of our reported warranty reserve and adjust the amounts in accordance with the changes in these factors.

Share-Based Payments

Effective January 1, 2006, we adopted SFAS 123(R), which requires companies to recognize in their statement of operations all share-based payments, including grants of stock options, based on their grant date fair value and requires the fair value of each option outstanding to be adjusted to reflect only those shares outstanding that are actually expected to vest. Our implementation of SFAS 123(R) used the modified-prospective transition method where the compensation cost related to each unvested option outstanding as of January 1, 2006, was recalculated and any necessary adjustments were reflected in the first quarter of adoption. We estimate the fair value of each share-based payment on the date of grant using the Black-Scholes-Merton valuation method.

Business Combinations

In accordance with business combination accounting, we allocate the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. We typically engage third-party appraisal firms to assist management in determining the fair values of certain assets acquired and liabilities assumed. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets and goodwill.

Management makes estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired companies and is inherently uncertain. Critical estimates in valuing certain of the intangible assets include but are not limited to: discount rates; future expected cash flows from maintenance agreements, customer contracts, acquired developed technologies and pending patents; expected costs to develop the in-process research and development into commercially viable products and estimating cash flows from the projects when completed; and the acquired company’s brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined company’s product portfolio. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.

Income Taxes

We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes.

Our effective tax rates differ from the statutory rate primarily due to foreign earnings taxed at lower rates, foreign losses not benefited, non-deductible share-based payment deductions under FAS 123(R) and provision changes for uncertain tax positions. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. We regularly assess the likelihood of adverse outcomes resulting from tax examinations to determine the adequacy of our provision for income taxes.

Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.

Recent Accounting Pronouncements

See Note 1 to the Condensed Consolidated Financial Statements in Item 1 of this Form 10-Q for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on results of operations and financial condition, which is incorporated herein by reference.

Results of Operations

Three months ended June 30, 2007 compared with the three months ended June 30, 2006

Net Sales


	Three months ended June 30,
	2007		2006		Change		% Change
Net sales	$	20,093,000	$	15,901,000	$	4,192,000		26	%

Net sales for the quarter ended June 30, 2007, increased by approximately $4.2 million (26%) over the quarter ended June 30, 2006. The increases in Net sales for the quarter ended June 30, 2007, consisted primarily of increased sales of approximately $2.9 million (47%) in Asia, $850,000 (43%) in Europe and $430,000 (6%) in the Americas over the same period in 2006. The $4.2 million increase in Asia was primarily due to $2.8 million of sales from RAE Fushun in the second quarter of 2007, which was not included in 2006. The increased sales in Europe for the quarter ended June 30, 2007, compared to the quarter ended June 30, 2006, was primarily the result of increased sales of our products into the Eastern Europe and Middle East markets. The increase in the Americas was primarily related to new product introductions such as DoseRAE and MiniRAE 3000 as well as increased sales in our legacy product lines.

Cost of Sales & Gross Margin


	Three months ended June 30,
	2007			2006			Change		% Change
Cost of sales	$	10,077,000		$	7,439,000		$	2,638,000		35	%
Gross profit	$	10,016,000		$	8,462,000		$	1,554,000		18	%
Gross margin		50	%		53	%

Cost of sales for the quarter ended June 30, 2007, increased by approximately $2.6 million (35%) over the quarter ended June 30, 2006, primarily as a result of increases in cost of sales due to the overall increased sales volume and due to increased sales in Asia, which generally has higher product costs and lower margins than other territories, primarily as a result of the distribution of third party products. Gross margin decreased by approximately 3% for the quarter ended June 30, 2007, compared to the quarter ended June 30, 2006. The decrease in gross margin was primarily the result of increased sales in Asia which resulted in approximately a 2% overall decrease in gross margin.

Sales and Marketing Expense


	Three months ended June 30,
	2007			2006			Change		% Change
Sales and marketing	$	6,328,000		$	4,420,000		$	1,908,000		43	%
As % of net sales		31	%		28	%

Sales and marketing expenses increased by approximately $1.9 million (43%) for the quarter ended June 30, 2007, compared to the quarter ended June 30, 2006, primarily due to $980,000 increased payroll and benefit related expenses as a result of headcount increase in the U.S. and from the formation of the joint venture in Fushun, China in December 2006. $290,000 of increased travel costs also related to increased headcount in the U.S. Project expenses increased by $91,000 related to product marketing development projects. In addition, $240,000 increase in marketing expenses was due to higher demo units and increase in amortization expenses of $108,000 related to intangible assets obtained from acquisitions of Aegison in July 2006 and RAE Fushun in December 2006.

Research and Development Expense


	Three months ended June 30,
	2007			2006			Change		% Change
Research and development	$	1,893,000		$	1,453,000		$	440,000		30	%
As % of net sales		9	%		9	%

Research and development expenses increased by approximately $440,000 (30%) during the quarter ended June 30, 2007, compared to the quarter ended June 30, 2006, primarily due to a $200,000 increase in payroll and benefit related expenses due to increase in headcount in U.S. and from the formation of joint venture in Fushun, China in December 2006. Amortization expenses increased by $51,000 from the IP purchased through the acquisition of Aegison in July 2006. Project expenses increased by $137,000 mainly related to the addition of RAE Fushun which began operations in the first quarter of 2007.

General and Administrative Expense


	Three months ended June 30,
	2007			2006			Change		% Change
General and administrative	$	4,053,000		$	3,033,000		$	1,020,000		34	%
As % of net sales		20	%		19	%

General and administrative expenses increased by $1.0 million (34%) in the quarter ended June 30, 2007, compared to the quarter ended June 30, 2006, primarily comprised of $586,000 in payroll and benefit related expenses due to increase in headcount in the U.S. and Shanghai, and the additional headcounts from the formation of joint venture in Fushun, China in December 2006. Increase of $356,000 in professional fees, primarily comprised of $295,000 of legal costs associated with the Polimaster arbitration, with the remaining balance related to accounting and tax services resulting from the international nature of the business.

Other Income/(Expense)


	Three months ended June 30,
	2007			2006			Change			% Change
Interest income	$	55,000		$	260,000		$	(205,000	)		(79	%)
Interest expense		(84,000	)		(65,000	)	$	(19,000	)		29	%
Other, net		70,000			138,000		$	(68,000	)		(49	%)
Equity in loss of unconsolidated affiliate		(57,000	)		(117,000	)	$	60,000			(51	%)

Total other income/(expense)	$	(16,000	)	$	216,000		$	(232,000	)		(107	%)

For the quarter ended June 30, 2007, total other expense was $16,000 compared to total other income of $216,000 for the quarter ended June 30, 2006. The decrease was primarily the result of lower cash and marketable securities from funding our investments in RAE Beijing, RAE Fushun, Securay and Aegison Corporation since the first quarter of 2006. In addition, increase in interest expense due to the bank borrowings in the U.S. and decrease in other income from reduction of currency exchange gain in Europe, offset by improvement in equity loss from unconsolidated affiliate.

Income Tax Benefit/(Expense)


	Three months ended June 30,
	2007			2006			Change			% Change
Income tax benefit (expense)	$	(184,000	)	$	305,000		$	(489,000	)		(160	%)
Effective tax rate		(8%	)		134	%

The tax expense for the quarter ended June 30, 2007 was $184,000, or 8% of the loss before income taxes and minority interest, compared to a tax benefit of $305,000, or 134% of the loss before income taxes and minority interest, for the quarter ended June 30, 2006. We calculated our interim income tax benefits based on the estimated annual effective tax rate for the Company. However, as required by FIN 18, the impact of items of tax expense (or benefit) that do not relate to “ordinary income” in the current year generally should be accounted

for discretely in the period in which it occurs and be excluded from the effective tax rate calculation. The tax rate for the first quarter of fiscal year 2007 differed from the U.S. statutory rate primarily due to foreign earnings taxed at lower rates, nondeductible share based payment expenses under FAS 123(R), changes in the valuation allowance and additional provisions for uncertain tax positions applicable to fiscal year 2007. The tax rate for the first quarter of fiscal year 2006 differed from the U.S. statutory rate primarily due to foreign earnings taxed at lower rates, nondeductible share based payment expenses under FAS 123(R), changes in the valuation allowance and additional provisions for uncertain tax positions applicable to fiscal year 2006.

Minority Interest in Loss of Consolidated Entities


	Three months ended June 30,
	2007		2006			Change		% Change
Minority interest in loss of consolidated subsidiaries	$	18,000	$	(131,000	)	$	149,000		(114	%)

For the quarter ended June 30, 2007, the minority interest in loss of consolidated entities allocated to minority interest was $18,000, which related to the minority interest share of 4% in the losses from RAE Beijing, the minority interest share of 30% in the losses of RAE Fushun and a 51% majority investors share in the income of RAE France. During the quarter ended June 30, 2006, the minority interest in income of consolidated entities allocated to minority interest was $131,000, which related to the minority interest share of 36% in the losses from RAE Beijing and a 51% majority investors share in the income of RAE France.

Six months ended June 30, 2007 compared with the six months ended June 30, 2006

Net Sales


	Six months ended June 30,
	2007		2006		Change		% change
Net sales	$	38,080,000	$	28,327,000	$	9,753,000		34	%

Net sales for the six-month period ended June 30, 2007 increased by $9.8 million (34%) over the same period in 2006. The increases in sales were primarily the result of increases in Asia of $6.2 million, the Americas of $2.3 million and Europe of $1.3 million. The increases during the six-month period ended June 30, 2007 as compared to the six-month period ended June 30, 2006 in Asia were primarily the result of sales from the joint venture at Fushun of $4.2 million during 2007. The increase in the Americas was primarily due to new product introductions which included the DoseRAE and the MiniRAE 3000. The increased sales in Europe were primarily due to sales to the industrial sector in Europe of our wireless systems in Europe during the six-month period ended June 30, 2007 as compared to the six-moth period ended June 30, 2006.

Cost of Sales & Gross Margin


	Six months ended June 30,
	2007			2006			Change		% change
Cost of sales	$	18,903,000		$	13,155,000		$	5,748,000		44	%
Gross profit	$	19,177,000		$	15,172,000		$	4,005,000		26	%
Gross margin		50	%		54	%

Cost of goods sold for the six-months ended June 30, 2007 increased by $5.7 million over the same period in 2006. The increase in cost of goods sold was primarily due to higher unit shipment volume, a shift in sales in the Americas towards lower-margin portable products as well as from increases in lower margin installation services and distributor products in Asia. During the six-moth period ended June 30, 2007, as compared to the six-months ended June 30, 2006, the Company’s sales in Asia increased at a higher rate than in the Americas or Europe. The Company’s sales in Asia generally have a lower gross margin than other territories, primarily as a result of the distribution of third party products and construction projects which resulted in approximately a 3% reduction in the Company’s overall margin for the six-months ended June 30, 2007 as compared to the six-months ended June 30, 2007.

Sales and Marketing Expense


	Six months ended June 30,
	2007			2006			Change		% change
Sales and marketing	$	11,681,000		$	8,491,000		$	3,190,000		38	%
As % of net sales		31	%		30	%

Sales and marketing expenses increased by approximately $3.2 million for the six-month period ended June 30, 2007 over the same period during 2006, primarily due to $2.0 million increased payroll and benefit related expenses as a result of headcount increase in the U.S. and from the formation of the joint venture in Fushun, China in December 2006. The $411,000 of increased travel costs also related to increase headcount in the U.S. Increase in amortization expenses of $253,000 related to intangible assets obtained from acquisitions of Aegison in July 2006 and RAE Fushun in December 2006 and increase in project expenses of $232,000 related to product marketing development projects. Marketing expenses increased by $151,000 due to increase in demo units in marketing department.

Research and Development Expense


	Six months ended June 30,
	2007			2006			Change		% change
Research and development	$	3,665,000		$	2,726,000		$	939,000		34	%
As % of net sales		10	%		10	%

Research and development expenses increased by approximately $939,000 (34%) for the six-month period ended June 30, 2007, primarily due to a $414,000 increase in payroll and benefit related expenses due to increase in headcount in U.S. and from the formation of the joint venture in Fushun, China in December 2006. The $242,000 increase in project expenses was due to the addition of RAE Fushun which began operations in the first quarter of 2007 and an increase in development expenses to qualify products for new markets in the U.S.

General and Administrative Expense


	Six months ended June 30,
	2007			2006			Change		% change
General and administrative	$	9,239,000		$	6,002,000		$	3,237,000		54	%
As % of net sales		24	%		21	%

General and administrative expenses increased by approximately $3.2 million (54%) for six months ended June 30, 2007 over the same period during 2006, primarily comprised of $1.5 million in payroll and benefit related expenses due to increase in headcount in the U.S. and Shanghai, and the additional headcount from the formation of the joint venture in Fushun, China in December 2006. The increase of $1.8 million in profession fees was primarily comprised of $1.4 million legal costs associated with the Polimaster arbitration, with the remaining balance related to accounting and tax services resulting from the international nature of the business.

Other Income/(Expense)


	Six months ended June 30,
	2007			2006			Change			% change
Interest income	$	119,000		$	434,000		$	(315,000	)		(73	)%
Interest expense		(153,000	)		(86,000	)		(67,000	)		78	%
Other, net		85,000			166,000			(81,000	)		(49	)%
Equity in loss of unconsolidated affiliate		(75,000	)		(181,000	)		106,000			(59	)%

Total other income/(expense)	$	(24,000	)	$	333,000		$	(357,000	)		(107	)%

For the six months ended June 30, 2007, total other expense was $24,000 as compared to total other income of $333,000 for the six months ended June 30, 2006. The decrease in total other income was primarily the result of lower cash and marketable securities from funding our investments in RAE Beijing, RAE Fushun, Securay and Aegison Corporation since the first quarter of 2006. In addition, increase in interest expense due to the bank borrowings in the U.S. and decrease in other income from reduction of currency exchange gain in Europe, offset by improvement in equity loss from unconsolidated affiliate.

Income Tax Benefit


	Six months ended June 30,
	2007			2006			Change			% change
Income tax benefit	$	23,000		$	484,000		$	(461,000	)		(95	%)
Effective tax rate		0.5	%		28	%

The tax benefit for the six-month period ended June 30, 2007 was $23,000 or 0.5% of the loss before income taxes and minority interest, compared to $484,000 or 28% of the loss before income taxes and minority interest in the same period of 2006. We calculated our income tax provisions based on the estimated annual effective tax rate for the Company. However, as required by FIN 18, the impact of items of tax expense (or benefit) that do not relate to “ordinary income” in the current year generally should be accounted for discretely in the period in which it occurs and be excluded from the effective tax rate calculation. The tax rate for the first six months of fiscal year 2007 differed from the U.S. statutory rate primarily due to foreign earnings taxed at lower rates, nondeductible share based payment expenses under FAS 123(R), changes in the valuation allowance and additional provisions for uncertain tax positions applicable to fiscal year 2007. The tax benefit for the six months ended June 30, 2006 primarily related to foreign earnings taxed at lower rates, nondeductible share based payment expenses under SFAS No. 123(R), changes in the valuation allowance and the release of tax reserves and interest at the conclusion of a regular IRS tax return audit for the year ended 2003.

Minority Interest in Loss of Consolidated Entities


	Six months ended June 30,
	2007		2006		Change			% change
Minority interest in loss of consolidated subsidiaries	$	39,000	$	145,000	$	(106,000	)		(73	)%

For the six months ended June 30, 2007, the minority interest in loss of consolidated entities allocated to minority interest was $39,000, which related to the minority interest share of 4% in the losses from RAE Beijing, the minority interest share of 30% in the losses of RAE Fushun and a 51% majority investors share in the income of RAE France. During the six months ended June 30, 2006, the minority interest in income of consolidated entities allocated to minority interest was $145,000, which related to the minority interest share of 36% in the losses from RAE Beijing and a 51% majority investors share in the income of RAE France.

Liquidity and Capital Resources

We have financed our operations primarily through cash flow from operations, proceeds from the issuance of equity securities, and bank borrowings. As of June 30, 2007, we had $10.4 million in cash and cash equivalents compared with $21.4 million of cash, cash equivalents and investments at December 31, 2006. At June 30, 2007, we had $32.7 million of working capital and had a current ratio of 2.5 to 1.0 compared to $36.6 million of working capital and a current ratio of 2.6 to 1.0 at December 31, 2006.

On March 14, 2007, we signed a one year $15.0 million revolving credit agreement, which is available to help fund future growth and expansion. The agreement provides for borrowings up to $7.0 million based on a blanket security interest in our assets. An additional $8.0 million of borrowings will be available based on a percentage of qualifying assets. We are required to comply with certain bank specific reporting requirements whenever borrowings against the line of credit exceed $3.0 million, in addition to the on-going requirement to submit quarterly financial statements. We are in full compliance with all of the borrowing requirements, including certain financial covenants, and as such, have the full line available. As of June 30, 2007, there was approximately $2.0 million outstanding under the line of credit agreement.


	Six months ended June 30,
	2007			2006
Net cash provided by/(used in):
Operating activities	$	(9,815,000	)	$	(2,138,000	)
Investing activities		397,000			1,657,000
Financing activities		1,644,000			282,000
Effect of exchange rate changes on cash and cash equivalents		89,000			84,000

Net decrease in cash and cash equivalents	$	(7,685,000	)	$	(115,000	)

Net cash used by operating activities for the six months ended June 30, 2007, was $9.8 million compared with $2.1 million for the six months ended June 30, 2006. The $7.7 million decrease in operating cash flows for the six months ended June 30, 2007, versus the six months ended June 30, 2006, was primarily due to $3.7 million of decreased profitability after adjusting for non-cash items combined with an increase of $4.0 million in net cash used to fund operations compared to the first six months of 2006. In addition to a net loss of $4.8 million for the six months ended June 30, 2007 compared to a net loss of $1.1 million for the same period ended June 30, 2006, the decrease in profitability after adjusting for non-cash items was increased due to $300,000 more in stock-based compensation and $400,000 of additional depreciation and amortization offset by a $600,000 gain on the adjustment to lease abandonment accrual. Cash used in funding the changes in operating assets and liabilities during the six month period ended June 30, 2007 was primarily made up of a $1.3 million increase in inventories, a $1.1 million increase in prepaid expenses and other current assets, a $1.0 million increase in other assets, a $3.1 million decrease in accounts payable, a $245,000 decrease in income taxes and a $360,000 decrease in accrued liabilities. Cash used in funding the changes in operating assets and liabilities during the six month period ended June 30, 2006 was primarily made up of a $2.4 million increase in inventory, a $800,000 increase in accounts receivable, a $900,000 increase in prepaid expenses and current assets, a $800,000 decrease in accrued liabilities and a $1.3 million decrease in income taxes, all offset by a $2.5 million increase in accounts payable.

Net cash provided by investing activities for the six months ended June 30, 2007 and 2006, was $397,000 and $1.7 million, respectively. Cash provided by investing activities consisted mainly of proceeds from investments ($3.2 million) offset by cash used in acquiring businesses, net of cash received ($1.7 million). Acquisition of property was $1.1 million for the first six months of 2007 and $1.4 million for the first six months of 2006, as we continued to make investments in our infrastructure to support our growth and productivity initiatives.

Net cash provided by financing activities was $1.6 million and $282,000 for the six months ended June 30, 2007 and 2006, respectively, primarily as a result of borrowings from our bank line of credit and the exercise of stock options, offset by decreases in notes payable to related parties.

We believe that our existing balances of cash and cash equivalents, cash generated from product sales and available bank line of credit will be sufficient to meet our cash needs for working capital and capital expenditures for at least the next twelve months. Our future capital requirements will depend on many factors that are difficult to predict, including the size, timing and structure of any future acquisitions, future capital investments, and future results of operations. Any future financing we may require may be unavailable or on unfavorable terms, if at all. Any difficulty in obtaining additional financial resources could force us to curtail our operations or could prevent us from pursuing our growth strategy. Any future funding may dilute the ownership of our current stockholders.

Contractual Obligations

We lease certain manufacturing, warehousing and other facilities under operating leases expiring in various years through 2011. The leases generally provide for the lessee to pay taxes, maintenance, insurance, and certain other operating costs of the leased property. The following table quantifies our known contractual obligations as of June 30, 2007:


	Total		2007 (six months)		2008		2009		2010		2011		Thereafter
Operating lease obligations	$	4,110,000	$	640,000	$	1,077,000	$	834,000	$	386,000	$	356,000	$	818,000
Open purchase orders	$	6,966,000	$	6,966,000		—		—		—		—		—
Notes payable to related parties	$	4,312,000	$	401,000	$	242,000	$	1,761,000	$	967,000	$	940,000		—

Total	$	15,388,000	$	8,007,000	$	1,319,000	$	2,595,000	$	1,353,000	$	1,296,000	$	818,000

Due to the adoption of FIN 48, a $146,000 liability was recorded in the first quarter of 2007. We do not expect this liability to be satisfied within the next twelve months.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The following discussion analyzes our disclosure of market risk related to concentration of credit risk, changes in interest rates and foreign currency exchange rates.

Concentration of Credit Risk

Currently, we have cash and cash equivalents deposited with major financial institutions in the countries where we conduct business. Our deposits may exceed the amount of insurance available to cover such deposits. To date, we have not experienced any losses of deposits of cash and cash equivalents. Management regularly reviews our deposit amounts and the credit worthiness of the financial institution which hold our deposits.

Interest Rate Risk

As of June 30, 2007, we had cash and cash equivalents of $10.4 million. Changes to interest rates over time may reduce or increase our interest income from our interest bearing cash accounts. However, if, for example, there is a hypothetical 150 basis point (1.5%) change in the interest rates in the United States, the impact on our current cash and cash equivalents would be insignificant.

Foreign Currency Exchange Rate Risk

For the second quarter of 2007, a substantial portion of our recognized revenue was generated by our Asia operations (46%) and was primarily denominated in Renminbi (“RMB”). Revenue denominated in U.S. dollars are generated primarily from operations in the Americas (40%) and revenues from our European operations (14%) was primarily denominated in Euros. We manufacture a majority of our component parts at our manufacturing facility in Shanghai, China. Since January 2006, our operations in China have been affected by currency fluctuations due to an approximate 5.5% appreciation of the RMB relative to the U.S. dollar.

Our strategy has been and will continue to be to increase our overseas manufacturing and research and development activities to capitalize on lower cost capacity and efficiencies in supply-chain management. In 2004 and 2006, we made strategic investments in China with the acquisition of a 96% interest in RAE Beijing, a Beijing-based manufacturer and distributor of environmental safety and security equipment and the formation of RAE Fushun in late 2006 to capitalize on increases in demand for safety equipment in the mining and energy sectors in China. There has been continued speculation in the financial press that China’s currency, the RMB, will be subject to a further market adjustment relative to the U.S. dollar and other currencies. If, for example, in the second quarter of 2007 there was a hypothetical 10% change in the RMB relative to the U.S. dollar, the impact on our profits would have been approximately $348,000 for the six months ended June 30, 2007. If the currencies in all other countries in Europe and Asia where we have operations were to change in unison with the RMB by a hypothetical 10% against the U.S. dollar the approximate impact on our profits would be approximately $570,000 for the quarter ended June 30, 2007. The reduction in the impact of the RMB is due to the offset of changes in reported net sales in our other units resulting from changes in those countries local currencies.

Furthermore, to the extent that we engage in international sales denominated in U.S. dollars in countries other than China, any fluctuation in the value of the U.S. dollar relative to foreign currencies could affect our competitive position in the international markets. Although we would continue to monitor our exposure to currency fluctuations and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, we cannot be certain that exchange rate fluctuations will not adversely affect our financial results in the future.

Item 4. Controls and Procedures

Evaluation of Effectiveness of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, the Company evaluated the effectiveness of its disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The evaluation considered the procedures designed to ensure that information required to be disclosed by us in the reports filed or submitted by the Company under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and communicated to our management as appropriate to allow timely decisions regarding required disclosure. Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of June 30, 2007 based on the material weaknesses in internal control over financial reporting as identified in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 which has not been fully remediated as of June 30, 2007.

Management believes its changes to internal control over financial reporting have mitigated the control deficiencies with respect to the preparation of this quarterly report on Form 10-Q and that these measures have provided reasonable assurance that information required to be disclosed in this report has been recorded, processed, summarized and reported correctly. In particular, the Company’s management believes that the measures implemented to date provide reasonable assurance that the Company’s financial statements included in this report are prepared in accordance with generally accepted accounting principles. Management believes that its controls and procedures will continue to improve as a result of the further implementation of its remediation plan.

Changes in Internal Control Over Financial Reporting

As previously disclosed in the Company’s annual report in Form 10-K for the fiscal year ending December 31, 2006, under Part II, Item 9A, Controls and Procedures, management identified a material weakness in the Company’s internal

control over financial reporting as of December 31, 2006, relating to assurance that information from its Chinese subsidiaries had been properly adjusted to U.S. GAAP for inclusion in its annual or interim financial statements. As a consequence, beginning with the first quarter of 2007, management of the Company initiated steps to implement a number of compensating controls and remediation measures to improve the level of assurance that the information from its Chinese subsidiaries has been properly adjusted to U.S. GAAP. These controls include:

	•		Implementation in China of U.S. GAAP accounting policies for depreciation, inventory reserves and balance sheet classification that is consistent with the Company’s overall accounting policy.

	•		Providing the Company’s accounting staff in China with extended training on the proper implementation of U.S. GAAP accounting policies for depreciation on property and equipment, inventory and balance sheet classification of assets and liabilities.

	•		Implementation of specific accounting procedures and templates for calculating and reporting depreciation, reserves and balance sheet classifications.

	•		The Corporate Controller and Chief Financial Officer conducting extensive quarterly reviews of financial records of the Company’s Chinese operations.

	•		Assessing the requirement to hire additional U.S. GAAP trained accounting personnel in China.

Management believes the additional reviews and monitoring procedures instituted by the Company have mitigated the control deficiencies with respect to the preparation of this quarterly report on Form 10-Q.

PART II. Other Information

Item 1. Legal Proceedings

Polimaster Ltd. v. RAE Systems Inc., United States District Court for the Northern District of California, Case No. 05-CV-01887-JF

Polimaster Ltd. (“Polimaster”) filed a complaint against the Company on May 9, 2005 in the United States District Court for the Northern District of California in a case styled Polimaster Ltd. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that the Company breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending arbitration by the parties.

A ten day arbitration proceeding was completed on March 16, 2007 under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. In an interim award, dated July 5, 2007, the arbitrator ruled that Polimaster failed to prove its claims and was not entitled to any relief, that the Company had proven its counterclaims and is to be awarded damages of approximately $2.4 million; and that the Company was entitled to file an application for attorney’s fees and costs, which it did on July 20, 2007. The interim award was unsealed pursuant to a stipulation and order dated July 24, 2007. Further determinations regarding the Company’s application for attorney’s fees will be included in a final award, which will also incorporate the contents of the interim award. As indicated in the Company’s July 13, 2007 announcement, although the Company has been awarded damages, and may also be awarded attorney’s fees and costs, at this time, the Company is unable to determine whether it will be able to collect on any such awards due to uncertainty regarding Polimaster’s financial condition and other factors.

Item 1A. Risk Factors

You should carefully consider the risks described below before making a decision regarding an investment in our common stock. If any of the following risks actually occur, our business could be harmed, the trading price of our common stock could decline and you may lose all or part of your investment. You should also refer to the other information contained in this report, including our financial statements and the related notes.

Our future revenues are unpredictable, our operating results are likely to fluctuate from quarter-to-quarter, and if we fail to meet the expectations of securities analysts or investors, our stock price could decline significantly.

Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, some of which are outside of our control. Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indications of future performance. Some of the factors that could cause our quarterly or annual operating results to fluctuate include significant shortfalls in revenue relative to our planned expenditures, changes in budget allocations by the federal government for homeland security purposes, changes in world-wide energy production and refining, market acceptance of our products, ongoing product development and production, competitive pressures and customer retention. It is likely that in some future quarters our operating results may fall below the expectations of investors. In this event, the trading price of our common stock could significantly decline.

We may have difficulty sustaining profitability and may experience additional losses in the future. If we continue to report losses or are marginally profitable, the financial impact of future events may be magnified and may lead to a disproportionate impact on the trading price of our stock.

We recorded a net loss of $4.8 million for the first half of fiscal 2007, $1.5 million for fiscal year 2006 and a net loss of $800,000 for fiscal year 2005. In order to improve our profitability, we will need to continue to generate new sales while controlling our costs. As we plan on continuing the growth of our business while implementing cost control measures, we may not be able to successfully generate enough revenues to return to profitability with this growth. Any failure to increase our revenues and control costs as we pursue our planned growth would harm our profitability and would likely result in a negative effect on the market price of our stock. In addition, our financial results have historically bordered at or near profitability, and if we continue to perform at this level, the financial impact may be magnified and we may experience a disproportionate impact on our trading price as a result.

We may require additional capital in the future, which may not be available or may only be available on unfavorable terms.

Our future capital requirements depend on many factors, including potential future acquisitions and our ability to generate revenue and control costs. Should we have the need to raise additional capital, there can be no assurance we will be able to do so at all or on favorable terms. In the case of any future equity financings, dilution to our stockholders could result and, in any case, such securities may have rights, preferences and privileges that are senior to those of our common stock. If we are unable to obtain needed capital on favorable terms, or at all, our business and results of operations could be harmed and our liquidity could be adversely affected.

As a result of our failure to timely file with the SEC two current reports on Form 8-K during fiscal year 2006 (related to our acquisitions of Aegison Corporation and Securay), we will be ineligible to register our securities on Form S-3 for sale by us or resale by others until we have timely filed all periodic reports under the Securities and Exchange Act of 1934 for a period of twelve months. We may use Form S-1 to raise capital or complete acquisitions, but doing so could increase transaction costs and adversely impact our ability to raise capital or complete acquisitions of other companies in a timely manner.

The market for gas and radiation detection monitoring devices is highly competitive, and if we cannot compete effectively, our business may be harmed.

The market for gas and radiation detection monitoring devices is highly competitive. Competitors in the gas and radiation monitoring industry differentiate themselves on the basis of their technology, quality of product and service offerings, cost and time to market. Our primary competitors in the gas detection market include Industrial Scientific Corporation, Mine Safety Appliances Company, Honeywell (BW Technologies), Ion Science, Draeger Safety Inc., Gastec Corporation and Bacou-Dalloz Group. Our competitors in the radiation market include TSA Limited, Polimaster, Exporanium and Santa Barbara Systems. Several of our competitors such as Mine Safety Appliances Company and Draeger Safety Inc. have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than we do. In addition, some of our competitors may be able to:

	•		devote greater resources to marketing and promotional campaigns;

	•		adopt more aggressive pricing policies; or

	•		devote more resources to technology and systems development.

In light of these factors, we may be unable to compete successfully.

We may not be successful in the development or introduction of new products and services in a timely and effective manner and, consequently, we may not be able to remain competitive and the results of operations may suffer.

Our revenue growth is dependent on the timely introduction of new products to market. We may be unsuccessful in identifying new product and service opportunities or in developing or marketing new products and services in a timely or cost-effective manner. In developing new products, we may be required to make significant investments before we can determine the commercial viability of the new product. If we fail to accurately foresee our customers’ needs and future activities, we may invest heavily in research and development of products that do not lead to significant sales.

We have expanded our current business of providing gas detection instruments to include radiation detection and wireless systems for local and remote security monitoring. While we perceive a large market for such products, the radiation detection and wireless systems markets are still evolving, and we have little basis to assess the demand for these products and services or to evaluate whether our products and services will be accepted by the market. If our radiation detection products and wireless products and services do not gain broad market acceptance or if we do not continue to maintain the necessary technology, our business and results of operations will be harmed.

In addition, compliance with safety regulations, specifically the need to obtain regulatory approvals in certain jurisdictions, could delay the introduction of new products by us. As a result, we may experience delays in realizing revenues from our new products.

U.S. securities laws and regulations have and are likely to continue to increase our costs.

Since passage of the Sarbanes-Oxley Act of 2002 (the “Act”), we have spent increased costs and efforts in corporate governance, securities disclosure and compliance practices. Compliance with these rules continues to cause us to maintain high legal, financial and accounting costs, and we expect these increased costs to continue indefinitely.

In the event we are unable to satisfy regulatory requirements relating to internal control over financial reporting or, if these controls are not effective, our business and financial results may suffer.

In designing and evaluating our internal control over financial reporting, we recognize that any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives. For example, a company’s operations may change over time as the result of new or discontinued lines of business and management must periodically modify a company’s internal controls and procedures to timely match these changes in its business. In addition, management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures and Company personnel are required to use judgment in their application. While we continue to improve upon our internal control over financial reporting so that it can provide reasonable assurance of achieving its control objectives, no system of internal controls can be designed to provide absolute assurance of effectiveness.

In our fiscal year 2005 annual report on Form 10-K, management identified three material weaknesses. The weaknesses were related to our calculation of share-based compensation and diluted shares in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” inadequate control over our accounting and reporting of certain non-routine transactions occurring at two of our foreign operations and an inadequate number of accounting and finance personnel or consultants sufficiently trained to address some of the complex accounting and financial reporting matters that arise from time-to-time. In connection with year-end work on our fiscal year 2006 Form 10-K, management identified a material weakness in the Company’s internal control relating to assurance that information from its Chinese subsidiaries has been properly adjusted to generally accepted accounting principles in the United States for inclusion in its annual or interim financial statements. A discussion of the material weaknesses in our internal control over financial reporting and management’s remediation efforts is available under the subheading “Management’s Report on Internal Control over Financial Reporting,” in our annual report of Form 10-K and under the subheading “Controls and Procedures” herein.

Material weaknesses in internal control over financial reporting may materially impact our reported financial results and the market price of our stock could significantly decline. Additionally, adverse publicity related to a material failure of internal control over financial reporting could have a negative impact on our reputation and business.

We are subject to risks and uncertainties of the government marketplace, including the risk that the government may not fund projects that our products are designed to address and that certain terms of our contracts with government agencies may subject us to adverse government actions or penalties.

Our business is increasingly dependent upon government funded projects. Decisions on what types of projects are to be funded by local, state and federal government agencies will have a material impact on our business. The current Federal budget for the Department of Homeland Security is a source for funding for many of our customers either directly or through grants to state and local agencies. However, if the government does not fund projects that our products are designed to address, or funds such projects at levels lower than we expect, our business and results of operations will be harmed.

Government contracts also contain provisions and are subject to laws and regulations that provide government clients with rights and remedies not typically found in commercial contracts. For example, a portion of our federal contracting was done, and may in the future be done, through the Federal Supply Schedules from the United States General Services Administration (GSA). Our GSA Schedule contract, like all others, included a clause known as the “Price Reductions” clause; the terms of that clause are similar but not identical to a “most favored customer” clause in commercial contracts. Under that clause, we had agreed that the prices to the government under the GSA Schedules contract would maintain a constant relationship to the prices charged to certain commercial customers, i.e., when prices to those benchmark customers drop, our prices on our GSA Schedules contract would be adjusted accordingly. Although we undertook extensive efforts to comply with the Price Reductions clause, it is possible that we may have an unreported discount offered to a “Basis of Award” customer and may have failed to honor the obligations of the Price Reductions clause. If that occurred, or if it occurs in the future under other GSA Schedule contracts, we could, under certain circumstances, be subject to an audit, an action in fraud, or other adverse government actions or penalties.

We may not be successful in promoting and developing our brand, which could prevent us from remaining competitive.

We believe that our future success will depend on our ability to maintain and strengthen the RAE brand, which will depend, in turn, largely on the success of our marketing efforts and ability to provide our customers with high-quality products. If we fail to successfully promote and maintain our brand, or incur excessive expenses in attempting to promote and maintain our brand, our business will be harmed.

We may face risks from our substantial international operations and sales.

We have significant operations in foreign countries, including manufacturing facilities, sales personnel and customer support operations. For the six months ended June 30, 2007, approximately 42% of our revenues were from sales to customers located in Asia and approximately 14% of our revenues were from sales to customers located in Europe. For the fiscal years ended December 31, 2006 and 2005, approximately 38% and 33% of our revenues, respectively, were from sales to customers located in Asia and approximately 13% and 11% of our revenues, respectively, were from sales to customers located in Europe. We have manufacturing facilities in China and in the United States. A significant portion of our products and components are manufactured at our facility in Shanghai, China.

Our international operations are subject to economic and other risks inherent in doing business in foreign countries, including the following:

	•		difficulties with staffing and managing international operations;

	•		transportation and supply chain disruptions and increased transportation expense as a result of epidemics, terrorist activity, acts of war or hostility, generally higher oil prices, increased security and less developed infrastructure;

	•		economic slowdown and/or downturn in foreign markets;

	•		international currency fluctuations;

	•		political and economic uncertainty caused by epidemics, terrorism or acts of war or hostility;

	•		legislative and regulatory responses to terrorist activity such as increased restrictions on cross-border movement of products and technology;

	•		legislative, regulatory, police, or civil responses to epidemics or other outbreaks of infectious diseases such as quarantines, factory closures, or increased restrictions on transportation or travel;

	•		increased costs and complexities associated with complying with Section 404 of the Act;

	•		general strikes or other disruptions in working conditions;

	•		labor shortages;

	•		political instability;

	•		changes in tariffs;

	•		generally longer periods to collect receivables;

	•		unexpected legislative or regulatory requirements;

	•		reduced protection for intellectual property rights in some countries;

	•		significant unexpected duties or taxes or other adverse tax consequences;

	•		difficulty in obtaining export licenses and other trade barriers; and

	•		ability to obtain credit and access to capital issues faced by our international customers.

The specific economic conditions in each country will impact our future international sales. For example, approximately half of our recognized revenue has been denominated in U.S. dollars. Significant downward fluctuations in currency exchange rates against the U.S. dollar could result in higher product prices and/or declining margins and increased manufacturing costs. If we do not effectively manage the risks associated with international operations and sales, our business, financial condition and operating results could suffer. In addition, to date we have experienced lower gross margins on sales in Asia. To the extent that the percentage of our total net sales from Asia increases and our gross margins do not improve, our business financial condition and operating results could suffer.

The loss of “Normal Trade Relation” status for China, changes in current tariff structures or adoption of other trade policies adverse to China could have an adverse effect on our business.

Our ability to import products from China at current tariff levels could be materially and adversely affected if the “normal trade relations” (“NTR,” formerly “most favored nation”) status the United States government has granted to China for trade and tariff purposes is terminated. As a result of its NTR status, China receives the same favorable tariff treatment that the United States extends to its other “normal” trading partners. China’s NTR status, coupled with its membership in the World Trade Organization, could eventually reduce barriers to manufacturing products in and exporting products from China. However, we cannot provide any assurance that China’s membership in the World Trade Organization or NTR status will not change. As a result of opposition to certain policies of the Chinese government and China’s growing trade surpluses with the United States, there has been, and in the future may be, opposition to NTR status for China. Also, the imposition of trade sanctions by the United States or the European Union against a class of products imported by us from, or the loss of NTR status with, China, could significantly increase our cost of products imported into the United States or Europe and harm our business. Because of the importance of our international sales and international sourcing of manufacturing to our business, our financial condition and results of operations could be significantly and adversely affected if any of the risks described above were to occur.

The government of China may change or even reverse its policies of promoting private industry and foreign investment, in which case our assets and operations may be at risk.

We currently manufacture and sell a significant portion of our components and products in China. Our existing and planned operations in China are subject to the general risks of doing business internationally and the specific risks related to the business, economic and political conditions in China, which include the possibility that the central government of China will change or even reverse its policies of promoting private industry and foreign investment in China. Many of the current reforms which support private business in China are unprecedented or experimental. Other political, economic and social factors, such as political changes, changes in the rates of economic growth, unemployment or inflation, or in the disparities of per capita wealth among citizens of China and between regions within China, could also lead to further readjustment of the government’s reform measures. It is not possible to predict whether the Chinese government will continue to be as supportive of private business in China, nor is it possible to predict how future reforms will affect our business.

Any failure to adequately protect and enforce our intellectual property rights could harm our business.

We regard our intellectual property as critical to our success. We rely on a combination of patent, trademark, copyright, trade secret laws and non-disclosure agreements and confidentiality procedures to protect our proprietary rights. Notwithstanding these laws, we may be unsuccessful in protecting our intellectual property rights or in obtaining patents or registered trademarks for which we apply. Although processes are in place to protect our intellectual property rights, we cannot guarantee that these procedures are adequate to prevent misappropriation of our current technology or that our competitors will not develop technology that is similar to our own.

While there is no single patent or license to technology of material significance to the Company, our ability to compete is affected by our ability to protect our intellectual property rights in general. For example, we have a collection of patents related to our photo ionization detector technology of which the first of such patents expires in 2012, and our ability to compete may be affected by any competing similar or new technology. In addition, if we lose the licensing rights to a

patented or other proprietary technology, we may need to stop selling products incorporating that technology and possibly other products, redesign our products or lose a competitive advantage. We cannot ensure that our future patent applications will be approved or that our current patents will not be challenged by third parties. Furthermore, we cannot ensure that, if challenged, our patents will be found to be valid and enforceable.

Any litigation relating to our intellectual property rights could, regardless of the outcome, have a material adverse impact on our business and results of operations.

We may face intellectual property infringement claims that might be costly to resolve and affect our results of operations.

In connection with the enforcement of our own intellectual property rights, the acquisition of third-party intellectual property rights or disputes relating to the validity or alleged infringement of third-party rights, including patent rights, we have been, and may in the future, be subject to claims, negotiations or complex, protracted litigation, such as our dispute with Polimaster. Intellectual property disputes and litigation are typically very costly and can be disruptive to our business operations by diverting the attention and energies of management and key technical personnel. Although we have successfully defended or resolved past litigation and disputes, we may not prevail in any ongoing or future litigation and disputes. We may incur significant costs in acquiring the necessary third party intellectual property rights for use in our products. Third party intellectual property disputes could subject us to significant liabilities, require us to enter into royalty and licensing arrangements on less favorable terms, prevent us from manufacturing or licensing certain of our products, cause severe disruptions to our operations or the markets in which we compete, or require us to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements any one of which could seriously harm our business.

Claims of this type, regardless of merit, can be time-consuming to defend, result in costly litigation, divert management’s attention and resources or require us to enter into royalty or license agreements. The terms of any such license agreements may not be available on reasonable terms, if at all, and the assertion or prosecution of any infringement claims could significantly harm our business.

Some of our products may be subject to product liability claims which could be costly to resolve and affect our results of operations.

There can be no assurance that we will not be subject to third-party claims in connection with our products or that any indemnification or insurance available to us will be adequate to protect us from liability. A product liability claim, product recall or other claim, as well as any claims for uninsured liabilities or in excess of insured liabilities, could have a material adverse effect on our business and results of operations.

We sell a majority of our products through distributors, and if our distributors stop selling our products, our revenues would suffer.

We distribute our products in the Americas primarily through distributors. We are dependent upon these distributors to sell our products and to assist us in promoting and creating a demand for our products. For example, we derived approximately 68% of our Americas’ revenues from our sales distribution channels in the six months ended June 30, 2007. We also believe our future growth depends materially on the efforts of distributors. In addition, the contractual obligations of our distributors to continue carrying our products are subject to a sixty-day termination notice by either party for convenience. If one or more of our distributors were to experience financial difficulties or become unwilling to promote and sell our products for any reason, including any refusal to renew their commitment as our distributor, we might not be able to replace such lost revenue, and our business and results of operations could be materially harmed.

Because we purchase a significant portion of our component parts from a limited number of third party suppliers, we are subject to the risk that we may be unable to acquire quality components in a timely manner, which could result in delays of product shipments and damage our business and operating results.

We currently purchase component parts used in the manufacture of our products from a limited number of third party suppliers. We depend on these suppliers to meet our needs for various sensors, microprocessors and other material components. Moreover, we depend on the quality of the products supplied to us over which we have limited control. Should we encounter shortages and delays in obtaining components, we might not be able to supply products in a timely manner due to a lack of components, and our business could be adversely affected.

Acquisitions that we undertake or entries into new lines of business could be difficult to integrate, disrupt our business, dilute stockholder value or harm our results of operations.

In 2006, we acquired Aegison Corporation, acquired an additional 32% of ownership of RAE Beijing and, with the formation of RAE Fushun, entered into the mine safety business. In addition, during January 2007, we completed the acquisition of Securay. We may acquire or make additional investments in complementary businesses, technologies, services

or products and enter into new lines of business if appropriate opportunities arise. The process of integrating any acquired business, technology, service or product into our business and operations or entry into a new line of business in which we are inexperienced may result in unforeseen operating difficulties and expenditures. Integration of an acquired company also may consume much of our management’s time and attention that would otherwise be available for ongoing development of our business. Moreover, the anticipated benefits of any acquisition may not be realized. Future acquisitions could result in dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or expenses related to goodwill recognition and other intangible assets, any of which could harm our business.

With the formation of RAE Fushun in December 2006, we are now involved in safety products in the Chinese coal mining industry and energy sectors. In developing and marketing this new line of business and new products, we will invest significant time and resources. Initial timetables for the introduction and development of this new line of business and new products may not be achieved, and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of this new line of business or new products in this line. Therefore, we may be unable to take full advantage of business opportunities for the mine safety business and we may encounter difficulties in meeting our expectations or the expectations of investors for the operating results of the mine safety business.

Our ownership interest in Renex may cause us to incur losses that we would not otherwise incur.

We currently own approximately 40% of Renex Technology Ltd., a wireless systems company still in the research and development stage. We are required to incorporate our share of its expenses as losses in our Consolidated Statements of Operations. If Renex does not begin to generate revenues at the level we anticipate or otherwise incurs greater losses, we could incur greater losses than we anticipate and our results of operations will suffer.

Our business could suffer if we lose the services of any of our executive officers.

Our future success depends to a significant extent on the continued service of our executive officers. We have no formal employment agreements with any of our executive other than their initial offer letter, if applicable. The loss of the services of any of our executive officers could harm our business.

Our officers, directors and principal stockholders beneficially own approximately 33% of our common stock and, accordingly, may exert substantial influence over the Company.

Our executive officers and directors and principal stockholders, in the aggregate, beneficially own approximately 33% of our common stock as of June 30, 2007. These stockholders acting together have the ability to substantially influence all matters requiring approval by our stockholders. These matters include the election and removal of the directors, amendment of our certificate of incorporation, and any merger, consolidation or sale of all or substantially all of our assets. In addition, they may dictate the management of our business and affairs. Furthermore, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination and may substantially reduce the marketability of our common stock.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Securities Holders

At our annual meeting on June 14, 2007, the stockholders elected the nominees for Class II directors to our Board of Directors. The votes were as follows:


			Withheld
Nominee	For		Authority
Lyle D. Feisel		53,613,943		26,073
Neil W. Flanzraich		53,635,187		4,829

The terms for Lyle D. Feisel and Neil W. Flanzraich will expire at the 2010 annual meeting. The following directors’ terms of office continue until the annual meeting indicated: Robert I. Chen and Sigrun Hjelmquist (Class III term expires at the 2008 annual meeting) and Peter C. Hsi, James W. Power and A. Marvin Strait (Class I term expires at the 2009 annual meeting).

The following matter was also submitted to and approved by a vote of the stockholders with the results of the voting being as shown:

Proposal to ratify to approve the 2007 equity incentive plan:


For:			32,600,408
Against:			4,274,772
Abstained:			178,411

Proposal to ratify the appointment of BDO Seidman, LLP as our independent registered public accounting firm for the fiscal year ended December 31, 2007:


For:			53,772,775
Against:			672,386
Abstained:			28,575

The proposal to ratify the appointment of BDO Seidman, LLP as our independent registered public accounting firm for the fiscal year ended December 31, 2007 was withdrawn as Deloitte & Touche, LLP has been appointed as the Company’s independent registered public accounting firm for the year ended December 31, 2007 as announced in the Company’s Form 8-K filing with the SEC on June 7, 2007.

Item 5. Other Information

None

Item 6. Exhibits

The following is a list of exhibits filed as part of this Report on Form 10-Q.


Exhibit
Number		Description of Document
2.1		Intellectual property purchase agreement signed January 3, 2007 between RAE Systems (Asia) Ltd., and Secuary Liquidation Team.(1)

2.2		Production equipment and inventory purchase agreement signed October 23, 2006 between RAE Systems (Shanghai) Inc. and Secuary Liquidation Team.(1)

2.3		Fixed assets purchase agreement signed October 23, 2006 between RAE KLH Technologies (Beijing) Company Limited. and Secuary Liquidation Team.(1)

10.15		RAE Systems Inc. 2007 Equity Incentive Plan.(2)

31.1		Certification of Robert I. Chen, President, Chief Executive Officer and Chairman of the Board of the Registrant, furnished pursuant to Rule 13a-14(a) adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Randall Gausman, Vice President and Chief Financial Officer of the Registrant, furnished pursuant to Rule 13a-14(a) adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Robert I. Chen, President, Chief Executive Officer and Chairman of the Registrant, furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Randall Gausman, Vice President and Chief Financial Officer of the Registrant, furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


(1)		Previously filed as an exhibit to the Registrant’s current report on Form 8-K on May 31, 2007 and incorporated herein by reference.
(2)		Previously filed as Appendix A to the Registrant’s Proxy Statement Pursuant to Section 14(a) of the Securities Exchange Act of 1934 on April 27, 2007 and incorporated herein by reference.

	a)		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	b)		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	c)		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	d)		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

	a)		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	b)		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	c)		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	d)		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

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		Page

Part I. Financial Information

	Item 1. Financial Statements (Unaudited)

	RAE Systems Inc. Condensed Consolidated Balance Sheets at June 30, 2007 and December 31, 2006		1

	RAE Systems Inc. Condensed Consolidated Statements of Operations for the three-month and six-month periods ended June 30, 2007 and 2006		2

	RAE Systems Inc. Condensed Consolidated Statements of Cash Flows for the six-month periods ended June 30, 2007 and 2006		3

	RAE Systems Inc. Notes to Condensed Consolidated Financial Statements		4

	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		13

	Item 3. Quantitative and Qualitative Disclosures About Market Risk		21

	Item 4. Controls and Procedures		22

Part II. Other Information			23

	Item 1. Legal Proceedings		23

	Item 1A. Risk Factors		23

	Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		29

	Item 3. Defaults Upon Senior Securities		29

	Item 4. Submission of Matters to a Vote of Security Holders		29

	Item 5. Other Information		30

	Item 6. Exhibits		30

Signatures			31
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


	RAE SYSTEMS INC.
	By:	/s/ Randall Gausman
		Randall Gausman
		Vice President and Chief Financial Officer



	By:	/s/ Robert I. Chen
		Robert I. Chen
		President, Chief Executive Officer and Chairman of the Board

	a)		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	b)		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.



	By:	/s/ Robert I. Chen
August 8, 2007		Robert I. Chen
		President, Chief Executive Officer and Chairman of the Board