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 March 31, 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		77-0280662
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

3775 North First Street
San Jose, California		95134
(Address of principal executive offices)		(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 April 23, 2007

Common stock, $0.001 par value per share		59,301,054 shares

PART I. Financial Information

Item 1. Financial Statements

RAE Systems Inc.
Condensed Consolidated Balance Sheets


	March 31,			December 31,
	2007			2006
	(Unaudited)
Assets

Current Assets:
Cash and cash equivalents	$	12,969,000		$	18,119,000
Short-term investments		—			3,248,000
Trade notes receivable		2,792,000			1,977,000
Accounts receivable, net of allowance for doubtful accounts of $675,000 and $843,000, respectively		17,933,000			16,966,000
Accounts receivable from affiliate		179,000			154,000
Inventory		15,131,000			15,382,000
Prepaid expenses and other current assets		3,499,000			2,530,000
Income tax receivable		1,316,000			968,000
Deferred tax assets, short-term		991,000			935,000

Total Current Assets		54,810,000			60,279,000


Property and equipment, net		15,186,000			15,120,000
Acquisition in-progress		—			820,000
Other intangible assets, net		5,740,000			5,304,000
Goodwill		4,475,000			3,760,000
Investment in unconsolidated affiliate		402,000			420,000
Deferred tax assets, long-term		3,401,000			3,402,000
Other long-term assets		658,000			648,000

Total Assets	$	84,672,000		$	89,753,000


Liabilities, Minority Interest in Consolidated Entities and Shareholders’ Equity

Current Liabilities:
Accounts payable	$	6,506,000		$	7,187,000
Account payable to affiliate		259,000			360,000
Account payable to Fushun shareholder		2,669,000			3,926,000
Accrued liabilities		8,061,000			8,793,000
Notes payable to related parties, short-term		601,000			822,000
Income taxes payable		—			520,000
Deferred revenue, current portion		1,729,000			2,030,000

Total Current Liabilities		19,825,000			23,638,000

Deferred revenue, net of current portion		685,000			736,000
Deferred tax liabilities, long-term		439,000			438,000
Other long-term liabilities		1,365,000			1,045,000
Notes payable to related parties, long-term		3,277,000			3,222,000

Total Liabilities		25,591,000			29,079,000


Commitments and Contingencies (Note 5)

Minority Interest in Consolidated Entities		4,510,000			4,495,000

Shareholders’ Equity:
Common stock, $0.001 par value; 200,000,000 shares authorized; 59,301,054 and 59,274,596 shares issued and outstanding, respectively		59,000			59,000
Additional paid-in capital		59,387,000			58,828,000
Accumulated other comprehensive income		1,551,000			1,245,000
Accumulated deficit		(6,426,000	)		(3,953,000	)

Total Shareholders’ Equity		54,571,000			56,179,000

Total Liabilities, Minority Interest in Consolidated Entities and Shareholders’ Equity	$	84,672,000		$	89,753,000

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.
Condensed Consolidated Statements of Operations


	Three Months Ended
	March 31,
	2007			2006
	(Unaudited)			(Unaudited)
Net Sales	$	17,987,000		$	12,426,000

Cost of Sales		8,832,000			5,716,000


Gross Profit		9,155,000			6,710,000


Operating Expenses:
Sales and marketing		5,353,000			4,071,000
Research and development		1,772,000			1,273,000
General and administrative		5,187,000			2,969,000
Adjustment to lease abandonment accrual		(611,000	)		—


Total Operating Expenses		11,701,000			8,313,000


Operating Loss		(2,546,000	)		(1,603,000	)


Other Income/(Expense):
Interest income		65,000			174,000
Interest expense		(69,000	)		(21,000	)
Other, net		13,000			26,000
Equity in loss of unconsolidated affiliate		(18,000	)		(64,000	)


Total Other Income/(Expense)		(9,000	)		115,000


Loss Before Income Taxes and Minority Interest		(2,555,000	)		(1,488,000	)

Income tax benefit		(207,000	)		(179,000	)


Loss Before Minority Interest		(2,348,000	)		(1,309,000	)

Minority interest in loss of consolidated subsidiaries		21,000			276,000


Net Loss	$	(2,327,000	)	$	(1,033,000	)


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


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


Weighted average common shares outstanding — Basic		59,293,664			57,901,002
Stock options and warrants		—			—


Weighted average common shares outstanding — Diluted		59,293,664			57,901,002

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.
Condensed Consolidated Statements of Cash Flows


	Three Months Ended
	March 31,
	2007			2006
	(Unaudited)			(Unaudited)
Increase/(Decrease) In Cash and Cash Equivalents

Cash Flows From Operating Activities:
Net loss	$	(2,327,000	)	$	(1,033,000	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		1,054,000			623,000
Provision for doubtful accounts		(150,000	)		(124,000	)
Loss on disposal of fixed assets		2,000			44,000
Inventory reserve		29,000			543,000
Compensation expense under fair value accounting of common stock options		491,000			343,000
Equity in loss of unconsolidated affiliate		18,000			64,000
Minority interest in loss of consolidated subsidiary		(21,000	)		(276,000	)
Deferred income taxes		(56,000	)		30,000
Adjustment to lease abandonment accrual		(611,000	)		—
Amortization of discount on notes payable		57,000			20,000
Changes in operating assets and liabilities:
Accounts receivable		235,000			2,885,000
Accounts receivable from affiliate		(24,000	)		(15,000	)
Trade notes receivable		(794,000	)		(294,000	)
Inventories		(126,000	)		(1,635,000	)
Prepaid expenses and other current assets		(539,000	)		(304,000	)
Other long-term assets		(10,000	)		69,000
Accounts payable		(700,000	)		46,000
Accounts payable to affiliate		(103,000	)		—
Accounts payable to Fushun shareholders		(1,287,000	)		—
Accrued liabilities		(650,000	)		(1,273,000	)
Income taxes		(314,000	)		(363,000	)
Deferred revenue		(363,000	)		21,000
Other long-term liabilities		42,000			(111,000	)


Net Cash Used In Operating Activities		(6,147,000	)		(740,000	)


Cash Flows From Investing Activities:
Purchases of investments		—			(5,045,000	)
Sales and maturities of investments		3,247,000			3,533,000
Business acquisitions, net of cash acquired		(1,715,000	)		—
Acquisition of property and equipment		(457,000	)		(529,000	)

Net Cash Provided By/(Used In) Investing Activities		1,075,000			(2,041,000	)


Cash Flows From Financing Activities:
Proceeds from the exercise of stock options and warrants		67,000			50,000
Payments on notes payable to related parties		(232,000	)		—


Net Cash Provided By/(Used In) Financing Activities		(165,000	)		50,000


Effect of exchange rate changes on cash and cash equivalents		87,000			14,000


Net Decrease In Cash and Cash Equivalents		(5,150,000	)		(2,717,000	)

Cash and Cash Equivalents, beginning of period		18,119,000			13,524,000


Cash and Cash Equivalents, end of period	$	12,969,000		$	10,807,000

See accompanying notes to condensed consolidated financial statements.

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”, “RAE Systems” or “RAE”). 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, results of operations and its cash flows for the stated periods, in conformity with the accounting principles generally accepted in the United States. 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

Reclassification

Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications have no effect on previously reported results of operations.

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 (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

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 estimated fair value is then amortized as compensation expense, on a straight-line basis, over the requisite service period of the award, which is generally the vesting period.

Determining Fair Value and Amortization Method —The Company estimates the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

Expected Term —The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined using the “Simplified Method” as defined in the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107.

Expected Volatility— The Company’s expected volatilities are based on the historical volatility of the Company’s stock, adjusted for unusual and non-representative stock price activity not expected to recur, as determined by management.

Expected Dividend —The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company currently pays no dividends and does not expect to pay dividends in the foreseeable future.

Risk-Free Interest Rate— The Company bases the risk-free interest rate on the implied yield currently available on United States Treasury zero-coupon issues with an equivalent remaining term.

Estimated Forfeitures— When estimating forfeitures, the Company uses the average historical option forfeitures over a period of four years.

Assumptions —There were no share-based payments during the three months ended March 31, 2007. The fair value of the Company’s stock options granted to employees for the three months ended March 31, 2006 was estimated using the following weighted-average assumptions:


	Three Months Ended
	March 31, 2006
Volatility		79.2	%
Expected dividend		0.0	%
Risk-free interest rate		4.8	%
Expected term in years		6.1
Weighted-average fair value	$	2.61

Stock Option Plans

In August 1993, the Company’s Board of Directors adopted the 1993 Stock Option Plan and in May 2002, the Board of Directors adopted the 2002 Stock Option Plan (collectively the “Plans”). The Plans authorize the grant of options to purchase shares of common stock to employees, directors, and consultants of the Company and its affiliates. The Plans feature both incentive and non-statutory options.

Incentive options may be granted at not less than 100% of the fair market value per share at the date of grant, and non-statutory options may be granted at not less than 85% of the fair market value per share at the date of grant as determined by the Board of Directors, or Committee thereof, except for options granted to a person owning greater than 10% of the outstanding stock, for which the exercise price may not be less than 110% of the fair market value at the date of grant. Options granted under the Plans generally vest 25% after one year with the remainder of the options vesting monthly over the following three years. Options granted under the Plans are generally exercisable over ten years.

As of March 31, 2007, the Company has reserved 235,870 shares of common stock for issuance under the 1993 Stock Option Plan and 2,857,425 shares of common stock for issuance under the 2002 Stock Option Plan. As of March 31, 2007, the Company had 918,338 shares of common stock available for future grants under the 2002 Stock Option Plan.

Non-Plan Stock Options

In 2002, the Company granted certain of its director’s non-plan options to purchase 400,000 shares of non-plan restricted stock at a weighted-average exercise price of $0.99. The non-plan options have a contractual term of 10 years and vest 25%

after one year with the remainder vesting monthly over the following three years. As of March 31, 2007, 100,000 non-plan options remained outstanding and exercisable and had a remaining contractual life of five years.

Earnings Per Share

Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per 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 share calculation for three month periods ended March 31, 2007 and 2006 were 4,860,541 and 2,864,353, 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 quarters ended March 31, 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. Total sales in the first quarters of 2007 and 2006 were $426,000 and $355,000, respectively. The Company has consolidated RAE France since December 2004.

Recent Accounting Pronouncements

On July 13, 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109”. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Only tax positions that meet the more-likely-than-not recognition threshold may be recognized or continue to be recognized upon adoption of FIN 48. The cumulative effect of applying the provisions of FIN 48 is reported as an adjustment to the income tax payable account and the opening balance of retained earnings for the fiscal year of adoption. The Company adopted FIN 48 effective January 1, 2007. In accordance with FIN 48, paragraph 19, the Company has continued to classify interest and penalties as a component of tax expense.

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 cannot estimate the impact, if any, on its results of operations or financial position.

Note 2. Composition of Certain Financial Statement Items

Short-term investments


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

	$	—	$	3,248,000

Inventory


	March 31,		December 31,
	2007		2006
Raw materials	$	4,503,000	$	4,675,000
Work-in-progress		923,000		1,858,000
Finished goods		9,705,000		8,849,000

	$	15,131,000	$	15,382,000

Prepaid expenses and other current assets


	March 31,		December 31,
	2007		2006
Supplier advances and deposits	$	2,513,000	$	1,671,000
Prepaid insurance		239,000		430,000
Prepaid licenses and maintenance		339,000		—
Other current assets		408,000		429,000

	$	3,499,000	$	2,530,000

Property and equipment, net


	March 31,		December 31,
	2007		2006
Building and building improvements	$	8,405,000	$	8,150,000
Land		3,220,000		3,220,000
Equipment		4,011,000		4,043,000
Computer equipment		3,921,000		3,498,000
Automobiles		1,229,000		1,126,000
Furniture and fixtures		673,000		550,000
Construction in progress		42,000		53,000

	$	21,501,000	$	20,640,000

Less: accumulated depreciation	$	6,315,000	$	5,520,000

	$	15,186,000	$	15,120,000

Other intangible assets, net


	March 31,		December 31,
	2007		2006
Customer list	$	3,708,000	$	3,059,000
Patents and technology		1,989,000		1,966,000
Trade name		1,786,000		1,661,000
Trade secret		79,000		79,000

	$	7,562,000	$	6,765,000

Less: accumulated amortization	$	1,822,000	$	1,461,000

	$	5,740,000	$	5,304,000

Accrued liabilities


	March 31,		December 31,
	2007		2006
Compensation and related benefits	$	1,896,000	$	2,233,000
Accrued commissions		1,781,000		1,815,000
Accrued professional fees		1,374,000		1,066,000
Warranty reserve		587,000		553,000
Taxes other than income tax		183,000		500,000
Abandonment of lease		291,000		478,000
Marketing and advertising		649,000		933,000
Customer advances		374,000		—
Accrued inventory receipts		—		242,000
Payable to Aegison shareholder		—		200,000
Other		926,000		773,000

Total	$	8,061,000	$	8,793,000

Note 3. Income Tax

The effective tax rate for the quarter ended March 31, 2007 was 8% of the loss before income taxes and minority interest, compared to 12% of the loss before income taxes and minority interest for the quarter ended March 31, 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 $8,000 for the accrual of interest applicable to uncertain tax positions through the period ended March 31, 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 Financial Standards Accounting Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes (“FIN 48”) an interpretation of FASB Statement No. 109 (“SFAS 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 adoption date, the Company had gross unrecognized tax benefits of $778,000, accrued interest expense related to the unrecognized tax benefits of $50,000, 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, $737,000 of the unrecognized benefit would reduce the effective tax rate. The Company anticipates a $300,000 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, Skat, 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
	March 31,
	2007			2006
Net loss	$	(2,327,000	)	$	(1,033,000	)
Other comprehensive income:
Foreign currency translation adjustment		305,000			160,000
Change in unrealized loss on investments, after tax		1,000			—

Total comprehensive income/(loss)	$	(2,021,000	)	$	(873,000	)

The components of accumulated other comprehensive income were as follows:


	March 31,		December 31,
	2007		2006
Foreign currency translation adjustments	$	1,551,000	$	1,246,000
Unrealized loss on investments, after tax		—		(1,000	)

Accumulated other comprehensive income	$	1,551,000	$	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. Polimaster moved for a preliminary injunction on June 17, 2005. The Court denied Polimaster’s request on September 6, 2005. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending arbitration by the parties.

Arbitration was formally commenced on June 12, 2006 for the Polimaster matter. Polimaster’s Demand for Arbitration asserts damages totaling $13.2 million and seeks an injunction against sales of the Company’s Gamma Rae II and Neutron RAE II radiation detection products. The Company has asserted counterclaims against Polimaster for breach of contract and tortuous interference with contract, among other things, and seeks monetary damages of its own. A ten day arbitration proceeding was completed on March 16, 2007. The arbitration was conducted under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. It is anticipated that the parties will file post hearing briefs in May 2007. It is expected that a decision for the arbitration will be forthcoming 30 days after the post-hearing briefing is concluded. At this time, due to the speculative nature of these proceedings, the Company does not believe an amount of loss, if any, can be reasonably estimated for this matter. The Company also believes the claim by Polimaster is without merit and expects to vigorously defend its position.

Notwithstanding the Polimaster proceeding described above, 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 March 31, 2007 and 2006 was $219,000 and $151,000,

respectively. Future minimum lease payments for each of the next five years, from 2007 (the remaining 9 months) through 2011 and thereafter, excluding the Sunnyvale, California abandoned building lease, are $678,000, $657,000, $442,000, $375,000, $352,000 and $809,000, 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 first quarter 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 $611,000. As of March 31, 2007, future discounted lease payments related to the Sunnyvale building are included in accrued liabilities totaling $291,000 and other long-term liabilities totaling $454,000. Future minimum lease payments relating to the Sunnyvale lease for each of the next three years, from 2007 (the remaining 9 months) through 2009, are $227,000, $271,000 and $238,000, 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 for the next three years, from 2007 (the remaining 9 months) through 2009, to be approximately $8,625,000, $58,000 and $44,000, respectively. As of March 31, 2007, there were no non-cancelable obligations beyond 2009. 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 condition, may negatively affect gross margins in future periods.

In December 2006, RAE Coal Mine Safety Instruments (Fushun) Co., Ltd. (“RAE Fushun”), a subsidiary of the Company, entered into an agreement with Fushun Economic Development Zone Administration to purchase a land use right for approximately $446,000. The land use right will be used to construct RAE Fushun’s new manufacturing and administrative facility.

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


	March 31,
	2007			2006
Provision for products sold during period	$	80,000		$	37,000
Adjustment of prior period provision		(46,000	)		16,000
Claims paid during the period		(2,000	)		(64,000	)
Foreign currency translation effects		2,000			—

Net increase/(decrease) in liabilities	$	34,000		$	(11,000	)

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

Balance, end of period	$	587,000		$	366,000

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 March 31, 2007, there were no outstanding amounts 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 March 31, 2007 and December 31, 2006, $601,000 and $822,000, respectively, were included in short-term notes payable to related parties and $3,277,000 and $3,222,000, respectively, were included in long-term notes payable to related parties.

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, 11.0 million shares of preferred stock were issued to four shareholders of RAE Beijing. In accordance with FAS 150, these preferred shares were classified as liabilities and were recorded as long-term notes payable to related parties. Although, these preferred shares bear a dividend yield rate of 3% per annum, the notes were discounted using a market interest rate of 6.48%.

Included in the current portion of notes payable is a sum of $216,000 due on demand as of March 31, 2007. In addition, the future payment requirements for each of the next five years, from 2007 (the remaining 9 months) through 2011 and thereafter, are $386,000, $239,000, $1,757,000, $967,000 and $940,000, respectively.

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 $18,000 and $64,000 of equity in loss in unconsolidated affiliate in the first quarters of 2007 and 2006, respectively. Additionally, the Company pays a 7.5% royalty to Renex for using certain modems developed by Renex. During the first quarters of 2007 and 2006, the Company made royalty payments to Renex in the amounts of $18,000 and $14,000, respectively. During the first quarters of 2007 and 2006, the Company also purchased $182,000 and $132,000, respectively, of inventory items from Renex and sold $57,000 and $32,000 of inventory items to Renex, respectively. The Company also paid $13,000 to Renex relating to a research project in the first quarter of 2007. Accounts receivable due from Renex at March 31, 2007 and December 31, 2006 were $179,000 and $154,000, respectively. Accounts payable due to Renex at March 31, 2007 and December 31, 2006 were $258,000 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 March 31, 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 properties of 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

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

RAE Systems is a leading global provider of rapidly-deployable sensor networks that enable customers to identify safety and security threats in real time. We were founded in 1991 and our products have evolved from being strictly focused on environmental, first response, and industrial safety to now encompassing public and mine safety applications.

In the first quarter of 2007, we saw the initial fruits of our recent China acquisition strategy. As we had expected, the Chinese central government issued a new set of mine safety standards effective January 1, 2007. In the first quarter, RAE Fushun, the Company’s newly formed Chinese joint venture secured over 20 mine safety certificates for all existing products. We believe RAE Fushun’s ability to quickly secure product certifications is one of our key competitive advantages in the coal mine safety market.

In the first quarter of 2007, we also saw the completion of our Securay acquisition. Securay is the China affiliate for Aegison Corporation which designs and manufactures the newly acquired digital video recording technology. The acquisition will help us provide next generation mobile and wireless digital video technology and execute our long term strategy to converge industrial safety and security.

We reorganized the operations in EMEA (Europe, Middle East, Africa, and Australia), among the fastest growing gas and radiation detection markets in the world, under the leadership of one of our senior sales executives. During the first quarter of 2007, local sales personnel and distributors were recruited, plus service and applications resources were identified, to support growth in this widely distributed and multicultural territory.

In the Americas, we made significant changes to the sales channel. We added several new programs for our major distributors: including the RAE Authorized Service Partner program, enabling warranty service for RAE Systems products across the United States and Canada; RAE Certified Sales Professional program to encourage technical and sales excellence in the channel; and other programs designed to encourage channel partner loyalty. Taken together, these programs give our customers access to fast, consistent service at locations close to their business, which we believe in the long-run will increase revenue, customer retention and loyalty to the RAE systems brand.

On the product side, we launched the DoseRAE, a successful collaboration with Science Applications International Corporation (“SAIC”) where we currently have exclusive international distribution rights. The PD3i (SAIC’s version of the DoseRAE) has already been deployed in mass quantities to support the emergency response organization for a major U.S. metropolitan area on the east coast. In February, we launched the QRAE II. The QRAE II is the first gas detector to include a lead-free oxygen sensor designed to meet the new global directives on the Reduction of Hazardous Substances (RoHS), including lead. As a result, we have seen rapid adoption of this product within the European community. Also during March, we launched the AreaRAE Steel, our second generation, wireless, multi-gas detector which was selected last fall by the U.S. National Guard Civil Support teams as their standard for wireless gas and radiation detection. Due to its unique stainless steel casing, AreaRAE Steel is useful in certain industrial applications.

Critical Accounting Policies and Significant Management Judgments

The preparation of financial statements in conformity with generally accepted accounting principles in the United States 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, restructuring costs, 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

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 (FOB factory) and provides 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 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.

Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

The Company grants credit to its 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. The Company generally does not require collateral for sales on credit. While management uses the best information available in making its 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 the Company 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 6 months.

Inventory

Inventory is stated at the lower of cost, using the first-in, first-out method, or market. The Company is exposed to a number of economic and industry factors that could result in portions of its 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 its suppliers. The Company has established inventory reserves when conditions exist that suggest that its inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for its 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

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 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 the Company’s 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. The Company periodically assesses the adequacy of its reported warranty reserve and adjusts the amounts in accordance with the changes in these factors.

Share-Based Payments

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), or “SFAS 123(R)”, “Share-Based Payment”, 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 estimated fair value is then amortized as compensation expense, on a straight-line basis, over the requisite service period of the award, which is generally the vesting period.

Risk-Free Interest Rate— The Company bases the risk-free interest rate on the implied yield currently available on United States Treasury zero-coupon issues with an equivalent remaining term.

Estimated Forfeitures— When estimating forfeitures, the Company uses the average historical option forfeitures over a period of four years.

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.

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 quarterly report on 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 March 31, 2007 compared with the three months ended March 31, 2006

Net Sales


	Three months ended March 31,
	2007		2006		Change		% Change
Net sales	$	17,987,000	$	12,426,000	$	5,561,000		45	%

Net sales for the quarter ended March 31, 2007, increased by approximately $5.6 million (45%) over the quarter ended March 31, 2006. Net sales for the quarter ended March 31, 2007, increased by approximately $3.3 million (91%) in Asia, $1.8 million (27%) in the Americas, and $445,000 (21%) in Europe over the same period in 2006. The $3.3 million increase in Asia was primarily due to $1.4 million of sales from RAE Fushun in the first quarter of 2007, which was not included in 2006, plus an increase in sales from RAE Beijing of approximately $1.7 million, resulting from increased sales of the Company’s products as well as third party products distributed by RAE Beijing. The increase in the Americas was primarily related to new product introductions such as DoseRAE and QRAE II, as well as increased sales in our legacy product lines. The increased sales in Europe for the quarter ended March 31, 2007, compared to the quarter ended March 31, 2006, was primarily the result of increased sales of our products into the Eastern Europe and Middle East marketplaces.

Cost of Sales & Gross Margin


	Three months ended March 31,
	2007			2006			Change		% Change
Cost of sales	$	8,832,000		$	5,716,000		$	3,116,000		55	%
Gross profit	$	9,155,000		$	6,710,000		$	2,445,000		36	%
Gross margin		51	%		54	%

Cost of sales for the quarter ended March 31, 2007, increased by approximately $3.1 million (55%) over the quarter ended March 31, 2006. Approximately $2.6 million of the increase in cost of sales was 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 March 31, 2007, compared to the quarter ended March 31, 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. Increased labor and overhead spending in the Americas was the primary reason for the remaining 1% decrease in gross margin during the quarter ended March 31, 2007, compared to the quarter ended March 31, 2006.

Sales and Marketing Expense


	Three months ended March 31,
	2007			2006			Change		% Change
Sales and marketing	$	5,353,000		$	4,071,000		$	1,282,000		31	%
As % of net sales		30	%		33	%

Sales and marketing expenses increased by approximately $1.3 million (31%) for the quarter ended March 31, 2007, compared to the quarter ended March 31, 2006. The increase in sales and marketing expense was primarily the result of $840,000 of increased spending in the Americas and $440,000 of increased spending in Europe and Asia combined. The

primary reason for the change was an increase in payroll in the Americas and Europe, the addition of RAE Fushun in the first quarter of 2007 and increased investment in infrastructure to support increasing sales.

Research and Development Expense


	Three months ended March 31,
	2007			2006			Change		% Change
Research and development	$	1,772,000		$	1,273,000		$	499,000		39	%
As % of net sales		10	%		10	%

Research and development expenses increased by approximately $500,000 (39%) during the quarter ended March 31, 2007, compared to the quarter ended March 31, 2006. The increased expenses were primarily the result of increased investment in new portable and wireless products and the addition of RAE Fushun which began operations in the first quarter of 2007.

General and Administrative Expense


	Three months ended March 31,
	2007			2006			Change		% Change
General and administrative	$	5,187,000		$	2,969,000		$	2,218,000		75	%
As % of net sales		29	%		24	%

General and administrative expenses increased by $2.2 million (75%) in the quarter ended March 31, 2007, compared to the quarter ended March 31, 2006. The increased expenses were primarily the result of $1.1 million of legal costs associated with the Polimaster arbitration in March 2007, $500,000 related to increased headcount and consulting costs primarily to support the growth of the Company and increased compliance costs resulting from the international nature of the business, and $200,000 from the addition of RAE Fushun in the first quarter of 2007.

Other Income/(Expense)


	Three months ended March 31,
	2007			2006			Change			% Change
Interest income	$	65,000		$	174,000		$	(109,000	)		(63	%)
Interest expense		(69,000	)		(21,000	)	$	(48,000	)		229	%
Other, net		13,000			26,000		$	(13,000	)		(50	%)
Equity in loss of unconsolidated affiliate		(18,000	)		(64,000	)	$	46,000			(72	%)

Total other income/(expense)	$	(9,000	)	$	115,000		$	(124,000	)		(108	%)

As % of net sales		0	%		1	%

For the quarter ended March 31, 2007, total other income/(expense) was $9,000 of expense compared to $115,000 of income for the quarter ended March 31, 2006. The decrease in total other income was primarily the result of lower cash and marketable securities resulting from our investments in RAE Beijing, RAE Fushun, Securay and Aegison Corporation since the first quarter of 2006.

Income Tax Benefit


	Three months ended March 31,
	2007			2006			Change		% Change
Income tax benefit	$	(207,000	)	$	(179,000	)	$	28,000		16	%
Effective tax rate		8	%		12	%

The tax benefit for the quarter ended March 31, 2007, was $207,000, or 8% of the loss before income taxes and minority interest, compared to $179,000, or 12% of the loss before income taxes and minority interest, for the quarter ended March 31, 2006. We calculated our interim income tax benefits 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”, 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 March 31,
	2006			2005			Change			% Change
Minority interest in loss of consolidated subsidiaries	$	21,000		$	276,000		$	(255,000	)		(92	%)
As % of net sales		0	%		2	%

For the quarter ended March 31, 2007, the minority interest in loss of consolidated entities allocated to minority interest was $21,000, 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 March 31, 2006, the minority interest in loss of consolidated entities allocated to minority interest was $276,000, 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

To date, we have financed our operations primarily through cash flow from operations and proceeds from the issuance of equity securities. As of March 31, 2007, we had $13.0 million in cash and cash equivalents compared with $21.4 million of cash, cash equivalents and investments at December 31 2006. At March 31, 2007, we had $35.0 million of working capital and had a current ratio of 2.8 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, 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 March 31, 2007, there are no outstanding amounts under the line of credit agreement.


	Three months ended March 31,
	2007			2006
Net cash provided by/(used in):
Operating activities	$	(6,147,000	)	$	(740,000	)
Investing activities		1,075,000			(2,041,000	)
Financing activities		(165,000	)		50,000
Effect of exchange rate changes on cash and cash equivalents		87,000			14,000

Net decrease in cash and cash equivalents	$	(5,150,000	)	$	(2,717,000	)

Net cash used by operating activities for the quarter ended March 31, 2007, was $6.1 million compared with $0.7 million for the quarter ended March 31, 2006. The $5.4 million decrease in operating cash flows for the quarter ended March 31, 2007, versus the quarter ended March 31, 2006, was primarily due to decreased profitability after adjusting for non-cash items ($1.8 million), a larger reduction in liabilities ($1.7 million) and an increase as opposed to a reduction of assets ($2.0 million) versus the first quarter of 2006. The change in liabilities was mainly from lower deferred revenue ($0.4 million), accounts payable ($2.1 million), accrued liabilities ($0.6 million). The largest component of the reduction in accounts payable is related to a $1.3 million reduction of the payable to Fushun shareholders. The impact of higher asset levels was primarily the result of increases to prepaid expenses ($0.5 million) and trade notes receivable ($0.8 million) offset by a slight decrease in accounts receivable ($0.2 million).

Net cash provided by investing activities for the quarter-ended March 31, 2007, was $1.1 million compared with net cash used in investing activities of $2.0 million for the quarter-ended March 31, 2006. 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 $0.5 million for the first quarter of 2007 and the first quarter of 2006 as we continued to make investments in our infrastructure to support our growth and productivity initiatives.

Net cash used in financing activities was $0.2 million for the first quarter of 2007 and net cash provided by financing activities was $0.1 million for the first quarter of 2006, primarily as a result of stock option exercises and, in the first quarter of 2007, from a decrease in notes payable to related parties.

We believe that our existing balances of cash and cash equivalents, together with cash generated from product sales, 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. 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 March 31, 2007:


			2007 (remaining 9
	Total		months)		2008		2009		2010		2011		Thereafter
Operating lease obligations	$	4,049,000	$	905,000	$	928,000	$	680,000	$	375,000	$	352,000	$	809,000

Open purchase orders		8,727,000		8,625,000		58,000		44,000		—		—		—

Notes payable to related parties		4,505,000		602,000		239,000		1,757,000		967,000		940,000		—


Total	$	17,281,000	$	10,132,000	$	1,225,000	$	2,481,000	$	1,342,000	$	1,292,000	$	809,000

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The following discussion analyzes our disclosure to 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 one large United States financial institution, one large Hong Kong financial institution, three large Shanghai financial institutions, one local Beijing financial institution, two large Beijing financial institutions and one large Danish financial institution. 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 March 31, 2007, we had cash and cash equivalents of $13.0 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 points, 1.5%) bps 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 first quarter of 2007, a substantial portion of our recognized revenue was denominated in U.S. dollars generated primarily from customers in the Americas (47%). Revenue generated from our European operations (14%) was primarily denominated in Euros while revenue generated by our Asia operations (39%) was primarily denominated in the Renminbi (“RMB”). 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 4.5% 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 a strategic investment in China with the acquisition of a 96% interest in RAE Beijing, a Beijing-based manufacturer and

distributor of environmental safety and security equipment. We also formed RAE Fushun in late 2006 to capitalize on increase 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 first 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 $125,000 for the quarter ended March 31, 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 $77,000 for the quarter ended March 31, 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 March 31, 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.

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 to ensure that the information from its Chinese subsidiaries has been properly adjusted to U.S. GAAP. These controls include:

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

	•		Provide the Company’s Chinese accounting staff 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 shall conduct extensive quarterly reviews of financial records of the Company’s Chinese operations.

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

Management believes the additional temporary reviews and monitoring procedures instituted by the Company in the first quarter of 2007 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. Polimaster moved for a preliminary injunction on June 17, 2005. The Court denied Polimaster’s request on September 6, 2005. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending arbitration by the parties.

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 $1.5 million for fiscal year 2006 and a net loss of $0.8 million 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 shareholders 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.

Recently enacted changes in the securities laws and regulations have and are likely to continue to increase our costs.

The Sarbanes-Oxley Act of 2002 (the “Act”) has required changes in some of our corporate governance, securities disclosure and compliance practices. In response to the requirements of the Act, the SEC and American Stock Exchange (“AMEX”) have promulgated new rules. Compliance with these new rules has increased our 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 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, which we refer to as “Homeland Security” herein, is a source for funding for many of our customers either directly or through grants to state and local agencies. The current Homeland Security budget increased by approximately 15% from $40.3 billion in fiscal year 2006 to $46.4 billion for fiscal 2007. 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 is done through the Federal Supply Schedules from the United States General Services Administration (GSA). Our GSA Schedule contract, like all others, includes 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 have agreed that the prices to the government under the GSA Schedules contract will 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 must be adjusted accordingly. Although we have undertaken 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, 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 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, are currently and may in the future be subject to claims, negotiations or complex, protracted litigation. 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.

For example, Polimaster Ltd. filed a complaint against us 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 we breached our contract with Polimaster and infringed upon Polimaster’s intellectual property rights. Polimaster moved for a preliminary injunction on June 17, 2005. The Court denied Polimaster’s request on September 6, 2005. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending arbitration by the parties.

Arbitration was formally commenced in June 2006 for the Polimaster matter. Polimaster’s Demand for Arbitration asserts damages totaling $13.2 million and seeks an injunction against sales of the Company’s Gamma Rae II and Neutron RAE II radiation detection products. We have asserted counterclaims against Polimaster for breach of contract and tortuous interference with contract, among other things, and seek monetary damages of its own. A ten day arbitration proceeding was completed on March 16, 2007. The arbitration was conducted under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. It is anticipated that the parties will file post-hearing briefs in May. It is expected that a decision from the arbitrator will be forthcoming 30 days after the post-hearing briefing is concluded. We believe the claim by Polimaster is without merit and we expect to vigorously defend our position. Were Polimaster to prevail in this arbitration, it would have a material adverse effect upon the business.

However, 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 55% of our Americas’ revenues from our sales distribution channels in fiscal year 2006. 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.

Future acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute stockholder value or harm our results of operations.

In 2006, we acquired Aegison Corporation, formed RAE Fushun and acquired an additional 32% of ownership of RAE Beijing. 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 if appropriate opportunities arise. The process of integrating any acquired business, technology, service or product into our business and operations 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.

Our ownership interest in Renex will 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 34% 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 34% of our common stock as of February 28, 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

None

Item 5. Other Information

None


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

Purchase price	$	2,027,000


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

Total	$	914,000


Exhibit
Number		Description of Document
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.


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


Exhibit
Number		Description of Document
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.

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	Page
Part I. Financial Information		3

Item 1. Financial Statements (Unaudited)		3

RAE Systems Inc. Condensed Consolidated Balance Sheets at March 31, 2007 and December 31, 2006		3

RAE Systems Inc. Condensed Consolidated Statements of Operations for the three-month periods ended March 31, 2007 and 2006		4

RAE Systems Inc. Condensed Consolidated Statements of Cash Flows for the three-month periods ended March 31, 2007 and 2006		5

RAE Systems Inc. Notes to Condensed Consolidated Financial Statements		6

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		15

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		29

Item 6. Exhibits		30

Signatures		31

Exhibits Index
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

	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)		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
		Robert I. Chen
		President, Chief Executive Officer and Chairman of the Board



May 9, 2007	By:	/s/ Robert I. Chen
		Robert I. Chen
		President, Chief Executive Officer and Chairman of the Board