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 September 30, 2007


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

For the transition period from to

Commission file number: 001-31783

RAE SYSTEMS INC.

(Exact name of registrant as specified in its charter)


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

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

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

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

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

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

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


Class		Outstanding at October 31, 2007

Common stock, $0.001 par value per share		59,171,980 shares

PART I. Financial Information

Item 1. Financial Statements

RAE Systems Inc.

Condensed Consolidated Balance Sheets

(in thousands, except share and par value data)
(unaudited)


	September 30,			December 31,
	2007			2006
ASSETS
Current assets:
Cash and cash equivalents	$	8,158		$	18,119
Short-term investments		—			3,248
Trade notes receivable		1,661			1,977
Accounts receivable, net of allowances of $1,510 and $843, respectively		24,597			16,966
Accounts receivable from affiliate		195			154
Inventories, net		17,994			15,382
Prepaid expenses and other current assets		3,677			2,530
Income taxes receivable		2,507			968
Deferred tax assets, current		1,106			935

Total current assets		59,895			60,279

Property and equipment, net		16,284			15,120
Acquisition in-progress		—			820
Intangible assets, net		3,271			5,304
Goodwill		3,058			3,760
Investment in unconsolidated affiliate		387			420
Deferred tax assets, non-current		2,864			3,402
Other assets		1,668			648

Total assets	$	87,427		$	89,753

LIABILITIES, MINORITY INTEREST IN CONSOLIDATED ENTITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	7,684		$	7,187
Accounts payable to affiliate		343			360
Payable to Fushun shareholders		1,516			3,926
Bank line of credit		6,720			—
Accrued liabilities		8,381			8,793
Notes payable to related parties, current		183			822
Income taxes payable		—			520
Deferred revenue, current		1,526			2,030

Total current liabilities		26,353			23,638

Deferred revenue, non-current		555			736
Deferred tax liabilities, non-current		448			438
Other long-term liabilities		1,246			1,045
Notes payable to related parties, non-current		2,327			3,222

Total liabilities		30,929			29,079

COMMITMENTS AND CONTINGENCIES (NOTE 5)

MINORITY INTEREST IN CONSOLIDATED ENTITIES		4,614			4,495


SHAREHOLDERS’ EQUITY:
Common stock, $0.001 par value, 200,000,000 shares authorized; 59,177,892 and 59,274,596 shares issued and outstanding, respectively		59			59
Additional paid-in capital		60,499			58,828
Accumulated other comprehensive income		2,639			1,245
Accumulated deficit		(11,313	)		(3,953	)

Total stockholders’ equity		51,884			56,179

Total liabilities, minority interest in consolidated entities and shareholders’ equity	$	87,427		$	89,753

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.

Condensed Consolidated Statements of Operations

(in thousands, except per share data)
(unaudited)


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006
Net sales	$	25,333		$	18,489		$	63,323		$	46,816
Cost of sales		12,011			8,588			30,880			21,743

Gross profit		13,322			9,901			32,443			25,073

Operating expenses:
Sales and marketing		6,021			4,040			17,323			12,531
Research and development		1,819			1,478			5,314			4,204
General and administrative		4,326			3,651			13,417			9,653
Adjustment to lease abandonment accrual		—			—			(595	)		—

Total operating expenses		12,166			9,169			35,459			26,388

Operating income (loss) from continuing operations		1,156			732			(3,016	)		(1,315	)
Other income (expense):
Interest income		26			195			145			629
Interest expense		(316	)		(73	)		(468	)		(159	)
Other, net		243			53			328			217
Equity in gain (loss) of unconsolidated affiliate		40			(54	)		(35	)		(235	)

Income (loss) from continuing operations before income taxes and minority interest		1,149			853			(3,046	)		(863	)
Income tax benefit (expense)		(270	)		(221	)		(403	)		264

Income (loss) before minority interest		879			632			(3,449	)		(599	)
Minority interest in income (loss) of consolidated subsidiaries		(4	)		(69	)		35			76

Income (loss) from continuing operations		875			563			(3,414	)		(523	)
Loss from discontinued operations, net of tax		(3,291	)		(51	)		(3,776	)		(51	)

Net income (loss)	$	(2,416	)	$	512		$	(7,190	)	$	(574	)


Basic net income (loss) per share
Continuing operations	$	0.01		$	0.01		$	(0.06	)	$	(0.01	)
Discontinued operations		(0.05	)		—			(0.06	)		—

Basic net income (loss) per share	$	(0.04	)	$	0.01		$	(0.12	)	$	(0.01	)

Diluted net income (loss) per share
Continuing operations	$	0.01		$	0.01		$	(0.06	)	$	(0.01	)
Discontinued operations		(0.05	)		—			(0.06	)		—

Diluted net income (loss) per share	$	(0.04	)	$	0.01		$	(0.12	)	$	(0.01	)


Weighted average common shares outstanding-Basic		58,889			58,546			58,806			58,179
Stock options and warrants		723			942			—			—

Weighted average common shares outstanding-Diluted		59,612			59,488			58,806			58,179

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.

Condensed Consolidated Statements of Cash Flows

(in thousands)
(unaudited)


	Nine Months Ended September 30,
	2007			2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(7,190	)	$	(574	)
Loss from discontinued operations		(3,776	)		(51	)

Loss from continuing operations		(3,414	)		(523	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		2,954			2,253
Loss on disposal of property and equipment		3			142
Stock based compensation expense		1,508			1,166
Equity in loss of unconsolidated affiliate		35			235
Minority interest in losses of consolidated subsidiary		(35	)		(76	)
Deferred income taxes		(37	)		10
Adjustment to lease abandonment accrual		(596	)		—
Amortization of discount on notes payable to related parties		66			132
Changes in operating assets and liabilities:
Accounts receivable		(6,057	)		(5,247	)
Accounts receivable from affiliate		(40	)		(39	)
Trade notes receivable		383			890
Inventories		(2,681	)		(1,943	)
Prepaid expenses and other current assets		(857	)		(13	)
Other assets		(1,004	)		192
Accounts payable		299			1,796
Accounts payable to affiliate		(25	)		72
Payable to Fushun shareholders		(2,435	)		—
Accrued liabilities		51			(197	)
Income taxes		(570	)		(1,249	)
Deferred revenue		(737	)		914
Other liabilities		(147	)		(332	)

Net cash used in operating activities of continuing operations		(13,336	)		(1,817	)
Net cash used in operating activities of discontinued operations		(1,029	)		(51	)

Net cash used in operating activities		(14,365	)		(1,868	)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments		—			(12,626	)
Proceeds from sales and maturities of investments		3,248			11,589
Proceeds from sales prior to maturity of investments		—			6,223
Business acquisitions, net of cash acquired		(1,014	)		(6,934	)
Acquisition of property and equipment		(2,587	)		(2,000	)

Net cash used in investing activities		(353	)		(3,748	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from the exercise of stock options and warrants		73			403
Repurchases of common stock		(315	)		—
Dividends paid		(22	)		—
Borrowings from bank line of credit		6,710			—
Payments on notes payable to related parties		(1,635	)		(400	)

Net cash provided by financing activities		4,811			3

Effect of exchange rate changes on cash and cash equivalents		(54	)		73
Decrease in cash and cash equivalents		(9,961	)		(5,540	)
Cash and cash equivalents at beginning of period		18,119			13,524

Cash and cash equivalents at end of period	$	8,158		$	7,984

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

Principles of Consolidation

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

Use of Estimates

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 shareholders’ equity. Realized gains and losses on available-for-sale securities are included in interest income.

Revenue Recognition

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

Share-Based Payments

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (R), Share-Based Payment, (“SFAS 123 (R)”). Accordingly, stock-based compensation cost is measured at grant date based on the fair value of the award and recognized in expense over the requisite service period.

The impact on the Company’s results from continuing operations of recording stock-based compensation by function for the three and nine month periods ended September 30, 2007 and 2006 was as follows:


	Three Months Ended				Nine Months Ended
(in thousands)	September 30,				September 30,
	2007		2006		2007		2006
Cost of sales	$	42	$	46	$	88	$	50
Sales and marketing		67		86		262		189
Research and development		87		65		254		134
General and administrative		274		269		904		793

Total	$	465	$	466	$	1,508	$	1,166

In addition, the Company recorded stock-based compensation expenses from discontinued operations of $549,000 and $47,000 during the third quarter of 2007 for sales and marketing and research and development, respectively. These costs are included in the loss from discontinued operations, net of tax on the Company’s Condensed Consolidated Statement of Operations.

The following is a summary of options (in thousands, except weighted-average exercise price):


	Options Outstanding
	Number			Weighted-Average
	Of Shares			Exercise Price
Balance as of January 1, 2007		3,139		$	3.22
Granted		—			—
Exercised		(27	)		2.55
Canceled		(19	)		3.91

Balance as of March 31, 2007		3,093			3.22
Granted		680			2.81
Exercised		(5	)		0.88
Canceled		(74	)		5.75

Balance as of June 30, 2007		3,694			3.10
Granted		150			2.34
Exercised		—			—
Canceled		(206	)		5.00

Balance as of September 30, 2007		3,638			2.98

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006
Expected volatility		65	%		77	%		65	%		78	%
Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Risk-free interest rate		4.4-4.9	%		4.9	%		4.4-5.0	%		4.8-5.1	%
Expected term in years		5.5			6.1			5.5			6.1
Weighted-average fair value	$	1.43		$	1.98		$	1.66		$	2.61

Stock Option Plans

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

As of September 30, 2007, the Company has reserved 235,870 shares of common stock for issuance under its 1993 Stock Option Plan, 3,161,797 shares under the 2002 Plan and 240,000 shares under the 2007 Plan. As of September 30, 2007, 3,966,086 shares of common stock remain available for future grants under the 2007 Plan.

Non-Plan Stock Options

In 2002, the Company granted certain of its directors options to purchase 400,000 shares of non-plan restricted stock at a weighted-average exercise price of $0.99. Twenty five percent of these options vested after one year with the remainder vesting monthly over the following three years. The vested shares are exercisable over ten years.

Non-Plan Restricted Stock

In August 2006, the Company granted 536,000 shares of restricted stock to four individuals as an inducement to enter the Company’s employ. Twenty five percent of this restricted stock or 134,000 shares vested in July 2007 with the remainder vesting quarterly over the following three years. The weighted-average fair value of these awards is $2.81.

In August 2007, concurrent with discontinuing the Company’s mobile digital video recording (“DVR”) business, the Company terminated two of these individuals. As a result, the remainder of their restricted stock awards or 203,571 shares vested immediately. See “Note 10. Discontinued Operations” for more detail.

As of September 30, 2007, 337,571 shares had vested and been released, and 198,429 shares were unvested.

Earnings Per Common Share

Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share reflects the potential dilution of common stock equivalents such as options and warrants, to the extent the impact is dilutive. Anti-dilutive shares excluded from diluted earnings per common share calculated for the three and nine month periods ended September 30, 2007 were 5,504,905 and 5,071,333, respectively. Anti-dilutive shares excluded from diluted earnings per common share calculated for the three and nine month periods ended September 30, 2006 were 2,286,936 and 3,113,257, respectively.

Segment Reporting

Statement of Financial Accounting Standard (“SFAS”) No. 131, Segment Reporting, establishes standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also established standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision-maker in deciding how to allocate and assess resources and performance. The Company’s chief operating decision-maker is the Chief Executive Officer. Although the Company’s operating divisions consist of entities geographically based in the Americas, Asia and Europe, the Company is in a single business segment worldwide in sale of portable and wireless gas and radiation detection products and related services. Accordingly, the Company operated as one reportable segment during the nine months ended September 30, 2007 and 2006.

Variable Interest Entities

S.A.R.L RAE France (“RAE France”) was identified by management as a variable interest entity. The Company is the primary beneficiary through its ownership of RAE Europe ApS. RAE France distributes and sells RAE products exclusively in France. RAE France had total sales of $675,000 and $556,000 in the three months ended September 30, 2007 and 2006, respectively, and total sales of $1,476,000 and $1,240,000 in the nine months ended September 30, 2007 and 2006, respectively. The Company has consolidated RAE France since December 2004.

Recent Accounting Pronouncements

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

In February 2007, the FASB issued SFAS No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115.” SFAS 159 expands the use of fair value

accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, a company may elect to use fair value to measure eligible items at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Eligible items include, but are not limited to, accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees, issued debt and firm commitments. If elected, SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing whether fair value accounting is appropriate for any of its eligible items and 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


(in thousands)	September 30,		December 31,
	2007		2006
Certificates of deposit	$	—	$	1,050
U.S. government agencies		—		2,198

	$	—	$	3,248

Inventory, net

Inventories are stated at the lower of cost or market and include material, labor and manufacturing overhead costs. The components of inventories were as follows:


(in thousands)	September 30,		December 31,
	2007		2006
Raw materials	$	5,380	$	4,675
Work-in-progress		3,009		1,858
Finished goods		9,605		8,849

	$	17,994	$	15,382

Prepaid expenses and other current assets


(in thousands)	September 30,		December 31,
	2007		2006
Supplier advances and deposits	$	2,072	$	1,671
Prepaid insurance		713		430
Other current assets		892		429

	$	3,677	$	2,530

Property and equipment, net


(in thousands)	September 30,			December 31,
	2007			2006
Buildings and improvements	$	9,265		$	8,150
Land		3,220			3,220
Equipment		4,719			4,043
Computer equipment		4,170			3,498
Automobiles		1,201			1,126
Furniture and fixtures		323			550
Construction in progress		1,057			53

		23,955			20,640
Less: Accumulated depreciation		(7,671	)		(5,520	)

	$	16,284		$	15,120

Intangible assets, net


(in thousands)	September 30, 2007							December 31, 2006
	Gross Carrying		Accumulated					Gross Carrying		Accumulated
	Amount		Amortization			Net Carrying Amount		Amount		Amortization			Net Carrying Amount
Customer list	$	2,611	$	(1,098	)	$	1,513	$	3,059	$	(676	)	$	2,383
Patent and technology		1,304		(502	)		802		1,966		(381	)		1,585
Trade name		1,496		(540	)		956		1,661		(401	)		1,260
Trade secret		—		—			—		79		(3	)		76

	$	5,411	$	(2,140	)	$	3,271	$	6,765	$	(1,461	)	$	5,304

Amortization expense associated with intangible assets was $174,000 and $267,000 for the three months ended September 30, 2007 and 2006, respectively, and $877,000 and $503,000 for the nine months ended September 30, 2007 and 2006, respectively. Based on the carrying amount of intangible assets as of September 30, 2007, and assuming no future impairment of the underlying assets, the estimated future amortization is as follows (in thousands):.


Years Ended December 31,
Remainder of 2007	$	206
2008		768
2009		706
2010		689
2011		399
Thereafter		503

Total amortization	$	3,271

Accrued liabilities


	September 30,		December 31,
(in thousands)	2007		2006
Compensation and related benefits	$	2,248	$	2,233
Accrued commission		1,461		1,815
Accrued professional fees		878		1,066
Other		3,794		3,679

	$	8,381	$	8,793

Note 3. Income Tax

The effective tax rate for the nine months ended September 30, 2007 was -13.74% of pretax income, compared to 23% of pretax loss in the third quarter of 2006. The Company calculated its 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 $55,000 for the accrual of interest applicable to uncertain tax positions through the period ended September 30, 2007.

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

Each quarter the Company assesses the likelihood that it will be able to recover its deferred tax assets in each of the jurisdictions where it operates. The Company considers all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and profitability in assessing the need for a valuation allowance. As a result of the Company’s analysis of all available evidence, it concluded that it is more likely than not that its net deferred tax assets will be realized, with the exception of the RAE Asia net operating losses which continue to carry a full valuation allowance. The Company continues 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.

The Company 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, the Company 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, $773,000 of the unrecognized benefit would reduce the effective tax rate. The Company anticipated a 2007 increase to the uncertain tax positions applicable to U.S and foreign transfer pricing exposures has been included as a component of the Company’s effective tax rate.

The Company conducts business globally and, as a result, the Company or one or more of its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions and, in the normal course of business, it is subject to examination by taxing authorities in each of these jurisdictions. Due to completed examinations, the Company is no longer subject to U.S. federal or state and local income tax examinations for years before 2005. The statute of limitations 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 the 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 adjustment was proposed. It is not currently under audit in any other tax jurisdictions.

Note 4. Comprehensive Income (Loss)

The components of comprehensive income (loss) were as follows:


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
(in thousands)	2007			2006		2007			2006
Net income (loss)	$	(2,416	)	$	512	$	(7,190	)	$	(574	)
Other comprehensive income:
Change in foreign currency translation		634			241		1,393			503
Change in unrealized loss on investments, net of tax		—			10		1			(4	)

Comprehensive income (loss)	$	(1,782	)	$	763	$	(5,796	)	$	(75	)

The Company’s accumulated other comprehensive income consists if the following:


	September 30,		December 31,
(in thousands)	2007		2006
Foreign currency translation adjustments	$	2,639	$	1,246
Unrealized loss on investments, net of tax		—		(1	)

Accumulated other comprehensive income	$	2,639	$	1,245

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 titled Polimaster Ltd. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that the Company breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. The dispute is subject to a contractual arbitration agreement, although the federal court has retained jurisdiction over the matter pending completion of the arbitration.

Polimaster initiated the arbitration on June 12, 2006, in a Demand for Arbitration asserting alleged damages totaling $13.2 million and seeking an injunction against sales of the Company’s Gamma Rae II and Neutron RAE II radiation detection products. The Company asserted counterclaims against Polimaster for breach of contract, among other things, and sought monetary damages of its own. The arbitration was conducted under the auspices of Judicial Arbitration and Mediation Services, Inc. (JAMS) in California. On July 13, 2007, the Company announced that it won the arbitration. In an Interim Award, dated July 5, 2007, the arbitrator ruled that Polimaster failed to prove its claims and was not entitled to any relief; that the Company had proven its counterclaims and is awarded damages of approximately $2.4 million; and that as the prevailing party, the Company was entitled to file an application for attorney’s fees and costs, which it did on July 20, 2007. The Interim Award was unsealed pursuant to a stipulation and order dated July 24, 2007.

A Final Award in the arbitration was issued on September 20, 2007, incorporating the contents of the Interim Award and awarding RAE recoverable costs in the amount of $46,000. On October 5, 2007, RAE filed a motion to confirm the Final Award. On October 17, 2007, Polimaster filed an opposition to RAE’s motion to confirm the Final Award and filed its own motion to vacate the Final Award. Both motions are set for hearing on December 7, 2007.

Although the Company has been awarded damages, attorney’s fees and costs, at this time, the Company is unable to determine whether it will be able to collect these amounts due to uncertainty regarding Polimaster’s financial condition and other factors.

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

Operating leases

The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the three months ended September 30, 2007 and 2006 was $278,000 and $146,000, respectively. Total rent expense for the nine months ended September 30, 2007 and 2006 was $789,000 and $498,000, respectively. Excluding the Sunnyvale, California abandoned building lease, future minimum annual lease payments under non-cancellable operating leases were as follows as of September 30, 2007 (in thousands):


Years Ended December 31,
Remainder of 2007	$	265
2008		761
2009		526
2010		374
2011		345
Thereafter		792

Total minimum operating lease payments	$	3,063

In December 2004, the Company purchased its current corporate headquarters in San Jose, California and abandoned a leased facility in Sunnyvale, California. During the second quarter of 2005, the Company accrued a restructuring reserve of approximately $2.0 million for the remaining lease term of the former headquarters in Sunnyvale. In March 2007, the Company revised the estimated loss on abandonment of the lease and reduced operating expense by $596,000. The change in estimate primarily reflected management’s expectation that the premises would be subleased under current market conditions for office rentals. During the second quarter of 2007, a sublease was executed with rents commencing in June. As of September 30, 2007, future discounted lease payments related to the Sunnyvale building are included in accrued liabilities totaling $253,000 and other long-term liabilities totaling $322,000. Future minimum annual lease payments relating to the Sunnyvale lease for each of the next three years, from 2007 (the remaining 3 months) through expiration of the lease in 2009, are $60,000, $315,000 and $303,000, respectively.

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 term of these indemnification agreements is generally perpetual and the maximum amount of potential future indemnification is unlimited. To date, the Company has not paid any amounts to settle such claims or defend related lawsuits.

Note 6. Warranty Reserves

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in thousands)	2007			2006			2007			2006
Warranty reserve at beginning of period	$	516		$	377		$	553		$	377
Provision for warranty		505			109			983			224
Utilization of reserve		(263	)		(68	)		(647	)		(219	)
Foreign currency translation effects		4			7			9			7
Adjustments related to pre-existing warranties (including changes in estimates)		(15	)		—			(151	)		36

Warranty reserve at end of period	$	747		$	425		$	747		$	425

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 is 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, based on the percentage of qualifying assets, has the full line available. As of September 30, 2007, there was approximately $5.5 million outstanding under the line of credit. Interest accrues at the floating prime bank lending rate minus 50 basis points. In addition, the Company pays 0.25% annually of the average unused portion of the facility.

On May 8, 2007, the Company signed a one year unsecured revolving credit agreement for Renminbi 20 million or approximately $2.66 million. Loan proceeds are primarily used to fund growth in China. As of September 30, 2007, Renminbi 9 million or approximately $1.2 million was outstanding under the line of credit. Interest accrues on this balance at a fixed rate of 6.48%.

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 September 30, 2007 and December 31, 2006, $183,000 and $822,000, respectively, were included in the current portion of notes payable to related parties and $2,327,000 and $3,222,000, respectively, were included in long-term notes payable to related parties. The future payment requirements for each of the next four years, from 2007 (the remaining three months) through final maturity in 2011, are $0, $183,000, $1,039,000, $633,000, and $655,000, respectively.

The notes issued in conjunction with the original RAE Beijing purchase in May 2004 were non-interest bearing and were recorded at net present value using a discount rate of 5.5%. In conjunction with the additional investment in RAE Beijing in July 2006, 11.0 million shares of preferred stock were issued to four shareholders of RAE Beijing. In accordance with SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”, these preferred shares were classified as liabilities as they are mandatorily redeemable and were recorded as long-term notes payable to related parties. These preferred shares bear a dividend yield of 3% per annum and were discounted using a market interest rate of 6.48%.

The Company has a 40% ownership interest in Renex Technologies Ltd. (“Renex”), a Hong Kong company, and is accounting for its investment in the entity using the equity method of accounting. Accordingly, the Company has recorded $40,000 and $(54,000) of equity in income (loss) of unconsolidated affiliate in the three months ended September 30, 2007 and 2006, respectively, and $(35,000) and $(235,000) in the nine months ended September 30, 2007 and 2006, respectively. Additionally, the Company pays a 7.5% royalty to Renex for using certain modems developed by Renex. The Company made royalty payments to Renex totaling $45,000 and $32,000 during the three months ended September 30, 2007 and 2006, respectively, and $70,000 and $88,000 during the nine months ended September 30, 2007 and 2006, respectively. The Company purchased inventories from Renex of $177,000 and $46,000 during the three months ended September 30, 2007 and 2006, respectively, and $273,000 and $247,000 during the nine months ended September 30, 2007 and 2006, respectively. The Company also made sales to Renex of $49,000 and $23,000 during the three months ended September 30, 2007 and 2006, respectively, and $166,000 and $71,000 for the nine months ended September 30, 2007 and 2006, respectively. The Company paid $63,000 and $114,000 to Renex relating to a research project in the three and nine months ended September 30, 2007, respectively. Accounts receivable due from Renex at September 30, 2007 and December 31, 2006 were $195,000 and $154,000, respectively. Accounts payable due to Renex at September 30, 2007 and December 31, 2006 were $340,000 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 $24,000 for the three months ended September 30, 2007 and 2006, and $72,000 for the nine months ended September 30, 2007 and 2006. Ms. Chen also receives standard employee benefits offered to all other full-time

employees located in the United States of America. Ms. Chen does not report directly to Robert Chen and accordingly, compensation decisions regarding Ms. Chen are performed in the same manner as other employees.

Note 9. Business Combinations

On January 3, 2007, RAE Systems (Asia) Ltd. entered into an agreement to purchase intellectual property from Tianjin Securay Technology Ltd. Co. (“Securay”) for Renminbi 12 million (approximately $1.5 million). This transaction, together with purchase agreements entered in 2006, completed our purchase of Securay. Including transactions entered into during 2006, the 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 Statement of Financial Accounting Standards No. 141, “Business Combinations”. The Company is in the process of completing the valuation of certain intangible assets and, accordingly, the purchase price allocation is subject to refinement. The following table allocates the purchase price to the preliminary fair values of assets acquired and liabilities assumed (in thousands):


Net tangible assets acquired:
Current assets	$	180
Property & equipment		287
Intangible assets acquired:
Technology		32
Trade name		141
Customer list		741
Goodwill		646

Total purchase price	$	2,027

The following table presents details of the purchased intangible assets (in thousands):


	Weighted
	Average
	Useful Life
	(Years)
Technology		5
Trade name		7
Customer List		7

Goodwill of $646,000 recorded in conjunction with the Securay purchase is not deductible for income tax purposes. The purchase of Securay has been deemed by management to be an immaterial business combination and therefore no pro forma information is included. In August 2007, the Company discontinued Securay’s operations. See “Note 10. Discontinued Operations” for more detail.

Note 10. Discontinued Operations

On August 24, 2007, the Board of Directors approved the discontinuation of the Company’s mobile DVR business in order to reduce expenses and concentrate its resources on the gas and radiation detection business. On August 28, 2007 the Company notified its DVR customers, terminated all personnel not reassigned to continuing operations and suspended the related production and sales activities. As the Company intends to keep the acquired intellectual property and because the DVR business operates at a substantial loss, management intends to liquidate the tangible assets, mainly inventories of component parts. Accordingly, the value of these assets has been adjusted to reflect the anticipated disposals.

As a result of discontinuing the DVR business and because it is not yet known when the Company might incorporate the acquired patents into its continuing operations, management impaired the remaining value of the intangible assets and goodwill acquired in the purchases of Aegison in July 2006 and Securay. Impairment expense recognized in the quarter ended September 30, 2007 totaled $3.0 million.

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the financial results of the DVR business are reported as discontinued operations for all periods presented. The financial results included in discontinued operations were as follows:

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

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

Overview

We are a leading global developer and manufacturer of rapidly-deployable, multi-sensor chemical and radiation detection monitors and networks. Founded in 1991 to develop technologies for the detection and early warning of hazardous materials, today we offer a full line of portable chemical and radiation detection solutions. These solutions have been deployed in over 65 countries on 6 continents and range from small handheld devices to rapidly deployable wireless systems to wall mounted facility safety solutions.

We are currently focused on delivering world wide solutions to four key market sectors:

	•		The Energy Market; which includes oil, natural gas, coal, and nuclear power.

	•		The Industrial Market; which includes metals production, chemical, plastics and industrial processes.

	•		The Global Environmental Market; which includes both regulatory compliance and environmental clean-up or remediation.

	•		And the Government Market; which includes solutions for emergency response, public safety, homeland security and defense applications.

Recent Developments

In China, our combination of Beijing and Fushun operations are delivering increased sales. With the conclusion of the 17th Chinese Peoples Congress, we continue to see a focus on increased worker safety, which we believe will have a positive impact on our future opportunities in China. In the Chinese oil and gas market, we sell fixed combustible and toxic gas monitors for both new installations and facility upgrades. In the energy market, the demand for our high-end products such as wireless equipped combustible and toxic gas monitors, including our AreaRAE Rapid Deployment Kits, continues to grow. In the industrial market, we continue to see demand for more personal protection equipment, including breathing apparatus and mobile quick breathing air filling stations. In the industrial market, we have contracts with long-term and new customers to provide gas monitors for production expansion and new facilities.

During 2007, RAE Fushun began operations and is contributing to the growth of our China operations. The Chinese Government has begun closing smaller unsafe coal mining operations and is expected to close up to 10,000 smaller and unsafe mines by the end of 2007. During the next 12 to 18 months, we expect to see an increase in the purchase of safety equipment as part of the government’s plan to improve mine safety.

In our Europe and Middle East regions, we continue to penetrate the industrial market with single gas detectors and our wireless AreaRAE Rapid Deployment Kits. In October we opened our new European headquarters facility in Copenhagen, Denmark to expand our capacity and better serve the European, Russian, and Middle Eastern Regions.

In the Americas, we won several US Government orders during the fourth quarter of the Federal fiscal year, including wing tank entry kits for military aviation safety from both the Navy and Air Force, orders from the EPA, FEMA, and the United States Postal Inspectors Service. We sold portable and wireless radiation detectors to multiple state and municipal first responders. Finally, we expanded market share in the industrial market with our new MiniRAE 3000, third generation photoionization detector.

During the second quarter of 2007, we received a final award in our arbitration with Polimaster. The arbitrator ruled that Polimaster failed to prove its claims and was not entitled to relief, while RAE Systems had proven its counter claims and was awarded damages of approximately $2.4 million plus attorney’s fees and costs. The final award was issued on September 20, 2007, incorporating the award for damages of $2.4 million and recoverable costs in the amount of $46,000. On October 5, 2007, RAE filed a motion to confirm the final award. On October 17, 2007, Polimaster

filed an opposition to RAE’s motion to confirm the final award and filed its own motion to vacate the final award. Both motions are set for hearing on December 7, 2007.

Critical Accounting Policies and Significant Management Judgments

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, we evaluate these estimates, including, but not limited to, those related to our revenue recognition, allowance for doubtful accounts, valuation of goodwill and other intangible assets, inventory valuation, valuation of deferred tax assets, warranty reserves and stock-based compensation expense. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates under different assumptions or conditions.

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

Revenue Recognition

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

Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

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

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

Inventory

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

Warranty Reserve

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

Share-Based Payments

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

Business Combinations

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

Management makes estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired companies and are 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 these projects when completed; the acquired company’s brand awareness and market position; and assumptions about the period of time an 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 statutory rates primarily due to foreign earnings taxed at lower rates, foreign losses not benefited, non-deductible share-based payment deductions under FAS 123(R) and provision changes for uncertain tax positions. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. We regularly assess the likelihood of adverse outcomes resulting from tax examinations to determine the adequacy of our provision for income taxes.

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

Recent Accounting Pronouncements

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

Results of Operations

Net Sales


	Three Months Ended									Nine Months Ended
	September 30,						Percentage			September 30,						Percentage
(in thousands)	2007		2006		Change		Change			2007		2006		Change		Change
Net sales	$	25,333	$	18,489	$	6,844		37	%	$	63,323	$	46,816	$	16,507		35	%

Net sales for the quarter ended September 30, 2007, increased by approximately $6.8 million (37%) over the quarter ended September 30, 2006. The increases in net sales for the quarter ended September 30, 2007, consisted primarily of increased sales of approximately $4.6 million (68%) in Asia, $0.6 million (25%) in Europe and $1.6 million (17%) in the Americas over the same period in 2006. The $4.6 million increase in Asia was primarily due to $3.5 million of sales from RAE Fushun in the third quarter of 2007, which was not included in 2006. The increased sales in Europe for the quarter ended September 30, 2007, compared to the quarter ended September 30, 2006, was primarily the result of increased sales of our products into the Eastern Europe and Middle East markets. The increase in the Americas was primarily related to strong demand for MultiRAEs for military applications, AreaRAEs for industrial turnarounds and RDKs for first responder.

Net sales for the nine-month period ended September 30, 2007 increased by $16.5 million (35%) over the same period in 2006. The increases in sales were primarily the result of increases in Asia of $11.1 million, the Americas of $3.7 million and Europe of $1.7 million. The increases during the nine-month period ended September 30, 2007 as compared to the nine-month period ended September 30, 2006 in Asia were primarily the result of sales from the joint venture at Fushun of $7.6 million during 2007 and increase in our sales in Asia Pacific. The increase in the Americas was primarily driven by an increase in the Americas sales force headcount, additional authorized service centers and higher demand in military and refinery industry turnaround markets. The increased sales in Europe were primarily in the Middle East markets during the nine-month period ended September 30, 2007 as compared to the nine-moth period ended September 30, 2006.

Cost of Sales & Gross Margin


	Three Months Ended											Nine Months Ended
	September 30,								Percentage			September 30,								Percentage
(in thousands)	2007			2006			Change		Change			2007			2006			Change		Change
Cost of sales	$	12,011		$	8,588		$	3,423		40	%	$	30,880		$	21,743		$	9,137		42	%
Gross profit	$	13,322		$	9,901		$	3,421		35	%	$	32,443		$	25,073		$	7,370		29	%
Gross margin		53	%		54	%							51	%		54	%

Cost of sales for the quarter ended September 30, 2007, increased by approximately $3.4 million (40%) over the quarter ended September 30, 2006, primarily as a result of increases in cost of sales due to the overall increased sales volume in Asia, which generally has higher product costs and lower margins than other market segments of the Company. Gross margin decreased by approximately 1% for the quarter ended September 30, 2007, compared to the quarter ended September 30, 2006. The decrease in gross margin was primarily due to increased sales from Asia.

Cost of sales for the nine-months ended September 30, 2007 increased by $9.1 million (42%) over the same period in 2006. The Company’s sales from RAE Fushun generally have a lower gross margin than other market segments, which resulted in approximately a 3% reduction in the Company’s overall margin for the nine-months ended September 30, 2007 as compared to the nine-months ended September 30, 2007.

Sales and Marketing Expense


	Three Months Ended											Nine Months Ended
	September 30,								Percentage			September 30,								Percentage
(in thousands)	2007			2006			Change		Change			2007			2006			Change		Change
Sales and marketing	$	6,021		$	4,040		$	1,981		49	%	$	17,323		$	12,531		$	4,792		38	%
Percentage of net sales		24	%		22	%							27	%		27	%

Sales and marketing expenses increased by approximately $2.0 million (49%) for the quarter ended September 30, 2007, compared to the quarter ended September 30, 2006, primarily due to a $0.3 million increase in payroll and benefit related expenses, as a result of headcount increases in the U.S., and from the formation of the joint venture in Fushun, China in December 2006, as well as $0.5 million of increased travel costs and $0.5 million of increased office and facility expenses. In addition, a $0.5 million increase in marketing expenses was due to higher demo units and trade show expenses in China.

Sales and marketing expenses increased by approximately $4.7 million (38%) for the nine-month period ended September 30, 2007 over the same period during 2006, primarily due to $1.6 million increased payroll and benefit related expenses, as a result of headcount increases in the U.S., and from the formation of the joint venture in Fushun, China in December 2006, as well as $1.0 million of increased travel costs and $0.8 million of increased office expenses. Marketing expenses increased by $0.9 million due to increases in demo units and certain major trade shows. Amortization expenses for intangibles related to the increase of our KLH ownership in June 2006 increased by $0.2 million.

Research and Development Expense


	Three Months Ended											Nine Months Ended
	September 30,								Percentage			September 30,								Percentage
(in thousands)	2007			2006			Change		Change			2007			2006			Change		Change
Research and development	$	1,819		$	1,478		$	341		23	%	$	5,314		$	4,204		$	1,110		26	%
Percentage of net sales		7	%		8	%							8	%		9	%

Research and development expenses increased by approximately $0.3 million (23%) during the quarter ended September 30, 2007, compared to the quarter ended September 30, 2006, primarily due to increases in payroll and benefit related expenses as well as increased office and facility expenses. Project expenses increased by $0.2 million mainly related to the addition of RAE Fushun which began operations in the first quarter of 2007.

Research and development expenses increased by approximately $1.1 million (26%) for the nine-month period ended September 30, 2007, primarily due to a $0.5 million increase in payroll and benefit related expenses. The $0.4 million increase in project expenses was due to the addition of RAE Fushun, which began operations in the first quarter of 2007, new projects in China and an increase in development expenses to qualify products for new markets in the U.S.

General and Administrative Expense


	Three Months Ended											Nine Months Ended
	September 30,								Percentage			September 30,								Percentage
(in thousands)	2007			2006			Change		Change			2007			2006			Change		Change
General and administrative	$	4,326		$	3,651		$	675		18	%	$	13,417		$	9,653		$	3,764		39	%
Percentage of net sales		17	%		20	%							21	%		21	%

General and administrative expenses increased by $0.7 million (18%) in the quarter ended September 30, 2007, compared to the quarter ended September 30, 2006, primarily comprised of $0.4 million in payroll and benefit related expenses due to increases in headcount in the U.S. and China, and a $0.3 million increase in office and facility expenses.

General and administrative expenses increased by approximately $3.8 million (39%) for the nine-months ended September 30, 2007 over the same period during 2006, primarily comprised of $0.7 million in payroll and benefit related expenses due to increases in headcount in the U.S. and China and a $0.5 million increase in office and facility expenses. The increase of $1.9 million in professional fees was primarily comprised of $1.4 million legal costs associated with the Polimaster arbitration, with the remaining balance related to accounting and tax services related to the international nature of the Company’s business.

Other Income/(Expense)


	Three Months Ended												Nine Months Ended
	September 30,									Percentage			September 30,									Percentage
(in thousands)	2007			2006			Change			Change			2007			2006			Change			Change
Interest income	$	26		$	195		$	(169	)		-87	%	$	145		$	629		$	(484	)		-77	%
Interest expense		(316	)		(73	)		(243	)		333	%		(468	)		(159	)		(309	)		194	%
Other, net		243			53			190			358	%		328			217			111			51	%
Equity in income (loss) of unconsolidated affiliate		40			(54	)		94			-174	%		(35	)		(235	)		200			-85	%

Total other income (expense)	$	(7	)	$	121		$	(128	)		-106	%	$	(30	)	$	452		$	(482	)		-107	%

For the quarter ended September 30, 2007, total other expense was $7,000 compared to total other income of $121,000 for the quarter ended September 30, 2006. The decrease was primarily the result of lower interest income as the Company has made substantial investments in RAE Beijing, RAE Fushun, Securay and Aegison Corporation since the first quarter of 2006. In addition, interest expense increased due to short term bank borrowings in the U.S. and China to support operations. Other expense was largely offset by realized and unrealized currency exchange gains in Europe and Asia as well as the earnings of an unconsolidated affiliate.

For the nine months ended September 30, 2007, total other expense was $30,000 as compared to total other income of $452,000 for the nine months ended September 30, 2006. The decrease in total other income was primarily the result of lower interest income following the Company’s investments in RAE Beijing, RAE Fushun, Securay and Aegison Corporation since the first quarter of 2006. In addition, interest expense increased due to short term bank borrowings in the U.S. and China to support operations. Other expense was largely offset by currency exchange gains in Europe and Asia as well as a much lower equity loss from an unconsolidated affiliate.

Income Tax Benefit/(Expense)


	Three Months Ended												Nine Months Ended
	September 30,									Percentage			September 30,									Percentage
(in thousands)	2007			2006			Change			Change			2007			2006			Change			Change
Income tax benefit (expense)	$	(270	)	$	(221	)	$	(49	)		22	%	$	(403	)	$	264		$	(667	)		-253	%
Effective tax rate		-24	%		28	%								-14	%		34	%

The tax expense for the nine month period ended September 30, 2007 was $403,000 or -14% of the income before income taxes, minority interest, discontinued operations and the cumulative effect on change in accounting principle, compared to a tax benefit of $264,000 or 34% of the income before income taxes and minority interest in the same period of 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” (“FIN 18”), the impact of items of tax expense (or benefit) that do not relate to “ordinary income” in the current year generally should be accounted for discretely in the period in which it occurs and be excluded from the effective tax rate calculation. The tax rate for the third quarter of fiscal year 2007 differed from the U.S. statutory rate primarily due to foreign earnings taxed at lower rates, nondeductible stock compensation deductions under FAS 123(R) and additional provisions for uncertain tax positions applicable to fiscal year 2007. Included in the tax expense for the nine months ended September 30, 2007 were discrete items of $55,000 related to the accrual of interest related to various uncertain tax benefits. The tax rate for the third quarter of fiscal year 2006 differed from the U.S. statutory rate primarily due to foreign earnings taxes at lower rates, foreign losses not benefited, nondeductible stock compensation deductions under FAS 123(R), Subpart F income inclusion and additional provisions for uncertain tax positions applicable to fiscal year 2006.

In the third quarter of 2007, we decided to discontinue operations for the Aegison and Securay lines of business. As such, the year to date loss before tax of $4,989,000 and the related tax benefit of $1,212,000 from these discontinued operations are reported separately in the financial statements as of September 30, 2007.

Minority Interest in Loss of Consolidated Entities


	Three Months Ended											Nine Months Ended
	September 30,								Percentage			September 30,							Percentage
(in thousands)	2007			2006			Change		Change			2007		2006		Change			Change
Minority interest in (income) loss of consolidated subsidiaries	$	(4	)	$	(69	)	$	65		-94	%	$	35	$	76	$	(41	)		-54	%

For the quarter ended September 30, 2007, the minority interest in the loss of consolidated entities was $4,000. The minority ownership was 4% of RAE Beijing, 30% of RAE Fushun and 51% of RAE France. During the quarter ended September 30, 2006, the minority interest in the loss of consolidated entities was $69,000. The minority ownership was 4% of RAE Beijing and 51% of RAE France.

For the nine months ended September 30, 2007, the minority interest in the income of consolidated entities was $35,000. The minority ownership was 4% of RAE Beijing, 30% of RAE Fushun and 51% of RAE France. During the nine months ended September 30, 2006, the minority interest in the income of consolidated entities was $76,000. The minority ownership was 36% of RAE Beijing through the second quarter of 2006 and 4% thereafter as well as 51% of RAE France.

Loss From Discontinued Operations

On August 24, 2007, the Board of Directors approved the discontinuation of the Company’s mobile DVR business in order to reduce expenses and concentrate resources on the Company’s gas and radiation detection business. On August 28, 2007 the Company notified its DVR customers, terminated all personnel not reassigned to continuing operations and suspended the related production and sales activities. As the Company intends to keep the acquired intellectual property and because the DVR business operates at a substantial loss, management intends to liquidate the tangible assets, mainly inventories of component parts. Accordingly, the value of these assets has been adjusted to reflect the anticipated disposals.


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in thousands)	2007			2006			2007			2006
Loss from discontinued operations before income taxes	$	4,348		$	73		$	4,988		$	73
Income tax benefit		(1,057	)		(22	)		(1,212	)		(22	)

Loss from discontinued operations	$	3,291		$	51		$	3,776		$	51

Liquidity and Capital Resources

We have financed our operations primarily through cash flow from operations, proceeds from the issuance of equity securities, and bank borrowings. As of September 30, 2007, we had $8.2 million in cash and cash equivalents compared with $21.4 million of cash, cash equivalents and investments at December 31, 2006. At September 30, 2007, we had $33.5 million of working capital and had a current ratio of 2.3 to 1.0 compared to $36.6 million of working capital and a current ratio of 2.6 to 1.0 at December 31, 2006.

On March 14, 2007, we signed a one year $15.0 million revolving credit agreement, which is available to help fund future growth and expansion. The agreement provides for borrowings up to $7.0 million based on a blanket security interest in our assets. An additional $8.0 million of borrowings will be available based on a percentage of qualifying assets. We are required to comply with certain bank specific reporting requirements whenever borrowings against the line of credit exceed $3.0 million, in addition to the on-going requirement to submit quarterly financial statements. We are in full compliance with all of the borrowing requirements, including certain financial covenants, and as such, have the full line available. As of September 30, 2007, there was approximately $5.5 million outstanding under the line of credit agreement.

On May 8, 2007, we signed a one year unsecured revolving credit agreement for Renminbi 20.0 million or approximately $2.66 million. Loan proceeds are primarily used to fund growth in China. As of September 30, 2007, Renminbi 9.0 million or approximately $1.2 million was outstanding under the line of credit.

A summary of our Condensed Consolidated Statement of Cash Flows follows:


	Nine Months Ended
	September 30,
(in thousands)	2007			2006
Net cash provided by (used in):
Operating activities	$	(14,365	)	$	(1,868	)
Investing activities		(353	)		(3,748	)
Financing activities		4,811			3
Effect of exchange rate changes on cash and cash equivalents		(54	)		73

Net decrease in cash and cash equivalents	$	(9,961	)	$	(5,540	)

Net cash used by operating activities for the nine months ended September 30, 2007, was $14.4 million compared to $1.9 million for the nine months ended September 30, 2006. The $12.5 million decrease in operating cash flows for the nine months ended September 30, 2007, versus the nine months ended September 30, 2006, was primarily due to application of $13.8 million towards operating assets and liabilities and an addition to cash flow of $3.9 million of non cash items contributed mainly by depreciation and amortization of $3.0 million stock-based compensation of $1.5 million offset by a $0.6 million gain towards lease abandonment.

Cash used in funding the changes in operating assets and liabilities during the nine month period ended September 30, 2007 was primarily made up of a $5.7 million increase in accounts receivable, $2.7 million increase in inventories (adjusted for reserves), a $0.9 million increase in prepaid expenses and other current assets, a $1.0 million increase in other assets, a $0.3 million decrease in accounts payable, a $0.6 million decrease in income taxes,a $0.7 million decrease in deferred revenue and a $0.1 million decrease in other liabilities.

Cash used in funding the changes in operating assets and liabilities during the nine month period ended September 30, 2006 was primarily made up of a $1.9 million increase in inventory, a $4.4 million increase in accounts receivable, and a $1.2 million decrease in income taxes, offset by a $1.9 million increase in accounts payable.

Net cash used by investing activities for the nine months ended September 30, 2007 and 2006, was $0.4 million and $3.7 million, respectively. Cash used by investing activities consisted mainly of $3.2 million proceeds from sales and maturities of investments offset by $1.0 million used in acquiring businesses and $2.6 million used in acquiring property and equipment during the first nine months of 2007. For the first nine months of 2006, we used $12.6 million to purchase investments, $6.9 million for acquisitions of businesses and $2.0 million to acquire property and equipment, offset by proceeds from sales of investments of $17.8 million.

Net cash provided by financing activities was $4.8 million and $3,000 for the nine months ended September 30, 2007 and 2006, respectively, primarily as a result of borrowings from our bank line of credit and the exercise of stock options, offset by decreases in notes payable to related parties.

We have reviewed options to monetize certain assets of the Company to increase our cash balances. Our goal is to finalize a transaction before December 31, 2007 that will result in a cash infusion to the Company. Upon expected completion of this transaction, we believe that our existing balances of cash and cash equivalents, cash generated from product sales and available bank line of credit will be sufficient to meet our cash needs for working capital and capital expenditures for at least the next twelve months. Our future capital requirements will depend on many factors that are difficult to predict, including the size, timing and structure of any future acquisitions, future capital investments, and future results of operations. Any future financing we may require may be unavailable or on unfavorable terms, if at all. Any difficulty in obtaining additional financial resources could force us to curtail our operations or could prevent us from pursuing our growth strategy. Any future funding may dilute the ownership of our current stockholders.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

Concentration of Credit Risk

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

Interest Rate Risk

As of September 30, 2007, we had cash and cash equivalents of $8.2 million. Changes to interest rates over time may reduce or increase our interest income from our interest bearing cash accounts. However, if, for example, there is a hypothetical 150 basis point (1.5%) change in the interest rates in the United States, the impact on our current cash and cash equivalents would be insignificant.

Foreign Currency Exchange Rate Risk

For the third quarter of 2007, a substantial portion of our recognized revenue was generated by our Asia operations (44%) and was primarily denominated in Renminbi (“RMB”). Revenue denominated in U.S. dollars is generated primarily from operations in the Americas (43%), and revenue from our European operations (13%) is primarily denominated in Euros. We manufacture a majority of our component parts at our manufacturing facility in Shanghai, China. Since January 2006, our operations in China have been affected by currency fluctuations due to an approximate 6.9% appreciation of the RMB relative to the U.S. dollar.

Our strategy has been to increase overseas manufacturing and research and development activities to capitalize on lower cost capacity and efficiencies in supply-chain management. In 2004 and 2006, we made strategic investments in China with the acquisition of a 96% interest in RAE Beijing, a Beijing-based manufacturer and distributor of environmental safety and security equipment and the formation of RAE Fushun in late 2006 to capitalize on increases in demand for safety equipment in the mining and energy market 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, there was a hypothetical 10% change in the RMB relative to the U.S. dollar, the effect on our profits would have been approximately $0.5 million for the nine months ended September 30, 2007. If the currencies in all other countries in Europe and Asia where we have operations were to change in unison with the RMB by a hypothetical 10% against the U.S. dollar, the approximate effect on our profits would be $0.4 million for the nine months ended September 30, 2007. The reduction in the impact of the RMB is due to the offset of changes in reported net sales in our other units resulting from changes in those countries local currencies.

Furthermore, to the extent that we engage in international sales denominated in U.S. dollars in countries other than China, any fluctuation in the value of the U.S. dollar relative to foreign currencies could affect our competitive position in the international markets. Although we 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

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 during the first three quarters of 2007 have mitigated the control deficiencies with respect to the preparation of this quarterly report on Form 10-Q.

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 September 30, 2007 based on the material weaknesses in internal control over financial reporting as identified in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

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.

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

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.

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. If we continue to border on profitability, any particular financial event could result in a relatively large change in our financial results or could be the difference between us having a profit or a loss for the particular quarter in which it occurs.

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 one current reports on Form 8-K during fiscal year 2006 (related to our acquisition of Fushun Anyi, Ltd.), 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.

From time to time we enter into government contracts that contain provisions which subject us 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 has been done through the Federal Supply Schedules from the United States General Services Administration (GSA). GSA Schedule contracts which we may enter into often include 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 may agree 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 when we are party to these contracts we undertake 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 occurs, 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. On July 13, 2007, the Company announced that it won the arbitration. In an Interim Award, dated July 5, 2007, the arbitrator ruled that Polimaster failed to prove its claims and was not entitled to any relief; that the Company had proven its counterclaims and is awarded damages of approximately $2.4 million; and that as the prevailing party, the Company was entitled to file an application for attorney’s fees and costs, which it did on July 20, 2007. The Interim Award was unsealed pursuant to a stipulation and order dated July 24, 2007.

A Final Award in the arbitration was issued on September 20, 2007, incorporating the contents of the Interim Award and awarding RAE recoverable costs in the amount $46,000. On October 5, 2007, RAE filed a motion to confirm the Final Award. On October 17, 2007, Polimaster filed an opposition to RAE’s motion to confirm the Final Award and filed its own motion to vacate the Final Award. Both motions are set for hearing on December 7, 2007.

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 shareholder 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. On August 24, 2007, the Board of Directors approved the discontinuation of the Aegison and Securay businesses. 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 shareholders beneficially own approximately 33% of our common stock and, accordingly, may exert substantial influence over the Company.

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

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

None

Item 3. Defaults Upon Senior Securities

None

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

None

Item 5. Other Information

None

Item 6. Exhibits

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


Exhibit
Number		Description of Document
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


Exhibit
Number		Description of Document
		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.

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents


			Page

Part I. Financial Information				3

	Item 1.	Financial Statements (Unaudited)		3

		RAE Systems Inc. Condensed Consolidated Balance Sheets at September 30, 2007 and December 31, 2006		3

		RAE Systems Inc. Condensed Consolidated Statements of Operations for the three-month and nine-month periods ended September 30, 2007 and 2006		4

		RAE Systems Inc. Condensed Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 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	17

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		24

	Item 4.	Controls and Procedures		25

Part II. Other Information				26
	Item 1.	Legal Proceedings		26

	Item 1A.	Risk Factors		26

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		32

	Item 3.	Defaults Upon Senior Securities		32

	Item 4.	Submission of Matters to a Vote of Security Holders		32

	Item 5.	Other Information		32

	Item 6.	Exhibits		32

Signatures				34

EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2