Form 10-Q

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 periods that the registrant was required to file such reports, and (2) has been subject to filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

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

In connection with becoming a public company through a reverse merger transaction, certain options under our 1993 Stock Plan became subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). As of December 31, 2002, there were 2,014,941 options outstanding under the 1993 Stock Plan that were subject to variable accounting. To eliminate the variable effects of such accounting treatment, we have adopted the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003 under the modified prospective method as provided for in SFAS 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. Our interim financial statements herein for the quarter ended March 31, 2003 reflect a non-cash compensation charge of $125,000. Stock-based compensation charges have significantly impacted our financial statements, and will continue to impact the financial statements on a prospective basis.

RAE Systems Inc. (“RAE”, the “Company”), established in 1991, is a leader in rapidly deployable sensing networks for homeland defense and a leading manufacturer of portable, wireless and fixed atmospheric monitors, photo-ionization detectors, radiation detectors, gas detection tubes, sampling pumps and security monitoring devices.

RAE’s products are used to detect weapons of mass destruction (WMD), environmental, safety, hazardous materials (HAZMAT), toxic industrial chemicals (TICs), petrochemicals, and semiconductor waste, including the detection of gamma rays, neutrons, combustible chemical and vapor accumulations, oxygen deficiencies, gasoline, benzene, paint, degreasers, jet fuel, carbon monoxide, hydrogen sulfide, carbon dioxide, and many other atmospheric hazards. RAE’s patented photo-ionization detector technology allows dependable, linear, part-per-billion range readings for many toxic chemicals and vapors that are effectively undetectable by any other means.

The Company’s customers include many of the world’s leading corporations in the airline, automotive, oil, computer and telecommunications industries. The Company also has significant numbers of instruments currently in service with many U.S. government agencies and the armed forces, and by numerous city, state and federal agencies and departments. RAE’s products are used in confined space entry monitoring programs throughout the world, and are used in civilian and government atmospheric monitoring programs in over 50 countries. A substantial number of municipal agencies and city departments have standardized their programs on the Company’s products for confined space and HAZMAT incident response. The Company is also a leading supplier of chemical detectors used for jet fuel vapor monitoring programs.

The Company sells its products through a network of approximately 180 distributors, which account for approximately 90% of its sales.

The Company has strategically redirected its focus on homeland security. To this extent, the Company launched a series of marketing campaigns geared towards this effort, and is starting to reap the benefits of these efforts, having sold a large number of MultiRAEs and MiniRAEs to various federal, state and local agencies and municipalities. The Company also saw an increase in the sales of our wireless smart sensing platform and solutions business, in which information from the gas detector is transmitted on a real-time basis to a base controller located up to two miles away. The Company recently launched a new campaign to sell its new suite of radiation detectors, and is starting to realize an increase in the sales of these products as well.

As discussed elsewhere in this report on Form 10-Q, RAE is currently involved in various legal proceedings. Regardless of the eventual outcome, such litigation will likely

be time consuming, and may result in the diversion of our internal resources. Each of the two remaining lawsuits is in a preliminary stage, therefore the eventual outcome of each is difficult to determine. Any adverse result in either of the lawsuits could materially affect RAE’s results of operations and financial position.

Management believes the following critical accounting policies affect its more significant estimates and assumptions used in the preparation of the condensed consolidated financial statements contained in this Form 10-Q.

The financial information presented in this Form 10-Q is not audited and is not necessarily indicative of the Company’s future consolidated financial position, results of operations or cash flows. The unaudited financial statements contained in this Form 10-Q have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position, results of operations and its cash flows for the stated periods, in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements include the accounts of RAE and its subsidiaries as described below. RAE owns 100% of RAE Systems Europe ApS (RAE Europe) and RAE Systems (Asia) Limited (RAE Asia). RAE Europe is a Denmark corporation which distributes and provides services for RAE’s products in Europe, Australia and New Zealand, and throughout the Middle East. RAE Asia is a Hong Kong holding corporation which owns (i) 100% of Wa-RAE Science Instruments, Ltd (Wa-RAE), (ii) 36% of REnex Technology Ltd (REnex) and (iii) 100% of RAE Systems Hong Kong Ltd. (RAE HK). Wa-RAE, which is incorporated in Jiading, Shanghai, designs and manufactures RAE’s products for final assembly in the United States. REnex, a Hong Kong based research and development corporation, designs and develops a wireless platform for detection and monitoring. RAE HK distributes and provides services for RAE’s products in Asia and the Pacific Rim.

All intercompany accounts and transactions have been eliminated in the consolidated financial statements.

RAE Asia’s equity interest in REnex has, in the accompanying financial statements, been accounted for under the equity method of accounting. Under the equity method of accounting, REnex’s results of operations are not reflected within the accompanying consolidated statements of operations; however, the Company’s share of the net loss of REnex is reflected in the equity in loss of unconsolidated affiliate in the accompanying consolidated statements.

The Company applies the provisions of SFAS No. 128, Earnings Per Share. SFAS No. 128 provides for the calculation of basic and diluted earnings per share. Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity. Anti-dilution provisions of SFAS No. 128 require consistency between diluted per-common-share amounts and basic per-common share amounts in loss periods. Incremental shares attributable to the assumed exercise of 3,107,571 outstanding options have increased diluted shares outstanding by 1,397,375 shares. Warrants to purchase 2,102,734 shares of common stock at prices between $1.19 per share and $1.34 per share, and non-plan options to purchase 400,000 shares of common stock at $0.98 per share, were not included in the computation of diluted earnings per share because the exercise prices were greater than the average market price of the common stock.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates are used for, but not limited to, allowance for doubtful accounts, inventory allowances, warranty costs, contingencies and taxes. Actual results could differ materially from those estimates. The following critical accounting policies are impacted significantly by judgments, assumptions, and estimates used in the preparation of the condensed consolidated financial statements.

The 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. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there were a deterioration of a major customer’s credit worthiness, or if actual defaults were higher than what has been experienced historically, the Company’s estimates of the recoverability of amounts due could be overstated. The Company’s operating results could be adversely affected.

Inventories are stated at the lower of cost (moving weighted average method) or market. Inventory purchases are typically based on estimated future demand. In the event of a sudden and significant decrease in demand for RAE’s products, or if there were a higher occurrence of inventory obsolescence due to changing technology and

customer requirements, RAE could be required to increase its inventory allowances. RAE’s gross margins could be adversely affected.

The Company generally provides a one to three year limited liability on its products and establishes the estimated costs of fulfilling these warranty obligations at the time the related revenue is recorded. Historically, warranty costs have been insignificant. If the Company were to experience an increase in warranty claims compared to its historical experience, or costs of servicing warranty claims were greater than expectations on which the warranty reserve has been based, RAE’s operating results could be adversely affected.

RAE is subject to various loss contingencies arising in the ordinary course of business. The Company considers the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as its ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when management concludes that it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. The Company regularly evaluates current information available to determine whether such accruals should be adjusted.

The Company recognizes deferred tax assets (future tax benefits) and liabilities for the expected future tax consequences of temporary differences between the book carrying amounts and the tax basis of assets and liabilities. The deferred tax assets and liabilities represent the expected future tax return consequences of those differences, which are expected to be either deductible or taxable when the assets and liabilities are recovered or settled. Future tax benefits pertaining to unrealized foreign losses have been fully offset by a 100% valuation allowance as management is unable to determine that it is more likely than not that this deferred tax asset will be realized.

In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (SFAS 145). This statement amends existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of SFAS 145, which the Company adopted during 2002, did not have a material impact on the Company’s financial position or results of operations.

In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities (SFAS 146). This Statement requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. SFAS 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of this Statement are effective for exit or disposal activities that are initiated after December

31, 2002. The adoption of this Statement did not have a material impact on the Company’s financial position or results of operations.

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123 (SFAS 148). This statement provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock based compensation. It also amends the disclosure provisions of SFAS 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. Further, SFAS 148 amends Accounting Principles Board Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. The Company has elected to adopt the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003 under the modified prospective method as provided for in SFAS 148. The effects of the adoption of SFAS 123 in accordance with SFAS 148 are reflected in the Company’s financial statements.

In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45). FIN 45 requires a guarantor to recognize, at the inception of a qualified guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 is effective on a prospective basis for qualified guarantees issued or modified after December 31, 2002. The adoption of this Interpretation did not have a material impact on the Company’s financial position or results of operations.

On October 23, 2001, the estate of Virgil Johnson filed a products liability and wrongful death lawsuit against the Company in the District Court of Harris County, Texas. The plaintiffs allege that the Company’s product was defective and unsafe for its intended purposes at the time it left the Company’s premises, and that the product was defective in that it failed to conform to the product design and specifications of other gas monitors. Additionally, the plaintiffs allege that the product was defectively designed and marketed so as to render it unreasonably dangerous to the plaintiff. In the event that the Company does not have adequate insurance coverage for the expenses related to the lawsuit, the Company may incur substantial legal fees and expenses in connection with the litigation. The litigation may also result in the diversion of the Company’s internal resources. The Company’s defense of this litigation, regardless of its eventual outcome, will likely be costly and time consuming. The litigation is in the preliminary stage, and management is unable to predict its final outcome. However, an adverse outcome could materially affect the Company’s results of operations and financial position.

On March 26, 2002, Straughan Technical Distribution, LLC, filed a lawsuit against the Company in the Superior Court of the State of California for the County of

Santa Clara. A similar lawsuit pending in District Court of Harris County, Texas was served on the Company on March 27, 2002. In these nearly identical lawsuits, Straughan, a distributor of Gastec Gas Detection Devices, claims to have experienced diminished sales to its customers, loss of profits and other damages as a result of the stated allegations, which include claims for interference with present and prospective business relations, false advertising, trade dress infringement, slander and antitrust violations. On April 17, 2002, the Company removed the California action to the United States District Court for the Northern District of California, and on April 18, 2002, the Company removed the Texas action to the United States District Court for the Southern District of Texas. On October 8, 2002, the principals of Straughan and RAE Systems met and discussed potential settlement opportunities. In February 2003, the Company agreed with Straughan to settle all claims asserted against each other. The Company is currently finalizing the terms of the settlement agreement.

In addition to the litigation described above, the Company may be subject to various legal proceedings and claims that arise in the ordinary course of business.

During the first quarter of fiscal 2003, the Company adopted the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, (SFAS 123) for stock-based employee compensation, effective as of January 1, 2003. Under the modified prospective method of adoption selected by the Company, stock-based employee compensation cost recognized in 2003 is the same as that which would have been recognized had the fair value recognition provisions of SFAS 123 been applied to all awards granted. The following table illustrates the effect on net income (loss) and earnings (loss) per share as if the fair value based method had been applied to all outstanding and unvested awards in each period.

Product warranty liabilities are provided for as described in Note 2 to these condensed consolidated financial statements. Following is a summary of the changes in these liabilities during the quarters ended March 31, 2003 and 2002:

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, the Company cannot guarantee future results, performance, or achievements. For further information, refer to the section entitled “Factors that May Affect Future Results” in 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.

Net Sales. Net sales increased from $4.5 million for the quarter ended March 31, 2002 to $7.3 million for the quarter ended March 31, 2003, an increase of 61.5%. This increase was due to a significant increase in government sales, particularly for homeland security where we recognized a significant increase in sales of our MultiRAE and MiniRAE 2000. We also experienced a substantial increase in Europe and Asia for the monitoring of toxic gases in confined space entry.

Cost of Sales. Cost of sales increased from $2 million for the quarter ended March 31, 2002 to $2.9 million for the quarter ended March 31, 2003, an increase of 43.9%. This increase was primarily due to an increase in the sales volume. Gross margins increased from $2.5 million, or 55.5% of revenue, for the quarter ended March 31, 2002 to $4.4 million, or 60.3% of revenue, for the quarter ended March 31, 2003. This increase was due to increased efficiency in production resulting from an increase in the sales volume. It was also a result of a decrease in the cost of our material.

Sales and Marketing. Sales and marketing expenses increased from $1.1 million for the quarter ended March 31, 2002 to $1.5 million for the quarter ended March 31, 2003, an increase of 37%. Our sales and marketing cost increased in the United States as a result of increases in our personnel and advertising expenses of $252,700 to support our homeland defense position, our wireless systems solution, and our new suite of radiation detectors. Our expenses increased in Europe by $136,500 to build the infrastructure to support the European sales and service center.

Research and Development. Research and development expenses increased from $594,000 for the quarter ended March 31, 2002 to $706,000 for the quarter ended March 31, 2003, an increase of 18.9%. The increase in research and development expenses of $112,000 was primarily the result of an increase in headcount to support further development of the wireless systems solution, as well as the development of our radiation detectors and sensors.

General and Administrative. General and administrative expenses increased from $845,200 for the quarter ended March 31, 2002 to $1.2 million for the quarter ended March 31, 2003, an increase of 40.5%. Due to the adoption of the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003, under the modified prospective method as provided for in SFAS 148, we incurred a non-cash compensation charge of $125,000 in connection with our outstanding options under our 1993 and 2002 stock option plans in the first quarter of 2003 as compared to a non-cash compensation charge of $49,200 in the same period of 2002. Additionally, certain costs associated with the Company’s operations as a public company increased general and administrative costs by $159,300 from the same period last year, including fees for public relations, investor relations, the design and distribution of our annual report and the cost of our D&O insurance.

Legal Fees and Settlement Costs. Legal fees and settlement costs increased from $77,900 for the quarter ended March 31, 2002 to $88,600 for the quarter ended March 31, 2003, an increase of 13.7%. Our legal costs were primarily for corporate matters, including the preparation and review of our Form 10-K and proxy statement for our annual meeting. Also included were fees associated with the lawsuits described in detail elsewhere in this Form 10-Q.

Other Income (Expense), net. Other expenses for the quarter ended March 31, 2002 was $109,100. For the same period in 2003, we had other expenses of $63,900, a change of

$45,200. The change was primarily due a decrease in interest expense resulting from the repayment of outstanding loans ($51,000).

Income Taxes. During the quarter ended March 31, 2003, we recognized a tax expense of $135,400, consisting of a provision of $400,000 relating to the current quarter pre-tax income, reduced by $264,600 relating to the settlement with the Internal Revenue Service of certain outstanding tax assessments originating in prior years.

Net Income (Loss). Net loss for the quarter ended March 31, 2002 was $179,000. For the same period in 2003, we had a net profit of $775,000. The increase was primarily the result of significant increases in sales from the government and from our international customers.

To date, we have financed our operations primarily through bank borrowings, revenues from operations and proceeds of issuances of equity securities. As of March 31, 2003, we had $7.4 million in cash and cash equivalents. At March 31, 2003, we had $9.4 million of working capital (the excess of current assets over current liabilities) and had a current ratio of 2.6 to 1.0.

Net cash provided by operating activities for the quarter ended March 31, 2003 was $359,000, as compared with net cash provided by operating activities of $560,300 for the quarter ended March 31, 2002. For the quarter ended March 31, 2003, changes in operating assets and liabilities used $836,500 in operating cash flows, whereas for the quarter ended March 31, 2002, operating assets and liabilities provided $676,500 in operating cash flows. The unfavorable effects on operating cash flows resulting from the change in operating assets and liabilities is primarily reflected in accounts receivable in the amount of $923,200 resulting from significant increases in sales, and inventories in the amount of $393,200 in anticipation of future growth. These were partially offset by accounts payable in the amount of $534,200.

Net cash used in investing activities for the quarter ended March 31, 2003 was $137,900, as compared with net cash used in investing activities of $1,600,900 for the quarter ended March 31, 2002. Cash used by investing activities in the quarter ended March 31, 2003 consisted primarily of acquisition of property and equipment in the amount of $116,000. Cash used by investing activities in the quarter ended March 31, 2002 consisted primarily of cash relinquished in the deconsolidation of REnex of $878,300 and investment in affiliate of $500,000.

Net cash used by financing activities for the quarter ended March 31, 2003 was $32,400 as compared with $31,900 for the quarter ended March 31, 2002. Cash used by financing activities for the quarter ended March 31, 2003 was primarily the result of payments on capital leases in the amount of $52,400, partially offset by the issuance of common stock for cash proceeds in the amount of $20,000.

We believe that our existing balances of cash and cash equivalents, together with cash generated from product sales, will be sufficient to meet our cash needs for working capital and capital expenditures for at least the next twelve months. Our future capital requirements will depend on many factors that are difficult to predict, including the size, timing and structure of any future acquisitions, future capital investments, and future

results of operations. Any future financing we may require may be unavailable on favorable 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 shareholders.

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

Currently, we have cash and cash equivalents deposited with four large United States financial institutions, one large Hong Kong financial institution, and one large Danish financial institution. Our deposits may exceed the amount of insurance available to cover such deposits. To date, we have not experienced any losses of deposit of cash and cash equivalents. Management regularly reviews our deposit amounts and the credit worthiness of the financial institution which holds our deposits.

As of March 31, 2003, we had cash and cash equivalents of $7.4 million consisting of cash and highly liquid short-term investments. The impact of interest rate fluctuations was immaterial. Declines of interest rates over time will, however, reduce our interest income from our short-term investments.

To date, substantially all of our recognized revenue has been denominated in United States dollars and generated primarily from customers in the United States, and our exposure to foreign currency exchange rates has been immaterial. We expect, however, that future products and service revenue may also be derived from international markets and may be denominated in the currency of the applicable market. As a result, our operating results may become subject to significant fluctuations based upon changes in exchange rates of specific currencies in relation to the United States dollar. Furthermore, to the extent that we engage in international sales denominated in United States dollars, any fluctuation in the value of the United States dollar relative to foreign currencies could affect our competitive position in the international markets. Although we would continue to monitor our exposure to currency fluctuations, and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, we cannot assure you that exchange rate fluctuations will not adversely affect our financial results in the future.

Currently, we are holding foreign currency at our Hong Kong and Danish banks. The risk associated with such holdings is immaterial.

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 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 would significantly decline.

Because our expense levels are based in large part on estimates of future revenues, an unexpected shortfall in revenue would significantly harm our results of operations.

Our expense levels are based largely on our investment plans and estimates of future revenue. We may be unable to adjust our spending to compensate for an unexpected shortfall in revenue. Accordingly, any significant shortfall in revenue relative to our planned expenditures in a particular quarter would harm our results of operations and could cause our stock price to fall sharply, particularly following quarters in which our operating results fail to meet the expectations of securities analysts or investors.

Our ownership interest in REnex will cause us to incur losses that we would not otherwise incur.

We own approximately 36 percent of REnex, a wireless systems development company. As such, we are required to incorporate our share of the losses into the Consolidated Statements of Operation. REnex is still in the research and development stage, and to date, REnex has not generated any revenues. 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.

The adoption of the fair value recognition provisions of SFAS 123 for stock-based employee compensation as provided for in SFAS 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123 will have a significant impact on the Company’s financial statements.

In connection with becoming a public company through a reverse merger transaction, certain options under our 1993 Stock Plan became subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). As of December 31, 2002, there were 2,014,941 options outstanding under the Plan that were subject to variable accounting. To eliminate the variable effects of such accounting treatment, we have adopted the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003 under the modified prospective method as provided for in SFAS 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. Our interim financial statements herein for the quarter ended March 31, 2003 reflect a non-cash compensation charge of $125,000. Stock-based compensation charges have significantly impacted our financial statements, and will continue to impact our financial statements on a prospective basis.

We may be unable to meet our future capital requirements. Any attempts to raise additional capital in the future may cause substantial dilution to our stockholders.

We may need to seek additional funding in the future and it is uncertain whether we will be able to obtain additional financing on favorable terms, if at all. Further, if we issue equity securities in connection with additional financing, our stockholders may experience dilution and/or the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any of which could seriously harm our business.

Should the benefits of our inventory procurement strategy in Asia not materialize as we anticipate, our results of operations may suffer.

As part of our overall strategy to increase gross margins and improve operating results, we are executing on a strategy to procure a number of our component parts closer to our production source in Asia. In the past, our strategy involved the purchase of parts in, and delivery of parts from our vendors, to the United States. The parts were then kitted, and shipped to Shanghai, where the subassemblies were made. Our current strategy involves the procurement of component parts in Asia, where the effective price is much lower. The parts will be shipped directly to Shanghai, thereby reducing the transit time and shipping cost of the inventory. The execution of the current strategy may have some adverse consequences. Our vendors have to be qualified to ensure that the parts are of acceptable quality and meet the requisite specifications called for by engineering drawings. A significant amount of time and funding may be required to complete the

analysis. Should we fail to execute on the currently procurement strategy in an effective manner, our results of operations may suffer.

We derive approximately 90% of our revenues via our sales distribution channels, and therefore are dependent on our distributors. Should any of our principal distributors, or a significant group of our distributors, experience financial difficulties or become unwilling to promote and sell our products for any reason, our business and results of operations could be materially harmed.

We are dependent on third party suppliers for our component parts, including various sensors, microprocessors and other material components. Should there be any interruption in the supply of these component parts, our business could be adversely affected.

If our expansion from a gas detection instrument manufacturer to a wireless systems and radiation detection company is unsuccessful, our business and results of operations will suffer.

We are in the process of expanding our current business of providing gas detection instruments to include radiation detection and wireless systems for local and remote security monitoring. The pricing of our radiation detection products and wireless products and services may be subject to rapid and frequent change. We may be forced for competitive or technical reasons to reduce prices for our products, which would reduce our revenue and could harm our business. Further, 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, our business and results of operations will be harmed.

The economic downturn in the United States and abroad could have a material adverse impact on our business and results of operations.

While our business to date has been minimally impacted by the current economic downturn in the United States and abroad, it could eventually succumb to such conditions. Many of our customers have already experienced severe declines in their revenues, which could impact the size and frequency of their purchases of our products and services. Although we routinely perform credit checks on our customer base to assess their creditworthiness, there can be no assurance that we will be able to collect payments from our customers as they become due. Any decrease in the size or frequency of purchases by our customers, or a failure by us to collect payments as they become due could have a material adverse impact on our business and results of operations.

Compliance with safety regulations could delay new product delivery and adversely affect our results of operations.

Compliance with safety regulations, specifically the need to obtain UL, CUL, ATEX and EEX approvals, could delay the introduction of new products by us. As a result, we may experience delays in realizing revenues from our new products, which could have an adverse effect on our results of operations.

A deterioration in trade relations with China could have a material adverse effect on our business and results of operations.

A significant portion of our products and components are manufactured at our wholly-owned facility in Shanghai, China. Should trade relations between the United States and China deteriorate, our ability to transfer products between China and other regions of the world, including the United States, Asia and Europe, could be significantly impacted. As a result, our business and results of operations would suffer.

On October 23, 2001, the estate of Virgil Johnson filed a products liability and wrongful death lawsuit against us in the District Court of Harris County, Texas. The plaintiffs allege that our product was defective and unsafe for its intended purposes at the time it left our premises, and that the product was defective in that it failed to conform to the product design and specifications of other gas monitors. Additionally, the plaintiffs allege that the product was defectively designed and marketed so as to render it unreasonably dangerous to the plaintiff. In the event that we do not have adequate insurance coverage for the expenses related to the lawsuit, we may incur substantial legal fees and expenses in connection with the litigation. The litigation may also result in the diversion of our internal resources. Our defense of this litigation, regardless of its eventual outcome, will likely be costly and time consuming. The litigation is in the preliminary stage, and we are unable to predict its final outcome. However, an adverse outcome could materially affect our results of operations and financial position.

On March 26, 2002, Straughan Technical Distribution, LLC, filed a lawsuit against us in the Superior Court of the State of California for the County of Santa Clara. A similar lawsuit pending in District Court of Harris County, Texas was served on us on March 27, 2002. In these nearly identical lawsuits, Straughan, a distributor of Gastec Gas Detection Devices, claims to have experienced diminished sales to its customers, loss of profits and other damages as a result of the stated allegations, which include claims for interference with present and prospective business relations, false advertising, trade dress infringement, slander and antitrust violations. On April 17, 2002, we removed the California action to the United States District Court for the Northern District of California, and on April 18, 2002, we removed the Texas action to the United States District Court for the Southern District of Texas. On October 8, 2002, the principals of Straughan and RAE Systems met and discussed potential settlement opportunities. In

February 2003, we agreed with Straughan to settle all claims asserted against each other. We are currently finalizing the terms of the settlement agreement.

In addition to the litigation described above, from time to time we may be subject to various legal proceedings and claims that arise in the ordinary course of business.

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

The market for gas detection monitoring devices is highly competitive. We expect the emerging wireless gas monitoring system market to be equally competitive. Competitors in the gas monitoring industry differentiate themselves on the basis of their technology, quality of product and service offerings, cost and time to market. In the market for gas detection monitoring devices, our primary competitors include Industrial Scientific Corporation, Mine Safety Appliances Company, BW Technologies, Ion Science, PerkinElmer, Inc., Drager Safety Inc., Gastec Corporation and Bacou-Dalloz. Most of our competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than us. In addition, some of our competitors may be able to:

We may not be successful in 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 Systems 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.

Our future success depends on our ability to attract, retain and motivate highly skilled employees. Despite the recent economic slowdown, competition for qualified employees in the Silicon Valley, particularly management, technical, and sales and marketing personnel, is intense. Although we provide compensation packages that include stock options, cash incentives and other employee benefits, we may be unable to retain our key employees or to attract, assimilate and retain other highly qualified employees in the future, which could harm our business.

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, including Robert I. Chen, Joseph Ng, Peter Hsi and Hong Tao Sun. The loss of the services of any of our executive officers could harm our business.

We might not be successful in the development or introduction of new products and services in a timely and effective manner.

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 addition, product innovations may not achieve the market penetration or price stability necessary for profitability.

Our officers, directors and principal stockholders beneficially own approximately 64% 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 64% of our common stock. These stockholders acting together have the ability to control 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.

Future sales of our common stock by existing stockholders could adversely affect our stock price.

Sales of substantial amounts of our common stock in the public market in connection with this offering could reduce the prevailing market prices for our common stock. We registered the resale of approximately 42,671,491 shares of common stock (including shares underlying outstanding warrants to purchase our common stock) on a registration statement on Form S-1. Of these shares, approximately 12,680,080 were subject to six month lock-up agreements which expired on October 9, 2002 and 23,261,326 were subject to one year lock-up agreements which expired on April 9, 2003. Future sales by the holders of such shares could adversely affect the trading price of our common stock.

Our facilities and operations are vulnerable to natural disasters and other unexpected losses.

Our success depends on the efficient and uninterrupted operation of our business. Our facilities in Sunnyvale, California are in an area that is susceptible to earthquakes. We do not have a backup facility to provide redundant capacity in the event of a natural disaster or other unexpected damage from fire, floods, power loss, telecommunications failures, break-in and similar events. If we seek to replicate our operations at other locations, we will face a number of technical as well as financial challenges, which we may not be able to address successfully. Although we carry property and business interruption insurance, our coverage may not be adequate to compensate us for all losses that may occur.

Our business is subject to risks associated with conducting business internationally.

Our business is subject to risks normally associated with conducting business outside the United States, such as foreign government regulations, nation-specific or region-specific certifications, political unrest, disruptions or delays in shipments, fluctuations in foreign currency exchange rates and changes in the economic conditions in the countries in which our raw materials suppliers, service providers, and customers are located. Our business may also be adversely affected by the imposition of additional trade restrictions related to imported products, including quotas, duties, taxes and other charges or restrictions. If any of the foregoing factors were to render the conduct of business in a particular country undesirable or impractical, or if our current foreign manufacturing sources were to cease doing business with us for any reason, our business and results of operations could be adversely affected.

For example, recently, we were informed that certain of our intercompany shipments between the United States and China were not compliant with the Chinese customs requirements. Although we believe that changes we are implementing to our standard procedures will avoid such issues in the future, there can be no assurance that we will not have issues in the future in China or other jurisdictions or that any such problems will not result in fines or restrictions on our operations that could adversely affect our business.

Our business is subject to risks associated with Severe Acute Respiratory Syndrome (SARS).

Our manufacturing facility located in Jia Ding, Shanghai, and sales office in Hong Kong are located in regions where the outbreak of SARS is prevalent. Although none of our employees have experienced any cases of SARS, the transient nature of the disease and local government reactions to the disease is such that in the event that any of our employees experience SARS or SARS cases become more prevalent, our operations in such areas may be subject to interruption and our business may suffer.

We regard our intellectual property as critical to our success. We rely on patent, trademark, copyright and trade secret laws 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. Our ability to compete is affected by our ability to protect the Company’s intellectual property rights. We rely on a combination of patents, trade secrets, non-disclosure agreements and confidentiality procedures. 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. Specifically, 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 materially adverse impact our business and results of operations.

We might face intellectual property infringement claims that might be costly to resolve.

We may, from time to time, be subject to claims of infringement of other parties’ proprietary rights or claims that our own trademarks, patents or other intellectual property rights are invalid. Any claims of this type, regardless of merit, could 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.

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

We may acquire or make 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.

Provisions in our charter documents and Delaware law could prevent or delay a change in control of the company, which could reduce the market price of our common stock or discourage potential acquirers from offering a premium over the prevailing trading price of our common stock.

Provisions in our certificate of incorporation and bylaws could have the effect of delaying or preventing a change of control of the company or changes in our

management. In addition, provisions of Delaware law may discourage, delay or prevent a third party from acquiring or merging with us. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions may also have the effect of discouraging or preventing a potential acquirer from offering our stockholders a premium over the prevailing trading price of our common stock.

(a) Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), within 90 days of the filing date of this report. Based on their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective.

(b) There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced in paragraph (a) above.

We are involved in several legal proceedings as discussed in Note 3—“Commitments and Contingencies” in this Form 10-Q.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on May 1, 2003.

RAE SYSTEMS INC.

By:		/s/ JOSEPH NG
		Joseph Ng Chief Financial Officer and Vice President, Business Development

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

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

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


Delaware		77-0588488

(State or other jurisdiction		(I.R.S. Employer

of incorporation)		Identification No.)


Class		Outstanding at May 1, 2003

Common Stock, $0.001 Par Value		45,825,127

Part I. Financial Information			3

	Item 1. Financial Statements (Unaudited)		4

		(a) RAE Systems Inc. Condensed Consolidated Balance Sheets at March 31, 2003 and December 31, 2002	4

		(b) RAE Systems Inc. Condensed Consolidated Statements of Operations for the three-month periods ended March 31, 2003 and 2002	5

		(c) RAE Systems Inc. Condensed Consolidated Statements of Cash Flows for the three-month periods ended March 31, 2003 and 2002	6

		(d) RAE Systems Inc. Notes to Condensed Consolidated Financial Statements	7

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

	Item 3. Quantitative and Qualitative Disclosures About Market Risk		16

	Item 4. Controls and Procedures		25

Part II. Other Information			25

	Item 1. Legal Proceedings		25

	Item 6. Exhibits and Reports on Form 8-K		26

Signatures			27

Certifications			28

Exhibit Index			30

Exhibits


	March 31, 2003			December 31, 2002

	(Unaudited)
Assets
Current Assets:
Cash and cash equivalents	$	7,382,200		$	7,193,500
Accounts receivable, net of allowance for doubtful accounts of $175,700 and $175,700, respectively		3,398,900			2,475,700
Inventories		3,526,600			3,176,400
Prepaid expenses and other current assets		461,600			402,000
Deferred income taxes		528,800			528,800

Total Current Assets		15,298,100			13,776,400

Property and Equipment, net		1,956,200			2,026,800
Deposits and Other Assets		103,700			81,800
Investment in Unconsolidated Affiliate		718,800			784,700

	$	18,076,800		$	16,669,700


Liabilities and Shareholders’ Equity
Current Liabilities:
Accounts payable	$	1,476,600		$	942,400
Accounts payable to affiliate		744,600			757,900
Accrued expenses		1,676,600			1,689,700
Income taxes payable		1,767,400			1,726,200
Current portion of deferred revenue		109,100			149,700
Current portion of capital lease obligations		159,600			159,600

Total Current Liabilities		5,933,900			5,425,500

Deferred Revenue, net of current portion		31,100			—
Capital Leases Obligations, net of current portion		54,900			107,300
Deferred Income Taxes		277,200			277,200

Total Liabilities		6,297,100			5,810,000

Commitments and Contingencies
Shareholders’ Equity:
Common stock, $0.001 par value; 200,000,000 shares authorized; 45,812,764 and 45,516,675 shares issued and outstanding, respectively		45,800			45,500
Additional paid-in capital		17,583,900			17,955,800
Deferred compensation		—			(516,600	)
Accumulated deficit		(5,850,000	)		(6,625,000	)

Total Shareholders’ Equity		11,779,700			10,859,700

	$	18,076,800		$	16,669,700



	Three months ended March 31,
	2003			2002

	(Unaudited)			(Unaudited)
Net Sales	$	7,339,400		$	4,545,300
Cost of Sales		2,912,800			2,024,800

Gross Margin		4,426,600			2,520,500

Operating Expenses:
Sales and marketing		1,470,100			1,073,300
Research and development		706,000			594,000
General and administrative		1,187,600			845,200
Legal fees and settlement costs		88,600			77,900

Total Operating Expenses		3,452,300			2,590,400

Operating Income (Loss)		974,300			(69,900	)

Other Income (Expense):
Interest income		9,400			14,100
Interest expense		(8,500	)		(59,500	)
Other, net		1,100			(2,400	)
Equity in loss of unconsolidated affiliate		(65,900	)		(61,300	)

Total Other Income (Expense)		(63,900	)		(109,100	)

Income (Loss) Before Income Taxes		910,400			(179,000	)
Income Taxes		(135,400	)		—

Net Income (Loss)	$	775,000		$	(179,000	)

Basic Earnings (Loss) Per Common Share	$	0.02		$	(0.01	)

Diluted Earnings (Loss) Per Common Share	$	0.02		$	(0.01	)

Weighted-average common shares outstanding		45,637,578			25,544,312
Stock Options		1,397,375			—
Net Income (Loss)	$	775,000		$	(179,000	)

Diluted weighted-average common shares outstanding		47,034,953			25,544,312

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Diluted earnings (loss) per share:
As reported	$	0.02	$	(0.01)
Pro forma	$	0.02	$	(0.01)

Exhibit Number		Description of Document

99.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.2		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


99.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.2		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002