10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-Q

(MARK ONE)

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

OR

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

FOR THE PERIOD FROM              TO             

COMMISSION FILE NUMBER: 001-31783

RAE Systems Inc.

(Exact name of registrant as specified in its charter)

Delaware	77-0588488
(State or other jurisdiction of incorporation)	(I.R.S. Employer Identification No.)

1339 Moffett Park Drive

Sunnyvale, California 94089

408-752-0723

(Address of registrant’s principal executive offices)

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.    YES  x    NO  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)    YES  ¨    NO  x

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 21, 2004
Common Stock, $0.001 Par Value	56,883,597

RAE Systems Inc.

INDEX

Part I.	Financial Information
	Item 1.	Financial Statements (Unaudited)
		(a)	RAE Systems Inc. Condensed Consolidated Balance Sheets at September 30, 2004 and December 31, 2003
		(b)	RAE Systems Inc. Condensed Consolidated Statements of Income for the three-month and nine-month periods ended September 30, 2004 and 2003
		(c)	RAE Systems Inc. Condensed Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2004 and 2003
		(d)	RAE Systems Inc. Notes to Condensed Consolidated Financial Statements
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.	Controls and Procedures
Part II.	Other Information
	Item 1.	Legal Proceedings
	Item 2.	Changes in Securities and Use of Proceeds
	Item 3.	Defaults Upon Senior Securities
	Item 4.	Submission of Matters to a Vote of Security Holders
	Item 5.	Other Information
	Item 6.	Exhibits and Reports on Form 8-K
Signatures
Exhibit Index
Exhibits

PART I. Financial Information

On May 27, 2004, we invested $9 million in cash for a 64% interest in Beijing Ke Li Heng Security Equipment Co., Ltd. (“KLH”). KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment. Our condensed consolidated financial statements include the results of operations of KLH since May 27, 2004.

On January 28, 2004, we closed our public offering of 8,050,000 shares of our common stock at $4.25 per share, less the applicable underwriting discount. The net proceeds, which approximated $31.8 million, will be used for mergers and acquisitions, working capital, and for general corporate purposes.

Effective January 1, 2003, we adopted the fair value recognition provisions of SFAS No. 123 for stock-based employee compensation under the modified prospective method as provided for in SFAS No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. These fair value recognition provisions generally result in stock-based compensation charges for options granted under our 1993 and 2002 stock option plans. While our interim financial statements herein for the three-month and nine-month periods ended September 30, 2004 reflect a non-cash compensation charge related to options of $213,000 and $881,000, respectively, these charges may increase significantly depending on the number of options granted in the future and, to a lesser extent, upon the volatility of our stock and the life of such options.

In April 2003, we issued a warrant to purchase 24,000 shares of our common stock, to Rubenstein Investor Relations. The warrant vested over a period of one year and was exercisable over such period. The fair value of this warrant, assessed at $4,000, was amortized over the service period. For the three-month and nine-month periods ended September 30, 2004, we took a charge related to this warrant in the amount of $0 and $1,000, respectively.

In June 2003, we issued a warrant to purchase 450,000 shares of our common stock, to Jefferies/Quarterdeck for the purpose of retaining their financial advisory services. The warrant vested immediately and is exercisable over four years. The fair value of this warrant, assessed at $329,000, will be amortized over the service period. For the three-month and nine-month periods ended September 30, 2004, we have taken a charge related to this warrant in the amount of $41,000 and $124,000, respectively.

In aggregate, non-cash charges related to the issuance of options and warrants were $254,000 and $1.0 million, respectively, for the three-month and nine-month periods ended September 30, 2004. Stock-based non-cash compensation charges have significantly impacted our financial statements, and will continue to impact the financial statements on a prospective basis.

Item 1. RAE Systems Inc. Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets

	September 30, 2004			December 31, 2003
	(Unaudited)
Assets
Current Assets:
Cash and cash equivalents	$	21,904,000		$	7,512,000
Short-term investments		10,000,000			—
Notes receivable		503,000			—
Accounts receivable, net of allowance for doubtful accounts of $656,000 and $176,000, respectively		9,863,000			5,380,000
Accounts receivable from affiliate		100,000			—
Inventories		8,277,000			3,659,000
Prepaid expenses and other current assets		2,347,000			762,000
Deferred income taxes		666,000			666,000
Total Current Assets		53,660,000			17,979,000
Property and Equipment, net		4,308,000			1,748,000
Long Term Investment		5,000,000			—
Intangible Assets		2,174,000			—
Deposits and Other Assets		292,000			327,000
Investment in Unconsolidated Affiliate		249,000			509,000
	$	65,683,000		$	20,563,000
Liabilities and Shareholders’ Equity
Current Liabilities:
Accounts payable	$	3,030,000		$	1,611,000
Notes payable		424,000			—
Accounts payable to affiliate		—			594,000
Accrued expenses		4,068,000			2,159,000
Income taxes payable		980,000			948,000
Current portion of deferred revenue		1,083,000			67,000
Current portion of capital lease obligations		31,000			122,000
Total Current Liabilities		9,616,000			5,501,000
Long term notes payable		1,695,000			—
Minority interest in consolidated entity		4,049,000			—
Deferred revenue, net of current portion		124,000			102,000
Total Liabilities		15,484,000			5,603,000
Commitments and Contingencies
Shareholders’ Equity:
Common stock, $0.001 par value; 200,000,000 shares authorized; 56,868,855 and 46,824,626 shares issued and outstanding, respectively		57,000			47,000
Additional paid-in capital		51,824,000			18,753,000
Cumulative other comprehensive income		19,000			7,000
Accumulated deficit		(1,701,000	)		(3,847,000	)
Total Shareholders’ Equity		50,199,000			14,960,000
	$	65,683,000		$	20,563,000

(See accompanying notes to condensed consolidated financial statements)

Condensed Consolidated Statements of Income

	Three months ended September 30,						Nine months ended September 30,
	2004			2003			2004			2003
	(Unaudited)			(Unaudited)			(Unaudited)			(Unaudited)
Net Sales	$	12,264,000		$	7,969,000		$	30,831,000		$	22,768,000
Cost of Sales		4,734,000			3,283,000			11,606,000			8,812,000
Gross Margin		7,530,000			4,686,000			19,225,000			13,956,000
Operating Expenses:
Sales and marketing		2,767,000			1,681,000			7,419,000			5,063,000
Research and development		1,063,000			717,000			2,965,000			2,180,000
General and administrative		2,055,000			1,322,000			5,541,000			3,760,000
Total Operating Expenses		5,885,000			3,720,000			15,925,000			11,003,000
Operating Income		1,645,000			966,000			3,300,000			2,953,000
Other Income (Expense):
Interest income		62,000			7,000			223,000			24,000
Interest expense		(3,000	)		(5,000	)		(11,000	)		(20,000	)
Other, net		19,000			(37,000	)		51,000			(14,000	)
Equity in loss of unconsolidated affiliate		(111,000	)		(65,000	)		(260,000	)		(198,000	)
Total Other (Expense) Income		(33,000	)		(100,000	)		3,000			(208,000	)
Income Before Income Taxes and Minority Interest		1,612,000			866,000			3,303,000			2,745,000
Income Taxes		478,000			141,000			1,033,000			450,000
Income before Minority Interest		1,134,000			725,000			2,270,000			2,295,000
Minority interest in income of consolidated subsidiary		(83,000	)		—			(124,000	)		—
Net Income	$	1,051,000		$	725,000		$	2,146,000		$	2,295,000
Basic Earnings Per Common Share	$	0.02		$	0.02		$	0.04		$	0.05
Diluted Earnings Per Common Share	$	0.02		$	0.01		$	0.04		$	0.05
Weighted-average common shares outstanding		56,801,158			46,246,408			55,373,290			45,914,155
Stock options		3,147,012			4,566,384			3,131,578			3,995,622
Diluted weighted-average common shares outstanding		59,948,170			50,812,792			58,504,868			49,909,777

(See accompanying notes to condensed consolidated financial statements)

Condensed Consolidated Statements of Cash Flows

	Nine months ended September 30,
	2004			2003
	(Unaudited)			(Unaudited)
Increase (Decrease) in Cash and Cash Equivalents
Cash Flows From Operating Activities:
Net Income	$	2,146,000		$	2,295,000
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		665,000			637,000
Provision for doubtful accounts		10,000			—
Inventory reserve		314,000			(94,000	)
Compensation expense related to options		881,000			497,000
Compensation expense related to warrants		124,000			57,000
Equity in loss of unconsolidated affiliate		260,000			198,000
Minority interest in income of consolidated subsidiary		113,000			—
Changes in operating assets and liabilities:
Accounts receivable		(2,303,000	)		(2,260,000	)
Accounts receivable from affiliate		(100,000	)		—
Notes receivable		(503,000	)		—
Inventories		(3,113,000	)		(613,000	)
Prepaid expenses and other current assets		(1,606,000	)		(159,000	)
Accounts payable		616,000			262,000
Accounts payable to affiliate		(594,000	)		(150,000	)
Accrued expenses		1,570,000			355,000
Notes payable		1,000			—
Income taxes payable		(17,000	)		(1,096,000	)
Deferred revenue		551,000			(14,000	)
Net Cash Used In Operating Activities		(985,000	)		(85,000	)
Cash Flows From Investing Activities:
Short-term investments		(15,000,000	)		—
Acquisition of property and equipment		(2,089,000	)		(416,000	)
Proceeds from business acquisition		683,000			—
Intangible assets		(306,000	)		—
Deposits and other		89,000			(69,000	)
Net Cash Used In Investing Activities		(16,623,000	)		(485,000	)
Cash Flows From Financing Activities:
Bank borrowing		(120,000	)		—
Proceeds from the exercise of stock options and warrants		408,000			172,000
Proceeds from the sale of common stock		32,160,000			—
Offering costs		(370,000	)		—
Payment on capital lease obligation		(90,000	)		(120,000	)
Net Cash Provided By Financing Activities		31,988,000			52,000
Effect of exchange rate changes		12,000			3,000
Net Increase in Cash and Cash Equivalents		14,392,000			(515,000	)
Cash and Cash Equivalents, beginning of period		7,512,000			7,193,000
Cash and Cash Equivalents, end of period	$	21,904,000		$	6,678,000
Supplemental Disclosure of Cash Flow Information:
Cash Paid:
Income taxes	$	724,000		$	1,543,000
Interest	$	6,000		$	22,000
Noncash Investing and Financing Activities:
Exchange of warrants for common stock	$	1,413,000		$	331,000

(See accompanying notes to condensed consolidated financial statements)

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1 – The Company

RAE Systems Inc. is a leading global developer and manufacturer of rapidly-deployable, multi-sensor chemical detection monitors and networks for homeland security and industrial applications. In addition, RAE offers a full line of portable single-sensor chemical and radiation detection products. RAE’s technologically advanced products are based on proprietary technology, and include portable, wireless and fixed atmospheric monitors and photo-ionization sensors, and gamma and neutron detectors. RAE’s products enable the military and first responders such as firefighters, law enforcement and other emergency management personnel to detect and provide early warning of weapons of mass destruction and other hazardous materials. Industrial applications include the detection of toxic industrial chemicals, volatile organic compounds and petrochemicals.

RAE Systems was founded in 1991 to develop technologies for the detection and early warning of hazardous materials. RAE has a broad patent portfolio consisting of 18 issued and pending patents that are the basis for many of its products. For example, RAE’s patented photo-ionization detector technology allows its products to rapidly and reliably indicate many toxic chemicals and vapors in the part-per-billion range readings. In 1994, RAE expanded its operations into Shanghai, China, giving the Company access to high-quality, cost-efficient manufacturing and world-class research capabilities.

RAE Systems’ products are used by many U.S. government agencies, including the Department of Homeland Security, the Department of Justice, and the Department of State, as well as all branches of the U.S. military, and by numerous city and state agencies. RAE’s end users also include many of the world’s leading corporations in the airline, automotive, computer and oil industries. The Company’s products are used in civilian and government atmospheric monitoring programs in over 50 countries. Several government agencies and departments have standardized their programs based on RAE’s products for hazardous materials incident response.

Note 2 – Summary of Significant Accounting Policies

Basis of Presentation

The financial information presented in this Form 10-Q is not audited and is not necessarily indicative of the 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.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of RAE Systems Inc. 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 company. RAE Asia owns (i) 100% of RAE Systems Shanghai Incorporated (“RAE Shanghai”), formerly known as Wa-RAE Science Instruments, Ltd, (ii) 100% of RAE Systems Hong Kong Limited (“RAE Hong Kong”), (iii) 64% of Beijing Ke Li Heng Security Equipment Co., Ltd. (“KLH”), and (iv) 36% of REnex Technology Ltd (“REnex”). RAE Shanghai, which is incorporated in Jiading, Shanghai, designs and manufactures RAE’s products for final assembly and testing in the United States. RAE Hong Kong distributes and provides services for RAE’s products in Asia and the Pacific Rim. KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment. REnex, a Hong Kong based research and development corporation, designs and develops a wireless platform for detection and monitoring.

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

Earnings Per Share

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 4,466,811 and 4,336,811 options and warrants have increased the diluted shares outstanding by 3,147,012 and 3,131,578, respectively, for the three-month and nine-month periods ended September 30, 2004. Warrants and options outstanding to purchase 3,307,012 shares and 3,437,012 shares at exercise prices between $5.35 per share and $22.68 per share, and $5.20 per share and $22.68 per share, respectively, were not included in the computation of diluted earnings per share for the three-month and nine-month periods ended September 30, 2004, respectively.

Stock-Based Compensation

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 the three month and nine-month periods ended September 30, 2004 and 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 and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Net income, as reported	$	1,051,000		$	725,000		$	2,146,000		$	2,295,000
Add: Stock-based employee compensation included in reported net income, net of related tax effects		213,000			217,000			881,000			497,000
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(213,000	)		(217,000	)		(881,000	)		(497,000	)
Pro forma net income	$	1,051,000		$	725,000		$	2,146,000		$	2,295,000
Basic earnings per share:
As reported	$	0.02		$	0.02		$	0.04		$	0.05
Pro forma	$	0.02		$	0.02		$	0.04		$	0.05
Diluted earnings per share:
As reported	$	0.02		$	0.01		$	0.04		$	0.05
Pro forma	$	0.02		$	0.01		$	0.04		$	0.05

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.

Use of Estimates

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’s gross margins could be adversely affected.

Management accounts for its debt and equity investments as held-to-maturity. These include United States Treasury Bills, United States Corporate Bonds and Notes, United States Government Agencies, and United States Treasury Notes ranging in maturity dates from October 2004 through September 2006.

The Company generally provides a one to three year limited warranty 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. A valuation allowance is provided against the deferred tax assets to the extent that management is unable to conclude that it is more likely than not that the deferred tax assets will be realized.

RECENT ACCOUNTING PRONOUNCEMENTS

In November 2003, the EITF issued EITF No. 03-6 “Participating Securities and the Two-Class Method under FASB Statement No. 128,” which provides for a two-class method of calculating earnings per share computations that relate to certain securities that would be considered to be participating in conjunction with certain common stock rights. This guidance became applicable to the Company starting with the third quarter beginning July 1, 2004. The adoption of this pronouncement did not have an impact on the Company’s financial statements.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement establishes

standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have a material impact on the Company’s financial position, results of operations or cash flows.

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.

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. This Interpretation requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. FIN 46 is effective immediately for variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. The adoption of this Interpretation did not have a material impact on the Company’s financial position or results of operations.

Note 3 - KLH Acquisition

On May 27, 2004, the Company invested $9 million in cash for a 64% interest in Beijing Ke Li Heng Security Equipment Co., Ltd. (“KLH”). KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment. The results of KLH’s operations have been included in the condensed consolidated financial statements of the Company since May 27, 2004.

The investment costs were allocated on a preliminary basis to the fair value of the assets acquired, including management’s estimate for developed technologies and liabilities assumed. The final adjustments to the purchase price allocations are not expected to be material to the consolidated financial statements.

The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition:

Current assets	$	13,814,000
Intangible Assets		2,329,000
Non-Current Assets		54,000
Property and Equipment, net		981,000
Assets		17,178,000
Current liabilities	$	(2,838,000	)
Long-term liabilities		(1,109,000	)
Minority interest		(3,925,000	)
Liabilities		(7,872,000	)
Purchase price (including transactions costs of $306,000)	$	9,306,000

The pro forma information is not necessarily indicative of what would have occurred had the acquisition been made as of such periods, nor is it indicative of future results of operations. The pro forma amounts give effect to appropriate adjustments for the fair value of the assets acquired, amortization of intangibles, and income taxes.

	Three Months Ended September 30,				Nine Months Ended September 30,
	2004		2003		2004		2003
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Revenue	$	12,264,000	$	10,161,000	$	33,744,000	$	27,913,000
Net income	$	1,051,000	$	720,000	$	2,160,000	$	2,409,000
Earnings per share-basic	$	0.02	$	0.01	$	0.04	$	0.04
Earnings per share-diluted	$	0.02	$	0.01	$	0.04	$	0.04

Note 4– Commitments and Contingencies

Royalty

Commencing January 1, 2001 and continuing through December 31, 2009, the Company is required to pay Dragerwerk a royalty equal to 7.5% of net sales of certain licensed products relating to U.S. Patent No. 5,654,498 issued August 5, 1997 and entitled “Device for the Selective Detection of a Component in a Gas Mixture”, manufactured or imported for sale by or for the Company in the United States. During the three-month and nine-month periods ended September 30, 2004 and 2003, the Company incurred royalty expenses of $12,000 and $12,000, and $33,000 and $32,000, respectively.

Litigation

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

Note 5 – Warranty Reserve

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 three-month and nine-month periods ended September 30, 2004 and 2003:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Provision for product sold during period	$	148,000		$	128,000		$	262,000		$	226,000
Adjustment of prior period provision		—			—			—			43,000
Claims paid during the period		(45,000	)		(89,000	)		(140,000	)		(119,000	)
Net increase (decrease) in liability		103,000			39,000			122,000			150,000
Balance beginning of period		377,000			317,000			358,000			206,000
Balance, end of period	$	480,000		$	356,000		$	480,000		$	356,000

Note 6 – Transactions with Affiliates

Certain of the Company’s sales made into the China market are made through TangRAE, a China distribution company that is owned by two individuals, one of whom is a current employee and one of whom is a former employee of one of the Company’s wholly-owned subsidiaries. TangRAE was organized as a sales office solely to facilitate the sale of the Company’s product into the China market. Total sales made by the Company to TangRAE for the three-month period ended September 30, 2004 and 2003 were $107,000 and $0, respectively. For the nine-month period ended September 30, 2004 and 2003, total sales made to TangRAE were $392,000, and $410,000, respectively.

The Company entered into an agreement with Shanghai Simax Technology Co. Ltd. (“Simax”) to finance the design of the benzene-specific gas detection module (GC-PID) in the amount of $100,000. The Company is to pay a royalty fee of 5% of all GC-PID products sold. The Chief Technology Officer of RAE Systems, is the acting general manager for Simax.

The Company entered into an agreement with REnex Technologies Ltd. to finance the development of the wireless communication modem for the RAELink product in the amount of $95,000 and to pay a royalty fee of 7.5% for all products sold. The Company has a

36% interest in REnex Technologies Ltd.

Note 7 – Subsequent Events

On October 1, 2004, the Company made an investment of $73,000 to acquire 100% of RAE United Kingdom (“RAE UK”) and of $19,000 to acquire 49% of RAE France. RAE UK and RAE France are wholly owned subsidiaries of RAE Systems Europe ApS and are distribution companies in the United Kingdom and France, respectively.

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.

RESULTS OF OPERATIONS

Three months ended September 30, 2003 compared to the three months ended September 30, 2004

Net Sales. Net sales increased from $8.0 million for the quarter ended September 30, 2003 to $12.3 million for the quarter ended September 30, 2004, an increase of 53.9%. This increase was primarily due to an increase in government sales, particularly for homeland security applications where we recognized a $2.0 million increase in the sales of our wireless mobile sensor and radiation products. Our net sales also increased due to the investment in KLH in the amount of $2.4 million.

Cost of Sales. Cost of sales increased from $3.3 million for the quarter ended September 30, 2003 to $4.7 million for the quarter ended September 30, 2004, an increase of 44.2%. Gross margins increased from $4.7 million, or 58.8% of revenue, for the quarter ended September 30, 2003 to $7.5 million, or 61.4% of revenue, for the quarter ended September 30, 2004. Gross margins for the base business were $6.6 million and $918,000 for KLH. Gross margins for the base business remained high due to significant increases in the sales of our higher margin integrated systems products.

Sales and Marketing. Sales and marketing expenses increased from $1.7 million for the quarter ended September 30, 2003 to $2.8 million for the quarter ended September 30, 2004, an increase of 64.6%. This increase was primarily attributable to the consolidation of KLH, in the amount of $332,000, increased infrastructure and marketing costs in the United States to enhance the sales of our wireless sensing solutions, in the amount of $242,000 and increased infrastructure costs in Europe to position the company for future growth in the amount of $243,000 and increased commissions to our manufacturers’ representatives for the sales of our wireless sensing solutions, in the amount of $242,000.

Research and Development. Research and development expenses increased from $717,000 for the quarter ended September 30, 2003 to $1.1 million for the quarter ended September 30, 2004, an increase of 48.3%. This increase was principally related to enhancements of our wireless products and to develop the RAEWatch, a wireless mesh network sensor system with a range of applications in cargo container security, transportation security and indoor air security.

General and Administrative. General and administrative expenses increased from $1.3 million for the quarter ended September 30, 2003 to $2.1 million for the quarter ended September 30, 2004, an increase of 55.4%. The increase in general and administrative expenses was primarily attributable to the consolidation of KLH, in the amount of $203,000, including a one-time post merger KLH accounts receivable write-off and increased costs associated with Section 404 of the Sarbanes-Oxley Act initiative, in the amount of $250,000.

Other Income (Expenses), net. Other Expense, net for the three-month period ended September 30, 2003 was $100,000. For the same period in 2004, we had Other Expense, net of $33,000. This decrease in expense is attributable to an increase in interest income, net of expense in the amount of $57,000 resulting from having raised a net of $31.8 million through our public offering which closed on January 28, 2004, partially offset by an increase in the loss of the unconsolidated entity in the amount of $46,000

Income Taxes. For the quarters ended September 30, 2003 and 2004, we recognized tax expenses of $141,000 and $478,000, respectively. Income taxes were relatively low in 2003 due to prior year tax refund in the amount of $100,000.

Minority Interest in Income of Consolidated Entity. For the quarter ended September 30, 2004, we recognized $83,000 representing the minority interest’s share in the net income of KLH.

Net Income. Net income for the quarter ended September 30, 2003 was $725,000. For the same period in 2004, we had net income of $1.1 million. The increase was primarily attributable to a significant increase in the sales of our higher margin integrated systems products. These increases were partially offset by an increase in our sales and marketing and general and administrative expenses. For the quarter ended September 30, 2004, KLH contributed $148,000 to net income.

Nine months ended September 30, 2003 compared to the nine months ended September 30, 2004

Net Sales. Net sales increased from $22.8 million for the nine-month period ended September 30, 2003 to $30.8 million for the nine-month period ended September 30, 2004, an increase of 35.4%. This increase was primarily due to an increase in government sales, particularly for homeland security applications where we recognized a $4.1 million increase in the sales of our wireless mobile sensor and radiation products. Our net sales also increased due to the investment in KLH in the amount of $3.2 million.

Cost of Sales. Cost of sales increased from $8.8 million for the nine-month period ended September 30, 2003 to $11.6 million for the nine-month period ended September 30, 2004, an increase of 31.7%. Gross margins increased from $14.0 million, or 61.3% of revenue, for the nine-month period ended September 30, 2003 to $19.2 million, or 62.4% of revenue, for the nine-month period ended September 30, 2004. Gross margins for the base business were $17.9 million and $1.3 million for KLH. Gross margins for the base business remained high due to significant increases in the sales of our higher margin integrated systems products. The investment in KLH, however, reduced our overall gross margins. KLH generated approximately 50% of its revenue from its distribution business, with inherently lower margins.

Sales and Marketing. Sales and marketing expenses increased from 5.1 million for the nine-month period ended September 30, 2003 to $7.4 million for the nine-month period ended September 30, 2004, an increase of 46.5%. This increase was primarily attributable to the consolidation of KLH, in the amount of $432,000, increased infrastructure and marketing costs in the United States to enhance the sales of our wireless sensing solutions, in the amount of $730,000 and increased infrastructure costs in Europe to position the company for future growth in the amount of $728,000 and increased commissions to our manufacturers’ representatives for the sales of our wireless sensing solutions, in the amount of $469,000

Research and Development. Research and development expenses increased from $2.2 million for the nine-month period ended September 30, 2003 to $3.0 million for the nine-month period ended September 30, 2004, an increase of 36.0%. This increase was principally related to enhancements of our wireless products and to develop the RAEWatch, a wireless mesh network sensor system with a range of applications in cargo container security, transportation security and indoor air security.

General and Administrative. General and administrative expenses increased from $3.8 million for the nine-month period ended September 30, 2003 to $5.5 million for the nine-month period ended September 30, 2004, an increase of 47.4%. The increase in general and administrative expenses was primarily attributable to the consolidation of KLH, in the amount of $272,000, including a one-time post merger KLH accounts receivable write-off, an increase in the fair value accounting charges in the amount of $452,000 and increased costs associated with Section 404 of the Sarbanes-Oxley Act initiative, in the amount of $410,000. In addition, an increase in headcount in our foreign subsidiaries contributed to the general and administrative increase, in the amount of $345,000.

Other Income (Expenses), net. Other Expense, net for the nine-month period ended September 30, 2003 was $208,000. For the same period in 2004, we had Other Income, net of $3,000. This was attributable to an increase in interest income, net of expense in the amount of $208,000, resulting from having raised a net of $31.8 million through our public offering which closed on January 28, 2004, and partially offset by an increase in the loss of the unconsolidated entity in the amount of $62,000.

Income Taxes. For the nine-month periods ended September 30, 2003 and 2004, we recognized tax expenses of $450,000 and $1.0 million, respectively. Income taxes were relatively low in both 2003 and 2004. In 2003, prior year carryforwards and refunds, in the amount of $569,000 were used to reduce the income taxes. In June 2004, 1,110,000 incentive stock options ranging in exercise prices between $3.15 and $5.35 were converted to non-qualified stock options. The conversion of such options generated a one-time income tax benefit which reduced our income tax expense and increased our net income by approximately $235,000 in the nine months ended September 30, 2004.

Minority Interest in Income of Consolidated Entity. For the nine-month period ended September 30, 2004, we recognized $124,000 representing the minority interest’s share in the net income of KLH.

Net Income. Net income for the nine-month period ended September 30, 2003 was $2.3 million. For the same period in 2004, we had net income of $2.1 million. The decrease in net income was primarily attributable to significant increases in sales and marketing and general and administrative expenses relative to the revenue obtained in the first quarter of 2004. For the nine-month period ended September 30, 2004, KLH contributed $222,000 to net income.

Liquidity and Capital Resources

To date, we have financed our operations primarily through bank borrowings, revenues from operations and proceeds from issuances of equity securities. As of September 30, 2004, we had $36.9 million in cash and cash equivalents and investments. At September 30, 2004, we had $44.0 million of working capital (the excess of current assets over current liabilities) and had a current ratio of 5.6:1. We also have a $10 million line of credit for future growth expansion.

Net cash used in operating activities for the nine months ended September 30, 2004 was $985,000, as compared with net cash used in operating activities of $85,000 for the nine months ended September 30, 2003. The unfavorable effects on operating cash flows is primarily due to an increased spending on inventory in the amount of $3.1 million and prepaid expenses in the amount of $1.6 million, and accounts receivable in the amount of $2.3 million and intercompany payments of $594,000. These were partially offset by net income in the amount of $2.1 million, accrued expenses of $1.6 million, fair value accounting charges of $881,000, depreciation and amortization of $665,000 and accounts payable of $616,000.

Net cash used in investing activities for the nine months ended September 30, 2004 was $17.0 million as compared to net cash used in investing activities of $485,000 for the nine months ended September 30, 2003. The unfavorable effects on investing cash flows was primarily due to investments in debt securities in the amount of $15 million, and the acquisition of property and equipment of $2.1 million.

Net cash provided by financing activities was $32.0 million for the nine months ended September 30, 2004. The favorable effects on financing cash flows was primarily the result of having raised a net of $31.8 million on January 28, 2004 in connection with the close of our public offering of 8,050,000 shares of our common stock at $4.25 per share, less the applicable underwriting discount.

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.

Contractual Obligations

The following table quantifies our future contractual obligations as of September 30, 2004:

	Total		2004		2005		2006		2007		2008		Thereafter
Contractual Obligations:
Operating Leases	$	2,530,000	$	128,000	$	563,000	$	512,000	$	396,000	$	492,000	$	439,000
Capital Leases	$	32,000	$	32,000	$	—	$	—	$	—	$	—	$	—
TOTAL	$	2,562,000	$	160,000	$	563,000	$	512,000	$	396,000	$	492,000	$	439,000

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

CONCENTRATION OF CREDIT RISK

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

INTEREST RATE RISK

As of September 30, 2004, we had cash and cash equivalents and investments of $36.9 million. Declines of interest rate over time will limit or reduce our interest income from our investments in debt securities.

FOREIGN CURRENCY EXCHANGE RATE RISK

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. As sales to our international customers increase, 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.

Factors that May Affect Future Results

Investing in our securities involves a high degree of risk. You should consider the following risk factors, as well as other information contained or incorporated by reference in any other filings we make with the Securities and Exchange Commission, before making an investment decision with respect to our securities. The risks and uncertainties described are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks occur, our business could suffer, the market price of our common stock could decline and you could lose all or part of your investment in our securities.

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, 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.

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 and 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. Our primary competitors include

Industrial Scientific Corporation, Mine Safety Appliances Company, BW Technologies, Ion Science, PerkinElmer, Inc., Draeger Safety Inc., Gastec Corporation and Bacou-Dalloz Group. 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:

• 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 might 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 addition, while our current technology enables us to create products targeted to address the evolving market, we are unable to foresee whether we will continue to have the necessary technology in the future. 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 recently 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.

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 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.

We 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 fiscal years 2004 and 2003, approximately 20% and 13%, respectively, of our revenue were from sales to customers located in Asia and approximately 10% and 11%, respectively, were from sales to customers located in Europe. We have manufacturing facilities in China in addition to those 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 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, 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;

• 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;

• increased transportation/shipping costs; and

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

The specific economic conditions in each country impact our international sales. For example, substantially all 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.

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

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.

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 may lose sales if our distributors stop selling our products.

We distribute our products primarily through distributors. We derive approximately 70% of our revenues via our sales distribution channels, and, as a result, we are dependent upon these distributors to sell our products and to assist us in promoting and creating a demand for our products. We believe that our future growth depends on the efforts of these distributors. For the year ended December 31, 2003, 25 distributors cumulatively account for approximately 42% of our total product sales. In addition, the contractual obligations of our distributors to continue carrying our products must be renewed annually. 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.

In addition to our recent investment in KLH, any future acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute stockholder value or harm our results of operations.

In May 2004, we completed our investment in KLH, a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors. 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.

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

We own approximately 36% of REnex Technology Ltd., a wireless systems company still in the research and development stage, and which to date has not generated any revenues. 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.

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

In connection with our merger with Nettaxi.com, certain options under our 1993 Stock Plan became subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). To eliminate the variable effects of such accounting treatment, we have adopted the fair value recognition provisions of SFAS No. 123 for stock-based employee compensation, effective January 1, 2003, under the modified prospective method as provided for in SFAS No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. These fair value recognition provisions generally result in stock-based compensation charges for options granted under our 1993 and 2002 stock option plans. For the three-month and nine-month periods ended September 30, 2004, the fair value charges for options granted under our 1993 and 2002 stock option plans were $213,000 and $881,000, respectively.

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. We do no have employment agreements with any of these officers. The loss of the services of any of our executive officers could harm our business.

Our officers, directors and principal stockholders beneficially own approximately 38% 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 38% 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.

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 has required changes in some of our corporate governance, securities disclosure and compliance practices. In response to the requirements of that Act, the SEC and American Stock Exchange have promulgated new rules. Compliance with these new rules has increased our legal and financial and accounting costs, and we expect these increased costs to continue indefinitely. We also expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be forced to accept reduced coverage or incur substantially higher costs to maintain or obtain coverage. In addition, these developments may make it more difficult for us to attract and retain qualified members of our board of directors or qualified executive officers.

Investor confidence and share value may be adversely impacted if our independent auditors are unable to provide us with the attestation of the adequacy of our internal controls over financial reporting as of December 31, 2004, as required by Section 404 of the Sarbanes-Oxley Act of 2002.

The Securities and Exchange Commission, as directed by Section 404 of the Sarbanes-Oxley Act of 2002, adopted rules requiring public companies to include a report of management on the company’s internal controls over financial reporting in its annual reports on Form 10-K that contain an assessment by management of the effectiveness of the company’s internal controls over financial reporting. In addition, the company’s independent auditors must attest to and report on management’s assessment of the effectiveness of the company’s internal controls over financial reporting. This requirement will first apply to our Annual report on Form 10-K for the fiscal year ending December 31, 2004. Although we are currently diligently and vigorously reviewing our internal controls over financial reporting in order to ensure compliance with the Section 404 requirements, if our independent auditors are not satisfied with our internal controls over financial reporting or the level at which these controls are documented, designed, operated, or reviewed, or if the independent auditors interpret the requirements, rules or regulations differently from us, then they may decline to attest to management’s assessment or may issue a report that is qualified. In the event that management is unable to complete its assessment of the effectiveness of the Company’s internal controls over financial reporting or our independent auditors are unable to attest to management’s assessment, then the filing of our Annual Report on Form 10-K with the Securities and Exchange Commission may not be deemed to constitute a timely filing. This could result in an adverse reaction in the financial marketplace due to a loss of investor confidence in the reliability of our financial statements, which ultimately could negatively impact the market price of our shares.

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

In designing and evaluating our internal controls 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 believe that our internal controls over financial reporting currently provide reasonable assurance of achieving their control objectives, no system of internal controls can be designed to provide absolute assurance of effectiveness. In particular, in connection with the review of our interim financial results for the quarter ended September 30, 2004 performed by BDO Seidman, LLP, our independent registered public accounting firm, BDO informed us and our Audit Committee of the Board of Directors that BDO had identified two matters that constituted “material weaknesses” in our internal controls, specifically, material weaknesses pertaining to: 1) inadequate controls over our information technology infrastructure in the area of security and data protection; and 2) inadequate controls over our review and oversight of subsidiary financial information originating from our newly acquired operations at our KLH subsidiary. We are in the process of implementing a plan to upgrade our information technology infrastructure in 2005, including the enhancement of its next enterprise resource planning system. Furthermore, we are in the process of remedying the KLH situation by establishing a more rigorous monitoring system, including sending an onsite representative to the KLH location to monitor our efforts. Material weaknesses in internal controls 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 controls over financial reporting would have a negative impact on our reputation and business.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act, as of September 30, 2004. Based on this evaluation, other than the two material weaknesses described below, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

On October 21, 2004, in connection with the review of our interim financial results for the quarter ended September 30, 2004 performed by BDO Seidman, LLP, our independent registered public accounting firm, BDO informed us and our Audit Committee of the Board of Directors that BDO had identified two matters concerning our internal control which BDO deemed to be “material weaknesses” (as defined by standards established by the Public Company Accounting Oversight Board).

BDO noted the following two material weaknesses: 1) inadequate controls pertaining to our information technology infrastructure in the area of security and data protection; and 2) inadequate controls pertaining to our review and oversight of subsidiary financial information originating from our newly acquired operations at our KLH subsidiary.

We are taking steps to address the identified areas and to attempt to improve the effectiveness of our internal controls and procedures, including: 1) implementing a plan to upgrade our information technology infrastructure in 2005, such as the enhancement of our next enterprise resource planning system; and 2) establishing a more rigorous monitoring system for foreign subsidiary internal controls, including sending an onsite representative to monitor our efforts. We also plan to implement further actions to address the identified weaknesses, including the institution of more detailed review, analysis and verification in the course of the financial statement close process and the receipt of information and updates from our foreign subsidiaries on a regular basis throughout each quarter.

Changes in Internal Control Over Financial Reporting

Other than the two material weaknesses noted above, which we plan to address through the process improvements described above, there were no changes in our internal controls over financial reporting during the quarter ended September 30, 2004, that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are from time to time involved in certain claims and legal proceedings as discussed in our previous reports on Form 10-K and Form 10-Q filed with the Securities and Exchange Commission. No material legal proceedings were initiated or terminated during the most recent fiscal quarter.

Item 2. Changes in 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 and Reports on Form 8-K

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

(b) Reports on Form 8-K:

(1) On July 30, 2004, we filed a report on Form 8-K with the Securities and Exchange Commission including our earnings release for the quarter ended June 30, 2004 and a transcript of a conference call conducted on July 26, 2004 to discuss our results of operations.

(3) On August 10, 2004, we filed a report on Form 8-K with the Securities and Exchange Commission including the audited financial statements and notes to financial statements for KLH for the years ended December 31, 2003 and 2002, and unaudited KLH financial statements for the period ended March 31, 2004 and the report also includes unaudited proforma financial statements for the year ended December 31, 2003 and for the three months ended March 31, 2004.

SIGNATURES

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 October 28, 2004.

RAE SYSTEMS INC.
By:	/s/ Joseph Ng
	Joseph Ng
	Chief Financial Officer and
	Vice President, Business
	Development

EXHIBIT INDEX

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 adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Joseph Ng, Chief Financial Officer and Vice-President, Business Development of the Registrant, furnished pursuant to Rule 13a-14 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 302 of the Sarbanes-Oxley Act of 2002 Certifications 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 Joseph Ng, Chief Financial Officer and Vice-President, Business Development of the Registrant, furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

EX-31.1

EXHIBIT 31.1

CERTIFICATION

I, Robert I. Chen, certify that:

1. I have reviewed this quarterly report on Form 10-Q of RAE Systems Inc.;

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-15(e) and 15d-15(e)) for the registrant and have:

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

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

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

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

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

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

October 29, 2004

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

EX-31.2

EXHIBIT 31.2

CERTIFICATION

I, Joseph Ng, certify that:

1. I have reviewed this quarterly report on Form 10-Q of RAE Systems Inc.;

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-15(e) and 15d-15(e)) for the registrant and have:

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

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

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

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

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

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

October 29, 2004

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

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of RAE Systems Inc. (the “Company”) on Form 10-Q for the period ended September 30, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, in the capacities and on the dates indicated below, each hereby certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

	By:	/s/ Robert I. Chen
October 29, 2004		Robert I. Chen
		President, Chief Executive Officer
		and Chairman of the Board

EX-32.2

EXHIBIT 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of RAE Systems Inc. (the “Company”) on Form 10-Q for the period ended September 30, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, in the capacities and on the dates indicated below, each hereby certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

	By:	/s/ Joseph Ng
October 29, 2004		Joseph Ng
		Chief Financial Officer and
		Vice-President, Business
		Development