Back to GetFilings.com



Table of Contents
 
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, 2002
 
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:  000-26109
 
 
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 the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
Class
  
Outstanding at September 30, 2002
Common Stock, $0.001 Par Value
  
45,299,848

Table of Contents
 
RAE Systems Inc.
 
INDEX
 
Part I.
     
3
   
Item 1.
     
4
       
(a)
     
4
       
(b)
     
5
       
(c)
     
6
       
(d)
     
7
       
(e)
     
8
   
Item 2.
     
14
   
Item 3.
     
19
   
Item 4.
     
28
Part II.
     
29
   
Item 1.
     
29
   
Item 6.
     
29
  
30
  
31
    
 

2

Table of Contents
 
PART I.    FINANCIAL INFORMATION
 
The interim financial statements of RAE Systems Inc. (“RAE” or the “Company”) herein reflect a non-cash credit (expense reduction) of $270,000 relating to the effects of accounting for the Company’s stock options under variable accounting for the quarter ended September 30, 2002, resulting from a decline in the share price from $0.75 on June 30, 2002 to $0.45 on September 30, 2002. For the nine month period ended September 30, 2002, the financial statements herein reflect a $9.3 million non-cash merger and variable accounting charge. These charges have significantly impacted the General and Administrative Expenses, Merger Costs, Net Loss, and Loss per Share in the Consolidated Statements of Operations, and the Additional Paid-In-Capital and Retained Earnings in the Consolidated Balance Sheet.
 
REnex Technology Ltd. (REnex) completed a $3 million private placement in July of 2002. Based on the terms and conditions of the contract, RAE Asia’s equity interest in REnex decreased from 47% to approximately 36%. Likewise, RAE Asia’s voting interest decreased from 90% to approximately 36%. As RAE Asia no longer owns majority interest in the voting shares, the financial statements herein reflect a change in the accounting of REnex from the consolidated method to the equity method. This change has been retroactively applied as of January 1, 2002 and, accordingly, this change has significantly impacted the comparability of the 2002 interim amounts versus the 2001 interim amounts regarding Research and Development Expenses, Loss from Unconsolidated Entity, and Minority Interest in Loss of Consolidated Subsidiary in the Consolidated Statements of Operations, and the Investments under Equity Method in the Consolidated Balance Sheet.

3

Table of Contents
 
Item 1:    RAE Systems Inc. Financial Statements (Unaudited)
 
Condensed Consolidated Balance Sheets
 
 
    
September 30, 2002
     
December 31, 2001
  
    
(Unaudited)
         
Assets
                  
Current Assets:
                  
Cash and cash equivalents
   
$
6,513,600
 
   
$
3,742,600
 
Restricted cash
   
 
—
 
   
 
3,000,000
 
Accounts receivable, net of allowance for doubtful accounts of $175,800 and $200,000, respectively
   
 
2,649,700
 
   
 
2,398,100
 
Inventories
   
 
3,503,000
 
   
 
3,715,800
 
Prepaid expenses and other current assets
   
 
435,000
 
   
 
267,100
 
Deferred income taxes
   
 
500,800
 
   
 
500,800
 
    
  
Total Current Assets
   
 
13,602,100
 
   
 
13,624,400
 
    
  
Property and Equipment, net
   
 
2,007,800
 
   
 
1,202,300
 
Deposits and Other Assets
   
 
152,700
 
   
 
216,500
 
Investments in Unconsolidated Affiliate
   
 
870,000
 
   
 
—
 
    
  
    
$
16,632,600
 
   
$
15,043,200
 
    
  
Liabilities, Convertible Redeemable Preferred Stock, and Shareholders’ Equity
                  
Current Liabilities:
                  
Note payable and lines of credit
   
$
—
 
   
$
4,425,800
 
Accounts payable
   
 
1,714,400
 
   
 
842,200
 
Accounts payable, related party
   
 
757,900
 
   
 
—
 
Accrued expenses
   
 
1,114,700
 
   
 
1,234,800
 
Income taxes payable
   
 
1,463,900
 
   
 
1,670,200
 
Current portion of deferred revenue
   
 
347,000
 
   
 
248,900
 
Current portion of capital lease obligations
   
 
159,600
 
   
 
96,600
 
    
  
Total Current Liabilities
   
 
5,557,500
 
   
 
8,518,500
 
    
  
Deferred Revenue, net of current portion
   
 
—
 
   
 
149,900
 
Capital Leases Obligations, net of current portion
   
 
170,000
 
   
 
51,300
 
Deferred Income Taxes
   
 
443,100
 
   
 
443,100
 
Minority Interest in Consolidated Subsidiary
   
 
—
 
   
 
1,141,900
 
    
  
Total Liabilities
   
 
6,170,600
 
   
 
10,304,700
 
    
  
Commitments and Contingencies
                  
Convertible Redeemable Preferred Stock:
                  
Series A, $0.01 par value; 700,000 shares authorized; 0 and 700,000 issued and outstanding, respectively, $.40 per share redemption value
   
 
—
 
   
 
300,000
 
Series B, $0.01 par value; 1,000,000 shares authorized; 0 and 1,000,000 issued and outstanding, respectively, $1.00 per share redemption value
   
 
—
 
   
 
1,000,000
 
    
  
    
 
—
 
   
 
1,300,000
 
    
  
Shareholders’ Equity
                  
Common stock, $0.001 par value; 200,000,000 shares authorized; 45,299,848 and 25,542,482 shares issued and outstanding, respectively
   
 
45,300
 
   
 
25,500
 
Additional paid-in capital
   
 
17,829,100
 
   
 
1,301,000
 
Deferred compensation
   
 
(406,300
)
   
 
(717,800
)
(Accumulated deficit) Retained earnings
   
 
(7,006,100
)
   
 
2,829,800
 
    
  
Total Shareholders’ Equity
   
 
10,462,000
 
   
 
3,438,500
 
    
  
    
$
16,632,600
 
   
$
15,043,200
 
    
  
 
(See accompanying notes to condensed consolidated financial statements)

4

Table of Contents
 
Condensed Consolidated Statements of Operations
 
    
Three months ended September 30,
     
Nine months ended September 30,
  
    
2002
     
2001
     
2002
     
2001
  
    
(Unaudited)
     
(Unaudited)
     
(Unaudited)
     
(Unaudited)
  
Net Sales
   
$
5,869,100
 
   
$
4,957,800
 
   
$
15,581,700
 
   
$
14,037,100
 
Cost of Sales
   
 
2,401,700
 
   
 
1,843,200
 
   
 
6,577,900
 
   
 
5,314,600
 
    
  
  
  
Gross Margin
   
 
3,467,400
 
   
 
3,114,600
 
   
 
9,003,800
 
   
 
8,722,500
 
    
  
  
  
Operating Expenses:
                                    
Sales and marketing
   
 
1,431,600
 
   
 
1,198,500
 
   
 
3,971,200
 
   
 
3,510,900
 
Research and development
   
 
741,600
 
   
 
850,700
 
   
 
1,946,900
 
   
 
2,331,300
 
General and administrative
   
 
515,000
 
   
 
591,200
 
   
 
3,311,600
 
   
 
2,112,800
 
Legal fees and settlement costs
   
 
331,100
 
   
 
504,000
 
   
 
575,100
 
   
 
733,100
 
Merger costs
   
 
—
 
   
 
—
 
   
 
8,734,700
 
   
 
—
 
    
  
  
  
Total Operating Expenses
   
 
3,019,300
 
   
 
3,144,400
 
   
 
18,539,500
 
   
 
8,688,100
 
    
  
  
  
Operating (Loss) Income
   
 
448,100
 
   
 
(29,800
)
   
 
(9,535,700
)
   
 
34,400
 
    
  
  
  
Other Income (Expense):
                                    
Interest income
   
 
14,400
 
   
 
32,700
 
   
 
46,400
 
   
 
101,300
 
Interest expense
   
 
(10,100
)
   
 
(91,200
)
   
 
(110,200
)
   
 
(209,800
)
Other, net
   
 
14,300
 
   
 
(4,900
)
   
 
(1,600
)
   
 
(11,800
)
Equity in loss of unconsolidated affiliate
   
 
(77,800
)
   
 
—
 
   
 
(198,400
)
   
 
—
 
Minority interest in loss of consolidated subsidiary
   
 
—
 
   
 
95,100
 
   
 
—
 
   
 
257,400
 
    
  
  
  
Income (Loss) Before Income Taxes
   
 
388,900
 
   
 
1,900
 
   
 
(9,799,500
)
   
 
171,500
 
Income Taxes
   
 
28,600
 
   
 
500
 
   
 
36,400
 
   
 
48,500
 
    
  
  
  
Net (Loss) Income
   
$
360,300
 
   
$
1,400
 
   
$
(9,835,900
)
   
$
123,000
 
    
  
  
  
Basic Earnings (Loss) Per Common Share
   
$
0.01
 
   
$
0.00
 
   
$
(0.26
)
   
$
0.01
 
    
  
  
  
Diluted Earnings (Loss) Per Common Share
   
$
0.01
 
   
$
0.00
 
   
$
(0.26
)
   
$
0.01
 
    
  
  
  
Weighted-average common shares outstanding
   
 
45,153,990
 
   
 
15,676,366
 
   
 
37,976,136
 
   
 
15,481,102
 
Convertible preferred stock
   
 
—
 
   
 
6,800,000
 
   
 
—
 
   
 
6,800,000
 
Stock options
   
 
1,919,593
 
   
 
1,507,438
 
   
 
—
 
   
 
1,507,438
 
    
  
  
  
Diluted weighted-average common shares outstanding
   
 
47,073,583
 
   
 
23,983,804
 
   
 
37,976,136
 
   
 
23,788,540
 
    
  
  
  
 
(See accompanying notes to condensed consolidated financial statements)

5

Table of Contents
 
Condensed Consolidated Statements of Cash Flows
 
    
Nine months ended September 30,
  
    
2002
     
2001
  
    
(Unaudited)
     
(Unaudited)
  
Increase (Decrease) in Cash and Cash Equivalents
                  
Cash Flows From Operating Activities:
                  
Net (Loss) Income
   
$
(9,835,900
)
   
$
123,000
 
Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities:
                  
Depreciation and amortization
   
 
411,400
 
   
 
422,900
 
Provision for doubtful accounts
   
 
(24,200
)
   
 
177,100
 
Compensation expense under variable accounting of common stock options
   
 
592,400
 
   
 
183,300
 
Equity in loss of unconsolidated affiliate
   
 
198,400
 
   
 
—
 
Minority interest in loss of consolidated subsidiary
   
 
—
 
   
 
(257,400
)
Common stock issuance for services
   
 
2,121,600
 
   
 
—
 
Common stock purchase rights granted below fair value
   
 
2,308,300
 
   
 
—
 
Common stock warrant granted for services
   
 
4,305,800
 
   
 
—
 
Changes in operating assets and liabilities (excluding deconsolidated entity):
                  
Accounts receivable
   
 
(227,400
)
   
 
(310,000
)
Inventories
   
 
212,800
 
   
 
(659,400
)
Prepaid expenses and other current assets
   
 
(169,000
)
   
 
(15,600
)
Accounts payable
   
 
872,200
 
   
 
(365,400
)
Accounts payable, related party
   
 
59,700
 
   
 
—
 
Accrued expenses
   
 
(117,000
)
   
 
(276,000
)
Income taxes payable
   
 
(206,300
)
   
 
(70,900
)
Deferred revenue
   
 
(51,800
)
   
 
(159,700
)
    
  
Net Cash Provided By (Used In) Operating Activities
   
 
451,000
 
   
 
(1,208,100
)
    
  
Cash Flows From Investing Activities:
                  
Restricted cash
   
 
3,000,000
 
   
 
(1,000,000
)
Cash relinquished in deconsolidated entity
   
 
(878,300
)
   
 
—
 
Acquisition of property and equipment
   
 
(968,700
)
   
 
(203,700
)
Investments in equity-method investee
   
 
(500,000
)
   
 
—
 
Merger costs
   
 
(762,000
)
   
 
—
 
Deposits and merger costs
   
 
20,700
 
   
 
(33,500
)
    
  
Net Cash Used In Investing Activities
   
 
(88,300
)
   
 
(1,237,200
)
    
  
Cash Flows From Financing Activities:
                  
Proceeds from the sale of common stock
   
 
27,800
 
   
 
52,100
 
Proceeds from business combination
   
 
6,965,500
 
   
 
—
 
Payment on capital lease obligation
   
 
(159,200
)
   
 
(58,600
)
Payments on notes payable and lines of credit
   
 
(4,425,800
)
   
 
2,337,500
 
    
  
Net Cash Provided By Financing Activities
   
 
2,408,300
 
   
 
2,331,000
 
    
  
Net Increase (Decrease) in Cash and Cash Equivalents
   
 
2,771,000
 
   
 
(114,300
)
Cash and Cash Equivalents, beginning of period
   
 
3,742,600
 
   
 
3,004,100
 
    
  
Cash and Cash Equivalents, end of period
   
$
6,513,600
 
   
$
2,889,800
 
    
  
Supplemental Disclosure of Cash Flow Information:
                  
Cash Paid:
                  
Income taxes
   
$
242,700
 
   
$
150,500
 
Interest
   
$
110,200
 
   
$
155,500
 
Noncash Investing and Financing Activities:
                  
Capital leases entered into for equipment
   
$
340,900
 
   
$
12,700
 
    
  
 
(See accompanying notes to condensed consolidated financial statements)

6

Table of Contents
 
Condensed Consolidated Statements of Shareholders’ Equity
 
    
Common Stock
   
Additional Paid-in Capital
   
Deferred Compensation
     
Retained Earnings (Accumulated Deficit)
     
Total
  
    
Shares
   
Amount
            
Balances, December 31, 2001
   
25,542,482
   
$
25,500
   
$
1,301,000
   
$
(717,800
)
   
$
2,829,800
 
   
$
3,438,500
 
(the following information is unaudited)
                                              
Common stock issuance due to exercise of option
   
369,439
   
 
400
   
 
27,400
   
 
—
 
   
 
—
 
   
 
27,800
 
Conversion of preferred stock
   
10,531,092
   
 
10,500
   
 
1,289,500
   
 
—
 
   
 
—
 
   
 
1,300,000
 
Common stock issued in connection with reorganization, net of merger cost $762,000
   
7,896,835
   
 
7,900
   
 
6,195,600
   
 
—
 
   
 
—
 
   
 
6,203,500
 
Common stock issued for services
   
960,000
   
 
1,000
   
 
2,120,600
   
 
—
 
   
 
—
 
   
 
2,121,600
 
Common stock purchase rights granted below fair value for services
   
—
   
 
—
   
 
2,308,300
   
 
—
 
   
 
—
 
   
 
2,308,300
 
Common stock warrant granted for services
   
—
   
 
—
   
 
4,305,800
   
 
—
 
   
 
—
 
   
 
4,305,800
 
Common stock option granted for services
   
—
   
 
—
   
 
16,400
   
 
(16,400
)
   
 
—
 
   
 
—
 
Compensation expense under variable accounting of common stock options
   
—
   
 
—
   
 
264,500
   
 
327,900
 
   
 
—
 
   
 
592,400
 
Net loss
   
—
   
 
—
   
 
—
   
 
—
 
   
 
(9,835,900
)
   
 
(9,835,900
)
    
  
  
  
  
  
Balances, September 30, 2002 (Unaudited)
   
45,299,848
   
$
45,300
   
$
17,829,100
   
$
(406,300
)
   
$
(7,006,100
)
   
$
10,462,000
 
    
  
  
  
  
  
 
(See accompanying notes to condensed consolidated financial statements)

7

Table of Contents
 
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
Note 1 – The Company
 
RAE Systems Inc. (“RAE”) is a smart sensing network platform and solution provider and a leading manufacturer of single and multiple sensor atmospheric monitors, photo-ionization detectors, gas detection tubes, sampling pumps and wirelessly connected gas detection and security monitoring devices. RAE’s products and services are designed to enable its customers to monitor gas and other volatile organic compounds in confined spaces, and to establish a perimeter security around hazardous material sites and sites of weapons of mass destruction. RAE’s customers operate in such industries as safety and security, oil and gas, pharmaceuticals, utilities, food, chemical, airlines, military and hazardous material storage and disposal, and its monitors are used in civilian and government atmospheric monitoring programs in over 50 countries. RAE’s headquarters are located in Sunnyvale, California. RAE has several manufacturing sites in Jiading, Shanghai, where it manufactures approximately 25% of its components and products, and a sales office in Hong Kong, China.
 
On April 9, 2002, the merger between RAE Systems Inc. and Nettaxi.com was consummated. Nettaxi was reincorporated under the laws of the state of Delaware, and the name was changed to RAE Systems Inc. Although the former Nettaxi was the surviving corporation in the merger transaction, the stockholders and management of the former RAE acquired control of Nettaxi at the effective time of the merger. The merger transaction has been treated as a reverse merger for accounting purposes, whereby RAE is deemed to be the acquirer and Nettaxi is deemed to be the acquired entity.
 
RAE generates revenue from the sale of its gas monitoring devices and smart sensing platform and solutions, as well as through the service and repair of its equipment. RAE sells its products through a network of approximately 140 distributors, which account for approximately 90% of its sales. RAE’s customer base is varied, spanning a variety of industries, including government, airlines, oil, industrial, aerospace, chemical and shipping. In the quarter ended September 30, 2002, approximately 71% of RAE’s sales were made to customers in North America, with the remaining 29% to customers in Europe, Asia and other countries around the world.
 
RAE continues to strengthen its presence in the portable gas monitoring business, as evidenced by RAE’s development of its first two consumable products, the BadgeRAE hydrogen sulfide and the BadgeRAE carbon monoxide, which offer two years of continuous protection against these commonly encountered toxic gases. The BadgeRAE is now available for volume sales, and comes equipped with ATEX, UL and C-UL certification. RAE is strategically redirecting the company’s focus to take advantage of its 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. RAE launched several marketing campaigns geared towards the sale of this technology, and is currently building its infrastructure to support the emerging opportunities in this area.

8

Table of Contents
 
In connection with becoming a public company through a reverse merger transaction, certain options granted under the 1993 Stock Plan of RAE Systems Inc., a California corporation (“RAE California”), are subject to variable accounting in accordance with FASB Interpretation No. 44 “Accounting for Certain Transactions involving Stock Compensation” (FIN 44). As of September 30, 2002, there were 2,301,138 options that were outstanding under the Plan that were subject to variable accounting. The interim financial statements herein reflect a non-cash credit (expense reduction) of $270,000 relating to the effects of accounting for the Company’s stock options under variable accounting for the quarter ended September 30, 2002 resulting from a decline in the share price from $0.75 on June 30, 2002 to $0.45 on September 30, 2002. For the nine month period ended September 30, 2002, the financial statements herein reflect a $592,400 variable accounting charge. Based on the life of these options, the variable accounting treatment may result in unpredictable stock-based compensation dependent on fluctuations in quoted prices of our common stock for the next ten years.
 
In December 2001, as described in detail in the Company’s proxy statement filed with the Securities and Exchange Commission on March 15, 2002, the Form 10-Q filed May 14, 2002, Form S-1 filed May 31, 2002, and prospectus filed June 24, 2002, the Company issued 700,000 non-plan stock purchase rights, which vested and were exercised immediately, to an officer, a director and a consultant at an exercise price of $0.125 per share. The fair value of the underlying shares of common stock on the date of issuance was approximately $700,000. Under the terms of the stock purchase agreement with these individuals, the shares were placed in escrow and were earned contingent upon the consummation of the Merger with Nettaxi.com. In accordance with the terms of the merger agreement, the 700,000 shares were converted using an exchange ratio of 1.54869 to 1,084,083 shares. Based on the intrinsic or fair value of the respective equity instruments as of April 9, 2002, the effective date of the Merger, the company recorded a non-cash compensation charge of $2.3 million. Additionally, in connection with the closing of the merger, we recorded a $2.1 million non-cash compensation charge for the 960,000 shares of stock that was issued to Baytree Capital, and a $4.3 million non-cash compensation charge for the warrants issued to Michael Gardner, Robert Rositano and Dean Rositano.
 
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 three 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.

9

Table of Contents
 
Note 2 – Summary of Significant Accounting Policies
 
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.
 
Basis of Presentation
 
The financial information presented in this Form 10-Q is not audited and is not necessarily indicative of our 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 corporation which distributes and provides services for RAE’s products in Asia and the Pacific Rim. RAE Asia owns (i) 100% of Wa-RAE Science Instruments, Ltd (“Wa-RAE”) and (ii) 36% of REnex Technology Ltd (REnex). 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. As of September 30, 2002, REnex completed a $3 million private placement of its capital stock. Based on the terms and conditions of the contract, RAE Asia’s equity interest in REnex decreased from 47% to approximately 36%. Likewise, RAE Asia’s voting interest decreased from 90% to approximately 36%. As RAE Asia no longer owns majority interest in the voting shares, the financial statements herein reflect a change in the accounting of REnex from the consolidated method to the equity method.
 
All intercompany accounts and transactions have been eliminated in the consolidated financial statements.
 
The 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. Actual results could differ from those estimates.

10

Table of Contents
 
Revenue Recognition
 
The Company recognizes sales upon shipment, at which time title is transferred to the customer, provided no significant obligations remain and collection is probable. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. The Company has historically experienced an insignificant amount or returns. Service revenues relating to maintenance services performed by the Company, which represent less than 5% of net revenues are recognized as earned based upon contract terms, which is generally ratable over the term of service. Net sales includes amounts billed to customers in sales transactions for shipping and handling, as prescribed by the Emerging Issues Task Force Issue No. 00-10 Accounting for Shipping and Handling Fees and Costs. Shipping fees represent approximately 2.1% of net revenues.
 
Stock Based Compensation
 
In connection with becoming a public company through a reverse merger transaction, certain options granted under the former RAE California 1993 Stock Option plan are subject to variable accounting in accordance with FIN 44. The company could be subject to variable accounting for the next 10 years, the life of the options.
 
Warranty Reserve
 
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.
 
Inventory
 
Inventories are stated at the lower of cost (moving weighted average method) or market.
 
Property Plant and Equipment
 
Property and equipment are stated at cost net of accumulated depreciation. Depreciation is provided using the straight–line method over the related estimated useful lives, as follows:
 
Equipment
   
5 to 7 years
Furniture and fixtures
   
5 to 7 years
Computers equipment
   
5 years
Automobiles
   
5 years
Building improvements
   
Lesser of 5 years or the remaining lease term

11

Table of Contents
 
Recent Accounting Pronouncements
 
In June 2001, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (“FAS 141”) and Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”). FAS 141 requires the purchase method of accounting for business combinations and prohibits the use of the pooling-of-interests method. FAS 141 also prescribes new rules for the measurement and carrying of values of intangible assets. FAS 142 mandates that goodwill should no longer be amortized, but instead tested for impairment at least annually. Other intangible assets with indefinite useful lives also should not be amortized, but tested for impairment. FAS 141 applies to all business combinations initiated after June 30, 2001, and FAS 142 applies to all fiscal years beginning after December 15, 2001. The adoption of FAS 141 and FAS 142 did not have a material impact on the Company’s financial statements.
 
In August 2001, the FASB issued Statement of Financial Accounting Standards No. 143, “Accounting for Obligations Associated with the Retirement of Long-Lived Assets” (FAS 143). FAS 143 requires that the cost of asset retirement should be included as part of the overall cost of an asset and that this cost should be recognized as a liability. The asset retirement liability should be amortized over time as interest expense. FAS 143 will be effective for fiscal years beginning after June 15, 2002. Management expects that the implementation of FAS 143 will have no material effect on the Company’s financial statements.
 
In October 2001, the FASB issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (FAS 144). FAS 144 supersedes FAS 121 and requires that one accounting model be used for all long-lived assets to be disposed of and by broadening the concept of discontinued operations to apply more broadly to asset disposals. FAS 144 is effective for fiscal years beginning after December 15, 2001. The implementation of FAS 144 did not have a material impact on the Company’s financial statements.
 
Note 3 – Commitments and Contingencies
 
On November 21, 2001, RAE filed a patent infringement claim in the United States District Court of the Northern District of California against Ion Science and its distributors. The suit alleges that Ion Science manufactures, uses, imports into the United States, offers for sale, and sells photo-ionization detectors, including but not limited to the “PhoCheck” line of photo-ionization detectors. The suit further alleges that Ion Science’s photo-ionization detectors, including but not limited to its “PhoCheck” line of photo-ionization detectors, infringe patents held by RAE. On August 15, 2002, the case was dismissed with prejudice. Ion Science is in the process of re-designing their unit so as not to infringe upon the RAE patents.

12

Table of Contents
 
On October 23, 2001, the estate of Virgil Johnson filed a products liability and wrongful death lawsuit against RAE in the District Court of Harris County, Texas. The plaintiffs allege that RAE’s product was defective and unsafe for its intended purposes at the time it left RAE’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 RAE does not have adequate insurance coverage for the expenses related to the lawsuit, RAE may incur substantial legal fees and expenses in connection with the litigation. The litigation may also result in the diversion of RAE’s internal resources. RAE’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 RAE is unable to predict its final outcome. However, an adverse outcome could materially affect RAE’s results of operations and financial position.
 
On March 26, 2002, Straughan Technical Distribution, LLC, filed a lawsuit against RAE 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 RAE 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, RAE removed the California action to the United States District Court for the Northern District of California, and on April 18, 2002, RAE 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 met and discussed potential settlement opportunities. An adverse outcome could materially affect RAE’s results of operations and financial position.
 
On July 31, 2001, Envision Media, Inc. filed a lawsuit against Nettaxi.Com and Glenn Goelz, the former CFO of Nettaxi in the Superior Court of the State of California for the County of Santa Cruz. In or about June 1999, Envision Media entered into a written contract with Nettaxi whereby they agreed to do web design work for Nettaxi. Envision Media alleges breach of written contract, stating that they did not receive payments for services they performed. On or about January 31, 2001, Envision Media entered into a settlement contract with Nettaxi whereby the Envision Media agreed to accept as partial payment for its services, options to purchase shares of Nettaxi’s common stock. The contract required Nettaxi to register the shares with the Securities and Exchange Commission within 15 days of entering into the contract. Envision Media alleges breach of contract, as Nettaxi failed to register the shares within the time required under the contract. In or about December 1999, Glenn Goelz represented to Envision Media’s officer, that Nettaxi had received commitments for back up financing in order to support its growing operation resulting in a stable price of its shares. Envision Media alleged that the representation made by Glenn Goelz was false. The parties have agreed in principle to the terms of a settlement of this litigation.

13

Table of Contents
 
On May 1, 2001, Thomas Lahey et al. filed a lawsuit against Nettaxi, Inc., Robert and Dean Rositano and Glenn Goelz, officers of Nettaxi in the United States District Court of the Central District of California Southern Division. The premise for this alleged securities fraud action is that Thomas Lahey et al. purchased shares of Nettaxi as part of a private placement in February 2000 based on misrepresentations and omissions of material information. On October 7, 2002, the judge dismissed the federal case with prejudice and the state case without prejudice.
 
In addition to the litigation described above, from time to time RAE may be subject to various legal proceedings and claims that arise in the ordinary course of business.
 
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 – Quarter ended September 30, 2002
 
Net Sales.    Net sales increased from $5.0 million for the quarter ended September 30, 2001 to $5.9 million for the quarter ended September 30, 2002, an increase of 18.4%. This increase was due to an increase in the sale of our confined space gas monitors and the sale of our flexible multi-gas monitors with our patented photo-ionization detector. Additionally, we saw an increase in the sale of our smart sensing solutions. Relative to the quarter ended September 30, 2001, we experienced significant increases in sales throughout the United States, particularly sales to the First Responder community and for confined space entry. We also realized significant increases in Asia and Latin America.
 
Cost of Sales.    Cost of sales increased from $1.8 million for the quarter ended September 30, 2001 to $2.4 million for the quarter ended September 30, 2002, an increase of 30.3%. This increase was primarily due to additional material requirements to support higher volume production as well as additional personnel and related expenses to support our expanding business opportunities and to bring the manufacturing of our key components in-house. Gross margins increased from $3.1 million, or 62.8% of revenue, for the quarter ended September 30, 2001 to $3.5 million, or 59.1% of revenue,

14

Table of Contents
for the quarter ended September 30, 2002. This increase was primarily due to an increase in sales volume. The decrease in the margin as a percent of revenue, however, was attributable to increases in our manufacturing costs to support our expanding business. It was also attributable to a decrease in the price of selected products to remain competitive in the marketplace and a change in the product mix.
 
Sales and Marketing.    Sales and marketing expenses increased from $1.2 million for the quarter ended September 30, 2001 to $1.4 million for the quarter ended September 30, 2002, an increase of 19.5%. Our sales and marketing cost increased as a result of an increase in our headcount. Additionally, our advertising and sales collateral increased to support our wireless systems business as well as our new line of consumable products. These increases were partially offset by a decrease in commissions resulting from the elimination of our outside sales representatives.
 
Research and Development.    Research and development expenses decreased from $850,700 for the quarter ended September 30, 2001 to $741,600 for the quarter ended September 30, 2002, a decrease of 12.8%. The decrease in research and development expenses of $109,200 was primarily the result of a change in the accounting of REnex from the consolidated method to the equity method ($179,400). This was partially offset by an increase in our research and development activities, specifically in the area of wireless communications and sensor development.
 
General and Administrative.    General and administrative expenses decreased from $591,200 for the quarter ended September 30, 2001 to $515,000 for the quarter ended September 30, 2002, a decrease of 12.9%. As a result of being a public entity, we incurred fees, including those for public relations, SEC filings, and D&O insurance of $69,400 that we would not have otherwise incurred. We also increased our professional fees for tax planning and preparation, and for the quarterly review and related accounting services by $76,400. Additionally, our general liability and workers’ compensation insurance premiums increased by $40,300 due to the post 9/11 environment. These increases were offset by a non-cash credit (expense reduction) of $270,000 relating to 2,301,138 options granted under the 1993 RAE California Stock Option Plan that were subject to variable accounting.
 
Legal Fees and Settlement Costs.    Legal fees and settlement costs decreased from $504,000 for the quarter ended September 30, 2001 to $331,100 for the quarter ended September 30, 2002, a decrease of 34.3%. Our legal costs remain relatively high as a result of our ongoing lawsuits, including those that we inherited as a result of the merger with Nettaxi. In the quarter ended September 30, 2002, however, we did not incur a large settlement fee as we did in the quarter ended September 30, 2001. The lawsuits are described in detail elsewhere in this Form 10-Q.
 
Other Income (Expense), net.    Other income for the quarter ended September 30, 2001 was $31,700. For the same period in 2002, we had other expenses of $59,200, a change of $90,900. The change was primarily due a change in the accounting of REnex from the consolidated method to the equity method ($172,900). This change was partially offset by a decrease in interest expense resulting from the repayment of outstanding loans ($81,100).

15

Table of Contents
 
Net (Loss) Income.    Net profit increased from $1,400 for the quarter ended September 30, 2001 to $360,300 for the quarter ended September 30, 2002. The increase was a result of an increase in sales volume and a non-cash credit (expense reduction) of $270,000 resulting from 2,301,138 outstanding options in our 1993 Stock Option Plan that were subject to variable accounting. These increases were partially offset by an increase in the cost of goods to support our expanding business opportunities, an increase in marketing expenses to support the new line of consumable products and the smart sensing solutions business, and an increase in public company activities and professional services.
 
Segment Information
 
We operate in one business segment, and we use one measure of profitability to manage our business. Approximately 31.5% of our long-lived assets are located in China, and approximately 8.8% of our long-lived assets are located in Hong Kong, with the remaining long-lived assets located in the United States.
 
RESULTS OF OPERATIONS – Nine Month Period ended September 2002
 
Net Sales.    Net sales increased from $14 million for the nine month period ended September 30, 2001 to $15.6 million for the nine month period ended September 30, 2002, an increase of 11%. This increase was primarily the result of a worldwide increase in the sale of our confined space gas monitors and the sale of our flexible multi-gas monitors with our patented photo-ionization detector. We also saw an increase in the sale of our smart sensing solutions.
 
Cost of Sales.    Cost of sales increased from $5.3 million for the nine month period ended September 30, 2001 to $6.6 million for the nine month period ended September 30, 2002, an increase of 23.8%. This increase was primarily due to additional material requirements as a result of higher volume production for the nine month period ended September 30, 2002, as well as additional personnel and related expenses to support our expanding business opportunities and to bring the manufacturing of our key components in-house. Gross margins increased from $8.7 million, or 62.1% of revenue, for the nine month period ended September 30, 2001 to $9 million, or 57.8% of revenue, for the nine month period ended September 30, 2002 due to sales volume increases. The decrease in the margin as a percent of revenue, however, was attributable to increases in our manufacturing cost to support our expanding business. It was also attributable to a decrease in the price of selected products to remain competitive in the marketplace and a change in the product mix.
 
Sales and Marketing.    Sales and marketing expenses increased from $3.5 million for the nine month period ended September 30, 2001 to $4 million for the nine month period ended September 30, 2002, an increase of 13.1%. We realized an increase in the sales

16

Table of Contents
and marketing cost resulting from an increase in our headcount. We also increased our advertising and sales collateral to support both the wireless systems business as well as our new line of consumable products. This increase was partially offset by a decrease in commissions resulting from the elimination of our outside sales representatives.
 
Research and Development.    Research and development decreased from $2.3 million for the nine month period ended September 30, 2001 to $1.9 million for the nine month period ended September 30, 2002, a decrease of 16.5%. The decrease in research and development expenses of $384,400 was primarily the result of a change in the accounting of REnex from the consolidated method to the equity method ($485,700). This was partially offset by an increase in our research and development activities, specifically in the area of wireless communications and sensor development.
 
General and Administrative.    General and administrative expenses increased from $2.1 million for the nine month period ended September 30, 2001 to $3.3 million for the nine month period ended September 30, 2002, an increase of 56.7%. As a result of being a public entity, we incurred fees, including those for public relations, SEC filings, and D&O insurance of $138,800 that we would not have otherwise incurred. We also increased our professional fees for tax planning and preparation, and for the quarterly review and related accounting services by $434,000. Additionally, our general liability and workers’ compensation insurance premiums increased by $108,500 due to the post 9/11 environment. Also included in the $3.3 million is an accounting charge of $592,400 relating to options granted under the 1993 RAE California Stock Option Plan that were subject to variable accounting.
 
Legal Fees and Settlement Costs.    Legal fees decreased from $733,100 for the nine month period ended September 30, 2001 to $575,100 for the nine month period ended September 30, 2002, a decrease of 21.6%. Our legal costs remain relatively high as a result of our ongoing lawsuits, including those that we inherited as a result of the merger with Nettaxi. In the nine month period ended September 30, 2002, however, we did not incur a large settlement fee as we did in the nine month period ended September 30, 2001. The lawsuits are described in detail elsewhere in this Form 10-Q.
 
Merger Costs.    Merger costs were $8.7 million for the nine month period ended September 30, 2002. Specifically, we recorded a non-cash compensation charge of $2.3 million based on the 1,084,083 shares of our common stock issued to Messrs. Ng, Flanzraich and Frost, a non-cash charge of $2.1 million based on the shares issued to Baytree Capital, a $4.3 million non-cash charge based on the warrants issued to Messrs. Gardner, Robert Rositano and Dean Rositano. These equity instruments were issued in connection with the closing of the merger between RAE and Nettaxi.
 
Other Income (Expense), net.    Other income for the nine month period ended September 30, 2001 was $137,100. For the same period in 2002, we had other expenses of $263,800, a change of $400,900. The change was primarily due a change in the accounting of REnex from the consolidated method to the equity method ($455,800) as well as a decrease in interest income resulting from a decline in interest rates ($54,900). This change was partially offset by a decrease in interest expense resulting from having paid off the existing loans ($99,600).

17

Table of Contents
 
Net (Loss) Income.    Net profit for the nine month period ended September 30, 2001 was $123,000. For the same period in 2002, we had a net loss of $9.8 million. The decrease of net income was primarily the result of a $9.3 million non-cash accounting charge, an increase in the cost of goods to support our expanding business opportunities, an increase in marketing expenses to support the new line of consumable products and the smart sensing solutions business, and an increase in public company activities and professional services.
 
Liquidity and Capital Resources
 
To date, we have financed our operations primarily through bank borrowings and revenues from operations. As of September 30, 2002, we had $6.5 million in cash and cash equivalents. At September 30, 2002, the Company had $8 million of working capital (the excess of current assets over current liabilities) and had a current ratio of 2.4 to 1.0.
 
The net loss for the nine month period ended September 30, 2002 was comprised primarily of non-cash stock-based compensation ($9.3 million), substantially all of which was related to stock and warrant issuances, and non-cash compensation charges relating to our common stock options. Net cash provided by operating activities for the nine month period ended September 30, 2002 was $451,000, as compared with net cash used by operating activities of $1.2 million for the nine month period ended September 30, 2001. For the nine month period ended September 30, 2002, changes in operating assets and liabilities provided an increase of $373,200 in operating cash flows, whereas for the nine month period ended September 30, 2001, operating assets and liabilities used $1.9 million in operating cash flows. The favorable effects on operating cash flows resulting from the change in operating assets and liabilities is primarily reflected in accounts payable in the amount of $872,200.
 
Net cash used in investing activities for the nine month period ended September 30, 2002 was $88,300, as compared with net cash used in investing activities of $1.2 million for the nine month period ended September 30, 2001. Cash used by investing activities in the nine month period ended September 30, 2002 consisted primarily of deposits and merger costs ($741,300), the de-consolidation of REnex ($878,300) and the acquisition of property and equipment ($968,700). Our investment in property and equipment is for the implementation of our Customer Relations Management System and the construction of our new Wa-RAE manufacturing building in Jia Ding, Shanghai. These costs were partially offset by the release of restricted cash ($3 million) as a result of having paid off the lines of credit.
 
Net cash provided by financing activities for the nine month period ended September 30, 2002 was $2.4 million as compared with $2.3 for the nine month period

18

Table of Contents
ended September 30, 2001. Cash provided by financing activities for the nine month period ended September 30, 2002 was primarily the result of the proceeds from the merger transaction of $7 million, partially offset by the payments on notes payable and lines of credit of $4.4 million.
 
We believe that our existing balances of cash and cash equivalents, together with cash generated from product sales and cash made available to us as a result of our merger with Nettaxi, 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 it from pursuing our growth strategy. Any future funding may dilute the ownership of our shareholders.
 
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 three large United States financial institutions and one large Hong Kong 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, 2002, we had cash and cash equivalents of $6.5 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.
 
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. 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,

19

Table of Contents
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
 
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.

20

Table of Contents
 
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.
 
Variable accounting related to past option grants under the 1993 RAE California Stock Option Plan may impact our earnings for the next ten years.
 
In connection with becoming a public company through a reverse merger transaction, certain options under the RAE California 1993 Stock Plan are subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). As of September 30, 2002, there were 2,301,138 options that were outstanding under the Plan that were subject to variable accounting. The financial statements herein reflect a $270,000 variable accounting credit for the period ending September 30, 2002 resulting from a decline in the share price from $0.75 on June 30, 2002 to $0.45 on September 30, 2002. For the nine month period ended September 30, 2002, the financial statements herein reflect a $592,800 variable accounting charge. Based on the life of these options, the variable accounting treatment may result in unpredictable stock-based compensation charges dependent on fluctuations in quoted prices of our common stock for the next ten years, which could adversely affect our results of operations.
 
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

21

Table of Contents
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 depend on our distributors.
 
We derive approximately 90% of our revenues via our sales distribution channels, and therefore are dependant 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 depend on third party suppliers.
 
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 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 wireless systems for local and remote security monitoring. The pricing of our 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 wireless products, which would reduce our revenue and could harm our business. Further, the wireless systems market is still evolving, and we have little basis to assess the demand for our wireless products and services or to evaluate whether our wireless products and services will be accepted by the market. If our 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

22

Table of Contents
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.
 
We are involved in pending legal proceedings.
 
On November 21, 2001, RAE filed a patent infringement claim in the United States District Court of the Northern District of California against Ion Science and its distributors. The suit alleges that Ion Science manufactures, uses, imports into the United States, offers for sale, and sells photo-ionization detectors, including but not limited to the “PhoCheck” line of photo-ionization detectors. The suit further alleges that Ion Science’s photo-ionization detectors, including but not limited to its “PhoCheck” line of photo-ionization detectors, infringe patents held by RAE. On August 15, 2002, the case was dismissed with prejudice. Ion Science is in the process of re-designing their unit so as not to infringe upon the RAE patents.
 
On October 23, 2001, the estate of Virgil Johnson filed a products liability and wrongful death lawsuit against RAE in the District Court of Harris County, Texas. The plaintiffs allege that RAE’s product was defective and unsafe for its intended purposes at the time it left RAE’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 RAE does not have adequate insurance coverage for the expenses related to the lawsuit, RAE may incur substantial legal fees and expenses in connection with the litigation. The litigation may also result in the diversion of RAE’s internal resources. RAE’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 RAE is unable to predict its final outcome. However, an adverse outcome could materially affect RAE’s results of operations and financial position.

23

Table of Contents
 
On March 26, 2002, Straughan Technical Distribution, LLC, filed a lawsuit against RAE 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 RAE 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, RAE removed the California action to the United States District Court for the Northern District of California, and on April 18, 2002, RAE 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 met and discussed potential settlement opportunities. An adverse outcome could materially affect RAE’s results of operations and financial position.
 
On July 31, 2001, Envision Media, Inc. filed a lawsuit against Nettaxi.Com and Glenn Goelz, the former CFO of Nettaxi in the Superior Court of the State of California for the County of Santa Cruz. In or about June 1999, Envision Media entered into a written contract with Nettaxi whereby they agreed to do web design work for Nettaxi. Envision Media alleges breach of written contract, stating that they did not receive payments for services they performed. On or about January 31, 2001, Envision Media entered into a settlement contract with Nettaxi whereby the Envision Media agreed to accept as partial payment for its services, options to purchase shares of Nettaxi’s common stock. The contract required Nettaxi to register the shares with the Securities and Exchange Commission within 15 days of entering into the contract. Envision Media alleges breach of contract, as Nettaxi failed to register the shares within the time required under the contract. In or about December 1999, Glenn Goelz represented to Envision Media’s officer, that Nettaxi had received commitments for back up financing in order to support its growing operation resulting in a stable price of its shares. Envision Media alleged that the representation made by Glenn Goelz was false. The parties have agreed in principle to the terms of a settlement of this litigation.
 
On May 1, 2001, Thomas Lahey et al. filed a lawsuit against Nettaxi, Inc., Robert and Dean Rositano and Glenn Goelz, officers of Nettaxi in the United States District Court of the Central District of California Southern Division. The premise for this alleged securities fraud action is that Thomas Lahey et al. purchased shares of Nettaxi as part of a private placement in February 2000 based on misrepresentations and omissions of material information. On October 7, 2002, the judge dismissed the federal case with prejudice and the state case without prejudice.
 
In addition to the litigation described above, from time to time RAE may be subject to various legal proceedings and claims that arise in the ordinary course of business.

24

Table of Contents
 
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, 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:
 
 
•
 
devote greater resources to marketing and promotional campaigns;
 
 
•
 
adopt more aggressive pricing policies; or
 
 
•
 
devote more resources to technology and systems development.
 
In light of these factors, we may be unable to compete successfully.
 
We may not be successful in 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 may not be able to recruit or retain qualified personnel.
 
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, 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 Robert Henderson. The loss of the services of any of our executive officers could harm our business.

25

Table of Contents
 
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 59% 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 59% 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 are subject to one year lock-up agreements set to expire 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

26

Table of Contents
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.
 
We may be unable to adequately protect our intellectual property rights.
 
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, including the patent infringement claim we have filed against Ion Science described above, 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

27

Table of Contents
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 acquirors 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 acquiror from offering our stockholders a premium over the prevailing trading price of our common stock.
 
Item 4.    Controls and Procedures
 
(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.

28

Table of Contents
 
PART II.    OTHER INFORMATION
 
Item 1.    Legal Proceedings
 
We are involved in several legal proceedings as discussed in Note 3 “Commitments and Contingencies” to the financial statements of this Form 10-Q.
 
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
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

29

Table of Contents
 
SIGNATURE
 
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 29, 2002.
 
RAE SYSTEMS INC.
By:
  
/s/    Joseph Ng
   
Joseph Ng
Chief Financial Officer and
Vice President, Business Development
 
 

30

Table of Contents
 
CERTIFICATIONS
 
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-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.
 
October 29, 2002
 
By:
  
/s/    Robert I. Chen
   
Robert I. Chen
President, Chief Executive Officer and
Chairman of the Board

31

Table of Contents
 
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-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.
 
October 29, 2002
 
By:
  
/s/    Joseph Ng
   
Joseph Ng
Chief Financial Officer and
Vice-President, Business Development

32

Table of Contents
 
EXHIBIT INDEX
 
 
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