Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2002

OR

For the transition period from                      To                     

Commission File Number: 000-26109

RAE Systems Inc.

(Exact name of registrant as specified in its charter)

1339 Moffett Park Drive

Sunnyvale, California 94089

(Address of principal executive offices)

408-752-0723

Registrant’s telephone number, including area code:  

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 par value

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is an accelerated filer. Yes  ¨  No  x

At February 20, 2003, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $9,792,204. At February 20, 2003, the number of shares of Common Stock outstanding was 45,603,283.

DOCUMENTS INCORPORATED BY REFERENCE

Definitive Proxy Statement for the Company’s 2003 Annual Meeting of Stockholders—

Part III of this Form 10-K.

Table of Contents

Table of Contents

PART 1

In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements. These statements typically are preceded or accompanied by words like “believe,” “anticipate,” “expect,” and words of similar meaning. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in these forward-looking statements. Readers are cautioned not to place undue reliance on those forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or update or publicly release the results of any revisions or update to these forward-looking statements. Readers should carefully review the risk factors described herein and in other documents that we file from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q to be filed by RAE Systems in fiscal year 2003.

ITEM 1. BUSINESS.

RAE Systems, established in 1991, is a leading manufacturer of technologically advanced single and multiple sensor atmospheric monitors, photo-ionization detectors, gas detection tubes, sampling pumps, and wirelessly-connected gas detection and security monitoring systems.

Our hazardous environment detection solutions are used to detect and measure a wide variety of dangerous atmospheric contaminants and conditions such as combustible gas and vapor accumulations, oxygen deficiencies, and toxic gases such as carbon monoxide, hydrogen sulfide, carbon dioxide, and many other commonly encountered atmospheric hazards. Our patented photo-ionization detector technology allows dependable, linear, part-per-million range readings for many toxic gases and vapors that are effectively undetectable by any other means. Our products are particularly well suited for the measurement of volatile organic compounds such as gasoline, benzene, paints, degreasers, jet fuel, and most organic solvents. Our products are used to detect weapons of mass destruction (WMD), environmental, safety, hazardous materials (HAZMAT), toxic industrial chemical (TIC), petrochemical and semiconductor materials, and for confined space entry monitoring programs all over the world.

Our monitors are used in civilian and government atmospheric monitoring programs in over 50 countries. Our products are used by manufacturers as well by numerous city, state and federal agencies and departments. A substantial number of municipal agencies and city departments have standardized their programs on our products for confined space and HAZMAT incident response. We are also a leading supplier of gas detectors used for jet fuel vapor monitoring programs. Our customers include many of the world’s leading corporations in the airline, automotive, oil, computer and telecommunications industries. We also have significant numbers of instruments currently in service with many U.S. governmental agencies and armed forces. Our instruments are used in a wide variety of programs for the detection of vapors associated with nerve agents, chemical warfare agents (CWAs), TICs, and as part of the personal

Table of Contents

protective equipment issued to bomb-disposal, hostage-rescue, clandestine crime lab, HAZMAT, and other high-risk response teams throughout the country. To date, we have over 3,000 instruments fielded with these various United States government departments, agencies and programs.

We were incorporated as a California corporation in 1991. In April 2002 we completed a reverse merger with Nettaxi.com, and became incorporated under the laws of the state of Delaware.

OUR STRATEGY

Since our inception, we have focused on becoming a leader in the development of gas detection monitoring devices. We intend to maintain this focus by pursuing the following strategies:

Transformation from an Analytical Instrument Company to a Network Instrumentation Company. We have transformed our company from an analytical instrument company to a network instrumentation company by offering products that enable data to be transmitted and analyzed from remote locations in the field to a base station located up to two miles from site of the detector, and ultimately hosted via the Internet. We have created a network environment in which each of our instruments represents a node in a local area network, or LAN, and each LAN is, in turn, made a part of a wide area network, or WAN, such as the Internet. In such a network environment, the instruments communicate with one another and across the Internet to provide systems solutions for various industrial and security markets that require a low cost feedback loop, including HAZMAT monitoring and homeland defense.

Expand into a Variety of Industries in Order to Achieve a Broad Customer Base. We intend to leverage our core technologies across many industries in order to achieve a broad and diverse customer base. By diversifying our customer base, we hope to become less susceptible to the economic downturns and business cycles of any single industry.

Continue to Develop and Bring to Market Products Based on Patented Technology. We intend to continue to develop products based on our patented technology that are distinguishable from other products in the marketplace, and therefore help provide insulation from competitive pricing pressures. Through collaboration efforts, acquisitions and in-house research and development efforts, we intend to develop new technologies such as radiation detection.

Fully Leverage Our Low-Cost Manufacturing Base in China. As part of our overall strategy, we intend to increasingly utilize our low-cost manufacturing facilities in China, thereby lowering our production costs and increasing the gross margins on our products.

RAE SYSTEMS CAPABILITIES

2

Table of Contents

Our main strengths are in both sensor and measurement technology and integrated wireless technology.

Sensor and Measurement Technology

Our products are based on a line of proprietary and patented gas and chemical sensors. We design and manufacture the following sensors:

Photo-ionization detectors use ultraviolet light to break up the molecules of the substances being detected into charged fragments or “ions.” This produces a flow of electrical current proportional to the concentration of contaminant. Our patented photo-ionization detector technology enables dependable, linear, part-per-million range readings for many toxic gases and vapors that are virtually undetectable by any other means. Photo-ionization detection is particularly suited to the detection of the highly toxic, long-chain, low vapor pressure volatile organic compounds associated with many toxic industrial chemicals, nerve agents and chemical warfare agents.

Catalytic bead pellistors, non-dispersive infrared sensors and electro-mechanical sensors measure combustible gas, carbon dioxide and hydrocarbons, and toxic gases such as carbon monoxide using our detector technology.

Integrated Wireless Technology

In 1999, anticipating the emergence of robust wireless IP networks, we began to develop wireless capabilities for our gas monitoring instruments that enable them to detect gas from remote locations. In May 2001, we introduced the AreaRAE, a wireless-enabled gas detector, which allows for the real-time transmission of monitoring information from a base station located up to two miles away from the detectors. The AreaRAE enables HAZMAT teams, fire fighters, law enforcement officials and other users to remain a safe distance away from toxins, flames and explosives. The AreaRAE incorporates technologies such as global positioning system and geographic information system capabilities. In addition, the AreaRAE can be made to interface with the Internet, making our measurements available from virtually any location with Internet access. We intend to further enhance our products to include video or imaging capabilities that will enable security monitoring.

3

Table of Contents

COMPETITIVE STRENGTHS

As an instrument manufacturer, we have differentiated ourselves from our competition by developing specific chemical sensors, including an array of gas detectors, photo-ionization detectors, catalytic combustion sensors, non-dispersive infrared sensors, corona discharge ionization detectors, and electrochemical gas sensors. These key components enable us to innovate and create new product offerings that other instrument manufacturers may find difficult to rival, especially those competitors that rely on off-the-shelf components. Our technology is protected by 17 patent applications, eight (8) of which have been granted.

As a design and development company, we have significant experience in our industry and understand the need for microprocessor-based instruments. We have successfully integrated our gas detection technology with advanced analog/digital electronics, rechargeable lithium batteries, miniature diaphragm pumps, and liquid crystal displays into a broad family of compact, technologically advanced gas detection products. Our instruments are user friendly, durable, and used by first responder teams, mobile industrial workers, municipal employees, law enforcement agencies, and safety and hygiene professionals.

A significant advantage of our sensor products is that data can be uploaded to the Internet. To facilitate this, we founded REnex in 2001, a Hong Kong-based, wireless systems company of which we own, as of December 31, 2002, approximately 36%. REnex has developed an Application Specific Private Exchange Network, or ASPEN, dedicated for use in industrial applications. ASPEN is a self-sufficient plug-and-play system that can be customized to meet application specific needs and market requirements. We are currently collaborating with REnex in the design of a robust wireless communications system to address the needs of the homeland security, petrochemical, and environmental markets, among others.

SALES AND MARKETING

Our products are sold through a worldwide organization that includes direct sales personnel and distributors managed through our Sunnyvale, California; Hong Kong; and Skanderborg, Denmark offices. We have a sales and distribution presence in the United States, Canada, Western Europe, Mexico, Latin America, Japan and Singapore, as well as in Beijing, Shanghai, and other petroleum-focused provinces in China. As of December 31, 2002, we employed 47 people in sales and marketing and customer support services. In addition, we have a total of 180 distributors worldwide that account for approximately 90% of our revenues.

In the year ended December 31, 2002, approximately 70% of our revenues were derived from sales in North America and approximately 30% of revenues were derived from sales outside of North America. Of the sales outside of North America, approximately 32% of sales represent sales in Europe and 52% represent sales in Asia.

4

Table of Contents

Our products are marketed through direct mail and print advertisements, as well as the dissemination of brochures and other marketing collateral. We participate in industry trade shows and have a presence on the Internet where we take orders and provide information on our product offerings.

RESEARCH AND DEVELOPMENT

We are in the process of expanding our product offerings to include a line of radiation detectors, a wider variation of tubes and pumps, as well as instruments that increase selectivity in gas monitoring. As of December 31, 2002, we employed 36 people in research, development and engineering.

Our research and development process is done in collaboration with our manufacturing department. Such collaboration ensures the manufacturability of the product, and expedites the transition from the conceptual design phase to actual production.

We are engaged in a collaborative effort with the Shanghai University in China, which is known for its research depth in the electronics engineering, telecommunications, and material science fields. This collaboration has enabled cost effective and high return research and development activities, including instrument development and sensor technology. We are able to draw on the expertise of the professors at Shanghai University and recruit from the talent pool that the university has to offer.

MANUFACTURING

We have a wholly owned offshore manufacturing subsidiary, Wa-RAE, in Shanghai, China where approximately half of our components and products are manufactured. Wa-RAE operates two manufacturing sites in Shanghai, both of which are leased. The facilities consist of 20,000 square feet and 44,000 square feet of manufacturing space, respectively, and enable us to be cost competitive, while maintaining high quality manufacturing standards. We also have a manufacturing, integration and test site in Sunnyvale, California, where we manufacture some of our more complex and sensitive sensors. We have been ISO 9001 certified since 1998, and were upgraded to ISO 9001:2000 in December 2001. Our international manufacturing subsidiary WaRAE was certified to ISO 9002, and was upgraded to ISO 9001 in 2001. As of December 31, 2002, we employed 171 people in manufacturing, of which 139 are located in Shanghai, and the remainder in the United States.

COMPETITION

Competitors in the gas monitoring industry differentiate themselves on the basis of their technology, quality of product, service offerings, cost, and time to market. While we believe we compete strongly in these categories, and thus consider ourselves one of the industry leaders in the design, development and manufacture of gas monitoring devices, we face significant competition. Our primary competitors include Industrial

5

Table of Contents

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

Many 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:

If we are unable to compete successfully, our business could be seriously harmed.

EMPLOYEES

As of December 31, 2002, we employed 295 individuals, 171 of which were in manufacturing (139 in China; 32 in the US), 36 in research, development and engineering, 47 in sales and marketing, and 41 in finance, administration and information technology. Our employees are not covered by a collective bargaining agreement. We have never experienced an employment-related work stoppage and consider our employee relations to be good.

Our core engineering staff has developed a deep knowledge base in instrumentation development, measurement and control systems. They understand the design and manufacture of compact microprocessor-based instruments, and have been able to integrate multiple gas sensors with advanced analog/digital electronics, rechargeable lithium batteries, miniature diaphragm pumps, and liquid crystal displays, into portable devices. We design our instruments to be compact, rugged and easy-to-use, as well as aesthetically pleasing.

6

Table of Contents

EXECUTIVE OFFICERS AND DIRECTORS OF THE REGISTRANT

Our executive officers and directors and their ages are:

ROBERT CHEN co-founded RAE Systems in 1991 and has served as President, Chief Executive Officer, and as a member of the board of directors since our inception. From 1981 to 1990, Mr. Chen served as President and Chief Executive Officer of Applied Optoelectronic Technology Corporation, a manufacturer of computer-aided test systems, a company he founded and subsequently sold to Hewlett Packard. Mr. Chen currently serves on the board of directors for the Shanghai Ericsson Simtek Electronics Company, Limited, a telecommunications and electronics company. Mr. Chen received a B.S.E.E. from Taiwan National Cheng Kung University, a M.S.E.E. from South Dakota School of Mines and Technology, and graduated from the Harvard Owner/President program.

JOSEPH NG has served as our Vice President of Business Development and Chief Financial Officer since February 2001. From 1999 to 2001, Mr. Ng was the Marketing Manager for the E-Services Division of Hewlett-Packard, and from 1997 to 1999, the Controller for the Personal Computer and Printer Division of Hewlett-Packard. From 1995 to 1997, Mr. Ng was the Controller for the Computer Division of Hewlett-Packard-Japan, and from 1988 to 1990, the Chief Financial Officer for Applied Optoelectronic Technology Corporation. Mr. Ng received a B.S. in Accounting from Baruch College, and a M.A. in History from Stanford University. Mr. Ng is a certified public accountant in the State of California.

PETER HSI co-founded RAE Systems in 1991 and has served as our Vice President, Chief Technology Officer, and as a member of the board of directors since our inception. Prior to co-founding RAE Systems, Dr. Hsi worked at Applied Optoelectronic Technology Corporation as the chief architect for semiconductor test systems. Dr. Hsi has filed seventeen (17) patent applications, of which eight (8) have been granted and nine (9) are pending. Dr. Hsi received a B.S.E.E. from the National Chiao-Tung University, and a M.S. and Ph.D. in Electrical Engineering from Syracuse University.

7

Table of Contents

HONG TAO SUN has served as our Vice President of Engineering since January 2002. Dr. Sun joined RAE Systems in 1997, where he was instrumental in the design and development of key sensor technologies. Prior to joining RAE Systems, Dr. Sun was a research fellow for the Royal Melbourne Institute of Technology in Australia and the University of L’Aquila in Italy. Dr. Sun has over 10 years as a research scientist in the fields of photo-ionization detection and sensor development. Dr. Sun has authored over 60 international research papers, and has written two scientific books. Dr. Sun has developed six patents, three of which are in the field of photo-ionization detection. In 1990, Dr. Sun received a Ph.D. in Electrical Engineering from Xi’an Jiaotong University.

LYLE FEISEL has served as a member of our board of directors since March 2001. In 2001, he retired as the Dean of the Thomas J. Watson School of Engineering and Applied Science, and Professor of Electrical Engineering at the State University of New York at Binghamton. Dr. Feisel joined the faculty of SUNY Binghamton in 1983. Dr. Feisel is a Life Fellow of the Institute of Electrical and Electronics Engineers and of the American Society for Engineering Education, and is a Fellow of the National Society of Professional Engineers. He is active in the affairs of those organizations and in the development and accreditation of engineering education worldwide. Dr. Feisel received his B.S., M.S. and Ph.D. degrees in Electrical Engineering from Iowa State University.

NEIL W. FLANZRAICH has served as a member of our board of directors since December 2000. Since May 1998, he served as Vice Chairman and President of IVAX Corporation, a pharmaceutical company. From 1995 to May 1998, Mr. Flanzraich served as Chairman of the Life Sciences Legal Practice Group of Heller Ehrman White and McAuliffe, and from 1981 to 1994, Senior Vice President and member of the corporate Operating Committee at Syntex Corporation, a pharmaceutical company. Mr. Flanzraich is a director of the Whitman Education Group, Inc., IVAX Diagnostics, and Continucare Corporation. He also serves as Chairman of the Israel America Foundation. Mr. Flanzraich received an A.B. from Harvard College and a J.D. from Harvard Law School.

EDWARD C. ROSS has served as a member of our board of directors since March 2001, and is currently the President of TSMC North America. From 1998 to 2000, Dr. Ross served as Senior Vice President of the Professional Services Group of Synopsys, Inc., a computer-aided design company, where he was responsible for developing and executing Synopsys’ consulting business practices. From 1995 to 1998, Dr. Ross was the President of the Technology and Manufacturing Group of Cirrus Logic, a semiconductor company. Dr. Ross received a B.S.E.E from Drexel University, and a M.S.E.E., M.A, and Ph.D. from Princeton University.

BO ANDERSSON has served as a member of our board of directors since June 2002. In September 2002, he was appointed President of Ericsson Micro Components, and from May 2000 to August 2002, served as President and CEO of Ericsson Microelectronics. In 1998, Mr. Andersson was appointed Head of the Microelectronics Business Unit and between 1994 to 1998, was the General Manager for the Power Modules Business within the Ericsson Components AB. In 1994, Mr. Andersson was the Project Manager for the building of the sub micron facility in Kista, Sweden, and in 1977,

8

Table of Contents

he joined Ericcson where he was the Head of Process Technology Development. Mr. Andersson is Chairman of the Board of Ericsson Power Modules AB and Chairman of the Board of Shanghai Ericsson Simtec Electronics Co., Ltd. He is also Chairman of the Steering Committee for the Microtechnologies Centre at Chalmers University in Sweden. Mr. Andersson received a Master of Science degree in Physical Engineering from the Royal Institute of Technology in Stockholm, Sweden in 1977.

ITEM 2. PROPERTIES.

Our corporate headquarters and principal offices are located in a leased facility in Sunnyvale, California. The Sunnyvale facility consists of approximately 25,000 square feet, which includes research and development, sales and marketing, and general and administrative operations, under a lease expiring in October 2009. The current facility is adequate to meet the needs of our current operations.

We maintain a sales office in Fan Ling, Hong Kong, from which we sell our products to Asia. The lease of the Fan Ling office has been renegotiated for a period of three years commencing in January 2002. Through our wholly-owned subsidiary, Wa-RAE, we lease two state-of-the-art manufacturing and research and development sites in Shanghai, China, consisting of approximately 20,000 square feet and 44,000 square feet, respectively. The first of the two leases will expire in phases as to portions of the property from March 2004 until March 2008. The second of the two leases expires in January 2007 and contains an option to purchase the property. We also maintain a sales and service center in Skanderborg, Denmark, from which we sell our products to Europe, Australia and New Zealand, the Middle East and Africa.

ITEM 3. LEGAL PROCEEDINGS.

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 law claims with prejudice and the state law claims without prejudice.

On July 31, 2001, Envision Media, Inc. filed a lawsuit against us in the Superior Court of the State of California for the County of Santa Cruz. In lieu of services provided, Envision Media agreed to accept as partial payment for its services, options to purchase shares of Nettaxi’s common stock. The contract required us to register the shares with the Securities and Exchange Commission within 15 days of entering into the contract. The premise for this lawsuit was that we failed to register the Nettaxi shares within the time specified in the contract. This case has been settled.

On October 23, 2001, the estate of Virgil Johnson filed a products liability and wrongful death lawsuit against us in the District Court of Harris County, Texas. The

9

Table of Contents

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

On March 26, 2002, Straughan Technical Distribution, LLC, filed a lawsuit against us in the Superior Court of the State of California for the County of Santa Clara. A similar lawsuit pending in District Court of Harris County, Texas was served on us on March 27, 2002. In these nearly identical lawsuits, Straughan, a distributor of Gastec Gas Detection Devices, claims to have experienced diminished sales to its customers, loss of profits and other damages as a result of the stated allegations, which include claims for interference with present and prospective business relations, false advertising, trade dress infringement, slander and antitrust violations. On April 17, 2002, we removed the California action to the United States District Court for the Northern District of California, and on April 18, 2002, we removed the Texas action to the United States District Court for the Southern District of Texas. On October 8, 2002, the principals of Straughan and RAE Systems met and discussed potential settlement opportunities. In February 2003, we agreed with Straughan to settle all claims asserted against each other. We are currently finalizing the terms of the settlement agreement.

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

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

Our common stock has been trading on the NASD OTC Market Bulletin Board under the trading symbol “RAEE.OB” since April 9, 2002, when we completed our merger with Nettaxi.com. The following table sets forth, for the periods indicated, the high and low bid prices for our common stock as reported by various Bulletin Board market makers. The quotations do not reflect adjustments for retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions.

10

Table of Contents

Prior to the merger, from October 12, 1998 until April 9, 2002, Nettaxi’s common stock was traded on the OTC Bulletin Board under the trading symbol “NTXY” and RAE Systems’ securities were not publicly traded. The following table sets forth, for the periods indicated, the high and low bid prices for our common stock as reported by various Bulletin Board market makers. The quotations do not reflect adjustments for retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions. The bid prices reflected below have been adjusted to account for a 1 for 5.67 reverse stock split of our common stock on April 9, 2002.

As of February 20, 2003, there were 427 shareholders of record who held shares of our common stock.

We have never declared or paid dividends on our common stock and currently do not intend to pay dividends in the foreseeable future so that we may reinvest our earnings in the development of our business. The payment of dividends in the future will be at the discretion of the Board of Directors.

The following table provides information as of December 31, 2002 with respect to our compensation plans under which our equity securities are authorized for issuance:

11

Table of Contents

ITEM 6. SELECTED FINANCIAL DATA.

SUMMARY FINANCIAL DATA

The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the Consolidated Financial Statements of RAE Systems Inc. and Notes thereto, and other financial information included elsewhere in this Form 10-K. Historical results are not necessarily indicative of results that may be expected for future periods.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.

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

12

Table of Contents

information, refer to the section entitled “Factors that May Affect Future Results” in this Form 10-K. The following discussion should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Form 10-K.

OVERVIEW

RAE Systems is a leading manufacturer of technologically advanced single and multiple sensor atmospheric monitors, photo-ionization detectors, gas detection tubes, sampling pumps, and wirelessly-connected gas detection and security monitoring systems. Our hazardous environment detection solutions are used to detect and measure a wide variety of dangerous atmospheric contaminants and conditions such as combustible gas and vapor accumulations, oxygen deficiencies, and toxic gases such as carbon monoxide, hydrogen sulfide, carbon dioxide, and many other commonly encountered atmospheric hazards. Our patented photo-ionization detector technology allows dependable, linear, part-per-million range readings for many toxic gases and vapors that are effectively undetectable by any other means. Our products are particularly well suited for the measurement of volatile organic compounds such as gasoline, benzene, paints, degreasers, jet fuel, and most organic solvents. Our products are used to detect weapons of mass destruction (WMD), environmental, safety, hazardous materials (HAZMAT), toxic industrial chemical (TIC), petrochemical and semiconductor materials, and for confined space entry monitoring programs all over the world.

On April 9, 2002, our merger with Nettaxi.com (“Nettaxi”) was consummated. Nettaxi, as the surviving corporation in the merger transaction and the Registrant, changed its name to RAE Systems Inc. Our stockholders received approximately 80% of the common stock of the newly merged entity at the effective time of the merger and our management team continued in their existing roles with our Company. Accordingly, our merger with Nettaxi has been accounted for as a reverse acquisition whereby, for accounting purposes, we are deemed to be the acquiror and Nettaxi is deemed to be the acquired entity. As Nettaxi had effectively ceased all revenue generating activities nine months prior to our merger and had planned to abandon (and did abandon) its business model with effect from the consummation of the merger, Nettaxi was deemed to be in substance a shell company. Accordingly, our merger with Nettaxi has been treated as a recapitalization with no goodwill. For this reason, pro forma information giving effect to the merger is not presented.

We generate revenue from the sale of our gas monitoring devices and smart sensing platform and solutions, as well as through the service and repair of our equipment. We sell our products through a network of approximately 180 distributors, which account for approximately 90% of our sales. Our customer base is varied, spanning a variety of industries, including government, airlines, oil, industrial, aerospace, chemical and shipping. In the year ended December 31, 2002, approximately 70% of our sales were made to customers in North America, 10% to customers in Europe and 16% to customers in Asia.

13

Table of Contents

We continue to strengthen our presence in the portable gas monitoring business, as evidenced by our development of two consumable products, the BadgeRAE hydrogen sulfide monitor and the BadgeRAE carbon monoxide monitor, 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. We are 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. We launched several marketing campaigns geared towards the sale of this technology, and are currently building our infrastructure to support the emerging opportunities in this area.

In connection with becoming a public company through a reverse merger transaction, certain options granted under our 1993 Stock Plan are subject to variable accounting in accordance with FASB Interpretation No. 44 “Accounting for Certain Transactions involving Stock Compensation” (FIN 44). As of December 31, 2002, there were 2,014,941 options that were outstanding under the Plan that were subject to variable accounting. For the year ended December 31, 2002, the financial statements herein reflect a $374,700 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 nine years.

In December 2001 we 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, we 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 were issued to Baytree Capital, and a $4.3 million non-cash compensation charge for the warrants issued to principals and advisors of Nettaxi.

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 and voting interest in REnex decreased from 47% to approximately 36%. Prior to July 2002, RAE Asia exercised managerial control over the day-to-day operations of Renex and held approximately 90% of the voting shares of REnex, accordingly, prior to 2002, REnex was consolidated in our financial statements. As RAE Asia no longer owns majority interest in the voting shares, our financial statements herein reflect a change in the accounting for REnex from the consolidated method to the equity method. This change has been applied with effect from January 1, 2002 and, accordingly, this change has significantly impacted

14

Table of Contents

the comparability of the 2002 amounts versus the 2001 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.

As discussed elsewhere in this report on Form 10-K, we are currently involved in various legal proceedings. Regardless of the eventual outcome, such litigation will likely be time consuming, and may result in the diversion of our internal resources. Each of the two remaining lawsuits is in a preliminary stage, therefore the eventual outcome of each is difficult to determine. Any adverse result in either of the lawsuits could materially affect our results of operations and financial position.

CRITICAL ACCOUNTING POLICIES

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. Note 1 to the Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the Consolidated Financial Statements. 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 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 our historical experience, our estimates of the recoverability of amounts due to us could be overstated, and our 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 our products, or if there were a higher occurrence of inventory obsolescence due to changing technology and customer requirements, we could be required to increase our inventory allowances and our gross margins could be adversely affected.

15

Table of Contents

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

We are subject to various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our 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. We regularly evaluate current information available to us to determine whether such accruals should be adjusted.

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

RECENT ACCOUNTING PRONOUNCEMENTS

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

In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities (SFAS 146). This Statement requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. SFAS 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002. We do not expect the adoption of this Statement to have a material impact on our financial position or results of operations.

16

Table of Contents

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123 (SFAS 148). This Statement provides alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock based compensation. It also amends the disclosure provisions of SFAS 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. Further, SFAS 148 amends Accounting Principles Board Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. SFAS 148 is effective for our financial statements beginning January 1, 2003. We are currently evaluating the effects of the adoption of SFAS 148 on our financial statements. We have not determined whether we will voluntarily change to the fair value based method of accounting for stock-based compensation.

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. We do not expect the adoption of this Interpretation to have a material impact on our 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. We do not expect the adoption of this Interpretation to have a material impact on our financial position or results of operations

COMPARISON OF 2002 AND 2001

Net Sales.    Net sales increased from $19 million for the year ended December 31, 2001 to $21.8 million for the year ended December 31, 2002, an increase of 14.9%. This increase was primarily the result of a worldwide increase in the sales of our confined space gas monitors and the sales of our flexible multi-gas monitors with our patented photo-ionization detector. We also saw an increase in the sales of our smart sensing solutions.

Cost of Sales.    Cost of sales increased from $7 million for the year ended December 31, 2001 to $8.8 million for the year ended December 31, 2002, an increase of 24.6%. This increase was primarily due to additional material required 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 $12 million, or 63% of revenue, for the year ended December 31, 2001 to $13.1 million, or 59.8% of revenue, for the year ended

17

Table of Contents

December 31, 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 shift in the product mix and a decrease in the price of selected products to remain competitive in the marketplace.

Sales and Marketing.    Sales and marketing expenses increased from $4.5 million for the year ended December 31, 2001 to $5.4 million for the year ended December 31, 2002, an increase of 19.4%. Our sales and marketing costs increased as a result of an increase in our headcount to support our expanding business. Additionally, our advertising and sales collateral increased to support our wireless systems business, our new line of consumable products, and our expanding international and homeland security businesses. 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 $3.3 million for the year ended December 31, 2001 to $2.5 million for the year ended December 31, 2002, a decrease of 23.1%. The decrease in research and development expenses of $758,200 was primarily the result of a change in the accounting of REnex from the consolidated method to the equity method. 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 $3.1 million for the year ended December 31, 2001 to $4.4 million for the year ended December 31, 2002, an increase of 45.6%. As a result of being a public entity, we incurred fees, including those for public relations, SEC filings, and D&O insurance of $202,400 that we would not have otherwise incurred. We also increased our professional fees for management consulting, tax planning and preparation, and for the quarterly review and yearly audit by $703,300. Also included in the $4.4 million is a non-cash accounting charge of $374,700 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 and settlement costs decreased from $1.2 million for the year ended December 31, 2001 to $968,700 for the year ended December 31, 2002, a decrease of 21.7%. Our legal costs were high because of our pending lawsuits. Three of the five lawsuits have been settled or dismissed The lawsuits are described in detail elsewhere in this Form 10-K.

Merger Costs.    Merger costs were $8.7 million for the year ended December 31, 2002. We recorded a non-cash compensation charge of $2.3 million based on the 1,084,083 shares of our common stock issued to our principals and advisors, a non-cash charge of $2.1 million based on the shares issued to Baytree Capital and a $4.3 million non-cash charge based on the warrants issued to principals and advisors of Nettaxi. These equity instruments were issued in connection with the closing of our merger with Nettaxi.

18

Table of Contents

Other Income (Expense), net.    Other expenses for the year ended December 31, 2001 were $167,100. For the same period in 2002, we had other expenses of $348,800, a change of $181,700. The change was primarily due to a change in the accounting of REnex from the consolidated method to the equity method ($283,700) as well as a decrease in interest income resulting from a decline in interest rates ($82,400). These changes were partially offset by a decrease in interest expense resulting from having paid off the existing loans ($175,300).

Net (Loss) Income.    Net income for the year ended December 31, 2001 was $136,800. For the same period in 2002, we had a net loss of $9.5 million. The decrease of net income was primarily the result of a $9.3 million non-cash accounting charge relating to merger costs and compensation, 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. These increases were partially offset by a deferred compensation charge in 2001, a decrease in the price of our material and a decrease in commissions resulting from the elimination of our outside sales representatives.

COMPARISON OF 2001 AND 2000

Net Sales.    Net sales increased from $18.2 million for the year ended December 31, 2000 to $19.0 million for the year ended December 31, 2001, an increase of 4.5%. Sales for the year ended December 31, 2000 included the recognition of $3.8 million from a single contract, the proceeds of which were recognized entirely in 2000. Excluding revenue derived from the contract, our net sales increased by $4.6 million, or 31.9%, for the year ended December 31, 2001 as compared to the year ended December 31, 2000. The increase in net sales was due to an increase in the amount of sales of our products, including sales in the tube market.

Cost of Sales.    Cost of sales increased from $6.6 million for the year ended December 31, 2000 to $7.0 million for the year ended December 31, 2001. The increase was due primarily to an increase in sales. Gross margins decreased from 63.8% for the year ended December 31, 2000 to 63.0% for the year ended December 31, 2001. The decrease in gross margins was primarily the result of decreases in the prices of certain products in order to remain competitive in the market place. This decrease was offset by the introduction of new products with higher gross margins.

Sales and Marketing.    Sales and marketing expenses decreased from $4.6 million for the year ended December 31, 2000 to $4.5 million for the year ended December 31, 2001. The decrease was due primarily to a decrease in trade show expenses.

Research and Development.    Research and development expenses increased from $3.2 million for the year ended December 31, 2000 to $3.3 million for the year ended December 31, 2001. The completion of the development of various products resulted in a reduction of approximately $500,000 in research and development expenses in 2001 as

19

Table of Contents

personnel costs, consulting fees and raw materials costs associated with such development were eliminated. The reclassification of five employees from research and development to manufacturing resulted in a decrease of $176,000 of research and development expenses in 2001. The consolidation of REnex, our 47% owned subsidiary resulted in an increase of research and development expenses of $792,000 for the year ended December 31, 2001.

General and Administrative.    General and administrative expenses increased from $2.2 million for the year ended December 31, 2000 to $3.1 million for the year ended December 31, 2001. The increase was primarily due to additional personnel and personnel related expenses as well as an increase in bad debt and miscellaneous reserves. Also, in connection with various stock option grants to employees and consultants, RAE incurred non-cash compensation charges of $200,100 for the year ended December 31, 2001 as compared to $62,100 for the year ended December 31, 2000.

Legal Fees and Settlement Costs.    Legal fees and settlement costs increased from $291,100 for the year ended December 31, 2000 to $1.2 million for the year ended December 31, 2001. The increase was primarily due to costs associated with the settlement and litigation of various lawsuits.

Other Income (Expense).    Other expense increased from $61,800 for the year ended December 31, 2000 to $167,100 for the year ended December 31, 2001. The increase was primarily attributable to the reduction of interest income in 2001 ($61,500) and an increase in interest expense in 2001 ($21,800).

Net income.    Net income decreased from $829,200 for the year ended December 31, 2000 to $136,800 for the year ended December 31, 2001. The decrease in net income was primarily the result of an increase in legal fees and settlement cost, general and administrative expenses, and the increased research and development activity at REnex, which was partially offset by the minority interest’s share in the losses of REnex and by lower research and development activity at RAE.

LIQUIDITY AND CAPITAL RESOURCES

To date, we have financed our operations primarily through bank borrowings, revenues from operations and proceeds of issuances of equity securities. As of December 31, 2002, we had $7.2 million in cash and cash equivalents. At December 31, 2002, we had $8.3 million of working capital (the excess of current assets over current liabilities) and had a current ratio of 2.5 to 1.0.

The net loss for the year ended December 31, 2002 was comprised primarily of non-cash stock-based compensation ($9.3 million), substantially all of which was related to stock and warrant issuances ($8.7 million), and non-cash compensation charges relating to our common stock options ($0.6 million). Net cash provided by operating activities for the year ended December 31, 2002 was $1.3 million, as compared with net cash used by operating activities of $947,500 for the year ended December 31, 2001. For

20

Table of Contents

the year ended December 31, 2002, changes in operating assets and liabilities provided an increase of $465,700 in operating cash flows, whereas for the year ended December 31, 2001, operating assets and liabilities used $1.4 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 accrued expenses in the amount of $458,000 and inventories in the amount of $304,100.

Net cash provided by investing activities for the year ended December 31, 2002 was $553,600, as compared with net cash used in investing activities of $1.2 million for the year ended December 31, 2001. Cash provided by investing activities in the year ended December 31, 2002 consisted primarily of the release of the restriction on $3 million in cash resulting from the repayment of our outstanding lines of credit, partially offset by the de-consolidation of REnex ($878,300), investments in REnex ($500,000) and the acquisition of property and equipment ($1.2 million). Our investment in property and equipment was for the implementation of our Customer Relations Management System and the construction of our new Wa-RAE manufacturing building in Jia Ding, Shanghai.

Net cash provided by financing activities for the year ended December 31, 2002 was $1.6 million as compared with $2.9 million for the year ended December 31, 2001. Cash provided by financing activities for the year ended December 31, 2002 was primarily the result of the proceeds from the merger transaction of $7 million, partially offset by the payment of merger costs of $762,000 and 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 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. In April 2002, we used the proceeds received from our merger with Nettaxi to pay off and cancel our outstanding lines of credit and, as of December 31, 2002, we do not have any lines of credit available from which to borrow. 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.

21

Table of Contents

CONTRACTUAL CASH OBLIGATIONS

The following table quantifies our future contractual obligations as of December 31, 2002:

ITEM 7A.    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, one large Hong Kong financial institution, and one large Danish financial institution. Our deposits may exceed the amount of insurance available to cover such deposits. To date, we have not experienced any losses of deposit of cash and cash equivalents. Management regularly reviews our deposit amounts and the credit worthiness of the financial institution which holds our deposits.

INTEREST RATE RISK

As of December 31, 2002, we had cash and cash equivalents of $7.2 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, 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

22

Table of Contents

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.

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

23

Table of Contents

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 our 1993 Stock Option Plan may impact our earnings for the next nine years.

In connection with becoming a public company through a reverse merger transaction, certain options under our 1993 Stock Plan are subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). As of December 31, 2002, there were 2,014,941 options that were outstanding under the Plan that were subject to variable accounting. For the year ended December 31, 2002, the financial statements herein reflect a $374,700 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 nine 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 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.

24

Table of Contents

We depend on our distributors.

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

We 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 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.

25

Table of Contents

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

On March 26, 2002, Straughan Technical Distribution, LLC, filed a lawsuit against us in the Superior Court of the State of California for the County of Santa Clara. A similar lawsuit pending in District Court of Harris County, Texas was served on us on March 27, 2002. In these nearly identical lawsuits, Straughan, a distributor of Gastec Gas Detection Devices, claims to have experienced diminished sales to its customers, loss of profits and other damages as a result of the stated allegations, which include claims for interference with present and prospective business relations, false advertising, trade dress infringement, slander and antitrust violations. On April 17, 2002, we removed the California action to the United States District Court for the Northern District of California, and on April 18, 2002, we removed the Texas action to the United States District Court for the Southern District of Texas. On October 8, 2002, the principals of Straughan and RAE Systems met and discussed potential settlement opportunities. In February 2003, we agreed with Straughan to settle all claims asserted against each other. We are currently finalizing the terms of the settlement agreement.

26

Table of Contents

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

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

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

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.

27

Table of Contents

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 and Peter Hsi. The loss of the services of any of our executive officers could harm our business.

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

Our revenue growth is dependent on the timely introduction of new products to market. We may be unsuccessful in identifying new product and service opportunities or in developing or marketing new products and services in a timely or cost-effective manner. In addition, product innovations may not achieve the market penetration or price stability necessary for profitability.

Our officers, directors and principal stockholders beneficially own approximately 64% of our common stock and, accordingly, may exert substantial influence over the company.

Our executive officers and directors and principal stockholders, in the aggregate, beneficially own approximately 64% of our common stock. These stockholders acting together have the ability to control all matters requiring approval by our stockholders. These matters include the election and removal of the directors, amendment of our certificate of incorporation, and any merger, consolidation or sale of all or substantially all of our assets. In addition, they may dictate the management of our business and affairs. Furthermore, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination, and may substantially reduce the marketability of our common stock.

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

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

28

Table of Contents

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

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

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

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

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.

29

Table of Contents

Any litigation relating to our intellectual property rights could, regardless of the outcome, have a materially adverse impact our business and results of operations.

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

We may, from time to time, be subject to claims of infringement of other parties’ proprietary rights or claims that our own trademarks, patents or other intellectual property rights are invalid. Any claims of this type, regardless of merit, could be time-consuming to defend, result in costly litigation, divert management’s attention and resources or require us to enter into royalty or license agreements. The terms of any such license agreements may not be available on reasonable terms, if at all, and the assertion or prosecution of any infringement claims could significantly harm our business.

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

We may acquire or make investments in complementary businesses, technologies, services or products if appropriate opportunities arise. The process of integrating any acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures. Integration of an acquired company also may consume much of our management’s time and attention that would otherwise be available for ongoing development of our business. Moreover, the anticipated benefits of any acquisition may not be realized. Future acquisitions could result in dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or expenses related to goodwill recognition and other intangible assets, any of which could harm our business.

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

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

30

Table of Contents

ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

Our consolidated financial statements included in this report beginning on page F-1 are incorporated herein by reference.

ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.

None.

PART III

ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

For information with respect to our directors and executive officers, see “Executive Officers and Directors” at the end of Item I in Part I of this report.

ITEM 11.    EXECUTIVE COMPENSATION.

The information required by this Item, which will be set forth in our Proxy Statement for our 2003 Annual Meeting of Stockholders under the caption “Executive Compensation and Other Matters”, is incorporated herein by reference.

ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.

The information required by this Item, which will be set forth in our Proxy Statement for our 2003 Annual Meeting of Stockholders under the caption “Security Ownership of Certain Beneficial Owners and Management”, is incorporated herein by reference.

ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

The information required by this Item, which will be set forth in our Proxy Statement for our 2003 Annual Meeting of Stockholders under the caption “Certain Relationships and Related Transactions”, is incorporated herein by reference.

ITEM 14.    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.

31

Table of Contents

(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.

PART IV.

ITEM 15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K.

See Contents containing an index of the Consolidated Financial Statements at page F-i of this Form 10-K.

Schedules are not provided because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.

(3)  Exhibits

32

Table of Contents

None.

33

Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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 February 27, 2003.

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Robert I. Chen and Joseph Ng, and each of them, as such person’s true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for such person and in such person’s name, place and stead, in any and all capacities, to sign any and all amendments to this report on Form 10-K, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as such person might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated:

34

Table of Contents

35

Table of Contents

CERTIFICATIONS

I, Robert I. Chen, certify that:

February 27, 2003

36

Table of Contents

I, Joseph Ng, certify that:

February 27, 2003

37

Table of Contents

F-1

Table of Contents

To the Board of Directors and Shareholders

RAE Systems Inc. and subsidiaries

We have audited the accompanying consolidated balance sheets of RAE Systems Inc. and subsidiaries (the Company) as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RAE Systems Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.

BDO Seidman, LLP

San Jose, California

January 28, 2003

F-2

Table of Contents

RAE Systems Inc.

Consolidated Balance Sheets

See accompanying notes to consolidated financial statements.

F-3

Table of Contents

RAE Systems Inc.

Consolidated Statements of Operations

See accompanying notes to consolidated financial statements.

F-4

Table of Contents

RAE Systems Inc.

Consolidated Statements of Shareholders’ Equity

(Note 10)