UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003

OR

FOR THE 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
408-752-0723
(Address of registrant’s principal executive offices)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the registrant was required to file such reports, and (2) has been subject to filing requirements for the past 90 days.

YES  |X|      NO  |_|

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

YES  |_|       NO  |X|

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

RAE Systems Inc.

INDEX

Part I.   Financial Information

Part II. Other Information

Signatures

Certifications

Exhibit Index

Exhibits

PART I.     Financial Information

In connection with our becoming a public company through a reverse merger transaction, certain options under our 1993 Stock Plan became subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). As of December 31, 2002, there were 2,014,941 options outstanding under the 1993 Stock Plan that were subject to variable accounting. To eliminate the variable effects of such accounting treatment, we have adopted the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003 under the modified prospective method as provided for in SFAS 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. Our interim financial statements herein for the quarter and the six-month period ended June 30, 2003 reflect a non-cash compensation charge related to options of $155,300 and $280,300, respectively. In June 2003, we issued a warrant to purchase 450,000 shares of our common stock, to Jefferies/Quarterdeck for the purpose of retaining their financial advisory services. The warrant vested immediately and is exercisable over four years. The fair value of this warrant, assessed to $328,800, will be amortized over the service period. For the quarter and six-month period ended June 30, 2003, we have taken a charge related to this warrant in the amount of $27,400. Stock-based compensation charges have significantly impacted our financial statements, and will continue to impact the financial statements on a prospective basis.

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

Condensed Consolidated Balance Sheets

RAE Systems Inc.

Condensed Consolidated Balance Sheets

(See accompanying notes to condensed consolidated financial statements)

Condensed Consolidated Statements of Operations

RAE Systems Inc.

Condensed Consolidated Statements of Operations

(See accompanying notes to condensed consolidated financial statements)

Condensed Consolidated Statements of Cash Flows

RAE Systems Inc.

Condensed Consolidated Statements of Cash Flows

(See accompanying notes to condensed consolidated financial statements)

Notes to Condensed Consolidated Financial Statements
(Unaudited)

Note 1 – The Company

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

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

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

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

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

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

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 the Company’s future consolidated financial position, results of operations or cash flows. The unaudited financial statements contained in this Form 10-Q have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position, results of operations and its cash flows for the stated periods, in conformity with accounting principles generally accepted in the United States of America.

        Principles of Consolidation

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

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

        RAE Asia’s equity interest in REnex has, been accounted for under the equity method in the accompanying financial statements. In this regard, the Company’s share of the net loss of REnex is reflected in the caption “equity in loss of unconsolidated affiliate” in the accompanying consolidated statements.

        Earnings Per Share

The Company applies the provisions of SFAS No. 128, Earnings Per Share. SFAS No. 128 provides for the calculation of basic and diluted earnings per share. Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity. Anti-dilution provisions of SFAS No. 128 require consistency between diluted per-common-share amounts and basic per-common share amounts in loss periods. Incremental shares attributable to the assumed exercise of 3,852,917 have increased the diluted shares outstanding by 1,597,686 for the quarter ended June 30, 2003 and 1,525,955 for the six-month period ended June 30, 2003. Of the 400,000 non-plan options to purchase shares of common stock at average price of $0.98, 100,000 of those shares is included in the diluted shares outstanding for the quarter ended June 30, 2003. Warrants outstanding to purchase 2,552,734 shares of common stock at prices between $1.07 per share and $1.34 per share were not included in the computation of diluted earnings per share because the exercise prices were greater than the average market price of the common stock during the three-month and six-month periods ended June 30, 2003.

        Use of Estimates

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

        The allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there were a deterioration of a major customer’s credit worthiness, or if actual defaults were higher than what has been experienced historically, the Company’s estimates of the recoverability of amounts due could be overstated. The Company’s operating results could be adversely affected.

        Inventories are stated at the lower of cost (moving weighted average method) or market. Inventory purchases are typically based on estimated future demand. In the event of a sudden and significant decrease in demand for RAE’s products, or if there were a higher occurrence of inventory obsolescence due to changing technology and customer requirements, RAE’s gross margins could be adversely affected. In addition, RAE could be required to increase its inventory allowances.

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

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

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

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 the Company adopted during 2002, did not have a material impact on the Company’s financial position or results of operations.

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

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

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

Note 3– Commitments and Contingencies

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

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

Note 4 – Stock Based Compensation

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

Note 5 – Warranty Reserve

Product warranty liabilities are provided for as described in Note 2 to these condensed consolidated financial statements. Following is a summary of the changes in these liabilities during the quarters and six-month periods ended June 30, 2003 and 2002:

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 June 30, 2003

Net Sales. Net sales increased from $5.2 million for the quarter ended June 30, 2002 to $7.5 million for the quarter ended June 30, 2003, an increase of 44.4%. This increase was due to a significant increase in government sales, particularly for homeland security where we recognized a significant increase in sales of our MiniRAE 2000 and our AreaRAE systems sales. We also recognized growth in our confined space entry products and in the introduction of our consumable and radiation products. We experienced increased US sales which was primarily due to government homeland defense spending. We also experienced increased sales in Asia for indoor air quality applications.

Cost of Sales. Cost of sales increased from $2.2 million for the quarter ended June 30, 2002 to $2.6 million for the quarter ended June 30, 2003, an increase of 21.6%. This increase was primarily due to an increase in the sales volume. Gross margins increased from $3.0 million, or 58.3% of revenue, for the quarter ended June 30, 2002 to $4.8 million, or 64.9% of revenue, for the quarter ended June 30, 2003. The gross margin increased due to production efficiencies resulting from the increase in sales volume as well as our product mix, specifically the growth in our systems sales with higher margins. The cost of material decreased slightly during this period as well. We had a reserve for inventory obsolescence and standard cost revisions; however, after analyzing our current situation we lowered this reserve based on historical obsolescence trends and the standard cost roll-up. This decrease in inventory reserves had a positive impact on our gross margin.

Sales and Marketing. Sales and marketing expenses increased from $1.5 million for the quarter ended June 30, 2002 to $1.9 million for the quarter ended June 30, 2003, an increase of 30.3%. Our sales and marketing cost increased in the United States as a result of increases in advertising and tradeshow expenses of $244,000 to support our homeland defense position, our wireless systems solution, and to launch our new suite of radiation detectors. Our expenses increased in Europe by $54,900 to grow the infrastructure to support the European sales and service center.

Research and Development. Research and development expenses increased from $611,300 for the quarter ended June 30, 2002 to $757,000 for the quarter ended June 30, 2003, an increase of 23.8%. The increase in research and development expenses of $145,700 was primarily the result of an increase in headcount to support further development of the wireless systems solution, as well as the development of our sensors.

General and Administrative. General and administrative expenses decreased from $2.0 million for the quarter ended June 30, 2002 to $1.2 million for the quarter ended June 30, a decrease of 40.5%. Due to the adoption of the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003, under the modified prospective method as provided for in SFAS 148, we incurred a non-cash compensation charge of $155,300 in connection with our outstanding options under our 1993 and 2003 stock option plans in the second quarter of 2003 as compared to a non-cash compensation charge of $813,600 in the same period of 2002. Accounting fees decreased for the quarter ended June 30, 2003 due to the absence of any large audit and tax planning initiatives.

Legal Fees and Settlement Costs. Legal fees and settlement costs decreased from $166,100 for the quarter ended June 30, 2002 to $1,900 for the quarter ended June 30, 2003. This was primarily due to the accrual adjustment based on the final settlement of four out of the five lawsuits that had been filed against the Company.

Merger Costs. Merger costs were $8.7 million for the quarter ended June 30, 2002. Last year merger costs were due to the completion of a reverse merger transaction with Nettaxi.com. These costs were not a factor for the quarter ended June 30, 2003.

Other Income (Expense), net. Other Expense, net was $95,500 for the quarter ended June 30, 2002. For the same period in 2003, we had Other Expense, net of $43,700, a difference of $51,800. We recognized a decrease in interest expense due to the payment of outstanding loans, which was off-set by the exchange rate gains and losses.

Income Taxes. During the quarter ended June 30, 2003, we recognized a tax expense of $174,100, consisting of a provision of $358,000 relating to the current quarter pre-tax income, reduced by $183,900 relating to the settlement with the Internal Revenue Service of certain outstanding tax assessments originating in prior years. For the quarter ended June 30, 2003, we recognized a tax expense of $7,800.

Net Income (Loss). Net loss for the quarter ended June 30, 2002 was $10.0 million. For the same period in 2003, we had a net income of $794,800. The net loss in 2002 was primarily the result of a $9.6 million non-cash accounting charge. The net income for the quarter ended June 30, 2003 was primarily the result of a significant increase in our revenue primarily caused by growth in government and system sales and a decrease in legal fees. The increase was partially offset by an increase in sales and marketing expenses.

RESULTS OF OPERATIONS – Six Month Period Ended June 30, 2003

Net Sales. Net sales increased from $9.7 million for the six-month period ended June 30, 2002 to $14.8 million for the six-month period ended June 30, 2003, an increase of 52.4%. This increase was due to a significant increase in government sales, particularly for homeland security applications where we recognized a significant increase in sales of our MultiRAE and MiniRAE 2000. We also experienced a substantial increase in Europe and Asia for indoor air quality applications. Additionally, we recognized growth in our system sales, confined space entry products and in the introduction of our consumable and radiation products.

Cost of Sales. Cost of sales increased from $4.2 million for the six-month period ended June 30, 2002 to $5.5 million for the six-month period ended June 30, 2003, an increase of 32.4%. This increase was primarily due to an increase in the sales volume. Gross margins increased from $5.5 million, or 57% of revenue, for the six-month period ended June 30, 2002 to $9.3 million, or 62.6% of revenue, for the six-month period ended June 30, 2003. The gross margin increased due to production efficiencies resulting from the increase in sales volume as well as our product mix, specifically the growth in our systems sales with higher margins. The cost of material decreased slightly during this period as well. We had a reserve for inventory obsolescence and standard cost revisions; however, after analyzing our current situation we lowered this reserve based on historical obsolescence trends and the standard cost roll-up. This decrease in inventory reserves had a positive impact on our gross margin.

Sales and Marketing. Sales and marketing expenses increased from $2.5 million for the six-month period ended June 30, 2002 to $3.4 million for the six-month period ended June 30, 2003, an increase of 33.1%. We realized an increase in the sales and marketing cost resulting from an increase in our tradeshow and advertising presence to support our homeland defense position, our wireless systems solution, and our new suite of radiation detectors. Our expenses increased in Europe by $190,900 to build the infrastructure to support the European sales and service center.

Research and Development. Research and development expenses increased from $1.2 million for the six-month period ended June 30, 2002 to 1.5 million for the six-month period ended June 30, 2003, an increase of 21.4%. The increase in research and development expenses of was primarily the result of an increase in headcount to support further development of the wireless systems solution, as well as the development of our sensors.

General and Administrative. General and administrative expenses decreased from $2.8 million for the six-month period ended June 30, 2002 to $2.3 million for the six-month period ended June 30, 2003, a decrease of 16%. This decrease was due to the adoption of the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003, under the modified prospective method as provided for in SFAS 148, we incurred a non-cash compensation charge of $280,300 in connection with our outstanding options under our 1993 and 2002 stock option plans in the first quarter of 2003 as compared to a non-cash compensation charge of $862,800 in the same period of 2002. In addition, the decrease was due to a decrease in accounting fees for the six-month period ended June 30, 2003 due to the absence of any large audit and tax planning initiatives.

Legal Fees and Settlement Costs. Legal fees and settlement costs decreased from $244,000 for the six-month period ended June 30, 2002 to $90,500 for the six-month period ended June 30, 2003, a decrease of 62.9%. This was primarily due to the accrual adjustment based on the final settlement of four out of the five lawsuits that had been filed against the Company.

Merger Costs. Merger costs were $8.7 million for the six-month period ended June 30, 2002. Last year merger costs were due to the completion of a reverse merger transaction with Nettaxi.com. These costs were not a factor for the six-month period ended June 30, 2003.

Other Income (Expense), net. Other Expense, net for the six-month period ended June 30, 2002 was $204,600. For the same period in 2003, we had Other Expenses, net of $107,600, a difference of $97,000. We recognized a decrease in interest expense due to the payment of outstanding loans, which was off-set by the exchange rate gains and losses.

Income Taxes. For the six-month period ended June 30, 2003, we recognized a tax expense of $309,500, consisting of a provision of $758,000 relating to the current period pre-tax income, reduced by $448,500 relating to the settlement with the Internal Revenue Service of certain outstanding tax assessments originating in prior years. For the quarter ended June 30, 2003, we recognized a tax expense of $7,800.

Net Income (Loss). For the six-month period ended June 30, 2003, we had a net income of $1.6 million, as compared to a net loss of $10.2 million for the for the six-month period ended June 30, 2002. The increase primarily resulted from the absence of the $9.6 million non-cash accounting charge incurred in the six-month period ended June 30, 2002 as well as an increase in our gross margin primarily caused by growth in government and system sales. This was also affected by an overall increase in sales volume and a decrease in legal fees. The increase was partially offset by an increase in sales and marketing expenses.

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 June 30, 2003, we had $7.1 million in cash and cash equivalents. At June 30, 2003, we had $10.6 million of working capital (the excess of current assets over current liabilities) and had a current ratio of 2.9 to 1.0. We also have a $3 million line of credit for future growth expansion.

        Net cash provided by operating activities for the six months ended June 30, 2003 was $410,400, as compared with net cash used by operating activities of $174,200 for the six months ended June 30, 2002. The favorable effects on operating cash flows is due to an increase in net income of $1.6 million, depreciation and amortization of $438,000, equity in loss of unconsolidated affiliate of $133,100 and compensation expense under fair value accounting of $307,700, partially offset by significant changes in operating assets and liabilities. For the six months ended June 30, 2003, changes in operating assets and liabilities used $1.9 million in operating cash flows, whereas for the six months ended June 30, 2002, operating assets and liabilities provided $63,400 in operating cash flows. The unfavorable effects on operating cash flows resulting from the change in operating assets and liabilities is primarily reflected in accounts receivable in the amount of $952,900 resulting from significant increases in sales, inventories in the amount of $848,300 in anticipation of future growth, prepaid expenses of $304,100 and income taxes payable of $223,600. These were partially offset by an increase in accounts payable in the amount of $565,400.

        Net cash used in investing activities for the six months ended June 30, 2003 was $488,000, as compared with net cash provided by investing activities of $365,000 for the six months ended June 30, 2002. Cash used by investing activities in the six months ended June 30, 2003 consisted primarily of acquisition of property and equipment in the amount of $426,800. Cash provided by investing activities in the six months ended June 30, 2002 consisted primarily of the release of the restricted cash of $3 million resulting from having paid off our lines of credit, partially offset by the acquisition of property and equipment of $570,300, deposits and merger costs of $686,400, investment and affiliate of $500,000 and cash relinquish in deconsolidation of $878,300.

        Net cash provided by financing activities for the six months ended June 30, 2003 was $100 as compared with $2.5 million for the six months ended June 30, 2002. Cash provided by financing activities for the six months ended June 30, 2002 was primarily the result of proceeds from the merger of $7 million, partially offset by payments on 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. Any future financing we may require may be unavailable on favorable terms, if at all. Any difficulty in obtaining additional financial resources could force us to curtail our operations or could prevent us from pursuing our growth strategy. Any future funding may dilute the ownership of our shareholders.

Contractual Cash Obligations

        The following table quantifies our future contractual obligations as of June 30, 2002:

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

INTEREST RATE RISK

        As of June 30, 2003, we had cash and cash equivalents of $7.1 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 these fluctuations, we cannot assure you that exchange rate fluctuations will not adversely affect our financial results in the future.

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

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 generate revenues at the level we anticipate or otherwise incurs greater losses, we could incur greater losses than we anticipate and our results of operations will suffer.

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

        In connection with becoming a public company through a reverse merger transaction, certain options under our 1993 Stock Plan became subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). As of December 31, 2002, there were 2,014,941 options outstanding under the Plan that were subject to variable accounting. To eliminate the variable effects of such accounting treatment, we have adopted the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003 under the modified prospective method as provided for in SFAS 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. Our interim financial statements herein for the quarter and the six months period ended June 30, 2003 reflect a non-cash compensation charge related to options of $155,300 and $280,300, respectively. In June 2003, we issued a warrant to purchase 450,000 shares of common stock to Jefferies/Quarterdeck for the purpose of retaining their financial advisement services. The warrant vested immediately and is exercisable over four years. The fair value of this warrant, assessed to $328,800, will be amortized over the service period. For the quarter and six-month period ended June 30, 2003 we have taken a charge related to this warrant in the amount of $27,400. Stock-based compensation charges have significantly impacted our financial statements, and will continue to impact our financial statements on a prospective basis.

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

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

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 and radiation detection company is unsuccessful, our business and results of operations will suffer.

        We are in the process of expanding our current business of providing gas detection instruments to include radiation detection and wireless systems for local and remote security monitoring. The pricing of our radiation detection products and wireless products and services may be subject to rapid and frequent change. We may be forced for competitive or technical reasons to reduce prices for our products, which would reduce our revenue and could harm our business. Further, the radiation detection and wireless systems markets are still evolving, and we have little basis to assess the demand for these products and services or to evaluate whether our products and services will be accepted by the market. If our radiation detection products and wireless products and services do not gain broad market acceptance, our business and results of operations will be harmed.

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

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

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

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

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

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

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.

        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, and sales and marketing personnel, is intense. Although we provide compensation packages that include stock options, cash incentives and other employee benefits, we may be unable to retain our key employees or to attract, assimilate and retain other highly qualified employees in the future, which could harm our business.

Our business could suffer if we lose the services of any of our executive officers.

        Our future success depends to a significant extent on the continued service of our executive officers, including Robert I. Chen, Joseph Ng, Peter Hsi and Hong Tao Sun. The loss of the services of any of our executive officers could harm our business.

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

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

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

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

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

        Sales of substantial amounts of our common stock in the public market in connection with this offering could reduce the prevailing market prices for our common stock. We registered the resale of approximately 43,926,582 shares of common stock (including shares underlying outstanding warrants to purchase our common stock) on a registration statement on Form S-1. Future sales by the holders of such shares could adversely affect the trading price of our common stock.

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

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

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

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

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

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 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.

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.

PART II. OTHER INFORMATION

          We are from time to time involved in certain claims and legal proceedings as discussed elsewhere in this Form 10-Q and in our previous reports on Form 10-K and Form 10-Q filed with the Securities and Exchange Commission.

          In May 2003, the Company settled its lawsuit with Straughan.

          None

          None

          We held an Annual Meeting of the Stockholders on April 25, 2003 for the following purposes:

          As a result of the above votes, Peter H. Hsi and Edward C. Ross were confirmed as Class I directors and proposals 2 and 3 were approved.

          None

                    (1)  On June 10, 2003, we furnished a report on Form 8-K with the Securities and Exchange Commission providing for Regulation FD disclosure regarding a presentation that was made to investors at a series of meetings during June 2003 and from time to time thereafter.

                    (2)  On May 2, 2003, we furnished a report on Form 8-K with the Securities and Exchange Commission including out earnings release for the quarter ended March 31, 2003.

SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized on July 30, 2003.

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