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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004

OR

FOR THE PERIOD FROM              TO             

COMMISSION FILE NUMBER: 001-31783

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.

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RAE Systems Inc.

INDEX

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PART I. Financial Information

Effective January 1, 2003, we adopted the fair value recognition provisions of SFAS No. 123 for stock-based employee compensation under the modified prospective method as provided for in SFAS No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. These fair value recognition provisions generally result in stock-based compensation charges for options granted under our 1993 and 2002 stock option plans. While our interim financial statements herein for the quarter ended March 31, 2004 reflect a non-cash compensation charge related to options of $363,000, these charges may increase significantly depending on the number of options granted in the future and, to a lesser extent, upon the volatility of our stock and the life of such options.

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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)

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Condensed Consolidated Statements of Income

RAE Systems Inc.

Condensed Consolidated Statements of Income

(See accompanying notes to condensed consolidated financial statements)

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Condensed Consolidated Statements of Cash Flows

RAE Systems Inc.

Condensed Consolidated Statements of Cash Flows

(See accompanying notes to condensed consolidated financial statements)

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Condensed Consolidated Statements of Shareholders’ Equity

RAE Systems Inc.

Condensed Consolidated Statements of Shareholders’ Equity

(See accompanying notes to condensed consolidated financial statements)

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Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1 – The Company

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

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

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

Note 2 – Summary of Significant Accounting Policies

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.

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Principles of Consolidation

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

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

Earnings Per Share

The Company applies the provisions of SFAS No. 128, Earnings Per Share. SFAS No. 128 provides for the calculation of basic and diluted earnings per share. Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity. Anti-dilution provisions of SFAS No. 128 require consistency between diluted per-common-share amounts and basic per-common share amounts in loss periods. Incremental shares attributable to the assumed exercise of 6,137,572 options and warrants have increased the diluted shares outstanding by 4,317,663, for the three-month period ended March 31, 2004. Warrants and options outstanding to purchase 3,344,577 shares at exercise prices between $5.35 per share and $24.83 per share were not included in the computation of diluted earnings per share for the three-month period ended March 31, 2004 because the exercise prices were greater than the average market price of the common stock.

Stock-Based Compensation

During the first quarter of fiscal 2003, the Company adopted the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, (SFAS 123) for stock-based employee compensation, effective as of January 1, 2003. Under the modified prospective method of adoption selected by the Company, stock-based employee compensation cost recognized in the three months ended March 31, 2004 and 2003 is the same as that which would have been recognized had the fair value recognition provisions of SFAS 123 been applied to all awards granted. The following table illustrates the effect on net income and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period.

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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.

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

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

The Company recognizes deferred tax assets (future tax benefits) and liabilities for the expected future tax consequences of temporary differences between the book carrying amounts and the tax basis of assets and liabilities. The deferred tax assets and liabilities represent the expected future tax return consequences of those differences, which are expected to be either deductible or taxable when the assets and liabilities are recovered or settled. A valuation allowance is provided against the deferred tax assets to the extent that management is unable to conclude that it is more likely than not that the deferred tax assets will be realized.

RECENT ACCOUNTING PRONOUNCEMENTS

In November 2003, the EITF issued EITF No. 03-6 “Participating Securities and the Two-Class Method under FASB Statement No. 128,” which provides for a two-class method of calculating earnings per share computations that relate to certain securities that would be considered to be participating in conjunction with certain common stock rights. This guidance would be applicable to the Company starting with the third quarter beginning July 1, 2004. The Company is currently evaluating the potential impact of this pronouncement on its financial statements.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have a material impact on the Company’s financial position, results of operations or cash flows.

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

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

Note 3– Commitments and Contingencies

Royalty

Commencing January 1, 2001 and continuing through December 31, 2009, the Company is required to pay Dragerwerk a royalty equal to 7.5% of net sales of certain licensed products relating to U.S. Patent No. 5,654,498 issued August 5, 1997 and entitled “Device for the Selective Detection of a Component in a Gas Mixture”, manufactured or imported for sale by or for the Company in the United States. During the three-month periods ended March 31, 2004 and 2003, the Company incurred royalty expenses of $10,800 and $11,300, respectively.

Litigation

The Company is engaged in various ongoing legal proceedings incidental to its normal business activities. The Company is unable, however, to predict the outcome of these matters, or reasonably estimate a range of possible losses given the current status of the litigation.

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Note 4 – Warranty Reserve

Product warranty liabilities are provided for as described in Note 2 to these condensed consolidated financial statements. Following is a summary of the changes in these liabilities during the three-month periods ended March 31, 2004 and 2003:

Note 5 – Transactions with Affiliates

Certain of the Company’s sales made into the China market are made through TangRAE, a China distribution company that is owned by two individuals, one of whom is a current employee and one of whom is a former employee of one of the Company’s wholly-owned subsidiaries. TangRAE was organized as a sales office solely to facilitate the sale of the Company’s product into the China market. Total sales made by the Company to TangRAE amounted to $167,000 and $118,000 for the period ended March 31, 2004 and 2003, respectively.

Note 6 – Subsequent Event

In April 2004, the Company signed a definitive agreement to acquire a 64% interest in Ke Li Heng (“KLH”), a privately-held company for a purchase price of $9 million. KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment.

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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. In some cases, readers can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue.” These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from those stated herein. Although management believes that the expectations reflected in the forward-looking statements are reasonable, the Company cannot guarantee future results, performance, or achievements. For further information, refer to the section entitled “Factors that May Affect Future Results” in this Form 10-Q. The following discussion should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Form 10-Q.

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RESULTS OF OPERATIONS – Quarter ended March 31, 2004

Net Sales. Net sales increased from $7.3 million for the quarter ended March 31, 2003 to $8.2 million for the quarter ended March 31, 2004, an increase of 11.5%. This increase was primarily due to an increase in government sales, particularly for homeland security applications where we recognized a $657,000 increase in sales of our wireless mobile sensor products.

Cost of Sales. Cost of sales increased from $2.9 million for the quarter ended March 31, 2003 to $3.0 million for the quarter ended March 31, 2004, an increase of 2.3%. Gross margins increased from $4.4 million, or 60.3% of revenue, for the quarter ended March 31, 2003 to $5.2 million, or 63.6% of revenue, for the quarter ended March 31, 2004. The increase in the cost of sales was primarily the result of an increase in sales volume. Gross margins increased due to the increased sales of our wireless mobile sensor products that have higher margins.

Sales and Marketing. Sales and marketing expenses increased from $1.5 million for the quarter ended March 31, 2003 to $2.1 million for the quarter ended March 31, 2004, an increase of 40.6%. Our sales and marketing cost increased in the United States as a result of increases in advertising and collateral expenses in the amount of $78,000. Commissions paid to outside sales representatives to support our wireless integrated systems business increased by $87,000. We also spent $305,000 to increase our sales and marketing infrastructure in order to support the anticipated sales growth in Europe and Asia. Personnel expenses in the United States also increased by $63,000 to increase our focus in the sales of our wireless mobile sensor product.

Research and Development. Research and development expenses increased from $706,000 for the quarter ended March 31, 2003 to $920,000 for the quarter ended March 31, 2004, an increase of 30.3% This was primarily due to increases in personnel expenses in the amount of $196,000 for the United States and China offices to support the development of a monitor that combines radiological and chemical sensors in a single unit, prototyping of a solution for cargo container security and inventory tracking, and adding to our line of consumable products.

General and Administrative. General and administrative expenses increased from $1.2 million for the quarter ended March 31, 2003 to $1.6 million for the quarter ended March 31, 2004. 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 fair value accounting charge of $363,000 in connection with our outstanding options under our 1993 and 2002 stock option plans for the quarter ended March 31, 2004 as compared to a non-cash fair value accounting charge of $125,000 for the same period in 2003. For the quarter ended March 31, 2004 we also incurred non-cash accounting charges of $42,000 in connection with the issuance of warrants to our financial advisor and investor relations firms. For the quarter ended March 31, 2004, accounting fees also increased by $56,000. Additionally, personnel expenses in the United States increased by $49,000 to comply with the requirements of Section 404 of the Sarbanes-Oxley Act.

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Legal Fees and Settlement Costs. Legal fees and settlement costs decreased slightly from $89,000 for the quarter ended March 31, 2003 to $77,000 for the quarter ended March 31, 2004. Legal fees are at a minimum and are primarily for general corporate matters.

Other Income (Expenses), net. Other Expense, net for the three-month period ended March 31, 2003 was $64,000. For the same period in 2004, we had Other Income, net of $20,000, a difference of $84,000. The difference was primarily due to an increase in interest income of $66,000 resulting from having raised a net of $31.8 million through our public offering which closed on January 28, 2004.

Income Taxes. For the quarters ended March 31, 2003 and 2004, we recognized tax expenses of $135,000 and $339,000, respectively. Tax expenses were higher in 2004 due to the $363,000 in non-cash fair value accounting charges that were not tax deductible. Income taxes were also higher because of prior year credit carryforwards that were not available in 2004.

Net Income. Net income for the quarter ended March 31, 2003 was $775,000. For the same period in 2004, we had net income of $185,000. The decrease in net income was primarily attributable to increases in sales and marketing to support the anticipated sales growth in Europe and Asia, an increase in research and development expenses to support the development of a monitor that combines radiological and chemical sensors in a single unit, prototyping of a solution for cargo container security and inventory tracking, and adding to our line of consumable products, an increase in general and administrative expenses resulting from an increase in non-cash accounting charges related to the issuances of options and warrants, and an increase in the tax provision. These were partially offset by a relative decrease in the cost of sales due to the sales of our higher margin AreaRAE product.

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 March 31, 2004, we had $37.8 million in cash and cash equivalents and highly-liquid short-term investments. At March 31, 2004, we had $44.8 million of working capital (the excess of current assets over current liabilities) and had a current ratio of 11:1. We also have a $3 million line of credit for future growth expansion.

Net cash used by operating activities for the three months ended March 31, 2004 was $1.2 million, as compared with net cash provided by operating activities of $359,000 for the three months ended March 31, 2003. The unfavorable effects on operating cash flows is due primarily to changes in operating assets and liabilities, specifically increases in accounts receivable of $432,000, inventories of $773,000, and accounts payable to and receivable from affiliate of $733,000. These were partially offset by compensation expense under fair value accounting of common stock options of $363,000.

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Net cash used by investing activities for the three months ended March 31, 2003 was $138,000 as compared to net cash used by investing activities of $7.0 million for the three months ended March 31, 2004. The unfavorable effects on investing cash flows was primarily due to our decision to place approximately $6.7 million of proceeds received from the sale of our common stock in short-term investments.

Net cash provided by financing activities was $31.9 million for the three months ended March 31, 2004 as compared to net cash used by financing activities of $32,000 for the three months ended March 31, 2003. The favorable effects on financing cash flows was primarily the result of having raised a net of $31.8 million on January 28, 2004 in connection with the close of our public offering of 8,050,000 shares of our common stock at $4.25 per share, less the applicable underwriting discount.

In April 2004, the Company signed a definitive agreement to acquire a 64% interest in Ke Li Heng (“KLH”), a privately-held company for a purchase price of $9 million. KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment.

We believe that our existing balances of cash and cash equivalents, together with cash generated from product sales, will be sufficient to meet our cash needs for working capital and capital expenditures for at least the next twelve months. Our future capital requirements will depend on many factors that are difficult to predict, including the size, timing and structure of any future acquisitions, future capital investments, and future results of operations. Any future financing we may require may be unavailable on favorable terms, if at all. Any difficulty in obtaining additional financial resources could force us to curtail our operations or could prevent us from pursuing our growth strategy. Any future funding may dilute the ownership of our shareholders.

Contractual Obligations

The following table quantifies our future contractual obligations as of March 31, 2004:

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

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CONCENTRATION OF CREDIT RISK

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

INTEREST RATE RISK

As of March 31, 2004, we had cash and cash equivalents and highly liquid short-term investments of $37.8 million. Declines of interest rate over time will limit or 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. As sales to our international customers increase, our operating results may become subject to significant fluctuations based upon changes in exchange rates of specific currencies in relation to the United States dollar. Furthermore, to the extent that we engage in international sales denominated in United States dollars, any fluctuation in the value of the United States dollar relative to foreign currencies could affect our competitive position in the international markets. Although we would continue to monitor our exposure to currency fluctuations, and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, we cannot assure you that exchange rate fluctuations will not adversely affect our financial results in the future.

Factors that May Affect Future Results

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

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Our future revenues are unpredictable, our operating results are likely to fluctuate from quarter to quarter, and if we fail to meet the expectations of securities analysts or investors, our stock price could decline significantly.

Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, some of which are outside of our control. Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indications of future performance. Some of the factors that could cause our quarterly or annual operating results to fluctuate include significant shortfalls in revenue relative to our planned expenditures, changes in budget allocations by the federal government for homeland security purposes, market acceptance of our products, ongoing product development and production, competitive pressures and customer retention.

It is likely that in some future quarters our operating results may fall below the expectations of investors. In this event, the trading price of our common stock could significantly decline.

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

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

In light of these factors, we may be unable to compete successfully.

We might not be successful in the development or introduction of new products and services in a timely and effective manner, and, consequently, we may not be able to remain competitive and the results of operations may suffer.

Our revenue growth is dependent on the timely introduction of new products to market. We may be unsuccessful in identifying new product and service opportunities or in developing or marketing new products and services in a timely or cost-effective manner. In addition, while our current technology enables us to create products targeted to address the evolving market, we are unable to foresee whether we will continue to have the necessary technology in the future. In developing new products, we may be required to make significant investments before we can determine the commercial viability of the new product. If we fail to accurately foresee our customers’ needs and future activities, we may invest heavily in research and development of products that do not lead to significant sales.

We have recently expanded our current business of providing gas detection instruments to include radiation detection and wireless systems for local and remote security monitoring. While

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we perceive a large market for such products, the radiation detection and wireless systems markets are still evolving, and we have little basis to assess the demand for these products and services or to evaluate whether our products and services will be accepted by the market. If our radiation detection products and wireless products and services do not gain broad market acceptance or if we do not continue to maintain the necessary technology, our business and results of operations will be harmed.

In addition, compliance with safety regulations, specifically the need to obtain regulatory approvals in certain jurisdictions, could delay the introduction of new products by us. As a result, we may experience delays in realizing revenues from our new products.

We may not be successful in promoting and developing our brand, which could prevent us from remaining competitive.

We believe that our future success will depend on our ability to maintain and strengthen the RAE Systems brand, which will depend, in turn, largely on the success of our marketing efforts and ability to provide our customers with high-quality products. If we fail to successfully promote and maintain our brand, or incur excessive expenses in attempting to promote and maintain our brand, our business will be harmed.

We depend on facilities located outside of the United States to manufacture a substantial portion of our products, which subjects us to additional risks.

A significant portion of our products and components are manufactured at our facility in Shanghai, China. Our business is subject to risks normally associated with conducting business outside the United States, such as foreign government regulations, changes in environmental laws, 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, or if our ability to transfer products between China and other regions of the world were impeded, our business and results of operations could be adversely affected.

Any failure to adequately protect and enforce our intellectual property rights could harm our business.

We regard our intellectual property as critical to our success. We rely on a combination of patent, trademark, copyright, trade secret laws and non-disclosure agreements and confidentiality procedures to protect our proprietary rights. Notwithstanding these laws, we may be unsuccessful in protecting our intellectual property rights or in obtaining patents or registered trademarks for which we apply. Although processes are in place to protect our intellectual property rights, we cannot guarantee that these procedures are adequate to prevent misappropriation of our current technology or that our competitors will not develop technology that is similar to our own.

While there is no single patent or license to technology of material significance to the Company, our ability to compete is affected by our ability to protect our intellectual property

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rights in general. For example, we have a collection of patents related to our photo-ionization detector technology of which the first of such patents expires in 2012, and our ability to compete may be affected by any competing similar or new technology. In addition, if we lose the licensing rights to a patented or other proprietary technology, we may need to stop selling products incorporating that technology and possibly other products, redesign our products or lose a competitive advantage. We cannot ensure that our future patent applications will be approved or that our current patents will not be challenged by third parties. Furthermore, we cannot ensure that, if challenged, our patents will be found to be valid and enforceable.

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

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

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

Some of our products may be subject to product liability claims which could be costly to resolve and affect our results of operations.

There can be no assurance that we will not be subject to third-party claims in connection with our products or that any indemnification or insurance available to us will be adequate to protect us from liability. A product liability claim, product recall or other claim, as well as any claims for uninsured liabilities or in excess of insured liabilities, could have a material adverse effect on our business and results of operations.

We may lose sales if our distributors stop selling our products.

We distribute our products primarily through distributors. We derive approximately 90% of our revenues via our sales distribution channels, and, as a result, we are dependent upon these distributors to sell our products and to assist us in promoting and creating a demand for our products. We believe that our future growth depends on the efforts of these distributors. For the year ended December 31, 2003, 25 distributors cumulatively account for approximately 42% of our total product sales. In addition, the contractual obligations of our distributors to continue carrying our products must be renewed annually. If one or more of our distributors were to experience financial difficulties or become unwilling to promote and sell our products for any reason, including any refusal to renew their commitment as our distributor, we might not be able to replace such lost revenue, and our business and results of operations could be materially harmed.

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Because we purchase a significant portion of our component parts from a limited number of third party suppliers, we are subject to the risk that we may be unable to acquire quality components in a timely manner, which could result in delays of product shipments and damage our business and operating results.

We currently purchase component parts used in the manufacture of our products from a limited number of third party suppliers. We depend on these suppliers to meet our needs for various sensors, microprocessors and other material components. Moreover, we depend on the quality of the products supplied to us over which we have limited control. Should we encounter shortages and delays in obtaining components, we might not be able to supply products in a timely manner due to a lack of components, and our business could be adversely affected.

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.

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

We own approximately 36% of REnex Technology Ltd., a wireless systems company still in the research and development stage, and which to date has not generated any revenues. We are required to incorporate our share of its expenses as losses in our Consolidated Statements of Operations. If REnex does not begin to generate revenues at the level we anticipate or otherwise incurs greater losses, we could incur greater losses than we anticipate and our results of operations will suffer.

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

In connection with our merger with Nettaxi.com, certain options under our 1993 Stock Plan became subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). To eliminate the variable effects of such accounting treatment, we have adopted the fair value recognition provisions of SFAS No. 123 for stock-based employee compensation, effective January 1, 2003, under the modified prospective method as provided for in SFAS No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. These fair value recognition provisions generally result in stock-based compensation charges for options granted under our 1993 and 2002 stock option plans. For the quarter ended March 31, 2004, the fair value charges for options granted under our 1993 and 2002 stock option plans were $363,000.

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

Our future success depends to a significant extent on the continued service of our executive officers, including Robert I. Chen, Joseph Ng, Peter Hsi and Hong Tao Sun. We have no employment agreements with any of these officers. The loss of the services of any of our executive officers could harm our business.

Our officers, directors and principal stockholders beneficially own approximately 39% 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 39% 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.

Item 4. Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we evaluated the effectiveness of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

There has been no change in our internal control over financial reporting during the quarter ended March 31, 2004 that has materially affected, or is reasonable likely to affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are from time to time involved in certain claims and legal proceedings as discussed 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.

Item 2. Changes in Securities and Use of Proceeds

None

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Item 3. Defaults upon Senior Securities

None

Item 4. Submission of Matters to a Vote of Securities Holders

None

Item 5. Other Information

None

Item 6. Exhibits and Reports on Form 8-K

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(b) Reports on Form 8-K:

(1) On February 5, 2004, we furnished a report on Form 8-K with the Securities and Exchange Commission including our earnings release for the quarter and year ended December 31, 2003 and a transcript of a conference call conducted on February 2, 2004 to discuss our results of operations.

(3) On January 26, 2004, we filed a report on Form 8-K with the Securities and Exchange Commission exhibiting an underwriting agreement dated January 23, 2004 regarding the sale of shares to Jefferies & Company, Inc. and Merriman Curhan Ford & Co. in connection with the Company’s January public offering of 8,050,000 shares of Common Stock.

(2) On January 12, 2004, we filed a report on Form 8-K with the Securities and Exchange Commission including a press release announcing preliminary results for 2003 and guidance for 2004. The report also included a presentation for investor meetings during January, 2004 and from time to time thereafter.

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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 May 5, 2004.

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EXHIBIT INDEX

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