UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

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

Commission file number: 001-31783

 

RAE SYSTEMS INC.

(Exact name of registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)		77-0280662 (I.R.S. Employer Identification No.)
3775 North First Street San Jose, California (Address of principal executive offices)		95134 (Zip Code)

     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 period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

     Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ (Do not check if a smaller reporting company)		Smaller reporting company o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

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

	Class			Outstanding at October 31, 2010
	Common stock, $0.001 par value per share			59,506,243 shares

 

 

RAE Systems Inc.

INDEX

				Page
Part I. Financial Information
Item 1.		Financial Statements (Unaudited)			3
		Condensed Consolidated Balance Sheets at September 30, 2010 and December 31, 2009			3
		Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2010 and 2009			4
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009			5
		Notes to Condensed Consolidated Financial Statements			6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			21
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			33
Item 4.		Controls and Procedures			34
Part II. Other Information
Item 1.		Legal Proceedings			35
Item 1A.		Risk Factors			36
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			43
Item 3.		Defaults Upon Senior Securities			43
Item 4.		Reserved			43
Item 5.		Other Information			43
Item 6.		Exhibits			44
Signatures
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I. Financial Information

Item 1. Financial Statements

RAE Systems Inc.

		September 30,				December 31,
		2010				2009
ASSETS
Current assets:
Cash and cash equivalents		$	17,882			$	18,528
Restricted cash			2,149				2,146
Trade notes receivable			1,957				2,039
Accounts receivable, net of allowances of $6,143 and $5,380, respectively			19,756				19,428
Accounts receivable from affiliate			217				322
Inventories			14,392				12,068
Prepaid expenses and other current assets			4,951				3,983
Income taxes receivable			—				659
Total current assets			61,304				59,173
Property and equipment, net			17,595				15,590
Intangible assets, net			284				2,428
Investments in unconsolidated affiliates			244				358
Other assets			554				1,325
Total assets		$	79,981			$	78,874
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	6,621			$	6,454
Accounts payable to affiliate			10				92
Bank debt, current			5,551				4,026
Accrued liabilities			15,557				15,753
Notes payable to related parties, current			365				370
Income taxes payable			851				199
Deferred revenue, current			454				603
Total current liabilities			29,409				27,497
Deferred revenue, non-current			435				615
Deferred tax liabilities, non-current			111				156
Bank debt, non-current			—				1,463
Deferred gain on sale of real estate, non-current			3,968				4,444
Other long-term liabilities			1,529				781
Notes payable to related parties, non-current			—				363
Total liabilities			35,452				35,319
COMMITMENTS AND CONTINGENCIES (NOTE 5)
SHAREHOLDERS’ EQUITY:
Common stock, $0.001 par value, 200,000,000 shares authorized; 59,476,243 and 59,438,328 shares issued and outstanding, respectively			59				59
Additional paid-in capital			64,804				63,832
Accumulated other comprehensive income			7,453				6,844
Accumulated deficit			(31,574	)			(31,706	)
Total RAE Systems Inc. shareholders’ equity			40,742				39,029
Noncontrolling interest			3,787				4,526
Total shareholders’ equity			44,529				43,555
Total liabilities and shareholders’ equity		$	79,981			$	78,874

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Net sales		$	24,948			$	19,909			$	67,043			$	58,929
Cost of sales			10,428				9,636				28,487				29,458
Gross profit			14,520				10,273				38,556				29,471
Operating expenses:
Sales and marketing			5,632				4,282				15,489				13,513
Research and development			2,028				1,787				5,559				4,766
General and administrative			5,815				8,118				14,782				18,223
Impairment of intangible asset			1,489				—				1,489				—
Total operating expenses			14,964				14,187				37,319				36,502
Operating (loss) income			(444	)			(3,914	)			1,237				(7,031	)
Other income (expense):
Interest income			17				13				64				30
Interest expense			(80	)			(79	)			(149	)			(314	)
Other, net			(207	)			148				(108	)			140
Equity in loss of unconsolidated affiliate			(17	)			(47	)			(113	)			(180	)
(Loss) income before income taxes			(731	)			(3,879	)			931				(7,355	)
Income tax (expense) benefit			(1,133	)			215				(1,421	)			(145	)
Net loss			(1,864	)			(3,664	)			(490	)			(7,500	)
Net loss attributable to the noncontrolling interest			387				175				622				773
Net (loss) income attributable to RAE Systems Inc.		$	(1,477	)		$	(3,489	)		$	132			$	(6,727	)
Net (loss) income per share-basic		$	(0.03	)		$	(0.06	)		$	—			$	(0.11	)
Net (loss) income per share-diluted		$	(0.03	)		$	(0.06	)		$	—			$	(0.11	)
Weighted-average common shares outstanding-basic			59,430				59,375				59,415				59,359
Stock options			—				—				221				—
Weighted-average common shares outstanding-diluted			59,430				59,375				59,636				59,359

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.

		Nine Months Ended
		September 30,
		2010				2009
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss		$	(490	)		$	(7,500	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization			2,074				2,528
Gain on disposal of property and equipment			(450	)			(474	)
Stock based compensation expense			926				923
Equity in loss of unconsolidated affiliate			113				180
Deferred income tax benefit			(137	)			(84	)
Amortization of discount on notes payable to related parties			39				82
Impairment of intangible asset			1,489				—
Changes in operating assets and liabilities:
Accounts receivable			(170	)			2,473
Accounts receivable from affiliate			107				(123	)
Trade notes receivable			122				119
Inventories			(2,134	)			3,136
Prepaid expenses and other current assets			(817	)			781
Income taxes receivable			659				793
Other assets			129				471
Accounts payable			96				482
Accounts payable to affiliate			(83	)			(299	)
Accrued liabilities			(922	)			1,102
Income taxes payable			622				(173	)
Deferred revenue			(330	)			(286	)
Other liabilities			660				64
Net cash provided by operating activities			1,503				4,195
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of property and equipment			(1,840	)			(2,222	)
Net cash used in investing activities			(1,840	)			(2,222	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from the exercise of stock options			57				—
Proceeds from bank loans			—				1,899
Repayments of bank loans			—				(732	)
Repurchases of common stock			(11	)			(7	)
Dividends paid			(117	)			—
Payments on notes payable to related parties			(318	)			(1,930	)
Net cash used in financing activities			(389	)			(770	)
Effect of exchange rate changes on cash and cash equivalents			80				109
(Decrease) increase in cash and cash equivalents			(646	)			1,312
Cash and cash equivalents at beginning of period			18,528				14,845
Cash and cash equivalents at end of period		$	17,882			$	16,157
Supplemental disclosure of cash flow information:
Cash paid for interest		$	324			$	674
Cash paid for taxes			141				370
Cash received for tax refunds			659				742
Non-cash investing and financing activities:
Unpaid property and equipment			861				1,339

See accompanying notes to condensed consolidated financial statements.

Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 1. Summary of Significant Accounting Policies

The Company

     Founded in 1991, RAE Systems Inc. (the “Company” or “RAE Systems”), a Delaware company, develops and manufactures rapidly-deployable, multi-sensor chemical and radiation detection monitors and networks for oil and gas, hazardous material management, industrial safety, civil defense and environmental remediation applications. The Company’s products are based on proprietary sensor technology, and include personal, breathing zone, portable, wireless and fixed chemical detection monitors and radiation detectors.

     As a result of an independent investigation conducted by the Audit Committee of the Board of Directors during fiscal year 2008, the Company made a voluntary disclosure to the United States Department of Justice (“DOJ”) and the United States Securities and Exchange Commission (“SEC”) that the Company may have violated United States Foreign Corrupt Practices Act (“FCPA”). The Company is cooperating with the DOJ and the SEC in connection with their review of the matter and is actively engaged in settlement discussions. Although no assurances can be given as to whether the matter will settle or the amount of any settlement, the Company accrued $3.5 million in the third quarter of 2009 for the potential settlement of this matter. In June 2010, the Company met with officials from the Department of Justice and the Securities and Exchange Commission to provide an update on the Company’s compliance with the FCPA. Management is working diligently with both the DOJ and the SEC to obtain closure on this matter

Definitive Acquisition Agreement with Battery Ventures

     On September 19, 2010, the Company signed a definitive agreement to be acquired by Battery Ventures for $1.60 in cash per share (other than certain shares held by our founders, Robert Chen, Peter Hsi and affiliated entities). The transaction is subject to customary closing conditions, including the approval of RAE Systems’ stockholders.

     In connection with the Battery Ventures acquisition agreement, ten lawsuits have been filed against the company and members of its board of directors. These suits were filed in State Courts in California and Delaware and in the Federal District Court in California. The suits allege that the individual defendants breached their fiduciary duties by conducting an unfair sales process and agreeing to an unfair price, are receiving improper personal benefits, and were aided and abetted by the other defendants, and the Federal suit alleges violations of federal securities laws as well. The company believes the claims in these suits are without merit and intends to vigorously defend against them. However, there can be no assurances as to the outcome of the litigation. See “Note 5. Commitments and Contingencies” for more detail.

Basis of Presentation

     The financial information presented in this Form 10-Q is unaudited and is not necessarily indicative of the future consolidated financial position, results of operations or cash flows of RAE Systems. The unaudited condensed consolidated financial statements contained in this Form 10-Q have been prepared on the same basis as the annual consolidated 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 at the date of the interim balance sheets, results of operations and its cash flows for the stated periods, in conformity with the accounting principles generally accepted in the United States of America. The consolidated balances at December 31, 2009, were derived from the audited consolidated financial statements included in the Company’s Annual Report (“Annual Report”) on Form 10-K for the year ended December 31, 2009. The condensed consolidated financial statements included in this report should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2009, included in the Annual Report.

Principles of Consolidation

     The condensed consolidated financial statements include the Company and its subsidiaries. All intercompany balances and transactions have been eliminated. The ownership of other interest holders of consolidated subsidiaries is reflected as noncontrolling interest.

Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable based on available information. Actual results may differ materially from these estimates and assumptions.

Revenue Recognition

     The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, the Company has experienced an insignificant amount of sales returns. The Company generally recognizes revenue upon shipment to its distributors in accordance with standard contract terms that pass title of all goods upon delivery to a common carrier (Free on board, “FOB”) and provides for sales returns under standard product warranty provisions. For non-standard contract terms where title to goods passes upon delivery to the customer (FOB destination), revenue is recognized after the Company has established proof of delivery. Revenues related to services performed under the Company’s extended warranty program are recognized as earned based upon contract terms, generally ratably over the term of service. The Company records project installation work in Asia using the percentage-of-completion method. Net sales also include amounts billed to customers for shipping and handling. The Company’s shipping costs are included in cost of sales. Net sales does not include sales tax.

Stock-Based Compensation Expense

     The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton valuation method. Accordingly, stock-based compensation cost is measured at grant date based on the fair value of the award and recognized in expense over the requisite service, which is generally the vesting period.

     The impact on the Company’s results from operations of recording stock-based compensation by function for the three and nine months ended September 30, 2010 and 2009 was as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
(in thousands)		2010				2009				2010				2009
Cost of sales		$	23			$	22			$	69			$	57
Sales and marketing			37				(119	)			102				(75	)
Research and development			30				(8	)			98				107
General and administrative			175				305				657				834
Total		$	265			$	200			$	926			$	923

     The following is a summary of options (in thousands, except weighted-average exercise price):

		Options Outstanding
		Number				Weighted-Average
		of Shares				Exercise Price
Balance as of January 1, 2010			5,393			$	1.97
Granted			10				0.85
Exercised			—				—
Canceled			(4	)			0.66
Balance as of March 31, 2010			5,399				1.97
Granted			110				0.78
Exercised			—				—
Canceled			—				—
Balance as of June 30, 2010			5,509				1.95
Granted			15				0.77
Exercised			(50	)			1.13
Canceled			(156	)			1.12
Balance as of September 30, 2010			5,318				1.98

     The fair value of the Company’s stock options granted to employees for the three and nine months ended September 30, 2010 and 2009 was estimated using the following weighted-average assumptions:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Expected volatility			110	%			85	%			110	%			85	%
Expected dividend yield			0	%			0	%			0	%			0	%
Risk-free interest rate			1.9	%			2.3	%			2.5	%			2.3	%
Expected term in years			6.0				6.0				6.0				6.0
Weighted-average grant date fair value		$	0.64			$	0.70			$	0.65			$	0.70

     Stock Option Plans

     In June 2007, the shareholders of RAE Systems approved the Company’s 2007 Equity Incentive Plan (the “2007 Plan”) at the annual meeting of shareholders. The 2007 Plan replaced the Company’s 2002 Stock Option Plan (the “2002 Plan”). A total of 4,000,000 shares of the Company’s common stock are authorized for issuance under the 2007 Plan. The maximum number of shares that may be issued under the 2007 plan will be increased from time to time by shares subject to options granted under the 2002 Plan that expire or are terminated and by shares acquired under the 2002 Plan that are forfeited or repurchased by the Company for the option holder’s purchase price. However, no more than 1,500,000 additional shares may be authorized for issuance under the 2007 Plan as a result of these adjustments.

     As of September 30, 2010, the Company has reserved 93,442 shares of common stock for issuance under its 1993 Stock Option Plan, 2,025,126 shares under the 2002 Plan and 3,199,479 shares under the 2007 Plan. As of September 30, 2010, 1,264,541 shares have been added to the balance available for grant under the 2007 Plan as a result of grants cancelled under the 2002 Plan and 1,908,812 shares of common stock remain available for future grants under the 2007 Plan.

     Non-Plan Stock Options

     In 2002, the Company granted certain of its director’s non-plan options to purchase 400,000 shares of common stock at a weighted-average exercise price of $0.99 per share. The options vested 25% after one year with the remainder vesting pro-rata monthly over the following three years. From 2002 to 2006, the Company issued 300,000 shares of common stock due to the exercise of such options. There have been no further grants, exercises or cancellations through September 30, 2010. As such, total outstanding non-plan stock options at September 30, 2010 were 100,000 at a weighted-average exercise price of $1.06. The vested options are

exercisable over ten years from the date of grant. There was no stock-based compensation expense recorded during the three and nine month periods ended September 30, 2010 and 2009, respectively, and no stock-based compensation expense remains to be recorded related to non-plan options.

     Non-Plan Restricted Stock

     In August 2006, the Company granted 536,000 shares of restricted stock to four individuals as an inducement to join the Company. Twenty five percent of this restricted stock or 134,000 shares vested in July 2007 with the remainder vesting quarterly over the following three years subject to accelerated vesting in certain circumstances.

     The fair market value of the Company’s common shares on the dates the awards were granted represents unrecognized stock-based compensation which is amortized ratably over the vesting period of the underlying stock awards. Vesting was completed during the third quarter of 2010. As of September 30, 2010, no stock-based compensation expense related to restricted stock awards remained to be recorded.

     The following is a summary of activity for the non-plan stock awards (in thousands, except per share amounts):

		Restricted Stock Awards
						Weighted-Average
		Number				Grant Date
		of Shares				Fair Value
Unvested as of January 1, 2010			47			$	2.81
Granted			—				—
Vested			(16	)			2.81
Forfeited			—				—
Unvested as of March 31, 2010			31				2.81
Granted			—				—
Vested			(15	)			2.81
Forfeited			—				—
Balance as of June 30, 2010			16				2.81
Granted			—				—
Vested			(16	)			2.81
Forfeited			—				—
Balance as of September 30, 2010			—				—

Earnings Per Share

     Basic earnings per common share includes no dilution and is computed by dividing net income or loss attributable to RAE Systems by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share reflects the potential dilution of common stock equivalents, such as options and warrants, to the extent the impact is dilutive. As the Company incurred a net loss for the three months ended September 30, 2010 and net losses for the three and nine months ended September 30, 2009, the effect of potentially dilutive securities on diluted net loss per share computations was anti-dilutive for these periods.

     The weighted-average number of shares attributable to anti-dilutive stock options excluded from the diluted net loss per common share calculation for the three and nine months ended September 30, 2010 was 4,790,334 and 4,801,147, respectively. The weighted-average number of anti-dilutive shares excluded from the diluted net loss per common share calculation for the three and nine months ended September 30, 2009 was 4,880,232 and 4,926,143, respectively.

Segment Reporting

     FASB Accounting Standards Codification (“ASC”) Topic 280, “Segment Reporting,” establishes standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also established standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are

components of an enterprise, which are evaluated regularly by the chief operating decision-makers in deciding how to allocate and assess resources and performance. The Company’s chief operating decision-makers are the Chief Executive Officer and the Chief Financial Officer. Although the Company’s operating segments consist of entities geographically based in the Americas, Asia and Europe, the Company operates in a single reportable segment worldwide in the sale of portable and wireless chemical and radiation detection products and related services.

Variable Interest Entities

     S.A.R.L RAE France (“RAE France”) is the exclusive distributor of RAE Systems products in France. RAE Systems owns 49% of RAE France’s common stock and is the distributor’s largest shareholder. Although the operations of RAE France generally are independent of RAE Systems, through governance rights, the Company may direct RAE France’s business strategies. The Company has identified RAE France as a variable interest entity with RAE Systems as the primary beneficiary since inception in the fourth quarter of 2004. Accordingly, the Company has consolidated RAE France since December 2004.

     RAE France had total sales of $602,000 and $600,000 in the three months ended September 30, 2010 and 2009, respectively, and total sales of $1.8 million and $1.8 million in the nine months ended September 30, 2010 and 2009, respectively. The carrying amounts of the major classes of RAE France assets and liabilities included in the Company’s Condensed Consolidated Balance Sheets were as follows:

		September 30,				December 31,
(in thousands)		2010				2009
Cash and cash equivalents		$	12			$	299
Accounts receivable			611				438
Inventories			198				198
Prepaid expenses and other current assets			123				142
Total current assets			944				1,077
Other non-current assets			50				77
Total assets		$	994			$	1,154
Accounts payable		$	16			$	24
Accrued liabilities			317				332
Total current liabilities		$	333			$	356

     There were no restrictions or other special conditions on the assets or liabilities of RAE France.

Recent Accounting Pronouncements

     In June 2009, the FASB issued authoritative guidance for determining whether an entity is a variable interest entity (“VIE”) and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. Under this guidance, an enterprise has a controlling financial interest when it has a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. The guidance also requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has power to direct the activities of the VIE that most significantly impact the entity’s economic performance. The guidance became effective for the Company on January 1, 2010, and requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE as well as certain enhanced disclosures. The Company evaluated its investments and concluded it does not have any additional variable interests which give it controlling financial interest in a VIE; therefore, the adoption of this new standard did not have a material impact on its financial statements.

     In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning January 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue

recognition guidance. Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. The Company is currently assessing the potential effect, if any, on its financial statements.

     In January 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Instruments.” ASU No. 2010-06 amends ASC 820 to require additional disclosures regarding fair value measurements. Specifically, the ASU requires entities to disclose the amounts and reasons for significant transfers between Level 1 and Level 2 of the fair value hierarchy, to disclose reasons for any transfers in or out of Level 3 and to separately disclose information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements. In addition, the ASU amends ASC 820 to clarify certain existing disclosure requirements. Except for the requirement to disclose information about purchases, sales, issuances and settlements in the reconciliation of recurring Level 3 measurements separately, the amendments to ASC 820 made by ASU No. 2010-06 are effective for interim and annual reporting periods beginning after December 15, 2009. The adoption of these provisions of ASU No. 2010-06 did not have a material impact on the Company’s condensed consolidated financial statements. The requirement to separately disclose purchases, sales, issuances and settlements of recurring Level 3 measurements is effective for interim and annual reporting periods beginning after December 15, 2010. The Company does not expect the adoption of the remaining provisions of this ASU to have a material impact on the Company’s condensed consolidated financial statements.

Note 2. Composition of Certain Financial Statement Items

Inventories

     Inventories are stated at the lower of standard cost, which approximates actual cost computed on a first-in, first-out basis, or market and include material, labor and manufacturing overhead costs. The components of inventories were as follows:

		September 30,				December 31,
(in thousands)		2010				2009
Raw materials		$	7,602			$	5,655
Work-in-progress			3,622				2,557
Finished goods			3,168				3,856
Total inventories		$	14,392			$	12,068

Prepaid expenses and other current assets

		September 30,				December 31,
(in thousands)		2010				2009
Supplier advances and deposits		$	944			$	1,330
Accounts receivable from employees			709				81
Prepaid insurance			375				275
Deferred tax assets, current			1,041				934
Other current assets			1,882				1,363
Total prepaid expenses and other current assets		$	4,951			$	3,983

Property and equipment, net

		September 30,				December 31,
(in thousands)		2010				2009
Buildings and improvements		$	12,190			$	11,945
Equipment			5,143				4,788
Computer equipment			5,178				4,996
Automobiles			1,285				1,385
Furniture and fixtures			442				444
Construction in progress			6,313				3,468
			30,551				27,026
Less: Accumulated depreciation			(12,956	)			(11,436	)
Total property and equipment, net		$	17,595			$	15,590

Intangible assets, net

		September 30, 2010												December 31, 2009
										Net												Net
		Gross Carrying				Accumulated				Carrying				Gross Carrying				Accumulated				Carrying
(in thousands)		Amount				Amortization				Amount				Amount				Amortization				Amount
Customer list		$	5,568			$	(4,001	)		$	1,567			$	5,456			$	(3,376	)		$	2,080
Impairment of customer list							(1,489	)			(1,489	)
Customer list, net			5,568				(5,490	)			78
Trade name			1,383				(1,177	)			206				1,356				(1,008	)			348
Total		$	6,951			$	(6,667	)		$	284			$	6,812			$	(4,384	)		$	2,428

     Amortization expense associated with intangible assets was $228,000 and $219,000 for the three months ended September 30, 2010 and 2009, respectively, and $680,000 and $714,000 for the nine months ended September 30, 2010 and 2009, respectively.

     In the third quarter of 2010 the Company evaluated the carrying values of its customer list and other long-lived assets at RAE Fushun. Revenues declined significantly in the quarter and the year to date, and the Company does not expect a near-term recovery in this market. As a result, the Company determined that the carrying value of the customer list and other long-lived assets was more than the estimated undiscounted cash flows. Accordingly, the Company estimated the fair value of the customer list using a discounted cash flow analysis and recorded an impairment charge of $1.5 million to write-off the carrying amount in excess of fair value. The other long-lived assets consisted principally of land use rights and buildings for which the Company has third party evidence indicating a fair market value in excess of the carrying amount. As a result, these long-term assets were not impaired at September 30, 2010.

     Based on the carrying amount of intangible assets as of September 30, 2010, and assuming no future impairment of the underlying assets, the estimated future amortization is as follows (in thousands):

Years Ended December 31,
Remainder of 2010		$	90
2011			140
2012			36
2013			18
Thereafter			—
Total amortization		$	284

Accrued liabilities

		September 30,				December 31,
(in thousands)		2010				2009
Compensation and related benefits		$	3,121			$	3,764
Accrued commissions			2,225				1,265
Accrued FCPA settlement (see Note 5)			3,500				3,500
Accrued construction in progress			1,857				1,170
Accrued professional fees			712				426
Customer deposits			934				941
Other			3,208				4,687
Total accrued liabilities		$	15,557			$	15,753

Note 3. Income Tax

     The Company estimates its annual effective tax rate for the year and applies that rate to the year to date profit before tax to determine the quarterly and year to date tax expense. Certain loss entities are excluded from the calculation of annual estimated effective tax rate if the Company anticipates that it will not be able to recognize a benefit from those loss entities at year end. Certain expenses are accounted for as discrete to the quarter and excluded from the estimated annual effective tax rate.

     The effective tax rate after discrete items for the nine months ended September 30, 2010, was 153% of pretax income, compared to 2% of pretax loss for the same period in 2009. The tax rate for the third quarter of 2010 differed from the U.S. statutory rate primarily due to the tax effect of foreign earnings taxed at lower rates, losses not benefited of $5.7 million, nondeductible costs of $1.4 million related to the acquisition transaction with Battery Ventures announced September 20, 2010, dividend income of $2.5 million from a foreign subsidiary, and discrete true-up adjustments applicable to 2010.

     The effective tax rate is highly dependent upon the geographic distribution of the Company’s worldwide earnings or loss, tax regulations in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of its tax planning strategies. The Company regularly monitors the assumptions used in estimating its annual effective tax rate and adjusts its estimates accordingly. If actual results differ from its estimates, future income tax expense could be materially affected.

     The Company’s valuation allowance was determined in accordance with the existing authoritative guidance, which requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable, with such assessment being required on a jurisdiction by jurisdiction basis. Management believes that sufficient uncertainty exists with regard to the realizability of some tax assets such that a valuation allowance is necessary. Factors considered in providing a valuation allowance include the lack of a significant history of consistent profits, the potential impact of historical losses on the Company’s ability to sustain or grow revenues and earnings in the future, and the length of carryback and carryforward periods.

     At December 31, 2009, the Company concluded it was appropriate to have a full valuation allowance for its deferred tax assets in certain jurisdictions. The Company continued to maintain a full valuation allowance for these jurisdictions as of September 30, 2010. During fiscal 2009, the Company concluded that the operating results of one of its Chinese subsidiaries had declined and that it was appropriate to put a full valuation allowance on the related deferred tax asset. The Company expects to provide a full valuation allowance on future tax benefits until it can sustain a level of profitability that demonstrates its ability to utilize these assets. The amount of the deferred tax asset valuation allowance, however, could be reduced in future periods to the extent that future taxable income is realized.

Note 4. Comprehensive Loss

     The components of comprehensive loss were as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
(in thousands)		2010				2009				2010				2009
Net loss		$	(1,864	)		$	(3,664	)		$	(490	)		$	(7,500	)
Other comprehensive income:
Change in foreign currency translation			1,177				205				609				337
Comprehensive loss			(687	)			(3,459	)			119				(7,163	)
Comprehensive loss attributable to the noncontrolling interest			387				175				622				773
Comprehensive (loss) income attributable to RAE Systems Inc.		$	(300	)		$	(3,284	)		$	741			$	(6,390	)

Note 5. Commitments and Contingencies

Regulatory Compliance

     During fiscal year 2008, the Company’s internal audit department identified certain payments and gifts made by certain personnel in the Company’s operations in the People’s Republic of China (“China”) that may have violated the United States Foreign Corrupt Practices Act (“FCPA”). Following this discovery, the Audit Committee of the Board of Directors initiated an independent investigation. The Company has made a voluntary disclosure to the United States Department of Justice (DOJ) and the United States Securities and Exchange Commission (SEC) regarding the results of its investigation. The Company has also implemented additional policies and controls with respect to compliance with the FCPA. The FCPA and related statutes and regulations provide for potential monetary penalties, criminal sanctions and in some cases debarment from doing business with the U.S. federal government in connection with violations. The Company is cooperating with the DOJ and the SEC in connection with their review of the matter and is actively engaged in settlement discussions. Although no assurances can be given as to whether the matter will settle or the amount of any settlement, the Company booked an accrual of $3.5 million in the third quarter of 2009 relating to the potential settlement of this matter. In June 2010, the Company met with officials from the DOJ and the SEC to provide an update on the Company’s compliance with the FCPA. Management is working diligently with both the DOJ and the SEC to obtain closure on this matter.

Polimaster Ltd. et al. v. RAE Systems Inc., United States District Court for the Northern District of California, Case No. 05-CV-01887-JF, United States Court of Appeals for the Ninth Circuit, No. 08-15708 and 09-15369

     Polimaster Ltd. and Na&Se Trading Company, Ltd. (“Polimaster”) filed a complaint against the Company on May 9, 2005, in the United States District Court for the Northern District of California in a case titled Polimaster Ltd., et al. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that the Company breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. The dispute was subject to a contractual arbitration agreement, although the federal court retained jurisdiction over the matter pending completion of the arbitration. The arbitration was conducted in the spring of 2007.

     In September 2007, a Final Award was issued in the arbitration. The arbitrator ruled that Polimaster failed to prove its claims and was not entitled to any relief; that the Company had proven its counterclaims and was awarded damages of approximately $2.4 million; and that as the prevailing party, the Company was entitled to recover costs in the amount of $46,000. On October 5, 2007, RAE Systems filed a motion to confirm the Final Award. On October 17, 2007, Polimaster filed an opposition to RAE Systems’ motion to confirm the Final Award and filed its own motion to vacate the Final Award. Both motions were heard on December 7, 2007, and the district court confirmed the Final Award in an order dated February 25, 2008. Polimaster appealed from the district court’s order confirming the arbitration award in Polimaster Ltd. et al. v. RAE Systems Inc., No. 08-15708.

     When the district court confirmed the Final Award in favor of RAE Systems it did not enter judgment, an omission the district court described as a non-substantive clerical error. On September 9, 2008, the court of appeal granted leave for the district court to correct this clerical error. On January 23, 2009, the district court entered judgment in favor of RAE Systems and against Polimaster, and included in the judgment post-arbitration/pre-judgment interest and post-judgment interest. Polimaster has appealed the inclusion of these two interest components in the judgment, in Polimaster Ltd. et al. v. RAE Systems Inc., No. 09-15369.

     On May 14, 2009, Polimaster and RAE Systems entered a First Amended And Restated Stipulation And Order Re Stay Of Execution Of Judgment In Favor Of RAE Systems Inc. (the “stipulation”), pursuant to which Polimaster wire transferred $1.4 million to the client trust account of RAE Systems’ counsel, McLeod, Witham & Flynn LLP, and agreed to wire transfer an additional $116,224.25 per month until the entire amount deposited equals the amount of the judgment (approximately $2.8 million) plus accrued interest at the judgment rate of 0.43 percent per annum. Pursuant to the stipulation, the amounts transferred by Polimaster are being maintained in the client trust account of McLeod, Witham & Flynn LLP, and shall not be distributed to RAE Systems or Polimaster, until the Ninth Circuit has ruled on Polimaster’s appeal (Nos. 08-15708 and 09-15369). McLeod, Witham & Flynn LLP shall release the funds in the account to RAE Systems and/or Polimaster within seven days of the Ninth Circuit’s final ruling on the appeal, in accordance with the Ninth Circuit’s decision. Polimaster has complied with the payment schedule provided in the stipulation, and an amount sufficient to satisfy the judgment has been deposited into the account.

     Briefing on both of the appeals has been completed. The appeals were argued before a three-judge panel and submitted to the Ninth Circuit for decision on January 15, 2010. On September 28, 2010, the Ninth Circuit issued a divided panel opinion finding that Polimaster has established a defense to the enforcement of the arbitration award in favor of RAE Systems under Article V (1)(d) of the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (the “New York Convention”) on the ground that the arbitrator’s decision permitting RAE Systems to assert its counterclaims in the arbitration was not in accordance with the agreement of the parties. On October 12, 2010, RAE Systems petitioned the Ninth Circuit for rehearing en banc, i.e., a reconsideration of the appeal before a larger panel of 11 judges. RAE Systems’ petition is currently pending with the Ninth Circuit.

Shareholder lawsuits

     On September 20, 2010, a putative class action suit, entitled Foley v. RAE Systems Inc., et al., No. 110CV182985, was filed in the Superior Court of California, County of Santa Clara, against the Company, members of its Board of Directors, the Company’s Chief Financial Officer, and entities affiliated with Battery Ventures. The suit alleges in summary that, in connection with the proposed acquisition of the Company by an affiliate of Battery Ventures, the individual defendants breached their fiduciary duties by conducting an unfair sale process and agreeing to an unfair price, are purportedly receiving improper personal benefits, and were aided and abetted by the other defendants. Plaintiff seeks, among other things, a declaration that the suit can be maintained as a class action, an injunction against the proposed merger, rescission of the Merger Agreement, a directive that the defendants exercise their fiduciary duties to implement a process to secure the best possible consideration for stockholders, imposition of a constructive trust on allegedly improper benefits, and fees and costs. Four other lawsuits making similar allegations have also been filed in the Superior Court of the State of California, County of Santa Clara against the Company, its Board of Directors and Battery Ventures or its affiliates: Angles v. RAE Systems Inc., et al., No. 110CV183606; Greenbaum v. Chen , et al., No. 110CV183814; AC Photonics, Inc. v. RAE Systems Inc., et al., No. 110CV183942; and Mann v. RAE Systems Inc., et al. , No. 110CV183960. Those actions have now been consolidated. In addition, four putative class action suits with similar allegations have been filed in Delaware Chancery Court: Nelson v. RAE Systems Inc., et al. , C.A. No. 5848-VCS; Venton v. RAE Systems Inc., et al. , C.A. No. 5854-VCS; Quintanilla v. RAE Systems Inc., et al. , C.A. No. 5872; Villeneuve v. RAE Systems Inc., et al. , C.A. No. 5877. Those actions have also been consolidated, and a consolidated amended complaint has been filed. Finally, one lawsuit has been filed against the Company, members of its Board of Directors, the Company’s Chief Financial Officer, and Battery Ventures in the United States District Court for the Northern District of California, LaPlante v. RAE Systems Inc., et al., No. CV104944. This suit makes allegations similar to the others, and also adds an allegation claiming violation of the federal securities laws in connection with the preparation of the proxy statement filed by the Company in connection with the proposed acquisition. The Company believes that the claims in the suits are without merit and intends to vigorously defend against them. However, there can be no assurances as to the outcome of the litigation. See “Note 1. Summary of Significant Accounting Policies” for more detail.

Leases

     The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the three months ended September 30, 2010 and 2009, was $339,000 and $366,000, respectively. Total rent expense for the nine months ended September 30, 2010 and 2009 was $1,016,000 and $1,110,000, respectively. Future minimum annual payments under non-cancellable leases were as follows as of September 30, 2010 (in thousands):

Years Ended December 31,		Operating
Remainder of 2010		$	451
2011			1,535
2012			1,349
2013			1,334
2014			1,302
Thereafter			3,489
Total minimum payments		$	9,460

     In December 2004, the Company moved into its current corporate headquarters in San Jose, California and abandoned a leased facility in Sunnyvale, California. During the second quarter of 2005, the Company accrued a restructuring reserve of approximately $2.0 million for the remaining lease term of the former headquarters in Sunnyvale. The discount rate used was 4.85% and the liability was not reduced for any anticipated future sublease income. In March 2007, due to improved conditions for office rentals, the Company revised the estimated loss on abandonment of the lease and reduced the operating expense by $595,000. During the second quarter of 2007, a sublease was executed with rental income commencing in June 2007. Both the master lease and the sublease expired in October 2009. Rent payments for the three months ended September 30, 2010 and 2009 were zero and $132,000, respectively, for the Sunnyvale building with sublease income of zero and $46,000 for the three months ended September 30, 2010 and 2009, respectively. Rent payments for the nine months ended September 30, 2010 and 2009 were zero and $395,000, respectively, for the Sunnyvale building with sublease income of zero and $136,000 for the nine months ended September 30, 2010 and 2009, respectively.

     In December 2008, the Company invested approximately $1.2 million for land use rights in Shanghai, China to construct a new manufacturing, engineering and administrative facility. Construction began during the first quarter of 2010. The estimated cost to complete this project is approximately $4.4 million with the work scheduled to be completed during the first half of 2011. Upon completion of construction, the Company intends to vacate its existing leased facility in Shanghai. Based on discussions with Shanghai government officials, the landlord of the existing Company facility, the Company believes it will be able to terminate the lease without penalty. However, no assurance can be given at this time that the Company will not be subject to a lease termination penalty.

     During the three and nine months ended September 30, 2010, $33,000 and $84,000, respectively, of interest expense was capitalized for construction of the Company’s new facility in Shanghai.

Guarantees

     The Company is permitted under Delaware law and required under RAE Systems’ Certificate of Incorporation and Bylaws to indemnify its officers and directors for certain events or occurrences, subject to certain limits, while the officer is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that limits its exposure and enables it to recover a portion of any future amounts paid. To date the Company has not incurred any losses under these agreements.

     The Company typically agrees to indemnify its customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date, the Company has not paid any amounts to settle claims or defend lawsuits.

Note 6. Warranty Reserves

     The Company sells the majority of its products with a 12 to 24 month repair or replacement warranty from the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized under Accrued liabilities on the Condensed Consolidated Balance Sheets. The following is a summary of the changes in these liabilities during the three and nine months ended September 30, 2010 and 2009, respectively:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
(in thousands)
Warranty reserve at beginning of period		$	757			$	645			$	926			$	707
Provision for warranty			183				299				493				922
Utilization of reserve			(133	)			(282	)			(600	)			(967	)
Foreign currency translation effects			12				3				—				3
Warranty reserve at end of period		$	819			$	665			$	819			$	665

Note 7. Bank Debt

     The Company maintains credit facilities to support its operations in the United States and China.

     In the United States, the Company had a $10.0 million revolving credit agreement as of December 31, 2009. This credit facility is renewed annually and, on April 26, 2010, was renewed to expire on April 25, 2011. Available credit is based on a percentage of specific qualifying assets and the total facility is collateralized by a blanket security interest in the Company’s assets in the United States. The Company is required to comply with certain reporting and financial requirements in addition to the ongoing requirement to submit quarterly financial statements. Interest accrues at the floating prime bank lending rate plus 100 basis points subject to a minimum total rate of 5%. In addition, the Company pays 30 basis points annually of the average unused portion of the facility and is required to maintain a compensating balance of at least $2.0 million at all times. The compensating balance is included in Restricted cash on the Condensed Consolidated Balance Sheets. As of September 30, 2010 and December 31, 2009, $1.8 million was outstanding against the revolving credit agreement.

     Financial covenants under the revolving credit agreement: 1) require the Company to maintain specified trailing two-quarter minimum earnings before interest, depreciation, amortization and non-cash stock compensation expenses; and 2) limit the size of potential monetary penalties under the FCPA to $3.5 million. The Company was in compliance with these covenants as of September 30, 2010 and December 31, 2009.

     In China, the Company generally maintains one or more unsecured revolving lines of credit to provide working capital. Borrowings under these credit facilities are generally at the current market rate for fixed rate loans of the amount and duration requested, up to one year. The maturity dates of such fixed rate loans may extend beyond the renewal date of the line of credit arrangement, which governs the advance of new loans. The availability of new loans under the Company’s current line of credit was allowed to expire in September 2010. The Company currently has adequate working capital in China and is negotiating long-term financing for its new facility under construction in Shanghai. See “Note 5. Commitments and Contingencies” for more detail.

     The following table presents the Company’s line of credit in China for working capital as of September 30, 2010 and December 31, 2009 (in millions):

		Chinese Renminbi												U.S. Dollars
						Amount				Total								Amount				Total
		Amount				Available				Line				Amount				Available				Line				Interest
		Outstanding				for Use				of Credit				Outstanding				for Use				of Credit				Rate
September 30, 2010:
Due October 12, 2010			15.0				5.0				20.0				2.2				0.7				2.9				5.04	%
			15.0				5.0				20.0				2.2				0.7				2.9
December 31, 2009:
Due October 12, 2010			15.0				5.0				20.0				2.2				0.7				2.9				5.04	%
			15.0				5.0				20.0				2.2				0.7				2.9

     The loan due in October 2010 was paid in full at maturity.

Term Loan

     On November 9, 2009, RAE Fushun, the Company’s 70% owned subsidiary in Fushun, China, borrowed RMB 10.0 million, or approximately $1.5 million, to provide working capital for its operations. The loan is due on April 26, 2011 and bears interest at a fixed rate of 8.1% for 12 months. The interest rate will be reset once in November 2010 at 1.5 times the People’s Bank of China benchmark rate. Loan repayment is guaranteed by an unrelated third party, to whom RAE Fushun has granted a lien which includes the wholly owned plant and associated land rights. As a condition of the loan, the lending bank required a deposit of approximately $0.1 million from the guarantor. This deposit was funded by RAE Fushun from the loan proceeds and is included in Restricted Cash on the Condensed Consolidated Balance Sheets.

Note 8. Related Party Transactions

     The Company accounts for its 40% ownership in Renex Technologies Ltd. (“Renex”), a Hong Kong company following the equity method. The Company’s total investment in Renex at September 30, 2010 and December 31, 2009 was $225,000 and $339,000, respectively. The Company recorded losses of $17,000 and $46,000 on its equity interest in Renex for the three months ended September 30, 2010 and 2009, respectively, and losses of $114,000 and $180,000 in Renex for the nine months ended September 30, 2010 and 2009, respectively.

     The Company paid Renex zero and $95,000 for research work during the nine months ended September 30, 2010 and 2009, respectively.

     In conjunction with the investment in RAE Beijing, unsecured notes payable bearing interest at 6.48% were established for the previous RAE Beijing shareholders as part of the purchase price agreement in July 2006. As of September 30, 2010 and December 31, 2009, $365,000 and $370,000, respectively, was included in current notes payable to related parties in the Company’s Condensed Consolidated Balance Sheets and zero and $363,000, respectively, was included in non-current notes payable to related parties. The remaining scheduled annual payment of principal and accrued interest under these notes at maturity in July 2011 is $365,000.

     In addition to its 40% ownership in Renex, the Company has investments in three distributors of RAE Systems products, RAE Australia, RAE Benelux and RAE Spain. The Company owns 19%, 10% and 19% of RAE Australia, RAE Benelux and RAE Spain, respectively. These investments are accounted for under the cost method.

     The Liaoning Coal Industry Group, Ltd. (“Liaoning Group”) owns a 30% interest in RAE Fushun and, on occasion, has also been a supplier to RAE Fushun.

     Transactions and balances with the Company’s related parties were as follows:

		Three Months Ended								Nine Months Ended
		September 30,								September 30,												September 30,				December 31,
(in thousands)		2010				2009				2010				2009								2010				2009
Sales:																	Accounts receivable:
Renex		$	95			$	104			$	300			$	292		Renex					$	217			$	322
RAE Australia			286				189				961				531		RAE Australia						149				59
RAE Benelux			434				610				1,870				2,002		RAE Benelux						199				253
RAE Spain			111				88				231				316		RAE Spain						104				119
		$	926			$	991			$	3,362			$	3,141							$	669			$	753
Purchases:																	Accounts payable:
Renex		$	111			$	45			$	270			$	142		Renex					$	10			$	92
																	Liaoning Group						—				14
																						$	10			$	106

     The Company’s Director of Information Systems, Lien Chen, is the wife of our Chief Executive Officer, Robert Chen. Ms. Chen was paid a salary of $29,000 and $33,000 for the three months ended September 30, 2010 and 2009, respectively, and $92,000 and $94,000 for the nine months ended September 30, 2010 and 2009, respectively. Ms. Chen also receives standard employee benefits offered to all other full-time U.S. employees. Ms. Chen does not report to Robert Chen and compensation decisions regarding Ms. Chen are performed in the same manner as other U.S. employees, with Robert Chen the final approval signatory on compensation recommendations.

Note 9. Fair Value Measurements

     The Company uses the following methods and assumptions in estimating the fair value of assets and liabilities:

     Cash and cash equivalents and restricted cash: The carrying amounts reported in the Condensed Consolidated Balance Sheets approximate fair value due to the short-term maturity of these instruments.

     Notes payable to related parties: The fair value was determined by discounting these notes payable with below market interest rates at an interest rate commensurate with commercial borrowing rates available to the Company in China.

     Intangible assets, net: The fair value is evaluated whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable.

     The existing authoritative guidance requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

     Level 1: Quoted market prices in active markets for identical assets or liabilities.

     Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data.

     Level 3: Unobservable inputs that are not corroborated by market data.

     The carrying amounts and fair values of the Company’s financial assets and liabilities were as follows:

						September 30, 2010								December 31, 2009
						Carrying				Fair				Carrying				Fair
		Category				Amounts				Value				Amounts				Value
										(In thousands)
Cash and cash equivalents		Level 1				$	17,882			$	17,882			$	18,528			$	18,528
Restricted cash		Level 1					2,149				2,149				2,146				2,146
Notes payable to related parties		Level 2					365				365				733				733

Note 10. Shareholders’ Equity

     The following table is a summary of the changes in equity:

		Three Months Ended September 30,												Three Months Ended September 30,
		2010												2009
		RAE Systems												RAE Systems
		Shareholders’				Noncontrolling				Total				Shareholders’				Noncontrolling				Total
(in thousands)		Equity				Interest				Equity				Equity				Interest				Equity
Equity, Beginning of Period		$	40,725			$	4,291			$	45,016			$	40,833			$	4,883			$	45,716
Net loss			(1,477	)			(387	)			(1,864	)			(3,489	)			(175	)			(3,664	)
Translation adjustments			1,177				—				1,177				205				—				205
Comprehensive loss			(300	)			(387	)			(687	)			(3,284	)			(175	)			(3,459	)
Exercise of stock options			57				—				57				—				—				—
Repurchases of restricted common stock			(5	)			—				(5	)			(7	)			—				(7	)
Dividends paid			—				(117	)			(117	)			—				—				—
Stock-based compensation expense			265				—				265				200				—				200
Equity, End of Period		$	40,742			$	3,787			$	44,529			$	37,742			$	4,708			$	42,450

		Nine Months Ended September 30,												Nine Months Ended September 30,
		2010												2009
		RAE Systems												RAE Systems
		Shareholders’				Noncontrolling				Total				Shareholders’				Noncontrolling				Total
(in thousands)		Equity				Interest				Equity				Equity				Interest				Equity
Equity, Beginning of Period		$	39,029			$	4,526			$	43,555			$	43,216			$	5,481			$	48,697
Net income (loss)			132				(622	)			(490	)			(6,727	)			(773	)			(7,500	)
Translation adjustments			609				—				609				337				—				337
Comprehensive income (loss)			741				(622	)			119				(6,390	)			(773	)			(7,163	)
Exercise of stock options			57				—				57				—				—				—
Repurchases of restricted common stock			(11	)			—				(11	)			(7	)			—				(7	)
Dividends paid			—				(117	)			(117	)			—				—				—
Stock-based compensation expense			926				—				926				923				—				923
Equity, End of Period		$	40,742			$	3,787			$	44,529			$	37,742			$	4,708			$	42,450

     During the third quarter of 2010, the Company declared a dividend at RAE Beijing. As a result, the noncontrolling interest received a dividend payment of $117,000. The dividend was necessary in order to redeploy excess cash from RAE Beijing to other business units.

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, we cannot guarantee future results, performance, or achievements. For further information, refer to the sections entitled “Risk Factors” in “Part II Item 1A” of 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.

Overview

     We are a leader in delivering innovative sensor solutions to serve industrial, energy, environmental and government safety markets worldwide. In addition, we offer a full line of portable single and multi-sensor chemical and radiation detection products. The market for our products has evolved from being strictly focused on environmental and industrial monitoring to now encompassing the public safety and energy markets. We have expanded our presence to include the broader global energy exploration and refining safety equipment market. With the formation of RAE Fushun, we are serving the coal mine safety equipment market in China.

     In 2006, we made two significant business investments in China. First in July 2006, we increased our ownership in RAE Beijing to 96%. RAE Beijing produces, sells and distributes safety and security solutions for the chemical, oil and gas, metals and energy sectors in China. Second, in December 2006, we formed RAE Fushun, a joint venture with Fushun Anyi, a former state owned company serving the coal mine safety market. This joint venture was formed to capitalize on China’s growing reliance on coal based energy. RAE Fushun manufactures and sells coal mine safety equipment. RAE Systems owns 70% of the joint venture and thus consolidates RAE Fushun. We recently informed our board of directors of our intention to exercise a disciplined exit from our investment in RAE Fushun as the performance of this business has not met our long-term growth expectations.

     In China, our focus is on growing the environmental protection market and the industrial sector, including oil and gas, petro-chemicals, steel, and telecommunications.

     We offer a complete line of products to meet the requirements of the various global markets that we serve. Products range from breathing zone single sensor products for specific toxic chemicals (ToxiRAE 3) to belt worn multi-gas monitors (QRAE 2) to handheld instruments (MiniRAE 3000, ppbRAE 3000 and UltraRAE) to measure total and specific volatile organic compounds, to wireless monitors for industrial and public safety applications (AreaRAE Steel and MeshGuard).

     We have expanded our wireless product offering with the introduction of MeshGuard, a single-gas, mesh radio-based monitor designed to replace single-gas fixed monitors in industrial environments that include steel mills, oil and gas exploration and chemical processing. We continue to improve our product offerings through advances in sensors and wireless networking technologies, including the RAELink 3, a wireless modem with integrated GPS and Bluetooth radio technologies that provides a data bridge for our products, and complementary products such as chemical warfare agents and particle counters. We updated several of our fixed gas monitors to meet the needs of the China market. We received an additional sensor patent for a new gamma radiation detector/dosimeter, and this was deployed in our GammaRAE II R product.

     In all of our markets we will continue to explore and develop strategic value added partnerships, to leverage our product and market expertise.

Recent Developments

     In 2008, we introduced eight new products. We now offer a complete line of products to serve the personnel safety, regulated worker safety and detection needs of the global energy market. Products range from breathing zone single sensor products for specific toxic chemicals (ToxiRAE 3 and AutoRAE Lite Calibration Station) to belt worn multi-gas monitors (QRAE II with AutoRAE Lite Calibration Station, and MultiRAE Plus) to handheld instruments (MiniRAE 3000, MiniRAE Lite, ppbRAE 3000 and UltraRAE) to measure total and specific volatile organic compounds, to wireless monitors for wireless industrial and public safety applications (AreaRAE Steel, RAELink3 and MeshGuard) as well as fixed monitors (RAEGuard, RAEGuard-S, RAEGuard PID and FMC Series Controllers) for deployment in factory or safety process management.

     During 2009 we focused on the energy sector, public safety, global confined space entry, worker safety regulation, and the health exposure gas detection markets. With our ToxiRAE 3, QRAE II, MiniRAE 3000, UltraRAE 3000, AreaRAE Steel and MeshGuard we offer a full suite of portable gas detection solutions for the oil production market. In addition, the MultiRAE Plus continues to be purchased by the U.S. military for aviation safety in the handling and detection of highly toxic and flammable jet fuel.

     In 2010, we enhanced the wireless sensor capability of our MeshGuard platform, with the addition of fixed system and wireless controllers, two additional toxic gas sensors and other accessories. RAE Systems products were key in providing public venue security at the National Football League Super Bowl, the National Basketball Association All Star Game as well as the Vancouver Winter Olympics. Our Americas operations focused on government contracts, first responders, and industrial safety applications, particularly in the energy sector. Our China operation continues to sell to state run steel mills, energy markets, including downstream oil processing, petrochemicals and electric utilities. Our Europe, Middle East, and Asia Pacific region generate sales primarily from the Middle East and Asia Pacific oil producers. All of our sales regions are driving adoption of our wireless sensor solutions for applications in both safety and security. Our global markets continue to be impacted by the effects of the 2009 global recession. In each of our markets we will continue to explore and develop strategic value added partnerships, to leverage our product and market expertise.

     We are deemphasizing the lower gross margin Fire and Security integrated project installation business in China and have refocused our attention in China on the markets and the products sold and produced by the Company on a global basis, and the fixed sensor systems sold by the Company’s operations in Beijing, China. We recently informed our board of directors of our intention to exercise a disciplined exit from our investment in RAE Fushun as the performance of this business has not met our long-term growth expectations.

     In June 2010, the Company met with officials from the DOJ and the SEC to provide an update on the Company’s compliance with the FCPA. Management is working diligently with both the DOJ and the SEC to obtain closure on this matter.

Definitive Acquisition Agreement with Battery Ventures

     On September 19, 2010, the Company signed a definitive agreement to be acquired by Battery Ventures for $1.60 in cash per share (other than certain shares held by our founders, Robert Chen, Peter Hsi and affiliated entities). The transaction is subject to customary closing conditions, including the approval of RAE Systems’ stockholders.

     In connection with the Battery Ventures acquisition agreement, ten lawsuits have been filed against the company and members of its board of directors. These suits were filed in State Courts in California and Delaware and in the Federal District Court in California. The suits allege that the individual defendants breached their fiduciary duties by conducting an unfair sales process and agreeing to an unfair price, are receiving improper personal benefits, and were aided and abetted by the other defendants, and the Federal suit alleges violations of federal securities laws as well. The company believes the claims in these suits are without merit and intends to vigorously defend against them. However, there can be no assurances as to the outcome of the litigation.

Critical Accounting Policies

     We believe the following critical accounting policies affect our more significant judgments or estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

     We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, we have experienced an insignificant amount of sales returns. We generally recognize revenue upon shipment to our distributors in accordance with standard contract terms that pass title of all goods upon delivery to a common carrier (FOB factory) and provide for sales returns under standard product warranty provisions. For non-standard contract terms, where title to goods passes upon delivery to the customer (FOB destination), revenue is recognized after we have established proof of delivery. Revenue related to services performed under our extended warranty program is recognized as earned based upon contract terms, generally ratably over the term of service. We record project installation work in Asia using the percentage-of-completion method. Net sales also include amounts billed to customers for shipping and handling. Our shipping costs are included in cost of sales. Net sales do not include sales tax.

Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

     We grant credit to our customers after undertaking an investigation of credit risk for significant amounts. An 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, history of adjustments, current economic conditions and other factors that deserve recognition in estimating potential losses. We generally do not require collateral for sales on credit. While management uses the best information available in making our 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 was a deterioration of a major customer’s credit-worthiness or if actual defaults were higher than what have been experienced historically, additional allowances would be required.

     Trade notes receivable are presented to us from some of our customers in China as a payment against the outstanding trade receivables. These notes receivable are bank guarantee promissory notes which are non-interest bearing and generally mature within nine months.

Inventories

     Inventories are stated at the lower of standard cost, which approximates actual cost computed on a first-in, first-out basis, or market and include material, labor and manufacturing overhead costs. We are exposed to a number of economic and market factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in the market, competitive pressures in products and prices, and the availability of key components from our suppliers. We establish inventory reserves when conditions exist that suggest our inventory may be in excess of anticipated demand, based upon assumptions about future demand for our products and market conditions, or the inventory is obsolete. When recorded, reserves are intended to reduce the carrying value of the inventory to its net realizable value. If actual demand for specified products deteriorates, or market conditions are less favorable than those projected, additional reserves may be required.

Long-Lived Assets

     We evaluate the recoverability of long-lived assets with finite lives periodically and whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. The carrying amount of a long-lived asset is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset. If the carrying amount of a long-lived asset is deemed not recoverable, an impairment loss is recognized for the difference between the carrying amount of the asset and its fair value, generally the present value of estimated future cash flows.

Share-Based Payments

     We recognize in our statement of operations all share-based payments, including grants of stock options, based on their grant date fair value after adjusting fair value to reflect only those shares outstanding that are actually expected to vest. We estimate the fair value of each share-based payment on the date of grant using the Black-Scholes-Merton valuation method. The Black-Scholes-Merton method requires certain assumptions about the expected life of the option and the volatility of the market price over the life of the option. The Company estimates these assumptions based on the Company’s historical experience of employee exercises and the historical market price of the Company’s stock.

Income Taxes

     We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes.

     Our effective tax rates differ from statutory rates primarily due to foreign earnings taxed at lower rates, losses not benefited, non-deductible share-based compensation deductions and provision changes for uncertain tax positions. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. We regularly assess the likelihood of adverse outcomes resulting from tax examinations to determine the adequacy of our provision for income taxes.

     Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.

Recent Accounting Pronouncements

     In June 2009, the FASB issued authoritative guidance for determining whether an entity is a variable interest entity (“VIE”) and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. Under this guidance, an enterprise has a controlling financial interest when it has a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. The guidance also requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has power to direct the activities of the VIE that most significantly impact the entity’s economic performance. The guidance became effective January 1, 2010, and requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE as well as certain enhanced disclosures. We evaluated our investments and concluded that we do not have any additional variable interests which give us a controlling financial interest in a VIE; therefore, the adoption of this new standard did not have a material impact on our condensed consolidated financial statements.

     In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning January 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. The Company is currently assessing the potential effect, if any, on its condensed consolidated financial statements.

     In January 2010, the FASB issued Accounting Standards Update (“ASU”) No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Instruments.” ASU No. 2010-06 amends ASC 820 to require additional disclosures regarding fair value measurements. Specifically, the ASU requires entities to disclose the amounts and reasons for significant transfers between Level 1 and Level 2 of the fair value hierarchy, to disclose reasons for any transfers in or out of Level 3 and to separately disclose information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements. In addition, the ASU amends ASC 820 to clarify certain existing disclosure requirements. Except for the requirement to disclose information about purchases, sales, issuances and settlements in the reconciliation of recurring Level 3 measurements separately, the amendments to ASC 820 made by ASU No. 2010-06 are effective for interim and annual reporting periods beginning after December 15, 2009. The adoption of these provisions of ASU No. 2010-06 did not have a material impact on our condensed consolidated financial statements. The requirement to separately disclose purchases, sales, issuances and settlements of recurring Level 3 measurements is effective for interim and annual reporting periods beginning after December 15, 2010. We do not expect the adoption of the remaining provisions of this ASU to have a material impact on our condensed consolidated financial statements.

Results of Operations

Net Sales

		Three Months Ended																Nine Months Ended
		September 30,												Percentage				September 30,												Percentage
(in thousands)		2010				2009				Change				Change				2010				2009				Change				Change
Net sales		$	24,948			$	19,909			$	5,039				25	%		$	67,043			$	58,929			$	8,114				14	%

     Net sales for the quarter ended September 30, 2010, increased by $5.0 million or 25% compared with the quarter ended September 30, 2009. Sales increased $5.2 million or 57% in Americas and $0.3 million or 9% in Europe and the Middle East, which was partially offset by a decrease of $0.5 million or 6% in Asia. The increase in the Americas was the result of orders related to the Gulf of Mexico oil spill of approximately $1.0 million and generally improved sales in all product categories, of approximately $4.2 million, compared with the quarter ended September 30, 2009. The increase in Europe and the Middle East of $0.3 million was primarily due to increased sales in the oil and gas market in the Middle East and the industrial safety market in Europe, which was partially offset by a $0.3 million foreign exchange loss. The foreign exchange loss in Europe was attributable to the Euro and Pound Sterling, during the quarter ended September 30, 2010. The decrease in Asia was primarily the result of decreased sales in Fire and Security integrated project installation revenue at our Beijing, China operations of approximately $1.2 million and in the Coal Mine Safety business in Fushun, China of approximately $1.2 million, which was partially offset by improved product sales at our operations in Beijing of approximately $1.0 million and improved Asia-Pacific sales of approximately $0.5 million.

     Net sales for the nine months ended September 30, 2010 increased $8.1 million or 14% compared with the nine months ended September 30, 2009. Sales increased $9.7 million or 38% in Americas and $0.6 million or 6% in Europe and the Middle East, which was partially offset by a decrease of $2.2 million or 10% in Asia. The increase in the Americas was primarily the result of orders related to the Gulf of Mexico oil spill of approximately $3.3 million, a large order from the U.S. Army of approximately $1.0 million, and generally improved sales in the emergency response market compared with the nine months ended September 30, 2009. The increase in Europe and the Middle East was primarily due to increased sales in the oil and gas market in the Middle East, which was partially offset by a $0.4 million foreign exchange loss, attributable to the Euro and Pound Sterling, during the nine months ended September 30, 2010. The decrease in Asia was primarily the result of decreased sales from the Fire and Security integrated project installation revenue at our Beijing, China operations of approximately $2.1 million and a decline in the Coal Mine Safety business in Fushun, China of approximately $1.8 million, which was partially offset by increased sales in China of the products sold and produced by the Company on a global basis, and fixed sensor systems sold by the Company’s operations in Beijing, China and product sales in Asia-Pacific.

Cost of Sales & Gross Margin

		Three Months Ended																Nine Months Ended
		September 30,												Percentage				September 30,												Percentage
(in thousands)		2010				2009				Change				Change				2010				2009				Change				Change
Cost of sales		$	10,428			$	9,636			$	792				8	%		$	28,487			$	29,458			$	(971	)			-3	%
Gross profit		$	14,520			$	10,273			$	4,247				41	%		$	38,556			$	29,471			$	9,085				31	%
Gross margin			58	%			52	%											58	%			50	%

     Cost of sales for the quarter ended September 30, 2010, increased by $0.8 million or 8% compared with the quarter ended September 30, 2009, primarily due to increased sales volume, partially offset by the lower cost associated with reduced project installation revenue at our Beijing, China operations of approximately $0.8 million, and an improved product mix in China which included more of the products sold and produced by the Company on a global basis and the fixed sensor systems sold by the Company’s operations in Beijing, China. Gross profit for the quarter ended September 30, 2010, increased by $4.3 million or 41% compared with the quarter ended September 30, 2009, primarily due to higher sales in the Americas, Europe and the Middle East, increased sales in Asia-Pacific, increased sales in China of products sold and produced by the Company on a global basis and the fixed sensor systems traditionally sold by the Company’s operations in Beijing, China, and an improved product mix that included increased in sales of multi-gas products, sensors and accessories.

     Cost of sales for the nine months ended September 30, 2010, decreased by $1.0 million or 3% compared with the nine months ended September 30. 2009, primarily due to lower costs associated with reduced project installation revenue at our Beijing, China operations of approximately $1.8 million, a reduction in our provision for the inventory reserves of approximately $0.8 million, an improved product mix, which was partially offset by incremental cost related to increased volume. Gross profit for the nine months ended September 30, 2010, increased by $9.1 million or 31% compared with the nine months ended September 30, 2009, primarily due to higher product sales in the Americas, the Middle East, China and Asia-Pacific and an improved product mix that included an increase in sales of multi-gas products, sensors and accessories.

Sales and Marketing Expense

		Three Months Ended																Nine Months Ended
		September 30,												Percentage				September 30,												Percentage
(in thousands)		2010				2009				Change				Change				2010				2009				Change				Change
Sales and marketing		$	5,632			$	4,282			$	1,350				32	%		$	15,489			$	13,513			$	1,976				15	%
Percentage of net sales			23	%			22	%											23	%			23	%

     Sales and marketing expenses increased by $1.4 million or 32% for the quarter ended September 30, 2010, compared with the quarter ended September 30, 2009. The increase was primarily due to higher internal sales commissions in the Americas, external commission in the Americas accrued on the sale of wireless products in the U.S. in lieu of discounts to distributors and additional management bonuses.

     Sales and marketing expenses increased by $2.0 million or 15% for the nine months ended September 30, 2010, compared with the nine months ended September 30, 2009. The increase in expense was due to an increase in the sales commissions in the Americas, increased headcount, additional management bonuses and marketing activities to improve sales management information, web service capabilities, and brand awareness for the Company and its products.

Research and Development Expense

		Three Months Ended																Nine Months Ended
		September 30,												Percentage				September 30,												Percentage
(in thousands)		2010				2009				Change				Change				2010				2009				Change				Change
Research and development		$	2,028			$	1,787			$	241				13	%		$	5,559			$	4,766			$	793				17	%
Percentage of net sales			8	%			9	%											8	%			8	%