UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number: 001-31783

RAE Systems Inc.

(Exact name of registrant as specified in its charter)

 

 

408-952-8200
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:

 

 

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

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No þ

 

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

 

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):

 

(Do not check if a smaller reporting company)

 

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

 

As of June 30, 2010, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $47,545,281, based upon the closing sale price of $0.80 on the NYSE Alternext US (formerly the American Stock Exchange) on June 30, 2010, the last business day of the registrant’s most recently completed second fiscal quarter. As of the close of business on February 28, 2011, the number of shares of registrant’s Common Stock outstanding was 59,512,064.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s proxy statement for its 2011 Annual Meeting of Stockholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

RAE SYSTEMS INC.

INDEX TO
ANNUAL REPORT ON FORM 10-K
FOR YEAR ENDED DECEMBER 31, 2010

 

TABLE OF CONTENTS

 

 

In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements. These statements typically are preceded or accompanied by words like “believe,” “anticipate,” “expect,” “may,” “will,” “should,” “intend,” “plan,” “estimate,” “potential,” or “continue,” and other words of similar meaning. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in these forward-looking statements. Readers are cautioned not to place undue reliance on those forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or update or publicly release the results of any revisions or update to these forward-looking statements. Readers should carefully review the risk factors described herein and in other documents that we file from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q that we file for the fiscal year 2011.

 

 

Overview

 

RAE Systems Inc. (referred to herein as the “Company”, “we”, or “our”) is a leading developer and manufacturer of rapidly-deployable, multi-sensor chemical and radiation detection monitors and wireless networks for application in five key markets: oil and gas, hazardous material management, industrial safety, civil defense and environmental remediation. We provide personal, portable and wireless sensor networks that enable our customers in more than 95 countries to identify safety and security threats in real-time. The Company was founded in 1991 and originally developed technologies for the detection of hazardous materials in environmental remediation and chemical spill clean-ups. We have a broad patent portfolio consisting of 14 issued U.S. patents, one patent issued in Japan, two issued and four pending EU patents, and ten issued and 13 pending technology patents in China. These patents in gas and radiation detection technology are the basis for many of our products.

 

We offer a comprehensive portfolio of fixed and portable breathing zone single and multi-sensor chemical and radiation detection products, many with wireless integrated systems capability. Industrial applications include the detection of toxic industrial chemicals, volatile organic compounds and petrochemicals. Our products are deployed in oil and gas facilities, petrochemical and plastics plants, steel mills and in other types of manufacturing facilities. Our products enable the military and first responders such as firefighters, law enforcement and other emergency management personnel to detect and provide early warning of hazardous materials.

 

We have significant operations in the People’s Republic of China (“China”), including research and development and manufacturing operations in Shanghai. We own 96% of RAE-KLH (Beijing) Co., Limited, or RAE Beijing, a manufacturer and distributor of safety, environmental and personal protection monitors and equipment. In December 2006 we formed RAE Fushun to serve the coal mine safety market in China. This joint venture was 30% owned by Fushun Anyi and 70% owned by RAE Systems. On January 12, 2011, we entered into a definitive agreement to sell our 70 percent ownership of RAE Fushun to the Shenyang Research Institute of China Coal Research Institute. The agreement is expected to close within 180 days of signing the definitive agreement and is subject to customary closing conditions.

 

Definitive Acquisition Agreements with Battery Ventures and Vector Capital

 

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 was subject to customary closing conditions, including the approval of RAE Systems’ shareholders. Subsequently, on January 12, 2011, the Company received a letter from Vector Capital setting forth an offer to acquire the outstanding shares of our common stock for $1.75 per share in cash (other than certain shares held by Robert Chen, Peter Hsi and affiliated entities). After extensive consideration by the Special Committee of the Board of Directors of the Company, the Company terminated the Battery Merger Agreement on January 18, 2011, paid a termination fee of $3.39 million to Battery Ventures in accordance with the terms of the Battery Merger Agreement, and signed a Merger Agreement with Vector Capital on the terms described above. This transaction is also subject to customary closing conditions, including the approval of RAE Systems’ shareholders.

Additional information about the Company is available on our web site at www.raesystems.com. Information contained on or accessible through our web site is not part of this Annual Report or our other filings with the Securities and Exchange Commission (“SEC”). We make available, free of charge on our web site, access to our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we file them electronically with or furnish them to the SEC.

 

The public may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Rooms by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet web site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The SEC’s internet web site is located at http://www.sec.gov.

 

Industry Background

 

The market for our products has evolved from being strictly focused on environmental and industrial monitoring to encompassing energy exploration and production, and public safety. Demand for our products has grown in the fields of petrochemical production, environmental remediation, confined space entry, and OSHA industrial safety compliance monitoring. The application of our products in these established markets stems from the dependence of numerous key industries on sensors that provide vital information that can affect worker safety, products, processes and systems.

 

Sophisticated monitoring is important for emergency response personnel to detect harmful agents that could create a potentially lethal situation. We believe first responders need a suite of products that provide a practical, comprehensive solution to protect them from this danger. Many of the same equipment capabilities that are necessary to support first responders are also necessary to address other areas where there are increasing demands for chemical and radiation detection. For example, wireless detection systems have been deployed at many of the world’s major spectator events for public venue protection.

 

RAE Systems offers a full suite of portable, fixed and wireless gas detection monitors for the oil, gas, petrochemical, adhesives and polymers markets. All of these markets require the constant monitoring of both flammable and toxic hydrocarbons.

 

Products

 

We manufacture and sell sensors and measurement products, which may also be integrated with wireless technology. As an instrument manufacturer, we have differentiated ourselves from our competition by developing a broad array of specific chemical sensors, including an array of electrochemical, solid polymer, infrared and catalytic-bead gas sensors as well as photoionization detectors.

 

Sensor and Measurement Products

 

Our products are based on proprietary and patented gas, chemical and radiation sensors. We design and manufacture the following sensors:

 

 

Photoionization detectors use ultraviolet light to ionize gas molecules into charged particles. This produces a flow of electrical current proportional to the concentration of the charge. Our patented photoionization detector technology enables dependable, linear, part-per-billion range readings for many toxic gases and vapors. Photoionization detection is particularly suited to the detection of the highly toxic, long-chain, low vapor pressure volatile organic compounds associated with many toxic industrial chemicals. Our products that use this technology include: the MultiRAE Plus, AreaRAE, AreaRAE Inert, AreaRAE Steel, MiniRAE 3000, MiniRAE Lite, ppbRAE 3000 and UltraRAE 3000.

 

Integrated Wireless Products

 

We have developed wireless capabilities for many of our gas monitoring instruments that enable detection from remote locations. Our AreaRAE and MeshGuard products offer wireless-enabled gas detectors, which provide real-time transmission of monitoring information to a base station located up to two miles away from the detectors. The AreaRAE incorporates technologies such as global positioning system (GPS) receivers and geographic information system (GIS) capabilities to create awareness of hazardous conditions for decision makers located remotely in a central command and control location. In addition, both the AreaRAE and MeshGuard can interface with the Internet, making measurements available from virtually any location with Internet access.

 

Our AreaRAE Gamma combines a multi-gas and radiation detector equipped with a wireless radio frequency modem that allows the unit to communicate and transmit sensor and location information on a real-time basis to a remotely located base controller. AreaRAE Steel is a stainless steel version of the AreaRAE that meets the intrinsic safety requirements of the United States, Canada and the European Union (ATEX). All of the AreaRAE models are available in Rapid Deployment kits to enable swift deployment in the field.

 

Meshguard, introduced in October 2008, is a new family of wireless products designed to replace the fixed sensor systems that are deployed for oil and gas exploration. The Meshguard family of products uses mesh-radio to create a self healing network where each sensor has both a radio receiver and transmitter. This architecture gives the MeshGuard sensor the ability to transmit radio data in and around metal structures that are generally difficult for clear radio transmission.

 

RAELink 3 provides the wireless network bridge to connect MultiRAE Plus, MiniRAE 3000, ppbRAE 3000 and UltraRAE 3000 to either the AreaRAE or MeshGuard networks.

 

Our wireless products include the AreaRAE, AreaRAE Steel, AreaRAEGamma, MeshGuard and RAELink3.

 

Radiation Products

 

We have developed technology for gamma and neutron radiation detection. These technologies are incorporated into highly sensitive handheld instruments capable of detecting low levels of radiation on a real-time basis and dosimeters which are used in nuclear power plants to protect personnel from long-term radiation exposure. Our radiation products include Gamma RAE IIR, NeutronRAE II, AreaRAE Gamma, AreaRAE Steel Gama and DoseRAE. Our markets include nuclear power plants and first responders.

 

Software Solutions

 

ProRAE Guardian was introduced in late 2010 and represents an advanced generation of real-time wireless threat detection solutions. This new software program serves as a mobile command center for safety managers and incident commanders by connecting and relaying data from RAE Systems AreaRAE family and select third party wireless products to remote locations anywhere in the world. ProRAE Guardian accepts real-time detector data and instantly displays device status, alarm, and sensor reading information — all integrated on a single map display. Because ProRAE Guardian is always on and always connected, geographically dispersed teams can coordinate threat responses while simultaneously viewing the same situational data, all in real time.

 

New Product Certifications

 

 

 

Sales, Marketing and Distribution

 

We sell our products in more than 95 countries and through an international network of direct sales personnel, representatives and distributors managed from San Jose, California, Beijing, China, Hong Kong and our Copenhagen, Denmark European and Middle East headquarters.

 

Currently, our predominant distribution channel is value added business-to-business or business-to-government distribution services companies that focus on the health, safety and security product markets. Many of our distributors are international companies with distribution rights in specific territories. We seek those distributors that have the greatest reach and broadest array of end-user customers. We monitor our distributors’ performance according to volume, payment schedule, training, services and other support programs.

 

Our wireless detection products, specifically the AreaRAE and MeshGuard suite of products and their peripherals, are largely sold through a direct sales channel in the United States and Europe. This channel was established because of the technical expertise required to advise and sell these complex monitoring systems.

 

Our marketing efforts are focused on increasing brand awareness and creating product preference through print advertising, direct mail, email marketing, web sites, trade shows and focused sales strategies. The primary responsibilities of our product managers is to create products and develop marketing programs targeted towards specific audiences in the areas of wireless systems, portable products, consumable products and government requirements.

 

Customers

 

We have significant numbers of instruments currently in service in more than 95 countries, with various government agencies and many of the world’s leading corporations. Our products are used in civilian and government atmospheric monitoring programs. Our end-user customers include many industrial companies that use hazardous chemicals as part of their manufacturing processes. We serve customers in five key markets: oil and gas, hazardous material management, industrial safety, civil defense and environmental remediation. Our products are used in confined space entry monitoring programs, public venue protection, first responders, law enforcement, all branches of the armed forces and numerous local, state and federal agencies and departments.

 

Research, Development and Engineering

 

As a toxic gas and radiation instruments manufacturer, we continue to invest in sensor technology. We were among the first companies in our industry to deploy Reduction of Hazardous Substances (RoHS) compliant oxygen sensors. These oxygen sensors meet the RoHS requirements of China, the European Union and the State of California. The Company maintains research, development and engineering facilities in San Jose, CA, and in Shanghai and Beijing, China. Our primary R&D facility is located in Shanghai, where we also have a radiation calibration lab. This lab is an important facility for the Company to expand its future radiation detection product offerings.

 

We use modular product design processes and flexible rapid manufacturing. These investments have resulted in improved system performance as well as advanced scalability, thereby allowing rapid development and regional certification of new products.

 

The Company currently holds a total of 27 patents granted with 17 patents pending. Theses patents include:

 

 

Manufacturing

 

We lease a modern 61,000 square foot manufacturing facility with laboratory space in Shanghai, China, where the majority of our components and products are manufactured. We are building a new 128,000 square foot manufacturing, research and development and administrative facility in Shanghai, China. We expect to relocate to this building in the summer of 2011 and terminate the lease of our existing Shanghai facility at the same time. We lease a 67,000 square foot office, manufacturing, integration and test site in San Jose, California, where we manufacture some of our more complex and sensitive sensors. Our manufacturing operations in Shanghai and California are ISO 9001 certified. We have limited manufacturing capabilities in our RAE Beijing operations, consisting of 106,000 square feet, of which 41,000 square feet are dedicated to manufacturing and the balance to sales, marketing and administrative functions.

 

Competition

 

The markets for gas detection monitoring devices and wireless gas monitoring systems are highly competitive. Our global gas detection competitors include Industrial Scientific Corporation, Mine Safety Appliances Company, Honeywell, Ion Science, Draeger Safety Inc., Gastec Corporation and Sperian Protection. In addition, China specific gas detection competitors include Ex-Saf, Cosmos, and local China companies with established distribution networks.

 

Competitors in the gas monitoring industry differentiate themselves on the basis of their sensor technology, product quality, language support, service offerings, sales capabilities, cost and time to market. An emerging differentiator is the ability to manage data for long term exposure records and incident management. We believe we compete strongly in each of these areas and consider ourselves an industry leader in the design, development, marketing and manufacture of toxic gas monitoring devices. In particular, we believe our ability to develop products that integrate different chemical detection techniques, such as photoionization detectors, electrochemical sensors for specific toxic chemicals and combustible gas detectors, along with communication technologies that allow wireless data transfer, provide us with a competitive advantage. In addition, we believe our single user interface, training and support materials are a valuable resource for our distributors and end-users, which make our products more attractive to customers.

 

Many of our gas detection competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources. In addition, some of our competitors may be able to devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing policies and/or devote more resources to technology and systems development.

 

We differentiate our radiation detection products on their intrinsic safety certifications and the dual nature of our products. Our GammRAE II R combines both a detector and dosimeter. Our NeutronRAE combines both gamma radiation and neutron detectors. Our AreaRAE Gamma combines wireless gas detection and gamma radiation monitoring. Competitors in the radiation detection market include Canberra, Exporanium, ICx, MGP Polimaster Ltd., Santa Barbara Systems, Smiths Detection, ThermoFisher and TSA Limited.

 

Employees

 

As of December 31, 2010, our workforce included 749 employees in our continuing operations and 506 in our business held for sale in Fushun, China. Our employees are not covered by a collective bargaining agreement. We have never experienced an employee-related work stoppage and consider our employee relations to be good.

Executive Officers of the Registrant

 

The following table sets forth the names, ages and positions held by our executive officers.

 

 

Robert I. Chen co-founded RAE Systems in 1991 and has served as President, Chief Executive Officer and a director since our inception. From 1981 to 1990, Mr. Chen served as President and Chief Executive Officer of Applied Optoelectronic Technology Corporation, a manufacturer of computer-aided test systems, a company he founded and subsequently sold to Hewlett-Packard. Mr. Chen currently serves on the board of directors of Shanghai Ericsson Simtek Electronics Company, Limited, a telecommunications and electronics company. Mr. Chen received a BS in electrical engineering from Taiwan National Cheng Kung University, an MS in electrical engineering from South Dakota School of Mines and Technology, an advanced engineering degree from Syracuse University and graduated from the Harvard Owner/President program.

 

Randall Gausman joined RAE Systems in October 2006 as Chief Financial Officer. From May 2006 until joining the Company, Mr. Gausman worked as an independent financial consultant. From April 2002 to May 2006, Mr. Gausman served as Chief Financial Officer of Tut Systems, Inc., which delivered industry leading content processing and distribution products for deploying next-generation video and IP services over broadband networks. Previously he served as co-founder and CFO of Zantaz, Inc. and a senior finance executive at American President Companies. Mr. Gausman holds both a BS and MBA from the University of Southern California, as well as a certificate in corporate finance from the University of Michigan School of Business Administration.

 

Dr. Peter C. Hsi co-founded RAE Systems in 1991 and has served as Chief Technology Officer and a director since our inception. Prior to co-founding RAE Systems, Dr. Hsi was the chief architect for semiconductor test systems at Applied Optoelectronic Technology Corporation. He was also the general manager for Shanghai Simax Technology Co. Ltd. Dr. Hsi has filed 21 patent applications, of which 16 have been granted and 5 are pending. Dr. Hsi received a BS in electrical engineering from the National Chiao-Tung University, and a MS and PhD in electrical engineering from Syracuse University.

 

Dr. Ming-Ching Tang joined RAE Systems in June 2007 as Vice President Manufacturing and was promoted to Executive Vice President Operations in August 2009. Prior to joining the Company, Dr. Tang was a senior executive of TDK China in Hong Kong and Trace Storage Technology in Taiwan. His previous professional experience included development engineering assignments with Western Digital, IBM and Seagate Technology. Dr. Tang received a BS in mechanical engineering from National Taiwan University, an MS in mechanical engineering from Massachusetts Institute of Technology and a PhD in mechanical engineering from University of California, Berkeley.

 

Christopher Hameister has served as Vice President of Asia-Pacific, Europe, and Middle East Business Operations since January 2007. Previously, Mr. Hameister served as Vice President of Worldwide Sales with RAE Systems from July 2006 to January 2007. In the last 25 years, Mr. Hameister’s experiences have all been with instrumentation companies, including seven years, prior to rejoining the company in July 2005, as Director of Marketing and Sales with RAE Systems and six years with Thermo Instruments as Business Operation Manager. Mr. Hameister holds a BS from the University of Adelaide, South Australia and a certificate in marketing from University of New South Wales.

Fei-Zhou Shen joined RAE Systems in May 2001 and has served in various key roles including Vice President of Worldwide Manufacturing and Vice President Corporate Development and Fushun Business Operations. Mr. Shen is currently Vice President Worldwide Manufacturing and Corporate Development. Mr. Shen has over 20 years of business experience serving in key business and strategic management roles. Mr. Shen has a BS in mechanical engineering from Shanghai Jiao-Tong University and a MS in mechanical engineering from the University of Idaho.

 

Ryan Watson joined RAE Systems in May 1999 as the Midwestern Regional Sales Manager. He has also served as Sales Director for the Eastern US and Canada and Central US Regional Sales Manager. He was promoted to Vice President of Americas Sales in March 2008. Mr. Watson has over 14 years of field experience selling into multiple market segments including industrial, first responder, government/military, oil-gas and petrochemical as well as environmental applications. Mr. Watson has a BS in human environmental sciences from the University of Missouri.

 

 

You should carefully consider the risks described below before making a decision regarding an investment in our common stock. If any of the following risks actually occur, our business could be harmed, the trading price of our common stock could decline and you may lose all or part of your investment. You should also refer to the other information contained in this report, including our financial statements and the related notes.

 

Although we have settled outstanding issues related to our possible violations of the Foreign Corrupt Practices Act, we still face risks of non-compliance with the FCPA going forward.

 

During fiscal year 2008, our internal audit department identified certain payments and gifts made by certain personnel in our China operations that may have violated the FCPA. Following this discovery, the Audit Committee of our Board of Directors initiated an independent investigation. We made a voluntary disclosure to the DOJ and the SEC regarding the results of our investigation. We 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 FCPA violations. We cooperated with the DOJ and the SEC in connection with their review of the matter, and we recorded an accrual of $3.5 million in the third quarter of 2009 relating to the potential settlement of this matter. In December 2010, we settled all outstanding issues with regard to his matter pursuant to separate agreements with the DOJ and the SEC, under which we agreed to pay a $1.7 million criminal penalty to the DOJ and about $1.15 million in restitution plus $109,000 in interest to the SEC. We also agreed to advise the DOJ and the SEC periodically until December 2013 as to our ongoing efforts to ensure continued compliance with the FCPA.

 

Economic conditions could materially adversely affect our business.

 

The financial turmoil that first arose in the fall of 2008 has resulted in a tightening in the credit markets and a low level of liquidity in many financial markets. There could be a number of follow-on effects from the credit crisis on our business, including the insolvency of key suppliers or their inability to obtain credit to finance manufacturing of their products, resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of our products; and/or customer, including channel partner, insolvencies. Our operations and performance depend significantly on worldwide economic conditions. Uncertainty about current global economic conditions poses a risk as businesses and governments may postpone spending in response to tighter credit and/or negative financial news, which could have a material negative effect on demand for our products. Our operating results could also be adversely affected if the U.S. dollar strengthens against various foreign currencies.

 

Political events, war, terrorism, natural disasters, and other circumstances could materially adversely affect us.

 

War, terrorism, geopolitical uncertainties, and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus could have a strong negative effect on us and our suppliers, logistics providers, manufacturing vendors, and customers, including channel

partners. Our business operations are potentially subject to interruption by natural disasters, fire, power shortages, terrorist attacks and other hostile acts, and other events beyond our control. Such events could decrease demand for our products, make it difficult or impossible for us to make and deliver products to our customers, including channel partners, or to receive components from our suppliers, and create delays and inefficiencies in our supply chain.

 

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, changes in world-wide energy production and refining, 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.

 

We may have difficulty achieving and sustaining profitability and may experience additional losses in the future. If we continue to report losses or are marginally profitable, the financial impact of future events may be magnified and may lead to a disproportionate impact on the trading price of our stock.

 

Although we reported income from continuing operations of $5.3 million for 2010, we recorded losses of $3.3 million and $5.7 million for 2009 and 2008, respectively. In order to improve our profitability, we will need to continue to generate new sales while controlling our costs. As we plan on continuing the growth of our business while implementing cost control measures, we may not be able to successfully generate enough revenues to sustain profitability. Any failure to increase our revenues and control costs as we pursue our planned growth would harm our profitability and would likely result in a negative effect on the market price of our stock. Our financial results have historically bordered at or near profitability, and if we continue to perform at this level, the financial impact may be magnified and we may experience a disproportionate impact on our trading price as a result. If we again incur losses in the future, any particular financial event could result in a relatively large change in our financial results that could be the difference between us having a profit or a loss for a particular quarter in which it occurs.

 

We may require additional capital in the future, which may not be available or may be available only on unfavorable terms.

 

Our future capital requirements depend on many factors, including potential future acquisitions and our ability to generate revenue and control costs. Should we have the need to raise additional capital, we might not be able to do so at all or on favorable terms. In the case of any future equity financings, dilution to our shareholders could result and, in any case, such securities may have rights, preferences and privileges that are senior to those of our common stock. If we are unable to obtain needed capital on favorable terms, or at all, our business and results of operations could be harmed and our liquidity could be adversely affected.

 

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

 

The market for gas and radiation detection monitoring devices is highly competitive. Competitors in the gas and radiation monitoring industry differentiate themselves on the basis of their technology, quality of product and service offerings, cost and time to market. Our primary competitors in the gas detection market include Industrial Scientific Corporation, Mine Safety Appliances Company, Honeywell, Ion Science, Draeger Safety Inc., Gastec Corporation and Sperian Protection. Our competitors in the radiation market include Canberra, Exporanium, ICx, MGP Polimaster Ltd., Santa Barbara Systems, Smiths Detection, ThermoFisher and TSA Limited. Several of our competitors such as Mine Safety Appliances Company, Draeger Safety Inc. and Smiths have longer operating

histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than we do. In addition, some of our competitors may be able to:

 

 

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

 

We may not be successful in 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 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 expanded our current business of providing gas detection instruments to include radiation detection and wireless systems for local and remote security monitoring. While 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.

 

The securities laws and regulations have and are likely to continue to have a significant effect on our costs.

 

The Sarbanes-Oxley Act of 2002 and the rules promulgated by the SEC and the New York Stock Exchange in relation thereto require significant legal, financial and accounting compliance costs.

 

In the event we are unable to satisfy regulatory requirements relating to internal control over financial reporting or, if these controls are not effective, our business and financial results may suffer.

 

In designing and evaluating our internal control over financial reporting, we recognize that any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives. For example, a company’s operations may change over time as the result of new or discontinued lines of business and management must periodically modify a company’s internal controls and procedures to timely match these changes in its business. In addition, management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures and company personnel are required to use judgment in their application. While we continue to improve upon our internal control over financial reporting, so that it can provide reasonable assurance of achieving its control objectives, no system of internal controls can be designed to provide absolute assurance of effectiveness.

 

Material weaknesses in internal control over financial reporting may materially impact our reported financial results and the market price of our stock could significantly decline. Additionally, adverse publicity related to a material failure of internal control over financial reporting could have a negative impact on our reputation and business.

We are subject to risks and uncertainties of the government marketplace, including the risk that the government may not fund projects that our products are designed to address and that certain terms of our contracts with government agencies may subject us to adverse government actions or penalties.

 

Some of our customers, such as first responders, rely to some extent on government grants to purchase our products. Decisions on what types of projects are to be funded by local, state and federal government agencies may have a material impact on our business. The Federal budget for the Department of Homeland Security, which we refer to as “Homeland Security” herein, is a source for funding for many of our customers either directly or through grants to state and local agencies. However, if the government does not fund projects that our products are designed to address, or funds such projects at levels lower than we expect, our business and results of operations will be harmed.

 

From time-to-time we enter into government contracts that contain provisions which subject us to laws and regulations that provide government clients with rights and remedies not typically found in commercial contracts. For example, a portion of our federal contracting has been done through our distributors who are on the Federal Supply Schedules from the United States General Services Administration (GSA). GSA Schedule contracts which we may enter into often include a clause known as the “Price Reductions” clause; the terms of that clause are similar but not identical to a “most favored customer” clause in commercial contracts. Under that clause, we may agree that the prices to the government under the GSA Schedules contract will maintain a constant relationship to the prices charged to certain commercial customers, i.e., when prices to those benchmark customers drop, our prices on our GSA Schedules contract must be adjusted accordingly. Although when we are party to these contracts we undertake extensive efforts to comply with the Price Reductions clause, it is possible that we may have an unreported discount offered to a “Basis of Award” customer and may have failed to honor the obligations of the Price Reductions clause. If that occurs, we could, under certain circumstances, be subject to an audit, an action in fraud, or other adverse government actions or penalties.

 

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 may face risks from our substantial international operations and sales.

 

We have significant operations in foreign countries, including manufacturing facilities, sales personnel and customer support operations. For the years ended December 31, 2010 and 2009, approximately 28% and 34% of our revenues, respectively, were from sales to customers located in Asia and approximately 18% and 19% of our revenues, respectively, were from sales to customers located in Europe. We have manufacturing facilities in China and in the United States. A significant portion of our products and components are manufactured at our facility in Shanghai, China.

 

Our international operations are subject to economic and other risks inherent in doing business in foreign countries, including the following:

 

 

 

The specific economic conditions in each country will impact our future international sales. For example, approximately half of our recognized revenue has been denominated in U.S. dollars. Significant downward fluctuations in currency exchange rates against the U.S. dollar could result in higher product prices and/or declining margins and increased manufacturing costs. If we do not effectively manage the risks associated with international operations and sales, our business, financial condition and operating results could suffer.

 

Like other companies operating or selling internationally, we are subject to the FCPA and other laws which prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. and other business entities for the purpose of obtaining or retaining business. We make sales in countries known to experience corruption. Our sales activities in such countries create the risk of unauthorized payments or offers of payments by one of our employees, consultants, sales agents or distributors which could be in violation of various laws including the FCPA, even though such parties are not always subject to our control. We have implemented new policies and procedures to prevent losses from such practices and to discourage such practices by our employees, consultants, sales agents and distributors and are continuing our efforts to improve such policies and procedures. Among other things, we have established on-going training programs for our employees to ensure that they are aware of their responsibilities under the FCPA and similar laws. However, our existing safeguards and any improvements may prove to be less than effective and our employees, consultants, sales agents or distributors may engage in conduct for which we might be held responsible. Violations of the FCPA may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, financial condition and results of operations.

 

The loss of “Normal Trade Relation” status for China, changes in current tariff structures or adoption of other trade policies adverse to China could have an adverse effect on our business.

 

Our ability to import products from China at current tariff levels could be materially and adversely affected if the “normal trade relations” (“NTR”, formerly “most favored nation”) status the United States government has granted to China for trade and tariff purposes is terminated. As a result of its NTR status, China receives the same favorable tariff treatment that the United States extends to its other “normal” trading partners. China’s NTR status, coupled with its membership in the World Trade Organization, could eventually reduce barriers to manufacturing products in and exporting products from China. However, we cannot provide any assurance that China’s membership in the World Trade Organization or NTR status will not change. As a result of opposition to certain policies

of the Chinese government and China’s growing trade surpluses with the United States, there has been, and in the future may be, opposition to NTR status for China. Also, the imposition of trade sanctions by the United States or the European Union against a class of products imported by us from, or the loss of NTR status with, China, could significantly increase our cost of products imported into the United States or Europe and harm our business. For example, in September 2009, the U.S. government imposed new tariffs on tires imported from China. Retaliatory actions by China could be harmful to our business. Because of the importance of our international sales and international sourcing of manufacturing to our business, our financial condition and results of operations could be significantly and adversely affected if any of the risks described above were to occur.

 

The government of China may change or even reverse its policies of promoting private industry and foreign investment, in which case our assets and operations may be at risk.

 

We currently manufacture and sell a significant portion of our components and products in China. Our existing and planned operations in China are subject to the general risks of doing business internationally and the specific risks related to the business, economic and political conditions in China, which include the possibility that the central government of China will change or even reverse its policies of promoting private industry and foreign investment in China. Many of the current reforms which support private business in China are unprecedented or experimental. Other political, economic and social factors, such as political changes, changes in the rates of economic growth, unemployment or inflation, or in the disparities of per capita wealth among citizens of China and between regions within China, could also lead to further readjustment of the government’s reform measures. It is not possible to predict whether the Chinese government will continue to be as supportive of private business in China, nor is it possible to predict how future reforms will affect our business.

 

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 rights in general. For example, we have a collection of patents related to our photoionization detector technology, the first of which 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 may face intellectual property infringement claims that might be costly to resolve and affect our results of operations.

 

In connection with the enforcement of our own intellectual property rights, the acquisition of third-party intellectual property rights or disputes relating to the validity or alleged infringement of third-party rights, including patent rights, we have been, are currently and may in the future be subject to claims, negotiations or complex, protracted litigation. Intellectual property disputes and litigation are typically very costly and can be disruptive to our business operations by diverting the attention and energies of management and key technical personnel. Although we have successfully defended or resolved past litigation and disputes, we may not prevail in any ongoing or future litigation and disputes. We may incur significant costs in acquiring the necessary third party intellectual property rights for use in our products. Third party intellectual property disputes could subject us to significant liabilities, require us to enter into royalty and licensing arrangements on less favorable terms, prevent us from

manufacturing or licensing certain of our products, cause severe disruptions to our operations or the markets in which we compete, or require us to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements, any one of which could seriously 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 sell a majority of our products through distributors, and if our distributors stop selling our products, our revenues would suffer.

 

We distribute our products in the Americas, Europe, Asia Pacific and the Middle East primarily through distributors. We are dependent upon these distributors to sell our products and to assist us in promoting and creating a demand for our products. Distributors are an important sales channel for our future growth. 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.

 

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.

 

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

 

In the last several years, we increased our ownership of RAE Beijing to 96%, acquired Aegison Corporation and Tianjin Securay Technology Co., Ltd. and formed RAE Fushun, of which we held 70% ownership. In August 2007, we determined to discontinue the Aegison and Securay businesses. On January 12, 2011, we entered into a definitive agreement to sell our 70 percent ownership of RAE Fushun to the Shenyang Research Institute of China Coal Research. The agreement is expected to close within 180 days of signing the definitive agreement and is subject to customary closing conditions. We may acquire or make additional 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, or contingent liabilities, 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 currently own approximately 40% of Renex, a wireless systems company. 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.

 

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. We have no formal employment agreements with any of our executives other than the initial offer letter, if applicable. The loss of the services of any of our executive officers could harm our business. We do not have key person life insurance on any of our personnel.

 

Our officers and directors beneficially own approximately 34% of our common stock and, accordingly, may exert substantial influence over the Company.

 

Our executive officers and directors, in the aggregate, beneficially own approximately 34% of our common stock as of December 31, 2010. These stockholders acting together have the ability to substantially influence 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.

 

 

None.

 

 

Our corporate headquarters and principal offices are located in a facility we lease in San Jose, California. The San Jose facility consists of approximately 67,000 square feet, which we have occupied since May 2005, and which includes research and development, sales and marketing, general and administrative and manufacturing operations. The lease expires in December 2017.

 

We lease manufacturing and research and development facilities in Shanghai, China. The lease on the manufacturing facility (44,000 square feet) expires in September 2011. The lease on the research and development/sensor laboratory (17,000 square feet) expires in October 2012.

 

In December 2008, we purchased the land use rights for 50 years to 5 acres of land in Shanghai. We currently are building a new 128,000 square foot manufacturing, research and development and administrative facility on this site. We expect to relocate to this building in the summer of 2011 and terminate the lease of our existing Shanghai facility at the same time.

 

In addition, RAE Beijing owns a manufacturing facility consisting of approximately 106,000 square feet, of which 41,000 square feet is dedicated to the manufacturing of RAE Beijing’s products and the storage of the inventory.

 

We maintain a sales office in Shatin, Hong Kong, from which we sell our products throughout Asia, excluding the People’s Republic of China. The lease expires in April 2013. We also maintain sales and service centers in Copenhagen, Denmark, the United Kingdom, France and United Arab Emirates, from which we sell our products to Europe, Australia, New Zealand, the Middle East and Africa. The lease of the Copenhagen facility expires in September 2014.

 

 

Regulatory Compliance

 

During fiscal year 2008, our internal audit department identified certain payments and gifts made by certain personnel in our China operations that may have violated the FCPA. Following this discovery, the Audit Committee

of our Board of Directors initiated an independent investigation. We made a voluntary disclosure to the DOJ and the SEC regarding the results of our investigation. We 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 FCPA violations. We cooperated with the DOJ and the SEC in connection with their review of the matter, and we recorded an accrual of $3.5 million in the third quarter of 2009 relating to the potential settlement of this matter. We subsequently settled all outstanding issues with regard to his matter, in December 2010, pursuant to separate agreements with the DOJ and the SEC, under which we agreed to pay a $1.7 million criminal penalty to the DOJ and about $1.15 million in restitution plus $109,000 in interest to the SEC. The Company also agreed to advise the DOJ and the SEC periodically until December 2013 as to its ongoing efforts to ensure continued compliance with the FCPA.

 

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, Nos. 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. The appeal is currently pending in the United States Court of Appeals for the Ninth Circuit. Briefing on the appeal has been completed by both sides and the appeal was argued and submitted to the Ninth Circuit for decision on January 15, 2010.

 

When 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, and briefing on the appeal has been completed by both sides and the appeal was argued and submitted to the Ninth Circuit for decision on January 15, 2010.

 

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 equaled 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 were maintained in the client trust account of RAE Systems’ counsel, McLeod, Witham & Flynn LLP, and were held until the Ninth Circuit had ruled on Polimaster’s appeal (Nos. 08-15708 and 09-15369). 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. On November 12, 2010, the Ninth Circuit denied RAE Systems’ petition, so the judgment of the Ninth Circuit is now final, and the escrowed funds have been returned to Polimaster.

 

Shareholder Lawsuits

 

The California State Court Actions:

 

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 a 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, would purportedly receive improper personal benefits in connection with the proposed acquisition, 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. On October 28, 2010 the California court consolidated all five California actions under the caption In re RAE Systems, Inc. Shareholder Litigation, Lead Case No. 110CV182985. On December 15, 2010, plaintiffs Mann and Angles filed an amended complaint continuing to set forth the claims set forth above and including additional disclosure claims based on allegations that the Company’s proxy filings contain materially false statements and fail to disclose material facts regarding, among other things, the Special Committee, the holders of the Rollover Shares, the process and events leading up to the proposed acquisition, the FCPA investigation, communications with Battery Ventures and other potential bidders, and the work performed by UBS and data underlying its analyses. On December 17, 2010, the California court issued an order staying all proceedings in California state court in favor of litigation pending in Delaware.

 

The Delaware Chancery Court Actions:

 

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. The Delaware actions have been consolidated under the caption In re RAE Systems, Inc. Shareholder Litigation, Consolidated C.A. No. 5848-VCS, and plaintiffs filed a Verified Consolidated Amended Class Action Complaint on or about October 28, 2010. In this pleading, plaintiffs continued to assert the claims set forth above, and in addition they alleged that the Company’s Preliminary Proxy Statement, filed with the SEC on October 21, 2010, contained materially false statements or failed to disclose material facts regarding, among other things, the Special Committee, the holders of the Rollover Shares, the process and events leading up to the proposed acquisition, the FCPA investigation, communications with Battery Ventures and other potential bidders, and the work performed by UBS and data underlying its analyses. Plaintiffs requested various forms of injunctive relief, as well as money damages allegedly suffered or to be suffered by the putative class. On December 17, 2010, two of the plaintiffs from the stayed California action (Mann and Angles) also filed a complaint in Delaware Chancery Court making essentially the same allegations as in their amended California complaint described above. Plaintiffs Mann and Angles subsequently voluntarily dismissed their Delaware complaint.

 

On February 24, 2011, the remaining Delaware plaintiffs filed a motion requesting leave to file a Supplemental and Amended Verified Class Action Complaint. The Delaware Chancery Court granted plaintiffs’ leave to amend their complaint on March 2, 2011. The Supplemental Amended Verified Class Action Complaint asserts claims against the Company, members of its Board of Directors, and entities affiliated with Vector Capital, and alleges in summary that, in connection with the proposed acquisition of the Company by an affiliate of Vector Capital, 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. The complaint also alleges that the Company’s Preliminary Proxy Statement, filed with the SEC on February 22, 2011, contains materially false statements or fails to disclose material facts regarding, among other things, the Special Committee, the holders of the Rollover Shares, the process and events leading up to the proposed acquisition, the work performed by UBS and data underlying its analyses, and communications with Battery Ventures, Vector Capital, and other potential bidders. Plaintiffs request various forms of injunctive relief, as well as money damages allegedly suffered or to be suffered by the putative class.

 

The Federal Court Actions:

 

Two other actions have been filed in the United States District Court for the Northern District of California against the Company, members of its Board of Directors, the Company’s Chief Financial Officer, and/or Battery Ventures, Rudy Merger Sub Corp. and Rudy Acquisition Corp. Those actions are entitled LaPlante v. RAE Systems Inc., et al., No. CV104944 and Mabry v. Chen, et al., No. CV 10-5328. They make allegations similar to the other lawsuits, and add claims for alleged violation of the federal securities laws in connection with the preparation of the proxy statement filed by the Company in connection with a proposed acquisition by affiliates of Battery Ventures. On January 10, 2011, the federal court issued an order pursuant to a stipulation of the parties staying proceedings in the LaPlante action in favor of litigation pending in Delaware. A similar order was entered by the federal court in the Mabry action on January 21, 2011, pursuant to stipulation of the parties.

 

The Company believes that the claims in the above shareholder lawsuits are without merit and intends to vigorously defend against them. However, there can be no assurances as to the outcome of the litigation. The Company is in the process of assessing these matters and is consulting with its external legal counsel and technical experts. The amount of loss related to these matters is not estimable at this time. Accordingly, the Company has not accrued an amount of the loss related to these matters.

 

 

 

Our common stock traded on the American Stock Exchange (“AMEX”) under the trading symbol “RAE” beginning on August 29, 2003. Effective October 1, 2008, the AMEX was acquired by NYSE Euronext, the holding company created by the combination of NYSE Group, Inc. and Euronext N.V. in April 2007. Since October 1, 2008, our common stock has traded on the NYSE Alternext US (“NYSE-Alt”). The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as derived from publicly reported AMEX and NYSE-Alt daily trading data. The quotations do not reflect adjustments for retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions.

 

 

As of December 31, 2010, there were 270 shareholders of record who held shares of our common stock.

 

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

 

PERFORMANCE GRAPH

 

The following chart presents a comparative analysis of the performance of our common stock relative to the NYSE AMEX Composite Index and NYSE AMEX Stock Market (U.S. Companies) and for a Peer Group of companies defined as for SIC codes 3800-3899, Measuring Instruments. This analysis assumes a $100 investment in our underlying common stock and these indices on December 31, 2005 through December 31, 2010. This analysis does not purport to be a representation of the actual market performance of our stock or these indices. This chart has been provided for informational purposes to assist the reader in evaluating the market performance of our common stock compared to other market participants.

 

Notwithstanding anything to the contrary set forth in our previous filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, which might incorporate future filings made by us under those statutes, the following Stock Performance Graph will not be deemed incorporated by reference into any future filings made by us under those statutes.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among RAE Systems Inc., the NYSE AMEX Composite Index, the NYSE Amex Stock Market (U.S. Companies), and a Peer Group of NYSE AMEX stocks for SIC codes 3800 — 3899 Measuring Instruments (photo, med & optical goods)

 

 

* $100 invested on 12/31/05 in stock or index-including reinvestment of dividends.

 

Fiscal year ending December 31,

 

 

Effective October, 2008, the AMEX was acquired by NYSE Euronext, the holding company created by the combination of NYSE Group, Inc. and Euronext N.V. in April 2007. Since October 1, 2008, our common stock has traded on the NYSE Alternext US (“NYSE-Alt”).

 

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

 

 

 

The following information summarizes events that affect comparability of the information reflected in selected financial data:

 

 

 

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. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in Item 1A, “Risk Factors” as well as in Item 1, “Business” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K. You should carefully review these risks and also review the risks described in other documents we file from time- to- time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q that we will file in fiscal year 2010. You are cautioned not to place undue reliance on these forward-looking statements, and we expressly assume no obligations to update the forward-looking statements in this report that occur after the date hereof.

 

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.

 

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. In December 2006 we formed RAE Fushun to serve the coal mine safety market in China. This joint venture was 30% owned by Fushun Anyi and 70% owned by RAE Systems. On January 12, 2011, we entered into a definitive agreement to sell our 70 percent ownership of RAE Fushun to the Shenyang Research Institute of China Coal Research Institute. The agreement is expected to close within 180 days of signing the definitive agreement and is subject to customary closing conditions. 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 markets we serve. Products range from breathing zone single sensor products for specific toxic chemicals (ToxiRAE 3) to multi-gas monitors (QRAE 2) to handheld instruments (MiniRAE 3000, ppbRAE 3000 and UltraRAE) to measure total and specific volatile organic compounds, and wireless monitors for industrial and public safety applications (AreaRAE Steel).

 

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 technology that provides a data bridge for our products and complementary products such as chemical warfare agents and particle counters. We have developed the ProRAE Guardian which represents an advanced generation of real-time wireless threat detection solutions. This new software program serves as a mobile command center for safety managers and incident commanders by connecting and relaying data from RAE Systems AreaRAE family and select third party wireless products to remote locations anywhere in the world.

 

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

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and

liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, we evaluate the estimates, including those related to our allowance for doubtful accounts, valuation of long-lived assets, goodwill and intangible assets, valuation of deferred tax assets, inventory valuation and stock-based compensation expense. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates under different assumptions or conditions.

 

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 when goods are shipped 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 at time of delivery (FOB destination), revenue is recognized after we have established proof of delivery. Revenues relating to services performed under our extended warranty program represent less than 5% of net revenues in each of 2010, 2009, and 2008 and are recognized as earned based upon contract terms, generally ratable over the term of service. We have project revenue in Asia where we use the percentage-of-completion method. Project revenue represents less than 8% of net revenue in 2010, 2009, and 2008. Net revenues include amounts billed to customers in sales transactions for shipping and handling. Shipping fees represent less than 1% of net revenues in each of 2010, 2009, and 2008. Shipping costs are included in cost of goods sold.

 

Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

 

We grant credit to our customers after undertaking an investigation of credit risk for all 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, adjustments history, 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.

 

We are not able to predict changes in the financial stability of our customers. Any material change in the financial status of any one or a group of customers could have a material adverse effect on our results of operations and financial condition.

 

Trade notes receivables are presented to us from some of our customers in China as a payment against the outstanding trade receivables. These notes receivables are bank guarantee promissory notes which are non-interest bearing and generally mature within 6 months.

 

Inventories

 

Inventories are stated at the lower of cost, using the first-in, first-out method, or market. We are exposed to a number of economic and industry 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 have established inventory reserves when conditions

exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for our products and market conditions. 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.

 

Goodwill

 

We test goodwill for possible impairment on an annual basis and at any other time if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. The recoverability of goodwill is measured at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill, to the fair value of the reporting unit, which is measured based upon, among other factors, market capitalization as well as forecasted operating results. We have one reporting unit. If the recorded value of the assets, including goodwill, and liabilities (“net book value”) of the reporting unit exceeds its fair value, an impairment loss may exist. Further, to the extent our consolidated net book value is greater than our market capitalization, all, or a significant portion of any goodwill may be impaired.

 

We experienced a significant decline in market capitalization during the fourth quarter of 2008. This decline in market capitalization was driven largely by deteriorating macroeconomic conditions that contributed to a decline in our forecasted operating results and business. As a result, we recognized a non-cash impairment charge of approximately $3.3 million for the three-month period and year ended December 31, 2008 to write-off the entire carrying value of goodwill.

 

Long-lived Assets

 

We test the recoverability of long-lived assets with finite lives periodically and whenever events occur or changes in circumstances indicate that 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 or an asset’s appraised value.

 

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 had declined significantly in the quarter and for the year to date, and the Company did not expect a near-term recovery in its coal mine safety equipment business. The Company determined that the carrying value of the customer list was more than the estimated undiscounted cash flows to be generated from the use and eventual disposition of these assets. 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, the remaining carrying amount of the asset. The impairment is included in the reported loss from discontinued operations in the Company’s Consolidated Statements of Operations.

 

On January 12, 2011, the Company signed a definitive agreement to sell its 70% interest in RAE Fushun to the Shenyang Research Institute of China Coal Research Institute (“Shenyang Institute”), a state-owned enterprise, for zero proceeds. ASC Topic 360, “Property, Plant and Equipment,” provides that a disposal group classified as held for sale is measured at the lower of its carrying amount or fair value less cost to sell. Based on RAE Fushun’s sales price, the carrying amount of its net assets exceeded fair value as of December 31, 2010. Accordingly, the Company recorded impairment expense in the fourth quarter of 2010 totaling $4.6 million, which includes $0.2 million estimated direct transaction costs. The impairment is included in the reported loss from discontinued operations in the Company’s Consolidated Statements of Operations.

 

Stock-Based Compensation Expense

 

We estimate the fair value of each option award on the date of grant using a Black-Scholes-Merton (“BSM”) valuation model and a single option award approach. 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 period, which is generally the vesting period.

We make the following estimates and assumptions in determining stock-based compensation:

 

Expected Term — Our expected term represents the weighted-average period that our stock-based awards are expected to be outstanding. We have used the historical exercise patterns of previously granted options in relation to the Company’s stock price to estimate expected exercise patterns.

 

Expected Volatility — The Company’s expected volatilities are based on historical volatility of the Company’s stock, adjusted where determined by management for unusual and non-representative stock price activity not expected to recur. Management determined the historical stock price volatility for period from April 11, 2002, the commencement of public trading of the common stock, through December 31, 2002, was not likely to be representative of the future and excluded this period. Management also applies mean reversion techniques to the historical stock prices, which results in an emphasis on recent activity over the distant past, when determining the expected volatility rate to be included in the Black-Sholes-Merton valuation model.

 

Expected Dividend — The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company currently pays no dividends and does not expect to pay dividends in the foreseeable future.

 

Risk-Free Interest Rate — The Company bases the risk-free interest rate on the implied yield currently available on United States Treasury zero-coupon issues with an equivalent remaining term.

 

Estimated Forfeitures — To estimate forfeitures, we apply our historical rate of option forfeitures. Estimated forfeiture rates are trued-up to actual forfeiture results as the stock-based awards vest.

 

Income Taxes

 

We are subject to income taxes in 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 the statutory rate primarily due to foreign earnings taxed at lower rates, foreign losses not benefited, stock compensation expenses, under ASC 718, “Stock Compensation,” which are not deductible for tax purposes and changes in our valuation allowances. 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 the need for 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.

 

RESULTS OF OPERATIONS

 

The financial data set forth below excludes discontinued operations.

 

Net Sales

 

 

Net sales during 2010 increased $12.1 million, or 16%, from $75 million in 2009. The increase was primarily the result of an increase in net sales of $12.4 million, or 36%, in Americas, $0.9 million, or 6%, in Europe and the Middle East, which was partially offset by a decrease of $1.3 million, or 5%, in Asia. The increase in the Americas

was primarily the result of orders related to the Gulf of Mexico oil spill of $3.3 million, an increase in sales to the U.S. government of $2.9 million and generally improved sales in the emergency response market compared with 2009. The increase in Europe and the Middle East was primarily due to sales in the oil and gas market in the Middle East, which was partially offset by foreign exchange losses attributable to the Euro and Pound Sterling of $0.8 million. 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 $3.5 million; which was partially offset by increased sales of fixed system products at our Beijing, China operations and increased Asia sales outside of China, increased sales into Australia and New Zealand, and a favorable foreign exchange gain of $0.2 million

 

Net sales during 2009 decreased $8.1 million, or 10%, from $83 million in 2008. The decease was primarily the result of a decrease in net sales of $3.5 million, or 9%, in Americas, $3.5 million, or 12%, in Asia and $1.0 million, or 6%, in Europe and the Middle East. The decrease is primarily attributable to the negative impact of the worldwide economic downturn during the first half of 2009 and disruption of our sales activity in China due to management changes at our Beijing operations. We believe these two factors negatively impacted our sales by approximately $2.0 during 2009. Additionally the decrease in 2009 resulted from the impact of two significant non-recurring orders in 2008 totaling approximately $5.6 million: one from the United States National Guard and another from the Beijing International Airport. Approximately $0.5 million of the decrease was due to unfavorable exchange rate fluctuations.

 

Cost of Sales and Gross Profit

 

 

Cost of sales in 2010 decreased $0.7 million or 2% from $35.4 million in 2009. The decrease in cost of sales was primarily due to a decrease of approximately $3.5 million associated with spreading fixed overhead costs over a higher production volume, and efficiencies resulting from moving the production of our fixed system products, sold in China, to the global manufacturing center in Shanghai; which were partially offset by approximately $2.8 million of higher material and labor cost due to higher sales volume. The gross margin increase to 60% in 2010 from 53% in 2009 was also the result of the year-over-year increase in the sales of higher margin products in the Americas and Europe.

 

Cost of sales in 2009 decreased $3.5 million or 9% from $38.9 million in 2008. The decrease in cost of sales was primarily the result of a decrease in net sales from $83 million in 2008 to $75 million in 2009. The gross margin remained constant at 53% in both 2009 and in 2008

 

Sales and Marketing Expense

 

 

Sales and marketing expenses increased by $3.1 million or 19% in 2010. The increase in expense was due to an increase in sales commissions of approximately $1.2 million and headcount increases in the in the Americas of approximately $0.6 million, additional management bonuses of approximately $0.6 million and marketing activities to improve sales management information, web service capabilities, and brand awareness for the Company and its products of approximately $0.4 million.

 

Sales and marketing expenses in 2008 decreased $1.6 million or 9% from $17.9 million in 2008. The decrease was primarily due to company-wide cost-control initiatives and a ten percent workforce reduction in the Americas,

at the end of the first quarter of 2008. Additional savings were realized by decreases in office expenses, advertising and trade show expenses, travel and entertainment expenses, consultant expenses and project expenses.

 

Research and Development Expense

 

 

Research and development expenses in 2010 increased $1.1 million, or 19%, from $6.0 million in 2009. The increase was primarily due to increased headcount and increased salaries at the RAE Engineering center in Shanghai, China and project expenses to support new product development.

 

Research and development expenses in 2009 increased approximately $7,000 from $5,949,000 in 2008.

 

General and Administrative Expense

 

 

General and administrative expenses in 2010 were $19.7 million, decreased by $1.5 million, or 7%, from $21.1 million in 2009. The decrease was primarily due to the $3.5 million accrual in 2009 of management’s estimate to settle the outstanding joint investigation into the Company’s alleged violations of the FCPA, the subsequent joint settlement of $3.0 million in December 2010 which resulted in a net reduction in 2010 expenses of $0.5 million, the collection of accounts receivable that had been previously written off as bad debt of approximately $0.3 million, and lower depreciation of assets that have been fully depreciated of approximately $0.3 million, which was partially offset by fees of approximately $3.1 million paid to legal and financial advisors to the Special Committee of the Company’s Board of Directors related to the proposed transaction to take the Company private.

 

General and administrative expenses in 2009 decreased approximately $11,000 from $21,160,000 in 2008. While general and administrative expenses were relatively constant during 2009 and 2008, management accrued $3.5 million as its estimate to settle the outstanding joint investigation into the Company’s alleged violations of the FCPA and increased bad debt expense associated with doubtful accounts receivable of $0.8 million, which was offset by lower professional fees of $4.5 million, consisting primarily of legal fees.

 

Impairment of Goodwill

 

 

We review goodwill for impairment annually during the fourth quarter or more frequently if events or circumstances indicate that an impairment loss may have occurred. Recoverability of goodwill is measured at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill, to the fair value of the reporting unit, which is measured based upon, among other factors, market capitalization as well as forecasted operating results. We have one reporting unit. If the recorded value of the assets, including goodwill, and liabilities (“net book value”) of our reporting unit exceeds its fair value, an impairment loss may exist. Further, to the extent our net book value as a whole is greater than our market capitalization, all, or a significant portion of our goodwill

may be considered impaired. We experienced a significant decline in market capitalization during the fourth quarter of 2008. This decline in market capitalization was driven largely by deteriorating macroeconomic conditions that contributed to a decline in our forecasted operating results and business uncertainties associated with the current FCPA investigation. As a result, we recognized a non-cash impairment charge of approximately $3.3 million for the three-month period and year ended December 31, 2008 to write-off the entire carrying value of our goodwill.

 

Other Income (Expense)

 

 

For 2010, total other expense of $0.5 million increased by $0.3 million, or 166%, from $0.2 million in 2009. The decrease in interest expense was primarily due to capitalizing the interest on the construction-in-progress for the Company’s new facility in Shanghai, China, offset by the increase in Other, net which is comprised primarily of net foreign exchange losses in Asia and Europe.

 

For 2009, total other expenses decreased by $0.8 million, or 81%, from $0.9 million in 2008. The decrease in interest income was primarily due to lower interest rates and decreased cash in interest earning accounts. The change of $1.0 million income in net other during 2009 was primarily from foreign exchange gains in Asia and Europe. The expense increase of $0.2 million in Equity in loss of unconsolidated affiliates represents the Company’s share in the unconsolidated losses of its investments in various businesses.

 

Income Tax (Expense) Benefit

 

 

Income tax expense increased $1.1 million from an income tax benefit of $0.8 million in 2009. Our effective tax rate was 5% in 2010 and 20% in 2009. The tax rate for years 2010 and 2009 differed from the United States statutory rate due to foreign earnings taxed at lower rates, foreign losses not benefited, non-deductible transaction costs, stock compensation expenses, which under ASC 718, “Stock Compensation,” are not deductible for tax purposes and changes in our valuation allowances. The Company recorded a tax benefit of approximately $0.6 million during the fourth quarter of 2010 related to the expiration of its high-tech status for its Shanghai and Beijing entities. This expiration resulted in an increase in the tax rate used to establish our deferred tax assets from 15% to 25%. We have applied for the renewal of the high-tech status in the respective jurisdictions to obtain the 15% tax rate, however, there can be no certainty that the renewal will be granted. If the high-tech status is granted we will calculate the deferred tax assets at the lower rate, of 15%, which would result in a tax expense in the period the new status is granted.

 

We currently have significant deferred tax assets resulting from anticipated net operating losses and other deductible temporary differences, which will reduce taxable income in future periods. We continue to maintain a full valuation allowance for all deferred assets except for $1.5 million related to certain of our foreign entities. Based on our current projections, we believe it is “more likely than not” we will not be able realize our deferred tax assets with the exception of the $1.5 million foreign deferred tax assets. ASC 740, “Income Taxes,” requires a valuation allowance be established when it is “not more likely than not” that all or a portion of deferred tax assets

will be realized. Negative evidence in the form of cumulative losses weighed heavily in the overall assessment. We believe that sufficient uncertainty exists with regard to the realizability of these 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 current and believed to be continued weakness in the overall market thereby potentially impacting our ability to sustain or grow revenues and earnings, and the length of carryback and carryforward periods. We considered expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies.

 

Based on the absence of sufficient positive objective verifiable evidence at December 31, 2009, we have placed a valuation on our deferred tax assets except for $0.9 million of foreign deferred tax assets. We expect to record a valuation allowance on future tax benefits until we can sustain an appropriate level of profitability and until such time, we would not expect to recognize any significant tax benefits in our future results of operations.

 

Our effective tax rate was a 20% tax expense in 2009 and a 10% tax benefit in 2008. The tax rate for 2009 and 2008 differed from the United States statutory rate due to the change in the realization of our deferred tax assets, foreign earnings taxed at lower rates, foreign earnings tax at lower rates, foreign losses not benefited, and non-deductible stock compensation deductions.

 

Net (Income) Loss Attributable to the Noncontrolling Interest

 

 

The noncontrolling interest in the Net income of the consolidated subsidiaries for 2010 increased $45,000 from a loss of $3,000 in 2009. The increase in the Net income attributable to the noncontrolling interest was primarily due to the income generated by RAE France, which partially offset by the losses at RAE Beijing.

 

The noncontrolling interest in the losses of consolidated subsidiaries for 2009 increased $151,000 from income of $148,000 in 2008. The increase in the loss attributable to the noncontrolling interest was mainly due to the increased loss generated by RAE Beijing.

 

Loss From Discontinued Operations

 

 

On December 22, 2010, the Board of Directors approved management’s plan to pursue sale of the Company’s 70% interest in RAE Coal Mine Safety Instruments (Fushun) Co., Ltd. (“RAE Fushun”), a Sino-Foreign joint venture in China. RAE Fushun had not met the Company’s revenue and earnings expectations, and the joint venture was not well positioned to capitalize on the Company’s future strategies. On January 12, 2011, the Company signed a definitive agreement to sell its 70% interest to the Shenyang Research Institute of China Coal Research Institute (“Shenyang Institute”), a state-owned enterprise, for zero proceeds. However, under the terms of the agreement the Shenyang Institute assumes all documented joint venture liabilities and will pay approximately RMB 12.25 million

(or approximately $1.85 million) intercompany balances owed to RAE Shanghai and RAE Beijing for products and services previously provided to the joint venture. As of March 15, 2011, Shenyang Institute had made scheduled payments to RAE Systems totaling RMB 6 million (or approximately $0.9 million). The Company expects to receive RMB 2 million (or approximately $0.3 million) monthly until paid in full.

 

The purchase agreement between RAE Systems and Shenyang Institute is subject to customary closing conditions in China, which includes obtaining certain government approvals. The Company and Shenyang Institute anticipate receiving all of the necessary approvals and final transfer of shares within six months from signing the definitive agreement. Therefore, RAE Systems provided Shenyang Institute with complete operating control of RAE Fushun as of January 12, 2011, and RAE Systems is not involved in the day-to-day management or operating activities of RAE Fushun. The Company still retains its 70% ownership in the entity until such time regulatory approvals are obtained; however, the Company does not anticipate providing any financial support or management support to the entity during this time.

 

ASC Topic 360, “Property, Plant and Equipment,” provides that a disposal group classified as held for sale is measured at the lower of its carrying amount or fair value less cost to sell. Based on RAE Fushun’s sales price, the carrying amount of its net assets exceeded fair value as of December 31, 2010. Accordingly, the Company recorded impairment expense in the fourth quarter of 2010 totaling $4.6 million, which includes $0.2 million estimated direct transaction costs. The impairment is included in the reported loss from discontinued operations in the Company’s Consolidated Statements of Operations.

 

Liquidity and Capital Resources

 

To date, we have financed our operations primarily through operating revenues, proceeds from the issuance of equity securities and short-term bank borrowings. As of December 31, 2010, we had $16.3 million in cash and cash equivalents compared with $17.2 million on December 31, 2009.

 

On December 31, 2010, we had $31.1 million in working capital (current assets less current liabilities) and a current ratio (ratio of current assets to current liabilities) of 2.2 to 1.0 compared to working capital of $31.7 million and a current ratio of 2.2 to 1.0 on December 31, 2009.

 

In the United States, we had a $10.0 million revolving credit agreement as of December 31, 2010. The credit facility is renewed annually and as of December 31, 2010, the line was scheduled to mature on May 14, 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. We are required to comply with certain reporting 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. As of December 31, 2010 and 2009, we were 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 Consolidated Balance Sheets. The compensating balance requirement was released in January 2011. As of December 31, 2010 and 2009, $1.8 million was outstanding against the revolving credit agreement and interest was accruing at 5% per annum.

 

Financial covenants under the revolving credit agreement 1) require us to maintain specified trailing two-quarter minimum earnings before interest, depreciation, amortization and non-cash stock compensation expenses and 2) limits the size of potential monetary penalties under the FCPA to $3.5 million. As a result of the impairment expense incurred to discontinue operations in Fushun, China, we were in default of the trailing two-quarter minimum earnings requirement for the period ended December 31, 2010. However, the lender issued a waiver for the non compliance. During the fourth quarter of 2010, we settled our FCPA violation with the DOJ and SEC for $3.0 million of which $1.3 million was paid in December 2010 and $1.7 million was paid in January 2011.

 

In March 2011, we amended the credit facility to extend the maturity date to the earlier of June 15, 2011 or consummation of a merger with Vector Capital and exclude the assets and liabilities held for sale of RAE Fushun from the financial covenants. (Refer to “Note 13. Subsequent Events” for details of the Merger Agreement). The amendment also allows borrowings of up to $2 million on a non-formula basis and increases the interest rate on such borrowings to the floating prime bank lending rate plus 400 basis points.

In China, we did not renew our credit facility and repaid our RMB 15 million, or approximately $2.2 million, bank loan at maturity in October 2010. At this time, cash balances in China are sufficient to fund operations; however, we may seek a new financing facility in the future.

 

In November 2009, RAE Fushun borrowed RMB 10.0 million, or approximately $1.5 million, for a term of 18 months to provide working capital. Loan repayment is guaranteed by an unrelated third party, to whom RAE Fushun granted a lien over its 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. In January 2011, we signed a definitive agreement to sell our 70% interest in RAE Fushun to the Shenyang Research Institute of China Coal Research Institute, who took immediate and complete operating control. RAE Fushun is included in our financial statements as a discontinued operation, and RAE Systems, is not involved in the day-to-day management or operating activities of RAE Fushun. The Company still retains 70% ownership in the entity until such time regulatory approvals are obtained; however, the Company does not anticipate providing any further financial support or management support to the entity during this time. (Refer to “Note 2. Discontinued Operation” for details of the transaction).

 

We believe 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, debt service 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 not be available 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.

 

Our Consolidated Statements of Cash Flows for 2010, 2009 and 2008 may be summarized as follows:

 

 

Operating Activities

 

For the year ended December 31, 2010, net cash provided by operating activities of $3.8 million, with $4.8 million from continuing operations and ($1.0) million from discontinued operations, was due to the following:

 

 

For the year ended December 31, 2009, net cash provided by operating activities of $7.7 million, with $7.6 million from continuing operations and $0.1 million from discontinued operations was due to the following:

 

 

For the year ended December 31 2008, net cash provided by operating activities of $3.2 million, with $2.4 million from continuing operations and $0.8 million from discontinued operations was due to the following:

 

 

Investing Activities

 

During 2010, cash of $3.1 million was invested the in construction and outfitting at our new manufacturing facility in Shanghai, China.

 

During 2009, investing activities primarily consisted of ongoing construction and outfitting activities at our new facility in Fushun, China and payment for land use rights and pre-construction site improvements in Shanghai. In December 2008, we purchased the land use rights for 50 years to 5 acres of land in Shanghai. We plan to use this site to construct a new manufacturing and research and development facility, which will replace our current Shanghai facility. Construction began during the first quarter of 2010. Upon completion, we intend to vacate our existing leased facility. Based on discussions with Shanghai government officials, our landlord, we believe we will be able to terminate the lease without penalty. Negotiations for project and long-term financing arrangements are ongoing. However, no assurance can be given that we will be able to arrange financing terms acceptable to us or that we will not be subject to lease termination penalties.

 

During 2008, cash used in investing activities was primarily used to complete and occupy the manufacturing facility in Fushun, China. The total project in Fushun also includes administrative offices, a research and development facility and living quarters. The estimated cost to complete the project was approximately $2.3 million. However, we have not committed to a timeline for the remaining construction.

 

Financing Activities

 

During 2010, we repaid a $2.3 million bank loan in Shanghai, China at maturity. We also made principal payments totaling $0.4 million on notes payable to related parties for the acquisition of RAE Beijing. These payments were made from general working capital. The next scheduled principal payment on the notes payable to related parties is in July 2011. In order to redeploy cash balances, we declared a dividend at RAE Beijing. As a result, a dividend of $0.1 million was paid to the noncontrolling interest.

 

The cash provided by financing activities of $1.0 million in 2009 was primarily from bank borrowings (net of payments made) of $2.9 million. As disclosed above in the discussion of banking relationships, $1.5 million was

borrowed by RAE Fushun (discontinued operation) for working capital. In addition, we borrowed $1.4 million to fund the purchase of land use rights in Shanghai for the construction of a new manufacturing facility as discussed in investing activities above.

 

We also made principal payments totaling $1.9 million to reduce the notes payable to related parties for the acquisition of RAE Beijing. These payments were made from general working capital. The next scheduled principal payment was in July 2010.

 

Cash used in financing activities of $1.4 million in 2008 was primarily applied to payments on related party notes totaling $1.2 million and payments on bank lines of credit of $0.2 million, net of amounts borrowed. The bank lines of credit provide working capital for our operations in the United States and China.

 

Commitments and Contingencies

 

Summary of Obligations

 

The following table quantifies our known contractual obligations in tabular form as of December 31, 2010. These obligations impact our short and long-term liquidity and capital resource needs. Certain of these contractual obligations are reflected in the Consolidated Balance Sheets, while others are disclosed as future obligations.

 

 

 

 

Guarantees

 

We are permitted under Delaware law and required under our Certificate of Incorporation and Bylaws to indemnify our officers and directors for certain events or occurrences, subject to certain limits, while the director or officer is or was serving at our 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, we have a Director and Officer Insurance Policy that reduces exposure and enables us to recover a portion of any future amounts paid. To date we have not incurred any losses under these agreements.

In our sales agreements, we typically agree to indemnify our 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, we have not paid any amounts to settle claims or defend lawsuits.

 

Product Warranties

 

We sell the majority of our products with a 12 to 24 month repair or replacement warranty from the date of shipment. We provide 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.

 

Uncertain Tax Positions

 

As of December 31, 2010, the liability for uncertain tax positions, including associated interest and penalties, was approximately $1.0 million. This liability represents an estimate of tax positions that the Company has taken in its tax returns which may ultimately not be sustained upon examination by the tax authorities. Since the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty, this estimated liability has been excluded from the contractual obligations table.

 

Recent Accounting Pronouncements

 

In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements, (amendments to FASB Accounting Standards Codification (“ASC”) Topic 605, Revenue Recognition) (“ASU 2009-13”) and ASU 2009-14, Certain Arrangements That Include Software Elements, (amendments to FASB ASC Topic 985, Software) (“ASU 2009-14”). ASU 2009-13 requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The amendments eliminate the residual method of revenue allocation and require revenue to be allocated using the relative selling price method. ASU 2009-14 removes tangible products from the scope of software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are covered by the scope of the software revenue guidance. ASU 2009-13 and ASU 2009-14 should be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

In January 2010, the FASB issued guidance to amend the disclosure requirements related to recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance became effective for entities with a reporting period beginning January 1, 2010, except for the disclosure on the roll forward activities for Level 3 fair value measurements, which will become effective for the reporting period beginning January 1, 2011. The adoption of these changes had no material impact on the Company’s consolidated financial statements.

 

In December 2010, the FASB issued ASU 2010-29, Disclosure of Supplementary Pro Forma Information for Business Combinations (amendments to FASB ASC Topic 805, Business Combinations). The guidance in ASU 2010-29 provides amendments to clarify the acquisition date which should be used for reporting the pro forma financial information disclosures in Topic 805 when comparative financial statements are presented. The amendments also improve the usefulness of the pro forma revenue and earnings disclosures by requiring a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination(s). The amendments in this update are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15,

2010. Early adoption is permitted. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

In December, 2010, the FASB issued ASU 2010-28, When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (amendments to FASB ASC Topic 350, Intangibles — Goodwill and Other). The objective of this ASU is to address diversity in practice in the application of goodwill impairment testing by entities with reporting units with zero or negative carrying amounts, eliminating an entity’s ability to assert that a reporting unit is not required to perform Step 2 because the carrying amount of the reporting unit is zero or negative despite the existence of qualitative factors that indicate the goodwill is more likely than not impaired. This ASU is effective for interim periods after January 1, 2011. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.

 

 

Concentration of Credit Risk

 

Currently, we have cash and cash equivalents deposited with major financial institutions in the countries where we conduct business. Our deposits may exceed the amount of insurance available to cover such deposits. To date, we have not experienced any losses of deposits of cash and cash equivalents. Management regularly reviews our deposit balances and the credit worthiness of the financial institutions which hold our deposits.

 

Interest Rate Risk

 

As of December 31, 2010, we had cash and cash equivalents of $16.3 million and restricted cash of $2.0 million. The Company had no other significant interest bearing assets. Over time changes to interest rates may reduce or increase our interest income, but the impact on our net income (loss) or the fair value of our interest bearing assets is not expected to be significant.

 

Our borrowings in China have generally been at fixed interest rates or at rates fixed for 12 months, and no adjustable rate debt was outstanding there as of December 31, 2010. The outstanding balance under our line of credit in the United States bears interest at the floating prime bank lending rate plus 100 basis points subject to a minimum total rate of 5%. As the prime rate as of December 31, 2010 was 3.25%, our cost of funds in the United States will not increase until the prime rate rises by more than 75 basis points. On an outstanding balance of $1.8 million, the loan balance in the United States on December 31, 2010, annual interest expense would increase by $1,800 for each basis point thereafter.

 

Foreign Currency Exchange Rate Risk

 

For the year ended December 31, 2010, a substantial portion of our recognized revenue was denominated in U.S. dollars generated primarily from customers in the Americas (54%). Revenue generated from our European operations (18%) was primarily in Euros; revenue generated by our Asia operations (28%) was primarily in RMB. We manufacture a majority of our component parts at our manufacturing facility in Shanghai, China. Since January 2010, our operations in China have been affected by currency fluctuations due to an approximate 3.4% appreciation of the RMB relative to the U.S. dollar.

 

Our strategy has been and will continue to be to increase our overseas manufacturing and research and development activities to capitalize on lower cost capacity and efficiencies in supply-chain management. In 2004 and 2006, we made a strategic investment with the acquisition of a 96% interest in RAE Beijing, a Beijing-based manufacturer and distributor of environmental safety and security equipment. There has been continued speculation in the financial press that China’s currency, the RMB, will be subject to a further market adjustment relative to the U.S. dollar and other currencies. If, for example, there was a hypothetical 10% change in the RMB relative to the U.S. dollar, the effect on our income from continuing operations would have been approximately $0.7 million for fiscal 2010. If the currencies in all other countries in Europe and Asia where we have operations were to change in unison with the RMB by a hypothetical 10% relative to the U.S. dollar, the effect on our loss would have been approximately $0.3 million for fiscal 2010. The difference of $0.4 million is attributable to the impact of foreign currencies outside of China.

To the extent that we have international sales denominated in U.S. dollars, any fluctuation in the value of the U.S. dollar relative to foreign currencies could affect our competitive position in the international markets. Although we 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 be certain that exchange rate fluctuations will not adversely affect our financial results in the future.

 

 

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

 

 

None.

 

 

Evaluation of Disclosure Controls and Procedures

 

RAE Systems, Inc. (the “Company”) maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports the Company files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required financial disclosure.

 

In connection with the preparation of this Annual Report on Form 10-K, the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the CEO and CFO, as of December 31, 2010, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based upon this evaluation, the CEO and CFO concluded that as of December 31, 2010, the Company’s disclosure controls and procedures were effective.

 

Management’s Report on Internal Control over Financial Reporting

 

Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles in the United States.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management has conducted an assessment, including testing, of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. In making its assessment of internal control over financial reporting, management used the criteria in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

 

Based on our assessment, we have concluded that our internal control over financial reporting was effective as of December 31, 2010.

 

This annual report does not include an attestation report of an independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to the attestation of an

independent registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this Annual Report.

 

Changes in Internal Control Over Financial Reporting

 

There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during our fourth quarter of fiscal 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Impact of 2011 Changes to Management and Operational Involvement in RAE Fushun

 

As of January 12, 2011, management entered into a definitive agreement to sell our 70 percent ownership of RAE Fushun to the Shenyang Research Institute of China Coal Research Institute. At that time, RAE Systems and RAE Fushun management allowed Shenyang Research Institute to begin managing and operating the entity without the involvement of RAE Systems or RAE Fushun management. As a result, from January 12, 2011, RAE Systems has had no day-to-day management or operating involvement in RAE Fushun and therefore no control oversight over the entity’s financial information. Accordingly, management believes that a material weakness in internal control over financial reporting related to this matter exists as of March 31, 2011.

 

 

None.

 

 

The information required by this item with respect to the Company’s executive officers is incorporated herein by reference from the information contained in Item 1 of Part I of this Report under the caption “Executive Officers of the Registrant.” The remaining information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2011 Proxy Statement to be filed with the U.S. Securities and Exchange Commission (“SEC”) in connection with the solicitation of proxies for the Company’s 2011 Annual Meeting of Shareholders (“2011 Proxy Statement”). The 2011 Proxy Statement will be filed with the SEC within 120 days after the end of the fiscal year to which this report relates.

 

 

The information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2011 Proxy Statement.

 

 

The information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2011 Proxy Statement.

 

 

The information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2011 Proxy Statement.

 

 

The information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2011 Proxy Statement.

 

 

(a) (1) Financial Statements

 

See the index of the Consolidated Financial Statements of this Form 10-K.

 

(2) Financial Statement Schedules

 

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

 

(3) Exhibits

 

See Index to Exhibits on page 39 herein.

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 31, 2011.

 

RAE SYSTEMS INC.

 

Robert I. Chen

President and Chief Executive Officer

 

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

 

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

 

INDEX TO EXHIBITS

 

 

 

RAE Systems Inc.

 

Consolidated Financial Statements

As of December 31, 2010 and 2009

 

 

To the Board of Directors and Shareholders of

RAE Systems Inc.

 

We have audited the accompanying consolidated balance sheets of RAE Systems Inc. and subsidiaries (collectively the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of operations, shareholders’ equity and comprehensive loss, and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting as of December 31, 2010. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2010 and 2009, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America.

 

 

San Jose, California

March 31, 2011

RAE SYSTEMS INC.

 

CONSOLIDATED BALANCE SHEETS

 

 

See accompanying notes to consolidated financial statements.

RAE SYSTEMS INC.