RAE SYSTEMS INC - FORM 10-Q

Attached files

file	filename
EX-31.2 - EX-31.2 - RAE SYSTEMS INC	f59213exv31w2.htm
EX-32.2 - EX-32.2 - RAE SYSTEMS INC	f59213exv32w2.htm
EX-32.1 - EX-32.1 - RAE SYSTEMS INC	f59213exv32w1.htm
EX-31.1 - EX-31.1 - RAE SYSTEMS INC	f59213exv31w1.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


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

For the quarterly period ended March 31, 2011


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

For the transition period from to

Commission file number: 001-31783

RAE SYSTEMS INC.

(Exact name of registrant as specified in its charter)


Delaware		77-0280662
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

3775 North First Street
San Jose, California		95134
(Address of principal executive offices)		(Zip Code)

408-952-8200
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

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

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

Large accelerated filer o

Accelerated filer o

Non-accelerated filer þ
(Do not check if a smaller reporting company)

Smaller reporting company o

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

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



	Class			Outstanding at April 30, 2011
	Common stock, $0.001 par value per share			59,512,064 shares

INDEX


		Page
Part I. Financial Information

Item 1.	Financial Statements (Unaudited)		3
	Condensed Consolidated Balance Sheets at March 31, 2011 and December 31, 2010		3
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2011 and 2010		4
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2011 and 2010		5
	Notes to Condensed Consolidated Financial Statements		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		31
Item 4.	Controls and Procedures		32

Part II. Other Information

Item 1.	Legal Proceedings		33
Item 1A.	Risk Factors		34
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		41
Item 3.	Defaults Upon Senior Securities		41
Item 4.	Reserved		41
Item 5.	Other Information		41
Item 6.	Exhibits		42
Signatures

EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I. Financial Information

Item 1. Financial Statements

RAE Systems Inc.
Condensed Consolidated Balance Sheets
(in thousands, except share and par value data)
(unaudited)


	March 31,			December 31,
	2011			2010
ASSETS
Current assets:
Cash and cash equivalents	$	13,380		$	16,296
Restricted cash		—			2,000
Trade notes receivable		2,117			2,018
Accounts receivable, net of allowances of $3,821 and $3,539, respectively		14,793			14,286
Accounts receivable from affiliate		187			200
Inventories		13,320			11,546
Prepaid expenses and other current assets		5,522			4,557
Income taxes receivable		133			130
Current assets of discontinued operation		—			6,093

Total current assets		49,452			57,126

Property and equipment, net		12,251			10,730
Intangible assets, net		110			196
Investments in unconsolidated affiliates		139			184
Other assets		396			393
Noncurrent assets of discontinued operation		—			3,478

Total assets	$	62,348		$	72,107

LIABILITIES AND EQUITY
Current liabilities:
Accounts payable	$	7,308		$	5,475
Accounts payable to affiliate		13			25
Bank debt, current		1,810			1,814
Accrued liabilities		9,878			11,957
Notes payable to related parties, current		286			278
Income taxes payable		428			128
Deferred revenue, current		586			557
Current liabilities of discontinued operation		—			5,790

Total current liabilities		20,309			26,024

Deferred revenue, non-current		796			776
Deferred tax liabilities, non-current		143			141
Deferred gain on sale of real estate, non-current		3,650			3,809
Other long-term liabilities		1,527			1,491
Noncurrent liabilities of discontinued operation		—			182

Total liabilities		26,425			32,423


COMMITMENTS AND CONTINGENCIES (NOTE 6)

EQUITY:
Common stock, $0.001 par value, 200,000,000 shares authorized; 59,512,064 and 59,512,064 shares issued and outstanding as of March 31, 2011 and December 31, 2010, respectively		59			59
Additional paid-in capital		65,238			65,041
Accumulated other comprehensive income		6,693			7,786
Accumulated deficit		(36,735	)		(34,311	)

Total RAE Systems Inc. shareholders’ equity		35,255			38,575
Noncontrolling interest		668			1,109

Total equity		35,923			39,684

Total liabilities and equity	$	62,348		$	72,107

.

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.
Condensed Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)


	Three Months Ended
	March 31,
	2011			2010
Net sales	$	22,447		$	16,855
Cost of sales		8,772			7,359

Gross profit		13,675			9,496

Operating expenses:
Sales and marketing		5,089			4,173
Research and development		1,761			1,579
General and administrative		8,961			3,826

Total operating expenses		15,811			9,578

Operating loss from continuing operations		(2,136	)		(82	)
Other income (expense):
Interest income		4			23
Interest expense		(26	)		(21	)
Other, net		(76	)		46
Equity in loss of unconsolidated affiliate		(46	)		(51	)

Loss from continuing operations before income taxes		(2,280	)		(85	)
Income tax expense		(585	)		(129	)

Loss from continuing operations		(2,865	)		(214	)
Loss from discontinued operations, net of tax		—			(194	)

Net loss		(2,865	)		(408	)
Net (income) loss attributable to the noncontrolling interest, continuing operations		(39	)		12
Net loss attributable to the noncontrolling interest, discontinued operations		—			32

Net (income) loss attributable to the noncontrolling interest		(39	)		44

Net loss attributable to RAE Systems Inc.	$	(2,904	)	$	(364	)


Earnings per common share — basic and diluted:
Continuing operations	$	(0.05	)	$	(0.01	)
Discontinued operations		—			—

Net loss per share — basic and diluted	$	(0.05	)	$	(0.01	)


Weighted-average common shares outstanding — basic and diluted		59,512			59,405

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)


	Three Months Ended March 30,
	2011			2010
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(2,865	)	$	(408	)
Loss from discontinued operations		—			(194	)

Loss from continuing operations		(2,865	)		(214	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		387			454
Gain on disposal of property and equipment		(158	)		(144	)
Stock based compensation expense		197			354
Equity in loss of unconsolidated affiliate		46			51
Amortization of discount on notes payable to related parties		1			3
Changes in operating assets and liabilities:
Accounts receivable		(270	)		1,366
Accounts receivable from affiliate		14			86
Trade notes receivable		(71	)		135
Inventories		(1,549	)		(329	)
Prepaid expenses and other current assets		950			331
Other assets		7			120
Accounts payable		1,760			(703	)
Accounts payable to affiliate		(12	)		(46	)
Accrued liabilities		(2,470	)		(549	)
Income taxes payable		323			5
Deferred revenue		49			(172	)
Other liabilities		16			59

Net cash (used in) provided by operating activities of continuing operations		(3,645	)		807
Net cash used in operating activities of discontinued operations		—			(738	)

Net cash (used in) provided by operating activities		(3,645	)		69

CASH FLOWS FROM INVESTING ACTIVITIES:
Changes in restricted cash		2,000			—
Acquisition of property and equipment		(1,379	)		(235	)
Proceeds from sale of net assets		—			16

Net cash provided by (used in) investing activities of continuing operations		621			(219	)
Net cash provided by investing activities of discontinued operations		—			86

Net cash provided by (used in) investing activities		621			(133	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Repayments of bank loans		(2	)		—
Payments on notes payable to related parties		—			(4	)

Net cash used in financing activities		(2	)		(4	)

Effect of exchange rate changes on cash and cash equivalents		76			(109	)
Decrease in cash and cash equivalents		(2,950	)		(177	)
Cash and cash equivalents at beginning of period		16,330			18,528

Cash and cash equivalents at end of period		13,380			18,351
Less cash and cash equivalents of discontinued operations at end of period		—			783

Cash and cash equivalents of continuing operations at end of period	$	13,380		$	17,568


Supplemental disclosure of cash flow information:
Cash paid for taxes, net	$	198		$	59
Cash paid for interest by continuing operations, net of amounts capitalized		22			60
Cash paid for interest by discontinued operation		—			30
Non-cash investing and financing activities:
Unpaid property and equipment of continuing operations		346			161
Unpaid property and equipment of discontinued operations		—			25

See accompanying notes to condensed consolidated financial statements.

Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 1. Summary of Significant Accounting Policies

The Company

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

As a result of an independent investigation conducted by the Audit Committee of the Board of Directors during fiscal year 2008, the Company made a voluntary disclosure to the United States Department of Justice (“DOJ”) and the United States Securities and Exchange Commission (“SEC”) that the Company may have violated the United States Foreign Corrupt Practices Act (“FCPA”). The Company cooperated with the DOJ and the SEC in connection with their review of the matter. In December 2010, the Company settled all outstanding issues with regard to this matter in separate agreements with the DOJ and the SEC. Pursuant to these agreements; the Company paid a $1.7 million criminal penalty to the DOJ and $1.3 million in restitution and interest to the SEC. The Company also agreed to advise the DOJ and the SEC periodically until December 2013 on its ongoing efforts to ensure continued compliance with the FCPA.

In April 2011, the SEC inquired whether the Company had adopted a sales program in China whereby customers are awarded points based on the level of their purchases of RAE products, which points they may later redeem for gifts, and if such a program was adopted, whether it complies with the FCPA. The Company conducted a review in response to the SEC’s inquiry and has concluded that no such program had been adopted in China.

Definitive Acquisition Agreement with Vector Capital

On September 19, 2010, the Company signed a definitive agreement to be acquired by an affiliate of Battery Ventures (the “Battery Merger Agreement”) for $1.60 in cash per share (other than certain shares held by our founders, Robert Chen, Peter Hsi and affiliated entities). Subsequently, on January 12, 2011, the Company received an offer from an affiliate of Vector Capital 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). 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 the affiliate of Vector Capital (the “Vector Merger Agreement”) on the terms described above. On April 2, 2011, we received an offer from an affiliate of Battery Ventures to acquire all of our outstanding capital stock for $1.90 per share in cash, and on April 3, 2011, we entered into an amendment to the Vector Merger Agreement increasing the per share cash price to be paid for the outstanding shares of our common stock (other than certain shares held by Robert Chen, Peter Hsi and affiliated entities) to $1.88. This transaction is subject to customary closing conditions, including the approval of RAE Systems’ shareholders.

In connection with the acquisition agreements, eleven lawsuits have been filed against the Company and members of its Board of Directors. These suits were filed in State Courts in California and Delaware and in the Federal District Court in California. In summary, the suits allege violations of federal securities laws and that the individual defendants breached their fiduciary duties by conducting an unfair sales process and agreeing to an unfair price, are receiving improper personal benefits, and were aided and abetted by the other defendants. The Company believes the claims in these lawsuits are without merit and intends to vigorously defend against them. However, there can be no assurances as to the outcome of the litigation. See “Note 6. Commitments and Contingencies” for more detail.

Basis of Presentation

The financial information presented in this Form 10-Q is unaudited and is not necessarily indicative of the future consolidated financial position, results of operations or cash flows of RAE Systems. The unaudited condensed consolidated financial statements contained in this Form 10-Q have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position at the date of the interim balance sheets, and its results of operations and cash flows for the stated periods, in conformity with the accounting principles generally accepted in the United States of America. The consolidated balances at December

31, 2010, were derived from the audited consolidated financial statements included in the Company’s Annual Report (“Annual Report”) on Form 10-K for the year ended December 31, 2010. The condensed consolidated financial statements included in this report should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2010, included in the Annual Report.

Principles of Consolidation

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

Use of Estimates

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

Revenue Recognition

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

Effective January 1, 2011, when a sales arrangement contains multiple elements, the Company allocates revenue to all deliverables based on their relative selling prices. Under this approach, the selling price of a deliverable is determined by using a selling price hierarchy which requires the use of Vendor Specific Objective Evidence (“VSOE”) of fair value if available, third party evidence (“TPE”) if VSOE is not available, or best estimated selling price (“BESP”) if neither VSOE nor TPE is available. The Company’s sales arrangements typically contain multiple elements when products and services are sold together. The adoption of this accounting standard did not impact the Company’s condensed consolidated financial statements.

Stock-Based Compensation Expense

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

The impact on the Company’s results from operations of recording stock-based compensation by function for the three months ended March 31, 2011 and 2010 was as follows:


	Three Months Ended
	March 31,
(in thousands)	2011		2010
Cost of sales	$	23	$	23
Sales and marketing		22		33
Research and development		28		36
General and administrative		124		262

Total	$	197	$	354

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


	Options Outstanding
	Number		Weighted-Average
	of Shares		Exercise Price
Balance as of January 1, 2011		5,266	$	1.99
Granted		—
Exercised		—
Canceled		—

Balance as of March 31, 2011		5,266		1.99

The fair value of the Company’s stock options granted to employees for the three months ended March 31, 2010 was estimated using the following weighted-average assumptions:


	Three
	Months
	Ended
	March 31,
	2010
Expected volatility		110	%
Expected dividend yield		0	%
Risk-free interest rate		2.8	%
Expected term in years		6.0
Weighted-average grant date fair value	$	0.71

No stock options were granted in the three months ended March 31, 2011.

Stock Option Plans

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

As of March 31, 2011, the Company has reserved 90,666 shares of common stock for issuance under its 1993 Stock Option Plan, 1,986,188 shares under the 2002 Plan and 3,189,167 shares under the 2007 Plan. As of March 31, 2011, 1,264,541 shares have been added to the balance available for grant under the 2007 Plan as a result of grants cancelled under the 2002 Plan and 1,919,124 shares of common stock remain available for future grants under the 2007 Plan.

Non-Plan Stock Options

In 2002, the Company granted certain of its directors non-plan options to purchase 400,000 shares of common stock at a weighted-average exercise price of $0.99 per share. The options vested 25% after one year with the remainder vesting pro-rata monthly over the following three years. From 2002 to 2006, the Company issued 300,000 shares of common stock due to the exercise of such options. There have been no further grants, exercises or cancellations through March 31, 2011. As such, non-plan stock options outstanding at March 31, 2011 and December 31, 2010, respectively, totaled 100,000 at a weighted-average exercise price of $1.06. The vested options are exercisable over ten years from the date of grant. There was no stock-based compensation expense recorded during

the three month periods ended March 31, 2011 and 2010, respectively, and no stock-based compensation expense remains to be recorded related to non-plan options.

Non-Plan Restricted Stock

In August 2006, the Company granted 536,000 shares of restricted stock to four individuals at a weighted-average grant date fair value of $2.81 per share as an inducement to join the Company. Twenty five percent of this restricted stock or 134,000 shares vested in July 2007 with the remainder vesting pro-rata quarterly over the following three years subject to accelerated vesting in certain circumstances.

The fair market value of the Company’s common shares on the date the awards were granted represents unrecognized stock-based compensation which was amortized ratably over the vesting period of the underlying stock awards. Vesting was completed during the third quarter of 2010. As such, no unvested restricted stock remained outstanding at March 31, 2011 and December 31, 2010, respectively. As of March 31, 2011, no stock-based compensation expense related to restricted stock awards remained to be recorded and none was recorded for the quarter then ended.

Earnings Per Share

Basic earnings per common share includes no dilution and is computed by dividing net income or loss available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per common share reflects the potential dilution of common stock equivalents, such as options and warrants, to the extent the impact is dilutive. As the Company incurred a net loss for the three months ended March 31, 2011 and March 31, 2010, the effect of potentially dilutive securities on diluted net loss per share computations was anti-dilutive for these periods.

The number of anti-dilutive shares excluded from the diluted earnings per common share calculations for the three months ended March 31, 2011 and March 31, 2010 was 5,366,021 and 5,530,171, respectively.

Segment Reporting

FASB Accounting Standards Codification (“ASC”) Topic 280, “Segment Reporting,” establishes standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also established standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision-makers in deciding how to allocate and assess resources and performance. The Company’s chief operating decision-makers are the Chief Executive Officer and the Chief Financial Officer. Although the Company’s operating segments consist of entities geographically based in the Americas, Asia and Europe, the Company operates in a single reportable segment worldwide in the sale of portable and wireless chemical and radiation detection products and related services.

Variable Interest Entities

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

RAE France had total sales of $948,000 and $724,000 in the three months ended March 31, 2011 and 2010, respectively. The carrying amounts of the major classes of RAE France assets and liabilities included in the Company’s Condensed Consolidated Balance Sheets were as follows:


	March 31,		December 31,
(in thousands)	2011		2010
Cash and cash equivalents	$	160	$	194
Accounts receivable		675		584
Inventories		365		209
Prepaid expenses and other current assets		127		119

Total current assets		1,327		1,106
Other non-current assets		34		40

Total assets	$	1,361	$	1,146

Accounts payable	$	16	$	25
Accrued liabilities		369		339

Total current liabilities	$	385	$	364

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

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 did not impact the Company’s condensed 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 became effective for the reporting period beginning January 1, 2011. The adoption of these changes had no material impact on the Company’s condensed 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 did not have a material impact on the Company’s condensed 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 did not have a material impact on the Company’s condensed consolidated financial statements.

Note 2. Discontinued Operation

On December 22, 2010, the Board of Directors approved management’s plan to pursue the 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 assumed all documented joint venture liabilities and agreed to pay approximately RMB 12.25 million (or approximately $1.87 million) intercompany balances owed to RAE Shanghai and RAE Beijing for products and services previously provided to the joint venture. As of April 30, 2011, Shenyang Institute had made scheduled payments to RAE Systems totaling RMB 8 million (or approximately $1.2 million). The Company expects to receive RMB 2 million (or approximately $0.3 million) monthly until paid in full. As of March 31, 2011 the remaining total balance owed to RAE Shanghai and RAE Beijing was $0.9 million which is included in Prepaid expenses and other current assets in the Company’s Condensed Consolidated Balance Sheets.

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 effecting the final transfer of shares within six months from signing the definitive agreement. In addition to assuming the entity’s liabilities, the purchase agreement required Shenyang Institute to begin funding the operations of the surviving company as of signature date. Therefore, RAE Systems provided Shenyang Institute with complete operating control of RAE Fushun on January 12, 2011, and RAE Systems subsequently has not been 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 as regulatory approvals are obtained; however, the Company has not provided nor does it anticipate providing any financial support or management support to the entity during the closing process. Management believes the activities from January 1 to January 12, 2011 are not material and no additional gain or loss on discontinued operations was incurred or recorded. In addition, since January 12, 2011, the Company has had no representation on the entity’s Board of Directors.

Prior to January 12, 2011, RAE Systems consolidated RAE Fushun in its financial statements based on its controlling financial interest. However, the Company believes that execution of the definitive agreement on January 12, 2011 constituted a reconsideration event under ASC Topic 810, “Consolidation”, requiring the Company to assess whether RAE Fushun meets the definition of a Variable Interest Entity (“VIE”) and whether RAE Systems is the primary beneficiary of RAE Fushun. Effective upon signing the agreement, Shenyang Institute superseded the Company as RAE Fushun’s controlling manager. Subsequently, Shenyang Institute has had the sole ability to establish RAE Fushun’s business strategies and to manage the entity’s day-to-day operations. Shenyang Institute also assumed the obligation to absorb RAE Fushun’s gains and losses, if any, by virtue of its contractual obligation to fund the entity’s ongoing operations. In the event that the necessary government approvals required in China were not obtained, that the capital contributions made by Shenyang Institute would not be refundable. At the same time, upon receipt of final government approvals, Shenyang Institute will be entitled to the benefits of RAE Fushun’s operations from the date of the purchase agreement. As the equity holders of RAE Fushun are protected from ongoing variability in the operations of the entity, RAE Fushun is deemed to be a VIE with Shenyang Institute being the primary beneficiary as of January 12, 2011. Consequently, RAE Systems deconsolidated RAE Fushun from its financial statements as of the same date and no gain or loss was recorded upon deconsolidation.

The financial results of RAE Fushun are reported as discontinued operations in accordance with ASC Subtopic 205-20, “Discontinued Operations.” The financial results included in discontinued operations were as follows:


	Three
	Months
	Ended
	March 31,
(in thousands)	2010
Net sales	$	1,940
Loss from discontinued operations before income taxes		(194	)
Income tax benefit		—

Loss from discontinued operations		(194	)
Net loss attributable to the noncontrolling interest		32

Net loss from discontinued operations attributable to RAE Systems Inc.	$	(162	)

Management believes the activities from January 1 to January 12, 2011 were not material and no additional gain or loss on discontinued operations was incurred or recorded.

Prior to deconsolidation, the carrying amounts of the major classes of assets and liabilities included as part of the disposal group were as follows:


	December 31,
(in thousands)	2010
Cash & cash equivalents	$	34
Restricted cash		151
Trade notes receivable		106
Accounts receivable, net of allowances of $3,591 and $2,705, respectively		2,533
Inventories		2,551
Prepaid expenses and other current assets		718

Total current assets		6,093

Property and equipment, net		3,478

Total assets	$	9,571


Accounts payable	$	1,122
Bank line of credit		1,512
Accrued liabilities		3,156

Total current liabilities		5,790

Other long-term liabilities		182

Total liabilities	$	5,972

Note 3. Composition of Certain Financial Statement Items

Inventories


	March 31,		December 31,
(in thousands)	2011		2010
Raw materials	$	7,363	$	6,770
Work-in-progress		3,453		2,396
Finished goods		2,504		2,380

Total inventories	$	13,320	$	11,546

Prepaid expenses and other current assets


	March 31,		December 31,
(in thousands)	2011		2010
Supplier advances and deposits	$	609	$	971
Accounts receivable from employees		434		368
Prepaid insurance		156		269
Deferred tax assets, current		1,612		1,595
Other current assets		2,711		1,354

Total prepaid expenses and other current assets	$	5,522	$	4,557

Property and equipment, net


	March 31,			December 31,
(in thousands)	2011			2010
Buildings and improvements	$	6,466		$	6,404
Equipment		4,595			4,489
Computer equipment		5,042			5,003
Automobiles		498			488
Furniture and fixtures		410			408
Construction in progress		7,178			5,478

		24,189			22,270
Less: Accumulated depreciation		(11,938	)		(11,540	)

Total property and equipment, net	$	12,251		$	10,730

Intangible assets, net


	March 31, 2011							December 31, 2010
	Gross					Net			Gross					Net
	Carrying		Accumulated			Carrying			Carrying		Accumulated			Carrying
(in thousands)	Amount		Amortization			Amount			Amount		Amortization			Amount
Customer list	$	1,748	$	(1,748	)	$	—		$	1,730	$	(1,693	)	$	37
Trade name		1,415		(1,305	)		110			1,402		(1,243	)		159

Total	$	3,163	$	(3,053	)	$	110		$	3,132	$	(2,936	)	$	196

Amortization expense associated with intangible assets was $86,000 and $89,000 for the three months ended March 31, 2011 and 2010, respectively. Based on the carrying amount of intangible assets as of March 31, 2011 and assuming no future impairment of the underlying assets, the estimated future amortization is as follows (in thousands):


Years Ended December 31,
Remainder of 2011	$	55
2012		37
2013		18
Thereafter		—

Total amortization	$	110

Accrued liabilities


	March 31,		December 31,
(in thousands)	2011		2010
Compensation and related benefits	$	2,532	$	4,249
Accrued commissions		1,107		938
Accrued FCPA settlement (see Note 1)		—		1,700
Accrued construction in progress		759		—
Accrued professional fees		2,103		1,014
Customer deposits		660		730
Other		2,717		3,326

Total accrued liabilities	$	9,878	$	11,957

Note 4. Income Tax

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

The effective tax rate after discrete items for the three months ended March 31, 2011, was 26% of pretax loss, compared to 152% of pretax loss for the same period in 2010. The tax rate for the first quarter of 2011 differed from the U.S. statutory rate primarily due to the tax effect of foreign earnings taxed at lower rates, losses not benefited, nondeductible stock compensation expenses, nondeductible costs related to the acquisition transaction, and discrete true-up adjustments applicable to 2010.

The effective tax rate is highly dependent upon the geographic distribution of the Company’s worldwide earnings or loss, tax regulations in each geographic region, the availability of tax credits and carryforwards, and the effectiveness of the Company’s tax

planning strategies. The Company regularly monitors the assumptions used in estimating its annual effective tax rate and adjusts its estimates accordingly. If actual results differ from its estimates, future income tax expense could be materially affected.

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

At December 31, 2010, the Company concluded it was appropriate to have a full valuation allowance for its deferred tax assets in certain jurisdictions. The Company continued to maintain a full valuation allowance for these jurisdictions as of March 31, 2011. The Company expects to provide a full valuation allowance on future tax benefits until it can sustain a level of profitability that demonstrates its ability to utilize these assets. The amount of the deferred tax asset valuation allowance, however, could be reduced in future periods to the extent that future taxable income is realized.

Note 5. Comprehensive Loss

The components of comprehensive loss were as follows:


	Three Months Ended
	March 31,
(in thousands)	2011			2010
Net loss	$	(2,865	)	$	(408	)
Other comprehensive income:
Change in foreign currency translation		(1,093	)		(295	)

Comprehensive loss		(3,958	)		(703	)
Comprehensive (income) loss attributable to the noncontrolling interest		(39	)		44

Comprehensive loss attributable to RAE Systems Inc.	$	(3,997	)	$	(659	)

Note 6. Commitments and Contingencies

Legal Proceedings

On January 2, 2011, Kuldip Shodhan, Polygon USA, and Polygon Agency Pvt. Ltd. (collectively, “Polygon”) commenced an arbitration action before the International Centre for Dispute Resolution division of the American Arbitration Association against the Company, ICDR Case No. 50 117 T 005 11, alleging causes of action for breach of a Sales Representative Agreement between Polygon and RAE-KLH (Beijing) Co., Limited, a subsidiary of the Company, and seeking damages incurred by Polygon resulting from the alleged breach. The dispute was submitted to mediation prior to commencement of formal arbitration proceedings, and Polygon and representatives of the Company agreed to a settlement pursuant to which the Company would pay to Polygon the sum of $260,000 in return for a complete release of all claims. This proposed settlement remains subject to the approval of the Company’s management as well as Vector Capital (see Note 1 of Notes to Condensed Consolidated Financial Statements). The Company has accrued the settlement amount of $260,000 in its financial statements as of March 31, 2011.

Shareholder Lawsuits

The California State Court Actions:

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 to the California state court actions, 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. On March 7, 2011, the Delaware plaintiffs filed a motion seeking to preliminarily enjoin the proposed acquisition of the Company by an affiliate of Vector Capital. On April 4, 2011, the Delaware Chancery Court held a conference regarding the Delaware plaintiffs’ motion for preliminary injunction. Following that conference, the Company postponed the shareholder vote on the proposed acquisition.

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.

Leases

The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the three months ended March 31, 2011 and 2010, was $345,000 and $340,000, respectively. Future minimum annual payments under non-cancellable leases were as follows as of March 31, 2011 (in thousands):


Years Ended December 31,	Operating
Remainder of 2011	$	1,259
2012		1,507
2013		1,419
2014		1,309
2015		1,140
Thereafter		2,350

Total minimum payments	$	8,984

In December 2008, the Company invested approximately $1.2 million for land use rights in Shanghai, China to construct a new manufacturing, engineering and administrative facility. Construction began during the first quarter of 2010. The estimated cost to complete this project is approximately $1.8 million with the work scheduled to be completed during the first half of 2011. Upon completion of construction, the Company intends to vacate its existing leased facility in Shanghai. Based on discussions with Shanghai government officials, the landlord of the existing Company facility, the Company believes it will be able to terminate the lease without penalty. However, no assurance can be given at this time that the Company will not be subject to a lease termination penalty.

During the three months ended March 31, 2011 and 2010, zero and $51,000, respectively, of interest expense was capitalized for construction of the Company’s new facility in Shanghai.

Guarantees

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

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

Note 7. Warranty Reserves

The Company sells the majority of its products with a 12 to 24 month repair or replacement warranty from the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized under Accrued liabilities on the Condensed Consolidated Balance Sheets. The following is a summary of the changes in these liabilities during the three months ended March 31, 2011 and 2010, respectively:


	Three Months Ended
	March 31,
(in thousands)	2011			2010
Warranty reserve at beginning of period	$	976		$	695
Provision for warranty		165			215
Utilization of reserve		(278	)		(229	)
Foreign currency translation effects		9			(5	)

Warranty reserve at end of period	$	872		$	676

Note 8. Bank Debt

In the United States, the Company had a $10.0 million revolving credit agreement as of December 31, 2010. On March 28, 2011, the credit facility maturity date was extended to the earlier of June 15, 2011 or consummation of a merger with Vector Capital. (Refer to “Note 1. Summary of Significant Accounting Policies” for details of the Merger Agreement). Available credit is based on a percentage of specific qualifying assets and the total facility is collateralized by a blanket security interest in the Company’s assets in the United States. The Company is required to comply with certain reporting and financial requirements in addition to the ongoing requirement to submit quarterly financial statements. Interest accrues at the floating prime bank lending rate plus 100 basis points subject to a minimum total rate of 5%. In addition, the Company pays 30 basis points annually of the average unused portion of the facility. Through December 31, 2010, the Company was required to maintain a compensating balance of at least $2.0 million at all times. The compensating balance was included in Restricted cash on the Condensed Consolidated Balance Sheets. The compensating balance requirement was released in January 2011. As of March 31, 2011 and December 31, 2010, $1.8 million was outstanding against the revolving credit agreement and interest was accruing at 5% per annum. The carrying amount reported in the Condensed Consolidated Balance Sheets approximates fair value due to the short-term maturity of the credit facility.

Financial covenants under the revolving credit agreement require the Company to maintain specified minimum quarterly earnings before interest, depreciation, amortization, income tax and non-cash stock compensation expenses. As a result of the impairment expense incurred to discontinue operations in Fushun, China, the Company was 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. The Company was in compliance with the loan covenants as of March 31, 2011.

On March 28, 2011, the Company amended the credit facility to allow borrowings of up to $2 million on a non-formula basis. Interest on non-formula advances accrues at the floating prime bank lending rate plus 400 basis points subject to a minimum total rate of 8%. No non-formula loan balances were outstanding as of March 31, 2011.

Note 9. Related Party Transactions

The Company accounts for its 40% ownership in Renex Technologies Ltd. (“Renex”), a Hong Kong company following the equity method. The Company’s total investment in Renex at March 31, 2011 and December 31, 2010 was $119,000 and $166,000, respectively. The Company recorded losses of $46,000 and $51,000 on its equity interest in Renex for the three months ended March 31, 2011 and 2010, respectively.

In conjunction with the Company’s investment in RAE Beijing, unsecured notes payable were established for the previous RAE Beijing shareholders as part of the purchase price agreement in July 2006. Although these notes bear a stated interest rate of 3% per annum, the notes were discounted using a market interest rate of 6.48%. As of March 31, 2011 and December 31, 2010, $286,000 and $278,000, respectively, was included in current notes payable to related parties in the Company’s Condensed Consolidated Balance Sheets. The final scheduled payment of principal and accrued interest under the notes at maturity in July 2011.

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

Transactions and balances with the Company’s related parties were as follows (in thousands):


	Three Months Ended
	March 31,
(in thousands)	2011		2010
Sales:
Renex	$	57	$	95
RAE Australia		224		335
RAE Benelux		1,822		517
RAE Spain		182		80

	$	2,285	$	1,027


Purchases:
Renex	$	74	$	74


	March 31,		December 31,
	2011		2010
Accounts receivable:
Renex	$	187	$	200
RAE Australia		180		131
RAE Benelux		664		268
RAE Spain		143		123

	$	1,174	$	722


Accounts payable:
Renex	$	13	$	25

The Company’s Director of Information Systems, Lien Chen, is the wife of our Chief Executive Officer, Robert Chen. Ms. Chen was paid a salary of $29,000 and $31,000 for the three months ended March 31, 2011 and 2010, respectively. Ms. Chen also receives standard employee benefits offered to all other full-time U.S. employees. Ms. Chen does not report to Robert Chen and compensation decisions regarding Ms. Chen are performed in the same manner as other U.S. employees, with Robert Chen the final approval signatory on compensation recommendations.

Note 10. Fair Value Measurements

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

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

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

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

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

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

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

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

Note 11. Shareholders’ Equity

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


	Three Months Ended March 31,										Three Months Ended March 31,
	2011									2010
	RAE Systems										RAE Systems
	Shareholders’			Noncontrolling			Total				Shareholders’			Noncontrolling			Total
(in thousands)	Equity			Interest			Equity				Equity			Interest			Equity
Equity, Beginning of Period	$	38,575		$	1,109		$	39,684			$	39,029		$	4,526		$	43,555
Net loss		(2,904	)		39			(2,865	)			(364	)		(44	)		(408	)
Translation adjustments		(1,093	)		—			(1,093	)			(295	)		—			(295	)

Comprehensive loss		(3,997	)		39			(3,958	)			(659	)		(44	)		(703	)
Impact to noncontrolling interest on deconsolidation of discontinued operations		480			(480	)		—				—			—			—
Stock-based compensation expense		197			—			197				354			—			354

Equity, End of Period	$	35,255		$	668		$	35,923			$	38,724		$	4,482		$	43,206

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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. In some cases, readers can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue.” These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from those stated herein. Although management believes that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance, or achievements. For further information, refer to the sections entitled “Risk Factors” in “Part II Item 1A” of this Form 10-Q. The following discussion should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Form 10-Q.

Overview

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

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

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

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

Recent Developments

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

In 2010, we enhanced the wireless sensor capability of our MeshGuard platform, with the addition of fixed system and wireless controllers, two additional toxic gas sensors and other accessories. RAE Systems products were key in providing public venue security at the National Football League Super Bowl, the National Basketball Association All Star Game as well as the Vancouver Winter Olympics. Our Americas operations focused on government contracts, first responders, and industrial safety applications, particularly in

the energy sector. Our China operation continues to sell to state run steel mills, energy markets, including downstream oil processing, petrochemicals and electric utilities. Our Europe, Middle East, and Asia Pacific region generate sales primarily from the Middle East and Asia Pacific oil producers. All of our sales regions are driving adoption of our wireless sensor solutions for applications in both safety and security. Our global markets continue to be impacted by the effects of the 2009 global recession. In each of our markets we will continue to explore and develop strategic value added partnerships, to leverage our product and market expertise. In the first quarter of 2011, RAE Systems products again provided public venue security at the National Football League Super Bowl.

We are deemphasizing the lower gross margin Fire and Security integrated project installation business in China and have refocused our attention in China on the markets and the products sold and produced by the Company on a global basis, and the fixed sensor systems sold by the Company’s operations in Beijing, China.

In December 2010, we settled all outstanding issues with regard to the ongoing investigation of violation of the FCPA. We signed separate agreements with the DOJ and the SEC. Pursuant to these agreements; we paid a $1.7 million criminal penalty to the DOJ and $1.3 million in restitution and interest to the SEC. We also agreed to advise the DOJ and the SEC periodically until December 2013 on our ongoing efforts to ensure continued compliance with the FCPA.

In the course of telephonic discussions between April 15 and 19, 2011, outside counsel for the Company was asked by the SEC whether RAE China had adopted a sales program whereby customers are awarded points based on the level of their purchases of RAE products, which points they may later redeem for gifts such as iPads or cameras, and if such a program was adopted, whether it complies with the FCPA. We have conducted a review in response to the SEC’s inquiry and have concluded that RAE China has not adopted any such program. We intend to provide our conclusions to the SEC and the DOJ.

During the quarter ended March 31, 2011, we enhanced our wireless product offering with the release of ToxiRAE Pro wireless single-gas monitors. The ToxiRAE Pro family extends the wireless capabilities of our products to the personnel operating in the hazardous area. We also released DoseRAE 2, an alarming personal radiation detector that provides real-time monitoring of personal dose and dose rate. The DoseRAE2 was designed for workers at nuclear power plants, research facilities, hospitals and industrial locations, such as oil exploration and imaging technology.

Definitive Acquisition Agreement with Battery Ventures

Critical Accounting Policies

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

Revenue Recognition

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

Effective January 1, 2011, when a sales arrangement contains multiple elements, we allocate revenue to all deliverables based on their relative selling prices. Under this approach, the selling price of a deliverable is determined by using a selling price hierarchy which requires the use of Vendor Specific Objective Evidence (“VSOE”) of fair value if available, third party evidence (“TPE”) if VSOE is not available, or best estimated selling price (“BESP”) if neither VSOE nor TPE is available. Our sales arrangements typically contain multiple elements when products and services are sold together. The adoption of this accounting standard did not impact our condensed consolidated financial statements.

Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

We grant credit to our customers after undertaking an investigation of credit risk for significant amounts. An allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, 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 receivable are presented to us from some of our customers in China as a payment against the outstanding trade receivables. These notes receivable are bank guarantee promissory notes which are non-interest bearing and generally mature within six months.

Inventories

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

Long-Lived Assets

We test the recoverability of long-lived assets with finite lives periodically and whenever events 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.

Share-Based Payments

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

Income Taxes

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

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

Recent Accounting Pronouncements

Results of Operations

Net Sales


	Three Months Ended
	March 31,						Percentage
(in thousands)	2011		2010		Change		Change
Net sales	$	22,447	$	16,855	$	5,592		33	%

Net sales for the quarter ended March 31, 2011, increased by $5.6 million or 33% compared with the quarter ended March 31, 2010. Sales increased $2.7 million or 33% in Americas and $2.2 million or 60% in Europe and the Middle East and $0.7 million or 14% in Asia. The increase in the Americas was primarily due to increased U.S. military revenue of $0.9 million, increased Canadian oil and gas revenue of $0.8 million and increased U.S. oil and gas and environmental safety revenue of $0.6 million. The increase in Europe and the Middle East of $2.2 million was primarily due to increased revenue for oil and gas and industrial safety of $1.3 million, and environmental safety and hazmat revenue of $0.9 million. The increase in Asia of approximately $0.7 million was primarily the result of increased sales in the industrial safety and hazmat markets.

Cost of Sales & Gross Margin


	Three Months Ended
	March 31,								Percentage
(in thousands)	2011			2010			Change		Change
Cost of sales	$	8,772		$	7,359		$	1,413		19	%
Gross profit	$	13,675		$	9,496		$	4,179		44	%
Gross margin		61	%		56	%

Cost of sales for the quarter ended March 31, 2011, increased by $1.4 million or 19% compared with the quarter ended March 31, 2010. Approximately $2.4 million of the increase in cost of sales was due to increased sales volume, which was partially offset by efficiencies gained by moving China fixed system production to our global manufacturing center in Shanghai and improved overhead absorption due to higher production volume in Shanghai. The improved gross margin of 61% for the quarter ended March 31, 2011, was primarily the result of the year-over-year increase in sales of the higher margin products in the Americas and Europe.

Sales and Marketing Expense


	Three Months Ended
	March 31,								Percentage
(in thousands)	2011			2010			Change		Change
Sales and marketing	$	5,089		$	4,173		$	916		22	%
Percentage of net sales		23	%		25	%

Sales and marketing expenses increased by $0.9 million or 22% for the quarter ended March 31, 2011, compared with the quarter ended March 31, 2010. The increase was primarily due to management bonuses and higher sales commissions of approximately $0.5 million, and additional spending on our web services, key trade shows and demo equipment of approximately $0.3 million.

Research and Development Expense


	Three Months Ended
	March 31,								Percentage
(in thousands)	2011			2010			Change		Change
Research and development	$	1,761		$	1,579		$	182		12	%
Percentage of net sales		8	%		9	%

Research and development expenses increased by approximately $0.2 million or 12% for the quarter ended March 31, 2011, compared with the quarter ended March 31, 2010. The increase was primarily due to increased headcount, increased salaries at the RAE Engineering Center in Shanghai, China and project expenses to support new product development programs.

General and Administrative Expense


	Three Months Ended
	March 31,								Percentage
(in thousands)	2011			2010			Change		Change
General and administrative	$	8,961		$	3,826		$	5,135		134	%
Percentage of net sales		40	%		23	%

General and administrative expenses increased by $5.0 million or 131% for the quarter ended March 31, 2011, compared with the quarter ended March 31, 2010. The increase was primarily due to increased legal expense of $1.7 million related to the Company’s “going private” transaction and payment of a termination fee of $3.4 million to Battery Ventures, in accordance with the terms of the Battery Merger Agreement.

Other Income (Expense)


	Three Months Ended
	March 31,									Percentage
(in thousands)	2011			2010			Change			Change
Interest income	$	4		$	23		$	(19	)		-83	%
Interest expense		(26	)		(21	)		(5	)		-24	%
Other, net		(76	)		46			(122	)		265	%
Equity in loss of unconsolidated affiliate		(46	)		(51	)		5			-10	%

Total other income (expense)	$	(144	)	$	(3	)	$	(141	)		-4700	%

For the quarter ended March 31, 2011, total other expense increased by approximately $141,000 compared with the quarter ended March 31, 2010. The change was primarily the result of foreign exchange losses in Asia and Europe.

Income Tax Benefit (Expense)


	Three Months Ended
	March 31,									Percentage
(in thousands)	2011			2010			Change			Change
Income tax expense	$	(585	)	$	(129	)	$	(456	)		353	%
Effective tax rate		-26	%		-152	%

Income tax expense for the three months ended March 31, 2011, was $585,000 compared to $129,000 for the three months ended March 31, 2010. At December 31, 2010 and March 31, 2011, respectively, we concluded it was appropriate to have a full valuation allowance for our net deferred tax assets in some jurisdictions. The interim income tax expense was calculated based on the estimated annual effective tax rate for the Company. The tax rate for the first quarter of fiscal year 2011 differed from the U.S. statutory rate primarily due to foreign earnings taxed at lower rates, losses not benefited, nondeductible stock compensation expense, nondeductible costs related to the acquisition transaction, and additional provisions for uncertain tax positions applicable to fiscal year 2011. Included in tax expense for the three months ended March 31, 2011, were discrete tax expense items of $26,000 related to the accrual of interest on various uncertain tax benefits, U.S. federal, state and local taxes of $39,000, and prior year’s true-ups of $125,000.

Net (Income) Loss Attributable to the Noncontrolling Interest


	Three Months Ended
	March 31,								Percentage
(in thousands)	2011			2010		Change			Change
Net (income) loss attributable to the noncontrolling interest	$	(39	)	$	12	$	(51	)		-425	%

For the quarter ended March 31, 2011, the noncontrolling interest in continuing operations of consolidated subsidiaries increased approximately $51,000 compared with the quarter ended March 31, 2010. The increase was primarily due to the income generated at RAE Beijing compared to a loss in the quarter ended March 31, 2010 and higher income generated at RAE France compared with the quarter ended March 31, 2010. The noncontrolling ownership was 4% of RAE Beijing and 51% of RAE France.

Loss From Discontinued Operations


	Three Months Ended
	March 31,								Percentage
(in thousands)	2011		2010			Change			Change
Loss from discontinued operations before income taxes	$	—	$	(194	)	$	194			-100	%
Income tax benefit		—		—			—			0	%

Loss from discontinued operations, net of tax		—		(194	)		194			-100	%
Net loss attributable to the noncontrolling interest, discontinued operations		—		32			(32	)		0	%

Loss from discontinued operations attributable to RAE Systems Inc.	$	—	$	(162	)	$	162			-100	%

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 effecting the final transfer of shares within six months from signing the definitive agreement. In addition to assuming the entity’s liabilities, the purchase agreement required Shenyang Institute to begin funding the operations of the surviving company as of signature date. Therefore, we provided Shenyang Institute with complete operating control of RAE Fushun on January 12, 2011, and we subsequently have not been 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 as regulatory approvals are obtained; however, we have not provided nor do we anticipate providing any financial support or management support to the entity during the closing process. We believe our activities from January 1 to January 12, 2011 are not material and no additional gain or loss on discontinued operations was incurred or recorded. In addition, since January 12, 2011, we have had no representation on the entity’s Board of Directors.

Prior to January 12, 2011, we consolidated RAE Fushun in our financial statements based on our controlling financial interest. However, we believe that execution of the definitive agreement on January 12, 2011 constituted a reconsideration event under ASC Topic 810, “Consolidation”, requiring us to assess whether RAE Fushun meets the definition of a Variable Interest Entity (“VIE”) and whether RAE Systems is the primary beneficiary of RAE Fushun. Effective upon signing the agreement, Shenyang Institute superseded the Company as RAE Fushun’s controlling manager. Subsequently, Shenyang Institute has had the sole ability to establish RAE Fushun’s business strategies and to manage the entity’s day-to-day operations. Shenyang Institute also assumed the obligation to absorb RAE Fushun’s gains and losses, if any, by virtue of its contractual obligation to fund the entity’s ongoing operations. In the event that the necessary government approvals required in China are not obtained, the capital contributions made by Shenyang Institute would not be

refundable. At the same time, upon receipt of final government approvals, Shenyang Institute will be entitled to the benefits of RAE Fushun’s operations from the date of the purchase agreement. As the equity holders of RAE Fushun are protected from ongoing variability in the operations of the entity, RAE Fushun is deemed to be a VIE with Shenyang Institute being the primary beneficiary as of January 12, 2011. Consequently, we deconsolidated RAE Fushun from our financial statements as of the same date and no gain or loss was recorded upon deconsolidation.

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. In 2007, we also sold and leased back our corporate headquarters in San Jose, California. As of March 31, 2011, we had $13.4 million in cash and cash equivalents compared with $16.3 million on December 31, 2010.

At March 31, 2011, we had $29.1 million in working capital (current assets less current liabilities) and a current ratio (ratio of current assets to current liabilities) of 2.4 to 1.0 compared to $31.1 million of working capital and a current ratio of 2.2 to 1.0 at December 31, 2010.

In the United States, we have a $10.0 million revolving credit agreement. On March 28, 2011, the credit facility maturity date was extended to the earlier of June 15, 2011 or consummation of a merger with Vector Capital. (Refer to “Note 1. Summary of Significant Accounting Policies” for details of the Merger Agreement). Available credit is based on a percentage of specific qualifying assets and the total facility is collateralized by a blanket security interest over our assets in the United States. We are required to comply with certain reporting and financial requirements in addition to the ongoing requirement to submit quarterly financial statements. Interest accrues at the floating prime bank lending rate plus 100 basis points subject to a minimum total rate of 5%. In addition, we pay 30 basis points annually of the average unused portion of the facility. Through December 31, 2010, we were required to maintain a compensating balance of at least $2 million at all times. The compensating balance was included in Restricted cash on the Condensed Consolidated Balance Sheets. The compensating balance requirement was released in January 2011. As of March 31, 2011 and December 31, 2010, $1.8 million was outstanding against the revolving credit agreement in the United States and interest was accruing at 5% per annum.

Financial covenants under the revolving credit agreement require us to maintain specified minimum quarterly earnings before interest, depreciation, amortization, income tax and non-cash stock compensation expenses 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. We were in compliance with the loan covenants as of March 31, 2011.

On March 28, 2011, we amended the credit facility to allow borrowings of up to $2 million on a non-formula basis. Interest on non-formula advances accrues at the floating prime bank lending rate plus 400 basis points subject to a minimum total rate of 8%. No non-formula loan balances were outstanding as of March 31, 2011.

In China as of March 31, 2011 and December 31, 2010, we did not have credit facilities in place. At this time, we believe the cash balances in China are sufficient to fund operation and capital requirements; however, we may seek a new financing facility in the future.

Our Condensed Consolidated Statements of Cash Flows may be summarized as follows:


	Three Months Ended
	March 31,
(in thousands)	2011			2010
Net cash provided by (used in):
Operating activities	$	(3,645	)	$	69
Investing activities		621			(133	)
Financing activities		(2	)		(4	)
Effect of exchange rate changes on cash and cash equivalents		76			(109	)

Net (decrease) increase in cash and cash equivalents	$	(2,950	)	$	(177	)

Operating Activities

For the three months ended March 31, 2011, net cash used in operating activities of $3.6 million was attributable to the following factors:

	•		Our net loss of $2.9 million (including the portion attributable to the noncontrolling interest) was partially offset by non-cash charges of $0.5 million. Our principal non-cash expenses were $0.4 million depreciation and amortization and $0.2 million stock-based compensation. These non-cash expenses were partially offset by a $0.1 million deferred gain on the disposal of property and equipment.

	•		The net change in operating assets and liabilities which consumed cash of $1.2 million. Cash was applied to increase inventories and accounts receivable by $1.5 million and $0.3 million, respectively and to reduce accrued expenses by $2.5 million. Cash was contributed by increases in accounts payable and income taxes payable of $1.8 million and $0.3 million, respectively, and reductions in prepaid expenses and other current assets totaling $1.0 million.

For the three months ended March 31, 2010, net cash provided by operating activities of $0.1 million, with $0.8 million from continuing operations and ($0.7) million from discontinued operations, was attributable to the following factors:

	•		Cash flow decreased due to the net loss from continuing operations of $0.2 million (including the portion attributable to the noncontrolling interest). However, because the net loss includes non-cash charges totaling $0.7 million, the net increase to cash was $0.5 million. Our principal non-cash expenses were as follows: $0.4 million depreciation and amortization and $0.4 million stock-based compensation. These non-cash expenses were partially offset by $0.1 million in deferred gains on the disposal of property and equipment.

	•		The net change in operating assets and liabilities generated cash of $0.3 million. Cash was primarily provided by decreases in accounts receivable, prepaid and other assets, notes receivable, other assets and accounts receivable from affiliate of $1.4 million, $0.3 million, $0.1 million, $0.1 million and $0.1 million respectively. Cash was applied to reduce accounts payable and accrued expenses by $0.7 million and $0.5 million, respectively. Cash was further used to increase inventories and deferred revenue by $0.3 million and 0.2 million respectively.

Investing Activities

Net cash provided by investing activities during the three months ended March 31, 2011, was $0.6 million compared with $0.2 million used for the three months ended March 31, 2010. Cash used during the first three months of 2011 of $1.4 million consisted of ongoing construction costs for our new facility in Shanghai. These construction costs were offset by the release of restricted cash related to our revolving bank line of credit in the United States. Cash used during the first three months of 2010 primarily consisted of equipment purchases to support our manufacturing operations.

In December 2008, we purchased the land use rights for 50 years to 5 acres of land in Shanghai to construct a new manufacturing, engineering and administrative facility, which is intended to replace our existing, leased Shanghai facility. Construction began during the first quarter of 2010. The estimated cost to complete this project is approximately $1.7 million with the work scheduled to be completed in the first half of 2011. Upon completion of construction, we intend to vacate our existing leased facility in Shanghai. Based on discussions with Shanghai government officials, the landlord of the existing Company facility, we believe we will be able to terminate the lease without penalty. However, no assurance can be given at this time that we will not be subject to lease a termination penalty.

Financing activities

The final scheduled principal payment of approximately $0.3 million on the notes payable to related parties for the acquisition of RAE Beijing is due in July 2011.

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 be unavailable on favorable terms, if at all. Any difficulty in obtaining additional financial resources could force us to curtail our operations, or could prevent us from pursuing our growth strategy. Any future funding may dilute the ownership of our stockholders.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

Concentration of Credit Risk

Currently, we have cash and cash equivalents as well as restricted cash on deposit 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 financial losses on these deposits. Management regularly reviews our deposit balances and the credit worthiness of the financial institutions which hold our deposits.

Interest Rate Risk

As of March 31, 2011, we had cash and cash equivalents of $13.4 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 March 31, 2011. 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 on March 31, 2011, 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 March 31, 2011, annual interest expense would increase by $1,800 for each basis point thereafter.

Foreign Currency Exchange Rate Risk

For the three months ended March 31, 2011, a substantial portion of our Asia revenue (25%) was denominated in RMB. Revenue denominated in U.S. dollars is generated primarily from operations in the Americas (49%), and revenue from our European operations (26%) is primarily denominated in Euros. We manufacture a majority of our products at our manufacturing facility in Shanghai, China.

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. Additionally, in 2004 and 2006, we made a strategic investment with the acquisition of 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 net income would have been approximately $0.2 million for the three months ended March 31, 2011. From January 1 through March 31, 2011, the RMB appreciated RMB 0.06 or 0.9% measured against the U.S. dollar.

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 net income would have been approximately $(0.3) million for the three months ended March 31, 2011. The difference of $0.5 million is attributable to the impact of foreign currencies outside of China, principally the Euro. From January 1 through March 31, 2011, the Euro appreciated $0.08 or 6.4% measured against the U.S. dollar.

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.

Item 4. Controls and Procedures

Evaluation of Effectiveness of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, the Company evaluated the effectiveness of its disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The evaluation considered the procedures designed to ensure that information required to be disclosed by us in the reports filed or submitted by the Company under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and communicated to our management as appropriate to allow timely decisions regarding required disclosure. Based on that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of March 31, 2011 as a result of the material weakness related to the Fushun operations discussed below.

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 existed as of March 31, 2011.

There were no changes in our internal control over financial reporting during the quarter ended March 31, 2011, that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting except for the material weakness discussed above.

PART II. Other Information

Item 1. Legal Proceedings

Legal Proceedings

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 to the California state court actions, 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.

The Federal Court Actions:

Item 1A. Risk Factors

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 issued 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 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 this matter pursuant to separate agreements with the DOJ and the SEC, under which we have paid a $1.7 million criminal penalty to the DOJ and about $1.15 million in restitution plus $0.1 million 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.

We reported a net loss of $2.9 million for the three months ended March 31, 2011 and we recorded net losses of $2.6 million, $5.8 million and $7.2 million for 2010, 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:

	•		devote greater resources to marketing and promotional campaigns;

	•		adopt more aggressive pricing policies; or

	•		devote more resources to technology and systems development.

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 (the “Act”) and the rules promulgated by the SEC and the New York Stock Exchange in relation thereto require significant legal, financial and accounting compliance costs, and we expect these costs to continue indefinitely.

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:

	•		difficulties with staffing and managing international operations;

	•		transportation and supply chain disruptions and increased transportation expense as a result of epidemics, terrorist activity, acts of war or hostility, natural disasters, increased security and less developed infrastructure;

	•		economic slowdown and/or downturn in foreign markets;

	•		international currency fluctuations;

	•		political and economic uncertainty caused by epidemics, terrorism or acts of war or hostility;

	•		legislative and regulatory responses to terrorist activity such as increased restrictions on cross-border movement of products and technology;

	•		legislative, regulatory, police, or civil responses to epidemics or other outbreaks of infectious diseases such as quarantines, factory closures, or increased restrictions on transportation or travel;

	•		increased costs and complexities associated with complying with Section 404 of the Sarbanes-Oxley Act of 2002;

	•		general strikes or other disruptions in working conditions;

	•		labor shortages;

	•		political instability;

	•		changes in tariffs;

	•		generally longer periods to collect receivables;

	•		unexpected legislative or regulatory requirements;

	•		reduced protection for intellectual property rights in some countries;

	•		significant unexpected duties or taxes or other adverse tax consequences;

	•		difficulty in obtaining export licenses and other trade barriers; and

	•		ability to obtain credit and access to capital issues faced by our international customers.

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 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% 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. 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 31% of our common stock and, accordingly, may exert substantial influence over the Company.

Our executive officers and directors, in the aggregate, beneficially own approximately 31% of our common stock as of March 31, 2011. 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.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Reserved

Item 5. Other Information

None

Item 6. Exhibits

The following is a list of exhibits filed as part of this Report on Form 10-Q.


Exhibit
Number		Description of Document
31.1		Certification of Robert I. Chen, President, Chief Executive Officer and Chairman of the Board of the Registrant, furnished pursuant to Rule 13a-14(a) adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Randall Gausman, Vice President and Chief Financial Officer of the Registrant, furnished pursuant to Rule 13a-14(a) adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Robert I. Chen, President, Chief Executive Officer and Chairman of the Registrant, furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Randall Gausman, Vice President and Chief Financial Officer of the Registrant, furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

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

May 16, 2011


	RAE SYSTEMS INC.
	By:	/s/ Randall Gausman
		Randall Gausman
		Vice President and Chief Financial Officer

Exhibit Index


Exhibit
Number		Description of Document
31.1		Certification of Robert I. Chen, President, Chief Executive Officer and Chairman of the Board of the Registrant, furnished pursuant to Rule 13a-14(a) adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Randall Gausman, Vice President and Chief Financial Officer of the Registrant, furnished pursuant to Rule 13a-14(a) adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Robert I. Chen, President, Chief Executive Officer and Chairman of the Registrant, furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Randall Gausman, Vice President and Chief Financial Officer of the Registrant, furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

RAE SYSTEMS INC - FORM 10-Q - May 16, 2011

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