UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q10-Q/A
(Amendment No. 2)
 
   
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended SeptemberJune 30, 2009
OR
   
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) 77-0280662
(I.R.S. Employer
Identification No.)
 
3775 North First Street
San Jose, California
95134
(Address of principal executive offices) 95134
(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. Yesþ Noo
     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). Yeso Noo
     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 fileroAccelerated filerþ  Non-accelerated filero
Smaller reporting companyo
(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). Yeso Noþ
     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
   
ClassOutstanding at October 31, 2009
   
ClassOutstanding at July 31, 2009
Common stock, $0.001 par value per share 59,438,328 shares
 
 

 

RAE Systems Inc.
INDEX
Page
Part I. Financial Information
Item 1.
Financial Statements (Unaudited)3
Condensed Consolidated Balance Sheets at September 30, 2009 and December 31, 20083
Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2009 and 20084
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2009 and 20085
Notes to Condensed Consolidated Financial Statements6
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations19
Item 3.
Quantitative and Qualitative Disclosures About Market Risk28
Item 4.
Controls and Procedures28
Part II. Other Information
Item 1.
Legal Proceedings30
Item 1A.
Risk Factors31
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds38
Item 3.
Defaults Upon Senior Securities38
Item 4.
Submission of Matters to a Vote of Security Holders38
Item 5.
Other Information38
Item 6.
Exhibits38
Signatures39
EX-31.1
EX-31.2
EX-32.1
EX-32.2

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)
         
  September 30,  December 31, 
  2009  2008 
ASSETS
        
Current assets:        
Cash and cash equivalents $16,157  $14,845 
Trade notes receivable  1,762   1,870 
Accounts receivable, net of allowances of $5,096 and $3,472, respectively  18,628   20,961 
Accounts receivable from affiliate  224   100 
Inventories  14,581   17,604 
Prepaid expenses and other current assets  4,235   4,991 
Income taxes receivable  102   895 
       
Total current assets  55,689   61,266 
       
Property and equipment, net  15,600   14,976 
Intangible assets, net  2,656   3,342 
Investments in unconsolidated affiliates  289   467 
Other assets  658   1,124 
       
Total assets $74,892  $81,175 
       
LIABILITIES AND SHAREHOLDERS’ EQUITY
        
Current liabilities:        
Accounts payable $7,003  $6,387 
Accounts payable to affiliate  83   382 
Payable to Fushun shareholder  2   64 
Bank lines of credit  3,739   2,584 
Accrued liabilities  13,598   12,318 
Notes payable to related parties, current  370   1,329 
Income taxes payable  267   425 
Deferred revenue, current  522   631 
       
Total current liabilities  25,584   24,120 
       
Deferred revenue, non-current  508   685 
Deferred tax liabilities, non-current  1   83 
Deferred gain on sale of real estate, non-current  4,602   5,079 
Other long-term liabilities  1,385   1,292 
Notes payable to related parties, non-current  362   1,219 
       
Total liabilities  32,442   32,478 
       
         
COMMITMENTS AND CONTINGENCIES (NOTE 5)
        
         
SHAREHOLDERS’ EQUITY:
        
Common stock, $0.001 par value, 200,000,000 shares authorized; 59,438,328 and 59,443,914 shares issued and outstanding, respectively  59   59 
Additional paid-in capital  63,465   62,549 
Accumulated other comprehensive income  6,892   6,555 
Accumulated deficit  (32,674)  (25,947)
       
Total RAE Systems Inc. shareholders’ equity  37,742   43,216 
Noncontrolling interest  4,708   5,481 
       
Total shareholders’ equity  42,450   48,697 
       
Total liabilities and shareholders’ equity $74,892  $81,175 
       
See accompanying notes to condensed consolidated financial statements.

3

RAE Systems Inc.
Condensed Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)
                 
  Three Months Ended  Nine Months Ended 
  September 30,  September 30, 
  2009  2008  2009  2008 
Net sales $19,909  $28,845  $58,929  $71,361 
Cost of sales  9,636   13,070   29,458   33,640 
             
Gross profit  10,273   15,775   29,471   37,721 
             
Operating expenses:                
Sales and marketing  4,282   5,197   13,513   15,998 
Research and development  1,787   1,541   4,766   4,822 
General and administrative  8,118   7,658   18,223   17,581 
             
Total operating expenses  14,187   14,396   36,502   38,401 
             
Operating (loss) income from continuing operations  (3,914)  1,379   (7,031)  (680)
Other income (expense):                
Interest income  13   36   30   122 
Interest expense  (79)  (91)  (314)  (292)
Other, net  148   (192)  140   (110)
Equity in loss of unconsolidated affiliate  (47)  10   (180)  (26)
             
(Loss) income from continuing operations before income taxes  (3,879)  1,142   (7,355)  (986)
Income tax benefit (expense)  215   (494)  (145)  (1,159)
             
(Loss) income from continuing operations  (3,664)  648   (7,500)  (2,145)
Gain from discontinued operations, net of tax  —   (4)  —   11 
             
Net (loss) income  (3,664)  644   (7,500)  (2,134)
Net loss (income) attributable to the noncontrolling interest  175   (90)  773   (115)
             
Net (loss) income attributable to RAE Systems Inc. $(3,489) $554  $(6,727) $(2,249)
             
                 
Basic net (loss) income per share                
Continuing operations $(0.06) $0.01  $(0.11) $(0.04)
Discontinued operations  —   —   —   — 
             
Basic net (loss) income per share $(0.06) $0.01  $(0.11) $(0.04)
             
Diluted net (loss) income per share                
Continuing operations $(0.06) $0.01  $(0.11) $(0.04)
Discontinued operations  —   —   —   — 
             
Diluted net (loss) income per share $(0.06) $0.01  $(0.11) $(0.04)
             
 
Weighted-average common shares outstanding-Basic  59,375   59,304   59,359   59,162 
Stock options  —   456   —   — 
             
Weighted-average common shares outstanding-Diluted  59,375   59,760   59,359   59,162 
             
See accompanying notes to condensed consolidated financial statements.

4

RAE Systems Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
         
  Nine Months Ended September 30, 
  2009  2008 
CASH FLOWS FROM OPERATING ACTIVITIES:
        
Net loss $(7,500) $(2,134)
Gain from discontinued operations  —   11 
       
Loss from continuing operations  (7,500)  (2,145)
Adjustments to reconcile net loss to net cash provided by operating activities:        
Depreciation and amortization  2,528   2,372 
Gain on disposal of property and equipment  (474)  (483)
Stock based compensation expense  923   1,238 
Equity in loss of unconsolidated affiliate  180   26 
Deferred income taxes  (84)  — 
Amortization of discount on notes payable to related parties  82   39 
Changes in operating assets and liabilities:        
Accounts receivable  2,473   1,590 
Accounts receivable from affiliate  (123)  (34)
Trade notes receivable  119   1,302 
Inventories  3,136   (1,742)
Prepaid expenses and other current assets  781   (1,371)
Income taxes receivable  793   132 
Other assets  471   (1,165)
Accounts payable  482   1,480 
Accounts payable to affiliate  (299)  4 
Accrued liabilities  1,102   292 
Income taxes payable  (173)  552 
Deferred revenue  (286)  452 
Other liabilities  64   (206)
       
Net cash provided by operating activities of continuing operations  4,195   2,333 
Net cash provided by operating activities of discontinued operations  —   7 
       
Net cash provided by operating activities  4,195   2,340 
       
CASH FLOWS FROM INVESTING ACTIVITIES:
        
Acquisition of property and equipment  (2,222)  (892)
       
Net cash used in investing activities  (2,222)  (892)
       
CASH FLOWS FROM FINANCING ACTIVITIES:
        
Proceeds from the exercise of stock options  —   34 
Proceeds from bank loans  1,899   431 
Repayments of bank loans  (732)  (2,758)
Repurchases of common stock  (7)  (35)
Payments on notes payable to related parties  (1,930)  (676)
       
Net cash used in financing activities  (770)  (3,004)
       
Effect of exchange rate changes on cash and cash equivalents  109   418 
Increase (decrease) in cash and cash equivalents  1,312   (1,138)
Cash and cash equivalents at beginning of period  14,845   15,906 
       
Cash and cash equivalents at end of period $16,157  $14,768 
       
         
Supplemental disclosure of cash flow information:        
Cash paid for interest $674  $247 
Cash paid for taxes  370   874 
Cash received for tax refunds  742   548 
Non-cash investing and financing activities:        
Unpaid property and equipment  1,339   27 
See accompanying notes to condensed consolidated financial statements.

5

Notes to Condensed Consolidated Financial Statements
(unaudited)
Note 1. Summary of Significant Accounting Policies
The Company
     Founded in 1991, RAE Systems Inc. (the “Company” or “RAE Systems”), a Delaware company, develops and manufactures rapidly-deployable, multi-sensor chemical and radiation detection monitors and networks for oil and gas, hazardous material management, industrial safety, civil defense and environmental remediation applications. The Company’s products are based on proprietary sensor technology, and include personal, breathing zone, portable, wireless and fixed chemical detection monitors and radiation detectors.
     As a result of an independent investigation conducted by the Audit Committee of the Board of Directors during fiscal year 2008, the Company made a voluntary disclosure to the United States Department of Justice (“DOJ”) and the United States Securities and Exchange Commission (“SEC”) that the company may have violated United States Foreign Corrupt Practices Act (“FCPA”). The Company is cooperating with the DOJ and the SEC in connection with their review of the matter and is actively engaged in settlement discussions. Although no assurances can be given as to whether the matter will settle or the amount of any settlement, the Company recorded and accrual of $3.5 million in the third quarter of 2009 relating to the potential settlement of this matter.
     Also, as a result of the proposed FCPA settlement, the Company is not in compliance with certain bank loan covenants and is in discussions with its lender to obtain a waiver for the breach of these covenants. No assurance can be given that relief will be obtained on acceptable terms or at all. In the event a waiver is not obtained, the outstanding amounts on our line of credit will become due and payable and the line of credit may be cancelled.
Basis of Presentation
     The financial information presented in this Form 10-Q is unaudited and is not necessarily indicative of the future consolidated financial position, results of operations or cash flows of RAE Systems. The unaudited condensed consolidated financial statements contained in this Form 10-Q have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position at the date of the interim balance sheets, results of operations and its cash flows for the stated periods, in conformity with the accounting principles generally accepted in the United States of America. The consolidated balances at December 31, 2008, 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, 2008. 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, 2008, included in the Annual Report. The Company evaluated subsequent events for recognition or disclosure through the time of filing these condensed consolidated financial statements on Form 10-Q with the U.S. Securities and Exchange Commission on November 6, 2009.
Principles of Consolidation
     The consolidated financial statements include the accounts of RAE Systems and its subsidiaries. The ownership of other interest holders of consolidated subsidiaries is reflected as noncontrolling interest. All intercompany balances and transactions have been eliminated in consolidation. Effective January 1, 2009, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance which changed the presentation requirements for noncontrolling (minority) interests for all periods presented.
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 other assumptions that are believed to be reasonable based on available information. Actual results may differ materially from these estimates and assumptions.
Revenue Recognition
     The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, the Company has experienced an insignificant amount of sales returns. The Company generally recognizes revenue upon shipment to its distributors in accordance with standard contract terms that pass title of all goods upon delivery to a common carrier (Free on board, “FOB”) and provides for sales returns under standard product warranty provisions. For non-standard contract terms where title to goods passes upon delivery to the customer (FOB destination), revenue is recognized after the Company has established proof of delivery. Revenues related to services performed under the Company’s extended warranty program are recognized as earned based upon contract terms, generally ratably over the term of service. The Company records project installation work in Asia using the percentage-of-completion method. Net sales also include amounts billed to customers for shipping and handling. The Company’s shipping costs are included in cost of sales.

6

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 continuing operations of recording stock-based compensation by function for the three and nine months ended September 30, 2009 and 2008, was as follows:
                 
  Three Months Ended  Nine Months Ended 
  September 30,  September 30, 
(in thousands) 2009  2008  2009  2008 
Cost of sales $5  $1  $11  $10 
Sales and marketing  (128)  15   (91)  35 
Research and development  68   69   207   240 
General and administrative  255   289   796   953 
             
Total $200  $374  $923  $1,238 
             
     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, 2009  4,193  $2.55 
Granted  —   — 
Exercised  —   — 
Canceled  (115)  3.75 
         
Balance as of March 31, 2009  4,078   2.51 
Granted  1,500   0.99 
Exercised  —   — 
Canceled  (270)  3.75 
         
Balance as of June 30, 2009  5,308   2.02 
Granted  —   — 
Exercised  —   — 
Canceled  (161)  2.44 
         
Balance as of September 30, 2009  5,147   2.01 
         
     The fair value of the Company’s stock options granted to employees for the nine months ended September 30, 2009 and September 30, 2008, was estimated using the following weighted-average assumptions:
         
  Nine Months Ended
  September 30,
  2009 2008
Expected volatility  85%  60-65%
Expected dividend yield  0%  0%
Risk-free interest rate  2.3%  2.7-3.6%
Expected term in years  6.0   5.5-6.0 
Weighted-average grant date fair value $0.70  $0.89 

7

     The Company did not grant any stock options during the three months ended September 30, 2009 or September 30, 2008, respectively.
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 replaces the Company’s existing 2002 Stock Option Plan (the “2002 Plan”). A total of 4,000,000 shares of the Company’s common stock are authorized for issuance under the 2007 Plan. The maximum number of shares that may be issued under the 2007 plan will be increased from time to time by shares subject to options granted under the 2002 Plan that expire or are terminated and by shares acquired under the 2002 Plan that are forfeited or repurchased by the Company for the option holder’s purchase price. However, no more than 1,500,000 additional shares may be authorized for issuance under the 2007 Plan as a result of these adjustments.
     As of September 30, 2009, the Company has reserved 120,877 shares of common stock for issuance under its 1993 Stock Option Plan, 2,083,042 shares under the 2002 Plan and 2,943,540 shares under the 2007 Plan. As of September 30, 2009, 1,250,376 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 2,156,836 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 options to purchase 400,000 shares of non-plan restricted common stock at a weighted-average exercise price of $0.99. Twenty five percent of these options vested after one year with the remainder vesting monthly over the following three years. The vested shares are exercisable over ten years. As of September 30, 2009, options to purchase 100,000 shares of restricted common stock remain unexercised at a weighted-average exercise price of $1.06. There was no stock compensation expense recorded during the three or nine-month periods ended September 30, 2008 and 2009, and no stock compensation expense remains to be recorded for these non-plan stock options.
Non-Plan Restricted Stock
     In August 2006, the Company granted 536,000 shares of restricted stock to four individuals as an inducement to enter the Company’s employ. Twenty five percent of this restricted stock or 134,000 shares vested in July 2007 with the remainder vesting quarterly over the following three years. The weighted-average fair value of these awards is $2.81. In August 2007, concurrent with discontinuing the Company’s mobile digital video recording (“DVR”) business, the Company terminated two of these individuals. As a result, the remainder of their restricted stock awards of 203,571 shares vested immediately and a charge of $596,000 was included in the loss from discontinued operations.

8

     The following is a summary of activity for the non-plan stock awards (in thousands, except per share amounts):
         
  Restricted Stock Awards
      Weighted-Average
  Number Grant Date
  of Shares Fair Value
Unvested as of January 1, 2009  109  $2.81 
Granted  —   — 
Vested  (15)  2.81 
Forfeited  —   — 
         
Unvested as of March 31, 2009  94   2.81 
Granted  —   — 
Vested  (16)  2.81 
Forfeited  —   — 
         
Unvested as of June 30, 2009  78   2.81 
Granted  —   — 
Vested  (15)  2.81 
Forfeited  —   — 
         
Unvested as of September 30, 2009  63   2.81 
         
Earnings Per Common Share
     Basic earnings per common share are computed by dividing income 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. The weighted-average number of anti-dilutive shares excluded from diluted earnings per common share calculated for the three and nine months ended September 30, 2009 was 4,880,232 and 4,926,143. The weighted-average number of anti-dilutive shares excluded from diluted earnings per common share calculated for the three and nine months ended September 30, 2008 was 3,458,741 and 3,824,776.
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-maker 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 reporting segment worldwide in the sale of portable and wireless gas and radiation detection products and related services.
Variable Interest Entities
     S.A.R.L RAE France (“RAE France”) was identified by management as a variable interest entity. The Company is the primary beneficiary through its ownership of RAE Europe ApS. RAE France distributes and sells RAE Systems products exclusively in France. RAE France had total sales of $600,000 and $831,000 in the three months ended September 30, 2009 and 2008, respectively, and total sales of $1.8 million and $2.2 million in the nine months ended September 30, 2009 and 2008, respectively. The Company has consolidated RAE France since December 2004.
Recent Accounting Pronouncements
     In December 2007, the FASB issued authoritative guidance which applies to business combinations. The new guidance changes the accounting for acquisition transaction costs by requiring them to be expensed in the period incurred, and also changes the accounting for contingent consideration, acquired contingencies and restructuring costs related to an acquisition. The new guidance was effective for the Company beginning January 1, 2009, and will change the Company’s accounting treatment for business combinations on a prospective basis.

9

     In June 2009, the FASB issued authoritative guidance for determining whether an entity is a variable interest entity (“VIE”) and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. Under this guidance, an enterprise has a controlling financial interest when it has a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. The guidance also requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has power to direct the activities of the VIE that most significantly impact the entity’s economic performance. The guidance is effective for the Company January 1, 2010, and requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE as well as certain enhanced disclosures. The Company is currently evaluating the potential impact, if any, of the adoption of this guidance on its consolidated financial statements.
     In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning January 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. The Company is currently assessing the potential effect, if any, on its financial statements.
Note 2. Composition of Certain Financial Statement Items
Inventories
     Inventories are stated at the lower of standard cost, which approximates actual cost computed on a first-in, first-out basis, or market and include material, labor and manufacturing overhead costs. The components of inventories were as follows:
         
  September 30,  December 31, 
(in thousands) 2009  2008 
Raw materials $6,466  $8,213 
Work-in-progress  2,384   2,910 
Finished goods  5,731   6,481 
       
  $14,581  $17,604 
       
Prepaid expenses and other current assets
         
  September 30,  December 31, 
(in thousands) 2009  2008 
Supplier advances and deposits $803  $977 
Accounts receivable from employees  231   661 
Prepaid insurance  381   437 
Deferred tax assets, current  693   578 
Other current assets  2,127   2,338 
       
  $4,235  $4,991 
       

10

Property and equipment, net
         
  September 30,  December 31, 
(in thousands) 2009  2008 
Buildings and improvements $10,360  $10,327 
Equipment  5,198   5,070 
Computer equipment  5,057   4,971 
Automobiles  1,453   1,590 
Furniture and fixtures  446   434 
Construction in progress  4,667   2,457 
       
   27,181   24,849 
Less: Accumulated depreciation  (11,581)  (9,873)
       
  $15,600  $14,976 
       
Intangible assets, net
                         
  September 30, 2009  December 31, 2008 
  Gross      Net  Gross      Net 
  Carrying  Accumulated  Carrying  Carrying  Accumulated  Carrying 
(in thousands) Amount  Amortization  Amount  Amount  Amortization  Amount 
Customer list $5,456  $(3,196) $2,260  $5,438  $(2,636) $2,802 
Trade name  1,355   (959)  396   1,352   (812)  540 
                   
  $6,811  $(4,155) $2,656  $6,790  $(3,448) $3,342 
                   
     Amortization expense associated with intangible assets was $219,000 and $254,000 for the three months ended September 30, 2009 and 2008, respectively, and $714,000 and $747,000 for the nine months ended September 30, 2009 and 2008, respectively. Based on the carrying amount of intangible assets as of September 30, 2009, and assuming no future impairment of the underlying assets, the estimated future amortization is as follows(in thousands):
     
Years Ended December 31,    
Remainder of 2009 $229 
2010  904 
2011  637 
2012  372 
2013  281 
Thereafter  233 
    
Total amortization $2,656 
    
Accrued liabilities
         
  September 30,  December 31, 
(in thousands) 2009  2008 
Compensation and related benefits $2,032  $2,445 
Accrued commission  2,287   2,010 
Accrued FCPA settlement (see Note 5)  3,500   — 
Accrued professional fees  750   755 
Customer deposits  1,264   1,792 
Other  3,765   5,316 
       
  $13,598  $12,318 
       

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Note 3. Income Tax
     The Company estimates its annual effective tax rate for the year and applies that rate to the quarter 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 before discrete items for the nine months ended September 30, 2009, was (2)% of pretax loss, compared to (118)% of pretax loss in the same period in 2008.
     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 carry-forwards, and the effectiveness of its tax planning strategies. The Company regularly monitors the assumptions used in estimating its annual effective tax rate and adjusts its estimates accordingly. If actual results differ from its estimates, future income tax expense could be materially affected.
     The Company’s valuation allowance was determined in accordance with the existing authoritative guidance, which requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are recoverable, with such assessment being required on a jurisdiction by jurisdiction basis. Management believes that sufficient uncertainty exists with regard to the realizability of some tax assets such that a valuation allowance is necessary. Factors considered in providing a valuation allowance include the lack of a significant history of consistent profits, the current belief of continued weakness in the overall market for the Company’s products thereby potentially impacting the Company’s ability to sustain or grow revenues and earnings, and the length of carryback and carryforward periods.
     At December 31, 2008, we concluded that it was appropriate to have a full valuation allowance for our deferred tax assets in certain jurisdictions and continue to maintain a full valuation allowance for these jurisdictions as of September 30, 2009. During fiscal 2009, the Company concluded that the operating results of one of its Chinese subsidiaries had declined and that it was appropriate to put a full valuation allowance on the related deferred tax asset of $285,000. The Company expects to provide a full valuation allowance on future tax benefits until it can sustain a level of profitability that demonstrates its ability to utilize these assets. The amount of the deferred tax asset valuation allowance, however, could be reduced in future periods to the extent that future taxable income is realized.
Note 4. Comprehensive Loss
     The components of comprehensive loss were as follows:
                 
  Three Months Ended  Nine Months Ended 
  September 30,  September 30, 
(in thousands) 2009  2008  2009  2008 
Net loss $(3,664) $644  $(7,500) $(2,134)
Other comprehensive income:                
Change in foreign currency translation  205   (325)  337   2,492 
             
Comprehensive (loss) income  (3,459)  319   (7,163)  358 
Comprehensive loss (income) attributable to the noncontrolling interest  175   (90)  773   (115)
             
Comprehensive (loss) income attributable to RAE Systems Inc. $(3,284) $229  $(6,390) $243 
             
     The Company’s accumulated other comprehensive income consists of foreign currency translation adjustments of $6.9 million and $6.6 million as of September 30, 2009 and December 31, 2008, respectively.

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Note 5. Commitments and Contingencies
Regulatory Compliance
     During fiscal year 2008, the Company’s internal audit department identified certain payments and gifts made by certain personnel in the Company’s operations in the People’s Republic of China (“China”) that may have violated the United States Foreign Corrupt Practices Act (“FCPA”). Following this discovery, the Audit Committee of the Board of Directors initiated an independent investigation. The Company has made a voluntary disclosure to the United States Department of Justice (DOJ) and the United States Securities and Exchange Commission (SEC) regarding the results of its investigation. The Company has also implemented additional policies and controls with respect to compliance with the FCPA. The FCPA and related statutes and regulations provide for potential monetary penalties, criminal sanctions and in some cases debarment from doing business with the U.S. federal government in connection with violations. The Company is cooperating with the DOJ and the SEC in connection with their review of the matter and is actively engaged in settlement discussions. Although no assurances can be given as to whether the matter will settle or the amount of any settlement, the company recorded an accrual of $3.5 million in the third quarter 2009 relating to the potential settlement of this matter. The timing and final outcome of this or any future government investigation cannot be predicted with certainty and any indictment, conviction or material fine, debarment or settlement arising out of these investigations could have a material adverse affect on the Company’s business, financial condition, results of operation and future prospects.
     As a result of the proposed FCPA settlement, the Company is not in compliance with loan covenants for minimum trailing 6 months earnings and for potential monetary penalties under the FCPA. The Company is in discussions with its lender to obtain a waiver for the breach of the minimum trailing 6 months earnings covenant and the potential violation stemming from the assessment of penalties. No assurance can be given that relief will be obtained on acceptable terms or at all. In the event a waiver is not obtained, the outstanding amounts on our line of credit will become due and payable and the line of credit may be cancelled. In the event we are unable to obtain needed capital on favorable terms, or at all, our liquidity could be adversely affected.
Polimaster Ltd. et al. v. RAE Systems Inc., United States District Court for the Northern District of California, Case No. 05-CV-01887-JF, United States Court of Appeals for the Ninth Circuit, No. 08-15708 and 09-15369
     Polimaster Ltd. and Na&Se Trading Company, Ltd. (“Polimaster”) filed a complaint against the Company on May 9, 2005, in the United States District Court for the Northern District of California in a case titled Polimaster Ltd., et al. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that the Company breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. The dispute was subject to a contractual arbitration agreement, although the federal court retained jurisdiction over the matter pending completion of the arbitration. The arbitration was conducted in the spring of 2007.
     In September 2007, a Final Award was issued in the arbitration. The arbitrator ruled that Polimaster failed to prove its claims and was not entitled to any relief; that the Company had proven its counterclaims and was awarded damages of approximately $2.4 million; and that as the prevailing party, the Company was entitled to recover costs in the amount of $46,000. On October 5, 2007, RAE Systems filed a motion to confirm the Final Award. On October 17, 2007, Polimaster filed an opposition to RAE Systems’ motion to confirm the Final Award and filed its own motion to vacate the Final Award. Both motions were heard on December 7, 2007, and the district court confirmed the Final Award in an order dated February 25, 2008. Polimaster appealed from the district court’s order confirming the arbitration award in Polimaster Ltd. et al. v. RAE Systems Inc., No. 08-15708. The appeal is currently pending in the United States Court of Appeals for the Ninth Circuit. Briefing on the appeal has been completed by both sides. Oral argument has not been scheduled at this time.
     When the district court confirmed the Final Award in favor of RAE Systems it did not enter judgment, an omission the district court described as a non-substantive clerical error. On September 9, 2008, the court of appeal granted leave for the district court to correct this clerical error. On January 23, 2009, the district court entered judgment in favor of RAE Systems and against Polimaster, and included in the judgment post-arbitration/pre-judgment interest and post-judgment interest. Polimaster has appealed the inclusion of these two interest components in the judgment, in Polimaster Ltd. et al. v. RAE Systems Inc., No. 09-15369, and briefing on the appeal is in progress.
     On May 14, 2009, Polimaster and RAE Systems entered a First Amended And Restated Stipulation And Order Re Stay Of Execution Of Judgment In Favor Of RAE Systems Inc. (the “stipulation”), pursuant to which Polimaster wire transferred $1.4 million to the client trust account of RAE Systems’ counsel McLeod, Witham & Flynn LLP, and agreed to wire transfer an additional $116,224.25 per month until the entire amount deposited equals the amount of the judgment (approximately $2.8 million) plus accrued interest at the judgment rate of 0.43 percent per annum. Pursuant to the stipulation, the amounts transferred by Polimaster are being maintained in the client trust account of McLeod, Witham & Flynn LLP, and shall not be distributed to RAE Systems or Polimaster, until the Ninth Circuit has ruled on Polimaster’s appeal (Nos. 08-15708 and 09-15369). McLeod, Witham & Flynn LLP shall release the funds in the account to RAE Systems and/or Polimaster within seven days of the Ninth Circuit’s final ruling on the appeal, in accordance with the Ninth Circuit’s decision. Polimaster is currently in compliance with the payment schedule provided in the stipulation. If RAE Systems is successful on appeal, it is expected that the Company would receive approximately $1.6 million, net of attorneys’ fees and expenses. The timing of a final ruling on the appeal is not currently determinable.

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Leases
     The Company and its subsidiaries lease certain manufacturing, warehousing and other facilities under operating leases. The leases generally provide for the lessee to pay taxes, maintenance, insurance and certain other operating costs of the leased property. Total rent expense for the three months ended September 30, 2009 and 2008, was $366,000 and $445,000, respectively. Total rent expense for the nine months ended September 30, 2009 and 2008, was $1,110,000 and $1,379,000, respectively. Excluding the Sunnyvale, California abandoned building lease as described below, future minimum annual payments under non-cancellable leases were as follows as of September 30, 2009(in thousands):
     
Years Ended December 31, Operating 
Remainder of 2009 $399 
2010  1,496 
2011  1,368 
2012  1,283 
2013  1,320 
Thereafter  4,749 
    
Total minimum payments $10,615 
    
     In December 2004, the Company moved into its current corporate headquarters in San Jose, California and abandoned a leased facility in Sunnyvale, California. During the second quarter of 2005, the Company accrued a restructuring reserve of approximately $2.0 million for the remaining lease term of the former headquarters in Sunnyvale. The discount rate used was 4.85% and the liability was not reduced for any anticipated future sublease income. In March 2007, due to improved conditions for office rentals, the Company revised the estimated loss on abandonment of the lease and reduced the operating expense by $595,000. During the second quarter of 2007, a sublease was executed with rental income commencing in June 2007. As of September 30, 2009, future discounted lease payments related to the Sunnyvale building are included in accrued liabilities totaling $36,000. Rent payments for the three months ended September 30, 2009 and 2008, were $132,000 and $128,000, respectively, for the Sunnyvale building with sublease income of $46,000 and $44,000 for the three months ended September 30, 2009 and 2008, respectively. Rent payments for the nine months ended September 30, 2009 and 2008, were $395,000 and $361,000, respectively, for the Sunnyvale building with sublease income of $136,000 and $131,000 for the nine months ended September 30, 2009 and 2008, respectively. The remaining lease payment through expiration of the lease on October 31, 2009, is $44,000.
     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. During the second quarter of 2009, the Company entered into an agreement for pre-construction land improvements of approximately $263,000. The Company expects to begin construction of the new facility in the second half of 2009 subject to arranging project and long-term financing. Upon completion of construction, the Company would vacate its existing leased facility in Shanghai. Based on discussions with Shanghai government officials, the landlord of the existing Company facility, the Company believes that it will be able to terminate the lease without penalty. No assurance can be given that the Company will be able to arrange financing terms acceptable to the Company and that it would not be subject to lease termination penalties.
Guarantees
     The Company is permitted under Delaware law and required under our 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.

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Note 6. Warranty Reserves
     The Company sells the majority of its products with a 12 to 24 month repair or replacement warranty from the date of shipment. The Company provides an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized under accrued liabilities on the Condensed Consolidated Balance Sheets. The following is a summary of the changes in these liabilities during the three months and nine months ended September 30, 2009 and 2008, respectively:
                 
  Three Months Ended  Nine Months Ended 
  September 30,  September 30, 
(in thousands) 2009  2008  2009  2008 
Warranty reserve at beginning of period $645  $438  $707  $884 
Provision for warranty  299   463   922   504 
Utilization of reserve  (282)  (269)  (967)  (785)
Foreign currency translation effects  3   (7)  3   22 
             
Warranty reserve at end of period $665  $625  $665  $625 
             
Note 7. Lines of Credit
     The Company maintains credit facilities to support its operations in the United States and China.
     In the United States, the Company had a $15.0 million revolving credit agreement as of December 31, 2008. This credit facility is renewed annually. On March 11, 2009, the Company received an extension of its existing line to May 12, 2009, which also changed certain other terms and conditions. On April 29, 2009, the revolving credit agreement, as amended, was renewed to expire on May 15, 2010. The amended credit agreement provides for borrowings of up to $10.0 million based on a percentage of specific qualifying assets and a blanket security interest in the Company’s assets in the United States. The Company is required to comply with certain reporting and financial covenants in addition to the ongoing requirement to submit monthly financial information. Interest accrues at the floating prime bank lending rate plus 100 basis points subject to a minimum total rate of 5%. In addition, the Company pays 30 basis points annually of the average unused portion of the facility. As of September 30, 2009 and December 31, 2008, $1.8 million was outstanding against the revolving credit agreement.
     As a result of the proposed FCPA settlement disclosed in Note 5, “Commitments and Contingencies,” the Company is not in compliance with loan covenants for minimum trailing 6 months earnings and for potential monetary penalties under the FCPA. The Company is in discussions with its lender to obtain a waiver of these covenants; however, no assurance can be given that relief will be obtained on acceptable terms or at all. In the event a waiver is not obtained, the outstanding amounts on our line of credit will become due and payable and the line of credit may be cancelled.
     In China, as of September 30, 2009, the Company had three unsecured revolving lines of credit, each in the amount of Renminbi (“RMB”) 20.0 million or approximately $2.9 million, available to provide working capital. Borrowings under these lines of credit are generally at the current market rate for fixed rate loans of the amount and duration requested, up to one year. The credit facilities are renewed annually in May, September and October, respectively. On September 30, 2009 and December 31, 2008, RMB 13.0 million and RMB 5.0 million or approximately $1.9 million and $0.7 million, respectively, was outstanding under the lines of credit.
     Advances under the lines of credit in China are generally tied to specific promissory notes. A loan in the amount of RMB 5.0 million or approximately $0.7 million bearing interest at a fixed rate of 6.33% due on April 30, 2009, was renewed at a fixed rate of 5.31% to mature on April 27, 2010. A second loan in the amount of RMB 8.0 million or approximately $1.2 million bearing interest at a fixed rate of 5.31% is due on January 4, 2010.
     In October 2009, the Company borrowed working capital of RMB 15 million or approximately $2.2 million bearing interest at 5.04% due October 13, 2010.
Note 8. Related Party Transactions
     The Company accounts for its 40% ownership in Renex Technologies Ltd. (“Renex”), a Hong Kong company, using the equity method. The Company’s total investment in Renex at September 30, 2009 and December 31, 2008 was $269,000 and $448,000, respectively. The Company recorded a loss of $46,000 and income of $10,000 in Renex for the three months ended September 30, 2009 and 2008, respectively, and losses of $180,000 and $26,000 in Renex for the nine months ended September 30, 2009 and 2008, respectively.

15

     The Company paid zero and $36,000 to Renex for research work for the three months periods ended September 30, 2009 and 2008, respectively, and $95,000 and $128,000 for the nine month periods ended September 30, 2009 and 2008, respectively.
     In conjunction with the original and subsequent additional investment in RAE Beijing, unsecured notes payable were established for the previous RAE Beijing shareholders as part of the purchase price agreement in May 2004 and July 2006. As of September 30, 2009 and December 31, 2008, $370,000 and $1,329,000, respectively, were included in current notes payable to related parties in the Company’s Condensed Consolidated Balance Sheets and $362,000 and $1,219,000, respectively, were included in noncurrent notes payable to related parties.
     The notes issued in conjunction with the original RAE Beijing purchase in May 2004 were non-interest bearing and were recorded at net present value using a discount rate of 5.5%. In conjunction with the additional investment in RAE Beijing in July 2006, 11.0 million shares of preferred stock were issued to four shareholders of RAE Beijing. In accordance with the authoritative accounting guidance, these preferred shares were classified as liabilities and were recorded as noncurrent notes payable to related parties. Although, these preferred shares bear a dividend yield rate of 3% per annum, the notes payable were discounted using a market interest rate of 6.48%.
     Scheduled annual payments of principal under the notes from 2009 through maturity in 2011 are zero, $370,000 and $362,000, respectively.
     In addition to its 40% ownership in Renex, the Company has investments in three distributors of RAE Systems products, RAE Australia, RAE Benelux and RAE Spain. The Company owns 19%, 10% and 19% of RAE Australia, RAE Benelux and RAE Spain, respectively. These investments are accounted for under the cost method.
     The Liaoning Coal Industry Group, Ltd. (“Liaoning Group”) owns a 30% interest in RAE Fushun and has also been a supplier to RAE Fushun.
     Transactions and balances with the Company’s related parties were as follows:
                           
  Three Months Ended  Nine Months Ended         
  September 30,  September 30,    September 30,  December 31, 
(in thousands) 2009  2008  2009  2008    2009  2008 
Sales:                 Accounts receivable:        
Renex $104  $80  $292  $199  Renex $224  $100 
RAE Australia  189   —   531   —  RAE Australia  98   — 
RAE Benelux  610   476   2,002   1,805  RAE Benelux  373   411 
RAE Spain  88   131   316   452  RAE Spain  136   192 
                     
  $991  $687  $3,141  $2,456    $831  $703 
                     
                           
Purchases:                 Accounts payable:        
Liaoning Group $—  $4  $—  $17  Liaoning Group $14  $72 
Renex  45   184   142   493  Renex  83   382 
                     
  $45  $188  $142  $510    $97  $454 
                     
     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 $33,000 and $30,000 for the three months ended September 30, 2009 and 2008, respectively, and $94,000 and $84,000 for the nine months ended September 30, 2009 and 2008, 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,.

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Note 9. Discontinued Operations
     On August 24, 2007, the Board of Directors approved the discontinuation of the Company’s DVR business in order to reduce expenses and concentrate its resources on the gas and radiation detection business. The Company’s mobile DVR business was acquired in the purchases of Aegison and Securay.
     On August 28, 2007, the Company notified its DVR customers, terminated all personnel not reassigned to continuing operations and suspended the related production and sales activities. The Company retained the acquired intellectual property; however, because the DVR business operated at a substantial loss, during 2007 management liquidated the tangible assets, mainly inventories of component parts, and impaired the remaining value of the intangible assets and goodwill.
In accordance with the existing authoritative guidance the financial results of the DVR business are reported as discontinued operations for all periods presented. The loss from discontinued operations net of tax was $4,000 for the three month period ended September 30, 2008, and the gain from discontinued operations net of tax was $11,000 for the nine month period ended September 30, 2008, respectively.
     There were no assets and liabilities related to the disposal group as of September 30, 2009 and 2008.
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 bank line of credit: The carrying amounts reported in the balance sheet 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 non interest bearing notes payables 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 will be classified and disclosed in one of the following three categories:
     Level 1: Quoted market prices in active markets for identical assets or liabilities.
     Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data.
     Level 3: Unobservable inputs that are not corroborated by market data.
     The following table reflects the carrying amounts and fair values of the Company’s assets and liabilities as of September 30, 2009 and December 31, 2008:
                     
      September 30, 2009 December 31, 2008
      Carrying     Carrying  
(in thousands) Category Amounts Fair Value Amounts Fair Value
Cash and cash equivalent Level 1 $16,157  $16,157  $14,845  $14,845 
Bank lines of credit Level 1  3,739   3,739   2,584   2,584 
Notes payable to related parties Level 2  732   732   2,548   2,548 

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Note 11. Shareholders’ Equity
     The following table is a summary of the changes in equity:
                         
  Three Months Ended September 30,  Three Months Ended September 30, 
  2009  2008 
  RAE Systems          RAE Systems       
  Shareholders’  Noncontrolling  Total  Shareholders’  Noncontrolling  Total 
(in thousands) Equity  Interest  Equity  Equity  Interest  Equity 
Equity, Beginning of Period $40,833  $4,883  $45,716  $47,209  $5,714  $52,923 
Net loss  (3,489)  (175)  (3,664)  554   90   644 
Translation adjustments  205   —   205   (325)  13   (312)
                   
Comprehensive (loss) income  (3,284)  (175)  (3,459)  229   103   332 
Exercise of stock options  —   —   —   24   —   24 
Repurchases of restricted common stock  (7)  —   (7)  —   —   — 
Stock-based compensation expense  200   —   200   374   —   374 
                   
Equity, End of Period $37,742  $4,708  $42,450  $47,836  $5,817  $53,653 
                   
                         
  Nine Months Ended September 30,  Nine Months Ended September 30, 
  2009  2008 
  RAE Systems          RAE Systems       
  Shareholders’  Noncontrolling  Total  Shareholders’  Noncontrolling  Total 
  Equity  Interest  Equity  Equity  Interest  Equity 
Equity, Beginning of Period $43,216  $5,481  $48,697  $46,356  $5,385  $51,741 
Net loss  (6,727)  (773)  (7,500)  (2,249)  115   (2,134)
Translation adjustments  337   —   337   2,492   317   2,809 
                   
Comprehensive (loss) income  (6,390)  (773)  (7,163)  243   432   675 
Exercise of stock options  —   —   —   24   —   24 
Repurchases of restricted common stock  (7)  —   (7)  (25)  —   (25)
Stock-based compensation expense  923   —   923   1,238   —   1,238 
                   
Equity, End of Period $37,742  $4,708  $42,450  $47,836  $5,817  $53,653 
                   

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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 thisForm 10-Q. The following discussion should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in thisForm 10-Q.
Overview
     Founded in 1991 to develop technologies for the detection and early warning of hazardous materials, today we offer a full line of chemical and radiation detection solutions. These solutions have been deployed in over 95 countries and range from small handheld devices to rapidly-deployable wireless systems to fixed facility safety solutions. We are a leading global developer and manufacturer of rapidly-deployable, multi-sensor chemical and radiation detection monitors, single gas monitors, 4-gas monitors, 5-gas monitors, photoionization instruments for the detection of total and specific volatile organic compounds, wireless gas detection networks and fixed gas detection monitors. In addition we have introduced calibration stations for key high volume/ high use products to facilitate the daily “bump testing” and periodic calibration of the toxic gas sensors in our products.
     We are currently focused on delivering world wide solutions to five key market sectors:
•The Energy market which includes oil exploration, oil refining, natural gas and coal mine safety.
•The Hazardous Material Management market which includes hazardous incident response teams, material transportation and fence line applications.
•The Industrial Safety market which includes metals production, chemicals, plastics, resins, adhesives, polymers and industrial processes.
•The Global Environmental market which includes both regulatory compliance and environmental clean-up or remediation.
•And the Government market which includes solutions for emergency response, public safety, homeland security and military applications at the municipal, state and federal levels.
Recent Developments
     In 2008, we introduced eight new products. We now offer a complete line of products to serve the personnel safety, regulated worker safety and detection needs of the global energy market. Products range from breathing zone single sensor products for specific toxic chemicals (ToxiRAE 3 and AutoRAE Lite Calibration Station) to belt worn multi-gas monitors (QRAE II with AutoRAE Lite Calibration station, and MultiRAE Plus) to handheld instruments (MiniRAE 3000, MiniRAE Lite, ppbRAE 3000 and UltraRAE) to measure total and specific volatile organic compounds, to wireless monitors for wireless industrial and public safety applications (AreaRAE Steel, RAELink3 and MeshGuard) as well as fixed monitors (RAEGuard, RAEGuard-S, RAEGuard PID and FMC Series Controllers) for deployment in factory or safety process management.
     Our 2009 sales goals are focused on the energy sector, public safety and the global confined space entry and worker safety regulation and health exposure driven gas detection markets. With the introduction of the 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.

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     In the third quarter of fiscal 2009, we had key wins in the oil and gas market, with two long term sole supplier contracts won in the Middle East and an Australian coal mining company ordered our new MeshGuard, single gas wireless monitors to facilitate the real-time monitoring of methane gas concentration.
     In the Civil Defense market, we continue to add states to the New York Hazardous Incident Response Equipment purchasing agreement, which allows states and municipalities to buy our equipment without an open bidding process. We received additional orders from the Federal Emergency Management Agency for AreaRAE wireless monitors and AreaRAE Rapid Deployment Kits, as part of their “Urban Area Security” initiative.
     In the radiation detection market we received significant orders for personal radiation detector/dosimeters from the Singapore Civil Defense Force and the Los Angeles County Sherriff’s Office. We also received orders from the China Environmental Protection Bureau for instruments to monitor and track radioactive sources.
     In the Environmental market, we sold ppbRAE 3000’s to a Taiwanese semiconductor company, a Korean automobile manufacturer, and to the Beijing Environmental Protection Bureau.
     In each of our markets we will continue to explore and develop strategic value added partnerships, to leverage our product and market expertise.
     The Company is actively engaged in discussions with the Department of Justice and the Securities and Exchange Commission to settle the outstanding joint investigation into the Company’s alleged violations of the FCPA.
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 are 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.
Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts
     We grant credit to our customers after undertaking an investigation of credit risk for significant amounts. An allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, history of adjustments, current economic conditions and other factors that deserve recognition in estimating potential losses. We generally do not require collateral for sales on credit. While management uses the best information available in making our determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there was a deterioration of a major customer’s credit-worthiness or if actual defaults were higher than what have been experienced historically, additional allowances would be required.
     Trade notes receivables are presented to us from some of our customers in China as a payment against the outstanding trade receivables. These notes receivables are bank guarantee promissory notes which are non-interest bearing and generally mature within nine months.

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Inventory
     Inventory is stated at the lower of cost, using the first-in, first-out method, or market. We are exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in the market, competitive pressures in products and prices, and the availability of key components from our suppliers. We have established inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for our products and market conditions. When recorded, reserves are intended to reduce the carrying value of the inventory to its net realizable value. If actual demand for specified products deteriorates, or market conditions are less favorable than those projected, additional reserves may be required.
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.
Business Combinations
     In accordance with business combination accounting standards, we allocate the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. We typically engage third-party appraisal firms to assist management in determining the fair values of certain assets acquired and liabilities assumed. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets and goodwill.
     Management makes estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Critical estimates in valuing certain of the intangible assets include, but are not limited to: discount rates; future expected cash flows from maintenance agreements, customer contracts, acquired developed technologies and pending patents; expected costs to develop the in-process research and development into commercially viable products and estimating cash flows from these projects when completed; the acquired company’s brand awareness and market position; and assumptions about the period of time an acquired brand will continue to be used in the combined company’s product portfolio. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.
Income Taxes
     We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes.
     Our effective tax rates differ from statutory rates primarily due to foreign earnings taxed at lower rates, losses not benefited, non-deductible share-based compensation deductions and provision changes for uncertain tax positions. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. We regularly assess the likelihood of adverse outcomes resulting from tax examinations to determine the adequacy of our provision for income taxes.
     Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets. In assessing the need for a valuation allowance, we consider all available evidence including past operating results, estimates of future taxable income, and the feasibility of tax planning strategies. In the event that we change our determination as to the amount of deferred tax assets that can be realized, we will adjust our valuation allowance with a corresponding impact to the provision for income taxes in the period in which such determination is made.

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Recent Accounting Pronouncements
     In December 2007, the FASB issued authoritative guidance which applies to business combinations. The new guidance changes the accounting for acquisition transaction costs by requiring them to be expensed in the period incurred, and also changes the accounting for contingent consideration, acquired contingencies and restructuring costs related to an acquisition. The new guidance was effective for the Company beginning January 1, 2009, and will change the Company’s accounting treatment for business combinations on a prospective basis.
     In June 2009, the FASB issued authoritative guidance for determining whether an entity is a variable interest entity (“VIE”) and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. Under this guidance, an enterprise has a controlling financial interest when it has a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. The guidance also requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has power to direct the activities of the VIE that most significantly impact the entity’s economic performance. The guidance is effective for the Company January 1, 2010, and requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE and requires certain enhanced disclosures. The Company is currently evaluating the potential impact, if any, of the adoption of this guidance on its consolidated financial statements.
     In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning January 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. The Company is currently assessing the potential effect, if any, on its financial statements.
Results of Operations
Net Sales
                                 
  Three Months Ended         Nine Months Ended      
  September 30,     Percentage September 30,     Percentage
(in thousands) 2009 2008 Change Change 2009 2008 Change Change
                                 
Net sales $19,909  $28,845  $(8,936)  -31% $58,929  $71,361  $(12,432)  -17%
Net sales for the quarter ended September 30, 2009, decreased by $8.9 million or 31% over the quarter ended September 30, 2008. Sales decreased $3.9 million or 30% in Americas, $4.2 million or 36% in Asia and $0.8 million or 20% in Europe. The decrease includes the impact of two significant non-recurring orders in the quarter ended September 30, 2008: one from the United States National Guard and another from the Beijing International Airport. Net sales also decreased due to a disruption of our sales activity in China due to management changes during the third quarter of 2009. Approximately $0.2 million of the decrease was due to unfavorable exchange rate fluctuations.
     Net sales for the nine months ended September 30, 2009, decreased by $12.4 million or 17% over the same period in 2008. Sales decreased $4.6 million or 15% in Americas, $6.3 million or 22% in Asia and $1.5 million or 13% in Europe. The decrease includes the negative impact of the worldwide economic downturn and two significant non-recurring orders in the nine months ended September 30, 2008: one from the United States National Guard and another from the Beijing International Airport, and a disruption of our sales activity in China due to management changes during the third quarter of 2009. Approximately $0.9 million of the decrease was due to unfavorable exchange rate fluctuations.

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Cost of Sales & Gross Margin
                                 
  Three Months Ended         Nine Months Ended      
  September 30,     Percentage September 30,     Percentage
(in thousands) 2009 2008 Change Change 2009 2008 Change Change
                                 
Cost of sales $9,636  $13,070  $(3,434)  -26% $29,458  $33,640  $(4,182)  -12%
Gross profit $10,273  $15,775  $(5,502)  -35% $29,471  $37,721  $(8,250)  -22%
Gross margin  52%  55%          50%  53%        
     Cost of sales for the quarter ended September 30, 2009, decreased by $3.4 million or 26% over the quarter ended September 30, 2008, mainly due to the decrease in sale volume. Gross profit for the quarter ended September 30, 2009, decreased by $5.5 million or 35% over the quarter ended September 30, 2008, primarily due to lower sales volume and the favorable product mix influence of two significant non-recurring orders shipped during the quarter ended September 30, 2008.
     Cost of sales for the nine months ended September 30, 2009, decreased by $4.2 million or 12% over the same period during 2008, mainly due to the decrease in sale volume. Gross profit for the nine months ended September 30, 2009, decreased by $8.2 million or 22% over the nine months ended September 30, 2008. Gross margin decreased by 3% for the nine months ended September 30, 2009, compared to the nine months ended September 30, 2008, primarily due to lower sales volume and a shift away from higher margin products to a higher mix of compliance products and lower margins contributed by system integration projects revenue in China.
Sales and Marketing Expense
                                 
  Three Months Ended         Nine Months Ended      
  September 30,     Percentage September 30,     Percentage
(in thousands) 2009 2008 Change Change 2009 2008 Change Change
                                 
Sales and marketing $4,282  $5,197  $(915)  -18% $13,513  $15,998  $(2,485)  -16%
Percentage of net sales  22%  18%          23%  22%        
     Sales and marketing expenses decreased by $0.9 million or 18% for the quarter ended September 30, 2009, compared to the quarter ended September 30, 2008, primarily due to reduced headcount, travel by employees and participation at trade shows.
     Sales and marketing expenses decreased by $2.5 million or 16% for the nine months ended September 30, 2009, over the same period during 2008, primarily due to reductions in headcount, travel by employees and participation at trade shows.
Research and Development Expense
                                 
  Three Months Ended         Nine Months Ended      
  September 30,     Percentage September 30,     Percentage
(in thousands) 2009 2008 Change Change 2009 2008 Change Change
                                 
Research and development $1,787  $1,541  $246   16% $4,766  $4,822  $(56)  -1%
Percentage of net sales  9%  5%          8%  7%        
     Research and development expenses increased by approximately $0.2 million or 16% during the quarter ended September 30, 2009, compared to the quarter ended September 30, 2008, primarily driven by increased headcount and project expenses at our engineering center in Shanghai, China.
     Research and development expenses decreased by $0.1 million or 1% for the nine months ended September 30, 2009

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General and Administrative Expense
                                 
  Three Months Ended         Nine Months Ended      
  September 30,     Percentage September 30,     Percentage
(in thousands) 2009 2008 Change Change 2009 2008 Change Change
                                 
General and administrative $8,118  $7,658  $460   6% $18,223  $17,581  $642   4%
Percentage of net sales  41%  27%          31%  25%        
     General and administrative expenses increased by $0.5 million or 6% in the quarter ended September 30, 2009, compared to the quarter ended September 30, 2008. The increase was primarily related to the $3.5 million accrual of management’s estimate to settle the outstanding joint investigation into the Company’s alleged violations of the FCPA, which was partially offset by lower professional fees of $2.5 million, consisting primarily of legal fees, reduced fees associated with the collection of previously reserved doubtful accounts receivables of $0.2 million, and generally lower travel and other discretionary expenses for the quarter ended September 30, 2009, as compared to the quarter ended September 30, 2008.
     General and administrative expenses increased by $0.6 million or 4% for the nine months ended September 30, 2009, over the same period during 2008. The increase was primarily related to the $3.5 million accrual of management’s estimate to settle the outstanding joint investigation into the Company’s alleged violations of the FCPA and increased fees associated with doubtful accounts receivable of $0.7 million, which was partially offset by lower professional fees of $3.7 million, consisting primarily of legal fees.
Other Income/(Expense)
                                 
  Three Months Ended          Nine Months Ended        
  September 30,      Percentage  September 30,      Percentage 
(in thousands) 2009  2008  Change  Change  2009  2008  Change  Change 
                                 
Interest income $13  $36  $(23)  -64% $30  $122  $(92)  -75%
Interest expense  (79)  (91)  12   13%  (314)  (292)  (22)  -8%
Other, net  148   (192)  340   177%  140   (110)  250   227%
Equity in loss of unconsolidated affiliate  (47)  10   (57)  -570%  (180)  (26)  (154)  -592%
                         
Total other income (expense) $35  $(237) $272   115% $(324) $(306) $(18)  -6%
                         
     For the quarter ended September 30, 2009, total other income increased by $0.3 million or 115% compared to the quarter ended September 30, 2008. The increase was primarily due to net other for the quarter ended September 30, 2009, which increased $0.3 million, or 177%, from other net for the quarter ended September 30, 2008, primarily as a result of foreign exchange gains in Asia and Europe.
     For the nine months ended September 30, 2009, total other expenses increased by $18,000 or 6% from the nine months ended September 30, 2008. The decrease in interest income was primarily due to lower interest rates and decreased cash in interest earning accounts. The income in net other of $250,000 for the nine months ended September 30, 2008, resulted primarily from foreign exchange gains in Asia and Europe.
Income Tax Benefit/(Expense)
                                 
  Three Months Ended         Nine Months Ended      
  September 30,     Percentage September 30,     Percentage
(in thousands) 2009 2008 Change Change 2009 2008 Change Change
                                 
Income tax benefit (expense) $215  $(494) $709   -144% $(145) $(1,159) $1,014   -87%
Effective tax rate  -6%  -43%          2%  118%        
     Income tax expense after discrete items for the nine months ended September 30, 2009 was $0.1 million compared to $1.2 million for the nine months ended September 30, 2008. At December 31, 2008 and September 30, 2009, 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 2009

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differed from the U.S. statutory rate primarily due to foreign earnings taxed at lower rates, losses not benefited, nondeductible stock compensation deductions and additional provisions for uncertain tax positions applicable to fiscal year 2008. Included in the tax expense for the nine months ended September 30, 2009, were discrete tax expense items of $100,000 related to the accrual of interest related to various uncertain tax benefits, $35,000 related to return to provision true up for our foreign entities, $(6,000) related to return to provision for federal income tax in the United States, and state and local taxes of $9,000.
Net Loss Attributable to the Noncontrolling Interest
                                 
  Three Months Ended         Nine Months Ended      
  September 30,     Percentage September 30,     Percentage
(in thousands) 2009 2008 Change Change 2009 2008 Change Change
                                 
Net loss (income) attributable to the noncontrolling interest $175  $(90) $265   -294% $773  $(115) $888   -772%
     For the quarter ended September 30, 2009, the noncontrolling interest in the operating loss of consolidated subsidiaries increased $0.3 million from an income of $90,000 for the quarter ended September 30, 2008. The increase was primarily due to losses incurred in RAE Fushun and RAE Beijing, during the quarter ended September 30, 2009, compared to profits for the quarter ended September 30, 2008. In addition, RAE France’s profitability declined for the quarter ended September 30, 2009. The noncontrolling ownership was 4% of RAE Beijing, 30% of RAE Fushun and 51% of RAE France.
     For the nine months ended September 30, 2009, the noncontrolling interest in the operating loss of consolidated subsidiaries increased $0.9 million from an income of $115,000 for the nine months ended September 30, 2009. The increase was primarily due to an operating loss at RAE Fushun and reduced profits in RAE Beijing and RAE France. The noncontrolling ownership was 4% of RAE Beijing, 30% of RAE Fushun and 51% of RAE France.
Gain From Discontinued Operations
     On August 24, 2007, the Board of Directors approved the discontinuation of the Company’s mobile DVR business in order to reduce expenses and concentrate resources on the Company’s gas and radiation detection business. On August 28, 2007, we notified our DVR customers, terminated all personnel not reassigned to continuing operations and suspended the related production and sales activities. Because the DVR business operated at a substantial loss, management liquidated the tangible assets, mainly inventories of component parts. Accordingly, the value of these assets was adjusted to reflect the anticipated disposals.
     As a result of discontinuing the DVR business, management impaired the remaining value of the intangible assets and goodwill acquired in the purchases of Aegison in July 2006 and Securay in January 2007. The recognized loss in the quarter ended September 30, 2008 of $4,000 and the gain of $11,000 for the nine months ended September 30, 2008 were mainly due to the sale of inventory previously reserved.
     In accordance with the existing authoritative guidance, the financial results of the DVR business are reported as discontinued operations for all periods presented. The financial results included in discontinued operations were as follows:
                                 
  Three Months Ended          Nine Months Ended        
  September 30,      Percentage  September 30,      Percentage 
(in thousands) 2009  2008  Change  Change  2009  2008  Change  Change 
 
(Loss) gain from discontinued operations before income taxes $—  $(4) $4   -100% $—  $11  $(11)  -100%
Income tax benefit  —   —   —   0%  —   —   —   0%
                           
(Loss) gain from discontinued operations, net of tax $—  $(4) $4   -100% $—  $11  $(11)  -100%
                           
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 September 30, 2009, we had $16.2 million in cash and cash equivalents compared with $14.8 million on December 31, 2008. The $1.3

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million increase in cash during the nine months ended September 30, 2009, was primarily due to the collection of trade accounts receivable and improved inventory turnover.
     At September 30, 2009, we had $30.1 million in working capital (current assets less current liabilities) and a current ratio (ratio of current assets to current liabilities) of 2.2 to 1.0 compared to $37.1 million of working capital and a current ratio of 2.5 to 1.0 at December 31, 2008. Of the $7.0 million reduction in working capital, $3.5 million is attributable to the proposed FCPA settlement discussed in Note 5 to the Condensed Consolidated Financial Statements.
     In the United States, we had a $15.0 million revolving credit agreement as of December 31, 2008. This credit facility is renewed annually. On March 11, 2009, we received an extension of our existing line to May 12, 2009, which also changed certain other terms and conditions. On April 29, 2009, the revolving credit agreement, as amended, was renewed to expire on May 15, 2010. The amended credit agreement provides for borrowings of up to $10.0 million based on a percentage of specific qualifying assets and 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 monthly financial information. At September 30, 2009 and December 31, 2008, $1.8 million was outstanding against the revolving credit agreement.
      As a result of the proposed FCPA settlement disclosed in Note 5 to the Condensed Consolidated Financial Statements, “Commitments and Contingencies,” as of September 30, 2009, the Company is not in compliance with loan covenants for minimum trailing 6 months earnings and for potential monetary penalties under the FCPA. The Company is in discussions with its lender to obtain a waiver of these covenants. While we believe a waiver will be obtained, no assurance can be given that relief will be obtained on acceptable terms or at all. In the event a waiver is not obtained, the outstanding amounts on our line of credit will become due and payable and the line of credit may be cancelled.
     In China, as of September 30, 2009, we had three unsecured revolving lines of credit, each in the amount of RMB 20.0 million or approximately $2.9 million, available to provide working capital. The credit facilities are renewed annually in May, September and October, respectively. Borrowings under these lines of credit are generally at the current market rate for fixed rate loans of the amount and duration requested, up to one year. On September 30, 2009, and December 31, 2008, RMB 13 million and RMB 5.0 million or approximately $1.9 million and $0.7 million, respectively, were outstanding under these lines of credit. A loan in the amount of RMB 5.0 million, or approximately $0.7 million, bearing interest at a fixed rate of 6.33% due on April 30, 2009, was renewed at a fixed rate of 5.31% to mature April 27, 2010. A second loan in the amount of RMB 8.0 million, or approximately $1.2 million, bearing interest at a fixed rate of 5.31% is due on January 4, 2010.
     A summary of our Condensed Consolidated Statement of Cash Flows follows:
         
  Nine Months Ended 
  September 30, 
(in thousands) 2009  2008 
 
Net cash provided by (used in):        
Operating activities $4,195  $2,340 
Investing activities  (2,222)  (892)
Financing activities  (770)  (3,004)
Effect of exchange rate changes on cash and cash equivalents  109   418 
       
Net increase (decrease) in cash and cash equivalents $1,312  $(1,138)
       
Operating Activities
     For the nine months ended September 30, 2009, net cash provided by operating activities of $4.2 million was attributable to the following factors:
•Cash flow decreased due to the net loss of $7.5 million (including the portion attributable to the noncontrolling interest). However, because the net loss includes non-cash charges totaling $3.1 million, the net decrease to cash was $4.4 million. Our principal non-cash expenses were as follows: $2.5 million depreciation and amortization, $0.9 million stock-based compensation, and $0.2 million equity in the loss of unconsolidated affiliates. We also recognized $0.5 million in deferred gains on the disposal of property and equipment.
•The net change in operating assets and liabilities which generated cash flow of $8.6 million. Cash was primarily provided by managed reductions of $2.6 million and $3.1 million in trade accounts and notes receivable and inventories, respectively, and the collection of income tax refunds totaling $0.8 million. Additional cash flow was contributed by

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increases to accounts payable and accrued liabilities and a reduction in prepaid expenses of $0.5 million, $1.1 million and $0.4 million, respectively. Cash was applied to reduce accounts payable to affiliates by $0.3 million.
     For the nine months ended September 30, 2008, net cash provided by operating activities of $2.3 million was attributable to the following:
•Cash decreased due to the net loss of $2.1 million (including the portion attributable to the noncontrolling interest), which included non-cash charges totaling $3.1 million. Our principal non-cash expenses were as follows: $2.4 million depreciation and amortization and $1.2 million stock-based compensation. These non-cash expenses were partially offset by $0.5 million in gains on disposal of property and equipment.
•The net change in operating assets and liabilities which generated cash of $1.3 million. $2.9 million and $0.1 million of cash was provided by the collection of trade accounts and notes receivable and income taxes receivable, respectively. Additional cash of $1.5 million, $0.6 million, $0.4 million and $0.3 million was provided by increased balances of accounts payable, income taxes payable, deferred revenue and accrued liabilities, respectively. Cash of $1.7 million and $1.4 million was used to fund increases in the balances of inventories and certain prepaid expenses, respectively. Additional cash of $1.2 million was applied to prepayments and deposits related to the new facility being built in Fushun, China. The net change in various other operating accounts consumed cash flow of $0.2 million during the period.
Investing Activities
     Net cash used in investing activities during the nine months ended September 30, 2009, was $2.2 million compared with $0.9 million for the nine months ended September 30, 2008. Cash used during the first nine months of 2009 primarily consisted of ongoing construction and outfitting activities at our new facility in Fushun, China and payment for land use rights in Shanghai. In December 2008, we purchased the land use rights for 50 years on a land parcel in Shanghai of approximately 6.5 acres. We plan to use this site to construct a new manufacturing and research and development facility, which would replace our current Shanghai facility. We expect to begin construction of the new facility in the second half of 2009, subject to arranging project and long-term financing. Upon the expected completion of construction, we would vacate our existing leased facility in Shanghai. Based on discussions with Shanghai government officials, the landlord of the existing Company facility, we believe that we will be able to terminate the lease without penalty. No assurance can be given that we will be able to arrange financing terms acceptable to us or that we would not be subject to lease termination penalties.
Financing activities
     Net cash used in financing activities for the nine months ended September 30, 2009, was $0.8 million compared with net cash used of $3.0 million for the nine months ended September 30, 2008. Through September 30, 2009, we have made principal payments totaling $1.9 million to reduce the notes payable to related parties for the acquisition of RAE Beijing. These payments were made from general working capital. The next scheduled principal payment is in July 2010. Aside from the renewal of a pre-existing loan, we also borrowed RMB 8.0 million, or approximately $1.2 million, to acquire land use rights in Shanghai for the construction of a new building as discussed above.
     Cash used in financing activities during the first nine months of 2008 was primarily for repayment of bank loans and payments on the notes payable to related parties for the acquisition of RAE Beijing.
     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, the ultimate resolution of issues arising from our internal investigation regarding potential FCPA violations, the resolution of obtaining a waiver for the breach of covenants on our U.S. line of credit, 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.

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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 deposited with major financial institutions in the countries where we conduct business. Our deposits may exceed the amount of insurance available to cover such deposits. To date, we have not experienced any losses of deposits of cash and cash equivalents. Management regularly reviews our deposit amounts and the credit worthiness of the financial institution which hold our deposits.
Interest Rate Risk
     As of September 30, 2009, we had cash and cash equivalents of $16.2 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 are at fixed interest rates. The outstanding balance under our line of credit in the United States bears interest at the floating prime bank lending rate plus 100 basis points subject to a minimum total rate of 5%. As the prime rate as of September 30, 2009, 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 September 30, 2009, annual interest expense would increase by $1,800 for each basis point thereafter.
Foreign Currency Exchange Rate Risk
     For the nine months ended September 30, 2009, a substantial portion of our recognized revenue was generated by our Asia operations (40%) and was primarily denominated in RMB. Revenue denominated in U.S. dollars is generated primarily from operations in the Americas (42%), and revenue from our European operations (18%) is primarily denominated in Euros. We manufacture a majority of our component parts at our manufacturing facility in Shanghai, China. Since January 2008, our operations in China have been affected by currency fluctuations due to an approximate 7.0% appreciation of the RMB relative to the U.S. dollar.
     Our strategy has been to increase overseas manufacturing and research and development activities to capitalize on lower cost capacity and efficiencies in supply-chain management. In 2004 and 2006, we made strategic investments in China with the acquisition of a 96% interest in RAE Beijing, a Beijing-based manufacturer and distributor of environmental safety and security equipment and the formation of RAE Fushun, in late 2006, to capitalize on increases in demand for safety equipment in the mining and energy market sectors in China. 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 losses would have been approximately $1.1 million for the nine months ended September 30, 2009. 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% against the U.S. dollar, the approximate effect on our losses would be approximately $0.7 million for the nine months ended September 30, 2009. The reduction in the impact of the RMB is due to the offset of changes in reported net sales in our other units resulting from changes in those countries local currencies.
     Furthermore, to the extent that we engage in international sales denominated in U.S. dollars in countries other than China, 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

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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 effective as of September 30, 2009.
     There were no changes in our internal control over financial reporting during the quarter ended September 30, 2009 that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.

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PART II. Other Information
Item 1. Legal Proceedings
Regulatory Compliance
     During fiscal year 2008, the Company’s internal audit department identified certain payments and gifts made by certain personnel in the Company’s operations in the People’s Republic of China (“China”) that may have violated the United States Foreign Corrupt Practices Act (“FCPA”). Following this discovery, the Audit Committee of the Board of Directors initiated an independent investigation. The Company has made a voluntary disclosure to the United States Department of Justice (DOJ) and the United States Securities and Exchange Commission (SEC) regarding the results of its investigation. The Company has also implemented additional policies and controls with respect to compliance with the FCPA. The FCPA and related statutes and regulations provide for potential monetary penalties, criminal sanctions and in some cases debarment from doing business with the U.S. federal government in connection with violations. The Company is cooperating with the DOJ and the SEC in connection with their review of the matter and is actively engaged in settlement discussions. Although no assurances can be given as to whether the matter will settle or the amount of any settlement, the company recorded an accrual of $3.5 million in the third quarter 2009 relating to the potential settlement of this matter. The timing and final outcome of this or any future government investigation cannot be predicted with certainty and any indictment, conviction or material fine, debarment or settlement arising out of these investigations could have a material adverse affect on the Company’s business, financial condition, results of operation and future prospects.
     As a result of the proposed FCPA settlement, the Company is not in compliance with loan covenants for minimum trailing 6 months earnings and for potential monetary penalties under the FCPA. The Company is in discussions with its lender to obtain a waiver for the breach of the minimum trailing 6 months earnings covenant and the potential violation stemming from the assessment of penalties. No assurance can be given that relief will be obtained on acceptable terms or at all. In the event a waiver is not obtained, the outstanding amounts on our line of credit will become due and payable and the line of credit may be cancelled. In the event we are unable to obtain needed capital on favorable terms, or at all, our liquidity could be adversely affected.
Polimaster Ltd. et al. v. RAE Systems Inc., United States District Court for the Northern District of California, Case No. 05-CV-01887-JF, United States Court of Appeals for the Ninth Circuit, No. 08-15708 and 09-15369
     Polimaster Ltd. and Na&Se Trading Company, Ltd. (“Polimaster”) filed a complaint against the Company on May 9, 2005, in the United States District Court for the Northern District of California in a case titled Polimaster Ltd., et al. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that the Company breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. The dispute was subject to a contractual arbitration agreement, although the federal court retained jurisdiction over the matter pending completion of the arbitration. The arbitration was conducted in the spring of 2007.
     In September 2007, a Final Award was issued in the arbitration. The arbitrator ruled that Polimaster failed to prove its claims and was not entitled to any relief; that the Company had proven its counterclaims and was awarded damages of approximately $2.4 million; and that as the prevailing party, the Company was entitled to recover costs in the amount of $46,000. On October 5, 2007, RAE Systems filed a motion to confirm the Final Award. On October 17, 2007, Polimaster filed an opposition to RAE Systems’ motion to confirm the Final Award and filed its own motion to vacate the Final Award. Both motions were heard on December 7, 2007, and the district court confirmed the Final Award in an order dated February 25, 2008. Polimaster appealed from the district court’s order confirming the arbitration award in Polimaster Ltd. et al. v. RAE Systems Inc., No. 08-15708. The appeal is currently pending in the United States Court of Appeals for the Ninth Circuit. Briefing on the appeal has been completed by both sides. Oral argument has not been scheduled at this time.
     When the district court confirmed the Final Award in favor of RAE Systems it did not enter judgment, an omission the district court described as a non-substantive clerical error. On September 9, 2008, the court of appeal granted leave for the district court to correct this clerical error. On January 23, 2009, the district court entered judgment in favor of RAE Systems and against Polimaster, and included in the judgment post-arbitration/pre-judgment interest and post-judgment interest. Polimaster has appealed the inclusion of these two interest components in the judgment, in Polimaster Ltd. et al. v. RAE Systems Inc., No. 09-15369, and briefing on the appeal is in progress.
     On May 14, 2009, Polimaster and RAE Systems entered a First Amended And Restated Stipulation And Order Re Stay Of Execution Of Judgment In Favor Of RAE Systems Inc. (the “stipulation”), pursuant to which Polimaster wire transferred $1.4 million to the client trust account of RAE Systems’ counsel McLeod, Witham & Flynn LLP, and agreed to wire transfer an additional $116,224.25 per month until the entire amount deposited equals the amount of the judgment (approximately $2.8 million) plus accrued interest at the judgment rate of 0.43 percent per annum. Pursuant to the stipulation, the amounts transferred by Polimaster are being maintained in the client trust account of McLeod, Witham & Flynn LLP, and shall not be distributed to RAE Systems or Polimaster, until the Ninth Circuit has ruled on Polimaster’s appeal (Nos. 08-15708 and 09-15369). McLeod, Witham & Flynn LLP shall release

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the funds in the account to RAE Systems and/or Polimaster within seven days of the Ninth Circuit’s final ruling on the appeal, in accordance with the Ninth Circuit’s decision. Polimaster is currently in compliance with the payment schedule provided in the stipulation. If RAE Systems is successful on appeal, it is expected that the Company would receive approximately $1.6 million, net of attorneys’ fees and expenses.
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.
We have discovered potential violations of the Foreign Corrupt Practices Act, the resolution of which could have a material adverse impact on our financial condition and results of operations.
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 have made a voluntary disclosure to the DOJ and the SEC regarding the results of our investigation. We have 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 are cooperating with the DOJ and the SEC in connection with their review of the matter, including responding to requests for information and are seeking to achieve a negotiated resolution of all matters pertaining to the transactions in question. However, the timing and final outcome of this or any future government investigation cannot be predicted with certainty and any indictment, conviction or material fine, debarment or settlement arising out of these investigations could have a material adverse affect on our business, financial condition, results of operation and future prospects.
Economic conditions could materially adversely affect our business.
     The financial turmoil that first rose last fall 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

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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 recorded net losses of $7.2 million, $14.7 million and $1.5 million for 2008, 2007 and 2006, 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 return to 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. In addition, 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 continue to incur losses, any particular financial event could result in a relatively large change in our financial results or could be the difference between us having a profit or a loss for the particular quarter in which it occurs.
We may require additional capital in the future, which may not be available or may only be available 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 (BW Technologies), 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, 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

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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 particular, given the complexity of our international operations relative to our size, our compliance costs are expected to continue to result in comparatively high general and administrative expenses as a percentage of our revenue.
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.
     In our 2006 annual report on Form 10-K, management identified one material weakness relating to assurance that information from our Chinese subsidiaries has been properly adjusted to generally accepted accounting principles in the United States of America (“U.S. GAAP”) for inclusion in our annual or interim financial statements. As a consequence, beginning with the first quarter of 2007, management of the Company initiated steps to implement a number of compensating controls and remediation measures to improve the level of assurance to ensure that the information from our Chinese subsidiaries had been properly adjusted to U.S. GAAP. As of December 31, 2007, our management concluded that the previously identified material weakness in our internal control over financial reporting had been remediated. Our internal control over financial reporting and management’s remediation efforts is available under the subheading “Management’s Report on Internal Control over Financial Reporting”, in our annual report of Form 10-K and under the subheading “Controls and Procedures” therein.
     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.
     Our business is dependent in part upon government funded projects. 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

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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, 2008 and 2007, approximately 43% and 46% of our revenues, respectively, were from sales to customers located in Asia and approximately 16% and 13% 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, 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;

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•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, 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.

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The government of China may change or even reverse its policies of promoting private industry and foreign investment, in which case our assets and operations may be at risk.
     We currently manufacture and sell a significant portion of our components and products in China. Our existing and planned operations in China are subject to the general risks of doing business internationally and the specific risks related to the business, economic and political conditions in China, which include the possibility that the central government of China will change or even reverse its policies of promoting private industry and foreign investment in China. Many of the current reforms which support private business in China are unprecedented or experimental. Other political, economic and social factors, such as political changes, changes in the rates of economic growth, unemployment or inflation, or in the disparities of per capita wealth among citizens of China and between regions within China, could also lead to further readjustment of the government’s reform measures. It is not possible to predict whether the Chinese government will continue to be as supportive of private business in China, nor is it possible to predict how future reforms will affect our business.
Any failure to adequately protect and enforce our intellectual property rights could harm our business.
     We regard our intellectual property as critical to our success. We rely on a combination of patent, trademark, copyright, trade secret laws and non-disclosure agreements and confidentiality procedures to protect our proprietary rights. Notwithstanding these laws, we may be unsuccessful in protecting our intellectual property rights or in obtaining patents or registered trademarks for which we apply. Although processes are in place to protect our intellectual property rights, we cannot guarantee that these procedures are adequate to prevent misappropriation of our current technology or that our competitors will not develop technology that is similar to our own.
     While there is no single patent or license to technology of material significance to the Company, our ability to compete is affected by our ability to protect our intellectual property rights in general. For example, we have a collection of patents related to our photoionization detector technology, the first of which expires in 2012, and our ability to compete may be affected by any competing similar or new technology. In addition, if we lose the licensing rights to a patented or other proprietary technology, we may need to stop selling products incorporating that technology and possibly other products, redesign our products or lose a competitive advantage. We cannot ensure that our future patent applications will be approved or that our current patents will not be challenged by third parties. Furthermore, we cannot ensure that, if challenged, our patents will be found to be valid and enforceable. Any litigation relating to our intellectual property rights could, regardless of the outcome, have a material adverse impact on our business and results of operations.
We may face intellectual property infringement claims that might be costly to resolve and affect our results of operations.
     In connection with the enforcement of our own intellectual property rights, the acquisition of third-party intellectual property rights or disputes relating to the validity or alleged infringement of third-party rights, including patent rights, we have been, are currently and may in the future be subject to claims, negotiations or complex, protracted litigation. Intellectual property disputes and litigation are typically very costly and can be disruptive to our business operations by diverting the attention and energies of management and key technical personnel. Although we have successfully defended or resolved past litigation and disputes, we may not prevail in any ongoing or future litigation and disputes. We may incur significant costs in acquiring the necessary third party intellectual property rights for use in our products. Third party intellectual property disputes could subject us to significant liabilities, require us to enter into royalty and licensing arrangements on less favorable terms, prevent us from manufacturing or licensing certain of our products, cause severe disruptions to our operations or the markets in which we compete, or require us to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements, any one of which could seriously harm our business. For example, for the last several years we have been involved in a dispute with Polimaster Ltd. which required us to incur substantial professional fees. Although we ultimately prevailed, it is uncertain whether we will be able to recover any of the amounts awarded to us.
     Claims of this type, regardless of merit, can be time-consuming to defend, result in costly litigation, divert management’s attention and resources or require us to enter into royalty or license agreements. The terms of any such license agreements may not be available on reasonable terms, if at all, and the assertion or prosecution of any infringement claims could significantly harm our business.
Some of our products may be subject to product liability claims which could be costly to resolve and affect our results of operations.

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     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 retain 70% ownership. In August 2007, we determined to discontinue the Aegison and Securay businesses. 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, contingent liabilities or expenses related to goodwill recognition and other intangible assets, any of which could harm our business.
Our ownership interest in Renex will cause us to incur losses that we would not otherwise incur.
     We 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 own approximately 32% of our common stock and, accordingly, may exert substantial influence over the Company.

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     Our executive officers and directors, in the aggregate, beneficially own approximately 33% of our common stock as of September 30, 2009. 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. Submission of Matters to a Vote of Securities Holders
     None
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
NumberDescription of Document
31.1Certification 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.
31.2Certification 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.
32.1Certification 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.
32.2Certification 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.

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SIGNATURES
     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
November 6, 2009January 28, 2010
     
 RAE SYSTEMS INC.
 		 
 By:  /s/ Randall Gausman   
  Randall Gausman  
  Vice President and Chief Financial Officer  

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Exhibit Index
Exhibit
NumberDescription of Document
31.1Certification 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.
31.2Certification 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.
32.1Certification 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.
32.2Certification 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.

402