Rae Systems 10Q 2005 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

¨	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		77-0588488
Delaware		77-0588488
(State or other jurisdiction of incorporation)		(I.R.S. Employer Identification No.)

3775 North First Street

San Jose, California 95134

(Address of principal executive offices)

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

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


Title of each class		Name of each exchange on which registered
Common Stock, $.001 par value		The American Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

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

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


Class		Outstanding at October 28, 2005
Common Stock, $0.001 Par Value		57,822,843

RAE Systems Inc.

INDEX


Part I. Financial Information				1

	Item 1.	Financial Statements (Unaudited)		1

		(a)	RAE Systems Inc. Condensed Consolidated Balance Sheets at September 30, 2005 and December 31, 2004	1

		(b)	RAE Systems Inc. Condensed Consolidated Statements of Operations for the three-month and nine-month periods ended September 30, 2005 and 2004	2

		(c)	RAE Systems Inc. Condensed Consolidated Statements of Cash Flows for the nine-month periods ended September 30, 2005 and 2004	3

		(d)	RAE Systems Inc. Notes to Condensed Consolidated Financial Statements	4

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		10

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk		20

	Item 4.	Controls and Procedures		30

Part II. Other Information				34

	Item 1.	Legal Proceedings		34

	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		34

	Item 3.	Defaults Upon Senior Securities		34

	Item 4.	Submission of Matters to a Vote of Security Holders		34

	Item 5.	Other Information		34

	Item 6.	Exhibits		35

Signatures				36

Exhibit Index

Exhibit

PART I. Financial Information

Item 1. Financial Statements

RAE Systems Inc

Condensed Consolidated Balance Sheets

(Unaudited)


	September 30, 2005			December 31, 2004
Assets
Current Assets:
Cash and cash equivalents	$	14,584,000		$	21,566,000
Short-term investments		12,983,000			6,745,000
Notes receivable		780,000			535,000
Accounts receivable, net of allowance for doubtful accounts of $879,000 and $665,000, respectively		11,322,000			9,934,000
Accounts receivable from affiliate		112,000			119,000
Inventories, net		9,434,000			7,815,000
Prepaid expenses and other current assets		2,258,000			1,558,000
Deferred income taxes		2,403,000			1,578,000

Total Current Assets		53,876,000			49,850,000

Property and Equipment,net		14,611,000			11,287,000
Long-Term Investments		1,816,000			4,500,000
Intangible Assets		1,915,000			2,150,000
Deposits and Other Assets		1,033,000			1,172,000
Investment in Unconsolidated Affiliate		—			156,000

Total Assets	$	73,251,000		$	69,115,000

Liabilities, Minority Interest in Consolidated Entities and Shareholders’ Equity
Current Liabilities:
Accounts payable	$	4,354,000		$	3,449,000
Accrued liabilities		5,566,000			5,582,000
Notes payable		827,000			423,000
Income taxes payable		337,000			417,000
Other current liabilities		60,000			—
Current portion of deferred revenue		1,874,000			1,122,000

Total Current Liabilities		13,018,000			10,993,000

Deferred Revenue, net of current portion		270,000			240,000
Deferred Tax Liability		109,000			—
Other Long-term Liabilities		1,730,000			145,000
Long-term Notes Payable		890,000			1,260,000

Total Liabilities		16,017,000			12,638,000

Commitments and Contingencies
Minority Interest in Consolidated Entities		4,089,000			4,288,000
Shareholders’ Equity:
Common stock, $0.001 par value; 200,000,000 shares authorized; 57,810,143 and 57,315,175 shares issued and outstanding, respectively		58,000			57,000
Additional paid-in capital		55,348,000			53,660,000
Accumulated other comprehensive income		254,000			137,000
Accumulated deficit		(2,515,000	)		(1,665,000	)

Total Shareholders’ Equity		53,145,000			52,189,000

Total Liabilities, Minority Interest in Consolidated Entities and Shareholders' Equity	$	73,251,000		$	69,115,000

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc

Condensed Consolidated Statements of Operations

(Unaudited)


	Three months ended September 30,						Nine months ended September 30
	2005			2004			2005			2004
Net Sales	$	16,152,000		$	12,229,000		$	42,024,000		$	30,504,000
Cost of Sales		6,494,000			4,717,000			16,837,000			11,556,000

Gross Margin		9,658,000			7,512,000			25,187,000			18,948,000

Operating Expenses:
Sales and marketing		4,346,000			2,772,000			12,131,000			7,075,000
Research and development		1,214,000			1,063,000			3,615,000			2,965,000
General and administrative		3,256,000			2,070,000			9,225,000			5,926,000
Loss on abandonment of lease		—			—			2,027,000			—

Total Operating Expenses		8,816,000			5,905,000			26,998,000			15,966,000

Operating Income/(Loss):		842,000			1,607,000			(1,811,000	)		2,982,000

Other Income (Expense):
Interest income		176,000			62,000			467,000			223,000
Interest expense		(3,000	)		(3,000	)		(37,000	)		(11,000	)
Other, net		57,000			20,000			2,000			52,000
Equity in loss of unconsolidated affiliate		(4,000	)		(111,000	)		(156,000	)		(260,000	)

Total Other Income/(Loss)		226,000			(32,000	)		276,000			4,000

Income/(Loss) Before Income Taxes and Minority Interest		1,068,000			1,575,000			(1,535,000	)		2,986,000
Income Tax Provision/(Benefit)		699,000			463,000			(486,000	)		906,000

Income/(Loss) Before Minority Interest		369,000			1,112,000			(1,049,000	)		2,080,000
Minority interest in loss / (income) of consolidated entities		28,000			(83,000	)		199,000			(124,000	)

Net Income/(Loss)	$	397,000		$	1,029,000		$	(850,000	)	$	1,956,000

Basic Earnings/(Loss) Per Common Share	$	0.01		$	0.02		$	(0.01	)	$	0.04

Diluted Earnings/(Loss) Per Common Share	$	0.01		$	0.02		$	(0.01	)	$	0.03

Weighted-average common shares outstanding		57,789,819			56,801,158			57,346,103			55,373,290
Stock options & warrants		1,542,125			3,147,012			—			3,131,578

Diluted weighted-average common shares outstanding		59,331,944			59,948,170			57,346,103			58,504,868

See accompanying notes to condensed consolidated financial statements.

RAE Systems Inc

Consolidated Statements of Cash Flows

(Unaudited)


	Nine Months ended September 30,
	2005			2004
Increase (Decrease) in Cash and Cash Equivalents
Cash Flows From Operating Activities:
Net Income	$	(850,000	)	$	1,956,000
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,483,000			665,000
Provision for doubtful accounts		214,000			10,000
Loss on disposal of fixed assets		17,000			—
Inventory reserve		255,000			314,000
Compensation expense under fair value accounting for common stock options		1,394,000			881,000
Common stock warrants granted for services		—			124,000
Equity in loss of unconsolidated affiliate		156,000			260,000
Minority interest in loss/(gain) of consolidated subsidiaries		(199,000	)		113,000
Deferred income taxes		(825,000	)		(127,000	)
Loss on abandonment of lease		2,027,000			—
Accounts receivable		(1,602,000	)		(2,303,000	)
Accounts receivable from affiliate		7,000			(100,000	)
Notes receivable		(245,000	)		(503,000	)
Inventories		(1,874,000	)		(3,164,000	)
Prepaid expenses and other current assets		(700,000	)		(1,586,000	)
Accounts payable		905,000			616,000
Accounts payable to affiliate		—			(594,000	)
Accrued liabilities		(487,000	)		1,566,000
Income taxes payable		(80,000	)		(17,000	)
Deposits and other		139,000			—
Other liabilities		97,000			46,000
Deferred revenue		782,000			878,000

Net Cash Provided By/(Used in) Operating Activities		614,000			(965,000	)

Cash Flows From Investing Activities:
Purchases of Investments		(3,554,000	)		(15,000,000	)
Acquisition of property and equipment		(4,488,000	)		(2,089,000	)
Proceeds from business acquisition		—			683,000
Purchases of Intangible assets		—			(326,000	)
Deposits and other		—			89,000

Net Cash Used In Investing Activities		(8,042,000	)		(16,643,000	)

Cash Flows From Financing Activities:
Bank borrowings		—			(120,000	)
Notes payable - related party		34,000			—
Proceeds from the exercise of stock options and warrants		295,000			408,000
Proceeds from the sale of common stock		—			32,160,000
Offering costs		—			(370,000	)
Payment on capital lease obligation		—			(90,000	)

Net Cash Provided By Financing Activities		329,000			31,988,000

Effect of exchange rate changes		117,000			12,000
Net (Decrease) Increase in Cash and Cash Equivalents		(6,982,000	)		14,392,000
Cash and Cash Equivalents, beginning of period		21,566,000			7,512,000

Cash and Cash Equivalents, end of period	$	14,584,000		$	21,904,000

See accompanying notes to condensed consolidated financial statements.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1. Basis of Presentation

The financial information presented in this Form 10-Q is not audited and is not necessarily indicative of the future consolidated financial position, results of operations or cash flows of RAE Systems Inc. (the “Company” or “RAE”). The Unaudited financial statements contained in this Form 10-Q have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position, results of operations and its cash flows for the stated periods, in conformity with the accounting principles generally accepted in the United States of America. Certain prior year amounts have been reclassified to conform to the current year presentation.

Note 2. Summary of Significant Accounting Policies

Principles of Consolidation

The Consolidated Financial Statements include the accounts of RAE and its subsidiaries as described below. RAE owns 100% of RAE Systems Europe ApS (“RAE Europe”) and RAE Systems (Asia) Limited (“RAE Asia”). RAE Europe is a Denmark corporation which distributes and provides services for RAE’s products in Europe, Australia and New Zealand, and throughout the Middle East. RAE Europe owns (i) 100% of RAE United Kingdom Limited (“RAE UK”) and (ii) 49% of RAE France (“RAE France”). Both RAE UK and RAE France are distribution companies. RAE Asia is a Hong Kong holding company. RAE Asia owns (i) 100% of RAE Systems Shanghai Incorporated (“RAE Shanghai”), (ii) 100% of RAE Systems Hong Kong Limited (“RAE Hong Kong”) and (iii) 64% of RAE KLH (Beijing) Co., Ltd, formerly known as Beijing Ke Li Heng Security Equipment Co., Ltd (“KLH”). RAE Shanghai, which is incorporated in Jiading, Shanghai, designs and manufactures RAE’s products for final assembly and testing in the United States. RAE Hong Kong distributes and provides services for RAE’s products in Asia and the Pacific Rim. KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment and also serves as a distributor of RAE products. All significant intercompany accounts and transactions have been eliminated.

Revenue Recognition

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectibility 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 recognizes revenue upon shipment to its distributors in accordance with standard contract terms that pass title to all goods upon delivery to a common carrier (FOB factory) and provides for sales returns under standard product warranty provisions. Service revenues relating to maintenance services performed by the Company are recognized as earned based upon contract terms, which is generally ratably over the term of service. Net revenues include amounts billed to customers in sales transactions for shipping and handling, as prescribed by the Emerging Issues Task Force Issue (“EITF”) No. 00-10Accounting for Shipping and Handling Fees and Costs. Shipping fees are included in the revenue and shipping costs are included in the cost of goods sold.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Estimates are used for, but not limited to, allowance for doubtful accounts, inventory allowances, warranty costs, contingencies and taxes. Actual results could differ materially from those estimates. The following critical accounting policies are impacted significantly by judgments, assumptions, and estimates used in the preparation of the condensed consolidated financial statements.

The allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. While management uses the best information available in making its determination, the ultimate collectibility of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there were a deterioration of a major customer’s credit worthiness or if actual defaults were higher than what has been experienced historically or if the Company’s estimates of the collectibility of amounts due were determined to be overstated, the Company’s operating results could be adversely affected.

Inventories are stated at the lower of cost (moving weighted average method) or market. Inventory purchases are typically based on estimated future demand. In the event of a sudden and significant decrease in demand for RAE’s products, or if there were a higher occurrence of inventory obsolescence due to changing technology and customer requirements, RAE’s gross margins could be adversely affected.

Management accounts for its debt and equity investments as held-to-maturity. These include United States treasury bills, United States corporate bonds and notes, United States government agency bonds, and United States treasury notes ranging in maturity dates from October 2005 through April 2007.

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

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

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

Earnings Per Share

The Company applies the provisions of FASB SFAS No. 128, Earnings Per Share. SFAS No. 128 provides for the calculation of basic and diluted earnings per share. Basic earnings per share include no dilution and are computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity. Anti-dilution provisions of SFAS No. 128 require consistency between diluted per-common-share amounts and basic per-common-share amounts in loss periods. Incremental shares attributable to the assumed exercise of 2,672,732 options and warrants would have increased the diluted shares outstanding by 1,542,125 and 1,668,941 for the three-month and nine-month period ended September 30, 2005, respectively. Warrants and options outstanding to purchase 872,750 shares at exercise prices between $4.16 per share and $7.81 per share, would not have been included in the computation of diluted earnings per share for the three-month and nine-month periods ended September 30, 2005, respectively because the exercise prices were greater than the average market price of the common stock. However, in the net loss per share computation, the effect of options to purchase shares of common stock has been excluded, as their effect is anti-dilutive.

Stock-Based Compensation

The Company applies SFAS 123,Accounting for Stock-Based Compensation. for the stock option plans. the Company estimates the fair value of stock options at the grant date using the Black-Scholes option valuation model with the following assumptions used:


	As of September 30, 2005		As of September 30, 2004
Average expected life of options in years	5		5
Risk free interest rate	4.32	%	3.53	%
Volatility (3 year rolling average)	135	%	130	%
Dividend yield	0		0

Total stock-based employee compensation for the three months ended September 30, 2005 and 2004 was $436,000 and $213,000 respectively. Total stock-based employee compensation for the nine months ended September 30, 2005 and 2004 was $1,394,000 and $881,000 respectively.

Recent Accounting Announcements

In May 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections.” SFAS No. 154 replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3,“Reporting Accounting Changes in Interim Financial Statements,” and changes the requirements for the accounting and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. According to SFAS No. 154, when financial statements are restated to correct an error, the entity shall disclose that its previously issued financial statements have been restated along with a description of the nature of the error. Also, the entity shall disclose the effect of the correction on each financial statement line item and any per-share amounts affected for each prior period presented and the cumulative effect of the change on retained earnings or other appropriate components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented. This Statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 is not expected to have an impact on the Company’s consolidated results of operations, financial position or cash flows.

In March 2005, the FASB issued FASB Interpretation No. 47 (“FIN 47”), an interpretation of FASB No. Statement No.143,Accounting for Conditional Asset Retirement Obligations. FIN 47 clarifies that the term conditional asset retirement obligation, as used in FASB Statement No. 43, refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. Uncertainty about the timing and (or) method of settlement of a conditional asset retirement obligation should be factored into the measurement of the liability when sufficient information exists. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. The Company is currently assessing the impact of this interpretation on the Company’s consolidated financial statements.

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R revises SFAS No. 123, “Accounting for Stock-Based Compensation” and generally requires the cost associated with employee services received in exchange for an award of equity instruments be measured based on the grant-date fair value of the award and recognized in the financial statements over the period during which employees are required to provide services in exchange for the award. SFAS No. 123R also provides guidance on how to determine the grant-date fair value for awards of equity instruments as well as alternative methods of adopting its requirements. On April 14, 2005, the Securities and Exchange Commission amended the compliance dates for SFAS No. 123R. As a result, SFAS No. 123R will be effective for the Company beginning January 1, 2006 and applies to all outstanding and unvested share-based payment awards at a company’s adoption date. The Company is currently assessing the impact of this statement on the Company’s consolidated financial statements.

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets” (“SFAS No. 153”). SFAS No. 153 amends the guidance in APB Opinion No. 29, “Accounting for Non-monetary Transactions” to eliminate certain exceptions to the principle that exchanges of non-monetary assets be measured based on the fair value of the assets exchanged. SFAS No. 153 eliminates the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. This statement is effective for non-monetary asset exchanges in fiscal years beginning after June 15, 2005. The adoption of SFAS No. 153 is not expected to have an impact on the Company’s consolidated results of operations, financial position or cash flows.

In November 2004, the FASB issued SFAS Statement No. 151, “Inventory Costs,” an amendment of the Accounting Research Bulletin (ARB) No. 43, Chapter 4. Under FASB Statement No. 151, all abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. SFAS No. 151 will be effective for the Company beginning January 1, 2006. The adoption of this pronouncement is not expected to have a material impact on the Company’s consolidated results of operations, financial position or cash flows.

In October 2004, the FASB issued FASB Staff Position (FSP) No. 109-1, Application of FASB Statement No. 109, “Accounting for Income Taxes,” to the Tax Deduction on Qualified Production Activities Provided by the American Job Creation Act of 2004, which provides a tax deduction of up to nine percent (when fully phased-in) of the lesser of (a) “qualified production activities income” or taxable income (after the deduction for the utilization of any net operating loss carry-forwards). FSP No. 109-1 was effective on December 21, 2004. The adoption of this pronouncement did not have a material impact on the Company’s results of operations, financial position or cash flows.

In October 2004, the FASB issued FSP No. 109-2 Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Job Creations Act of 2004 for a special one-time

tax deduction of 85 percent of certain foreign earnings that are repatriated in either an enterprise’s last tax year that began before the enactment date, or the first tax year that begins during the one-year period beginning on the date of enactment. FSP No. 109-2 was effective on December 21, 2004. The adoption of this pronouncement did not have a material impact on the Company’s results of operations, financial position or cash flows.

Note 3. Mergers and Acquisitions

On May 27, 2004, the Company acquired a 64% interest in Beijing Ke Li Heng Security Equipment Co., Ltd. (“KLH”) for $9 million in cash. KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment. The results of KLH’s operations have been included in the consolidated financial statements of the Company since May 27, 2004.

Note 4. Commitments and Contingencies

Royalty

In June 2004, the Company entered into an agreement with REnex Technologies Ltd. (“REnex”) to develop six prototype RAELink modems for a price of $107,000 and to pay a royalty fee of 7.5% for all products sold for which REnex’s intellectual property is used. As of September 30, 2005, the Company has made a payments to REnex in the amount $124,000 and has accrued an additional $21,000 that will be paid during the fourth quarter of 2005. The Company signed an additional agreement with REnex on August 5, 2005, for the development of a controller, a specialized modem, certain firmware and a network evaluation. The Company expects to pay REnex approximately $157,000 for these developments as well as a royalty of 7% on future products sold as payment for development of the modem. The Company has a 36% interest in REnex and accounts for it under the equity method with effect from January 1, 2002

The Company also has an agreement with Draeger Safety Inc. that requires the Company to pay 7.5% of sales, after selling commissions, for certain consumable items sold by RAE. The Company has paid $12,000 to Draeger Safety, Inc. during 2005 under this agreement.

Litigation

From time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. On October 5, 2005 the Company was served with a summons related to an ex-employee’s claim for stock options, which the Company intends to oppose. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

Operating leases

As of May 31, 2005, the majority of the Company’s U.S. operations have been transferred to its new facility in San Jose, California. During the quarter ended June 30, 2005, the Company recorded a one-time charge of $2.0 million for abandonment of the Company’s lease on its former headquarters and U.S. manufacturing site in Sunnyvale, California. The one-time charge of $2.0 million was based on the estimated cash flow to maintain the abandoned facility and rental obligation through the end of the lease term in 2009, discounted at an interest rate of 4.85 percent. Based on broker estimates of current real estate market conditions and other factors, it was considered more likely than not that any potential sublease income would be offset by brokerage, refurbishment and other costs to make the facility ready for a sublease.

Note 5. Guarantees

The Company has contractual obligations under its operating leases in the amount of $2.9 million. The Company recorded a liability of $2.0 million for abandonment of the Company’s lease on our former headquarters and U.S. manufacturing site in Sunnyvale, California.

The Company is permitted under Delaware law and in accordance with its 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. As a result of our insurance policy coverage, the Company believes the fair value of these indemnification agreements is minimal.

In the Company’s sales 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 incurred or paid any amounts to settle claims or defend lawsuits for indemnification of customers.

Note 6. Warranty Reserves

Product warranty liabilities are provided for as described in Note 2 to these condensed consolidated financial statements. Following is a summary of the changes in these liabilities during the nine-month periods ended September 30, 2005 and 2004:


	Nine Months Ended September 30,
	2005			2004
Balance beginning of period	$	490,000		$	358,000
Provision for products sold during period		106,000			262,000
Adjustment of prior period provision		(91,000	)
Claims paid during the period		(166,000	)		(140,000	)

Balance, end of period	$	339,000			480,000

Note 7. Related Party Transactions

(a) REnex Technologies, Ltd

In June 2004, the Company entered into an agreement with REnex to develop six prototype RAELink modems for a price of $107,000 and to pay a royalty fee of 7.5% for all products sold for which REnex’s intellectual property is used. As of September 30, 2005, the Company has made a payments to REnex in the amount $124,000 and has accrued an additional $21,000 that will be paid during the fourth quarter of 2005. The Company signed an additional agreement with REnex on August 5, 2005, for the development of a controller, a specialized modem, certain firmware and a network evaluation. The Company expects to pay REnex approximately $157,000 for these developments as well as a royalty of 7% on future products sold as payment for development of the modem. The Company has a 36% interest in REnex and accounts for it under the equity method with effect from January 1, 2002.

(b) Shanghai Simax Technology Co. Ltd

In August 2004, the Company entered into an agreement with Shanghai Simax Technology Co. Ltd. (“Simax”) to finance the design of a benzene-specific gas detection module (GC-PID) in the amount of $100,000. To date, $50,000 has been paid to Simax and the balance is expected to be paid during the fourth quarter of 2005. RAE has the right to use the technology in any of its future products. The Company is to pay a royalty fee of 5% of all GC-PID products sold. To date, there have been no royalty payments for this technology. Dr. Peter C. Hsi, the Company’s Chief Technology Officer was acting General Manager of Simax from March 2003 until his resignation in December 2004. Dr. Hsi had no equity ownership in Simax.

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 section entitled “Factors That May Affect Future Results” in this Form 10-Q. The following discussion should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Form 10-Q.

Overview

We are a leading global developer and manufacturer of rapidly-deployable, multi-sensor chemical detection monitors and networks for homeland security and industrial applications. In addition, we offer a full line of portable single-sensor chemical and radiation detection products. We were founded in 1991 to develop technologies for the detection and early warning of hazardous materials. The market for our products has evolved from being strictly focused on environmental and industrial monitoring to now encompassing public safety and the threat of terrorism.

In May 2004, we acquired a 64% interest in KLH, a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment, for $9 million in cash. As a result, our sales into the Asia market increased as a percentage of total net sales from 26% for the three-month period ended September 30, 2004 to 33% for the three-month period ended September 30, 2005. Excluding the impact of KLH, Company sales in North America and Europe continued to grow, primarily from the sales of our patented photoionization detection (“PID”) products as well as our integrated wireless technology.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates are used for, but not limited to, allowance for doubtful accounts, inventory allowances, warranty costs, contingencies and taxes. Actual results could differ materially from those estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectibility 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 recognizes revenue upon shipment to its distributors in accordance with standard contract terms that pass title to all goods upon delivery to a common carrier (FOB factory) and provides for sales returns under standard product warranty provisions. Service revenues relating to maintenance services performed by the Company, which represent less than 5% of net revenues in each of 2004, 2003 and 2002, are recognized as earned based upon contract terms, which is generally ratably over the term of service. Net revenues include amounts billed to customers in sales transactions for shipping and handling, as prescribed by the Emerging Issues Task Force Issue (“EITF”) No. 00-10Accounting for Shipping and Handling Fees and Costs. Shipping fees are included in revenue and shipping costs are included in the cost of goods sold.

The allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there were a deterioration of a major customer’s credit worthiness, or if actual defaults were higher than what has been experienced historically, our estimates of the recoverability of amounts due could be overstated and our operating results could be adversely affected.

Inventories are stated at the lower of cost (moving weighted average method) or market. Inventory purchases are typically based on estimated future demand. In the event of a sudden and significant decrease in demand for our products, or if there were a higher occurrence of inventory obsolescence due to changing technology and customer requirements, we could be required to increase our inventory allowances.

We generally provide a one to three year limited warranty on the majority of our products and establish the estimated costs of fulfilling these warranty obligations at the time the related revenue is recorded. If we were to experience an increase in warranty claims compared to our historical experience, or costs of servicing warranty claims were greater than expectations on which the warranty reserve has been based, our operating results could be adversely affected.

We recognize deferred tax assets (future tax benefits) and liabilities for the expected future tax consequences of temporary differences between the book carrying amounts and the tax basis of assets and liabilities. The deferred tax assets and liabilities represent the expected future tax return consequences of those differences, which are expected to be either deductible or taxable when the assets and liabilities are recovered or settled.

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

We adopted the fair value recognition provisions of SFAS No. 123 for stock-based employee compensation effective January 1, 2003, under the modified prospective method as provided for in SFAS No. 148.

We consolidate all investments in which we have a controlling financial interest to comply with Financial Accounting Standards Board (“FASB”) Interpretation No. 46R. We also consolidate investments where we are the primary beneficiary of a variable interest entity.

Results of Operations

Three Months ended September 30, 2005 compared to the Three Months ended September 30, 2004

Total Net Sales


	Three Months Ended September 30,				Increase/(Decrease)
	2005		2004		Dollar		Percentage
Net sales	$	16,152,000	$	12,229,000	$	3,923,000	32	%

Net sales for the quarter ended September 30, 2005 increased by approximately $3.9 million over the same quarter in 2004. KLH net sales increased by $2.5 million or 107% for the quarter ended September 30, 2005 as compared to the same quarter in 2004. The sales growth for KLH was partially offset by a $280,000 decrease as RAE products previously sold by other affiliates in Asia were transferred to KLH. Sales in North America and Europe increased by $1.7 million or 18% for the quarter ended September 30, 2005 as compared to the same quarter in 2004.

Cost of Sales & Gross Margin


	Three Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
Cost of Sales	$	6,494,000		$	4,717,000		$	1,777,000	38	%
Gross Margin	$	9,658,000		$	7,512,000		$	2,146,000	29	%
Gross Margin as percentage of net sales		60	%		61	%

Cost of sales for the quarter ended September 30, 2005 increased by $1.8 million over the same quarter in 2004, of which approximately $1.4 million was due to the additional sales volume from KLH and $500,000 from additional volume in the rest of the Company’s units. Partially offsetting the volume increase was a $100,000 decrease in cost of goods sold for KLH due to increased sales of higher margin RAE and KLH-manufactured product versus distribution products. Gross margin as a percentage of net sales for the Company was 60% for the quarter ended September 30, 2005 versus 61% for the quarter ended September 30, 2004. While the Company benefited by about $100,000 from improvements in products sold in KLH, overall margins declined by about 1% as KLH sales increased as a portion of the Company’s overall sales. KLH has a significant distribution business with inherently lower margins.

Sales and Marketing Expense


	Three Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
Sales and marketing expense	$	4,346,000		$	2,772,000		$	1,574,000	57	%
Percentage of total net sales		27	%		23	%

Sales and marketing expenses increased by approximately $1.6 million, or 57%, in the third quarter of 2005 over the same period during 2004. The additional sales and marketing expense was primarily due to the increase of expenses from KLH in the amount of $1.2 million in support of increased sales. The balance of sales and marketing increases over second quarter of 2004 were largely related to $125,000 write-down of equipment used for customer demonstrations and $275,000 of additional operating expenses to support the increased sales in North America and Europe.

Research and Development Expense


	Three Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
Research and development expense	$	1,214,000		$	1,063,000		$	151,000	14	%
Percentage of total net sales		8	%		9	%

Research and development expenses increased by approximately $151,000, 14%, in the third quarter 2005 over the same period of 2004. The additional research and development expenses were primarily the result of increased expenses in Shanghai of $150,000 related to wireless and portable products, increased expenses at KLH of $150,000 which was primarily related to fixed systems and $125,000 of lower expenses in the U.S. and Asia.

General and Administrative Expense


	Three Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
General and administrative expense	$	3,256,000		$	2,070,000		$	1,186,000	57	%
Percentage of total net sales		20	%		17	%

General and administrative expenses increased by approximately $1.2 million in the third quarter 2005 over the same period during 2004. General and administrative expenses increased primarily due to increased KLH expenses of $200,000, principally related to facilities and insurance, plus additional expenses in the U.S. of $900,000. The increases in the U.S. were primarily related to audit and Sarbanes Oxley related fees of $275,000, increased legal and professional fees in the amount of $275,000 and non-cash charges related to the issuances of options and warrants in the amount of $125,000 as well as $225,000 of additional expenses related to insurance, depreciation, rent and information technology.

Other Income (Expense)


	Three Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
Interest income	$	176,000		$	62,000		$	114,000	184	%

Interest expense		(3,000	)		(3,000	)		—	—
Other, net		57,000			20,000			37,000	185	%

Equity in loss of unconsolidated Affiliate		(4,000	)		(111,000	)		107,000	96	%
Total other income/(loss)	$	226,000		$	(32,000	)	$	258,000	806	%
Percentage of total net sales		1	%		—	%

For the quarter ended September 30, 2005, we had Total other income of $226,000 as compared to a Total other loss of $32,000 for the quarter ended September 30, 2004, an increase of $258,000. The increase was due to an increase in interest income of $114,000 primarily from higher interest rates on investments, a $107,000 decrease in equity in loss of unconsolidated affiliate and a $37,000 increase in Other, net, mainly due to an $82,000 refund from a Chinese government education fund, offset primarily by currency exchange rate losses on China-based U. S. dollar account from a appreciation in the value of the RMB relative to the U.S. Dollar for the third quarter of 2005.

Income Taxes


	Three Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
Income tax (credit)/expense	$	699,000		$	463,000		$	236,000	51	%
Percent of pretax income		65	%		29	%

The effective tax rate for the quarter ended September 30, 2005 was 65% of pretax income, compared to 29% in the third quarter of 2004. We calculated our income tax provisions based on the estimated annual effective tax rate for the Company. However, as required by FASB Interpretation 18, the impact of the discrete lease abandonment on our former Sunnyvale headquarters, a $2 million loss recorded in the second quarter, was not included in our third quarter tax provision calculation. As a result, high permanent non-tax deductible items resulted in a high effective tax rate in the third quarter. Including this discrete item, our year-to-date effective tax rate was 36% compared to 32% in 2004.

Minority interest in loss/(income) of consolidated entities


	Three Months Ended September 30,					Increase/(Decrease)
	2005		2004			Dollar		Percentage
Minority interest in loss/(gain) of consolidated entities	$	28,000	$	(83,000	)	$	111,000	n/a

For the quarter ended September 30, 2005, we recognized $28,000 in net loss allocated to minority interests consisting of the 36% minority interest’s share in KLH, partially and our 51% majority investor’s share in the net income of RAE France. During the same quarter of 2004, we recognized $83,000 in net gain mainly representing the 36% minority interest’s share in the net income of KLH.

Net Income


	Three Months Ended September 30,				Increase/(Decrease)
	2005		2004		Dollar			Percentage
Net (loss)/ income	$	397,000	$	1,029,000	$	(632,000	)	(61	)%

Net income for the quarter ended September 30, 2005 was $397,000. For the same period in 2004, we had net income of $1,029,000. The main reasons for the $632,000 decrease in net income were the additional legal expenses, relating to litigation, and the incremental accounting fees associated with Sarbanes-Oxley along with generally increased operating expenses associated with growth of our infrastructure.

Nine Months ended September 30, 2005 compared to the Nine Months ended September 30, 2004

Total Net Sales


	Nine Months Ended September 30,				Increase/(Decrease)
	2005		2004		Dollar		Percentage
Net sales	$	42,024,000	$	30,504,000	$	11,520,000	38	%

Net sales for the nine-month period ended September 30, 2005 increased by $11.5 million over the same period in 2004. KLH net sales increased by $7.7 million for the nine-month period ended September 30, 2005 as compared to the same period in 2004 due to the inclusion of nine months of sales in 2005 versus four months in the same period in 2004 and a growth in overall KLH sales. The growth for KLH was partially offset by a $1.6 million decrease as RAE products previously sold by other affiliates in Asia were transferred to KLH. In addition, sales in North America and Europe increased by approximately $5.4 million, or 22%,for the quarter ended September 30, 2005 as compared to the same quarter in 2004.

Cost of Sales & Gross Margin


	Nine Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
Cost of Sales	$	16,837,000		$	11,556,000		$	5,281,000	46	%
Gross margin	$	25,187,000		$	18,948,000		$	6,239,000	33	%
Gross margin as percentage of net sales		60	%		62	%

Cost of sales for the nine-month period ended September 30, 2005 increased by approximately $5.3 million, or 47%, over the same period in 2004, of which approximately $4.7 million was due to the addition of sales from our KLH investment as only four months of results were included in last year’s nine-month period as well as from increases in KLH’s sales of both products of its own and RAE manufacture. Approximately $1.2 million of the increase in product cost was due to sales increases in all other units. Partially offsetting the volume product cost increases were reductions of approximately $300,000 in the cost of RAE products from manufacturing efficiencies and $300,000 from KLH’s increasing percentage of higher margin products of their own and RAEs’ manufacture. Gross margin as a percentage of net sales for the Company was 60%. Gross margin as a percentage of net sales for KLH was 43% for the nine-month period ended September 30, 2005. While the Company benefited from manufacturing efficiencies from products produced in its Shanghai facilities, the impact of our increased percentage of KLH sales reduced the consolidated gross margin for the nine-month period ended September 30, 2005 by two percentage points. KLH has a significant distribution business with inherently lower margins.

Sales and Marketing Expense


	Nine Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
Sales and marketing expense	$	12,131,000		$	7,075,000		$	5,056,000	71	%
Percentage of total net sales		29	%		23	%

Sales and marketing expenses increased by approximately $5.1 million, or 71%, in the nine-month period ended September 30, 2005 over the same period during 2004. Approximately $3.3 million of the increase was attributable to an increase in KLH sales and marketing expenses for the nine-month period ended September 30, 2005 versus four months included during the same timeframe of 2004 as well as from higher infrastructure costs to support KLH’s growth. Sales and marketing expenses also increased due to severance expense of $200,000 and operating expenses of approximately $1.6 million across the sales and marketing organizations to support the increased sales.

Research and Development Expense


	Nine Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
Research and development expense	$	3,615,000		$	2,965,000		$	650,000	22	%
Percentage of total net sales		9	%		10	%

Research and development expenses increased by approximately $650,000, or 22%, in the first nine months of 2005 over the same period during 2004. The increase was primarily from research and development expenses in KLH of approximately $350,000 for improvement of their fixed systems

products as well as inclusion of nine months of expenses during 2005 versus four months during the same period in 2004. In addition there was $400,000 of increased spending on new product development for wireless and portable products in Shanghai partially offset by a reduction of expenses in the U.S and Asia.

General and Administrative Expense


	Nine Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar		Percentage
General and administrative expense	$	9,225,000		$	5,926,000		$	3,299,000	56	%
Percentage of total net sales		22	%		19	%

General and administrative expenses increased by approximately $3.3 million, or 56%, in the first nine months of 2005 over the same period during 2004. The addition of KLH added approximately $850,000 to our general and administrative expenses covering the cost of additional personnel and other operating costs for the nine-month period ended September 30, 2005 as only four months of their expenses were reported in the same period of 2004. The KLH increase also was the result of additions to personnel to support additional sales The remainder of the increase in general and administrative expenses was primarily due to costs of increased legal and professional fees, including charges related to Section 404 of the Sarbanes-Oxley Act, of $1.1 million, non-cash charges related to the issuances of options and warrants in the amount of $515,000, outside services in the amount of $275,000, and $575,000 increased allocations charges to cover insurance, depreciation, rent, and information technology expenses.

Loss on Abandonment of Lease


	Nine Months Ended September 30,					Increase/(Decrease)
	2005			2004		Dollar
General and administrative expense	$	2,027,000		$	0	$	2,027,000
Percentage of total net sales		5	%

The loss on abandonment of lease cost of approximately $2.0 million in 2005 was associated with our abandonment of our former U.S. manufacturing and headquarters leased site in Sunnyvale, California. We completed our move to a larger headquarters and U.S. manufacturing facility during the second quarter of 2005 to support our increased growth.

Other Income (Expense)


	Nine Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar
Interest income	$	467,000		$	223,000		$	244,000

Interest expense		(37,000	)		(11,000	)		(26,000	)
Other, net		2,000			52,000			(50,000	)

Equity in loss of unconsolidated affiliate		(156,000	)		(260,000	)		104,000

Total other income	$	276,000		$	4,000		$	272,000
Percentage of total net sales		1	%		—	%

For the nine-month period ended September 30, 2005, we had total other income of $276,000 as compared to $4,000 for the nine-month period ended September 30, 2004, an increase of $272,000. The increase was due to an increase in interest income of $244,000 primarily from higher interest rates on investments, partially offset by a $26,000 increase in interest expense and a $50,000 cost increase in Other, net mainly due to net currency exchange rate losses related the appreciation of the RMB relative to the U.S. Dollar during the third quarter of 2005 There was also a $104,000 decrease in equity in loss of our unconsolidated affiliate.

Income Taxes


	Nine Months Ended September 30,						Increase/(Decrease)
	2005			2004			Dollar			Percentage
Income tax (credit)/expense	$	(486,000	)	$	906,000		$	(1,392,000	)	154	%
Percent of pretax income		32	%		30	%

For the nine-month periods ended September 30, 2005 and 2004, we recognized a tax benefit of $486,000 and tax expense of $906,000, respectively. The tax benefit is primarily from the operating losses which were largely the result of the abandonment of the lease on our former Sunnyvale headquarters in the second quarter. As of September 30, 2005 and 2004, our year to date effective rate was 36% and 32% respectively. The increase was primarily due to higher permanent non tax-deductible items which resulted in a higher effective tax rate.

Minority interest in loss/(gain) of consolidated entities


	Nine Months Ended September 30,					Increase/(Decrease)
	2005		2004			Dollar			Percentage
Minority interest in loss/(gain) of consolidated entities	$	199,000	$	(124,000	)	$	(323,000	)	(260	)%

For the nine-month period ended September 30, 2005, we recognized $199,000 in net loss allocated to minority interests, of which related to the 36% minority interest’s share of KLH and our 51% majority investor’s share in RAE France. During the same period in 2004, our minority partners’ share was $124,000 representing minority interest’s share of 36% of KLH and 51% share of France.

Net Income


	Nine Months Ended September 30,					Increase/(Decrease)
	2005			2004		Dollar			Percentage
Net (loss) income	$	(850,000	)	$	1,956,000	$	(2,806,000	)	(143	)%

Net loss for the nine-month period ended September 30, 2005 was $850,000. For the same period in 2004, we had net income of $1.9 million. The main reasons for the $2.8 million decrease in net income was the one-time charge of $2.0 million related to the abandonment of the lease on the Company’s former headquarters and the U.S. manufacturing site and generally higher operating expenses.

Liquidity and Capital Resources


	Nine Months Ended September 30,
	2005			2004
Net cash provided by:
Operating activities	$	614,000		$	(965,000	)
Investing activities	$	(8,042,000	)	$	(16,643,000	))
Financing activities	$	329,000		$	31,988,000
Effect of exchange rate changes	$	117,000		$	12,000
Net (decrease) increase in cash and cash equivalents	$	(6,982,000	)		14,392,000

To date, we have financed our operations primarily through bank borrowings, cash flow from operations and proceeds from the issuances of equity securities. As of September 30, 2005, we had $29.4 million in cash and investments. As of September 30, 2005, we had $40.9 million of working capital (current assets less current liabilities) and had a current ratio (current assets divided by current liabilities) of 4.14 to 1.00.

We have two lines of credit available for future growth, which in the aggregate total $10 million. In October 2005, we increased and renewed the line of credit based on the prime-lending rate from $3 million to $5 million. In October 2005, we also renewed and reduced the additional $5 million line of credit that was based on a fixed rate to $3 million. The new fixed rate on the $3 million line of credit is 5.3%. Both of the Lines of Credit are open for twelve months and expire in October, 2006. We are currently in compliance with the debt covenants, and as such, have these lines available to us in full. At present, there are no amounts outstanding under these agreements.

Net cash provided by operating activities for the nine-month period ended September 30, 2005 was $614,000 as compared to ($965,000) for the nine-month period ended September 30, 2004. The favorable effects on operating cash flows for the nine-month period ended September 30, 2005, as compared to September 30, 2004, was primarily due to, depreciation and amortization of $818,000, non-cash fair value accounting charges related to the issuance of options and warrants in the amount of $513,000, and an increase in the provision for doubtful Accounts of $204,000.

Net cash used in investing activities for the nine-month period ended September 30, 2005 was $8.0 million as compared with $16.6 million for the nine-month period ended September 30, 2004. Cash used in investing activities consisted of $4.5 million which was used primarily for improvements to the Company’s new headquarters, new equipment for the Company’s Shanghai and KLH manufacturing operations and purchase of a new ERP system.

Net cash provided by financing activities for the nine-month period ended September 30, 2005 was $329,000 as compared with $32.0 million for the nine-month period ended September 30, 2004. Cash provided by financing activities for the nine-month period ended September 30, 2005 was largely due to proceeds from the exercise of stock options in the amount of $295,000. The $32.0 million increase for the nine months ended September 30, 2004 was primarily from having raised $31.8 million through a public offering of 8,050,000 shares of common stock at $4.25 per share less the applicable underwriting discount, which closed on January 28, 2004.

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

Contractual Obligations

We lease certain manufacturing, warehousing and other facilities under operating leases expiring in various years through 2009. The leases generally provide for the lessee to pay taxes, maintenance, insurance, and certain other operating costs of the leased property. We recently completed a contract with a vendor to improve the property located at 3775 North First Street in San Jose for $1.2 million and as of September 30, 2005, approximately $4,000 remains to be paid. In addition, during the second quarter of 2005, we terminated an employee agreement with a non-executive officer in Europe for which the accrued termination liability is $251,000 for a period of 10 months. The following table quantifies our known contractual obligations as of September 30, 2005:


	Total		2005		2006		2007		2008		2009		Thereafter
Contractual Obligations:
Capital Lease Obligations	$	175,708	$	19,523	$	19,523	$	19,523	$	19,523	$	19,523	$	78,093
Operating Lease Obligations		2,933,615		413,808		713,579		561,795		660,471		583,962
Open Purchase Orders		2,700,754		2,700,754
Notes Payable – Related Parties		1,683,000		423,000		388,000		388,000		242,000		242,000
Other Liabilities		1,207,737		231,002		493,156		278,338		159,585		45,656
TOTAL	$	8,700,814	$	3,788,087	$	1,614,258	$	1,247,656	$	1,081579	$	891,141	$	73,093

In December 2004, the Company purchased the property located at 3775 North First Street in San Jose, California for a purchase price of $5.0 million in cash. The Company financed this transaction with available cash. During the quarter ended June 30, 2005, the Company moved its headquarters and its U.S. manufacturing site to the new facility in San Jose, California. The lease abandonment of the Company’s former headquarters resulted in a one-time charge of $2.0 million for the second quarter of 2005. The one-time charge of $2.0 million was based on the estimated cash flow to maintain the abandoned facility and rental obligation through the end of the lease term in 2009, discounted at an interest rate of 4.85 percent. Based on broker estimates of current real estate market conditions and other factors, it was considered more likely than not that any potential sublease income would be offset by brokerage, refurbishment and other costs to make the facility ready for a sublease.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

CONCENTRATION OF CREDIT RISK

Currently, we have cash and cash equivalents deposited with two large United States financial institutions, one large Hong Kong financial institution, two large Shanghai financial institutions, two local Beijing financial institutions, and one large Danish financial institution. Our deposits generally 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, 2005, we had cash and investments of $29.4 million consisting largely of cash and highly liquid short-term investments. The impact of interest rate fluctuations was immaterial. Changes to interest rates over time may, however, reduce or increase our interest income from our short-term investments. If, for example, there is a hypothetical 150 basis points change in the interest rates in the United States, the approximate impact on our cash and short-term investments would be +/- $125,000.

FOREIGN CURRENCY EXCHANGE RATE RISK

For the third quarter of 2005, a substantial portion of our recognized revenue was denominated in United States dollars generated primarily from customers in North America (58 %). Revenue generated from our European operations (9 %) is primarily in euros, revenue generated by our KLH operations (30%) is in renminbi (the “RMB”), and revenue generated from our Hong Kong-based operations (3%) is in both Hong Kong dollars and United States dollars. We manufacture a majority of our component parts at our manufacturing facility in Shanghai, China. Our operations in China have been largely unaffected by currency fluctuations until the July 2005, 2% appreciation of the RMB relative to the U.S. dollar.

Our strategy has been and will continue to be to increase our overseas manufacturing and research and development activities to capitalize on low-cost intellectual property and efficiency in supply chain management. In 2004, we made a strategic investment in China with the acquisition of KLH, a Beijing-based manufacturer and distributor of environmental safety and security equipment. On July 21, 2005, the RMB appreciated by approximately 2% relative to the U.S. dollar and experts are generally predicting further revaluation in the next several months. If, for example, there is a hypothetical 10% increase in the RMB relative to the United States dollar, the approximate impact on our profits would be unfavorable by approximately $750,000 for a one-year period.

Furthermore, to the extent that we engage in international sales denominated in United States 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. Also, since we manufacture a large portion of our products in China, any additional increase in the RMB relative to other currencies would likely further decrease our margins outside of China. Increased revenue as a result of appreciation of the RMB relative to the U.S. dollar from China sales at KLH would likely be a partial offset to the increase in costs that would occur to our manufacturing costs in China from appreciation of the RMB. Although we would continue to monitor our exposure to currency fluctuations and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, we cannot be certain that exchange rate fluctuations will not adversely affect our financial results in the future. In addition, there is no regular market for forward currency positions in the RMB except for the derivatives market known as the nondeliverable forward market (NDF), which remains an expensive method of hedging the RMB.

FACTORS THAT MAY AFFECT FUTURE RESULTS

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.

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

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

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

While we were profitable for the third quarter of 2005, we remain unprofitable on a year to date basis through the end of the third quarter. We might continue to incur operating losses and may not be profitable in the future. In addition, if our financial results continue to border on profitability, the financial impact of future events may be magnified and may lead to disproportionate impact on the trading price of our stock.

We experienced a net profit for the quarter ended September 30, 2005 of $397,000, but remain unprofitable on a year to date basis by $850,000. While we have been profitable for four of the last five years, there can be no assurance when or if we will return to profitability or if we can remain profitable. In addition, our financial results have historically bordered on profitability, with our results over the last twelve quarters ranging from $1.3 million quarterly loss to a $1.2 million quarterly profit, and if we continue to border on profitability, the financial impact may be magnified. For example, for a company with more considerable income or losses, a $250,000 impact may not be significant, whereas $250,000 in additional net loss in the last quarter would have reduced our profit by 63%. If we continue to border on profitability, 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. Because the impact of any such events may be magnified, we may experience a disproportionate impact on our trading price as a result.

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, BW Technologies, Ion Science, Draeger Safety Inc., Gastec Corporation and Bacou-Dalloz Group. Our competitors in the radiation market include TSA Limited, Polimaster, Exporanium and Santa Barbara Systems. Several of our competitors such as Mine Safety Appliances Company and Draeger Safety Inc. have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than us. In addition, some of our competitors may be able to:

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devote greater resources to marketing and promotional campaigns;

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adopt more aggressive pricing policies; or

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devote more resources to technology and systems development.

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

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

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

We have 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.

Recently enacted changes in the securities laws and regulations have and are likely to continue to increase our costs.

The Sarbanes-Oxley Act of 2002 has required changes in some of our corporate governance, securities disclosure and compliance practices. In response to the requirements of that Act, the Securities Exchange Commission (“SEC”) and American Stock Exchange (“AMEX”) have promulgated new rules. Compliance with these new rules has increased our legal and financial and accounting costs, and we expect these increased costs to continue indefinitely. We also expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be forced to accept reduced coverage or incur substantially higher costs to maintain or obtain coverage. In addition, these developments may make it more difficult for us to attract and retain qualified members of our board of directors or qualified executive officers.

In the event we are unable to satisfy regulatory requirements relating to internal control over financial reporting or, if these internal 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 connection with the work on the Company’s internal control over financial reporting for 2004, the Company has identified a number of material weaknesses as previously described in our earlier periodic and current reports, including weaknesses relating to inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period.

After conferring with the Audit Committee of the Company and its independent registered public accounting firm on these matters, another independent certified public accounting firm was engaged to conduct an independent study (agreed-upon procedures report) of the impact of the Company’s revenue recognition practices. Based on the findings of the study by the independent certified public accounting firm and as previously disclosed, the consolidated financial statements for the years ended December 31, 2004, 2003 and 2002 and for the interim periods of fiscal years 2004 and 2003 were restated in the Company’s Amendment No. 2 on Form 10-K/A. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for its amended Form 10-K/A for 2004. Furthermore, as part of the restatement process, the Company made a correction to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability). The error had been previously identified but not considered material to require correction.

In addition, the Company’s acquisition of a 64% interest in KLH and our expanded presence in China presents additional challenges. While we implemented a locally developed enterprise resource planning (“ERP”) system in Beijing and continue to improve upon our internal control over financial reporting so that it can provide reasonable assurance of achieving its control objectives, our internal controls with respect to our China operations have not yet been fully developed and will require continued resources to reach adequacy.

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 would have a negative impact on our reputation and business.

If our new enterprise resource planning software is not implemented correctly, it could cause errors in our financial reporting or unexpected business interruptions.

We have begun implementing a new Company-wide ERP system to mitigate the risk of future deficiencies and strengthen our procedures for internal control over financial reporting, During the implementation period, we are at a higher risk while we evaluate the configuration of the software, the processes implemented and the training of our personnel in the new software. While we expect that the design and operation of our new ERP system will help us improve our internal control over financial reporting, there can be no assurance that we will not have a future error in our financial statements. Such an error, if material, could require their restatement, having adverse effects on our stock price, potentially causing additional expense and limiting our access to financial markets. Moreover, ERP implementations are challenging initiatives that carry substantial project risk including the risk of unexpected business interruptions. Failure to properly implement the new information technology system could have an adverse impact on our operating results.

Investor confidence and share value may be adversely impacted or we could be found to be in noncompliance with applicable SEC or AMEX requirements since our independent certified public accountants disclaimed an opinion on management’s assessment on the effectiveness of internal control over financial reporting as of December 31, 2004.

Our independent registered public accountants, BDO Seidman, LLP, disclaimed an opinion on management’s assessment on the effectiveness of internal control over financial reporting as of December 31, 2004. It is unclear what legal effect this will have on our compliance with rules and regulations of the SEC and the continued listing standards of the American Stock Exchange. It could be determined that we are not in compliance with applicable SEC or stock exchange requirements, which could affect the listing of our stock for trading on the American Stock Exchange or the trading price of our stock.

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 increasingly dependent upon government funded projects. Decisions on what types of projects are to be funded by local, state and federal government agencies will have a material impact on our business. For example, because much of the 2005 Homeland Security budget was allocated for airline security rather than security for shipping containers, the market opportunity for our products that address the shipping container market was reduced. 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.

Government contracts also contain provisions and are subject 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 is done through the Federal Supply Schedules from the U.S. General Services Administration (GSA). Our GSA Schedule contract, like all others, includes 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 have agreed 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, so too must our prices on our GSA Schedules contract. Although we have undertaken extensive efforts to comply with the Price Reductions clause, it is possible that we, through, for example, an unreported discount offered to a “Basis of Award” customer, might fail to honor the obligations of the Price Reductions clause. If that occurred, 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 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 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 three and nine-month periods ended September 30, 2005 approximately 33% and 29% of our revenue, respectively, were from sales to customers located in Asia and approximately 9% and 11%, respectively, were from sales to customers located in Europe. For the

three and nine-month periods ended June, 2005 approximately 30% and 26%, respectively, were from sales to customers located in China specifically. 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:

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difficulties with staffing and managing international operations;

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transportation and supply chain disruptions and increased transportation expense as a result of epidemics, terrorist activity, acts of war or hostility, generally higher oil prices, increased security and less developed infrastructure;

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economic slowdown and/or downturn in foreign markets;

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international currency fluctuations;

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

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

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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;

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

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general strikes or other disruptions in working conditions;

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labor shortages;

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political instability;

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changes in tariffs;

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generally longer periods to collect receivables;

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unexpected legislative or regulatory requirements;

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reduced protection for intellectual property rights in some countries;

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significant unexpected duties or taxes or other adverse tax consequences;

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difficulty in obtaining export licenses and other trade barriers; and

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

The specific economic conditions in each country impact our international sales. For example, a majority 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.

In addition, to date we have experienced lower gross margins on sales in certain jurisdictions, particularly China. To the extent that the percentage of our total net sales from China increases and our gross margins do not improve, our business financial condition and operating results could suffer.

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.

Manufacturing and retail sales in China are material to our business plan and results of operations. For the three and nine-month periods ended September 30, 2005, approximately 30% and 26% of our revenue, respectively, were sales to customers located in China. In May 2004, our acquisition of a 64% interest in KLH increased both our manufacturing and retail presence in China.

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 WTO membership 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. Because of the importance of our international sales and international sourcing of manufacturing to our business, our financial condition and results of operations could be significantly and adversely affected if any of the risks described above were to occur.

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

Through our subsidiary RAE Shanghai and investment in KLH, we currently manufacture and sell a significant portion of our components and products in China. China is a socialist state, which since 1949 has been, and is expected to continue to be, controlled by the Communist Party of 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 photo-ionization detector technology of which the first of such patents expires in 2012, and our ability to compete may be affected by any competing similar or new technology. In addition, if we lose the licensing rights to a patented or other proprietary technology, we may need to stop selling products incorporating that technology and possibly other products, redesign our products or lose a competitive advantage. We cannot ensure that our future patent applications will be approved or that our current patents will not be challenged by third parties. Furthermore, we cannot ensure that, if challenged, our patents will be found to be valid and enforceable.

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

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

We may, from time to time, be subject to claims of infringement of other parties’ proprietary rights or claims that our own trademarks, patents or other intellectual property rights are invalid. For example, a motion was filed on June 17, 2005, by Polimaster Ltd. and Na & SE Trading Co. Limited, for an injunction that would prevent RAE Systems from shipping its Gamma RAE II product and prohibiting RAE from making any additional sales of products in its possession licensed from Polimaster Ltd. and Na & SE Trading Co. Limited, pending resolution of arbitration between the parties. The motion was denied on September 6, 2005.

The denial of the injunction was related to a May 9, 2005, Polimaster Ltd. complaint filed against the Company in the U.S. District Court for the Northern District of California alleging that the Company had misappropriated and misused technological and proprietary information developed by Polimaster to manufacture the GammaRAE II hand-held radiation detection unit. The complaint stated that Polimaster intends to prosecute its claims against RAE in arbitration, in accordance with the terms of the contracts between the parties. While management will defend the matter vigorously, any claims of this type, regardless of merit, could be time-consuming to defend, result in costly litigation, divert management’s attention and resources or require us to enter into royalty or license agreements. The terms of any such license agreements may not be available on reasonable terms, if at all, and the assertion or prosecution of any infringement claims could significantly harm our business.

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

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

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

We distribute our products primarily through distributors. We derived approximately 68% of our revenues from our sales distribution channels for the third quarter of 2005, and, as a result, we are dependent upon these distributors to sell our products and to assist us in promoting and creating a demand for our products. We believe that our future growth depends on the efforts of these distributors. For the nine-month period ended September 30, 2005, 23 distributors cumulatively account for approximately 31% of our total product sales. In addition, the contractual obligations of our distributors to continue carrying our products must be renewed annually. If one or more of our distributors were to experience financial difficulties or become unwilling to promote and sell our products for any reason, including any refusal to renew their commitment as our distributor, we might not be able to replace such lost revenue, and our business and results of operations could be materially harmed.

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.

In addition to our recent investment in KLH, any future acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute stockholder value or harm our results of operations.

In May 2004, we completed our 64% investment in KLH, a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors. We may acquire or make investments in complementary businesses, technologies, services or products if appropriate opportunities arise. The process of integrating any acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures. Integration of an acquired company also may consume much of our management’s time and attention that would otherwise be available for ongoing development of our business. Moreover, the anticipated benefits of any acquisition may not be realized. Future acquisitions could result in dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or expenses related to goodwill recognition and other intangible assets, any of which could harm our business.

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

We own approximately 36% of REnex Technology Ltd., a wireless systems company still in the research and development stage. We are required to incorporate our share of its expenses as losses in our Consolidated Statements of Operations. We have reduced the value of our investment in REnex over time to zero because of our share of continued losses. If we were to make an additional investment in REnex and REnex does not begin to generate revenues at the level we anticipate or otherwise incurs greater losses, we could incur greater losses than we anticipate and our results of operations will suffer.

The adoption of the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-based Compensation,” as provided for in SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of SFAS No. 123,” has had and will continue to have a significant impact on our financial statements.

In connection with our merger with Nettaxi.com, certain options under our 1993 Stock Plan became subject to variable accounting in accordance FIN 44. To eliminate the variable effects of such accounting treatment, we adopted the fair value recognition provisions of SFAS No. 123 for stock-based employee compensation, effective January 1, 2003, under the modified prospective method as provided for in SFAS No. 148. These fair value recognition provisions generally result in stock-based compensation charges for options granted under our 1993 and 2002 stock option plans. For the three and nine—month periods ended September 30, 2005, the fair value charges for options granted under our 1993 and 2002 stock option plans were $436,000 and $1394,000, respectively.

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

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

Our officers, directors and principal stockholders beneficially own approximately 36% of our common stock and, accordingly, may exert substantial influence over the company.

Our executive officers and directors and principal stockholders, in the aggregate, beneficially own approximately 36% of our common stock. 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 4. Controls and Procedures

Changes to Internal Control over Financial Reporting

As previously disclosed in the Company’s periodic filings with the SEC, the Company identified the following material weaknesses in its internal control over financial reporting: (i) inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period; (ii) inadequate training and supervision practices necessary to ensure that all of the Company’s key controls are effective; (iii) inadequate record retention policies and procedures to ensure that all key documents in support of the Company’s transactions are obtained, retained and safeguarded; (iv) inadequate controls pertaining to the segregation of duties relative to certain of the Company’s processes, especially in locations where the Company has limited staff; (v) inadequate controls pertaining to the preparation or maintenance of adequate documentation in support of all disbursements made at the newly acquired KLH subsidiary; (vi) inadequate controls pertaining to the Company’s review and oversight of its subsidiary’s financial information originating at the newly acquired KLH subsidiary; (vii) inadequate controls pertaining to the Company’s information technology infrastructure in the area of security and data protection; and (viii) and inadequate planning, organization and supervision of the Company’s Sarbanes-Oxley 404 process.

During 2005 the Company has implemented a number of compensating internal controls and will continue to remediate controls in an effort to improve the level of assurance regarding the accuracy of the Company’s financial information. These compensating internal controls and remediation efforts include the following:

Controls related to inadequate codification of the Company’s revenue recognition policies and review procedures to ensure revenues are recorded in the proper period:

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During the first quarter of 2005, the Company clarified and re-emphasized, to its employees, its worldwide revenue recognition policy.

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During the first quarter of 2005, a standard process was put in place in the United States to review customer contracts and purchase order terms. This process was extended worldwide during the second quarter of 2005.

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During the second quarter of 2005, the Company engaged another independent certified public accounting firm to test selective revenue transactions for purchase order or contract terms that might require deferral. The study is complete and adjustments have been made to the consolidated financial statements accordingly.

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During the second quarter of 2005, based on the findings of the revenue recognition study by the independent certified public accounting firm, the Company decided to restate its consolidated financial statements for years ended December 31, 2004, 2003 and 2000. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for its amended Form 10-K/A for 2004. An amended annual report was filed with the Securities and Exchange Commission on June 6, 2005.

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During the second quarter of 2005, the Company’s revenue recognition policy was reviewed with each financial manager for each of our subsidiaries.

Controls related to inadequate training and supervision practices necessary to ensure that all of the Company’s key controls are effective:

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During the second quarter of 2005, the Company started to implement a series of training programs to educate its employees on the Company’s internal control standards. Key management and sales personnel in Asia attended a seminar provided by our legal counsel on the fundamentals of the U. S. Foreign Corrupt Practices Act.

Controls related to inadequate record retention policies and procedures to ensure that all key documents in support of the Company’s transactions are obtained, retained and safeguarded.

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During the first quarter of 2005, the Company developed a world-wide records retention policy.

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During the second quarter of 2005, the Company completed an inventory of its North American distributor contracts and identified contracts not yet signed and returned. The Company is currently following-up with distributors who have not returned signed contracts.

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During the second quarter of 2005, the Company revised its procedures for retaining its customer purchase orders in the U.S.

Controls pertaining to the segregation of duties relative to a few of the Company’s processes:

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During the first quarter of 2005, the Company implemented additional levels of approval, verification and sign-off processes for the Company’s key controls.

Controls related to the preparation or maintenance of adequate documentation in support of all disbursements made at the newly acquired KLH subsidiary:

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During the fourth quarter of 2004 and through the first quarter of 2005, the Company implemented a locally developed ERP system in Beijing to improve the reporting and controls over disbursements. KLH completed the implementation in March of 2005 and used this system during the second quarter as the basis for providing financial results, eliminating its reliance on manual systems used in prior periods.

Controls related to the Company’s review and oversight of its subsidiary’s financial information originating at the newly acquired KLH subsidiary:

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During the fourth quarter of 2004, the Company hired an experienced financial controller with United States accounting experience to manage the Shanghai manufacturing operations and to provide some in-country supervision to the financial manager at the Company’s newly acquired KLH operations in Beijing.

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During the first quarter of 2005, the Company transferred a United States trained accountant to assist in the financial management of the Company’s newly acquired KLH operations.

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Starting with the filing of the 2004 Form 10-K on March 18, 2005, the Company instituted a sub-certification process, including KLH, whereby all key finance and operations personnel within the Company are held accountable for the accuracy of the financial statements.

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During the second quarter of 2005, the Company engaged an independent audit firm based in China to supplement personnel from the U.S. and Shanghai, China, to conduct its first complete test of KLH’s controls against the Sarbanes – Oxley Section 404 Standard. Our resulting evaluation confirmed the general weaknesses reported in paragraph one of this item 4: (v) inadequate controls pertaining to the preparation or maintenance of adequate documentation in support of all disbursements made at the newly acquired KLH subsidiary and (vi) inadequate controls pertaining to the Company’s review and oversight of its subsidiary’s financial information originating at the newly acquired KLH subsidiary. The Company has revised it control program at KLH based on the testing performed and with the assistance of the independent audit firm, it expects to complete a remediation and retesting program by the fourth quarter of 2005.

Controls related to the Company’s information technology infrastructure in the area of data security and data protection:

•

During the fourth quarter of 2004, the Company formed a team to select a new enterprise resource planning system to replace the current system that was determined to be inadequate in the area of security and data protection. During the second quarter of 2005, an enterprise resource planning system was selected and the implementation effort commenced.

Controls related to inadequate planning, organization and supervision of the Company’s Sarbanes-Oxley 404 process:

•

During the first quarter of 2005, the Company supplemented the Sarbanes-Oxley 404 team to include every member of the United States finance department. This team developed and implemented standard documentation and test procedures worldwide to comply with the requirements of Section 404 of the Sarbanes-Oxley Act.

•

During the same period, the Company hired an experienced consultant to assist with the Sarbanes-Oxley 404 testing and remediation process. The consultant was converted to a full-time employee during the second quarter of 2005, and is currently leading our internal Sarbanes – Oxley compliance program.

As previously disclosed in the Company’s periodic reports and filed with the SEC, management previously concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, because of the material weaknesses identified above. The control deficiencies requiring a restatement of the Company’s fiscal year 2004, 2003 and 2000 financial statements were not a result of an additional material weakness and have not caused the Company to modify its previously issued Report on Assessment of Internal Control Over Financial Reporting, except insofar as to restate its financial results for the years ended December 31, 2004, 2003 and 2000 because of inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period. In addition, as previously disclosed, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for its amended Form 10-K/A for 2004. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), an error which had been previously identified but not considered to be sufficiently material to require correction. The Company is in the process of developing procedures for the testing of the remediated controls to determine if the control deficiencies have been remediated and expects that testing of these controls will be substantially completed by the end of its fiscal year 2005. The Company believes that the compensating internal controls and remediation efforts, taken as a whole, mitigated the risk of error with respect to our preparation of this quarterly report on Form 10-Q for the period ended September 30, 2005, and that these measures have been effective to ensure that information required to be disclosed in this quarterly report has been recorded, processed, summarized and reported correctly. Management believes that its controls and procedures will continue to improve as a result of the further implementation of these measures.

Material weaknesses in internal control over financial reporting may materially impact the Company’s reported financial results and the market price of its stock could significantly decline. Since the Company’s auditors have disclaimed an opinion on management’s assessment on the effectiveness of internal control over financial reporting, it is unclear what legal effect this will have on the Company’s compliance with the rules and regulations of the SEC and the continued listing standards of the American Stock Exchange. Additionally, adverse publicity related to a material failure of internal control over financial reporting could have a negative impact on the Company’s reputation and business.

Evaluation of Effectiveness of Disclosure Controls and Procedures

Under the supervision and with the participation of the Company’s management, including the Company’s principal executive officer and principal accounting officer, the Company evaluated the effectiveness of its disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based upon that evaluation, the Company’s principal executive officer and principal accounting officer concluded that the Company’s disclosure controls and procedures

were ineffective as of September 30, 2005 with regard to the material weaknesses identified and discussed above, under “Changes to Internal Control Over Financial Reporting.”

PART II. Other Information

Item 1. Legal Proceedings

A motion was filed on June 17, 2005, by Polimaster Ltd. and Na & SE Trading Co. Limited, for an injunction that would prevent RAE Systems from shipping its Gamma RAE II product and prohibiting RAE from making any additional sales of products in its possession licensed from Polimaster Ltd. and Na & SE Trading Co. Limited, pending resolution of arbitration between the parties. The motion was denied on September 6, 2005. The denial of the injunction was related to a May 9, 2005, Polimaster Ltd. complaint filed against the Company in the U.S. District Court for the Northern District of California alleging that the Company had misappropriated and misused technological and proprietary information developed by Polimaster to manufacture the GammaRAE II hand-held radiation detection unit. The complaint stated that Polimaster intends to prosecute its claims against RAE in arbitration, in accordance with the terms of the contracts between the parties. The Company will defend the matter vigorously.

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

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


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

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

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

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

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on November 8, 2005.


RAE SYSTEMS INC.

By:		/s/ Donald W. Morgan
		Donald W. Morgan
		Chief Financial Officer and Vice President, Finance

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Rae Systems (RAE) Inactive 10-Q2005 Q3 Quarterly report

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