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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-K

For the fiscal year ended December 31, 2002

OR

For the transition period from                      To                     

Commission File Number: 000-26109

RAE Systems Inc.

(Exact name of registrant as specified in its charter)

1339 Moffett Park Drive

Sunnyvale, California 94089

(Address of principal executive offices)

408-752-0723

Registrant’s telephone number, including area code:  

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

None

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

Common Stock, $.001 par value

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

Indicate by check mark whether the registrant is an accelerated filer. Yes  ¨  No  x

At February 20, 2003, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $9,792,204. At February 20, 2003, the number of shares of Common Stock outstanding was 45,603,283.

DOCUMENTS INCORPORATED BY REFERENCE

Definitive Proxy Statement for the Company’s 2003 Annual Meeting of Stockholders—

Part III of this Form 10-K.

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PART 1

In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements. These statements typically are preceded or accompanied by words like “believe,” “anticipate,” “expect,” and words of similar meaning. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in these forward-looking statements. Readers are cautioned not to place undue reliance on those forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or update or publicly release the results of any revisions or update to these forward-looking statements. Readers should carefully review the risk factors described herein and in other documents that we file from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q to be filed by RAE Systems in fiscal year 2003.

ITEM 1. BUSINESS.

RAE Systems, established in 1991, is a leading manufacturer of technologically advanced single and multiple sensor atmospheric monitors, photo-ionization detectors, gas detection tubes, sampling pumps, and wirelessly-connected gas detection and security monitoring systems.

Our hazardous environment detection solutions are used to detect and measure a wide variety of dangerous atmospheric contaminants and conditions such as combustible gas and vapor accumulations, oxygen deficiencies, and toxic gases such as carbon monoxide, hydrogen sulfide, carbon dioxide, and many other commonly encountered atmospheric hazards. Our patented photo-ionization detector technology allows dependable, linear, part-per-million range readings for many toxic gases and vapors that are effectively undetectable by any other means. Our products are particularly well suited for the measurement of volatile organic compounds such as gasoline, benzene, paints, degreasers, jet fuel, and most organic solvents. Our products are used to detect weapons of mass destruction (WMD), environmental, safety, hazardous materials (HAZMAT), toxic industrial chemical (TIC), petrochemical and semiconductor materials, and for confined space entry monitoring programs all over the world.

Our monitors are used in civilian and government atmospheric monitoring programs in over 50 countries. Our products are used by manufacturers as well by numerous city, state and federal agencies and departments. A substantial number of municipal agencies and city departments have standardized their programs on our products for confined space and HAZMAT incident response. We are also a leading supplier of gas detectors used for jet fuel vapor monitoring programs. Our customers include many of the world’s leading corporations in the airline, automotive, oil, computer and telecommunications industries. We also have significant numbers of instruments currently in service with many U.S. governmental agencies and armed forces. Our instruments are used in a wide variety of programs for the detection of vapors associated with nerve agents, chemical warfare agents (CWAs), TICs, and as part of the personal

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protective equipment issued to bomb-disposal, hostage-rescue, clandestine crime lab, HAZMAT, and other high-risk response teams throughout the country. To date, we have over 3,000 instruments fielded with these various United States government departments, agencies and programs.

We were incorporated as a California corporation in 1991. In April 2002 we completed a reverse merger with Nettaxi.com, and became incorporated under the laws of the state of Delaware.

OUR STRATEGY

Since our inception, we have focused on becoming a leader in the development of gas detection monitoring devices. We intend to maintain this focus by pursuing the following strategies:

Transformation from an Analytical Instrument Company to a Network Instrumentation Company. We have transformed our company from an analytical instrument company to a network instrumentation company by offering products that enable data to be transmitted and analyzed from remote locations in the field to a base station located up to two miles from site of the detector, and ultimately hosted via the Internet. We have created a network environment in which each of our instruments represents a node in a local area network, or LAN, and each LAN is, in turn, made a part of a wide area network, or WAN, such as the Internet. In such a network environment, the instruments communicate with one another and across the Internet to provide systems solutions for various industrial and security markets that require a low cost feedback loop, including HAZMAT monitoring and homeland defense.

Expand into a Variety of Industries in Order to Achieve a Broad Customer Base. We intend to leverage our core technologies across many industries in order to achieve a broad and diverse customer base. By diversifying our customer base, we hope to become less susceptible to the economic downturns and business cycles of any single industry.

Continue to Develop and Bring to Market Products Based on Patented Technology. We intend to continue to develop products based on our patented technology that are distinguishable from other products in the marketplace, and therefore help provide insulation from competitive pricing pressures. Through collaboration efforts, acquisitions and in-house research and development efforts, we intend to develop new technologies such as radiation detection.

Fully Leverage Our Low-Cost Manufacturing Base in China. As part of our overall strategy, we intend to increasingly utilize our low-cost manufacturing facilities in China, thereby lowering our production costs and increasing the gross margins on our products.

RAE SYSTEMS CAPABILITIES

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Our main strengths are in both sensor and measurement technology and integrated wireless technology.

Sensor and Measurement Technology

Our products are based on a line of proprietary and patented gas and chemical sensors. We design and manufacture the following sensors:

Photo-ionization detectors use ultraviolet light to break up the molecules of the substances being detected into charged fragments or “ions.” This produces a flow of electrical current proportional to the concentration of contaminant. Our patented photo-ionization detector technology enables dependable, linear, part-per-million range readings for many toxic gases and vapors that are virtually undetectable by any other means. Photo-ionization detection is particularly suited to the detection of the highly toxic, long-chain, low vapor pressure volatile organic compounds associated with many toxic industrial chemicals, nerve agents and chemical warfare agents.

Catalytic bead pellistors, non-dispersive infrared sensors and electro-mechanical sensors measure combustible gas, carbon dioxide and hydrocarbons, and toxic gases such as carbon monoxide using our detector technology.

Integrated Wireless Technology

In 1999, anticipating the emergence of robust wireless IP networks, we began to develop wireless capabilities for our gas monitoring instruments that enable them to detect gas from remote locations. In May 2001, we introduced the AreaRAE, a wireless-enabled gas detector, which allows for the real-time transmission of monitoring information from a base station located up to two miles away from the detectors. The AreaRAE enables HAZMAT teams, fire fighters, law enforcement officials and other users to remain a safe distance away from toxins, flames and explosives. The AreaRAE incorporates technologies such as global positioning system and geographic information system capabilities. In addition, the AreaRAE can be made to interface with the Internet, making our measurements available from virtually any location with Internet access. We intend to further enhance our products to include video or imaging capabilities that will enable security monitoring.

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COMPETITIVE STRENGTHS

As an instrument manufacturer, we have differentiated ourselves from our competition by developing specific chemical sensors, including an array of gas detectors, photo-ionization detectors, catalytic combustion sensors, non-dispersive infrared sensors, corona discharge ionization detectors, and electrochemical gas sensors. These key components enable us to innovate and create new product offerings that other instrument manufacturers may find difficult to rival, especially those competitors that rely on off-the-shelf components. Our technology is protected by 17 patent applications, eight (8) of which have been granted.

As a design and development company, we have significant experience in our industry and understand the need for microprocessor-based instruments. We have successfully integrated our gas detection technology with advanced analog/digital electronics, rechargeable lithium batteries, miniature diaphragm pumps, and liquid crystal displays into a broad family of compact, technologically advanced gas detection products. Our instruments are user friendly, durable, and used by first responder teams, mobile industrial workers, municipal employees, law enforcement agencies, and safety and hygiene professionals.

A significant advantage of our sensor products is that data can be uploaded to the Internet. To facilitate this, we founded REnex in 2001, a Hong Kong-based, wireless systems company of which we own, as of December 31, 2002, approximately 36%. REnex has developed an Application Specific Private Exchange Network, or ASPEN, dedicated for use in industrial applications. ASPEN is a self-sufficient plug-and-play system that can be customized to meet application specific needs and market requirements. We are currently collaborating with REnex in the design of a robust wireless communications system to address the needs of the homeland security, petrochemical, and environmental markets, among others.

SALES AND MARKETING

Our products are sold through a worldwide organization that includes direct sales personnel and distributors managed through our Sunnyvale, California; Hong Kong; and Skanderborg, Denmark offices. We have a sales and distribution presence in the United States, Canada, Western Europe, Mexico, Latin America, Japan and Singapore, as well as in Beijing, Shanghai, and other petroleum-focused provinces in China. As of December 31, 2002, we employed 47 people in sales and marketing and customer support services. In addition, we have a total of 180 distributors worldwide that account for approximately 90% of our revenues.

In the year ended December 31, 2002, approximately 70% of our revenues were derived from sales in North America and approximately 30% of revenues were derived from sales outside of North America. Of the sales outside of North America, approximately 32% of sales represent sales in Europe and 52% represent sales in Asia.

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Our products are marketed through direct mail and print advertisements, as well as the dissemination of brochures and other marketing collateral. We participate in industry trade shows and have a presence on the Internet where we take orders and provide information on our product offerings.

RESEARCH AND DEVELOPMENT

We are in the process of expanding our product offerings to include a line of radiation detectors, a wider variation of tubes and pumps, as well as instruments that increase selectivity in gas monitoring. As of December 31, 2002, we employed 36 people in research, development and engineering.

Our research and development process is done in collaboration with our manufacturing department. Such collaboration ensures the manufacturability of the product, and expedites the transition from the conceptual design phase to actual production.

We are engaged in a collaborative effort with the Shanghai University in China, which is known for its research depth in the electronics engineering, telecommunications, and material science fields. This collaboration has enabled cost effective and high return research and development activities, including instrument development and sensor technology. We are able to draw on the expertise of the professors at Shanghai University and recruit from the talent pool that the university has to offer.

MANUFACTURING

We have a wholly owned offshore manufacturing subsidiary, Wa-RAE, in Shanghai, China where approximately half of our components and products are manufactured. Wa-RAE operates two manufacturing sites in Shanghai, both of which are leased. The facilities consist of 20,000 square feet and 44,000 square feet of manufacturing space, respectively, and enable us to be cost competitive, while maintaining high quality manufacturing standards. We also have a manufacturing, integration and test site in Sunnyvale, California, where we manufacture some of our more complex and sensitive sensors. We have been ISO 9001 certified since 1998, and were upgraded to ISO 9001:2000 in December 2001. Our international manufacturing subsidiary WaRAE was certified to ISO 9002, and was upgraded to ISO 9001 in 2001. As of December 31, 2002, we employed 171 people in manufacturing, of which 139 are located in Shanghai, and the remainder in the United States.

COMPETITION

Competitors in the gas monitoring industry differentiate themselves on the basis of their technology, quality of product, service offerings, cost, and time to market. While we believe we compete strongly in these categories, and thus consider ourselves one of the industry leaders in the design, development and manufacture of gas monitoring devices, we face significant competition. Our primary competitors include Industrial

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Scientific Corporation, Mine Safety Appliances Company, BW Technologies, Ion Science, PerkinElmer, Inc., Draeger Safety Inc., Gastec Corporation, and Bacou-Dalloz.

Many of our competitors 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:

If we are unable to compete successfully, our business could be seriously harmed.

EMPLOYEES

As of December 31, 2002, we employed 295 individuals, 171 of which were in manufacturing (139 in China; 32 in the US), 36 in research, development and engineering, 47 in sales and marketing, and 41 in finance, administration and information technology. Our employees are not covered by a collective bargaining agreement. We have never experienced an employment-related work stoppage and consider our employee relations to be good.

Our core engineering staff has developed a deep knowledge base in instrumentation development, measurement and control systems. They understand the design and manufacture of compact microprocessor-based instruments, and have been able to integrate multiple gas sensors with advanced analog/digital electronics, rechargeable lithium batteries, miniature diaphragm pumps, and liquid crystal displays, into portable devices. We design our instruments to be compact, rugged and easy-to-use, as well as aesthetically pleasing.

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EXECUTIVE OFFICERS AND DIRECTORS OF THE REGISTRANT

Our executive officers and directors and their ages are:

ROBERT CHEN co-founded RAE Systems in 1991 and has served as President, Chief Executive Officer, and as a member of the board of directors since our inception. From 1981 to 1990, Mr. Chen served as President and Chief Executive Officer of Applied Optoelectronic Technology Corporation, a manufacturer of computer-aided test systems, a company he founded and subsequently sold to Hewlett Packard. Mr. Chen currently serves on the board of directors for the Shanghai Ericsson Simtek Electronics Company, Limited, a telecommunications and electronics company. Mr. Chen received a B.S.E.E. from Taiwan National Cheng Kung University, a M.S.E.E. from South Dakota School of Mines and Technology, and graduated from the Harvard Owner/President program.

JOSEPH NG has served as our Vice President of Business Development and Chief Financial Officer since February 2001. From 1999 to 2001, Mr. Ng was the Marketing Manager for the E-Services Division of Hewlett-Packard, and from 1997 to 1999, the Controller for the Personal Computer and Printer Division of Hewlett-Packard. From 1995 to 1997, Mr. Ng was the Controller for the Computer Division of Hewlett-Packard-Japan, and from 1988 to 1990, the Chief Financial Officer for Applied Optoelectronic Technology Corporation. Mr. Ng received a B.S. in Accounting from Baruch College, and a M.A. in History from Stanford University. Mr. Ng is a certified public accountant in the State of California.

PETER HSI co-founded RAE Systems in 1991 and has served as our Vice President, Chief Technology Officer, and as a member of the board of directors since our inception. Prior to co-founding RAE Systems, Dr. Hsi worked at Applied Optoelectronic Technology Corporation as the chief architect for semiconductor test systems. Dr. Hsi has filed seventeen (17) patent applications, of which eight (8) have been granted and nine (9) are pending. Dr. Hsi received a B.S.E.E. from the National Chiao-Tung University, and a M.S. and Ph.D. in Electrical Engineering from Syracuse University.

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HONG TAO SUN has served as our Vice President of Engineering since January 2002. Dr. Sun joined RAE Systems in 1997, where he was instrumental in the design and development of key sensor technologies. Prior to joining RAE Systems, Dr. Sun was a research fellow for the Royal Melbourne Institute of Technology in Australia and the University of L’Aquila in Italy. Dr. Sun has over 10 years as a research scientist in the fields of photo-ionization detection and sensor development. Dr. Sun has authored over 60 international research papers, and has written two scientific books. Dr. Sun has developed six patents, three of which are in the field of photo-ionization detection. In 1990, Dr. Sun received a Ph.D. in Electrical Engineering from Xi’an Jiaotong University.

LYLE FEISEL has served as a member of our board of directors since March 2001. In 2001, he retired as the Dean of the Thomas J. Watson School of Engineering and Applied Science, and Professor of Electrical Engineering at the State University of New York at Binghamton. Dr. Feisel joined the faculty of SUNY Binghamton in 1983. Dr. Feisel is a Life Fellow of the Institute of Electrical and Electronics Engineers and of the American Society for Engineering Education, and is a Fellow of the National Society of Professional Engineers. He is active in the affairs of those organizations and in the development and accreditation of engineering education worldwide. Dr. Feisel received his B.S., M.S. and Ph.D. degrees in Electrical Engineering from Iowa State University.

NEIL W. FLANZRAICH has served as a member of our board of directors since December 2000. Since May 1998, he served as Vice Chairman and President of IVAX Corporation, a pharmaceutical company. From 1995 to May 1998, Mr. Flanzraich served as Chairman of the Life Sciences Legal Practice Group of Heller Ehrman White and McAuliffe, and from 1981 to 1994, Senior Vice President and member of the corporate Operating Committee at Syntex Corporation, a pharmaceutical company. Mr. Flanzraich is a director of the Whitman Education Group, Inc., IVAX Diagnostics, and Continucare Corporation. He also serves as Chairman of the Israel America Foundation. Mr. Flanzraich received an A.B. from Harvard College and a J.D. from Harvard Law School.

EDWARD C. ROSS has served as a member of our board of directors since March 2001, and is currently the President of TSMC North America. From 1998 to 2000, Dr. Ross served as Senior Vice President of the Professional Services Group of Synopsys, Inc., a computer-aided design company, where he was responsible for developing and executing Synopsys’ consulting business practices. From 1995 to 1998, Dr. Ross was the President of the Technology and Manufacturing Group of Cirrus Logic, a semiconductor company. Dr. Ross received a B.S.E.E from Drexel University, and a M.S.E.E., M.A, and Ph.D. from Princeton University.

BO ANDERSSON has served as a member of our board of directors since June 2002. In September 2002, he was appointed President of Ericsson Micro Components, and from May 2000 to August 2002, served as President and CEO of Ericsson Microelectronics. In 1998, Mr. Andersson was appointed Head of the Microelectronics Business Unit and between 1994 to 1998, was the General Manager for the Power Modules Business within the Ericsson Components AB. In 1994, Mr. Andersson was the Project Manager for the building of the sub micron facility in Kista, Sweden, and in 1977,

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he joined Ericcson where he was the Head of Process Technology Development. Mr. Andersson is Chairman of the Board of Ericsson Power Modules AB and Chairman of the Board of Shanghai Ericsson Simtec Electronics Co., Ltd. He is also Chairman of the Steering Committee for the Microtechnologies Centre at Chalmers University in Sweden. Mr. Andersson received a Master of Science degree in Physical Engineering from the Royal Institute of Technology in Stockholm, Sweden in 1977.

ITEM 2. PROPERTIES.

Our corporate headquarters and principal offices are located in a leased facility in Sunnyvale, California. The Sunnyvale facility consists of approximately 25,000 square feet, which includes research and development, sales and marketing, and general and administrative operations, under a lease expiring in October 2009. The current facility is adequate to meet the needs of our current operations.

We maintain a sales office in Fan Ling, Hong Kong, from which we sell our products to Asia. The lease of the Fan Ling office has been renegotiated for a period of three years commencing in January 2002. Through our wholly-owned subsidiary, Wa-RAE, we lease two state-of-the-art manufacturing and research and development sites in Shanghai, China, consisting of approximately 20,000 square feet and 44,000 square feet, respectively. The first of the two leases will expire in phases as to portions of the property from March 2004 until March 2008. The second of the two leases expires in January 2007 and contains an option to purchase the property. We also maintain a sales and service center in Skanderborg, Denmark, from which we sell our products to Europe, Australia and New Zealand, the Middle East and Africa.

ITEM 3. LEGAL PROCEEDINGS.

On May 1, 2001, Thomas Lahey et al. filed a lawsuit against Nettaxi, Inc., Robert and Dean Rositano and Glenn Goelz, officers of Nettaxi in the United States District Court of the Central District of California Southern Division. The premise for this alleged securities fraud action is that Thomas Lahey et al. purchased shares of Nettaxi as part of a private placement in February 2000 based on misrepresentations and omissions of material information. On October 7, 2002, the judge dismissed the federal law claims with prejudice and the state law claims without prejudice.

On July 31, 2001, Envision Media, Inc. filed a lawsuit against us in the Superior Court of the State of California for the County of Santa Cruz. In lieu of services provided, Envision Media agreed to accept as partial payment for its services, options to purchase shares of Nettaxi’s common stock. The contract required us to register the shares with the Securities and Exchange Commission within 15 days of entering into the contract. The premise for this lawsuit was that we failed to register the Nettaxi shares within the time specified in the contract. This case has been settled.

On October 23, 2001, the estate of Virgil Johnson filed a products liability and wrongful death lawsuit against us in the District Court of Harris County, Texas. The

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plaintiffs allege that our product was defective and unsafe for its intended purposes at the time it left our premises, and that the product was defective in that it failed to conform to the product design and specifications of other gas monitors. Additionally, the plaintiffs allege that the product was defectively designed and marketed so as to render it unreasonably dangerous to the plaintiff. In the event that we do not have adequate insurance coverage for the expenses related to the lawsuit, we may incur substantial legal fees and expenses in connection with the litigation. The litigation may also result in the diversion of our internal resources. Our defense of this litigation, regardless of its eventual outcome, will likely be costly and time consuming. The litigation is in the preliminary stage, and we are unable to predict its final outcome. However, an adverse outcome could materially affect our results of operations and financial position.

On March 26, 2002, Straughan Technical Distribution, LLC, filed a lawsuit against us in the Superior Court of the State of California for the County of Santa Clara. A similar lawsuit pending in District Court of Harris County, Texas was served on us on March 27, 2002. In these nearly identical lawsuits, Straughan, a distributor of Gastec Gas Detection Devices, claims to have experienced diminished sales to its customers, loss of profits and other damages as a result of the stated allegations, which include claims for interference with present and prospective business relations, false advertising, trade dress infringement, slander and antitrust violations. On April 17, 2002, we removed the California action to the United States District Court for the Northern District of California, and on April 18, 2002, we removed the Texas action to the United States District Court for the Southern District of Texas. On October 8, 2002, the principals of Straughan and RAE Systems met and discussed potential settlement opportunities. In February 2003, we agreed with Straughan to settle all claims asserted against each other. We are currently finalizing the terms of the settlement agreement.

In addition to the litigation described above, from time to time we may be subject to various legal proceedings and claims that arise in the ordinary course of business.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

None.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

Our common stock has been trading on the NASD OTC Market Bulletin Board under the trading symbol “RAEE.OB” since April 9, 2002, when we completed our merger with Nettaxi.com. The following table sets forth, for the periods indicated, the high and low bid prices for our common stock as reported by various Bulletin Board market makers. The quotations do not reflect adjustments for retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions.

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Prior to the merger, from October 12, 1998 until April 9, 2002, Nettaxi’s common stock was traded on the OTC Bulletin Board under the trading symbol “NTXY” and RAE Systems’ securities were not publicly traded. The following table sets forth, for the periods indicated, the high and low bid prices for our common stock as reported by various Bulletin Board market makers. The quotations do not reflect adjustments for retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions. The bid prices reflected below have been adjusted to account for a 1 for 5.67 reverse stock split of our common stock on April 9, 2002.

As of February 20, 2003, there were 427 shareholders of record who held shares of our common stock.

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

The following table provides information as of December 31, 2002 with respect to our compensation plans under which our equity securities are authorized for issuance:

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ITEM 6. SELECTED FINANCIAL DATA.

SUMMARY FINANCIAL DATA

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