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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-Q

(MARK ONE)


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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003

OR


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

FOR THE PERIOD FROM ____________ TO _____________

COMMISSION FILE NUMBER: 000-26109

RAE Systems Inc.
(Exact name of registrant as specified in its charter)


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

1339 Moffett Park Drive
Sunnyvale, California 94089
408-752-0723
(Address of registrant’s principal executive offices)

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  |_|       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 July 22, 2003  
Common Stock, $0.001 Par Value     46,006,943  




RAE Systems Inc.

INDEX

Part I.   Financial Information


  Item 1. Financial Statements (Unaudited)

  (a) RAE Systems Inc. Condensed Consolidated Balance Sheets at June 30, 2003 and December 31, 2002

  (b) RAE Systems Inc. Condensed Consolidated Statements of Operations for the three-month and six-month periods ended June 30, 2003 and 2002

  (c) RAE Systems Inc. Condensed Consolidated Statements of Cash Flows for the six-month periods ended June 30, 2003 and 2002

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

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

  Item 3. Quantitative and Qualitative Disclosures About Market Risk

  Item 4. Controls and Procedures

Part II. Other Information


  Item 1.  Legal Proceedings

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

  Item 6. Exhibits and Reports on Form 8-K

Signatures

Certifications

Exhibit Index

Exhibits




PART I.     Financial Information

In connection with our becoming a public company through a reverse merger transaction, certain options under our 1993 Stock Plan became subject to variable accounting in accordance with FASB Interpretation No. 44 (FIN 44). As of December 31, 2002, there were 2,014,941 options outstanding under the 1993 Stock Plan that were subject to variable accounting. To eliminate the variable effects of such accounting treatment, we have adopted the fair value recognition provisions of SFAS 123 for stock-based employee compensation, effective January 1, 2003 under the modified prospective method as provided for in SFAS 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. Our interim financial statements herein for the quarter and the six-month period ended June 30, 2003 reflect a non-cash compensation charge related to options of $155,300 and $280,300, respectively. In June 2003, we issued a warrant to purchase 450,000 shares of our common stock, to Jefferies/Quarterdeck for the purpose of retaining their financial advisory services. The warrant vested immediately and is exercisable over four years. The fair value of this warrant, assessed to $328,800, will be amortized over the service period. For the quarter and six-month period ended June 30, 2003, we have taken a charge related to this warrant in the amount of $27,400. Stock-based compensation charges have significantly impacted our financial statements, and will continue to impact the financial statements on a prospective basis.




Item 1: RAE Systems Inc. Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets

RAE Systems Inc.

Condensed Consolidated Balance Sheets


 
June 30,
2003 		  December 31,
2002 		 
 
(Unaudited)  
Assets          
   
Current Assets:  
    Cash and cash equivalents   $ 7,116,000   $ 7,193,500  
    Accounts receivable, net of allowance for doubtful accounts  
      of $175,700 and $175,700, respectively     3,428,600     2,475,700  
    Inventories     4,204,500     3,176,400  
    Prepaid expenses and other current assets     1,007,500     402,000  
    Deferred income taxes     528,800     528,800  
 
Total Current Assets     16,285,400     13,776,400  
 
Property and Equipment, net     2,015,600     2,026,800  
Deposits and Other Assets     143,000     81,800  
Investment in Unconsolidated Affiliate     651,600     784,700  
 
    $ 19,095,600   $ 16,669,700  
 
Liabilities and Shareholders’ Equity              
               
Current Liabilities:              
    Accounts payable   $ 1,507,800   $ 942,400  
    Accounts payable to affiliate     725,400     757,900  
    Accrued expenses     1,699,600     1,689,700  
    Income taxes payable     1,502,600     1,726,200  
    Current portion of deferred revenue     50,700     149,700  
    Current portion of capital lease obligations     159,600     159,600  
 
Total Current Liabilities     5,645,700     5,425,500  
 
Deferred Revenue, net of current portion     26,700     —  
Capital Leases Obligations, net of current portion     14,200     107,300  
Deferred Income Taxes     277,200     277,200  
 
Total Liabilities     5,963,800     5,810,000  
 
Commitments and Contingencies  
   
Shareholders’ Equity:  
    Common stock, $0.001 par value; 200,000,000 shares authorized;  
      45,982,223 and 45,516,675 shares issued and outstanding, respectively     46,000     45,500  
    Additional paid-in capital     18,141,000     17,955,800  
    Deferred compensation     —     (516,600 )
    Accumulated deficit     (5,055,200 )   (6,625,000 )
 
Total Shareholders’ Equity     13,131,800     10,859,700  
 
    $ 19,095,600   $ 16,669,700  
 

(See accompanying notes to condensed consolidated financial statements)




Condensed Consolidated Statements of Operations

RAE Systems Inc.

Condensed Consolidated Statements of Operations


Three months ended June 30,   Six months ended June 30,  
 
 
 
2003   2002   2003   2002  
 
(Unaudited)   (Unaudited)   (Unaudited)   (Unaudited)  
   
Net Sales   $ 7,459,100   $ 5,167,300   $ 14,798,500   $ 9,712,600  
Cost of Sales     2,615,700     2,151,400     5,528,500     4,176,200  
 
Gross Margin     4,843,400     3,015,900     9,270,000     5,536,400  
 
Operating Expenses:  
    Sales and marketing     1,911,500     1,466,300     3,381,600     2,539,600  
    Research and development     757,000     611,300     1,463,000     1,205,300  
    General and administrative     1,160,400     1,951,400     2,348,000     2,796,600  
    Legal fees and settlement costs     1,900     166,100     90,500     244,000  
    Merger costs     —     8,734,700     —     8,734,700  
 
Total Operating Expenses     3,830,800     12,929,800     7,283,100     15,520,200  
 
Operating Income (Loss)     1,012,600     (9,913,900 )   1,986,900     (9,983,800 )
 
Other Income (Expense):  
    Interest income     7,300     17,900     16,700     32,000  
    Interest expense     (5,700 )   (40,600 )   (14,200 )   (100,100 )
    Other, net     21,900     (13,500 )   23,000     (15,900 )
    Equity in loss of unconsolidated affiliate     (67,200 )   (59,300 )   (133,100 )   (120,600 )
 
Total Other Income (Expense)     (43,700 )   (95,500 )   (107,600 )   (204,600 )
 
Income (Loss) Before Income Taxes     968,900     (10,009,400 )   1,879,300     (10,188,400 )
Income Taxes     174,100     7,800     309,500     7,800  
 
Net Income (Loss)   $ 794,800   $ (10,017,200 ) $ 1,569,800   $ (10,196,200 )
 
Basic Earnings (Loss) Per Common Share   $ 0.02   $ (0.23 ) $ 0.03   $ (0.30 )
 
Diluted Earnings (Loss) Per Common Share   $ 0.02   $ (0.23 ) $ 0.03   $ (0.30 )
 
Weighted-average common shares outstanding     45,851,788     43,228,593     45,745,275     34,435,323  
Stock options     1,697,686     —     1,525,955     —  
 
Diluted weighted-average common shares
    outstanding 		    47,549,474     43,228,593     47,271,230     34,435,323  
 

(See accompanying notes to condensed consolidated financial statements)




Condensed Consolidated Statements of Cash Flows

RAE Systems Inc.

Condensed Consolidated Statements of Cash Flows


Six months ended June 30,  
 
 
2003   2002  
 
(Unaudited)   (Unaudited)  
Increase (Decrease) in Cash and Cash Equivalents          
Cash Flows From Operating Activities:  
    Net Income (Loss)   $ 1,569,800   $ (10,196,200 )
       Adjustments to reconcile net income to net cash  
          (used in) provided by operating activities:  
            Depreciation and amortization     438,000     263,800  
            Provision for doubtful accounts     —     (24,300 )
            Inventory reserve     (179,800 )   —  
            Compensation expense related to options     280,300     —  
            Amortization of deferred compensation     —     862,800  
            Common stock issued for services     —     2,121,600  
            Common stock purchase rights granted below fair value     —     2,308,300  
            Compensation expense related to warrants     27,400     4,305,800  
            Equity in loss of unconsolidated affiliate     133,100     120,600  
            Deferred income taxes     —     —  
            Changes in operating assets and liabilities, net of effects of deconsolidation:  
               Accounts receivable     (952,900 )   (31,400 )
               Inventories     (848,300 )   532,800  
               Prepaid expenses and other current assets     (304,100 )   (72,200 )
               Accounts payable     565,400     (50,100 )
               Accounts payable to affiliate     (32,500 )   59,200  
               Accrued expenses     9,900     (69,400 )
               Income taxes payable     (223,600 )   (211,000 )
               Deferred revenue     (72,300 )   (94,500 )
 
Net Cash Provided by (Used In) Operating Activities     410,400     (174,200 )
 
Cash Flows From Investing Activities:  
    Cash relinquished in deconsolidation     —     (878,300 )
    Restricted cash     —     3,000,000  
    Investment in affiliate     —     (500,000 )
    Acquisition of property and equipment     (426,800 )   (570,300 )
    Deposits and other     (61,200 )   (686,400 )
 
Net Cash (Used In) Provided By Investing Activities     (488,000 )   365,000  
 
Cash Flows From Financing Activities:  
    Proceeds from the issuance of common stock     93,200     200  
    Proceeds from merger/reorganization     —     6,965,500  
    Payments on notes payable and lines of credit     —     (4,425,800 )
    Payment on capital lease obligation     (93,100 )   (65,000 )
 
Net Cash Provided By Financing Activities     100     2,474,900  
 
Net (Decrease) Increase in Cash and Cash Equivalents     (77,500 )   2,665,700  
Cash and Cash Equivalents, beginning of period     7,193,500     3,742,600  
 
Cash and Cash Equivalents, end of period   $ 7,116,000   $ 6,408,300  
 
Supplemental Disclosure of Cash Flow Information:              
    Cash Paid:              
       Income taxes   $ 509,500   $ 218,800  
       Interest   $ 14,200   $ 100,100  
    Noncash Investing and Financing Activities:  
       Warrant issued for services   $ 328,800   $ —  
       Capital leases entered into for equipment   $ —   $ 329,800  
 

(See accompanying notes to condensed consolidated financial statements)




Notes to Condensed Consolidated Financial Statements
(Unaudited)

Note 1 – The Company

        RAE Systems Inc. (“RAE”, the “Company”), established in 1991, is a leader in rapidly deployable sensing networks for homeland defense and a leading manufacturer of portable, wireless and fixed atmospheric monitors, photo-ionization detectors, radiation detectors, gas detection tubes, sampling pumps and security monitoring devices.

        RAE’s products are used to detect weapons of mass destruction (WMD), environmental, safety, hazardous materials (HAZMAT), toxic industrial chemicals (TICs), petrochemicals, and semiconductor waste, including the detection of gamma rays, neutrons, combustible chemical and vapor accumulations, oxygen deficiencies, gasoline, benzene, paint, degreasers, jet fuel, carbon monoxide, hydrogen sulfide, carbon dioxide, and many other atmospheric hazards. RAE’s patented photo-ionization detector technology allows dependable, linear, part-per-billion range readings for many toxic chemicals and vapors that are effectively undetectable by any other means.

        The Company’s customers include many of the world’s leading corporations in the airline, automotive, oil, computer and telecommunications industries. The Company also has significant numbers of instruments currently in service with many U.S. government agencies and the armed forces, and by numerous city, state and federal agencies and departments. RAE’s products are used in confined space entry monitoring programs throughout the world, and are used in civilian and government atmospheric monitoring programs in over 50 countries. A substantial number of municipal agencies and city departments have standardized their programs on the Company’s products for confined space and HAZMAT incident response. The Company is also a leading supplier of chemical detectors used for jet fuel vapor monitoring programs.

        The Company sells its products through a network of approximately 180 distributors, which account for approximately 90% of its sales.

        The Company has strategically redirected its focus on homeland security. To this extent, the Company launched a series of marketing campaigns geared towards this effort, and is starting to reap the benefits of these efforts, having sold a large number of MultiRAEs and MiniRAEs to various federal, state and local agencies and municipalities. The Company also saw an increase in the sales of our wireless smart sensing platform and solutions business, in which information from the gas detector is transmitted on a real-time basis to a base controller located up to two miles away. The Company recently launched a new campaign to sell its new suite of radiation detectors, and is starting to realize an increase in the sales of these products as well.

        As discussed elsewhere in this report on Form 10-Q, RAE is currently involved in various legal proceedings. Regardless of the eventual outcome, such litigation will likely be time consuming, and may result in the diversion of our internal resources. The remaining lawsuit is in a preliminary stage, therefore the eventual outcome is difficult to determine. Any adverse result in either of the lawsuits could materially affect RAE’s results of operations and financial position.




Note 2 – Summary of Significant Accounting Policies

Management believes the following critical accounting policies affect its more significant estimates and assumptions used in the preparation of the condensed consolidated financial statements contained in this Form 10-Q.

        Basis of Presentation

        The financial information presented in this Form 10-Q is not audited and is not necessarily indicative of the Company’s future consolidated financial position, results of operations or cash flows. 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 inc