UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

 

 

Commission file number: 001-31783

RAE Systems Inc.

(Exact name of registrant as specified in its charter)

 

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

 

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

 

 

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

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No þ

 

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

 

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

 

Indicate by check mark 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.  þ

 

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

 

 

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

 

As of June 30, 2009, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $82,032,601, based upon the closing sale price of $1.38 on the NYSE Alternext US (formerly the American Stock Exchange) on June 30, 2009, the last business day of the registrant’s most recently completed second fiscal quarter. As of the close of business on February 26, 2010, the number of shares of registrant’s Common Stock outstanding was 59,438,328.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s proxy statement for its 2010 Annual Meeting of Stockholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

RAE SYSTEMS INC.

 

INDEX TO

 

ANNUAL REPORT ON FORM 10-K

FOR YEAR ENDED DECEMBER 31, 2009

TABLE OF CONTENTS

 

 

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,” “may,” “will,” “should,” “intend,” “plan,” “estimate,” “potential,” or “continue,” and other 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 that we file for the fiscal year 2010.

 

 

Overview

 

RAE Systems Inc. (referred to herein as the “Company”, “we”, or “our”) is a leading developer and manufacturer of rapidly-deployable, multi-sensor chemical and radiation detection monitors and wireless networks for application in five key markets: oil and gas, hazardous material management, industrial safety, civil defense and environmental remediation. We provide personal, portable and wireless sensor networks that enable our customers in more than 95 countries to identify safety and security threats in real-time. The Company was founded in 1991 and originally developed technologies for the detection of hazardous materials in environmental remediation and chemical spill clean-ups. We have a broad patent portfolio consisting of 14 issued U.S. patents, one patent issued in Japan, one issued and five pending EU patents, and five issued and 14 pending technology patents in China. These patents in gas and radiation detection technology are the basis for many of our products.

 

We offer a comprehensive portfolio of fixed and portable breathing zone single and multi-sensor chemical and radiation detection products, many with wireless integrated systems capability. Industrial applications include the detection of toxic industrial chemicals, volatile organic compounds and petrochemicals. Our products are deployed in oil and gas facilities, petrochemical and plastics plants, steel mills and in other types of manufacturing facilities. Our products enable the military and first responders such as firefighters, law enforcement and other emergency management personnel to detect and provide early warning of hazardous materials.

 

We have significant operations in the People’s Republic of China (“China”), including research and development and manufacturing operations in Shanghai. We own 96% of RAE-KLH (Beijing) Co., Limited, or RAE Beijing, a manufacturer and distributor of safety, environmental and personal protection monitors and equipment. We own a 70% interest in RAE Coal Mine Safety Instruments (Fushun) Co., Ltd., hereinafter referred to as RAE Fushun. RAE Fushun offers a range of portable and fixed use safety products, primarily to the China coal mining industry.

 

Additional information about the Company is available on our web site at www.raesystems.com. Information contained on or accessible through our web site is not part of this Annual Report or our other filings with the Securities and Exchange Commission (“SEC”). We make available, free of charge on our web site, access to our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we file them electronically with or furnish them to the SEC.

 

The public may also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Rooms by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet web site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. The SEC’s internet web site is located at http://www.sec.gov.

Industry Background

 

The market for our products has evolved from being strictly focused on environmental and industrial monitoring to encompassing energy exploration and production, mining and public safety. Demand for our products has grown in the fields of petrochemical production, environmental remediation, confined space entry, and OSHA industrial safety compliance monitoring. The application of our products in these established markets stems from the dependence of numerous key industries on sensors that provide vital information that can affect worker safety, products, processes and systems.

 

Sophisticated monitoring is important for emergency response personnel to detect harmful agents that could create a potentially lethal situation. We believe first responders need a suite of products that provide a practical, comprehensive solution to protect them from this danger. Many of the same equipment capabilities that are necessary to support first responders are also necessary to address other areas where there are increasing demands for chemical and radiation detection. For example, wireless detection systems have been deployed at many of the world’s major spectator events for public venue protection.

 

RAE Systems now offers a full suite of gas detection solutions for the oil, gas, petrochemical, adhesives and polymers markets. All of these markets require the constant monitoring of both flammable and toxic hydrocarbons. In 2009, RAE Systems began offering a full suite of personal, portable, fixed and wireless gas detection monitors for these markets.

 

Products

 

We manufacture and sell sensors and measurement products, which may also be integrated with wireless technology. As an instrument manufacturer, we have differentiated ourselves from our competition by developing a broad array of specific chemical sensors, including an array of electrochemical, solid polymer, infrared and catalytic-bead gas sensors as well as photoionization detectors.

 

Sensor and Measurement Products

 

Our products are based on proprietary and patented gas, chemical and radiation sensors. We design and manufacture the following sensors:

 

 

Photoionization detectors use ultraviolet light to ionize gas molecules into charged particles. This produces a flow of electrical current proportional to the concentration of the charge. Our patented photoionization detector technology enables dependable, linear, part-per-billion range readings for many toxic gases and vapors. Photoionization 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. Our products that use this technology include: the MultiRAE Plus, AreaRAE, AreaRAE Inert, AreaRAE Steel, MiniRAE 3000, MiniRAE Lite, ppbRAE 3000 and UltraRAE 3000.

 

Integrated Wireless Products

 

We have developed wireless capabilities for many of our gas monitoring instruments that enable detection from remote locations. Our AreaRAE and MeshGuard products offer wireless-enabled gas detectors, which provide

real-time transmission of monitoring information to a base station located up to two miles away from the detectors. The AreaRAE incorporates technologies such as global positioning system (GPS) receivers and geographic information system (GIS) capabilities to create awareness of hazardous conditions for decision makers located remotely in a central command and control location. In addition, both the AreaRAE and MeshGuard can interface with the Internet, making measurements available from virtually any location with Internet access.

 

Our AreaRAE Gamma combines a multi-gas and radiation detector equipped with a wireless radio frequency modem that allows the unit to communicate and transmit sensor and location information on a real-time basis to a remotely located base controller. AreaRAE Steel is a stainless steel version of the AreaRAE that meets the intrinsic safety requirements of the United States, Canada and the European Union (ATEX). All of the AreaRAE models are available in Rapid Deployment kits to enable swift deployment in the field.

 

Meshguard, introduced in October 2008, is a new family of wireless products designed to replace the “fixed” sensor systems that are deployed for oil and gas exploration. This family of products uses “mesh-radio” to create a self healing network where each sensor has both a radio receiver and transmitter. This architecture gives the MeshGuard sensor the ability to transmit radio data in and around metal structures that are generally difficult for clear radio transmission.

 

RAELink 3 provides the wireless network bridge to connect MultiRAE Plus, MiniRAE 3000, ppbRAE 3000 and UltraRAE 3000 to either the AreaRAE or MeshGuard networks.

 

Our wireless products include the AreaRAE, AreaRAE Steel, AreaRAE Gamma, MeshGuard and RAELink3.

 

Radiation Products

 

We have developed technology for gamma and neutron radiation detection. These technologies are incorporated into highly sensitive handheld instruments capable of detecting low levels of radiation on a real-time basis and dosimeters which are used in nuclear power plants to protect personnel from long-term radiation exposure. Our radiation products include GammaRAE II R, NeutronRAE II, AreaRAE Gamma, AreaRAE Steel Gama and DoseRAE. Our markets include nuclear power plants and first responders.

 

Sales, Marketing and Distribution

 

We sell our products in more than 95 countries and through an international network of direct sales personnel, representatives and distributors managed from our San Jose, California headquarters, our Beijing and Fushun, China operations, Hong Kong and our Copenhagen, Denmark European headquarters.

 

Currently, our predominant distribution channel is value added business-to-business or business-to-government distribution services companies that focus on the health, safety and security product markets. Many of our distributors are international companies with distribution rights in specific territories. We seek those distributors that have the greatest reach and broadest array of end-user customers. We monitor our distributors’ performance according to volume, payment schedule, training, services and other support programs.

 

Our wireless detection products, specifically the AreaRAE and MeshGuard suite of products and their peripherals, are largely sold through a direct sales channel in the United States and Europe. This channel was established because of the technical expertise required to advise and sell these complex monitoring systems.

 

Our marketing efforts are focused on increasing brand awareness and creating product preference through print advertising, direct mail, email marketing, web sites, trade shows and focused sales strategies. The primary responsibilities of our product managers is to create products and develop marketing programs targeted towards specific audiences in the areas of wireless systems, portable products, consumable products and government requirements.

 

Customers

 

We have significant numbers of instruments currently in service in more than 95 countries, with various government agencies and many of the world’s leading corporations. Our products are used in civilian and government atmospheric monitoring programs. Our end-user customers include many industrial companies that

use hazardous chemicals as part of their manufacturing processes. We serve customers in five key markets: oil and gas, hazardous material management, industrial safety, civil defense and environmental remediation. Our products are used in confined space entry monitoring programs, public venue protection, first responders, law enforcement, all branches of the armed forces and numerous local, state and federal agencies and departments.

 

Research, Development and Engineering

 

As a stand-alone toxic gas and radiation instruments manufacturer, we continue to invest in sensor technology. We were among the first companies in our industry to deploy Reduction of Hazardous Substances (RoHS) compliant oxygen sensors. These oxygen sensors meet the RoHS requirements of China, the European Union and the State of California. The Company maintains research, development and engineering facilities in San Jose, CA, and in Shanghai and Beijing, China. Our primary R&D facility is located in Shanghai, where we also have a radiation calibration lab. This lab is an important facility for the Company to expand its future radiation detection product offerings.

 

We use modular product design processes and flexible rapid manufacturing. These investments have resulted in improved system performance as well as advanced scalability, thereby allowing rapid development and regional certification of new products.

 

The Company currently holds a total of 21 patents granted with 19 patents pending. Theses patents include:

 

 

Manufacturing

 

We lease a modern 61,000 square foot manufacturing facility with laboratory space in Shanghai, China, where the majority of our components and products are manufactured. We lease a 67,000 square foot office, manufacturing, integration and test site in San Jose, California, where we manufacture some of our more complex and sensitive sensors. Our manufacturing operations in Shanghai and California are ISO 9001 certified. We have limited manufacturing capabilities in our RAE Beijing operations, consisting of 106,000 square feet, of which 41,000 square feet are dedicated to manufacturing and the balance to sales, marketing and administrative functions. We own a 239,000 square foot facility in Fushun, China, of which 179,000 square feet are dedicated to manufacturing and the balance to sales, marketing and administrative functions.

 

Competition

 

The markets for gas detection monitoring devices and wireless gas monitoring systems are highly competitive. Our global gas detection competitors include Industrial Scientific Corporation, Mine Safety Appliances Company, Honeywell, Ion Science, Draeger Safety Inc., Gastec Corporation and Sperian Protection. In addition, China specific gas detection competitors include Ex-Saf, Cosmos, and local China companies with established distribution networks.

 

Competitors in the gas monitoring industry differentiate themselves on the basis of their sensor technology, product quality, language support, service offerings, sales capabilities, cost and time to market. An emerging differentiator is the ability to manage data for long term exposure records and incident management. We believe we compete strongly in each of these areas and consider ourselves an industry leader in the design, development, marketing and manufacture of toxic gas monitoring devices. In particular, we believe our ability to develop products that integrate different chemical detection techniques, such as photoionization detectors, electrochemical sensors for specific toxic chemicals and combustible gas detectors, along with communication technologies that allow wireless data transfer, provide us with a competitive advantage. In addition, we believe our single user interface, training and support materials are a valuable resource for our distributors and end-users, which make our products more attractive to customers.

Many of our gas detection competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources. In addition, some of our competitors may be able to devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing policies and/or devote more resources to technology and systems development.

 

We differentiate our radiation detection products on their intrinsic safety certifications and the dual nature of our products. Our GammaRAE II R combines both a detector and dosimeter. Our NeutronRAE combines both gamma radiation and neutron detectors. Our AreaRAE Gamma combines wireless gas detection and gamma radiation monitoring. Competitors in the radiation detection market include Canberra, Exporanium, ICx, MGP Polimaster Ltd., Santa Barbara Systems, Smiths Detection, ThermoFisher and TSA Limited.

 

Employees

 

As of December 31, 2009, we employed 1,259 people. Our employees are not covered by a collective bargaining agreement. We have never experienced an employee-related work stoppage and consider our employee relations to be good.

 

Executive Officers of the Registrant

 

The following table sets forth the names, ages and positions held by our executive officers.

 

 

Robert I. Chen co-founded RAE Systems in 1991 and has served as President, Chief Executive Officer and a director 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 of Shanghai Ericsson Simtek Electronics Company, Limited, a telecommunications and electronics company. Mr. Chen received a BS in electrical engineering from Taiwan National Cheng Kung University, an MS in electrical engineering from South Dakota School of Mines and Technology, an advanced engineering degree from Syracuse University and graduated from the Harvard Owner/President program.

 

Randall Gausman joined RAE Systems in October 2006 as Chief Financial Officer. From May 2006 until joining the Company, Mr. Gausman worked as an independent financial consultant. From April 2002 to May 2006, Mr. Gausman served as Chief Financial Officer of Tut Systems, Inc., which delivered industry leading content processing and distribution products for deploying next-generation video and IP services over broadband networks. Previously he served as co-founder and CFO of Zantaz, Inc. and a senior finance executive at American President Companies. Mr. Gausman holds both a BS and MBA from the University of Southern California, as well as a certificate in corporate finance from the University of Michigan School of Business Administration.

 

Dr. Peter C. Hsi co-founded RAE Systems in 1991 and has served as Chief Technology Officer and a director since our inception. Prior to co-founding RAE Systems, Dr. Hsi was the chief architect for semiconductor test

systems at Applied Optoelectronic Technology Corporation. He was also the general manager for Shanghai Simax Technology Co. Ltd. Dr. Hsi has filed 21 patent applications, of which 16 have been granted and 5 are pending. Dr. Hsi received a BS in electrical engineering from the National Chiao-Tung University, and a MS and PhD in electrical engineering from Syracuse University.

 

Dr. Ming-Ching Tang joined RAE Systems in June 2007 as Vice President Manufacturing and was promoted to Executive Vice President Operations in August 2009. Prior to joining the Company, Dr. Tang was Senior Vice President of TDK China from 2004 to 2007, and was President of Trace Storage Technology, a thin film magnetic recording media company in Taiwan from 2001 to 2004. Prior to 2001, Dr. Tang held senior executive positions in hard drive technology development with Western Digital, Seagate Technology and IBM. Dr. Tang received a BS in mechanical engineering from National Taiwan University, an MS in mechanical engineering from Massachusetts Institute of Technology and a PhD in mechanical engineering from University of California, Berkeley.

 

Christopher Hameister has served as Vice President of Asia-Pacific, Europe, and Middle East Business Operations since January 2007. Previously, Mr. Hameister served as Vice President of Worldwide Sales with RAE Systems from July 2006 to January 2007. In the last 25 years, Mr. Hameister’s experiences have all been with instrumentation companies, including seven years, prior to rejoining the company in July 2005, as Director of Marketing and Sales with RAE Systems and six years with Thermo Instruments as Business Operation Manager. Mr. Hameister holds a BS from the University of Adelaide, South Australia and a certificate in marketing from University of New South Wales.

 

William Jackson joined RAE Systems in July 2009 and serves as our Vice President Global Marketing. Before joining RAE Systems, Mr. Jackson was Vice President of Product Marketing at ARC International, a leading supplier of semiconductor intellectual property. Prior to ARC, Mr. Jackson held management, marketing and business development positions at Eastman Kodak, MIPS Technologies, Toshiba, Digital Equipment Corporation and RCA. Mr. Jackson holds a MBA from Boston University and a BS in electrical engineering from the University of Pittsburgh.

 

Bin Lu joined RAE Systems in July 2006 as Director of the Company’s security business in China. He was promoted to Vice President and General Manager of RAE Beijing in September 2009. Prior to joining RAE Systems, Mr. Lu held management and engineering positions with several international technology companies. Mr. Lu holds both a BS and MS in computer science from Nankai University.

 

Fei-Zhou Shen joined RAE Systems in May 2001 and has served in various key roles including Vice President of Worldwide Manufacturing. Mr. Shen is currently Vice President Corporate Development and Fushun Business Operations. Mr. Shen has over 20 years of business experience serving in key business and strategic management roles. Mr. Shen has a BS in mechanical engineering from Shanghai Jiao-Tong University and a MS in mechanical engineering from the University of Idaho.

 

Ryan Watson joined RAE Systems in May 1999 as the Midwestern Regional Sales Manager. He has also served as Sales Director for the Eastern US and Canada and Central US Regional Sales Manager. He was promoted to Vice President of Americas Sales in March 2008. Mr. Watson has over 14 years of field experience selling into multiple market segments including industrial, first responder, government/military, oil-gas and petrochemical as well as environmental applications. Mr. Watson has a BS in human environmental sciences from the University of Missouri.

 

 

You should carefully consider the risks described below before making a decision regarding an investment in our common stock. If any of the following risks actually occur, our business could be harmed, the trading price of our common stock could decline and you may lose all or part of your investment. You should also refer to the other information contained in this report, including our financial statements and the related notes.

We have discovered potential violations of the Foreign Corrupt Practices Act, the resolution of which could have a material adverse impact on our financial condition and results of operations.

 

During fiscal year 2008, our internal audit department identified certain payments and gifts made by certain personnel in our China operations that may have violated the Foreign Corrupt Practices Act (“FCPA”). Following this discovery, the Audit Committee of our Board of Directors initiated an independent investigation. We have made a voluntary disclosure to the United States Department of Justice (“DOJ”) and the SEC regarding the results of our investigation. We have also implemented additional policies and controls with respect to compliance with the FCPA. The FCPA and related statutes and regulations provide for potential monetary penalties, criminal sanctions and in some cases debarment from doing business with the U.S. federal government in connection with FCPA violations. We are cooperating with the DOJ and the SEC in connection with their review of the matter and are actively engaged in settlement discussions. Although no assurances can be given as to whether the matter will settle or the amount of any settlement, the Company recorded an accrual of $3.5 million in the third quarter of 2009 relating to the potential settlement of this matter. The timing and final outcome of this or any future government investigation cannot be predicted with certainty and any indictment, conviction or material fine, debarment or settlement arising out of these investigations could have a material adverse affect on our business, financial condition, results of operation and future prospects.

 

Economic conditions could materially adversely affect our business.

 

The financial turmoil that first arose in the fall of 2008 has resulted in a tightening of the credit markets and a low level of liquidity in many financial markets. There could be a number of follow-on effects from the credit crisis on our business, including the insolvency of key suppliers or their inability to obtain credit to finance manufacturing of their products, resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of our products; and/or customer, including channel partner, insolvencies. Our operations and performance depend significantly on worldwide economic conditions. Uncertainty about current global economic conditions poses a risk as businesses and governments may postpone spending in response to tighter credit and/or negative financial news, which could have a material negative effect on demand for our products. Our operating results could also be adversely affected if the U.S. dollar strengthens against various foreign currencies.

 

Political events, war, terrorism, natural disasters, and other circumstances could materially adversely affect us.

 

War, terrorism, geopolitical uncertainties, and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus could have a strong negative effect on us and our suppliers, logistics providers, manufacturing vendors, and customers, including channel partners. Our business operations are potentially subject to interruption by natural disasters, fire, power shortages, terrorist attacks and other hostile acts, and other events beyond our control. Such events could decrease demand for our products, make it difficult or impossible for us to make and deliver products to our customers, including channel partners, or to receive components from our suppliers, and create delays and inefficiencies in our supply chain.

 

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

 

Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, some of which are outside of our control. Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indications of future performance. Some of the factors that could cause our quarterly or annual operating results to fluctuate include significant shortfalls in revenue relative to our planned expenditures, changes in budget allocations by the federal government for homeland security purposes, changes in world-wide energy production and refining, market acceptance of our products, ongoing product development and production, competitive pressures and customer retention. It is likely that in some future quarters our operating results may fall below the expectations of investors. In this event, the trading price of our common stock could significantly decline.

We may have difficulty achieving and sustaining profitability and may experience additional losses in the future. If we continue to report losses or are marginally profitable, the financial impact of future events may be magnified and may lead to a disproportionate impact on the trading price of our stock.

 

We recorded net losses of $5.8 million, $7.2 million and $14.7 million for 2009, 2008 and 2007, respectively. In order to improve our profitability, we will need to continue to generate new sales while controlling our costs. As we plan on continuing the growth of our business while implementing cost control measures, we may not be able to successfully generate enough revenues to return to profitability. Any failure to increase our revenues and control costs as we pursue our planned growth would harm our profitability and would likely result in a negative effect on the market price of our stock. In addition, our financial results have historically bordered at or near profitability, and if we continue to perform at this level, the financial impact may be magnified and we may experience a disproportionate impact on our trading price as a result. If we continue to incur losses, any particular financial event could result in a relatively large change in our financial results or could be the difference between us having a profit or a loss for the particular quarter in which it occurs.

 

We may require additional capital in the future, which may not be available or may only be available on unfavorable terms.

 

Our future capital requirements depend on many factors, including potential future acquisitions and our ability to generate revenue and control costs. Should we have the need to raise additional capital, we might not be able to do so at all or on favorable terms. In the case of any future equity financings, dilution to our shareholders could result and, in any case, such securities may have rights, preferences and privileges that are senior to those of our common stock. If we are unable to obtain needed capital on favorable terms, or at all, our business and results of operations could be harmed and our liquidity could be adversely effected.

 

The market for gas and radiation detection monitoring devices is highly competitive, and if we cannot compete effectively, our business may be harmed.

 

The market for gas and radiation detection monitoring devices is highly competitive. Competitors in the gas and radiation monitoring industry differentiate themselves on the basis of their technology, quality of product and service offerings, cost and time to market. Our primary competitors in the gas detection market include Industrial Scientific Corporation, Mine Safety Appliances Company, Honeywell, Ion Science, Draeger Safety Inc., Gastec Corporation and Sperian Protection. Our competitors in the radiation market include Canberra, Exporanium, ICx, MGP Polimaster Ltd., Santa Barbara Systems, Smiths Detection, ThermoFisher and TSA Limited. Several of our competitors such as Mine Safety Appliances Company, Draeger Safety Inc. and Smiths have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than we do. In addition, some of our competitors may be able to:

 

 

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

 

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

 

Our revenue growth is dependent on the timely introduction of new products to market. We may be unsuccessful in identifying new product and service opportunities or in developing or marketing new products and services in a timely or cost-effective manner. In developing new products, we may be required to make significant investments before we can determine the commercial viability of the new product. If we fail to accurately foresee our customers’ needs and future activities, we may invest heavily in the research and development of products that do not lead to significant sales.

We have expanded our current business of providing gas detection instruments to include radiation detection and wireless systems for local and remote security monitoring. While we perceive a large market for such products, the radiation detection and wireless systems markets are still evolving, and we have little basis to assess the demand for these products and services or to evaluate whether our products and services will be accepted by the market. If our radiation detection products and wireless products and services do not gain broad market acceptance or if we do not continue to maintain the necessary technology, our business and results of operations will be harmed.

 

In addition, compliance with safety regulations, specifically the need to obtain regulatory approvals in certain jurisdictions, could delay the introduction of new products by us. As a result, we may experience delays in realizing revenues from our new products.

 

The securities laws and regulations have and are likely to continue to have a significant effect on our costs.

 

The Sarbanes-Oxley Act of 2002 (the “Act”) and the rules promulgated by the SEC and the New York Stock Exchange in relation thereto require significant legal, financial and accounting compliance costs, and we expect these costs to continue indefinitely.

 

In the event we are unable to satisfy regulatory requirements relating to internal control over financial reporting or, if these controls are not effective, our business and financial results may suffer.

 

In designing and evaluating our internal control over financial reporting, we recognize that any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives. For example, a company’s operations may change over time as the result of new or discontinued lines of business and management must periodically modify a company’s internal controls and procedures to timely match these changes in its business. In addition, management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures and company personnel are required to use judgment in their application. While we continue to improve upon our internal control over financial reporting so that it can provide reasonable assurance of achieving its control objectives, no system of internal controls can be designed to provide absolute assurance of effectiveness.

 

Material weaknesses in internal control over financial reporting may materially impact our reported financial results and the market price of our stock could significantly decline. Additionally, adverse publicity related to a material failure of internal control over financial reporting could have a negative impact on our reputation and business.

 

We are subject to risks and uncertainties of the government marketplace, including the risk that the government may not fund projects that our products are designed to address and that certain terms of our contracts with government agencies may subject us to adverse government actions or penalties.

 

Our business is dependent in part upon government funded projects. Decisions on what types of projects are to be funded by local, state and federal government agencies may have a material impact on our business. The Federal budget for the Department of Homeland Security, which we refer to as “Homeland Security” herein, is a source for funding for many of our customers either directly or through grants to state and local agencies. However, if the government does not fund projects that our products are designed to address, or funds such projects at levels lower than we expect, our business and results of operations will be harmed.

 

From time to time we enter into government contracts that contain provisions which subject us to laws and regulations that provide government clients with rights and remedies not typically found in commercial contracts. For example, a portion of our federal contracting has been done through our distributors who are on the Federal Supply Schedules from the United States General Services Administration (GSA). GSA Schedule contracts which we may enter into often include a clause known as the “Price Reductions” clause. The terms of that clause are similar but not identical to a “most favored customer” clause in commercial contracts. Under that clause, we may agree that the prices to the government under the GSA Schedules contract will maintain a constant relationship to the prices charged to certain commercial customers, i.e., when prices to those benchmark customers drop, our prices on our GSA Schedules contract must be adjusted accordingly. Although when we are party to these contracts we

undertake extensive efforts to comply with the Price Reductions clause, it is possible that we may have an unreported discount offered to a “Basis of Award” customer and may have failed to honor the obligations of the Price Reductions clause. If that occurs, we could, under certain circumstances, be subject to an audit, an action in fraud, or other adverse government actions or penalties.

 

We may not be successful in promoting and developing our brand, which could prevent us from remaining competitive.

 

We believe that our future success will depend on our ability to maintain and strengthen the RAE brand, which will depend, in turn, largely on the success of our marketing efforts and ability to provide our customers with high-quality products. If we fail to successfully promote and maintain our brand, or incur excessive expenses in attempting to promote and maintain our brand, our business will be harmed.

 

We may face risks from our substantial international operations and sales.

 

We have significant operations in foreign countries, including manufacturing facilities, sales personnel and customer support operations. For the years ended December 31, 2009 and 2008, approximately 41% and 43% of our revenues, respectively, were from sales to customers located in Asia and approximately 17% and 16% of our revenues, respectively, were from sales to customers located in Europe. We have manufacturing facilities in China and in the United States. A significant portion of our products and components are manufactured at our facility in Shanghai, China.

 

Our international operations are subject to economic and other risks inherent in doing business in foreign countries, including the following:

 

 

 

The specific economic conditions in each country will impact our future international sales. For example, approximately half of our recognized revenue has been denominated in U.S. dollars. Significant downward fluctuations in currency exchange rates against the U.S. dollar could result in higher product prices and/or declining margins and increased manufacturing costs. If we do not effectively manage the risks associated with international operations and sales, our business, financial condition and operating results could suffer.

 

Like other companies operating or selling internationally, we are subject to the FCPA and other laws which prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. and other business entities for the purpose of obtaining or retaining business. We make sales in countries known to experience corruption. Our sales activities in such countries create the risk of unauthorized payments or offers of payments by one of our employees, consultants, sales agents or distributors which could be in violation of various laws including the FCPA, even though such parties are not always subject to our control. We have implemented new policies and procedures to prevent losses from such practices and to discourage such practices by our employees, consultants, sales agents and distributors and are continuing our efforts to improve such policies and procedures. Among other things, we have established ongoing training programs for our employees to ensure that they are aware of their responsibilities under the FCPA and similar laws. However, our existing safeguards and any improvements may prove to be less than effective and our employees, consultants, sales agents or distributors may engage in conduct for which we might be held responsible. Violations of the FCPA may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, financial condition and results of operations.

 

The loss of “Normal Trade Relations” status for China, changes in current tariff structures or adoption of other trade policies adverse to China could have an adverse effect on our business.

 

Our ability to import products from China at current tariff levels could be materially and adversely affected if the “normal trade relations” (“NTR”, formerly “most favored nation”) status the United States government has granted to China for trade and tariff purposes is terminated. As a result of its NTR status, China receives the same favorable tariff treatment that the United States extends to its other “normal” trading partners. China’s NTR status, coupled with its membership in the World Trade Organization, could eventually reduce barriers to manufacturing products in and exporting products from China. However, we cannot provide any assurance that China’s membership in the World Trade Organization or NTR status will not change. As a result of opposition to certain policies of the Chinese government and China’s growing trade surpluses with the United States, there has been, and in the future may be, opposition to NTR status for China. Also, the imposition of trade sanctions by the United States or the European Union against a class of products imported by us from, or the loss of NTR status with, China, could significantly increase our cost of products imported into the United States or Europe and harm our business. For example, in September 2009, the U.S. government imposed new tariffs on tires imported from China. Retaliatory actions by China could be harmful to our business. Because of the importance of our international sales and international sourcing of manufacturing to our business, our financial condition and results of operations could be significantly and adversely affected if any of the risks described above were to occur.

 

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

 

We currently manufacture and sell a significant portion of our components and products in China. Our existing and planned operations in China are subject to the general risks of doing business internationally and the specific risks related to the business, economic and political conditions in China, which include the possibility that the central government of China will change or even reverse its policies of promoting private industry and foreign investment in China. Many of the current reforms which support private business in China are unprecedented or experimental. Other political, economic and social factors, such as political changes, changes in the rates of economic growth, unemployment or inflation, or in the disparities of per capita wealth among citizens of China and between regions within China, could also lead to further readjustment of the government’s reform measures. It is not possible to predict whether the Chinese government will continue to be as supportive of private business in China, nor is it possible to predict how future reforms will affect our business.

Any failure to adequately protect and enforce our intellectual property rights could harm our business.

 

We regard our intellectual property as critical to our success. We rely on a combination of patent, trademark, copyright, trade secret laws and non-disclosure agreements and confidentiality procedures to protect our proprietary rights. Notwithstanding these laws, we may be unsuccessful in protecting our intellectual property rights or in obtaining patents or registered trademarks for which we apply. Although processes are in place to protect our intellectual property rights, we cannot guarantee that these procedures are adequate to prevent misappropriation of our current technology or that our competitors will not develop technology that is similar to our own.

 

While there is no single patent or license to technology of material significance to the Company, our ability to compete is affected by our ability to protect our intellectual property rights in general. For example, we have a collection of patents related to our photoionization detector technology, the first of which expires in 2012, and our ability to compete may be affected by any competing similar or new technology. In addition, if we lose the licensing rights to a patented or other proprietary technology, we may need to stop selling products incorporating that technology and possibly other products, redesign our products or lose a competitive advantage. We cannot ensure that our future patent applications will be approved or that our current patents will not be challenged by third parties. Furthermore, we cannot ensure that, if challenged, our patents will be found to be valid and enforceable. Any litigation relating to our intellectual property rights could, regardless of the outcome, have a material adverse impact on our business and results of operations.

 

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

 

In connection with the enforcement of our own intellectual property rights, the acquisition of third-party intellectual property rights or disputes relating to the validity or alleged infringement of third-party rights, including patent rights, we have been, are currently and may in the future be subject to claims, negotiations or complex, protracted litigation. Intellectual property disputes and litigation are typically very costly and can be disruptive to our business operations by diverting the attention and energies of management and key technical personnel. Although we have successfully defended or resolved past litigation and disputes, we may not prevail in any ongoing or future litigation and disputes. We may incur significant costs in acquiring the necessary third party intellectual property rights for use in our products. Third party intellectual property disputes could subject us to significant liabilities, require us to enter into royalty and licensing arrangements on less favorable terms, prevent us from manufacturing or licensing certain of our products, cause severe disruptions to our operations or the markets in which we compete, or require us to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements, any one of which could seriously harm our business. For example, for the last several years we have been involved in a dispute with Polimaster Ltd. which required us to incur substantial professional fees. Although we ultimately prevailed, it is uncertain whether we will be able to recover any of the amounts awarded to us.

 

Claims of this type, regardless of merit, can be time-consuming to defend, result in costly litigation, divert management’s attention and resources or require us to enter into royalty or license agreements. The terms of any such license agreements may not be available on reasonable terms, if at all, and the assertion or prosecution of any infringement claims could significantly harm our business.

 

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

 

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

We sell a majority of our products through distributors, and if our distributors stop selling our products, our revenues would suffer.

 

We distribute our products in the Americas, Europe, Asia Pacific and the Middle East primarily through distributors. We are dependent upon these distributors to sell our products and to assist us in promoting and creating a demand for our products. Distributors are an important sales channel for our future growth. If one or more of our distributors were to experience financial difficulties or become unwilling to promote and sell our products for any reason, including any refusal to renew their commitment as our distributor, we might not be able to replace such lost revenue, and our business and results of operations could be materially harmed.

 

Because we purchase a significant portion of our component parts from a limited number of third party suppliers, we are subject to the risk that we may be unable to acquire quality components in a timely manner, which could result in delays of product shipments and damage our business and operating results.

 

We currently purchase component parts used in the manufacture of our products from a limited number of third party suppliers. We depend on these suppliers to meet our needs for various sensors, microprocessors and other material components. Moreover, we depend on the quality of the products supplied to us over which we have limited control. Should we encounter shortages and delays in obtaining components, we might not be able to supply products in a timely manner due to a lack of components, and our business could be adversely affected.

 

Future acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute shareholder value or harm our results of operations.

 

In the last several years, we increased our ownership of RAE Beijing to 96%, acquired Aegison Corporation and Tianjin Securay Technology Co., Ltd. and formed RAE Fushun, of which we retain 70% ownership. In August 2007, we determined to discontinue the Aegison and Securay businesses. We may acquire or make additional investments in complementary businesses, technologies, services or products if appropriate opportunities arise. The process of integrating any acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures. Integration of an acquired company also may consume much of our management’s time and attention that would otherwise be available for ongoing development of our business. Moreover, the anticipated benefits of any acquisition may not be realized. Future acquisitions could result in dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or expenses related to goodwill recognition and other intangible assets, any of which could harm our business.

 

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

 

We currently own approximately 40% of Renex Technology Ltd. (“Renex”), a wireless systems company. We are required to incorporate our share of its expenses as losses in our Consolidated Statements of Operations. If Renex does not begin to generate revenues at the level we anticipate or otherwise incurs greater losses, we could incur greater losses than we anticipate and our results of operations will suffer.

 

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

 

Our future success depends to a significant extent on the continued service of our executive officers. We have no formal employment agreements with any of our executives other than the initial offer letter, if applicable. The loss of the services of any of our executive officers could harm our business. We do not have key person life insurance on any of our personnel.

 

Our officers and directors beneficially own approximately 32% of our common stock and, accordingly, may exert substantial influence over the Company.

 

Our executive officers and directors, in the aggregate, beneficially own approximately 32% of our common stock as of December 31, 2009. These stockholders acting together have the ability to substantially influence all matters requiring approval by our stockholders. These matters include the election and removal of the directors, amendment of our certificate of incorporation, and any merger, consolidation or sale of all or substantially all of our

assets. In addition, they may dictate the management of our business and affairs. Furthermore, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination and may substantially reduce the marketability of our common stock.

 

 

None.

 

 

Our corporate headquarters and principal offices are located in a facility we lease in San Jose, California. The San Jose facility consists of approximately 67,000 square feet, which we have occupied since May 2005, and which includes research and development, sales and marketing, general and administrative and manufacturing operations. The lease expires in December 2017.

 

We lease manufacturing and research and development facilities in Shanghai, China. The lease on the manufacturing facility (44,000 square feet) expires in September 2011. The lease on the research and development/sensor laboratory (17,000 square feet) expires in October 2012.

 

In December 2008, we purchased the land use rights for 50 years to 5 acres of land in Shanghai. We plan to use this site to construct a new manufacturing and research and development facility, which would replace our current Shanghai facility.

 

In addition, RAE Beijing owns a manufacturing facility consisting of approximately 106,000 square feet, of which 41,000 square feet is dedicated to the manufacturing of RAE Beijing’s products and the storage of the inventory.

 

In October 2008, we relocated our operations to a new owner occupied 239,000 square foot manufacturing facility in Fushun, China. Related offices, a research and development facility and living quarters totaling 152,000 square feet have not been completed at this time.

 

We maintain a sales office in Shatin, Hong Kong, from which we sell our products throughout Asia, excluding the People’s Republic of China. The lease expires in April 2011. We also maintain sales and service centers in Copenhagen, Denmark, the United Kingdom, France and United Arab Emirates, from which we sell our products to Europe, Australia, New Zealand, the Middle East and Africa. The lease of the Copenhagen facility expires in September 2014.

 

 

Regulatory Compliance

 

During fiscal year 2008, our internal audit department identified certain payments and gifts made by certain personnel in our China operations that may have violated the FCPA. Following this discovery, the Audit Committee of our Board of Directors initiated an independent investigation. We have made a voluntary disclosure to the DOJ and the SEC regarding the results of our investigation. We have also implemented additional policies and controls with respect to compliance with the FCPA. The FCPA and related statutes and regulations provide for potential monetary penalties, criminal sanctions and in some cases debarment from doing business with the U.S. federal government in connection with FCPA violations. We are cooperating with the DOJ and the SEC in connection with their review of the matter and are actively engaged in settlement discussions. Although no assurances can be given as to whether the matter will settle or the amount of any settlement, the Company recorded an accrual of $3.5 million in the third quarter 2009 relating to the potential settlement of this matter. The timing and final outcome of this or any future government investigation cannot be predicted with certainty and any indictment, conviction or material fine, debarment or settlement arising out of these investigations could have a material adverse affect on our business, financial condition, results of operation and future prospects.

Polimaster Ltd., et al. v. RAE Systems Inc., United States District Court for the Northern District of California, Case No. 05-CV-01887-JF, United States Court of Appeals for the Ninth Circuit, Nos. 08-15708 and 09-15369.

 

Polimaster Ltd. and Na&Se Trading Company, Ltd. (“Polimaster”) filed a complaint against the Company on May 9, 2005, in the United States District Court for the Northern District of California in a case titled Polimaster Ltd., et al. v. RAE Systems Inc. (Case No. 05-CV-01887-JF). The complaint alleges, among other things, that the Company breached its contract with Polimaster and infringed upon Polimaster’s intellectual property rights. The dispute was subject to a contractual arbitration agreement, although the federal court retained jurisdiction over the matter pending completion of the arbitration. The arbitration was conducted in the spring of 2007.

 

In September 2007, a Final Award was issued in the arbitration. The arbitrator ruled that Polimaster failed to prove its claims and was not entitled to any relief; that the Company had proven its counterclaims and was awarded damages of approximately $2.4 million; and that as the prevailing party, the Company was entitled to recover costs in the amount of $46,000. On October 5, 2007, RAE Systems filed a motion to confirm the Final Award. On October 17, 2007, Polimaster filed an opposition to RAE Systems’ motion to confirm the Final Award and filed its own motion to vacate the Final Award. Both motions were heard on December 7, 2007, and the district court confirmed the Final Award in an order dated February 25, 2008. Polimaster appealed from the district court’s order confirming the arbitration award in Polimaster Ltd. et al. v. RAE Systems Inc., No. 08-15708. The appeal is currently pending in the United States Court of Appeals for the Ninth Circuit. Briefing on the appeal has been completed by both sides and the appeal was argued and submitted to the Ninth Circuit for decision on January 15, 2010.

 

When district court confirmed the Final Award in favor of RAE Systems, it did not enter judgment, an omission the district court described as a non-substantive clerical error. On September 9, 2008, the court of appeal granted leave for the district court to correct this clerical error. On January 23, 2009, the district court entered judgment in favor of RAE Systems and against Polimaster, and included in the judgment post-arbitration/pre-judgment interest and post-judgment interest. Polimaster has appealed the inclusion of these two interest components in the judgment, in Polimaster Ltd. et al. v. RAE Systems Inc., No. 09-15369, and briefing on the appeal has been completed by both sides and the appeal was argued and submitted to the Ninth Circuit for decision on January 15, 2010.

 

On May 14, 2009, Polimaster and RAE Systems entered a First Amended And Restated Stipulation And Order Re Stay Of Execution Of Judgment In Favor Of RAE Systems Inc. (the “stipulation”), pursuant to which Polimaster wire transferred $1.4 million to the client trust account of RAE Systems’ counsel McLeod, Witham & Flynn LLP, and agreed to wire transfer an additional $116,224.25 per month until the entire amount deposited equals the amount of the judgment (approximately $2.8 million) plus accrued interest at the judgment rate of 0.43 percent per annum. Pursuant to the stipulation, the amounts transferred by Polimaster are being maintained in the client trust account of McLeod, Witham & Flynn LLP, and shall not be distributed to RAE Systems or Polimaster, until the Ninth Circuit has ruled on Polimaster’s appeal (Nos. 08-15708 and 09-15369). McLeod, Witham & Flynn LLP shall release the funds in the account to RAE Systems and/or Polimaster within seven days of the Ninth Circuit’s final ruling on the appeal, in accordance with the Ninth Circuit’s decision. Polimaster is currently in compliance with the payment schedule provided in the stipulation. If RAE Systems is successful on appeal, it is expected that the Company would receive approximately $1.6 million, net of attorneys’ fees and expenses.

 

 

 

Our common stock traded on the American Stock Exchange (“AMEX”) under the trading symbol “RAE” beginning on August 29, 2003. Effective October 1, 2008, the AMEX was acquired by NYSE Euronext, the holding company created by the combination of NYSE Group, Inc. and Euronext N.V. in April 2007. Since October 1, 2008, our common stock has traded on the NYSE Alternext US (“NYSE-Alt”). The following table sets forth, for the

periods indicated, the high and low sales prices for our common stock as derived from publicly reported AMEX and NYSE-Alt daily trading data. The quotations do not reflect adjustments for retail mark-ups, mark-downs, or commissions and may not necessarily represent actual transactions.

 

 

As of December 31, 2009, there were 272 shareholders of record who held shares of our common stock.

 

We have never declared or paid dividends on our common stock. We do not have any plans 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.

 

PERFORMANCE GRAPH

 

The following chart presents a comparative analysis of the performance of our common stock relative to the NYSE AMEX Composite Index and NYSE AMEX stock index for SIC codes 3800-3899, Measuring Instruments. This analysis assumes a $100 investment in our underlying common stock and these indices on December 31, 2004 through December 31, 2009. This analysis does not purport to be a representation of the actual market performance of our stock or these indices. This chart has been provided for informational purposes to assist the reader in evaluating the market performance of our common stock compared to other market participants.

 

Notwithstanding anything to the contrary set forth in our previous filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, which might incorporate future filings made by us under those statutes, the following Stock Performance Graph will not be deemed incorporated by reference into any future filings made by us under those statutes.

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

 

Among RAE Systems Inc., the NYSE AMEX Composite Index, the NYSE Amex Stock Market (U.S. Companies), and a Peer Group of NYSE AMEX stocks for SIC codes 3800 — 3899 Measuring Instruments (photo, med & optical goods)

 

Comparison of 5 Year Cumulative Total Return

Assumes Initial Investment of $100

December 2009

 

 

 

 

Fiscal year ending December 31,

 

 

Effective October, 2008, the AMEX was acquired by NYSE Euronext, the holding company created by the combination of NYSE Group, Inc. and Euronext N.V. in April 2007. Since October 1, 2008, our common stock has traded on the NYSE Alternext US (“NYSE-Alt”).

 

 

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.

 

 

The following information summarizes events that affect comparability of the information reflected in selected financial data:

 

 

 

 

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. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in Item 1A, “Risk Factors” as well as in Item 1, “Business” and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K. You should carefully review these risks and also review the risks described in other documents we file from time- to- time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q that we will file in fiscal year 2010. You are cautioned not to place undue reliance on these forward-looking statements, and we expressly assume no obligations to update the forward-looking statements in this report that occur after the date hereof.

 

Overview

 

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

 

In 2006, we made two significant business investments in China. First in July 2006, we increased our ownership in RAE Beijing to 96%. RAE Beijing produces, sells and distributes safety and security solutions for the chemical, oil and gas, metals and energy sectors in China. Second, in December 2006, we formed RAE Fushun, a joint venture with Fushun Anyi, a former state owned company serving the coal mine safety market. This joint venture was formed to capitalize on China’s growing reliance on coal based energy. RAE Fushun manufactures and sells coal mine safety equipment. RAE Systems owns 70% of the joint venture.

 

In China, our focus is on growing the environmental protection market and the industrial sector, including oil and gas, petro-chemicals, steel, telecommunications and coal mining. A major priority will be to introduce new products for the coal mine safety market through RAE Fushun. We believe this market will provide us a number of new business opportunities, as China continues to modernize its coal mining industry.

 

We offer a complete line of products to meet the requirements of the various markets we serve. Products range from breathing zone single sensor products for specific toxic chemicals (ToxiRAE 3) to belt worn multi-gas monitors (QRAE 2) to handheld instruments (MiniRAE 3000, ppbRAE 3000 and UltraRAE) to measure total and specific volatile organic compounds, to wireless monitors for industrial and public safety applications (AreaRAE Steel).

 

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

 

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

Critical Accounting Policies

 

The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, we evaluate the estimates, including those related to our allowance for doubtful accounts, valuation of long-lived assets, goodwill and intangible assets, valuation of deferred tax assets, contingencies, inventory valuation, warranty accrual and stock-based compensation expense. In conjunction with acquisitions, we allocate investment costs based on the fair value of the assets acquired and liabilities assumed. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates under different assumptions or conditions.

 

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

 

Revenue Recognition

 

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, we have experienced an insignificant amount of sales returns. We generally recognize revenue when goods are shipped to our distributors in accordance with standard contract terms that pass title of all goods upon delivery to a common carrier (FOB factory) and provide for sales returns under standard product warranty provisions. For non-standard contract terms where title to goods passes at time of delivery (FOB destination), revenue is recognized after we have established proof of delivery. Revenues relating to services performed under our extended warranty program represent less than 5% of net revenues in each of 2009, 2008 and 2007 and are recognized as earned based upon contract terms, generally ratable over the term of service. We record project installation work in Asia using the percentage-of-completion method. Installation revenue represents less than 7% of net revenue in 2009, 2008 and 2007. Net revenues include amounts billed to customers in sales transactions for shipping and handling. Shipping fees represent less than 1% of net revenues in each of 2009, 2008 and 2007. Shipping costs are included in cost of goods sold.

 

Accounts Receivable, Trade Notes Receivable and Allowance for Doubtful Accounts

 

We grant credit to our customers after undertaking an investigation of credit risk for all significant amounts. An allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. We generally do not require collateral for sales on credit. While management uses the best information available in making our determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there was a deterioration of a major customer’s credit-worthiness or if actual defaults were higher than what have been experienced historically, additional allowances would be required.

 

We are not able to predict changes in the financial stability of our customers. Any material change in the financial status of any one or a group of customers could have a material adverse effect on our results of operations and financial condition.

 

Trade notes receivables are presented to us from some of our customers in China as a payment against the outstanding trade receivables. These notes receivables are bank guarantee promissory notes which are non-interest bearing and generally mature within 6 months.

Inventories

 

Inventories are stated at the lower of cost, using the first-in, first-out method, or market. We are exposed to a number of economic and industry factors that could result in portions of our inventory becoming either obsolete or in excess of anticipated usage, or saleable only for amounts that are less than their carrying amounts. These factors include, but are not limited to, technological changes in the market, competitive pressures in products and prices, and the availability of key components from our suppliers. We have established inventory reserves when conditions exist that suggest that our inventory may be in excess of anticipated demand or is obsolete based upon assumptions about future demand for our products and market conditions. When recorded, reserves are intended to reduce the carrying value of the inventory to its net realizable value. If actual demand for specified products deteriorates, or market conditions are less favorable than those projected, additional reserves may be required.

 

Goodwill and Other Intangible Assets

 

We test goodwill and other intangible assets for possible impairment on an annual basis and at any other time if events occur or circumstances indicate that the carrying amount may not be recoverable. The recoverability is measured at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill, to the fair value of the reporting unit, which is measured based upon, among other factors, market capitalization as well as forecasted operating results. We have one reporting unit. If the recorded value of the assets, including goodwill and other intangible assets, and liabilities (“net book value”) of the reporting unit exceeds its fair value, an impairment loss may exist. Further, to the extent our consolidated net book value is greater than our market capitalization, all, or a significant portion of any goodwill may be impaired.

 

We experienced a significant decline in market capitalization during the fourth quarter of 2008. This decline in market capitalization was driven largely by deteriorating macroeconomic conditions that contributed to a decline in our forecasted operating results and business. As a result, we recognized a non-cash impairment charge of approximately $3.3 million for the three-month period and year ended December 31, 2008 to write-off the entire carrying value of goodwill.

 

Long-lived Assets

 

We test long-lived asset groups for recoverability when events occur or circumstances indicate that their carrying amounts may not be recoverable. Recoverability is assessed based on the carrying amounts of the asset and its fair value which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset, as well as specific appraisals in certain instances. An impairment loss is recognized when the carrying amount is not recoverable and exceeds fair value.

 

Stock-Based Compensation Expense

 

We estimate the fair value of each option award on the date of grant using a Black-Scholes-Merton (“BSM”) valuation model and a single option award approach. Accordingly, stock-based compensation cost is measured at grant date based on the fair value of the award and recognized in expense over the requisite service period, which is generally the vesting period.

 

We make the following estimates and assumptions in determining fair value:

 

Expected Term — Our expected term represents the weighted-average period that our stock-based awards are expected to be outstanding. We have used the historical exercise patterns of previously granted options in relation to the Company’s stock price to estimate expected exercise patterns.

 

Expected Volatility — The Company’s expected volatilities are based on historical volatility of the Company’s stock, adjusted where determined by management for unusual and non-representative stock price activity not expected to recur. Management determined the historical stock price volatility for period from April 11, 2002, the commencement of public trading of the common stock, through December 31, 2002, was not likely to be representative of the future and excluded this period. Management also applies mean reversion techniques to the historical stock prices, which results in an emphasis on recent activity over the distant past, when determining the expected volatility rate to be included in the Black-Scholes-Merton valuation model.

Expected Dividend — The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company currently pays no dividends and does not expect to pay dividends in the foreseeable future.

 

Risk-Free Interest Rate — The Company bases the risk-free interest rate on the implied yield currently available on United States Treasury zero-coupon issues with an equivalent remaining term.

 

Estimated Forfeitures — To estimate forfeitures, we apply our historical rate of option forfeitures. Estimated forfeiture rates are trued-up to actual forfeiture results as the stock-based awards vest.

 

Business Combinations

 

In accordance with the authoritative accounting guidance, we allocate the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. We engage third-party appraisal firms to assist management in determining the fair values of certain assets acquired and liabilities assumed. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.

 

Management makes estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired companies and is inherently uncertain. Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from customer contracts, acquired developed technologies and pending patents; expected costs to develop the in-process research and development into commercially viable products and estimating cash flows from the projects when completed; the acquired company’s brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined company’s product portfolio; and discount rates. Unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or actual results.

 

Income Taxes

 

We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes.

 

Our effective tax rates differ from the statutory rate primarily due to foreign earnings taxed at lower rates, foreign losses not benefited, stock compensation expenses, under ASC 718, “Stock Compensation,” which are not deductible for tax purposes and changes in our valuation allowances. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, accounting principles, or interpretations thereof. We regularly assess the likelihood of adverse outcomes resulting from tax examinations to determine the adequacy of our provision for income taxes.

 

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

 

RESULTS OF OPERATIONS

 

Net Sales

 

 

Net sales during 2009 decreased $12.2 million, or 13%, from $95.4 million in 2008. The decease was primarily the result of a decrease in net sales of $3.5 million, or 9%, in Americas, $7.7 million, or 19%, in Asia and

$1.0 million, or 6%, in Europe. The decrease is primarily attributable to the negative impact of the worldwide economic downturn during the first half of 2009 and disruption of our sales activity in China due to management changes at our Fushun and Beijing operations. We believe these two factors negatively impacted our sales by approximately $6.2 million in the first nine months of 2009. Additionally, the decrease in 2009 resulted from the impact of two significant non-recurring orders in 2008 totaling approximately $5.6 million: one from the United States National Guard and another from the Beijing International Airport. Approximately $0.5 million of the decrease was due to unfavorable exchange rate fluctuations.

 

Net sales during 2008 increased $4.5 million, or 5%, from $90.8 million in 2007. The increase was primarily the result of an increase in net sales of $1.4 million and $3.8 million in the Americas and Europe, respectively, offset by a decrease of net sales in Asia by $0.7 million. The increase from 2007 to 2008 consisted primarily of two large non-recurring orders in 2008 totaling approximately $5.6 million: one from the United States National Guard and another from the Beijing International Airport. Additional increases in net sales of approximately $4.2 million were due to the appreciation of the Renminbi (“RMB”) and Euro against the U.S. dollar from 2007 to 2008. The increase was partially offset by an economic slow down in China following the Beijing Olympics, in the second half of 2008.

 

Cost of Sales and Gross Profit

 

 

Cost of sales consists of direct material, labor and overhead. Cost of sales in 2009 decreased $5.0 million or 11% from $47.2 million in 2008. The decrease in cost of sales was primarily the result of a decrease in net sales from $95.4 million in 2008 to $83.2 million in 2009. The gross margin change to 49% in 2009 from 51% in 2008 was primarily the result of the year-over-year decline in revenue, particularly in the Americas and Europe, regions where we generally sell higher margin products.

 

Cost of sales in 2008 increased $2.7 million or 6% from $44.4 million in 2007. The increase in cost of sales was primarily the result of an increase in net sales from $90.8 million in 2007 to $95.4 million in 2008. Gross margin in 2008 remained consistent with 2007 at 51%.

 

Sales and Marketing Expense

 

 

Sales and marketing expenses in 2009 decreased $2.6 million, or 12%, from $21.4 million in 2008. The decrease was primarily due to reduced headcount, travel by employees and participation at trade shows.

 

Sales and marketing expenses in 2008 decreased $4.0 million or 16% from $25.4 million in 2007. The decrease was primarily due to company-wide cost-control initiatives and a ten percent workforce reduction in the Americas, at the end of the first quarter of 2008. Additional savings were realized by decreases in office expenses, advertising and trade show expenses, travel and entertainment expenses, consultant expenses and project expenses.

Research and Development Expense

 

 

Research and development expenses in 2009 decreased $0.3 million, or 5%, from $6.7 million in 2008. The decrease was primarily the result of a business tax exemption from the PRC granted to RAE Shanghai for engineering services provided by RAE Shanghai to RAE Asia and lower project related expenses, partially offset by an increase in payroll expenses due to an increase in headcount.

 

Research and development expenses in 2008 decreased $1.3 million or 16% from $8.0 million in 2007. The decrease was primarily due to a $0.7 million decrease in amortization expense as certain intangible assets were fully amortized and a $0.7 million decrease in project expenses due to completion of certain R&D projects in 2008.

 

General and Administrative Expense

 

 

General and administrative expenses in 2009 increased $0.3 million from $22.9 million in 2008. While general and administrative expenses were relatively constant during 2009 and 2008, management accrued $3.5 million as its estimate to settle the outstanding joint investigation into the Company’s alleged violations of the FCPA and increased bad debt expense associated with doubtful accounts receivable of $0.8 million, which was offset by lower professional fees of $4.5 million, consisting primarily of legal fees.

 

General and administrative expenses in 2008 increased $5.1 million or 29% from $17.8 in 2007. The increase was primarily due to a net increase of $2.5 million in professional service expenses. The charge was comprised of a $4.0 million increase related to the previously disclosed FCPA investigation and related remediation plans conducted under the supervision of the Audit Committee of the Board of Directors, offset by a decrease in legal costs associated with the conclusion of the Polimaster arbitration in 2007. Bad debt expenses increased by $1.4 million due to an increase in accounts receivable reserves at RAE Fushun and RAE Beijing.

 

Impairment of Goodwill

 

 

We experienced a significant decline in market capitalization during the fourth quarter of 2008. This decline in market capitalization was driven largely by deteriorating macroeconomic conditions that contributed to a decline in our forecasted operating results and business. As a result, we recognized a non-cash impairment charge of approximately $3.3 million for the three-month period and year ended December 31, 2008 to write-off the entire carrying value of goodwill.

Gain/loss on Abandonment of Lease

 

 

Other Income (Expense)

 

 

For 2009, Total other expenses decreased by $0.5 million, or 64%, from $0.8 million in 2008. The decrease in interest income was primarily due to lower interest rates and decreased cash in interest earning accounts. The change of $0.8 million income in net other during 2009 was primarily from foreign exchange gains in Asia and Europe. The expense increase of $0.2 million in Equity in loss of unconsolidated affiliates represents the Company’s share in the unconsolidated losses of its investments in various businesses.

 

For 2008, total other expenses increased $0.3 million or 57% from $0.5 million in 2007. The increase was primarily due to increases in foreign exchange losses from balances and payments in Euro and RMB, offset by decreases in interest expenses as we repaid our outstanding loan balance using funds from sale of the San Jose building.

 

Income Tax (Benefit) Expense

 

 

Income tax expense decreased $1.4 million from an income tax expense of $0.5 million in 2008. Our effective tax rate was 12% in 2009 and (8)% in 2008. The tax rate for years 2009 and 2008 differed from United States statutory rate due to the realization of certain deferred tax assets (DTAs), foreign earnings taxed at lower rates, foreign losses not benefited and non-deductible stock compensation deductions.

 

In November 2009, the Worker, Homeownership, and Business Assistance Act of 2009 was enacted. Under this law, companies may elect to increase the carryback period for the net operating loss of a tax year ending after December 31, 2007 and beginning before January 1, 2010 to 3, 4 or 5 years. Accordingly, we have elected to carry our 2008 net operating loss back to 2003, which will result in a refund of approximately $659,000.

 

We currently have significant deferred tax assets resulting from anticipated net operating losses and other deductible temporary differences, which will reduce taxable income in future periods. We continue to maintain a full valuation allowance for all deferred assets except for $0.9 million related to certain of our foreign entities. Based on our current projections, we believe it is “more likely than not” we will not be able realize our deferred tax assets with the exception of the $0.9 million foreign deferred tax assets. ASC 740, “Income Taxes,” requires a valuation allowance be established when it is “more likely than not” that all or a portion of deferred tax assets will not be realized and that it is difficult to conclude that a valuation allowance is not needed when there is negative

evidence such as cumulative losses in recent years. Therefore, cumulative losses weighed heavily in the overall assessment. We believe that sufficient uncertainty exists with regard to the realizability of these tax assets such that a valuation allowance is necessary. Factors considered in providing a valuation allowance include the lack of a significant history of consistent profits, the current and believed to be continued weakness in the overall market thereby potentially impacting our ability to sustain or grow revenues and earnings, and the length of carryback and carryforward periods. We considered expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies. Based on the absence of sufficient positive objective verifiable evidence at December 31, 2009, we have placed a valuation on our deferred tax assets except for $0.9 million of foreign deferred tax assets. We expect to record a valuation allowance on future tax benefits until we can sustain an appropriate level of profitability and until such time, we would not expect to recognize any significant tax benefits in our future results of operations.

 

Our effective tax rate was a (8)% tax expense in 2008 and (126)% tax in 2007. The tax rate for 2008 and 2007 differed from the United States statutory rate due to the change in the realization of our deferred tax assets, foreign earnings taxed at lower rates, foreign losses not benefited, and non-deductible stock compensation deductions.

 

Net Loss Attributable to the Noncontrolling Interest

 

 

The noncontrolling interest in the losses of consolidated subsidiaries for 2009 increased $735,000 from a loss of $220,000 in 2008. The increase in the loss attributable to the noncontrolling interest was mainly due to the increased loss generated by RAE Fushun and RAE Beijing.

 

Net loss attributable to the noncontrolling interest for 2008 increased $226,000 from income of $6,000 in 2007. The increase in loss attributable to the noncontrolling interest was mainly due to the increased loss generated by RAE Fushun, offset by increased profitability at RAE France in 2008.

 

Gain (loss) From Discontinued Operations

 

 

On August 24, 2007, the Board of Directors approved the discontinuation of our mobile DVR business in order to reduce expenses and concentrate resources on our gas and radiation detection business. Our mobile DVR business was acquired through the purchases of Aegison and Securay. See “Note 2. Business Combinations and Dispositions” of the Notes to Consolidated Financial Statements for details. On August 28, 2007, we notified our DVR customers, terminated all personnel not reassigned to continuing operations and suspended the related production and sales activities. Because the DVR business operates at a substantial loss, management intended to liquidate the tangible assets, mainly inventories of component parts. Accordingly, the value of these assets had been adjusted to reflect the anticipated disposals.

 

As a result of discontinuing the DVR business, management impaired the remaining value of the intangible assets and goodwill acquired in the purchases of Aegison in July 2006 and Securay in January 2007. Impairment expense recognized in fiscal 2007 totaled $4.2 million.

In accordance with the authoritative accounting guidance, the financial results of the DVR business are reported as discontinued operations for all periods presented. The financial results included in discontinued operations were as follows:

 

Liquidity and Capital Resources

 

To date, we have financed our operations primarily through operating revenues, proceeds from the issuance of equity securities and short-term bank borrowings. In 2007, we also sold and leased back our corporate headquarters in San Jose, California. As of December 31, 2009, we had $18.5 million in cash and cash equivalents compared with $14.8 million on December 31, 2008. The $3.7 million year-over-year increase in company cash was due in part to our global initiatives to reduce worldwide inventory levels.

 

On December 31, 2009, we had $31.7 million in working capital (current assets less current liabilities) and a current ratio (ratio of current assets to current liabilities) of 2.2 to 1.0 compared to working capital of $37.1 million and a current ratio of 2.5 to 1.0 on December 31, 2008. Of the $5.4 million reduction in working capital, $3.5 million is attributable to the proposed FCPA settlement discussed in Note 7 to the Consolidated Financial Statements.

 

In the United States, we had a $10.0 million revolving credit agreement as of December 31, 2009, and a $15.0 million revolving credit agreement as of December 31, 2008. This credit facility is renewed annually and currently expires on May 15, 2010. Available credit is based on a percentage of specific qualifying assets and the total facility is collateralized by a blanket security interest over the Company’s assets in the United States. We are required to comply with certain reporting and financial requirements in addition to the ongoing requirement to submit monthly financial information. We must also maintain a compensating balance with the lending bank of at least $2.0 million at all times, which is included in Restricted cash on the Consolidated Balance Sheets. While we intend to pursue renewal, there is no assurance we will be successful in securing a renewed agreement on this line of credit for any time period after May 15, 2010. As of December 31, 2009 and December 31, 2008, $1.8 million was outstanding against the revolving credit agreements in the United States.

 

During the fourth quarter of 2009, the Company obtained an amendment to the financial covenants of its revolving credit agreement, as a result of non-compliance. The amended financial covenants under the revolving credit agreement 1) require us to maintain specified trailing two-quarter minimum earnings before interest, depreciation, amortization and non-cash stock compensation expenses and 2) limits the size of potential monetary penalties under the FCPA to $3.5 million. We were in compliance with these covenants as of December 31, 2009.

 

In China, we had two unsecured revolving lines of credit as of December 31, 2009 and December 31, 2008, each in the amount of RMB 20 million or approximately $2.9 million. Borrowings under these lines of credit are available to provide working capital and are generally at the current market rate for fixed rate loans of the amount and duration requested, up to one year. The continuing credit facilities are renewed annually. As of December 31, 2009 and December 31, 2008, RMB 15 million, or approximately $2.2 million, and RMB 5 million, or approximately $0.7 million, respectively, was outstanding against loan agreements in China.

 

In November 2009, we borrowed RMB 10.0 million, or approximately $1.5 million, for a term of 18 months to provide working capital for our 70% owned subsidiary in Fushun, China (“RAE Fushun”). Loan repayment is guaranteed by an unrelated third party, to whom RAE Fushun granted a lien over its wholly owned plant and associated land rights. As a condition of the loan, the lending bank required a deposit of approximately $0.1 million from the guarantor. This deposit was funded by RAE Fushun from the loan proceeds and is included in Restricted Cash on the Consolidated Balance Sheets.

 

We believe our existing balances of cash and cash equivalents, together with cash generated from product sales, will be sufficient to meet our cash needs for working capital, debt service and capital expenditures for at least the next twelve months. Our future capital requirements will depend on many factors that are difficult to predict, including the size, timing and structure of any future acquisitions, future capital investments, the ultimate resolution of potential FCPA violations 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 shareholders.

Our Consolidated Statements of Cash Flows for 2009, 2008 and 2007 may be summarized as follows:

 

 

Operating Activities

 

For the year ended December 31, 2009, net cash provided by operating activities of $7.6 million was due to the following:

 

 

For the year ended December 31 2008, net cash provided by operating activities of $3.2 million was due to the following:

 

 

For the year ended December 31, 2007, net cash used by operating activities was $10.0 million which was due to the following:

 

 

Investing Activities

 

As disclosed above in the discussion of banking relationships, during 2009 we agreed to maintain restricted cash arrangements of $2.1 million. Other 2009 investing activities primarily consisted of ongoing construction and outfitting activities at our new facility in Fushun, China and payment for land use rights and pre-construction site improvements in Shanghai. In December 2008, we purchased the land use rights for 50 years to 5 acres of land in Shanghai. We plan to use this site to construct a new manufacturing and research and development facility, which will replace our current Shanghai facility. Construction began during the first quarter of 2010. Upon completion, we intend to vacate our existing leased facility. Based on discussions with Shanghai government officials, our landlord, we believe we will be able to terminate the lease without penalty. Negotiations for project and long-term financing arrangements are ongoing. However, no assurance can be given that we will be able to arrange financing terms acceptable to us or that we will not be subject to lease termination penalties.

 

During 2008, cash used in investing activities was primarily used to complete and occupy the manufacturing facility in Fushun, China. The total project in Fushun also includes administrative offices, a research and development facility and living quarters. The estimated cost to complete the project is approximately $2.3 million. However, we have not committed to a timeline for the remaining construction.

 

During 2007, the increase in cash due to investing activities of $10.0 million was primarily due to the net proceeds from the sale and leaseback of our San Jose headquarters building for approximately $12.4 million and the sale of investments in securities for $3.2 million, partially offset by approximately $4.0 million used for the acquisition of property and equipment and $1.6 million used for business acquisitions. During 2007, we began to construct RAE Fushun’s new manufacturing and administrative facility in China.

 

Financing Activities

 

The cash provided by financing activities of $1.0 million in 2009 was primarily from bank borrowings (net of payments made) of $2.9 million. As disclosed above in the discussion of banking relationships, $1.5 million was borrowed by RAE Fushun for working capital. In addition, we borrowed $1.4 million to fund the purchase of land use rights in Shanghai for the construction of a new manufacturing facility as discussed in investing activities above.

 

We also made principal payments totaling $1.9 million to reduce the notes payable to related parties for the acquisition of RAE Beijing. These payments were made from general working capital. The next scheduled principal payment is in July 2010.

 

Cash used in financing activities of $1.4 million in 2008 was primarily applied to payments on related party notes totaling $1.2 million and payments on bank lines of credit of $0.2 million, net of amounts borrowed. The bank lines of credit provide working capital for our operations in the United States and China.

 

The cash provided by financing activities was $2.7 million in 2007 and was primarily from bank borrowings (net of repayment) of $2.6 million, which was used to repay a related party note of $5.0 million and the repurchase of restricted stock awards of $0.3 million.

Commitments and Contingencies

 

Summary of Obligations

 

The following table quantifies our known contractual obligations in tabular form as of December 31, 2009. These obligations impact our short and long-term liquidity and capital resource needs. Certain of these contractual obligations are reflected in the Consolidated Balance Sheets, while others are disclosed as future obligations.

 

 

 

 

Guarantees

 

We are permitted under Delaware law and required under our Certificate of Incorporation and Bylaws to indemnify our officers and directors for certain events or occurrences, subject to certain limits, while the director or officer is or was serving at our 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, we have a Director and Officer Insurance Policy that reduces exposure and enables us to recover a portion of any future amounts paid. To date we have not incurred any losses under these agreements.

 

In our sales agreements, we typically agree to indemnify our 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, we have not paid any amounts to settle claims or defend lawsuits.

Product Warranties

 

We sell the majority of our products with a 12 to 24 month repair or replacement warranty from the date of shipment. We provide an accrual for estimated future warranty costs based upon the historical relationship of warranty costs to sales. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized.

 

Uncertain Tax Positions

 

As of December 31, 2009, the liability for uncertain tax positions, including associated interest and penalties, was approximately $1.5 million. This liability represents an estimate of tax positions that the Company has taken in its tax returns which may ultimately not be sustained upon examination by the tax authorities. Since the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty, this estimated liability has been excluded from the contractual obligations table.

 

Recent Accounting Pronouncements

 

In December 2007, the FASB issued authoritative guidance which applies to business combinations. The new guidance changes the accounting for acquisition transaction costs by requiring them to be expensed in the period incurred, and also changes the accounting for contingent consideration, acquired contingencies and restructuring costs related to an acquisition. The new guidance was effective for the Company beginning January 1, 2009, and will change the Company’s accounting treatment for business combinations on a prospective basis.

 

In June 2009, the FASB issued authoritative guidance for determining whether an entity is a variable interest entity (“VIE”) and requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a VIE. Under this guidance, an enterprise has a controlling financial interest when it has a) the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. The guidance also requires an enterprise to assess whether it has an implicit financial responsibility to ensure that a VIE operates as designed when determining whether it has power to direct the activities of the VIE that most significantly impact the entity’s economic performance. The guidance is effective for the Company January 1, 2010, and requires ongoing assessments of whether an enterprise is the primary beneficiary of a VIE as well as certain enhanced disclosures. The Company is currently evaluating the potential impact, if any, of the adoption of this guidance on its consolidated financial statements.

 

In October 2009, the FASB issued authoritative guidance on revenue recognition that will become effective for the Company beginning January 1, 2011, with earlier adoption permitted. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued authoritative guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. The Company is currently assessing the potential effect, if any, on its financial statements.

 

 

Concentration of Credit Risk

 

Currently, we have cash and cash equivalents deposited with major financial institutions in the countries where we conduct business. Our deposits may exceed the amount of insurance available to cover such deposits. To date, we

have not experienced any losses of deposits of cash and cash equivalents. Management regularly reviews our deposit balances and the credit worthiness of the financial institutions which hold our deposits.

 

Interest Rate Risk

 

As of December 31, 2009, we had cash and cash equivalents of $18.5 million and restricted cash of $2.1 million. The Company had no other significant interest bearing assets. Over time changes to interest rates may reduce or increase our interest income, but the impact on our net income (loss) or the fair value of our interest bearing assets is not expected to be significant.

 

Our borrowings in China are at fixed interest rates or at rates fixed for 12 months. The outstanding balance under our line of credit in the United States bears interest at the floating prime bank lending rate plus 100 basis points subject to a minimum total rate of 5%. As the prime rate as of December 31, 2009 was 3.25%, our cost of funds in the United States will not increase until the prime rate rises by more than 75 basis points. On an outstanding balance of $1.8 million, the loan balance in the United States on December 31, 2009, annual interest expense would increase by $1,800 for each basis point thereafter.

 

Foreign Currency Exchange Rate Risk

 

For the year ended December 31, 2009, a substantial portion of our recognized revenue was denominated in U.S. dollars generated primarily from customers in the Americas (42%). Revenue generated from our European operations (17%) was primarily in Euros; revenue generated by our Asia operations (41%) was primarily in RMB. We manufacture a majority of our component parts at our manufacturing facility in Shanghai, China. Since January 2009, our operations in China have been affected by currency fluctuations due to an approximate 0.3% 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 lower cost capacity and efficiencies in supply-chain management. In 2004 and 2006, we made a strategic investment with the acquisition of a 96% interest in RAE Beijing, a Beijing-based manufacturer and distributor of environmental safety and security equipment, and the formation of RAE Fushun in late 2006 to capitalize on increases in demand for safety equipment in the mining and energy sectors in China. There has been continued speculation in the financial press that China’s currency, the RMB, will be subject to a further market adjustment relative to the U.S. dollar and other currencies. If, for example, there was a hypothetical 10% change in the RMB relative to the U.S. dollar, the effect on our loss would have been approximately $1.1 million for fiscal 2009. If the currencies in all other countries in Europe and Asia where we have operations were to change in unison with the RMB by a hypothetical 10% relative to the U.S. dollar, the effect on our loss would have been approximately $0.7 million for fiscal 2009. The difference of $0.4 million is attributable to the impact of foreign currencies outside of China.

 

To the extent that we have international sales denominated in U.S. dollars, any fluctuation in the value of the U.S. dollar relative to foreign currencies could affect our competitive position in the international markets. Although we continue to monitor our exposure to currency fluctuations and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, we cannot be certain that exchange rate fluctuations will not adversely affect our financial results in the future.

 

 

Our consolidated financial statements included in this report beginning on page F-1 are incorporated herein by reference.

 

None.

 

 

Evaluation of Disclosure Controls and Procedures

 

RAE Systems, Inc. (the “Company”) maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports the Company files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required financial disclosure.

 

In connection with the preparation of this Annual Report on Form 10-K, the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the CEO and CFO, as of December 31, 2009 of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based upon this evaluation, the CEO and CFO concluded that as of December 31, 2009 the Company’s disclosure controls and procedures were effective.

 

Management’s Report on Internal Control over Financial Reporting

 

Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles in the United States.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management has conducted an assessment, including testing, of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009. In making its assessment of internal control over financial reporting, management used the criteria in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

 

Based on our assessment, which was conducted according to the COSO criteria, we have concluded that our internal control over financial reporting was effective as of December 31, 2009.

 

The effectiveness of the Company’s internal control over financial reporting as of December 31, 2009 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which appears herein.

 

Changes in Internal Control Over Financial Reporting

 

There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) during our fourth quarter of fiscal 2009 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and Stockholders of RAE Systems Inc.:

 

We have audited the internal control over financial reporting of RAE Systems Inc. and subsidiaries (collectively the “Company”) as of December 31, 2009, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2009 of the Company and our report dated March 11, 2010 expressed an unqualified opinion on those financial statements.

 

 

San Jose, California

March 11, 2010

 

None.

 

 

The information required by this item with respect to the Company’s executive officers is incorporated herein by reference from the information contained in Item 1 of Part I of this Report under the caption “Executive Officers of the Registrant.” The remaining information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2010 Proxy Statement to be filed with the U.S. Securities and Exchange Commission (“SEC”) in connection with the solicitation of proxies for the Company’s 2010 Annual Meeting of Shareholders (“2010 Proxy Statement”). The 2010 Proxy Statement will be filed with the SEC within 120 days after the end of the fiscal year to which this report relates.

 

 

The information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2010 Proxy Statement.

 

 

The information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2010 Proxy Statement.

 

 

The information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2010 Proxy Statement.

 

 

The information required by this item is incorporated herein by reference from the information to be contained in the Company’s 2010 Proxy Statement.

 

 

(a) (1) Financial Statements

 

See the index of the Consolidated Financial Statements of this Form 10-K.

 

(2) Financial Statement Schedules

 

Schedules are not provided because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.

 

(3) Exhibits

 

See Index to Exhibits on page 38 herein.

 

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 March 12, 2010.

 

RAE SYSTEMS INC.

 

Robert I. Chen

President and Chief Executive Officer

 

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Robert I. Chen and Randall Gausman, and each of them, as such person’s true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for such person and in such person’s name, place and stead, in any and all capacities, to sign any and all amendments to this report on Form 10-K, and to file same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as such person might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons in the capacities and on the dates indicated:

 

INDEX TO EXHIBITS

 

 

 

 

RAE Systems Inc.

 

Consolidated Financial Statements
As of December 31, 2009 and 2008

 

 

To the Board of Directors and Shareholders of RAE Systems Inc.

 

We have audited the accompanying consolidated balance sheets of RAE Systems Inc. and subsidiaries (collectively the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations, shareholders’ equity and comprehensive loss, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with accounting principles generally accepted in the United States of America.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2010 expressed an unqualified opinion on the Company’s internal control over financial reporting.

 

 

San Jose, California

March 11, 2010

RAE SYSTEMS INC.

 

 

See accompanying notes to consolidated financial statements.

RAE SYSTEMS INC.

 

 

See accompanying notes to consolidated financial statements.

RAE SYSTEMS, INC.

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE LOSS