##### Table of Contents





UNITED STATES SECURITIES AND
    EXCHANGE COMMISSION
 Washington, D.C.
    20549
 Form 10-K
  þ

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended
    December 31,
    2009ORo

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)  OF
    THE SECURITIES EXCHANGE ACT OF 1934For the transition period
    from          to   Commission file number:
    001-31783
 RAE Systems Inc.
 (Exact name of registrant as
    specified in its charter)
  Delaware

77-0280662(State or other jurisdiction
    of
    incorporation or organization)

(I.R.S. Employer
    Identification No.)3775 North First Street San Jose, California

95134(Address of principal executive
    offices)

(Zip Code)  408-952-8200 (Registrants telephone number, including area
    code)
  Securities registered pursuant to Section 12(b) of the
    Act:
  Title of Each Class

Name of Each Exchange on Which RegisteredCommon Stock, $0.001 par value per share

NYSE Alternext US   Securities registered pursuant to Section 12(g) of the
    Act: None
  o þ
  o þ
  þ o
  Regulation S-T o o
  Regulation S-K Form 10-K Form 10-K. þ
  Rule 12b-2
  Large accelerated
    filer o

Accelerated
    filer þ

Non-accelerated
    filer o

Smaller reporting
    company o(Do not check if a smaller
    reporting company)   Rule 12b-2 o þ
    DOCUMENTS INCORPORATED BY REFERENCE
  Form 10-K.




---



##### 





RAE
    SYSTEMS INC.
  INDEX TO
  ANNUAL REPORT ON
    FORM 10-K
 FOR YEAR ENDED DECEMBER 31, 2009
 TABLE OF CONTENTS
  PagePART IITEM 1.

BUSINESS

2ITEM 1A.

RISK FACTORS

7ITEM 1B.

UNRESOLVED STAFF COMMENTS

15ITEM 2.

PROPERTIES

15ITEM 3.

LEGAL PROCEEDINGS

15ITEM 4.

RESERVED

16PART IIITEM 5.

MARKET FOR REGISTRANTS COMMON EQUITY,
    RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
    SECURITIES

16ITEM 6.

SELECTED FINANCIAL DATA

18ITEM 7.

MANAGEMENTS DISCUSSION AND ANALYSIS OF
    FINANCIAL CONDITION AND RESULTS OF OPERATIONS

20ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
    MARKET RISK

32ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

33ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
    ACCOUNTING AND FINANCIAL DISCLOSURE

34ITEM 9A.

CONTROLS AND PROCEDURES

34ITEM 9B.

OTHER INFORMATION

36PART IIIITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
    GOVERNANCE

36ITEM 11.

EXCUTIVE COMPENSATION

36ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
    AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

36ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
    AND DIRECTOR INDEPENDENCE

36ITEM 14.

PRINCIPAL ACCOUNTANT FEES AND SERVICES

36PART IVITEM 15.

EXHIBITS AND FINANCIAL STATEMENT
    SCHEDULES

36SIGNATURES

37EX-23.2EX-31.1EX-31.2EX-32.1EX-32.2   1




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##### Table of Contents



PART I  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.
  ITEM 1.
    BUSINESS  Overview
  clean-ups.
      www.raesystems.com Form 10-K, Form 10-Q, Form 8-K
  1-800-SEC-0330. http://www.sec.gov.
 2




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##### Table of Contents



Industry
    Background
        Products
    Sensor
    and Measurement Products
    
    photoionization detectors for the measurement of volatile
    organic compounds, highly toxic chemical warfare agents and
    toxic industrial chemicals;
    catalytic bead pellistors for the detection and measurement of
    combustible gas;
    non-dispersive infrared sensors for the measurement of carbon
    dioxide and hydrocarbons;
    electro-chemical sensors for the measurement of oxygen and toxic
    gases such as ammonia, carbon monoxide, chlorine and hydrogen
    sulfide;
    solid polymer electrode sensors for the measurement of
    oxygen; and
    solid-state scintillation detectors for both neutron and gamma
    radiation.  part-per-billion
  Integrated
    Wireless Products
   3




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##### Table of Contents



Radiation
    Products
    Sales,
    Marketing and Distribution
          Customers
   4




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##### Table of Contents



Research,
    Development and Engineering
        
    14 United States patents granted;
    5 China patents granted with 14 pending;
    1 Europe patent granted with 5 pending; and
    1 Japan patent granted.  Manufacturing
    Competition
     5




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##### Table of Contents



and/or
    Employees
    Executive
    Officers of the Registrant
    Name

Age

PositionRobert I. Chen


62


President, Chief Executive Officer and Chairman of the BoardRandall Gausman


60


Vice President and Chief Financial OfficerPeter C. Hsi


59


Chief Technology OfficerMing-Ching Tang


59


Executive Vice President OperationsChristopher Hameister


55


Vice President Asia-Pacific, Europe and Middle East Business
    OperationsWilliam Jackson


50


Vice President Global MarketingBin Lu


37


Vice President and General Manager Beijing Business OperationsFei-Zhou Shen


47


Vice President Corporate Development and Fushun Business
    OperationsRyan Watson


37


Vice President Americas Sales   Robert I. Chen
  Randall Gausman
  Dr. Peter C. Hsi
 6




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##### Table of Contents



Dr. Ming-Ching Tang
  Christopher Hameister
  William Jackson
  Bin Lu
  Fei-Zhou Shen
  Ryan Watson
  ITEM 1A.
    RISK
    FACTORS  You should carefully consider the risks described below
    before making a decision regarding an investment in our common
    stock. If any of the following risks actually occur, our
    business could be harmed, the trading price of our common stock
    could decline and you may lose all or part of your investment.
    You should also refer to the other information contained in this
    report, including our financial statements and the related
    notes.
 7




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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.
    Economic
    conditions could materially adversely affect our
    business.
  and/or and/or
  Political
    events, war, terrorism, natural disasters, and other
    circumstances could materially adversely affect
    us.
    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.
   8




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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 may
    require additional capital in the future, which may not be
    available or may only be available on unfavorable
    terms.
    The
    market for gas and radiation detection monitoring devices is
    highly competitive, and if we cannot compete effectively, our
    business may be harmed.
    
    devote greater resources to marketing and promotional campaigns;
    adopt more aggressive pricing policies; or
    devote more resources to technology and systems development.    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.
   9




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The
    securities laws and regulations have and are likely to continue
    to have a significant effect on our costs.
    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.
      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.
     10




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##### Table of Contents



We may
    not be successful in promoting and developing our brand, which
    could prevent us from remaining competitive.
    We may
    face risks from our substantial international operations and
    sales.
      
    difficulties with staffing and managing international operations;
    transportation and supply chain disruptions and increased
    transportation expense as a result of epidemics, terrorist
    activity, acts of war or hostility, increased security and less
    developed infrastructure;
    economic slowdown
    and/or
    downturn in foreign markets;
    international currency fluctuations;
    political and economic uncertainty caused by epidemics,
    terrorism or acts of war or hostility;
    legislative and regulatory responses to terrorist activity such
    as increased restrictions on cross-border movement of products
    and technology;
    legislative, regulatory, police, or civil responses to epidemics
    or other outbreaks of infectious diseases such as quarantines,
    factory closures, or increased restrictions on transportation or
    travel;
    increased costs and complexities associated with complying with
    Section 404 of the Sarbanes-Oxley Act of 2002;
    general strikes or other disruptions in working conditions;
    labor shortages;
    political instability;
    changes in tariffs;
    generally longer periods to collect receivables;
    unexpected legislative or regulatory requirements;
    reduced protection for intellectual property rights in some
    countries;
    significant unexpected duties or taxes or other adverse tax
    consequences;
    difficulty in obtaining export licenses and other trade
    barriers; and 11




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##### Table of Contents




    ability to obtain credit and access to capital issues faced by
    our international customers.  and/or
    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.
    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.
   12




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##### Table of Contents



Any
    failure to adequately protect and enforce our intellectual
    property rights could harm our business.
      We may
    face intellectual property infringement claims that might be
    costly to resolve and affect our results of
    operations.
      Some
    of our products may be subject to product liability claims which
    could be costly to resolve and affect our results of
    operations.
   13




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##### Table of Contents



We
    sell a majority of our products through distributors, and if our
    distributors stop selling our products, our revenues would
    suffer.
    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.
    Future
    acquisitions that we undertake could be difficult to integrate,
    disrupt our business, dilute shareholder value or harm our
    results of operations.
    Our
    ownership interest in Renex will cause us to incur losses that
    we would not otherwise incur.
    Our
    business could suffer if we lose the services of any of our
    executive officers.
    Our
    officers and directors beneficially own approximately 32% of our
    common stock and, accordingly, may exert substantial influence
    over the Company.
   14




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##### Table of Contents



ITEM 1B.
    UNRESOLVED
    STAFF COMMENTS    ITEM 2.
    PROPERTIES              ITEM 3.
    LEGAL
    PROCEEDINGS  Regulatory
    Compliance
   15




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##### Table of Contents



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.
  No. 05-CV-01887-JF).
  No. 08-15708.
  No. 09-15369,
  08-15708 09-15369). and/or
  ITEM 4.
    RESERVED PART II  ITEM 5.
    MARKET
    FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS
    AND ISSUER PURCHASES OF EQUITY SECURITIES   16




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##### Table of Contents



mark-ups,
  2009

2008High

Low

High

LowFirst Quarter

$
1.00


$
0.28


$
2.81


$
1.07Second Quarter

$
1.70


$
0.42


$
1.92


$
1.30Third Quarter

$
2.23


$
1.00


$
2.18


$
1.03Fourth Quarter

$
1.48


$
0.65


$
1.72


$
0.38       PERFORMANCE
    GRAPH
  3800-3899,
   17




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##### Table of Contents



COMPARISON
    OF 5 YEAR CUMULATIVE TOTAL RETURN*
        
    *
    
    $100 invested on 12/31/04 in stock or index-including
    reinvestment of dividends.    2004


2005


2006


2007


2008


2009RAE Systems, Inc.



100.00




48.09




43.84




36.99




7.40




15.07NYSE AMEX Composite Index



100.00




126.17




151.23




181.81




108.34




146.73NYSE AMEX Stock Market (US Companies)



100.00




108.14




125.58




130.13




82.95




101.45Peer Group



100.00




96.08




129.00




119.31




66.01




177.59     ITEM 6.
    SELECTED
    FINANCIAL DATA  Form 10-K.
  18




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##### Table of Contents



2007

2006

20052009

2008

(1)(2)(3)

(4)(5)(6)(7)

(8)(In thousands, except share and per share data)Operating Data:Net sales

$
83,172


$
95,383


$
90,836


$
67,721


$
60,293Gross profit

$
40,979


$
48,215


$
46,408


$
35,523


$
35,603Operating loss from continuing operations

$
(7,323
)

$
(6,089
)

$
(4,171
)

$
(2,871
)

$
(1,588
)Loss from continuing operations

$
(6,714
)

$
(7,383
)

$
(10,536
)

$
(1,418
)

$
(821
)Basic loss per share from continuing operations

$
(0.10
)

$
(0.12
)

$
(0.18
)

$
(0.03
)

$
(0.01
)Diluted loss per share from continuing operations

$
(0.10
)

$
(0.12
)

$
(0.18
)

$
(0.03
)

$
(0.01
)Weighted-average common shares:Basic outstanding shares


59,366,850



59,204,262



58,852,172



58,424,970



57,687,714Diluted outstanding shares


59,366,850



59,204,262



58,852,172



58,424,970



57,687,714Balance Sheet Data:Working capital

$
31,676


$
37,146


$
40,850


$
36,641


$
41,366Total assets

$
78,874


$
81,175


$
85,343


$
89,753


$
76,264Long-term liabilities

$
7,822


$
8,358


$
10,442


$
5,441


$
2,962Total RAE Systems Inc. shareholders equity

$
39,029


$
43,216


$
46,356


$
56,179


$
54,573       (1)
    
    In January 2007, the Company entered into an agreement to
    purchase the intellectual properties of Tianjin Securay
    Technology Ltd. Co. for approximately $1.5 million.
    Including transactions entered into during fiscal 2006, the
    total purchase price was $2.0 million in cash.(2)
    
    In August 2007, the Board of Directors approved the
    discontinuation of the Companys DVR business. Impairment
    expenses recognized in fiscal 2007 totaled $4.2 million.(3)
    
    In December 2007, the Company sold its headquarters building in
    San Jose, California for $12.7 million and leased back
    the facility for a period of 10 years. The Company
    recognized a gain on sale of $0.4 million in 2007 and
    recorded a deferred gain of $6.3 million. The deferred gain
    will be recognized in income straight-line over the life of the
    leaseback beginning in January 2008.(4)
    
    RAE Fushun joint venture was formed in December 2006. The fair
    value of assets acquired and liabilities assumed were included
    in the consolidated balance sheet as of December 31, 2006.
    There were no operating activities recorded in 2006.(5)
    
    The Company purchased an additional 32% ownership in RAE Beijing
    in July 2006. The Company has consolidated RAE Beijing since
    2004. With the purchase in July 2006, minority
    shareholders interest was reduced to 4%.(6)
    
    In July 2006, the Company purchased Aegison Corporation. The
    fair value of assets acquired and liabilities assumed were
    included in the consolidated balance sheet as of
    December 31, 2006.(7)
    
    As of December 31, 2006, the Company was in the process of
    acquiring Securay. The Company recorded $820,000 of acquisition
    in progress as of December 31, 2006.(8)
    
    During the second quarter of 2005, the Company abandoned its
    leased facility in Sunnyvale California and moved to a new
    headquarters and U.S. manufacturing facility. As a result, the
    Company took a before-tax charge of approximately
    $2.0 million for abandonment of its lease in the second
    quarter of 2005. 19




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##### Table of Contents



ITEM 7.
    MANAGEMENTS
    DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
    OPERATIONS  The following Managements Discussion and Analysis of
    Financial Condition and Results of Operations contains
    forward-looking statements. In some cases, readers can identify
    forward-looking statements by terminology such as
    may, will, should,
    could, expects, plans,
    anticipates, believes,
    estimates, predicts,
    potential, or continue. These statements
    involve known and unknown risks, uncertainties and other factors
    that may cause our actual results, performance or achievements
    to be materially different from those stated herein. 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
             20




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##### Table of Contents



Critical
    Accounting Policies
      Revenue
    Recognition
    Accounts
    Receivable, Trade Notes Receivable and Allowance for Doubtful
    Accounts
       21




---



##### Table of Contents



Inventories
  first-in,
  Goodwill
    and Other Intangible Assets
      Long-lived
    Assets
    Stock-Based
    Compensation Expense
      Expected Term
  Expected Volatility
 22




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##### Table of Contents



Expected Dividend
  Risk-Free Interest Rate
  Estimated Forfeitures trued-up
  Business
    Combinations
      Income
    Taxes
        RESULTS
    OF OPERATIONS
  Net
    Sales
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)Net sales

$
83,172


$
95,383


$
(12,211
)


(13
)%

$
95,383


$
90,836


$
4,547



5
%    23




---



##### Table of Contents



Cost
    of Sales and Gross Profit
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)Cost of sales

$
42,193


$
47,168


$
(4,975
)


(11
)%

$
47,168


$
44,428


$
2,740



6
%Gross profit

$
40,979


$
48,215


$
(7,236
)


(15
)%

$
48,215


$
46,408


$
1,807



4
%Gross margin


49
%


51
%










51
%


51
%       Sales
    and Marketing Expense
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)Sales and marketing

$
18,824


$
21,427


$
(2,603
)


(12
)%

$
21,427


$
25,434


$
(4,007
)


(16
)%Percentage of net sales


23
%


22
%










22
%


28
%      24




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##### Table of Contents



Research
    and Development Expense
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)Research and development

$
6,354


$
6,665


$
(311
)


(5
)%

$
6,665


$
7,973


$
(1,308
)


(16
)%Percentage of net sales


8
%


7
%










7
%


9
%       General
    and Administrative Expense
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)General and administrative

$
23,124


$
22,864


$
260



1
%

$
22,864


$
17,767


$
5,097



29
%Percentage of net sales


28
%


24
%










24
%


20
%       Impairment
    of Goodwill
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)Impairment of goodwill

$



$
3,348


$
(3,348
)


100
%

$



$



$




0
%Percentage of net sales


0
%


4
%










0
%


0
%    25




---



##### Table of Contents



Gain/loss
    on Abandonment of Lease
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)(Gain) loss on abandonment of lease

$



$



$







$



$
(595
)

$
595



100
%Percentage of net sales


0
%


0
%










0
%


(1
)%   Other
    Income (Expense)
  Percentage











Percentage2009


2008


Change


Change


2008


2007


Change


Change(In thousands)Interest income

$
48


$
173


$
(125
)


(72
)%

$
173


$
162


$
11



7
%Interest expense


(402
)


(397
)


(5
)


1
%


(397
)


(705
)


308



-44
%Other, net


188



(575
)


763



(133
)%


(575
)


58



(633
)


-1091
%Equity in loss of unconsolidated affiliate


(109
)


43



(152
)


(353
)%


43



3



40



1333
%Total other income (expense)

$
(275
)

$
(756
)

$
481



(64
)%

$
(756
)

$
(482
)

$
(274
)


57
%       Income
    Tax (Benefit) Expense
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)Income tax (benefit) expense

$
(884
)

$
538


$
(1,422
)


(264
)%

$
538


$
5,883


$
(5,345
)


(91
)%Effective tax rate


12
%


(8
)%










(8
)%


(126
)%        26




---



##### Table of Contents



Net
    Loss Attributable to the Noncontrolling Interest
  Percentage







Percentage2009

2008

Change

Change

2008

2007

Change

Change(In thousands)Net loss (income) attributable to the noncontrolling interest

$
955


$
220


$
735



334
%

$
220


$
(6
)

$
226



(3767
)%       Gain
    (loss) From Discontinued Operations
  Percentage











Percentage2009


2008


Change


Change


2008


2007


Change


Change(In thousands)Gain (loss) from discontinued operations before income taxes

$



$
11


$
(11
)


(100
)%

$
11


$
(4,939
)

$
4,950



(100
)%Income tax benefit














0
%






(785
)


785



(100
)%Gain (loss) from discontinued operations

$



$
11


$
(11
)


(100
)%

$
11


$
(4,154
)

$
4,165



(100
)%      27




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##### Table of Contents



Liquidity
    and Capital Resources
               28




---



##### Table of Contents



Year Ended December 31,2009


2008


2007(In thousands)Net cash provided by (used in):Operating activities

$
7,657


$
3,178


$
(9,979
)Investing activities


(5,000
)


(3,351
)


10,023Financing activities


954



(1,391
)


(2,684
)Effect of exchange rate changes on cash and cash equivalents


72



503



427Net increase (decrease) in cash and cash equivalents

$
3,683


$
(1,061
)

$
(2,213
)   Operating
    Activities
    
    Non-cash charges included in our net loss of $6.7 million
    totaled $5.6 million. Our principal non-cash expenses were
    as follows: $3.2 million depreciation and amortization;
    $1.9 million provision for doubtful accounts; and
    $1.3 million stock-based compensation. These non-cash
    expenses were partially offset by $0.6 million in gains on
    disposal of property and equipment; $0.4 million in
    deferred income tax benefits; and other net losses of
    $0.2 million.
    The net change in operating assets and liabilities which
    generated cash flow of $8.7 million. Cash was primarily
    provided by the managed reduction of $5.6 million in
    inventories. Additional cash flow was contributed by increases
    to accounts payable and accrued liabilities and a reduction in
    prepaid expenses of $1.1 million, $2.2 million and
    $1.4 million, respectively. Cash was applied to reduce
    accounts payable to affiliate by $0.3 million. The net
    change in other operating assets and liabilities used cash
    totaling $1.3 million.    
    Non-cash charges included in our net loss of $7.4 million
    totaled $7.8 million. Our principal non-cash expenses were
    as follows: $3.3 million reduction in goodwill;
    $3.3 million depreciation and amortization;
    $1.6 million stock-based compensation; and
    $1.3 million provision for doubtful accounts. These
    non-cash expenses were partially offset by $0.6 million in
    gains on disposal of property and equipment; $1.2 million
    in deferred income tax benefits; and other net gains of
    $0.1 million.
    The net reduction in working capital of $2.8 million
    attributable to changes in operating assets and liabilities. The
    decrease in working capital resulted primarily from a
    $1.2 million decline in accounts receivable and a
    $1.1 million decline in trade notes receivable. Other
    operating accounts provided net cash of $0.5 million.    
    Cash was used mainly to support an increase of $9.5 million
    in working capital primarily consisting of an increase of
    $5.7 million in accounts receivable and $1.8 million
    in inventories primarily related to increased sales. The
    remaining $2.0 million was primarily comprised of changes
    in deferred revenue, deposits and other current operating
    accounts.
    The positive effect of the non-cash adjustments was due to
    depreciation and amortization of long lived assets of
    $3.7 million, deferred taxes of $4.0 million, stock
    based compensation expense of $1.9 million and provision
    for doubtful accounts of $1.9 million. 29




---



##### Table of Contents



Investing
    Activities
        Financing
    Activities
         30




---



##### Table of Contents



Commitments
    and Contingencies
  Summary
    of Obligations
    Less than


1-3


3-5


AfterTotal


1 Year


Years


Years


5 Years(In thousands)Contractual ObligationsAmounts reflected in Consolidated Balance Sheets:Long-term debt(1)

$
1,463


$



$
1,463


$



$
Notes payable to related parties(2)


733



370



363







Deferred gain on sale of real estate(3)


5,079



635



1,270



1,270



1,904Deferred revenue


1,218



603



542



73



Deferred tax liabilities, non-current


156















156Other long-term liabilities


781







542



55



184Other cash obligations not reflected in Consolidated Balance
    Sheets:Operating lease obligations(4)


10,683



1,733



2,816



2,644



3,490Open purchase orders(4)(5)


4,484



4,484











Total

$
24,597


$
7,825


$
6,996


$
4,042


$
5,734     (1)
    
    For further discussion surrounding long-term debt, refer to
    Note 6. Bank Debt to the Consolidated Financial
    Statements.(2)
    
    For further discussion surrounding notes payable-related
    parties, refer to Note 10. Related Party
    Transactions to the Consolidated Financial Statements.(3)
    
    For further discussion surrounding deferred gain on sale of real
    estate, refer to Note 3. Balance Sheet Details
    to the Consolidated Financial Statements.(4)
    
    For further discussion surrounding purchase and lease
    obligations, refer to Note 7. Commitments and
    Contingencies to the Consolidated Financial statements.(5)
    
    Represents estimated cancelable open purchase orders to purchase
    inventory and other goods and services in the normal course of
    business to meet operational requirements.  Guarantees
     31




---



##### Table of Contents



Product
    Warranties
    Uncertain
    Tax Positions
    Recent
    Accounting Pronouncements
        ITEM 7A.
    QUANTITATIVE
    AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK  Concentration
    of Credit Risk
   32




---



##### Table of Contents



Interest
    Rate Risk
      Foreign
    Currency Exchange Rate Risk
        ITEM 8.
    FINANCIAL
    STATEMENTS AND SUPPLEMENTARY DATA   33




---



##### Table of Contents



ITEM 9.
    CHANGES
    IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
    FINANCIAL DISCLOSURE    ITEM 9A.
    CONTROLS
    AND PROCEDURES  Evaluation
    of Disclosure Controls and Procedures
    Form 10-K, Rules 13a-15(e) 15d-15(e)
  Managements
    Report on Internal Control over Financial Reporting
  Rules 13a-15(f) 15d-15(f)
    Internal Control 
    Integrated Framework
      Changes
    in Internal Control Over Financial Reporting
  Rule 13a-15(f)
 34




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##### Table of Contents



Report of
    Independent Registered Public Accounting Firm
    Internal Control 
    Integrated Framework
        Internal Control  Integrated Framework
    
    35




---



##### Table of Contents



ITEM 9B.
    OTHER
    INFORMATION   PART III  ITEM 10.
    DIRECTORS,
    EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE    ITEM 11.
    EXECUTIVE
    COMPENSATION    ITEM 12.
    SECURITY
    OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
    RELATED STOCKHOLDER MATTERS    ITEM 13.
    CERTAIN
    RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
    INDEPENDENCE    ITEM 14.
    PRINCIPAL
    ACCOUNTING FEES AND SERVICES   PART IV.  ITEM 15.
    EXHIBITS,
    FINANCIAL STATEMENT SCHEDULES  Financial Statements
  Form 10-K.
  Financial Statement Schedules
    Exhibits
   36




---



##### Table of Contents



SIGNATURES      By:
    /s/  Robert
    I. Chen  Robert I. Chen
 President and Chief Executive Officer
  KNOW ALL PERSONS BY THESE PRESENTS Form 10-K,
    Signature

Title

Date/s/  Robert
    I. ChenRobert
    I. Chen

President, Chief Executive Officer and Chairman of the Board 
    (Principal Executive Officer)

March 12, 2010/s/  Randall
    GausmanRandall
    Gausman

Vice President and Chief Financial
    Officer (Principal Financial and
    Accounting Officer)

March 12, 2010/s/  Peter
    C. HsiPeter
    C. Hsi

Chief Technology Officer and Director

March 12, 2010/s/  Lyle
    D. FeiselLyle
    D. Feisel

Director

March 12, 2010/s/  Sigrun
    HjelmqvistSigrun
    Hjelmqvist

Director

March 12, 2010/s/  Keh
    Shew LuKeh
    Shew Lu

Director

March 12, 2010/s/  James
    W. PowerJames
    W. Power

Director

March 12, 2010/s/  Susan
    WangSusan
    Wang

Director

March 12, 2010  37




---



##### Table of Contents



INDEX TO
    EXHIBITS
  ExhibitNumber

Description of Document3
.1

Certificate of Incorporation of Registrant(1)3
.2

Amended and Restated Bylaws of Registrant(3)4
.1

Specimen certificate representing the common stock of
    Registrant(1)10
.0

Form of Indemnity Agreement between the Registrant and the
    Registrants directors and officers(1)10
.1

RAE Systems Inc. 2007 Equity Incentive Plan(2)10
.2

RAE Systems Inc. 2002 Stock Option Plan(1)10
.3

RAE Systems Inc. 1993 Stock Plan(1)10
.4

Form of Stock Option Agreement under the Registrants 2007
    Equity Incentive Plan(9)10
.5

Lease Agreement by and between Inland American/Stephens (N
    First) Ventures, LLC and RAE Systems Inc., dated
    December 20, 2007(9)10
.6

Purchase and Sale Agreement by and between D.R.
    Stephens & Company, LLC and RAE Systems Inc., dated
    November 9, 2007(9)10
.7

Manufacturing Building Lease Agreement by and between Shanghai
    China Academic Science High Tech Industrial Park Development
    Co., Ltd. and RAE Systems(Asia), Ltd., incorporated in Hong
    Kong, dated September 15, 2001(1)10
.8

Lease Agreement by and between Shanghai Institute of Metallurgy
    Research, Chinese Academy of Sciences and WARAE
    Instrument(Shanghai) Incorporated, incorporated in Jiading,
    Shanghai, dated January 8, 1999(1)10
.9

Form of Share Transfer Agreement by and between RAE-KLH
    shareholders and RAE Systems Asia (Hong Kong) Ltd.(4)10
.10

Separation Agreement and General Release of Claims by and
    between Donald W. Morgan and the Registrant dated August 8,
    2006(5)10
.11

RAE Systems Inc. Management Incentive Plan(6)10
.12

Employment Offer Letter by and between Randall Gausman and the
    Registrant dated October 17, 2006(7)10
.13

Loan and Security Agreement dated as of March 14, 2007
    between Silicon Valley Bank and the Registrant(8)10
.14

Joint Venture Agreement by and between Liaoning Coal Industry
    Group Co., Ltd. and RAE Systems (Asia), Ltd. dated
    December 10, 2006(8)10
.15

Separation Agreement and General Release of Claims by and
    between Rudy Mui and the Registrant dated March 4, 2008(9)10
.16

Form of Indemnity Agreement between RAE Systems Inc. and each of
    its directors and executive officers(10)21
.1

Subsidiaries of the Registrant(9)23
.2

Consent of Deloitte & Touche LLP(11)24
.1

Power of Attorney(11) (included on signature page)31
.1

Certifications of Robert I. Chen, President and Chief Executive
    Officer of Registrant, pursuant to
    Rule 13a-14
    adopted under the Securities Exchange Act of 1934, as amended,
    and Section 302 of the Sarbanes-Oxley Act of 2002(11)31
.2

Certifications of Randall Gausman, Vice President and Chief
    Financial Officer of Registrant, pursuant to
    Rule 13a-14
    adopted under the Securities Exchange Act of 1934, as amended,
    and Section 302 of the Sarbanes-Oxley Act of 2002(11)32
.1

Certification pursuant to 18 U.S.C. Section 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002(11)32
.2

Certification pursuant to 18 U.S.C. Section 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002(11)     (1)
    
    Previously filed as an exhibit to the Registrants
    quarterly report on
    Form 10-Q,
    for the quarter ended March 31, 2002 and incorporated
    herein by reference.(2)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on June 19, 2007 and incorporated herein by reference. 38




---



##### Table of Contents



(3)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on December 21, 2007 and incorporated herein by reference.(4)
    
    Previously filed on August 8, 2006 as an exhibit to the
    Registrants quarterly report on
    Form 10-Q
    for the quarter ended June 30, 2006 and incorporated herein
    by reference.(5)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on August 8, 2006 and incorporated herein by reference.(6)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on August 16, 2006 and incorporated herein by reference.(7)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on October 18, 2006 and incorporated herein by reference.(8)
    
    Previously filed as an exhibit to the Registrants annual
    report on
    Form 10-K
    for the year ended December 31, 2006 and incorporated
    herein by reference.(9)
    
    Previously filed as an exhibit to the Registrants annual
    report on
    Form 10-K
    for the year ended December 31, 2007 and incorporated
    herein by reference.(10)
    
    Previously filed as an exhibit to the Registrants
    quarterly report on
    Form 10-Q
    for the quarter ended June 30, 2009 and incorporated herein
    by reference.(11)
    
    Filed herewith. 39




---



##### 



RAE
    Systems Inc.
  Consolidated
    Financial Statements
    As of December 31, 2009 and 2008
   
 Consolidated Financial StatementsReport of Independent Registered Public
    Accounting Firm


F-2Consolidated balance sheets


F-3Consolidated statements of operations


F-4Consolidated statements of shareholders
    equity and comprehensive loss


F-5Consolidated statements of cash flows


F-6Notes to consolidated financial statements


F-7   F-1




---



##### Table of Contents



Report of
    Independent Registered Public Accounting Firm            
    F-2




---



##### Table of Contents



RAE
    SYSTEMS INC.
 CONSOLIDATED
    BALANCE SHEETS  December 31,


December 31,2009


2008(In thousands, except shareand par value data)ASSETSCurrent assets:Cash and cash equivalents

$
18,528


$
14,845Restricted cash


2,146



Trade notes receivable


2,039



1,870Accounts receivable, net of allowances of $5,380 and $3,472,
    respectively


19,428



20,961Accounts receivable from affiliate


322



100Inventories


12,068



17,604Prepaid expenses and other current assets


3,983



4,991Income taxes receivable


659



895Total current assets


59,173



61,266Property and equipment, net


15,590



14,976Intangible assets, net


2,428



3,342Investments in unconsolidated affiliates


358



467Other assets


1,325



1,124Total assets

$
78,874


$
81,175LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable

$
6,454


$
6,387Accounts payable to affiliate


92



382Payable to Fushun shareholder






64Bank lines of credit


4,026



2,584Accrued liabilities


15,753



12,318Notes payable to related parties, current


370



1,329Income taxes payable


199



425Deferred revenue, current


603



631Total current liabilities


27,497



24,120Deferred revenue, non-current


615



685Deferred tax liabilities, non-current


156



83Long-term debt


1,463



Deferred gain on sale of real estate


4,444



5,079Other long-term liabilities


781



1,292Notes payable to related parties, non-current


363



1,219Total liabilities


35,319



32,478COMMITMENTS AND CONTINGENCIES (NOTE 7)SHAREHOLDERS EQUITY:Common stock, $0.001 par value, 200,000,000 shares
    authorized; 59,438,328 and 59,443,914 shares issued and
    outstanding, respectively


59



59Additional paid-in capital


63,832



62,549Accumulated other comprehensive income


6,844



6,555Accumulated deficit


(31,706
)


(25,947
)Total RAE Systems Inc. shareholders equity


39,029



43,216Noncontrolling interest


4,526



5,481Total shareholders equity


43,555



48,697Total liabilities and shareholders equity

$
78,874


$
81,175    F-3




---



##### Table of Contents



RAE
    SYSTEMS INC.
 CONSOLIDATED
    STATEMENTS OF OPERATIONS  Year Ended December 31,2009


2008


2007(In thousands, except per share data)Net sales

$
83,172


$
95,383


$
90,836Cost of sales


42,193



47,168



44,428Gross profit


40,979



48,215



46,408Operating expenses:Sales and marketing


18,824



21,427



25,434Research and development


6,354



6,665



7,973General and administrative


23,124



22,864



17,767Impairment of goodwill






3,348



Gain on abandonment of lease










(595
)Total operating expenses


48,302



54,304



50,579Operating loss from continuing operations


(7,323
)


(6,089
)


(4,171
)Other income (expense):Interest income


48



173



162Interest expense


(402
)


(397
)


(705
)Other, net


188



(575
)


58Equity in (loss) gain of unconsolidated affiliates


(109
)


43



3Loss from continuing operations before income taxes


(7,598
)


(6,845
)


(4,653
)Income tax (benefit) expense


(884
)


538



5,883Loss from continuing operations


(6,714
)


(7,383
)


(10,536
)Gain (loss) from discontinued operations, net of tax






11



(4,154
)Net loss


(6,714
)


(7,372
)


(14,690
)Net loss (income) attributable to the noncontrolling interest


955



220



(6
)Net loss attributable to RAE Systems Inc.

$
(5,759
)

$
(7,152
)

$
(14,696
)Net loss per share  basic and dilutedContinuing operations

$
(0.10
)

$
(0.12
)

$
(0.18
)Discontinued operations










(0.07
)Net loss per share  basic and diluted

$
(0.10
)

$
(0.12
)

$
(0.25
)Weighted average common shares outstanding  Basic and
    Diluted


59,367



59,204



58,852    F-4




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##### Table of Contents



RAE
    SYSTEMS, INC.
  CONSOLIDATED
    STATEMENTS OF SHAREHOLDERS EQUITY AND COMPREHENSIVE
    LOSS
  AccumulatedAdditional


OtherCommon Stock


Paid-In


Comprehensive


Accumulated


NoncontrollingShares


Amount


Capital


Income


Deficit


Interest


Total(In thousands, except share data)December 31, 2006


59,274,596


$
59


$
58,828


$
1,245


$
(3,953
)

$
4,495


$
60,674Cumulative effect of adopting FIN 48  adjustment to
    accumulated deficit


















(146
)






(146
)Components of comprehensive loss:Net loss


















(14,696
)


6



(14,690
)Foreign currency translation adustments














2,889







884



3,773Unrealized loss on investment, net of tax














1











1Total comprehensive loss


























(10,916
)Exercise of stock options


32,291







72















72Repurchase of restricted common stock


(134,907
)






(335
)














(335
)Stock-based compensation expense










2,553















2,553Investment in unconsolidated entity










(1
)














(1
)Tax benefit from stock options










(160
)














(160
)December 31, 2007


59,171,980



59



60,957



4,135



(18,795
)


5,385



51,741Components of comprehensive loss:Net loss


















(7,152
)


(220
)


(7,372
)Foreign currency translation adustments














2,420







316



2,736Total comprehensive loss


























(4,636
)Exercise of stock options


149,458







43















43Repurchase of restricted common stock


(27,524
)






(44
)














(44
)Stock issued for services


150,000







210















210Stock-based compensation expense










1,383















1,383December 31, 2008


59,443,914



59



62,549



6,555



(25,947
)


5,481



48,697Components of comprehensive loss:Net loss


















(5,759
)


(955
)


(6,714
)Foreign currency translation adustments














289











289Total comprehensive loss


























(6,425
)Repurchase of restricted common stock


(5,586
)






(7
)














(7
)Stock-based compensation expense










1,290















1,290December 31, 2009


59,438,328


$
59


$
63,832


$
6,844


$
(31,706
)

$
4,526


$
43,555    F-5




---



##### Table of Contents



RAE
    SYSTEMS INC.
 CONSOLIDATED
    STATEMENTS OF CASH FLOWS  Year Ended December 31,2009


2008


2007(In thousands)CASH FLOWS FROM OPERATING ACTIVITIES:Net loss

$
(6,714
)

$
(7,372
)

$
(14,690
)Gain (loss) from discontinued operations






11



(4,154
)Loss from continuing operations


(6,714
)


(7,383
)


(10,536
)Adjustments to reconcile net loss to net cash provided by (used
    in) operating activities:Depreciation and amortization


3,215



3,344



3,715Provision for doubtful accounts


1,904



1,275



1,948Gain on disposal of property and equipment


(572
)


(586
)


(285
)Stock-based compensation expense


1,290



1,593



1,871Equity in loss (gain) of unconsolidated affiliates


109



(43
)


(3
)Deferred income tax (benefit) expense


(380
)


(1,221
)


3,999Gain on abandonment of lease










(595
)Amortization of discount on notes payable to related parties


85



52



79Impairment of intangible assets










609Impairment of goodwill






3,348



Changes in operating assets and liabilities:Accounts receivable


(221
)


1,174



(5,719
)Accounts receivable from affiliate


(221
)


(77
)


25Trade notes receivable


(154
)


1,056



(689
)Inventories


5,645



661



(1,831
)Prepaid expenses and other current assets


1,389



(1,361
)


(46
)Income taxes receivable


237



1,167



Other assets


(174
)


557



(1,004
)Accounts payable


1,053



(1,036
)


(1,473
)Accounts payable to affiliate


(290
)


(52
)


35Accrued liabilities


2,252



356



1,876Income taxes payable


(240
)


(287
)


541Deferred revenue


(98
)


314



(977
)Other liabilities


(458
)


320



(117
)Net cash provided by (used in) operating activities of
    continuing operations


7,657



3,171



(8,577
)Net cash provided by (used in) operating activities of
    discontinued operations






7



(1,402
)Net cash provided by (used in) operating activities


7,657



3,178



(9,979
)CASH FLOWS FROM INVESTING ACTIVITIES:Proceeds from sales and maturities of investments










3,248Business acquisitions, net of cash acquired










(1,618
)Changes in restricted cash


(2,146
)






Acquisition of property and equipment


(2,959
)


(3,501
)


(4,014
)Proceeds from sale of net assets


105



150



12,407Net cash (used in) provided by investing activities


(5,000
)


(3,351
)


10,023CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from the exercise of stock options






43



72Repurchases of common stock


(7
)


(44
)


(335
)Borrowings from bank lines of credit


5,555



4,961



12,156Payments on bank lines of credit


(2,649
)


(5,195
)


(9,600
)Payments on payables to related parties


(1,945
)


(1,156
)


(4,977
)Net cash provided by (used in) financing activities


954



(1,391
)


(2,684
)Effect of exchange rate changes on cash and cash equivalents


72



503



427Increase (decrease) in cash and cash equivalents


3,683



(1,061
)


(2,213
)Cash and cash equivalents at beginning of period


14,845



15,906



18,119Cash and cash equivalents at end of period

$
18,528


$
14,845


$
15,906Supplemental disclosure of cash flow information:Cash paid for taxes, net

$
(10
)

$
687


$
1,133Cash paid for interest


750



333



422Non-cash investing and financing activities:Unpaid property and equipment


1,274



1,100



589    F-6




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##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS
  Note 1.
    Summary
    of Significant Accounting Policies  The
    Company
      Principles
    of Consolidation
    Use of
    Estimates
    Revenue
    Recognition
  percentage-of-completion
 F-7




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Cash
    and Cash Equivalents
    Allowance
    for Doubtful Accounts
      Trade
    Notes Receivable
    Concentration
    of Credit Risk
    Inventories
  first-in,
 F-8




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Property
    and Equipment
    Buildings

20 to 25 yearsEquipment

3 to 10 yearsFurniture and fixtures

3 to 7 yearsComputers and software

3 to 7 yearsAutomobiles

3 to 5 yearsBuilding improvements

Lesser of useful life or remaining lease term   Warranty
    Repairs
    Research
    and Development
    Advertising
    Costs
    Income
    Taxes
       F-9




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Goodwill
    and Other Intangible Assets
      Long-Lived
    Assets
    Fair
    Values of Financial Instruments
    
    Cash and Cash Equivalents, Accounts Receivable, Trade Notes
    Receivables, Accounts Receivable from Affiliate, Accounts
    Payable, Accrued Expenses, Inventory Purchase Obligations:    
    Notes Payable to Related Parties:    Translation
    of Foreign Currencies
  non-U.S. subsidiaries non-U.S. subsidiaries.
  Stock-Based
    Compensation Expense
   F-10




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Net
    Loss Per Share
    Retained
    Earnings
      Variable
    Interest Entities
    Segment
    Reporting
  Segment Reporting,
  Recent
    Accounting Pronouncements
   F-11




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        Note 2.
    Business
    Combinations and Dispositions  Aegison
    Corporation and Tianjin Securay Technology Ltd.
    Co.
     F-12




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2009


2008


2007(In thousands)Net sales

$



$
3


$
319Gain (loss) from discontinued operations before income taxes






11



(4,939
)Income tax benefit










(785
)Gain (loss) from discontinued operations

$



$
11


$
(4,154
)     Note 3.
    Balance
    Sheet Details  Allowance
    for Doubtful
    Accounts :
    Year Ended December 31,2009


2008


2007(In thousands)Allowance for doubtful accounts at beginning of year

$
3,472


$
2,060


$
843Charges to expense


2,164



1,345



1,948Write-offs of uncollectible accounts, net of recoveries


(260
)


(70
)


(833
)Foreign currency translation effects


4



137



102Allowance for doubtful accounts at end of year

$
5,380


$
3,472


$
2,060   Inventories:
    December 31,


December 31,2009


2008(In thousands)Raw materials

$
5,655


$
8,213Work-in-progress


2,557



2,910Finished goods


3,856



6,481Total inventories

$
12,068


$
17,604    F-13




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Prepaid
    Expenses and Other Current Assets:
    December 31,


December 31,2009


2008(In thousands)Supplier advances and deposits

$
1,330


$
977Amounts receivable from employees


81



661Prepaid insurance


275



437Deferred tax assets, current


934



577Other current assets


1,363



2,339Total prepaid expenses and other current assets

$
3,983


$
4,991   Property
    and Equipment, net:
    December 31,


December 31,2009


2008(In thousands)Buildings and improvements

$
11,945


$
10,327Equipment


4,788



5,070Computer equipment


4,996



4,971Automobiles


1,385



1,590Furniture and fixtures


444



434Construction in progress


3,468



2,45727,026



24,849Less: Accumulated depreciation


(11,436
)


(9,873
)Total property and equipment, net

$
15,590


$
14,976      F-14




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Accrued
    Liabilities:
    December 31,


December 31,2009


2008(In thousands)Compensation and related benefits

$
3,764


$
2,445Accrued commissions


1,265



2,010Accrued FCPA settlement (see Note 8)


3,500



Customer deposits


941



1,792Accrued professional fees


426



755Other


5,857



5,316Total accrued liabilities

$
15,753


$
12,318   Note 4.
    Goodwill
    and Intangible Assets    (In thousands)Balance as of December 31, 2006

$
3,760Acquisitions:Securay


646Purchase price adjustment  Aegison


(19
)Impairment charges due to discontinued operations


(1,443
)Currency translation adjustment


199Balance as of December 31, 2007


3,143Currency translation adjustment


205Impairment charges


(3,348
)Balance as of December 31, 2008

$
      F-15




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
          December 31, 2009


December 31, 2008Gross Carrying


Accumulated


Net Carrying


Gross Carrying


Accumulated


Net CarryingAmount


Amortization


Amount


Amount


Amortization


Amount(In thousands)Customer list

$
5,456


$
(3,376
)

$
2,080


$
5,438


$
(2,636
)

$
2,802Trade name


1,356



(1,008
)


348



1,352



(812
)


540Total intangible assets, net

$
6,812


$
(4,384
)

$
2,428


$
6,790


$
(3,448
)

$
3,342        F-16




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  (in thousands)
  Years Ended December 31,2010

$
9042011


6382012


3722013


2812014


161Thereafter


72Total amortization

$
2,428   Note 5.
    Income
    Taxes    Year Ended December 31,2009


2008


2007(In thousands)United States

$
(4,526
)

$
(4,934
)

$
(5,973
)Foreign


(3,072
)


(1,911
)


1,320Loss from continuing operations before income taxes

$
(7,598
)

$
(6,845
)

$
(4,653
)     Year Ended December 31,2009


2008


2007(In thousands)Current:Federal

$
(1,072
)

$
(91
)

$
819State


23



18



53Foreign


545



1,832



1,012(504
)


1,759



1,884Deferred:Federal










2,917State






(48
)


862Foreign


(380
)


(1,173
)


220(380
)


(1,221
)


3,999Total income tax (benefit) expense

$
(884
)

$
538


$
5,883  F-17




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2009


2008


2007(In thousands)Federal income tax benefit at statutory rate

$
(2,584
)

$
(2,327
)

$
(1,582
)State income tax expense (benefit), net of federal benefit


13



18



(486
)Foreign tax expense (benefit)


326



1,116



(53
)Nondeductible expenses


1,281



90



132Subpart F






320



Contingencies released


(799
)






Net operating loss carryback


65







Other


870



363



561Change in valuation allowance


(56
)


958



7,311Total income tax (benefit) expense

$
(884
)

$
538


$
5,883     December 31,


December 31,2009


2008(In thousands)Deferred tax assets:Fixed assets

$
90


$
30Other temporary differences


477



547Other accruals


3,380



4,468Capitalized research and development


76



233Unrealized foreign losses & temporary differences


3,789



2,722Federal and state tax credits


611



423Stock-based compensation


2,208



2,034Valuation allowance


(9,332
)


(9,389
)Total deferred tax assets


1,299



1,068Deferred tax liabilities:Intangibles


(376
)


(574
)Total deferred tax liabilities


(376
)


(574
)Net deferred tax assets

$
923


$
494     December 31


Dec. 312009


2008Prepaid expenses and other current assets

$
934


$
577Other assets

$
145


$
Deferred tax liabilities, non-current

$
(156
)

$
(83
)    F-18




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    non-U.S. subsidiaries. non-U.S. subsidiaries
        2008-2009
       F-19




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
              (In thousands)Balance at January 1, 2008

$
1,193Positions taken related to prior years


Positions taken during the current year


(64
)Reduction to UTB due to settlement with tax authories


(12
)Balance at January 1, 2009


1,117Positions taken related to prior years


Positions taken during the current year


(6
)Reduction to UTB due to settlement with tax authories


102Balance at December 31, 2009

$
1,213      F-20




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  non-U.S. income
    United States  Federal






2003 - presentUnited States  State






2004 - presentChina






2005 - presentHong Kong






2004 - presentDenmark






2007 - present   Note 6.
    Bank
    Debt         F-21




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  in millions
  Chinese Renminbi

U.S. DollarsAmount

Total



Amount

TotalAmount

Available

Line

Amount

Available

Line

InterestOustanding

for Use

of Credit

Oustanding

for Use

of Credit

RateDecember 31, 2009:Due October 12, 2010


15.0



5.0



20.0



2.2



0.7



2.9



5.04
%No balance outstanding






20.0



20.0







2.9



2.9



n/a15.0



25.0



40.0



2.2



3.6



5.8December 31, 2008:Due April 30, 2009


5.0



15.0



20.0



0.7



2.2



2.9



6.33
%No balance outstanding






20.0



20.0







2.9



2.9



n/a5.0



35.0



40.0



0.7



5.1



5.8   Term
    Loan
    Note 7.
    Commitments
    and Contingencies  Legal
    Proceedings
  Regulatory
    Compliance
   F-22




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Legal
    proceedings
  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
  No. 05-CV-01887-JF).
  No. 08-15708.
  No. 09-15369,
  08-15708 09-15369). and/or
   F-23




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Leases
  (in thousands)
  Years Ended December 31,2010

$
1,7332011


1,4772012


1,3392013


1,3372014


1,307Thereafter


3,490Total minimum lease payments

$
10,683     Purchase
    obligations
       F-24




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Guarantees
      Product
    Warranties
    Year Ended December 31,2009


2008(In thousands)Balance at beginning of year

$
707


$
884Provision for warranty


1,429



844Utilization of reserve


(1,212
)


(1,041
)Foreign currency translation effects


2



20Balance at end of year

$
926


$
707   Note 8.
    Employee
    Benefit Plan    Note 9.
    Stock-Based
    Compensation  Stock
    Option Plans
     F-25




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        in
    thousands, except weighted-average amounts
  Options OutstandingNumber

Weighted-Averageof Shares

Exercise PriceBalance as of December 31, 2006


3,139


$
3.22Granted


855



2.73Exercised


(32
)


2.25Canceled


(239
)


4.18Balance as of December 31, 2007


3,723



3.05Granted


1,299



1.51Exercised


(149
)


0.29Canceled


(680
)


3.83Balance as of December 31, 2008


4,193



2.55Granted


1,870



1.03Exercised






Canceled


(670
)


2.96Balance as of December 31, 2009


5,393



1.97  F-26




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Options Outstanding


Options ExercisableWeighted











WeightedAverage











AverageRemaining


Weighted


Aggregate





Remaining


Weighted


AggregateNumber


Contractual


Average


Intrinsic


Number


Contractual


Average


IntrinsicRange of

of


Life


Exercise


Value


of


Life


Exercise


ValueExercise Prices

Shares


(In Years)


Price


(000)


Shares


(In Years)


Price


(000)$0.00 - 0.50


120,877



1.51


$
0.08


$
123



120,877






$
0.08


$
1230.51 - 1.00


1,197,936



8.86



0.95



180



251,466







0.84


$
651.01 - 1.50


2,018,282



6.98



1.26



23



863,270







1.22


$
191.51 - 2.00


200,000



8.28



1.87







83,333







1.87



2.01 - 2.50


259,167



7.65



2.26







147,760







2.26



2.51 - 3.00


445,000



7.25



2.88







301,558







2.87



3.01 - 4.00


804,324



6.03



3.62







723,488







3.60



4.01 - 5.00


152,500



4.38



4.81







152,500







4.815.01 - 6.00


170,000



4.24



5.30







170,000







5.306.01 - 7.00


25,000



4.87



6.43







25,000







6.43



5,393,086



7.07



1.97


$
326



2,839,252



5.78



2.48


$
207   in-the-money
    Non-Plan
    Stock Options
   F-27




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Options Outstanding

Options ExercisableWeighted







WeightedAverage







AverageRemaining

Weighted

Aggregate



Remaining

Weighted

AggregateNumber

Contractual

Average

Intrinsic

Number

Contractual

Average

IntrinsicRange of

of

Life

Exercise

Value

of

Life

Exercise

ValueExercise Prices

Shares

(In Years)

Price

(000)

Shares

(In Years)

Price

(000)$1.06


100,000



2.41


$
1.06


$
5



100,000



2.41


$
1.06


$
5   Non-Plan
    Restricted Stock
      in thousands, except per share amounts
  Restricted Stock AwardsWeighted-AverageNumber

Grant-Datedof Shares

Fair ValueBalance as of December 31, 2006


536


$
2.81Granted






Vested


(354
)


2.81Forfeited






Balance as of December 31, 2007


182



2.81Granted






Vested


(73
)


2.81Forfeited






Balance as of December 31, 2008


109



2.81Granted






Vested


(62
)


2.81Forfeited






Balance as of December 31, 2009


47



2.81   Stock-Based
    Compensation Expense
   F-28




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2009


2008


2007(In thousands)Cost of sales

$
80


$
66


$
50Sales and marketing


(43
)


61



114Research and development


143



348



453General and administrative


1,110



1,118



1,254Total

$
1,290


$
1,593


$
1,871     Year EndedDecember 31,2007(In thousands)Sales and marketing

$
628Research and development


53Total

$
681     Valuation
    Assumptions
    Year Ended December 31,2009

2008

2007Expected volatility


85
%


60-65
%


65
%Expected dividend yield


0.0
%


0.0
%


0.0
%Risk-free interest rate


2.0-3.0
%


2.7-3.6
%


4.8
%Expected term in years


6.0



5.5-6.0



5.5Weighted-average grant date fair value

$
0.73


$
0.89


$
1.66   Expected Volatility
  Expected Dividend
 F-29




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Risk-Free Interest Rate
  Expected Term
  Estimated Forfeitures trued-up
  Note 10.
    Related
    Party Transactions               F-30




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,




December 31,


December 31,2009


2008


2007




2009


2008(In thousands)Sales:













Accounts receivable:Renex

$
509


$
282


$
228


Renex

$
322


$
100RAE Australia


714










RAE Australia


59



RAE Benelux


2,698



2,287



1,596


RAE Benelux


253



411RAE Spain


429



604



442


RAE Spain


119



192$
4,350


$
3,173


$
2,266




$
753


$
703Purchases:













Accounts payable:Liaoning Group

$



$
20


$
4,448


Liaoning Group

$
14


$
72Renex


256



677



675


Renex


92



382$
256


$
697


$
5,123




$
106


$
454     Note 11.
    Fair
    Value Measurements    Cash and cash equivalents and bank line of
    credit:
  Notes payable to related parties:
  Intangible assets, net:
         F-31




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    December 31, 2009

December 31, 2008Carrying



CarryingCatergory

Amounts

Fair Value

Amounts

Fair Value(In thousands)Cash and cash equivalents

Level 1

$
18,528


$
18,528


$
14,845


$
14,845Bank lines of credit

Level 1


4,026



4,026



2,584



2,584Notes payable to related parties

Level 2


733



733



2,548



2,548   Note 12.
    Geographic
    Information    Year Ended December 31,2009


%


2008


%


2007


%(In thousands)Net sales:Americas

$
34,935



42


$
38,467



40


$
37,011



41Asia


33,749



41



41,422



44



42,107



46Europe


14,488



17



15,494



16



11,718



13Total net sales

$
83,172



100


$
95,383



100


$
90,836



100   December 31,





December 31,2009


%


2008


%(In thousands)Property and equipment, netAmericas

$
317



2


$
533



4Asia


15,103



97



14,228



95Europe


170



1



215



1Total property and equipment, net

$
15,590



100


$
14,976



100      F-32




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   Note 13.
    Quarterly
    Information (Unaudited)    First


Second


Third


FourthQuarter


Quarter


Quarter


Quarter


2009(In thousands, except per share data)Net sales

$
19,113


$
19,907


$
19,909


$
24,243


$
83,172Gross profit


9,330



9,868



10,273



11,508



40,979Operating loss from continuing operations


(1,060
)


(2,057
)


(3,914
)


(292
)


(7,323
)Income (loss) from continuing operations


(1,283
)


(2,553
)


(3,664
)


786



(6,714
)Income (loss) from discontinued operations, net of tax


















Net income (loss) attributable to RAE Systems Inc.


(988
)


(2,250
)


(3,489
)


968



(5,759
)Basic net income (loss) per common share:Continuing operations

$
(0.02
)

$
(0.03
)

$
(0.06
)

$
0.01


$
(0.10
)Discontinued operations

$



$



$



$



$
Basic net income (loss) per common share

$
(0.02
)

$
(0.03
)

$
(0.06
)

$
0.01


$
(0.10
)Diluted net income (loss) per common share:Continuing operations

$
(0.02
)

$
(0.03
)

$
(0.06
)

$
0.01


$
(0.10
)Discontinued operations


















Diluted net income (loss) per common share

$
(0.02
)

$
(0.03
)

$
(0.06
)

$
0.01


$
(0.10
)   First


Second


Third


FourthQuarter


Quarter


Quarter


Quarter


2008Net sales

$
17,869


$
24,647


$
28,845


$
24,022


$
95,383Gross profit


8,855



13,091



15,775



10,494



48,215Operating income (loss) from continuing operations


(2,557
)


498



1,379



(5,409
)


(6,089
)Income (loss) from continuing operations


(2,346
)


(472
)


558



(5,123
)


(7,383
)Loss from discontinued operations, net of tax


10



5



(4
)






11Net income (loss) attributable to RAE Systems Inc.


(2,336
)


(467
)


554



(4,903
)


(7,152
)Basic net income (loss) per common share:Continuing operations

$
(0.04
)

$
(0.01
)

$
0.01


$
(0.08
)

$
(0.12
)Discontinued operations


















Basic net loss per common share

$
(0.04
)

$
(0.01
)

$
0.01


$
(0.08
)

$
(0.12
)Diluted net income (loss) per common share:Continuing operations

$
(0.04
)

$
(0.01
)

$
0.01


$
(0.08
)

$
(0.12
)Discontinued operations


















Diluted net loss per common share

$
(0.04
)

$
(0.01
)

$
0.01


$
(0.08
)

$
(0.12
)  F-33