| RAE SYSTEMS INC 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 |
| Our future revenues are unpredictable, our operating results are likely to fluctuate from quarter to quarter, and if we fail to meet the expectations of securities analysts or investors, our stock price could decline significantly |
| Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, some of which are outside of our control |
| Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indications of future performance |
| Some of the factors that could cause our quarterly or annual operating results to fluctuate include significant shortfalls in revenue relative to our planned expenditures, changes in budget allocations by the federal government for homeland security purposes, market acceptance of our products, ongoing product development and production, competitive pressures and customer retention |
| It is likely that in some future quarters our operating results may fall below the expectations of investors |
| In this event, the trading price of our common stock could significantly decline |
| 12 ______________________________________________________________________ [39]Table of Contents While we were profitable for the fourth quarter of 2005, we remain unprofitable on a year to date basis through the end of the fourth quarter |
| We might continue to incur operating losses and may not be profitable in the future |
| In addition, if our financial results continue to border on profitability, the financial impact of future events may be magnified and may lead to disproportionate impact on the trading price of our stock |
| We experienced a net profit for the quarter ended December 31, 2005, of dlra91cmam000, but remain unprofitable on a year to date basis with a loss of dlra759cmam000 |
| While we have been profitable for three of the last five years, there can be no assurance when or if we will return to profitability or if we can remain profitable |
| In addition, our financial results have historically bordered on profitability, with our results over the last twelve quarters ranging from dlra1dtta3 million quarterly loss to a dlra1dtta0 million quarterly profit, and if we continue to border on profitability, the financial impact may be magnified |
| For example, for a company with more considerable income or losses, a dlra250cmam000 impact may not be significant, whereas dlra250cmam000 in additional net loss in the last quarter would have increased our loss for the year ended December 31, 2005, by 33prca |
| If we continue to border on profitability, any particular financial event could result in a relatively large change in our financial results or could be the difference between us having a profit or a loss for the particular quarter in which it occurs |
| Because the impact of any such events may be magnified, we may experience a disproportionate impact on our trading price as a result |
| The market for gas and radiation detection monitoring devices is highly competitive, and if we cannot compete effectively, our business may be harmed |
| The market for gas and radiation detection monitoring devices is highly competitive |
| Competitors in the gas and radiation monitoring industry differentiate themselves on the basis of their technology, quality of product and service offerings, cost and time to market |
| Our primary competitors in the gas detection market include Industrial Scientific Corporation, Mine Safety Appliances Company, BW Technologies, Ion Science, Draeger Safety Inc, Gastec Corporation and Bacou-Dalloz Group |
| Our competitors in the radiation market include TSA Limited, Polimaster, Exporanium and Santa Barbara Systems |
| Several of our competitors such as Mine Safety Appliances Company and Draeger Safety Inc |
| have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial and marketing resources than we do |
| In addition, some of our competitors may be able to: • devote greater resources to marketing and promotional campaigns, • adopt more aggressive pricing policies or • devote more resources to technology and systems development |
| In light of these factors, we may be unable to compete successfully |
| We might not be successful in the development or introduction of new products and services in a timely and effective manner and, consequently, we may not be able to remain competitive and the results of operations may suffer |
| Our revenue growth is dependent on the timely introduction of new products to market |
| We may be unsuccessful in identifying new product and service opportunities or in developing or marketing new products and services in a timely or cost-effective manner |
| In addition, while our current technology enables us to create products targeted to address the evolving market, we are unable to foresee whether we will continue to have the necessary technology in the future |
| In developing new products, we may be required to make significant investments before we can determine the commercial viability of the new product |
| If we fail to accurately foresee our customers’ needs and future activities, we may invest heavily in research and development of products that do not lead to significant sales |
| We have expanded our current business of providing gas detection instruments to include radiation detection and wireless systems for local and remote security monitoring |
| While we perceive a large market for such 13 ______________________________________________________________________ [40]Table of Contents 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 |
| Recently enacted changes in the securities laws and regulations have and are likely to continue to increase our costs |
| The Sarbanes-Oxley Act of 2002 has required changes in some of our corporate governance, securities disclosure and compliance practices |
| In response to the requirements of that Act, the Securities Exchange Commission (“SEC”) and American Stock Exchange (“AMEX”) have promulgated new rules |
| Compliance with these new rules has increased our legal, financial and accounting costs, and we expect these increased costs to continue indefinitely |
| We also expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be forced to accept reduced coverage or incur substantially higher costs to maintain or obtain coverage |
| In addition, these developments may make it more difficult for us to attract and retain qualified members of our board of directors or qualified executive officers |
| In the event we are unable to satisfy regulatory requirements relating to internal control over financial reporting or, if these controls are not effective, our business and financial results may suffer |
| In designing and evaluating our internal control over financial reporting, we recognize that any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives |
| For example, a company’s operations may change over time as the result of new or discontinued lines of business and management must periodically modify a company’s internal controls and procedures to timely match these changes in its business |
| In addition, management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures and company personnel are required to use judgment in their application |
| While we continue to improve upon our internal control over financial reporting so that it can provide reasonable assurance of achieving its control objectives, no system of internal controls can be designed to provide absolute assurance of effectiveness |
| In our fiscal year 2004 annual report on Form 10-K, management identified eight material weaknesses that were discovered as part of our implementation of Section 404 of the Sarbanes—Oxley Act of 2002 |
| In connection with year-end work on our fiscal year 2005 Form 10-K, management identified three material weaknesses |
| The weaknesses were related to our calculation of share-based compensation and diluted shares in accordance with SFAS 123, “Accounting for Stock-Based Compensation,” inadequate control over our accounting and reporting of certain non-routine transactions occurring at two of our foreign operations and an inadequate number of accounting and finance personnel or consultants sufficiently trained to address some of the complex accounting and financial reporting matters that arise from time-to-time |
| A discussion of the material weaknesses in our internal control over financial reporting and management’s remediation efforts is available herein under the subheading “Management’s Report on Internal Control over Financial Reporting |
| ” 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 |
| 14 ______________________________________________________________________ [41]Table of Contents If our new enterprise resource planning software is not implemented correctly, it could cause errors in our financial reporting or unexpected business interruptions |
| During July 2005, we began implementing a new Company-wide Enterprise Resource Planning (ERP) system to mitigate the risk of future deficiencies and strengthen our procedures for internal control over financial reporting |
| During the implementation period, which we expect to be completed before the end of the second quarter of 2006, we are at a higher risk while we configure the software, redesign some of our processes and train our personnel in the new software |
| While we expect that the design and operation of our new ERP system will help us improve our internal control over financial reporting, there can be no assurance that we will not have a future error in our financial statements |
| Such an error, if material, could require their restatement, having adverse effects on our stock price, potentially causing additional expense and limiting our access to financial markets |
| Moreover, ERP implementations are challenging initiatives that carry substantial project risk including the risk of unexpected business interruptions |
| Failure to properly implement the new information technology system could have an adverse impact on our operating results |
| Future changes in accounting and taxation standards or practices can have a significant effect on our reported results |
| A change in accounting standards or practices or a change in existing taxation rules or practices can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change is effective |
| New accounting pronouncements and taxation rules and varying interpretations of accounting pronouncements and taxation practice have occurred and may occur in the future |
| Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct 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 increasingly dependent upon government funded projects |
| Decisions on what types of projects are to be funded by local, state and federal government agencies will have a material impact on our business |
| The current 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 |
| The current Homeland Security budget increased by approximately 5prca from dlra38dtta4 billion in fiscal year 2005 to dlra40dtta3 billion for fiscal 2006 |
| 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 |
| Government contracts also contain provisions and are subject to laws and regulations that provide government clients with rights and remedies not typically found in commercial contracts |
| For example, a portion of our federal contracting is done through the Federal Supply Schedules from the US General Services Administration (GSA) |
| Our GSA Schedule contract, like all others, includes a clause known as the “Price Reductions” clause; the terms of that clause are similar but not identical to a “most favored customer” clause in commercial contracts |
| Under that clause, we have agreed that the prices to the government under the GSA Schedules contract will maintain a constant relationship to the prices charged to certain commercial customers, ie, when prices to those benchmark customers drop, so too must our prices on our GSA Schedules contract |
| Although we have undertaken extensive efforts to comply with the Price Reductions clause, it is possible that we, through, for example, an unreported discount offered to a “Basis of Award” customer, might fail to honor the obligations of the Price Reductions clause |
| If that occurred, we could, under certain circumstances, be subject to an audit, an action in fraud, or other adverse government actions or penalties |
| 15 ______________________________________________________________________ [42]Table of Contents We may not be successful in promoting and developing our brand, which could prevent us from remaining competitive |
| We believe that our future success will depend on our ability to maintain and strengthen the RAE brand, which will depend, in turn, largely on the success of our marketing efforts and ability to provide our customers with high-quality products |
| If we fail to successfully promote and maintain our brand, or incur excessive expenses in attempting to promote and maintain our brand, our business will be harmed |
| We face risks from our substantial international operations and sales |
| We have significant operations in foreign countries, including manufacturing facilities, sales personnel and customer support operations |
| For the fiscal years ended December 31, 2004 and 2005, approximately 24prca and 33prca of our revenues, respectively, were from sales to customers located in Asia and approximately 10prca and 11prca of our revenues, respectively, were from sales to customers located in Europe |
| For fiscal years ended December 31, 2004 and 2005, approximately 20prca and 30prca, of our revenues, respectively, were from sales in China through our KLH subsidiary |
| 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: • 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, generally higher oil prices, 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 • ability to obtain credit and access to capital issues faced by our international customers |
| The specific economic conditions in each country will impact our future international sales |
| For example, a majority of our recognized revenue has been denominated in US dollars |
| Significant downward fluctuations in 16 ______________________________________________________________________ [43]Table of Contents currency exchange rates against the US dollar could result in higher product prices and/or declining margins and increased manufacturing costs |
| If we do not effectively manage the risks associated with international operations and sales, our business, financial condition and operating results could suffer |
| In addition, to date we have experienced lower gross margins on sales in certain jurisdictions, particularly China |
| To the extent that the percentage of our total net sales from China increases and our gross margins do not improve, our business financial condition and operating results could suffer |
| The loss of “Normal Trade Relation” status for China, changes in current tariff structures or adoption of other trade policies adverse to China could have an adverse effect on our business |
| Manufacturing and retail sales in China are material to our business plan and results of operations |
| In May, 2004, our acquisition of a 64prca interest in KLH increased both our manufacturing and retail presence in China |
| Our ability to import products from China at current tariff levels could be materially and adversely affected if the “normal trade relations” (“NTR”, formerly “most favored nation”) status the United States government has granted to China for trade and tariff purposes is terminated |
| As a result of its NTR status, China receives the same favorable tariff treatment that the United States extends to its other “normal” trading partners |
| China’s NTR status, coupled with its membership in the World Trade Organization, could eventually reduce barriers to manufacturing products in and exporting products from China |
| However, we cannot provide any assurance that China’s WTO membership or NTR status will not change |
| As a result of opposition to certain policies of the Chinese government and China’s growing trade surpluses with the United States, there has been, and in the future may be, opposition to NTR status for China |
| Also, the imposition of trade sanctions by the United States or the European Union against a class of products imported by us from, or the loss of NTR status with, China, could significantly increase our cost of products imported into the United States or Europe and harm our business |
| Because of the importance of our international sales and international sourcing of manufacturing to our business, our financial condition and results of operations could be significantly and adversely affected if any of the risks described above were to occur |
| The government of China may change or even reverse its policies of promoting private industry and foreign investment, in which case our assets and operations may be at risk |
| 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 |
| 17 ______________________________________________________________________ [44]Table of Contents While there is no single patent or license to technology of material significance to the Company, our ability to compete is affected by our ability to protect our intellectual property rights in general |
| For example, we have a collection of patents related to our photo-ionization detector technology of which the first of such patents expires in 2012, and our ability to compete may be affected by any competing similar or new technology |
| In addition, if we lose the licensing rights to a patented or other proprietary technology, we may need to stop selling products incorporating that technology and possibly other products, redesign our products or lose a competitive advantage |
| We cannot ensure that our future patent applications will be approved or that our current patents will not be challenged by third parties |
| Furthermore, we cannot ensure that, if challenged, our patents will be found to be valid and enforceable |
| Any litigation relating to our intellectual property rights could, regardless of the outcome, have a material adverse impact on our business and results of operations |
| We might face intellectual property infringement claims that might be costly to resolve and affect our results of operations |
| We may, from time to time, be subject to claims of infringement of other parties’ proprietary rights or claims that our own trademarks, patents or other intellectual property rights are invalid |
| For example, a motion was filed on June 17, 2005, by Polimaster Ltd |
| Limited, for an injunction that would prevent RAE Systems from shipping its Gamma RAE II product and prohibiting RAE from making any additional sales of products in its possession licensed from Polimaster Ltd |
| Limited, pending resolution of arbitration between the parties |
| The motion was denied on September 6, 2005 |
| While this claim may be subject to arbitration in accordance with the original contract between the parties, we do not expect it to have a material effect upon our business or results of operations |
| Management will defend itself vigorously, against any claims of this type |
| However, 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 may lose sales if our distributors stop selling our products |
| We distribute our products 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 |
| For example, we derived approximately 59prca of our North American revenues from our sales distribution channels in fiscal year 2005 |
| For the fiscal year ended December 31, 2005, 50 distributors cumulatively accounted for approximately 51prca of our total product sales in the United States |
| We also believe our future growth outside of China depends on the efforts of distributors |
| In addition, the contractual obligations of our distributors to continue carrying our products are subject to a sixty-day termination notice by either party for convenience |
| 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 |
| 18 ______________________________________________________________________ [45]Table of Contents 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 stockholder value or harm our results of operations |
| We may acquire or make investments in complementary businesses, technologies, services or products if appropriate opportunities arise |
| The process of integrating any acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures |
| Integration of an acquired company also may consume much of our management’s time and attention that would otherwise be available for ongoing development of our business |
| Moreover, the anticipated benefits of any acquisition may not be realized |
| Future acquisitions could result in dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or expenses related to goodwill recognition and other intangible assets, any of which could harm our business |
| Our ownership interest in Renex will cause us to incur losses that we would not otherwise incur |
| We own approximately 36prca of Renex Technology Ltd, a wireless systems company still in the research and development stage |
| We are required to incorporate our share of its expenses as losses in our Consolidated Statements of Operations |
| 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, including Robert I Chen, Donald W Morgan, Peter Hsi, Rudy Mui and Hong Tao Sun |
| We have no employment agreements with any of these officers |
| The loss of the services of any of our executive officers could harm our business |
| Our officers, directors and principal stockholders beneficially own approximately 35prca of our common stock and, accordingly, may exert substantial influence over the company |
| Our executive officers and directors and principal stockholders, in the aggregate, beneficially own approximately 35prca of our common stock |
| These stockholders acting together have the ability to substantially influence all matters requiring approval by our stockholders |
| These matters include the election and removal of the directors, amendment of our certificate of incorporation, and any merger, consolidation or sale of all or substantially all of our assets |
| In addition, they may dictate the management of our business and affairs |
| Furthermore, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination and may substantially reduce the marketability of our common stock |