The following discussion should be read in conjunction with, and is qualified in its entirety to, the financial statements and notes thereto included in Item 1 of this Form 10-Q and the financial statements and notes thereto and our Management's Discussion and Analysis of Financial Condition and Results of Operation for the year ended December 31, 2006 included in our 2006 Annual Report on Form 10-K. This report contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that involve risks and uncertainties. Our expectations with respect to future results of operations that may be embodied in oral and written forward-looking statements, including any forward looking statements that may be included in this report, are subject to risks and uncertainties that must be considered when evaluating the likelihood of our realization of such expectations. Our actual results could differ materially. The words "believe," "expect," "intend," "plan," "project," "will" and similar phrases as they relate to us are intended to identify such forward-looking statements. In addition, please see the "Risk Factors" in Part 1, Item 1A in our 2006 Annual Report on Form 10-K for a discussion of items that may affect our future results.

Overview

We design, manufacture and market efficient, reliable and green power quality solutions and Uninterruptible Power Supply (UPS) systems to enable business continuity in the event of power disturbances. Our solutions provide ride-through, or temporary, power for the majority of power disturbances such as voltage sags and surges, and bridge the gap between a utility outage and restoration of power, or the time required to switch to generator power. Our products are designed to be environmentally friendly compared to existing solutions without compromising functionality, efficiency or cost. We have shipped over 1,500 flywheels or more than 375 megawatts of our products to businesses in over 40 countries since we were founded in 1992.

Our patented flywheel energy storage systems store kinetic energy by constantly spinning a compact steel wheel (flywheel) driven from utility power in a low friction environment. When the utility power used to spin the flywheel fluctuates or is interrupted, the flywheel's inertia causes it to continue spinning. The resulting kinetic energy of the spinning flywheel generates electricity known as "bridging power" for short periods until utility power is fully restored or a backup electricity generator starts and takes over generating longer term power in the case of an extended electrical outage. We believe that our flywheel products provide many advantages over traditional battery-based systems, including substantial space savings, higher power densities, "green" energy storage and power efficiencies as high as 98% that reduce total operating costs. We offer our flywheel products with load capabilities from 130 kVA to 3,600 kVA, while typically targeting power density applications above 200 kVA since the majority of these customers already have back-up generators. We market our flywheel products under the brand name CleanSource®. CleanSource DC is a non-chemical replacement for lead-acid batteries used for bridging power. Utilizing our flywheel energy storage technology, the CleanSource DC is a stand-alone, direct current (DC) product that is compatible with all major brands of uninterruptible power supplies (UPS). We built on the technological success of CleanSource DC by creating a battery-free UPS, CleanSource UPS, which integrates the UPS electronics and our flywheel energy storage system into one compact cabinet. CleanSource UPS represents the majority of our current revenue. The CleanSource UPS is also marketed by Caterpillar Inc. under the brand name "Cat® UPS". Combining our CleanSource UPS with a generator provides customers with complete short and long-term protection in the event of a power disturbance. We sell our CleanSource flywheel products to commercial and industrial customers across a variety of vertical markets, including manufacturing, technology, communications, utilities, healthcare, banking and military and in all major geographic regions of the world, but particularly in North America and Europe.

Our primary sales channels in North America have traditionally been through our OEM partners, Caterpillar, Inc. and Eaton Electrical (formerly known as PowerWare). Since 2005 we have developed additional sales channels in North America including direct sales employees and a network of manufacturer's representatives. Direct sales tend to improve our relationships with clients, improve our gross margins and add service and other revenue opportunities.

Our primary sales channels in Europe, Middle East and Asia (EMEA) include selling directly to end users and indirectly through select value added resellers (VARs). We also provide services including engineering, installation, start-up, monitoring, and repair for our products under contracts with our customers.

Results of Operations



                                                                                                   Variance
($ in thousands)                                   Three months ended March 31,                 2007 vs. 2006
                                                     % of total                 % of total
                                           2007       revenue         2006       revenue           $        %
Product revenue                          $   5,271           88 %   $   5,044           91 %   $     227      5 %
Service and spares revenue                     702           12           525            9           177     34 %

Total revenue                                5,973          100         5,569          100           404      7 %

Cost of product revenue                      4,911           82         5,140           92         (229)    (4) %
Cost of service and spares revenue             725           12           576           10           149     26 %

Total cost of revenue                        5,636           94         5,716          103          (80)    (1) %

Gross profit (loss)                            337            6         (147)          (3)           484    329
Operating expenses:
Research and development                     1,584           27         2,238           40         (654)    -29 %
Selling and marketing                        2,625           44         2,685           48          (60)    (2) %
General and administrative                   2,751           46         1,653           30         1,098     66 %

Total operating expenses                     6,960          117         6,576          118           384      6 %

Operating loss                             (6,623)        (111)       (6,723)        (121)           100      1 %
Interest income                                201            3           394            7         (193)   (49) %
Other income (expense)                         (2)           -             79          (1)            81    103 %

Net loss                                 $ (6,424)        (108) %   $ (6,250)        (112) %   $   (174)     -3 %

Product revenue. Product revenue consists of sales of our CleanSource power quality products, comprising both UPS and DC product lines, and sales of third-party ancillary equipment, such as engine generators, electrical and switchgear products.

The increase in product revenue from the same period of 2006 was due to higher sales of our 250-900 kVA UPS product line and continued growth from our direct sales channel. When we sell product directly, as compared to through our OEM channels, we typically generate higher prices and better contribution margins as we do not have to offer channel discounts. The average selling price over the first three months of 2007 was $82,000 per quarter-megawatt flywheel, compared to $54,000 over the same period in 2006 due to higher direct sales and selling products with more options, which occurs more frequently with direct transactions compared to our OEM sales. A single product, depending on its power rating, may be comprised of multiple flywheel units.

During the quarter ended March 31, 2007 we sold 48 flywheel units compared to 91 in the comparable period of 2006. In the prior year period there was a large OEM transaction of 8 megawatt-class UPS machines (representing 32 flywheels) that sold at lower average selling prices than our direct UPS sales and which negatively influenced the average selling price. Excluding this transaction, the average selling price of a flywheel in 2006 would have been $74,000. The frequency and timing of our larger system sales, including megawatt class UPS products, is more volatile and can result in material changes in period-to-period revenue. Such revenues may also occur in periods other than when originally anticipated, which can add to the potential volatility and affect our ability to meet forecasted targets.

Since 2005 we have been increasing the size of our direct sales organization in an effort to expand the territories in which we sell our Active Power branded products. Most of this effort initially was focused in the EMEA market where we now have multiple sales offices. During the current quarter we opened our first office in the Asia Pacific region, located in Tokyo. We also plan on expanding into Central America in 2007. Sales of Active Power branded products through our direct and manufacturer's representative channels were 76% of our total revenues for the three-month period ended March 31, 2007 compared to 36% for the same period of 2006, reflecting the impact of this direct sales strategy. Direct sales typically have higher profit margins than sales through our OEM channels; therefore, increasing our direct sales channel is expected to result in increased revenue and improved profit margins. We believe sales of our Active Power branded products to government facilities and industrial customers in regions that were not covered by our OEMs will continue to increase over time and will continue to become a larger percentage of our total revenue.

Caterpillar remains our largest OEM partner and largest overall customer and represented 23% of our revenue for the three-month period ended March 31, 2007 compared to 46% of our revenue for the three-month period ended March 31, 2006. We have had recent success with Caterpillar selling our megawatt-class UPS products along with their large engine generators, and expect total revenue from this channel to increase in 2007.

Our products perform well in harsh environments where power quality is particularly poor, which makes them a good fit for industrial countries with a poor power infrastructure and therefore we have focused our direct sales efforts to these customers. Due to the large size of some of our customer orders relative to our current total revenue levels, our quarterly total revenue trend and the proportion of sales made directly by us can be expected to fluctuate quarterly from the amounts recorded so far in 2007. We have also seen and anticipate a further increase in capital spending in data centers where there is a requirement for higher-density power solutions such as flywheels, and believe that this along with our expanding direct sales strategy will result in higher product revenue levels for us in 2007.

Service and spares revenue. Service and spares revenue primarily relates to revenue generated from installation, startup, repairs or reconfigurations of our product, and the sale of spare or replacement parts to our OEM and end-user customers. It also includes revenue associated with the costs of travel of our service personnel. Service and spares revenue increased by 34% for the three-month period ended March 31, 2007 compared to the same prior year period. This increase is primarily due to higher levels of service and contract work from direct product sales made in the last two quarters. For some of these customers we provide a full power solution, including site preparation, installation of an entire power solution and provision of all products required to provide a turnkey product to the end user. We anticipate that service and spares revenue will continue to grow with product revenue and as our installed base of product expands, because as more units are sold to customers, more installation, startup and maintenance services will be required. Where we make sales through our OEM channel, it is typical for the OEM to provide these type of services to their end-user customers.

Cost of product revenue. Cost of product revenue includes the cost of component parts of our products that are sourced from suppliers, personnel, equipment and other costs associated with our assembly and test operations, including costs from having underutilized facilities, shipping costs, warranty costs, and the costs of manufacturing support functions such as logistics and quality assurance. The cost of product revenue as a percentage of total product revenue in the three-month period ended March 31, 2007 decreased by 10% compared to the comparable period in 2006 due to the effect of higher selling prices, improved efficiency in our manufacturing operations and material and overhead costs

Items that could impact our ability to further improve our gross margin include sales product volume and mix, pricing discounts and customer incentives, currency fluctuations, and variations in our product cost and productivity.

Cost of service and spares revenue. Cost of service and spares revenue includes the cost of component parts, as well as labor and overhead of our spare parts, costs associated with travel and labor used in servicing a unit and unabsorbed overhead from the service group. The cost of service and spares revenue decreased to 103% of service and spares revenue in the three-month period ended of March 31, 2007 compared to 110% in the same period of 2006. This decrease reflects better utilization of our service personnel, improved pricing for service, and higher margins on contract work compared to the prior period.

Research and development. Research and development expense primarily consists of compensation and related costs of employees engaged in research, development and engineering activities, third party consulting and product development activities, as well as an allocated portion of our occupancy costs. Overall our research and development expenses were $654,000 or 29% lower that the first quarter of 2006, and were $23,000 or 1% higher than the preceding quarter. The major reason for the decrease from 2006 was due to the effect of headcount reductions that the Company made in the third quarter of 2006, and due to lower project related development costs this year. The prior year expenses included higher prototype and development costs for our CoolAir DC product and costs incurred in paralleling our megawatt-class UPS product. We believe research and development expenses in the second quarter will stay at similar levels to those recorded in the first quarter.

Selling and marketing. Selling and marketing expenses primarily comprise compensation, including variable sales compensation, and related costs for sales and marketing personnel, and related travel, selling and marketing expenses, as well as an allocated portion of our occupancy costs. Sales and marketing costs were $60,000 or 2% lower than the amounts recorded in the first quarter of 2006, and were $202,000 or 8% higher than the immediately preceding quarter. The increase in our sales and marketing costs from the last quarter reflects higher marketing expenditures to support our direct sales force, re-branding of the Company's collateral and other direct sales activities as part of our effort to facilitate more direct sales. We also wrote off $200,000 of expenses relating to fixed assets used for demonstration purposes. Our total headcount in sales and marketing remains at similar levels to last quarter, although we have changed the composition of our sales team over the last year as we expand our direct sales force. We believe that sales and marketing expenses will increase slightly in the second quarter as we expand into the Asia market with a new office, and as our revenue levels increase and our variable compensation increases.

Interest income. Interest income has decreased from $394,000 in 2006 to $201,000 in the three-month periods ended March 31, 2007. This reflects the decrease in our average cash and investments balance compared to the prior year as the Company has used its investments to fund operations. Our average cash and investments balance over the three month period ending March 31, 2007 has decreased by approximately $20.7 million or 52% compared to the average balance over the comparable period ending March 31, 2006.

Other income (expense). Other income in the corresponding quarter of 2006 included cost recoveries from annual audits of our real estate leases.

Liquidity and Capital Resources

Our principal sources of liquidity as of March 31, 2007 consisted of $17.0 million of cash and investments. We have primarily funded our operations through public and private placements of our common stock as well as $10.0 million in development funding received from Caterpillar since 1999, and from our product, service and spares revenue. Although we believe that our cash and investments on hand will be sufficient to fund our operations through at least the middle of 2008, based upon our historical and projected cash burn it is likely that the Company will raise additional funds before the end of 2007, either through future equity or debt offerings, in order to continue to fund and grow its business beyond that date and to ensure that we have adequate cash reserves. In August of 2006 we filed a universal Shelf Registration Statement on Form S-3 with the Securities and Exchange Commission that would have provided for the sale of up to $75 million of equity or debt instruments. Due to the failure to file our 2006 Annual Report on Form 10-K in a timely fashion, we are no longer eligible to use our Shelf Registration Statement. This will influence the type and amount of any future capital raisings that the Company may complete but will not prevent the Company from raising additional funds. At this point, the Company has made no determination as to the amount, timing or type of any future capital raising that it will undertake, but we have had ongoing discussions with a number of investment banking organizations. The Company is also evaluating a number of proposals to establish a bank revolving line of credit to provide additional liquidity to assist in managing its short-term working capital.

Three months ended Variance ($ in thousands) March 31, 2006 vs. 2005 2007 2006 $ % Cash used in operating activities $ (3,241 ) $ (6,204 ) $ (2,963 ) (48 )%

Cash used in operating activities decreased by 48% compared to the same period of 2006. This is primarily attributable to a decrease in our receivables balance following collections from the immediately preceding quarter where the Company had record revenue levels. Receivables decreased by $2.4 million from the prior quarter. The company also had a $2 million increase in accrued expenses mostly connected with the costs associated with the option review. Offsetting these sources of funds were decreases in our accounts payable reflecting our lower business level in the quarter from the prior quarter, and an increase in inventory as we prepared goods for second quarter shipment. We anticipate cash used in operating activities to increase in the second quarter as we discharge the liabilities from the stock option review, reach settlement of the related income tax liabilities, and record an expected increase in receivables due to anticipated higher revenues.

Investing activities primarily consist of sales and purchases of investments and purchases of property and equipment. Fluctuations in the sale and purchase of investments generally reflect our use of these funds to finance our ongoing operations. Capital expenditures were $355,000 in the three-month period ending March 31, 2007 compared to $345,000 in the same period of 2006.

Funds provided by financing activities during the three-months ended March 31, 2006 reflect proceeds from employee share purchases. The significant decrease in funds from financing activities compared to the comparable period of 2006 is due to the fact that during the first quarter of 2006 we had proceeds from an employee stock purchase plan, and significantly higher levels of stock option exercises because of a much higher stock price for the Company's common stock that fueled more exercises.

As noted above, we believe our existing cash and investments balances at March 31, 2007 will be sufficient to meet our cash requirements through at least the next 12 months, although we may elect to seek additional funding prior to that time. Beyond the next 12 months, our cash requirements will depend on many factors, including the rate of sales growth, the success of our direct selling strategy, the market acceptance of our products, including the CoolAir DC product family, the timing and level of development funding, the rate of expansion of our sales and marketing activities, the efficiency of our manufacturing processes, and the timing and extent of research and development projects.

Recent Accounting Pronouncements

In September 2006 the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). SFAS 157 provides enhanced guidance for using fair value to measure assets and liabilities. The standard also responds to investors' requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted. The Company is currently evaluating the effect that the adoption of SFAS 157 will have on its financial position and results of operations.

The Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48) at the beginning of 2007. Adoption of FIN 48 did not have a material impact upon the Company. We have no unrecognized tax benefits and have not recognized any interest and penalties relating to uncertain tax positions. The Company will recognize interest and penalties related to . . .