The following discussion should be read in conjunction with, and is qualified in its entirety by reference 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 Operations for the year ended December 31, 2007 included in our 2007 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" of Part 1, Item 1A of our 2007 Annual Report on Form 10-K and in Part II, Item 1A of this Form 10-Q 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 that provide business continuity and protect customers in the event of an electric power disturbance. Our products are designed to provide power quality to protect customers from voltage fluctuations, such as surges and sags, and frequency fluctuations, and also to provide ride-through, or temporary, power to bridge the gap between a power outage and the restoration of utility power, or the time required to switch to electric generator power. Our products are designed to be environmentally friendly compared to existing solutions without compromising functionality, efficiency or cost. As of September 30, 2008 we have shipped over 2,000 flywheels in UPS system installations, delivering more than 500 megawatts of power to customers in over 40 countries around the world.

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 sell our 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 geographic regions of the world, but particularly in North America, Western Europe and Asia.

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 CleanSourceŽ. 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 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 directly by Caterpillar Inc. under an OEM relationship with us. Combining our CleanSource UPS with a generator provides customers with complete short and long-term protection in the event of a power disturbance.

To meet the requirements of customers without backup generators that require protection from utility disturbances, we have also developed a patented extended runtime product that we call CoolAirTM DC. We initially have targeted CoolAir DC at lower power levels than our flywheel products, and it is sold as a minute-for-minute replacement for lead-acid batteries. CoolAir DC can provide backup power for several minutes to hours depending on the customer application. CoolAir DC utilizes mature thermal and compressed air storage (TACAS) technologies combined in a proprietary manner to produce backup power during an electrical disturbance. This product discharges cool air as a by-product of its operation that also can be used by customers during an electrical disturbance as a transitional source of backup cooling. CoolAir DC is a DC only, or battery-type product, that is designed to operate with traditional double-conversion UPS systems.

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
                                                  Three months ended September 30,                2008 vs. 2007
                                                         % of                       % of
                                                         total                      total
($ in thousands)                            2008        revenue        2007        revenue          $          %
Product revenue                           $  10,193          82 %    $   7,007          85 %    $   3,186      45 %
Service and spares revenue                    2,255          18 %        1,227          15 %        1,028      84 %

Total revenue                                12,448         100 %        8,234         100 %        4,214      51 %

Cost of product revenue                       9,515          76 %        5,675          69 %        3,840      68 %
Cost of service and spares revenue            1,810          15 %          974          12 %          836      86 %

Total cost of revenue                        11,325          91 %        6,649          81 %        4,676      70 %

Gross profit                                  1,123           9 %        1,585          19 %         (462 )   (29 )%
Operating expenses:
Research and development                      1,197          10 %        1,412          17 %         (215 )   (15 )%
Selling and marketing                         2,795          22 %        2,654          32 %          141       5 %
General and administrative                    1,317          11 %        1,244          15 %           73       6 %

Total operating expenses                      5,309          43 %        5,310          64 %           (1 )    -

Operating loss                               (4,186 )       (34 )%      (3,725 )       (45 )%         461      12 %
Interest income                                  68           1 %          207           3 %         (139 )   (67 )%
Other income                                      3          -               6          -              (3 )   (50 )%

Net loss                                  $  (4,115 )       (33 )%   $  (3,512 )       (43 )%   $    (603 )   (17 )%


                                                                                                    Variance
                                                  Nine months ended September 30,                 2008 vs. 2007
                                                         % of                       % of
                                                         total                      total
($ in thousands)                            2008        revenue        2007        revenue          $          %
Product revenue                           $  22,033          82 %    $  20,003          86 %    $   2,030      10 %
Service and spares revenue                    4,741          18 %        3,386          14 %        1,355      40 %

Total revenue                                26,774         100 %       23,389         100 %        3,385      14 %

Cost of product revenue                      19,937          74 %       17,055          73 %        2,882      17 %
Cost of service and spares revenue            3,989          15 %        2,865          12 %        1,124      39 %

Total cost of revenue                        23,926          89 %       19,920          85 %        4,006      20 %

Gross profit                                  2,848          11 %        3,469          15 %         (621 )   (18 )%
Operating expenses:
Research and development                      3,903          15 %        4,322          18 %         (419 )   (10 )%
Selling and marketing                         8,800          33 %        7,900          34 %          900      11 %
General and administrative                    3,685          14 %        6,451          28 %       (2,766 )   (43 )%

Total operating expenses                     16,388          61 %       18,673          80 %       (2,285 )   (12 )%

Operating loss                              (13,540 )       (51 )%     (15,204 )       (65 )%      (1,664 )   (11 )%
Interest income                                 322           1 %          567           2 %         (245 )   (43 )%
Other income                                    207           1 %           55          -             152     276 %

Net loss                                  $ (13,011 )       (49 )%   $ (14,582 )       (62 )%   $  (1,571 )   (11 )%

Product revenue. Product revenue consists of sales of our CleanSource power quality products, comprised of 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 for the three and nine month periods ended September 30, 2008 was due to an increase in the number of flywheel systems sold and from higher ancillary project revenue compared to the same periods of 2007. A single product, depending on its power rating or size, may be comprised of multiple flywheel units. The average selling price during the third quarter of 2008 was $77,000 per quarter-megawatt flywheel, compared to $83,000 over the same period in 2007. Although the average selling price decreased compared to the prior year, the number of wheels sold in the third quarter was 94 flywheel units compared to 73 flywheel units in the comparable period of 2007, an increase of 29%. For the nine-months ended September 30, 2008 our number of wheels sold was 220 units compared to 202 units in 2007, a 9% increase. This higher volume of units resulted in higher product revenues in the three and nine-month periods ended September 30, 2008 compared to the comparable periods in 2007. During 2008 we have also emphasized selling systems to our direct customers whereby we sell a complete power solution that includes a flywheel-based UPS unit, and engine generator and related components. This results in higher revenues for us from each customer and enables us to develop a closer relationship with our customers and leads to future service revenue opportunities. This has also resulted in an increase in the size of orders compared to prior years. For example, we have now received individual orders in excess of $5 million.

The frequency and timing of our larger multi-element system sales, including megawatt class UPS products, made directly by us is more unpredictable than smaller orders and can result in material changes in period-to-period revenue and the number of units sold. Such revenues may also occur in periods other than when originally anticipated, which can add to the potential variability in our quarterly financial results and affect our ability to meet forecasted targets.

North American sales were 44% of our total revenue for the three-month periods ended September 30, 2008 and 2007, and 77% in the immediately preceding quarter of 2008. The decrease as a percentage of total revenue compared to the prior quarter reflects the increases in foreign sales during the third quarter. In absolute terms, our American sales increased by 20% during the third quarter compared to the immediately preceding quarter. For the nine-months ended September 30, 2008 our North American sales were 57%, the same level as in 2007.

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. In 2007 we also opened our first Asian sales office in Tokyo. Sales of Active Power branded products through our direct and manufacturer's representative channels were 57% of our total revenues for the three-month period ended September 30, 2008, compared to 73% for the same period of 2007. For the nine-months ended September 30, 2008 direct sales have represented 55% of our revenues compared to 71% for the comparable period in 2007. Although our overall direct sales have decreased during the nine-months ended September 30, 2008 due to stronger than anticipated performance from our OEM partners, we expect direct sales will continue to increase in both the EMEA and North American markets as we continue to focus on building a direct sales organization. As direct sales typically involve multi-element larger system components and often lead to future recurring service and support revenue, we will continue to focus on our direct sales channel to increase revenue and improve profit margins. We believe sales of our Active Power branded products to government facilities and industrial customers in regions that are 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 41% of our revenue for the three-month period ended September 30, 2008, compared to 27% of our revenue for the three-month period ended September 30, 2007. For the nine-month period ended September 30, 2008 Caterpillar represented 44% of our revenues compared to 27% in 2007. On April 23, 2008, we entered into a new purchase agreement with Caterpillar, effective as of January 1, 2008, governing the sale of products by us to Caterpillar. This purchase agreement has an initial term of three years and provides that Caterpillar will continue to market certain of our flywheel-based uninterruptible power supply products under the Caterpillar brand as a complement to Caterpillar's own product line. We will supply and Caterpillar will purchase all of Caterpillar's Electric Power Division's requirements for our products. 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 continue to increase in 2008 in absolute terms.

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. 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 2008. 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 for the remainder of 2008.

Service and spares revenue. Service and spares revenue primarily relates to revenue generated from installation, startup, repairs or reconfigurations of our products 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 84% for the three-month

period ended September 30, 2008 compared to the same prior year period. For the nine-month period ended September 30, 2008 our service and spares revenue increased by 40% compared to the comparable period in 2007. This increase was primarily due to the timing of contract work related to large systems projects and from having a larger install base of customers that we have sold directly to and for which we have established ongoing service arrangements. For some of these project 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. As we sell more solutions to customers, we can expect more project-related revenue, however the amount of such revenues in any one period may fluctuate significantly due to the timing and size of the project opportunities. We also 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 types of services directly 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 revenue in the three-month period ended September 30, 2008 was 76%, compared to 69% for the comparable period in 2007 and 70% in the second quarter of 2008. For the nine-month period ended September 30, 2008 the cost of product revenue as a percentage of total revenue was 74% compared to 73% in 2007. Although we have instituted programs to reduce product and component costs where feasible, the impact of increased raw commodity pricing has kept the product cost as a percentage of total product revenue from decreasing. Additionally, during the third quarter of 2008 we recorded an additional reserve of $1.5 million against the CoolAir inventory as a result of our decreased expectations of future product demand and to adjust this inventory to its expected salvage value. We continue to operate a manufacturing facility that has a capacity level significantly greater than our current product revenue levels. In addition, a large portion of the costs involved in operating our manufacturing facility are fixed in nature and we incur approximately $0.6 million to $1.2 million in unabsorbed overhead each quarter. As we increase our volume of production we are able to more efficiently utilize our manufacturing facility, and this results in a decrease in our unabsorbed product overhead, and results in higher gross margins. We also continue to work on reducing our product costs through design enhancements and modifications and vendor management programs. The accomplishment of material gross margin levels is heavily dependent upon our sales channel mix and the effectiveness of our product pricing to our customers, as well as the actual volume of units produced. Our ability to maintain and grow positive product gross margin will depend on multiple factors, including our ability to continue to reduce material costs, improve our sales channel mix in favor of direct sales versus OEM, increase product prices, and increase our unit volume and total revenues to a level that will allow us to improve the utilization of our manufacturing operations.

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, including commodity prices, and productivity.

Cost of service and spares revenue. Cost of service and spares revenue includes the cost of component parts, 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. We incur between $0.5 million and $0.7 million in unabsorbed service overhead each quarter. The cost of service and spares revenue was 80% of total service and spares revenue in the three-month period ended September 30, 2008, compared to 79% in the same period of 2007 and 90% in the second quarter of 2008. For the nine months ended September 30, 2008 the cost of service and spares was 84% of service and spares revenue compared to 85% in the same period of 2007. Generally we have managed to match increases in service revenues with the growth of our service operations. Managing our level of service and support staff to match increases in service and spares revenue remains a continual operational challenge, particularly as new customers are requiring us to broaden our service capabilities as we sell into new markets which is impacting our ability to fully absorb our service overhead expenses.

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 decreased by $215,000, or 15%, from the third quarter of 2007, and decreased by $107,000, or 8%, from the second quarter of 2008. For the nine-months ended September 30, 2008, our research and development expenses were $419,000 or 10% lower than for the same period in 2007. The decrease from the same period in 2007 was due to headcount reductions and lower project related development costs in 2008. The prior year expenses included higher prototype and development costs incurred in paralleling our megawatt-class UPS product. We believe research and development expenses in the fourth quarter of 2008 will stay at similar levels to those recorded in the third quarter.

Selling and marketing. Selling and marketing expenses primarily consist of compensation, including variable sales compensation, and related costs for sales and marketing personnel, related travel, selling and marketing expenses, other costs of operating foreign sales locations, as well as an allocated portion of our occupancy costs. For the third quarter of 2008, selling and marketing costs were $141,000, or 5%, higher than the amount recorded in the third quarter of 2007, and were $260,000, or 9%, lower than the level of the second quarter of 2008. For the nine-months ended September 30, 2008, our selling and marketing expenses were $900,000 or 11% higher than the same period in 2007. The increase from the same period in 2007 was due to increased variable sales

compensation associated with increased channel partners and distributors compared to 2007 and due to the higher product revenue levels achieved, higher marketing and promotion spending in 2008 and from increased marketing efforts of our products globally. Our total headcount in sales and marketing has decreased slightly compared to last quarter, and 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 fourth quarter in response to anticipated higher revenue levels and variable compensation increases.

General and administrative. General and administrative expense is primarily comprised of compensation and related costs for executive and administrative personnel, professional and director fees, and taxes, including sales, property and franchise taxes. For the third quarter of 2008 general and administrative expenses increased by $73,000, or 6%, from the levels of the same period in 2007 and increased $131,000 or 11% from the second quarter of 2008. The increase from the second quarter of 2008 related to higher bad debt expense and professional fees related to hiring. For the nine-month period ended September 30, 2008, our general and administrative expenses decreased by $2.8 million or 43% compared to the same period of 2007. This decrease from the same period in the prior year was primarily attributable to $2.9 million of professional fees incurred last year with a review of our historical stock option granting procedures that covered the period from 2000 through 2006. We anticipate that the level of general and administrative expenses should stay at similar levels in the fourth quarter of 2008.

Interest income. Interest income has decreased from $207,000 in the three-month period ended September 30, 2007 to $68,000 in the three-month period ended September 30, 2008. Our average cash and investments balance over the three month period ending September 30, 2008 has decreased by approximately $4.7 million, or 36%, compared to the average balance over the comparable period ending September 30, 2007. Interest income also decreased due to decreasing interest rates available in credit markets and the mix of our investments between short and long term and cash and cash equivalents.

Other income. Other income in the third quarter of 2008 decreased over the immediately preceding quarter due to sales in the second quarter of previously expensed equipment, resulting in the recognition of a gain in that quarter and foreign exchange gains on a bank account held in foreign currency.

Liquidity and Capital Resources

Our principal sources of liquidity as of September 30, 2008 consisted of $11.8 million of cash and investments and the funds available to us under our $5.0 million revolving credit facility with our bank. We have primarily funded our operations through public and private placements of our capital stock as well as $10.0 million in development funding received from Caterpillar since 1999, and from our product, service and spares revenue. We believe that our cash and investments on hand will be sufficient to fund our operations through the next twelve months based upon our historical and projected cash burn.

In October 2007, we entered into a Loan and Security Agreement (Loan Agreement) with Silicon Valley Bank (SVB). The Loan Agreement provides for a secured revolving line of credit in an amount of up to $5.0 million, subject to a borrowing base formula based on eligible receivables and inventory. The revolving line of credit can be used to borrow revolving loans, issue standby . . .