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, 2008 included in our 2008 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 of our 2008 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

Active Power is a manufacturer and provider of critical power solutions incorporating uninterruptible power supply (UPS) systems that provide business continuity to enterprises requiring protection against electrical power disturbances. Our products are designed to deliver continuous clean power, protecting 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. Our target customers are those global enterprises requiring "power insurance" because they have zero tolerance for downtime in their mission critical operations. The UPS products we manufacture utilize green technology to create a renewable energy source. These products are highly reliable, are energy and space efficient, and significantly reduce client electricity expenses. As of September 30, 2009, we have shipped more than 2,400 flywheels in UPS system installations, delivering more than 600 megawatts of power to customers in more than 40 countries around the world. We are headquartered in Austin, Texas, with international offices in the U.K., Germany and Japan. Our patented flywheel-based UPS 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 restored or a backup electricity generator starts and takes over generating longer-term power in the case of an extended electrical outage. We believe our flywheel products provide many competitive advantages over conventional battery-based UPS systems, including substantial space savings, higher power densities, "green" energy storage, and higher power efficiencies of up to 98%. This high energy efficiency reduces operating costs and provides customers a lower total cost of ownership. We offer our flywheel products with load capabilities from 150 kVA to 8,400 kVA. We typically target higher power applications of 200 kVA and above, largely because a majority of customers in this market segment have backup generators. Our flywheel products are marketed under the brand name CleanSource ®. Our continuous power systems are marketed under the name PowerHouse and combine our UPS system with switchgear and a generator to provide complete short- and long-term protection in the event of a power disturbance.

We believe a number of underlying macroeconomic trends place Active Power in a strong position to be one of the leading providers of critical power protection. These trends include:

• the ever-increasing demands placed on the public utility infrastructure;

• an inadequate investment in global utility infrastructure;

• rising costs of energy world wide;

• significant costs of downtime;

• a rapidly expanding need for data centers that require reliable, efficient power; and

• an increasing demand for economically green solutions.

We have evolved significantly since our founding in 1992 as an engineering business focused on research, development and invention. The technological foundation of Active Power has yielded more than 150 worldwide patents and a highly differentiated, cost-efficient product platform. Since 2005, we have changed our business focus to successfully commercialize our technologies by building the Active Power brand, expanding our sales distribution, focusing on product cost reduction, and building technical innovations to serve clients with mission critical power applications globally.

We sell our products to a wide array of commercial and industrial customers and across a variety of vertical markets, including data centers, manufacturing, technology, broadcast and communications, financial, utilities, healthcare, government and airports. We have expanded our global sales channels and direct sales force, selling in all major geographic regions of the world, but particularly in North America, EMEA and Asia.

Results of Operations



                                                                                                     Variance
($ in thousands)                                Three months ended September 30,                   2009 vs. 2008
                                                      % of                         % of
                                                      total                        total
                                         2009        revenue         2008         revenue          $            %
Product revenue                        $  6,947           81 %     $  10,193           82 %     $ (3,246 )      (32 )%
Service and other revenue                 1,587           19 %         2,255           18 %         (668 )      (30 )%

Total revenue                             8,534          100 %        12,448          100 %       (3,914 )      (31 )%

Cost of product revenue                   5,751           67 %         9,515           76 %       (3,764 )      (40 )%
Cost of service and other revenue           901           11 %         1,810           15 %         (909 )      (50 )%

Total cost of revenue                     6,652           78 %        11,325           91 %       (4,673 )      (41 )%

Gross profit                              1,882           22 %         1,123            9 %         (759 )      (68 )%
Operating expenses:
Research and development                  1,095           13 %         1,197           10 %         (102 )       (9 )%
Selling and marketing                     2,572           30 %         2,795           22 %         (223 )       (8 )%
General and administrative                1,201           14 %         1,317           11 %         (116 )       (9 )%

Total operating expenses                  4,868           57 %         5,309           43 %         (441 )       (8 )%

Operating loss                           (2,986 )        (35 )%       (4,186 )        (34 )%      (1,200 )      (29 )%
Interest income (expense)                   (20 )          -              68            1 %          (88 )     (129 )%
Other income (expense)                       46            -               3            -             43      1,433 %

Net loss                               $ (2,960 )        (35 )%    $  (4,115 )        (33 )%    $ (1,155 )      (28 )%


                                                                                                     Variance
($ in thousands)                                Nine months ended September 30,                    2009 vs. 2008
                                                      % of                         % of
                                                      total                        total
                                         2009        revenue         2008         revenue          $            %
Product revenue                        $ 21,863           83 %     $  22,033           82 %     $   (170 )       (1 )%
Service and other revenue                 4,444           17 %         4,741           18 %         (297 )       (6 )%

Total revenue                            26,307          100 %        26,774          100 %         (467 )       (2 )%

Cost of product revenue                  16,874           64 %        19,937           74 %       (3,063 )      (15 )%
Cost of service and other revenue         2,814           11 %         3,989           15 %       (1,175 )      (29 )%

Total cost of revenue                    19,688           75 %        23,926           89 %       (4,238 )      (18 )%

Gross profit                              6,619           25 %         2,848           11 %        3,771        132 %
Operating expenses:
Research and development                  3,254           12 %         3,903           15 %         (649 )      (17 )%
Selling and marketing                     8,562           33 %         8,800           33 %         (238 )       (3 )%
General and administrative                3,517           13 %         3,685           14 %         (168 )       (5 )%

Total operating expenses                 15,333           58 %        16,388           61 %       (1,055 )       (6 )%

Operating loss                           (8,714 )        (33 )%      (13,540 )        (51 )%      (4,826 )      (36 )%
Interest income (expense)                   (48 )          -             322            1 %         (370 )     (115 )%
Other income (expense)                      (31 )          -             207            1 %         (238 )     (115 )%

Net loss                               $ (8,793 )        (33 )%    $ (13,011 )        (49 )%    $ (4,218 )      (32 )%

Product revenue. Product revenue consists of sales of our CleanSource power quality products, comprised of both UPS and DC product lines, and sales of Continuous Power Systems (CPS) which are comprised of our UPS systems and some combination of third-party ancillary equipment, such as engine generators and electrical and switchgear products. The CPS products may be sold in a containerized solution that we call PowerHouse, or as separate equipment. Product revenue also includes sales of our CoolAir DC and CoolAir UPS products.

The decrease in product revenue of $3.2 million compared to the third quarter of 2008 was primarily due to lower sales from our OEM channel, where sales decreased by $4.2 million, or 82%, compared to the third quarter of 2008. Some of this decrease is

attributable to the timing of larger orders from our OEM partner for its customers. We believe that the OEM channel has been negatively influenced by external economic conditions that have caused its customers to delay product purchase decisions due to uncertainty or lack of liquidity. Sales of our UPS products are also a much smaller part of our OEM partner's total business and subject to more volatility in quarterly sales, particularly during difficult economic periods as the OEM focuses on its core business.

Although we have experienced similar uncertainty on our direct sales efforts, during the third quarter we saw an improvement in sales and orders received, such that our direct sales actually increased by 6% or approximately $400,000 compared to the third quarter of 2008. The improvement is much more pronounced since our second quarter of 2009, and our direct sales during the third quarter of 2009 were 87%, or $3.5 million higher than the levels we had during the second quarter of 2009. We saw revenue from our European business increase significantly during this period also as we received a number of large orders from that region. Our sales through our OEM channel however were down by $1.6 million, or 63%, compared to the second quarter of 2009. Overall our revenues in the third quarter of 2009 increased by 29% from the second quarter of 2009.

Sales of our PowerHouse products represented approximately $1.9 million, or 22% of our total revenues, during the third quarter of 2009. UPS product sales represented approximately 43% of total revenue for the third quarter of 2009, compared to 59% of total revenue in the third quarter of 2008. The average selling price of our UPS product sales during the third quarter of 2009 was $78,000 per quarter-megawatt flywheel, compared to $77,000 in the comparable period in 2008. The increase in average selling price compared to 2008 was primarily a result of more sales through our direct sales channels where we typically have been able to generate higher average selling prices.

For the nine-month period ended September 30, 2009, our total revenues were $0.5 million, or 2%, lower than that recorded in the same period of 2008. Our OEM revenues for the nine-month period ended September 30, 2009 were $8.4 million, compared to $12.1 million for the same period in 2008, a decrease of $3.7 million, or 30%. This has been offset by increases in our direct sales channel, which has been positively impacted by the introduction of our PowerHouse containerized product in the U.S. market during 2009 and from the receipt of several larger orders in the European market.

During the three-month period ended September 30, 2009, we sold 56 flywheel units compared to 94 flywheel units in the comparable period of 2008 and 55 wheels sold during the second quarter of 2009. For the nine-month period ended September 30, 2009, we sold 230 wheels, which compares to 220 wheels sold in the comparable period of 2008. A single product, depending on its power rating, may be comprised of multiple flywheel units, so the number of wheels sold does not correlate to the number of orders received. As we have started selling more PowerHouse products and total systems to our customers, which includes our UPS system bundled together with switchgear and diesel generators, the number of flywheels sold becomes less reflective of trends in our total revenue, such that a large increase in system or PowerHouse revenues could result in large increases in revenue without a comparable increase in the number of flywheel units sold.

The frequency and timing of our larger system sales, including megawatt class UPS products, total system and PowerHouse product sales, made directly by us is more unpredictable than orders received directly from our OEM partners. Variability in the receipt of such large orders or in the number of such orders in any period 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 variability in our quarterly financial results and affect our ability to meet forecasted targets. For example, the absence of large system sales in the first and second quarters of 2009 contributed to the decrease in total revenues from their respective immediately preceding quarters.

North American sales were 40% of our total revenue for the three-month period ended September 30, 2009, compared to 44% for the three-month period ended September 30, 2008 and 77% in the second quarter of 2009. In absolute terms, our North American sales in the third quarter of 2009 were 37% lower than the third quarter of 2008, which was due to the lower level of OEM revenues that had decreased by $4.3 million over this period. For the nine months ended September 30, 2009, our North American sales were 65% of total revenue, which compared to 57% of total revenue in the comparable period of 2008. In total, our North American sales increased by 12% for the nine-month period ended September 30, 2009 compared to the comparable period of 2008, reflecting the overall growth in the acceptance of and market for our product in North America.

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 Active Power sales offices and distributors who buy and resell our products. In 2007, we also opened our first Asian sales office in Tokyo. In these markets, customers are more likely to purchase a total solution rather than a stand alone UPS system. This usually results in a longer selling cycle and makes quarterly results more volatile and dependent upon a smaller number of transactions. Thus the amount of revenue from our international markets can change significantly on a quarterly basis. Sales of Active Power branded products through our direct and manufacturer's representative channels were 88% of our total revenue for the three-month period ended September 30, 2009, compared to 57% for the third quarter of 2008, and direct sales were 68% of our total revenue for the nine-month period ended September 30, 2009 compared to 55% for the same nine-month period of 2008. As direct sales typically have higher profit margins than sales through our OEM channels, we will continue to focus on our direct sales channel to increase revenue and improve profit margins and to decrease our dependency upon our OEM channel. We believe sales of our Active Power branded products in markets 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. We believe that our direct sales volumes have not been impacted as much by external factors compared to our OEM channels. This is highlighted by the fact that our direct sales increased by 22% in total for the nine-month period ended September 30, 2009 compared to the comparable period of 2008. There was a 30% decrease for our OEM channel over the same periods.

Caterpillar remains our largest OEM partner and historically was our largest overall customer. Sales to Caterpillar represented 11% of our total revenue for the three-month period ended September 30, 2009, compared to 41% of our revenue for the three-month period ended September 30, 2008, and 31% of our revenue for the nine-month period ended September 30, 2009, compared to 44% of our revenue for the nine-month period ended September 30, 2008. Throughout 2009, we have continued to invest in our marketing and training efforts with Caterpillar, and have taken steps to increase revenues from Caterpillar in foreign markets and to reduce their dependency on the North American market only. We believe that these market development efforts will result in an increase in absolute terms of revenue from the OEM channel over the next year.

Our products perform well in harsh environments where power quality or reliability is particularly poor, which makes them a good fit for countries with a poor power infrastructure or in harsh manufacturing or process environments, or situations where reliability is paramount, such as mission-critical business applications. Therefore we have traditionally focused our direct sales efforts on these types of customer situations. 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.

Service and other revenue. Service and other revenue primarily relates to revenue generated from both traditional (after-market) service work and from customer-specific system engineering. This includes revenue from design, 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 and revenues or fees received upon contract deferment or cancellation.

Service and other revenue increased by 12% for the three-month period ended September 30, 2009, compared to the second quarter of 2009, but were $0.7 million, or 30% lower than the third quarter of 2008. This increase since the second quarter is primarily due to higher levels of service and contract work from direct product sales made in prior 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. The decrease compared to 2008 is due to lower project and contract work compared to that period, which is impacted by the timing of large system orders that we have received. Where we make sales through our OEM channel, it is typical for the OEM to provide these types of services to their end-user customers. We anticipate that service and other 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.

For the nine-month period ended September 30, 2009, our service and other revenues decreased by 6% when compared to the same period of 2008. Although our larger installed base of customers that purchased products directly from us has resulted in a higher level of customers with recurring maintenance contract agreements, our revenues from project installation and commissioning has decreased compared to 2008 due to a smaller number of large projects in 2009 compared to the prior year.

Cost of product revenue. Cost of product revenue includes the cost of component parts of our products, ancillary equipment that is sourced from external suppliers, personnel, equipment and other costs associated with our assembly and test operations, including costs from having underutilized facilities, depreciation of our manufacturing property and equipment, 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 decreased from 93% in the third quarter of 2008 to 83% in the three-month period ended September 30, 2009 due to the effects of lower product costs and from lower levels of manufacturing overhead, as well as the absence in 2009 of a $1.5 million excess inventory charge of a discontinued product line that we recorded in 2008. We have ongoing programs to reduce product and component costs where feasible, and this has resulted in a decrease in materials costs as a percentage of product revenue and helped us to mitigate the impact of fluctuating raw commodity pricing on our total product costs. We continue to operate a manufacturing facility that has a capacity significantly greater than our current product revenue levels. A large portion of the costs involved in operating this manufacturing facility are fixed in nature and we incur approximately $300,000 to $700,000 in unabsorbed overhead each quarter. We 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 volume of flywheels manufactured. 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 total revenues to a level that will allow us to improve the utilization of our manufacturing operations.

For the nine months ended September 30, 2009, the cost of product revenue decreased to 64% of total revenue, compared to 74% of total revenue for the same period of 2008. This improvement reflects the impact of increased flywheels sold, which causes improved efficiency in our manufacturing organization and lower unabsorbed overhead costs, as well as the impact of material and overhead cost reductions and the absence of excess inventory charges that we had in 2008.

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 other revenue. Cost of service and other revenue includes the cost of component parts that we use in service or sell as spare parts, as well as labor and overhead costs of our service organization, including travel and related costs incurred in fulfilling our service obligations to our customers. The cost of service and other revenue decreased to 57% of service and other revenue in the three-month period ended of September 30, 2009, compared to 80% in the same period of 2008, and decreased to 63% of service and other revenue in the nine-month period ended September 30, 2009, compared to 84% in the same period of 2008. This decrease reflects better utilization of our service personnel in 2009, improved pricing for service, and higher margins on contract work compared to the prior period and the benefits of higher service volume to help meet the fixed costs of our service infrastructure. A large portion of the costs involved in operating our service organization are fixed in nature and we incur approximately $300,000 to $500,000 in unabsorbed overhead each quarter. We continue to work on reducing our service overhead through better utilization of our service employees and cost control measures.

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 $102,000, or 9%, lower in the third quarter of 2009 compared to the third quarter of 2008, and were $37,000, or 3%, higher than the second quarter of 2009. For the nine-month period ended September 30, 2009, our research and development expenses were $649,000, or 17%, lower than the comparable period of 2008. These decreases from the same period in 2008 were due to headcount reductions compared to 2008 and lower project related development costs this year. The prior year expenses included higher prototype and development costs for paralleling our megawatt-class UPS products. We believe research and development expenses in the fourth quarter will remain at similar levels to those recorded in the third quarter.

Selling and marketing. Selling and marketing expense primarily consists of 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 and the cost of our foreign sales operations. Selling and marketing costs were $223,000, or 8%, lower in the third quarter of 2009 compared to the amount recorded in the third quarter of 2008, and were $88,000, or 3%, lower than the second quarter of 2009. The decrease from the same period in 2008 reflects decreased spending on marketing activities in 2009, including tradeshows, as well as decreased third party manufacturing representative commissions and lower variable sales compensation expense on lower revenue levels. The decrease in our sales and marketing costs from second quarter of 2009 is due to decreased variable sales compensation, as well as decreased spending on marketing activities. For the nine-month period ended September 30, 2009, our selling and marketing costs were . . .