Our discussion and analysis of the financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the related disclosures included elsewhere herein and in Management's Discussion and Analysis of Financial Condition and Results of Operations included as part of our Annual Report on Form 10-K for the year ended December 31, 2007.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this Quarterly Report on Form 10-Q constitute forward-looking statements within the meaning of the securities laws. Forward-looking statements include all statements that do not relate solely to the historical or current facts, and can be identified by the use of forward looking words such as "may", "believe", "will", "expect", "expected", "project", "anticipate", "anticipated", "estimates", "plans", "strategy", "target", "prospects" or "continue". These forward looking statements are based on the current plans and expectations of our management and are subject to a number of uncertainties and risks that could significantly affect our current plans and expectations, as well as future results of operations and financial condition and may cause our actual results, performances or achievements to be materially different from any future results, performances or achievements expressed or implied by such forward-looking statements. Important factors that could cause our actual results to differ materially from our expectations are described in Item 1A. (Risk Factors) of our Annual Report on Form 10-K for the year ended December 31, 2007. In making these forward-looking statements, we claim the protection of the safe-harbor for forward-looking statements contained in the Private Securities Reform Act of 1995. Although we believe that the expectations reflected in such forward-looking statements are reasonable, there can be no assurance that such expectations will prove to have been correct. We do not assume any obligation to update these forward-looking statements to reflect actual results, changes in assumptions, or changes in other factors affecting such forward-looking statements.

OVERVIEW

Applied Energetics is a developer and manufacturer of applied energy systems, primarily for military applications, utilizing our proprietary knowledge of high performance lasers, high-voltage electronics, advanced adaptive optics and atmospheric and plasma energy interactions. We apply these technologies to deliver innovative solutions to urgent military missions, including neutralizing improvised explosive devices ("IEDs"), neutralizing vehicle-borne IEDs (i.e. car bombs), and non-lethal methods for vehicle stopping, among other high priority missions of U.S. and allied military forces. Additionally, we develop and manufacture high-voltage and laser products for government and commercial customers for a range of applications

In April 2008, we received a $4.5 million sole source contract from the Advanced Munitions Technology Development office at the U.S. Army's Research, Development and Engineering Command (ARDEC - Picatinny NJ) for the development and advancement of the company's Laser Guided Energy technology. This funding is directly from ARDEC's discretionary funds.

In June 2008, we received a $9.3 million cost-plus fixed fee contract for a system for the U.S. Marine Corps. Due to the sensitivity of the effort, the customer has asked that program details not be publicly disclosed. The twelve-month contract is administered by the U.S. Army (Aberdeen Proving Ground, MD).

RESULTS OF OPERATIONS

COMPARISON OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007:

                                               2008           2007
              Revenue                      $  4,014,302   $  3,608,584
              Cost of revenue                 3,789,962      5,641,565
              General and administrative      1,647,366      2,851,179
              Selling and marketing              61,565         76,340
              Research and development          359,807        548,895
              Other (expense) income:
              Interest expense                     (388 )         (453 )
              Interest income                   123,558        341,872

              Net loss                     $ (1,721,228 ) $ (5,167,976 )

REVENUE

Revenue increased approximately $406,000 for the three months ended September 30, 2008 compared to the three months ended September 30, 2007, which is attributable to an increase in revenue from Counter-IED projects of approximately $1.7 million from the U.S. Marine Corps contract received in June 2008, offset by a reduction in revenue on our LGE projects and High Voltage projects of $1.2 million and $49,000, respectively.

COST OF REVENUE

Cost of revenue decreased approximately $1.9 million compared to the three months ended September 30, 2007 primarily due to a lower of cost or market provision of $1.5 million and the decrease of approximately $803,000 related to a provision for loss on our high voltage product line, each in the three months ended September 30, 2007, offset by a $449,000 increase of costs related to increased revenue for the same period in 2008. Cost of revenue includes manufacturing labor, fringe and overhead, and an allocation of allowable general and administration and research and development costs in accordance with the terms of our government contracts.

GENERAL AND ADMINISTRATIVE

General and administrative ("G&A") expenses decreased approximately $1.2 million for the three months ended September 30, 2008 compared to the three months ended September 30, 2007 largely due to allocable and allowable costs contained in cost of revenue. The decrease primarily consists of a $555,000 increase in applied labor, overhead and material handling costs allocated to cost of revenue, decreases of $362,000 of non-cash share-based expense, $205,000 in professional fees and $159,000 in building related expenses largely related to the purchase of our principal Tucson facility in February 2008 and the exit from our leased facility at the Stennis Space Center, Mississippi in September 2007. These decreases were partially offset by increases of $192,000 of salaries and benefits and $132,000 of travel related expenses for the quarter.

SELLING AND MARKETING

Selling and marketing expenses decreased approximately $15,000 for the quarter ended September 30, 2008 from the same period in 2007, reflecting reduced payroll costs, travel expenses and professional fees.

RESEARCH AND DEVELOPMENT

Internal research and development ("R&D") expenses decreased approximately $189,000 during the three months ended September 30, 2008 as compared to the same period in 2007. The decrease is primarily due to the redirection of our principal technical staff to customer funded projects.

INTEREST INCOME AND INTEREST EXPENSE

Net interest income for the third quarter of 2008 was lower by approximately $218,000 from the same period of 2007 primarily due to the lower balance of invested funds and lower interest rates on our investments in 2008.

NET LOSS

As a result of the foregoing, our operations for the three months ended September 30, 2008 resulted in a net loss of approximately $1.7 million, a reduction of approximately $3.4 million compared to the $5.2 million loss for the same period of 2007.

COMPARISON OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007:

                                               2008           2007
              Revenue                      $ 11,653,390   $  8,828,367
              Cost of revenue                10,719,524     10,989,077
              General and administrative      6,170,107      7,514,464
              Selling and marketing             173,003        331,155
              Research and development          965,017        856,722
              Other (expense) income:
              Interest expense                   (1,940 )       (1,941 )
              Interest income                   539,166      1,079,841
              Other                                  10          7,847

              Net loss                     $ (5,837,025 ) $ (9,777,304 )

REVENUE

Revenue increased approximately $2.8 million to $11.7 million for the nine months ended September 30, 2008 compared to 2007, which is primarily attributable to increased revenues from our new U.S. Marine Corps contract received in June 2008 of approximately $5.1 million and our commercial projects of $212,000, offset by a reduction in LGE revenue of approximately $2.5 million.

COST OF REVENUE

Cost of revenue decreased approximately $270,000 to $10.7 million compared to the nine months ended September 30, 2007. The decrease is related to a provision for loss on our High Voltage product line of $1.2 million and to a lower of cost or market reserve of $1.4 million for the nine months ended September 30, 2007, offset by an increase of costs related to increased revenue of $2.3 million for the same period in 2008. Cost of revenue includes manufacturing labor, fringe and overhead, and an allocation of allowable general and administration and research and development costs in accordance with the terms of our government contracts.

GENERAL AND ADMINISTRATIVE

G&A expenses decreased approximately $1.3 million in the first three quarters of 2008 compared to 2007. The decrease primarily consists of a $1.2 million increase in applied labor, overhead and material handling costs allocated to cost of revenue and decreases of $486,000 of professional fees and $432,000 in building related expenses largely due to the purchase of our principal Tucson facility in February 2008 and the exit from our leased facilities at the Stennis Space Center, Mississippi in September 2007. The decrease was partially offset by increases of $210,000 in non-cash share-based expenses, $392,000 of salaries and accrued compensation, $265,000 of related benefits and $178,000 of travel expenses for the same period.

SELLING AND MARKETING

Selling and marketing expenses decreased approximately $158,000 for the three quarters ended September 30, 2008 from the same period in 2007, reflecting reduced payroll costs and professional fees.

RESEARCH AND DEVELOPMENT

Internal R&D expenses increased approximately $108,000 during the nine months ended September 30, 2008 as compared to the same period in 2007 primarily due to the $315,000 increase in R&D materials offset by $207,000 decrease in payroll costs and professional fees charged to R&D projects.

INTEREST INCOME AND INTEREST EXPENSE

Net interest income for the first three quarters of 2008 was lower by approximately $549,000 from the same period of 2007 primarily due to the lower balance of invested funds and lower interest rates on our investments in 2008.

NET LOSS

As a result of the foregoing, our operations for the nine months ended September 30, 2008 resulted in a net loss of approximately $5.8 million, a reduction of approximately $3.9 million compared to the $9.8 million loss for the same period of 2007. This decrease in loss incorporates an increase in revenues of $2.8 million a decrease in costs of revenue of $270,000, decreases in G&A of $1.3 million and sales and marketing of $158,000, offset by a decrease in net interest income of $549,000, and an increase in R&D of $108,000.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2008, we had approximately $8.5 million of cash and cash equivalents and $7.0 million securities available-for-sale (net of a temporary impairment of $370,000). Our cash position decreased during the first nine months of 2008 by approximately $6.5 million. During the first nine months of 2008, we used $3.7 million of cash in operating activities. This amount is comprised primarily of our net loss of $5.8 million, an increase in accounts receivable of $807,000, an increase in inventory of $711,000 associated with our counter-IED efforts, an increase in long term receivables of $253,000 and a decrease in accounts payable of $212,000. Offsetting these amounts are non-cash share-based compensation expense of $3.0 million, depreciation and amortization of $650,000 and a decrease in prepaid expenses and deposits of $294,000. As part of our total cash use during the first nine months of 2008, investment activities used approximately $2.6 million, primarily from the acquisition of our principal Tucson manufacturing and engineering facility and financing activities used approximately $287,000, primarily from the $275,000 preferred stock cash dividend paid in August 2008.

Certain of our marketable securities are facing a temporary illiquidity as the underlying auction markets have failed. It is not known when the underlying auction markets will regain liquidity, if at all. On July 8, 2008, we sold $100,000 of these securities at par. Our Auction Rate Securities are held in our brokerage account at RBC Dain Rauscher ("RBC"). On October 8, 2008, we received notice that RBC had entered into a settlement agreement with the United States Securities and Exchange Commission, the New York Attorney General's office, and the North American Securities Administrators Association whereby RBC would offer to purchase, at par, the Auction Rate Securities held by certain of its clients. On October 31, 2008 we received written notice from RBC that we were an eligible client. According to the October 8th announcement it is expected that the RBC purchase offer will begin December 15, 2008 and continue for a period of six months. The company expects to participate in this settlement.

We anticipate that short-term and long-term funding needs will be provided by the cash flows from current and future contracts and existing cash and marketable securities. We determined that we have sufficient working capital to fulfill existing contracts and expected contracts in 2008 and into 2009.

BACKLOG OF ORDERS

At September 30, 2008, we had a backlog (workload remaining on signed contracts) of approximately $9.4 million to be completed within the next twelve months. The backlog does not include proposals and contracts under negotiation at September 30, 2008.