Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Note Regarding Forward Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements concerning, among other things, our expected future revenues, operations and expenditures, and estimates of the potential markets for our products and services. Such statements made may fall within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. All such forward-looking statements are necessarily only estimates of future results and the actual results we achieve may differ materially from these projections due to a number of factors as discussed in the section entitled "Risk Factors" of this Form 10-Q. New risks can arise and it is not possible for management to predict all such risks, nor can management assess the impact of all such risks on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statement. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. All forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update publicly any forward-looking statement in order to reflect any event or circumstance that may arise after the date of this Quarterly Report on Form 10-Q, other than as required by law.

Critical Accounting Policies and Estimates

The preparation of financial statements requires management to make estimates and judgments that may significantly affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an ongoing basis, management evaluates our estimates and assumptions including, but not limited to, those related to revenue recognition, asset impairments, inventory valuation, warranty reserves and other assets and liabilities. Management bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Loss on Research and Development Contract Commitments

We establish reserves for anticipated losses on contract commitments if, based on our cost estimates to complete the commitment, we determine that the cost to complete the contract will exceed the total expected contract revenue. Most of our contracts have been granted on a cost-share basis, for which the expected cost-share is recorded as a contract loss. The U.S. Naval Sea Systems Command (NAVSEA) contract, however, has been granted on a cost-plus-fixed-fee basis. Each quarter, we perform an evaluation of expected costs to complete our in-progress contracts and adjust the contract loss reserve accordingly.

During the quarter ended March 31, 2009, we increased the loss reserve for the Tehachapi contract by approximately $133,000 to reflect the difference between the overhead rate used when we bid on the contract, and our current "full-capacity" rate. Our current manufacturing capacity is 600 flywheels per year, and current overhead rates are based on our forecasted costs at this capacity. Because we are not yet operating at this capacity, use of this rate results in a significant portion of our costs being expensed as period costs. However, we bid on the Tehachapi contract mid-2007, prior to our move to the Tyngsboro facility. At the time, we had anticipated expanding our manufacturing capacity to 1,000 units per year, and had calculated the overhead rate used in our bid based on that capacity. Our engineering and manufacturing overhead rates are based upon direct labor hours, and thus are sensitive to changes in capacity or headcount. Cost estimates for our contracts are also subject to change based upon the number of hours required to complete the project as well as the cost of direct materials, contract-related travel and outside services such as consultants.

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Our contracts historically have been completed over multiple fiscal periods, and a reserve for contract losses is recorded at the point when we estimate that such a loss may occur. Although the allocation of overhead to a fixed-price contract does not impact the Company's total costs or loss from operations, it may result in such costs being recognized in an earlier period than when the costs are actually incurred. Moreover, since our current production levels are significantly lower than those used in our "full-capacity" overhead rate, our forecasted costs are based upon subjective estimates and management judgment, and actual results may differ significantly. However, the two fixed price contracts that we are currently working on are relatively small, and the impact of our estimates and assumptions relative to these contracts are not expected to have a material impact on our financial condition or operating performance.

Fixed Assets

Property and equipment in service is stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Property and equipment are defined as tangible items with unit costs exceeding our capitalization threshold that are used in the operation of the business, are not intended for resale and which have a useful life of one year or more. The cost of fixed assets is defined as the purchase price of the item, as well as all of the costs necessary to bring it to the condition and location necessary for its intended use. These costs include material, labor, overhead, capitalized interest and, if applicable, exit costs. Exit costs for which we are obligated are accounted for in accordance with SFAS No. 143, "Accounting for Asset Retirement Obligations." No overhead is generally applied for internally-constructed projects not directly related to our core business (e.g., leasehold improvements.) Repair and maintenance costs are expensed as incurred. Materials used in our development efforts are considered research and development materials, and are expensed as incurred in accordance with SFAS No. 2 "Accounting for Research and Development Costs."

Capital assets are classified as "Construction in Progress" when initially acquired, and reclassified to the appropriate asset account when placed into service, with the exception of land, which is capitalized upon purchase. Depreciation expense is not recorded on assets not yet placed into service.

Materials purchased to build flywheels, power electronics and other components used in our frequency regulation installations are classified as CIP, along with the related labor and overhead costs. Some components of the Smart Energy Matrix™, such as the flywheels and power electronics, are considered "fungible" in that they can be moved and redeployed at a different location. Non-fungible costs are costs which would not be recovered if we redeployed the matrix or portions thereof. In some cases, we may elect to deploy a Smart Energy Matrix™ system at a location for the purpose of demonstrating our technology or gaining experience operating in that particular market. In these instances, the costs of the fungible components are capitalized, and the remaining costs, which may include such costs as site preparation, interconnection costs, capitalized interest and estimated exit costs are expensed.

Impairment of Long-Lived Assets

In accordance with SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets" long-lived assets we hold and use are reviewed to determine whether any events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. The conditions to be considered include whether or not the asset is in service, has become obsolete, is damaged, or whether external market circumstances indicate that the carrying amount may not be recoverable. When appropriate we recognize a loss for the difference between the estimated fair value of the asset and the carrying amount. The fair value of the asset is measured using either available market prices or estimated discounted cash flows.

In certain instances, we may determine that it is in the best interest of the Company to re-deploy all or part of a Smart Energy Matrix™ system installed at a given location. When such a determination has been made, we will determine which costs are associated with the movable (fungible) components, and which costs are non-fungible. We will record a period expense for the net book value not associated with the fungible components.

As of March 31, 2009, in order to determine whether or not the current inventory of flywheels and related equipment on hand is impaired, we reviewed the current status of the 20 MW system, and noted the following:

† The first 20MW installation, expected to be in Stephentown, NY, is expected to cost more than $60 million, which includes substantial administrative costs related to the Department of Energy due diligence and review process.

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† The second 20MW installation is expected to cost approximately 25% less than the first 20MW plant. Cost reductions for the second plant are expected to occur due to potential volume supplier agreements and our own construction experience.

† The location for the first 20MW installation will be in NYISO. This is the most attractive market for regulation services in that they offer the highest historical frequency regulation clearing prices and will provide us with an optimum signal that is ideal for our resource. We are currently planning to deploy our flywheels in New York.

† We performed cash flow testing based upon a variety of scenarios, using historical 12-month average day-ahead and real-time clearing prices for regulation in the NYISO. Our analysis included the potential impact of various "worst case" scenarios based upon potential negative factors, individually and in combination, such a reduction in the frequency regulation clearing price of up to 20%, increases in energy costs of up to 20%, higher construction costs of up to 30% or certain changes in energy signals.

† Our forecast and models indicate that we can expect positive cash flows from a 20 MW frequency regulation installation in New York, and that consequently, as of March 31, 2009 no impairment reserve is required for our current supply of flywheels and related fungible Smart Energy Matrix™ materials.

Overview

We design, develop, configure and are taking steps to commercialize advanced products and services to support more reliable and cost-effective electricity grid operation. The focus of our research and development has been to establish commercially viable flywheel-based energy storage technologies that can provide highly reliable energy solutions for the worldwide electricity grid at competitive costs. Initially, we expect to generate revenues from the commercialization of our flywheel energy storage systems to supply frequency regulation services to the electricity grid in North America. We believe that, as we expand our production capabilities, we can become a provider of frequency regulation services to grid operators on a global basis. In addition we believe that as the commercialization of our technologies continues, we will develop other cost-effective applications for our flywheel systems that will provide additional revenue opportunities.

Our market focus is on the geographic regions of the domestic grid that provide open bid markets for regulation services. These regions and their Independent System Operator (ISO) or Regional Transmission Organization (RTO) designations are: New England (ISO New England or ISO-NE); California (California ISO or CAISO); New York (New York ISO or NYISO); Mid-Atlantic (PJM Interconnect); Midwest ISO (MISO) and Texas (ERCOT). Because ERCOT is not regulated by FERC, we are not able to encourage beneficial market rule changes in ERCOT by leveraging Federal Energy Regulatory Committee (FERC) Order 890, which was intended to promote greater competition in electricity markets, in part by allowing non-generative resources such as ours the ability to bid and sell into frequency regulation markets. As a result, we are focusing on the other open bid markets first and will begin to work on entry into ERCOT once we are operating in the other markets.

These regional ISOs/RTOs or grid operators purchase frequency regulation services from independent providers in open bid markets that they manage and maintain. We are seeking to become one such provider. We believe our technology will offer grid operators the benefits of greater reliability; faster response time; cleaner operation, including zero direct emissions of carbon dioxide (CO2), nitrogen oxide, sulfur dioxide and mercury; and lower maintenance costs compared to conventional power generation facilities that also provide frequency regulation services. We believe that we will have lower operating costs and faster response time than the majority of other entities that provide frequency regulation services, which we believe will allow us to have sufficient margins to make the company economically viable.

Under the open-bid market like that operated by NYISO, grid operators forecast the need for frequency regulation as a percentage of expected power demand, and approved suppliers submit bids for these services. Bids are stacked from lowest to highest prices until the cumulative amount of bids is sufficient to meet the calculated need. The price submitted by the highest selected bidder determines the price paid to every bidder that has been scheduled to provide service, although each ISO may calculate payments based on formulas that yield different revenue results even with equivalent frequency regulation clearing prices.

Our Smart Energy Matrix™ recycles excess energy when generated power exceeds load and delivers it when load increases. We believe that our low operating costs coupled with a useful life of 20 years will allow us to participate in these open markets with a very favorable profit margin. Also, our systems respond up to 100 times faster than fossil fuel generators providing

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frequency regulation. Certain ISOs have or are considering tariff changes that would provide payment mechanisms to compensate resources, such as ours, for faster regulation response. If such performance-based tariffs are approved, we believe that there is potential for us to receive greater revenues for providing regulation services.

To participate in this regulatory-driven open-bid market, we expect to build, own and operate a number of frequency regulation installations known as Smart Energy Matrix™ systems designed to provide reliable and sustainable frequency regulation services for utility grids. Our primary business model is a sale-of-services model, similar to that of independent power producers who also build, own and operate their own power plants. Under this model, we will be bidding our services into multiple open-bid markets for regulation on a daily basis. Additionally, we may:

† Participate in pilot programs to demonstrate our technology, such as the ISO-NE Alternative Energy Storage Pilot Program, under rules that may provide alternative bidding and payment plans than those provided by the permanent market rules

† Sell Smart Energy Matrix™ systems on an equipment-sale basis in both the US and overseas markets

† Become fractional owners of some plants as a means of accelerating cash flow during the early years of our commercial deployment

† Enter into bi-lateral contracts with utilities that currently self-provide or purchase regulation services to satisfy their obligations to pay for or self-provide regulation services in their respective ISOs.

Our Smart Energy 25 flywheels consist of the flywheels and the associated power electronics. A Smart Energy Matrix™ is an array of ten Smart Energy 25 flywheels that can provide 1 MW of energy storage. A frequency regulation installation includes one or more Smart Energy Matrices™, along with ancillary equipment and site work. A typical full-scale installation would have a capacity of 20 MW. The components of a frequency regulation installation are divided into three categories:

† Non-fungible location-based costs which would not be economically viable for redeployment

† Fungible location-based costs which would be economically viable for redeployment

† Fungible flywheel and power electronics costs which would be economically viable for redeployment.

On November 18, 2008, we connected our first 1 MW Smart Energy Matrix™ to the electric grid in Tyngsboro, Massachusetts. The 1 MW system was installed under the ISO New England Alternative Technologies Pilot Program, which allows us to generate revenue for regulation services while we, and ISO-NE, explore ways to optimize the beneficial impact of the technology and while ISO-NE develops permanent market rules that will govern the application of the technology. The pilot program and its revenue component will continue until such rules are in place. This process is expected to take approximately 18 months from the November 2008 start. The pilot program was approved by FERC as part of ISO New England's compliance with FERC Order No. 890, which is intended to promote greater competition in electricity markets, strengthen the reliability of the grid, and allow so-called "non-generation" resources (which include our flywheel technology), to participate in frequency regulation markets on a non-discriminatory basis.

As part of the process of modifying its market rules, ISO New England is working with us to optimize performance by adjusting the control signal sent from the ISO to our Smart Energy Matrix™ to help maximize regulation effectiveness for the grid while providing fair and equitable regulation service payments to us and other energy storage-based providers of frequency regulation service. In contrast to, say, NYISO's single part payment model for regulation, ISO New England has a three-part payment model:

1. Payment for the resource's MWs of capacity that are scheduled to perform regulation called "Time-On-Regulation".

2. Payment based on the amount a resource is signaled to change its output called "Regulation Service" or "Mileage". Faster response resources receive higher mileage payments.

3. Opportunity cost payments to compensate generators for lost revenue as a consequence of providing frequency regulation rather than conventional power generation.

Revenues we are currently receiving from this pilot program are less than those that we expect to receive under permanent market rules for two reasons. First, under pilot program market rules, we are not eligible for opportunity cost payments, which represent approximately one-third of the revenue received by conventional regulating generators. We are encouraging ISO-NE to develop permanent market rules that will provide an additional payment component for alternative technologies that would be approximately equal to opportunity cost. The trend at other ISOs has been to incorporate features in their tariffs that intrinsically compensate all resources, including energy storage providers, for opportunity cost. Second, the current signal we are receiving from ISO-NE does not take full advantage of our speed of response and therefore our mileage payments are not as high as we expect them

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to be in the future. As discussed above, we are working with ISO-NE to convince them to adopt a regulation signal that will better utilize our technology's fast response capability in order to maximize benefits to the grid and payments for our regulation.

Electricity costs for operating the 1 MW pilot Smart Energy Matrix™ in Tyngsboro through the end of March 2009 are higher than what we expect our electricity costs to be in the future. Because the 1 MW pilot project is connected to a distribution level power line, from November 2008 through late April, 2009, we paid the retail price for all the electricity that we withdrew from the grid instead of paying the wholesale price of electricity for the net electricity we withdrew from the grid (withdrawals minus injections). Since our 1 MW pilot resource is connected at distribution level, the price of electricity was determined by the retail tariff of the local distribution company versus the ISO wholesale tariff. The retail cost of electricity included charges for both the delivery of the electricity and the electricity commodity itself, and was about twice the cost of wholesale. Furthermore, the retail tariff does not have a provision for netting the electricity withdrawn and injected back to the grid. As of late April 2009, ISO-NE and our local distribution company implemented a change which will reduce our cost of electricity by netting the electricity withdrawn and injected to the grid, and billing us for that net usage at the wholesale rate. We are working to reduce the electricity delivery charges as well. In the future, our 20 MW facilities will be connected to transmission level power lines and therefore our cost for electricity will be the wholesale commodity price for electricity for our net withdrawals, and we will not incur delivery charges.

The location of our regulation installations and the sequence in which they will be constructed depend on a number of factors, including but not limited to:

† Comparative market pricing available for frequency regulation in different markets

† Our ability to receive appropriate revenues and payments within the Market Rules of each regional market

† Availability of the transmission lines to connect directly to an ISO

† Availability and cost of land

† Receipt of all necessary environmental and related permits

† Grid interconnection approvals.

On July 17, 2008, we received a land-use permit we had requested from the town of Stephentown, New York. During the third quarter of 2008, we purchased approximately seven acres of land at a site in the town where we plan to build our first 20 MW installation. The site is served by two transmission companies:
National Grid and NYSEG. National Grid owns a 115 KVA transmission line that abuts the site, and NYSEG owns a substation that also abuts the site.

Our interconnection request for the 20 MW plant includes National Grid as the transmission provider. Before we can enter into an interconnection agreement with NYISO, a System Impact Study, which is currently underway, must be completed. The purpose of the study is to ensure that our installation can safely interface with the grid, and to identify any utility upgrades or other equipment that may be needed before construction can begin.

We may elect to install 1 MW installations in ISOs to provide early insight to operating within each market. The economics of these 1 MW systems may not be representative of expected revenues and costs for a 20 MW plant, and therefore the non-fungible costs may be expensed. For example, in the New York market, we are planning to deploy a 1 MW resource on the Stephentown site, but interconnected to NYSEG. On October 10, 2008, we entered into a 1 MW interconnection agreement with NYSEG that would connect directly to its substation. Pending application for and receipt of a building permit from the town of Stephentown for a 1 MW installation, we have the right to build and operate a 1 MW resource connected to the NYSEG substation. We believe that the value of gaining early insight into the best way to operate and bid our planned 20 MW resource into the NYISO market more than compensates for the costs associated with deploying a 1 MW resource. In addition, the 1 MW resource can later be electrically connected to National Grid's 115 KVA transmission line should we choose to do so. Similarly, in Ohio we expect to deploy 1 MW at the AEP facility as described below. The non-fungible costs associated with deploying small installations which are not intended to remain in service for terms exceeding two years will be expensed.

On February 23, 2009, we announced that we had signed a contract with American Electric Power, one of the largest generators of electricity in the U.S., and one of its operating subsidiaries, Columbus Southern Power Company. The contract will entail building a 1 MW Smart Energy Matrix™ regulation facility at an AEP site in Groveport, Ohio. The system, which will be connected to the grid within the operating region of the PJM Interconnection (PJM), will provide flywheel-based frequency regulation services. Installation of this Smart Energy Matrix™ is scheduled to begin in 2009. The 1 MW system will provide valuable insight into the operation of our technology on PJM's grid and make us better prepared to deploy and profitably operate full scale 20 MW plants in PJM's area of coverage. We also expect that the facility will provide us with additional market credibility.

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We have applied to the US Department of Energy (DOE) for a loan guarantee that would enable to us to fund a majority of the planned 20 MW installation in Stephentown. The satisfactory completion of NYISO's System Impact Study and clear resolution of market rule issues that affect our ability to enter and operate in the NYISO market (described elsewhere) could affect the timing or success of our DOE loan guarantee application, among other factors. In addition, there is no guarantee that the DOE loan guarantee will be offered to us on terms that we consider acceptable.

By the end of 2009, we plan to have deployed up to 7 MW of frequency regulation among three locations: Stephentown New York, Groveport Pennsylvania and Tyngsboro Massachusetts. Our deployment schedule requires that we have sufficient funding to build these facilities. We are also identifying and developing additional sites in our target markets.

In volume production, our goal is to complete 20 MW facilities at a cost of approximately $25 to $30 million each, though the first 20 MW plant will cost more than $60 million which includes substantial administrative costs related to the Department of Energy due diligence and review process. In 2010 and 2011, we will continue to have capital needs that will require additional funding through equity and debt to fund the ongoing deployment of frequency regulation installations. In addition to obtaining sufficient funding, our deployment plans are affected by other factors and activities, including but not limited to the following:

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† Component development and quality:

† Completing the engineering and testing of certain components to improve highly durable operation at commercial operating speeds.

† Developing multiple sources for our key components. We are working to expand our supplier base to qualify their components to our designs and specifications.

† Continue working closely with our suppliers to refine their manufacturing processes and ensure quality results.

† Market rules and participation:

† We must become a member of each ISO in order to participate in its market. We have been a member of the PJM Interconnection since 2004. We are also members of ISO New England, New York ISO and Midwest ISO.

† The need to change some ISO market rules to be compatible with our technology is requiring more time to complete than we had previously anticipated, although in 2008 we made good progress. See "Regulatory and Market Affairs" for details on market rule changes within each of our target markets.

Regulatory and Market Affairs

Within each ISO there is a market tariff and set of market rules that determine who is allowed to bid into regulation markets, how much regulation providers are paid for their services, and what costs providers must pay to participate in . . .