The following discussion should be read in conjunction with the condensed consolidated financial statements and notes included in this Form 10-Q and in our Annual Report on Form 10-K for the year ended March 31, 2009. When used in this Form 10-Q, and in the following discussion, the words "believes", "anticipates", "intends", "expects" and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. These risks include those identified under Risk Factors in Item 1A of Part II of this Form 10-Q, under Risk Factors in our Annual Report on Form 10-K for Fiscal 2009 and in other reports we file with the SEC. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date hereof. All dollar amounts are approximate.

Overview

We develop, manufacture, market and service microturbine technology solutions for use in stationary distributed power generation applications, including cogeneration (combined heat and power ("CHP"), integrated combined heat and power ("ICHP") and combined cooling, heat and power ("CCHP")), resource recovery and secure power. In addition, our microturbines can be used as battery charging generators for hybrid electric vehicle applications. Microturbines allow customers to produce power on-site in parallel with the electric grid or stand alone when no utility grid is available. There are several technologies which are used to provide "on-site power generation" (also called "distributed generation"), such as reciprocating engines, solar power, wind powered systems and fuel cells. For customers who do not have access to the electric utility grid, microturbines can provide clean, on-site power with lower scheduled maintenance intervals and greater fuel flexibility than competing technologies. For customers with access to the electric grid, microturbines can provide an additional source of continuous duty power, thereby providing additional reliability and potential cost savings. With our stand-alone feature, customers can produce their own energy in the event of a power outage and can use the microturbines as their primary source of power for extended periods. Because our microturbines also produce clean, usable heat energy, they can provide economic advantages to customers who can benefit from the use of hot water, chilled water, air conditioning and heating. Our microturbines are sold primarily through our distributors and our Authorized Service Companies ("ASCs") install the microturbines. Service is provided directly by us through our Factory Protection Plan ("FPP") or by our distributors and ASCs. Successful implementation of the microturbine relies on the quality of the microturbine, marketability for appropriate applications, and the quality of the installation and support.

We believe we were the first company to offer a commercially available power source using microturbine technology. We offer microturbines from 30 kilowatts up to 1 megawatt in electric power output, designed for commercial, industrial, and utility users. Our 30-kilowatt ("C30") microturbine can produce enough electricity to power a small convenience store. The 60 and 65 kilowatt ("C60 Series") microturbine can produce enough heat to provide hot water to a 100-room hotel while also providing about one-third of its electrical requirements. Our 200-kilowatt ("C200") microturbine is well suited for larger hotels, office buildings, and wastewater treatment plants, among others. By packaging the C200 microturbine power modules into an International Organization for Standardization ("ISO") sized container, Capstone has created a family of microturbine offerings from 600-kilowatts up to one megawatt in a compact footprint. Our 1000-kilowatt ("C1000 Series") microturbines are well suited for utility substations, larger commercial and industrial facilities and remote oil and gas applications. Our microturbines combine patented air-bearing technology, advanced combustion technology and sophisticated power electronics to form efficient and ultra low emission electricity and cooling and heat production systems. Because of our air-bearing technology, our microturbines do not require liquid lubricants. This means they do not require routine maintenance to change and dispose of oil or other liquid lubricants, as do the most common competing products. Capstone microturbines can be fueled by various sources including natural gas, propane, sour gas, renewable fuels such as landfill or digester gas, kerosene, diesel and biodiesel. The C60 Series and C200 microturbines are available with integrated heat exchangers, making them easy to engineer and install in applications where hot water is used. Our C60 Series was certified by the California Air Resources Board ("CARB") to meet its stringent 2007 emissions requirements-the same emissions standard used to certify fuel cells and the same emissions levels as a state-of-the-art central power plant. Our C65 Landfill and Digester Gas systems were certified in January 2008 by CARB to meet 2008 waste gas emissions requirements for landfill and digester gas applications. In March 2009, our 30-kilowatt microturbines successfully demonstrated ultra-low emissions by complying with the Environmental Protection Agency and CARB 2010 emissions requirements which reduced previous requirements for NOx by 86%, carbon monoxide (CO) by 98%, and volatile organic compounds (VOCs) by 98%.

An overview of our direction, targets and key initiatives follows:

1) Focus on Vertical Markets- Within the distributed generation markets that we serve, we focus on vertical markets that we identify as having the greatest near-term potential. In our primary products and applications, we identify specific targeted vertical market segments. Within each of these markets, we identify what we believe to be the critical factors to penetrating these markets and base our plans on those factors.

During the first quarter of Fiscal 2010, we booked total orders of $7.8 million for 86 units, or 7.2 megawatts, compared to $20.0 million for 230 units, or 21.8 megawatts, during the first quarter of Fiscal 2009. We shipped 80 units with an aggregate of 11.8 megawatts, generating revenue of $10.2 million compared to 89 units with an aggregate of 5.0 megawatts, generating revenue of $5.0 million during the first quarter of Fiscal 2009. Total backlog as of June 30, 2009 increased $16.4 million, or 38%, to $59.1 million from $42.7 million as of June 30, 2008. As of June 30, 2009, we had 611 units, or 67.4 megawatts, in total backlog compared to 567 units, or 46.2 megawatts, as of June 30, 2008. As of June 30, 2009, 487 units, or 63.7 megawatts, valued at $54.8 million, were current and expected to be shipped within the next twelve months compared to 523 units, or 44.9 megawatts, valued at $41.4 million as of June 30, 2008. The timing of shipments is subject to change based on several variables (including customer payments and customer delivery schedules), many of which are not in our control and can affect our quarterly revenue and backlog. Our actual product shipments during the first quarter of Fiscal 2010 were: 76% for use in CHP applications, 14% for use in resource recovery applications and 10% for use in other applications (including secure power).

The following table summarizes our backlog:

                                     As of June 30,
                                2009                2008
                          Megawatts   Units   Megawatts   Units
Current
C30                             6.3     208         7.1     238
C60 Series                     11.8     182        13.4     206
C200                           12.2      61        13.4      67
C600                            1.2       2         1.2       2
C800                            7.2       9         0.8       1
C1000                          25.0      25         9.0       9
Total Current Backlog          63.7     487        44.9     523

Long-term
C30                             3.7     124         1.3      44
Total Long-term Backlog         3.7     124         1.3      44

Total Backlog                  67.4     611        46.2     567

2) Sales and Distribution Channels- We seek out distributors and representatives that have business experience and capabilities to support our growth plans in our targeted markets. In North America, we currently have 24 distributors and Original Equipment Manufacturers ("OEMs"). Internationally, outside of North America, we currently have 37 distributors and OEMs. We continue to refine the distribution channels to address our specific targeted markets.

3) Service-We serve our customers directly and through qualified distributors and ASCs, all of whom will perform their service work using technicians specifically trained by Capstone. In Fiscal 2009, we continued to present alternatives to customers under-served by our distributor and ASC base through Capstone factory direct service.

4) Product Robustness and Life Cycle Maintenance Costs- To provide us with the ability to evaluate microturbine performance in the field, we developed a "real-time" remote monitoring and diagnostic feature. This feature allows us to monitor installed units and rapidly collect operating data on a continual basis. We use this information to anticipate and more quickly respond to field performance issues, evaluate component robustness and identify areas for continuous improvement. This feature is important in allowing us to better serve our customers.

5) New Product Development- Our new product development is targeted specifically to meet the needs of our selected vertical markets. We expect that our existing product platforms, the C30, C60 Series, C200 and C1000 Series microturbines, will be our foundational product lines for the foreseeable future. Our product development efforts are centered on enhancing the features of these base products. Our C200 product beta testing was successfully implemented during Fiscal 2005 and the first commercial shipment was on August 28, 2008. Our C1000 Series product was developed based on Capstone's C200 microturbine product line. This product family can be configured into 1,000-kW, 800-kW and 600-kW solutions in a single ISO-sized container. Our C1000 product beta testing was successfully implemented during Fiscal 2009 and the first commercial shipment was on December 29, 2008.

6) Cost and Core Competencies- We are making progress towards achieving overall cost improvements through design changes, automation, parts commonality across multiple product lines and by outsourcing areas not consistent with our core competencies. In conjunction with these changes, we launched a strategic supply chain initiative to develop suppliers on a global basis. The Company continues to review avenues for cost reduction by sourcing to the best value supply chain option. We have made progress diversifying our suppliers in the international "marketplace" as well as within the United States. We expect to leverage our costs as product volumes increase.

We believe that effective execution in each of these key areas will be necessary to leverage Capstone's promising technology and early market leadership into achieving positive cash flow with growing market presence and improving financial performance. Based on our recent progress and assuming achievement of targeted contribution margins, our financial model indicates that we will achieve positive cash flow when we ship approximately 200 units in a quarter, depending on product mix. We believe our manufacturing facilities located in Chatsworth and Van Nuys, California have a combined production capacity of approximately 2,000 units per year, depending on product mix. Excluding working capital requirements, we believe we can expand our combined production capacity to approximately 4,000 units per year, depending on product mix, with approximately $10 to $15 million of capital expenditures. We have not committed to this expansion nor identified a source for its funding, if available.

Critical Accounting Policies and Estimates

The preparation of our condensed consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Management believes the most complex and sensitive judgments, because of their significance to the condensed consolidated financial statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Actual results could differ from management's estimates. We believe the critical accounting policies listed below affect our more significant accounting judgments and estimates used in the preparation of the condensed consolidated financial statements. These policies (except as noted below) are described in greater detail in our Annual Report on Form 10-K for Fiscal 2009 and continue to include the following areas:

† Impairment of long-lived assets, including intangible assets;

† Inventory write-downs and classification of inventories;

† Estimates of warranty obligations;

† Sales returns and allowances;

† Allowance for doubtful accounts;

† Deferred tax assets and valuation allowance;

† Stock-based compensation expense;

† Loss contingencies; and

† Fair value of financial instruments.

As discussed in note 10 -Fair Value Measurements, the Company adopted EITF No. 07-5, which requires that our warrants be accounted for as derivative instruments under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 requires that we mark the value of our warrant liability to market and recognize the change in valuation in our statement of operations each reporting period. Determining the warrant liability to be recorded requires us to develop estimates to be used in calculating the fair value of the warrants. We calculate the fair values using the Black-Scholes valuation model.

The use of the Black-Scholes model requires us to make estimates of the following assumptions:

† Expected volatility-The estimated stock price volatility was derived based upon the Company's actual historic stock prices over the contractual life of the warrants, which represents the Company's best estimate of expected volatility.

† Risk-free interest rate-We used the yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the warrant contractual life assumption as the risk-free interest rate.

Results of Operations

Three Months Ended June 30, 2009 and 2008

Revenue. Revenue is reported net of sales returns and allowances. Revenue for the first quarter of Fiscal 2010 increased $6.2 million, or 83%, to $13.7 million from $7.5 million for the first quarter of Fiscal 2009.

Revenue from microturbine product shipments increased $5.2 million, or 104%, to $10.2 million for 80 units during the first quarter of Fiscal 2010 from $5.0 million for 89 units during the first quarter of Fiscal 2009. Shipments of microturbine units were 11.8 megawatts during the first quarter of Fiscal 2010 compared to 5.0 megawatts during the first quarter of Fiscal 2009. Revenue from C30 product shipments decreased $0.4 million, or 40%, to $0.6 million for 16 units during the first quarter of Fiscal 2010 from $1.0 million for 21 units during the first quarter of Fiscal 2009. Shipments of C30 product were 0.5 megawatts during the first quarter of Fiscal 2010 compared to 0.6 megawatts during the first quarter of Fiscal 2009. Revenue from C60 Series product shipments decreased $0.6 million, or 15%, to $3.4 million for 53 units during the first quarter of Fiscal 2010 from $4.0 million for 68 units during the first quarter of Fiscal 2009. Shipments of C60 Series products were 3.5 megawatts during the first quarter of Fiscal 2010 compared to 4.4 megawatts during the first quarter of Fiscal 2009. Revenue from C200 product shipments was $0.5 million for three units, or 0.6 megawatts, during the first quarter of Fiscal 2010. There were no C200 product shipments in the same period last year. Revenue from C600 product shipments was $0.5 million for one unit, or 0.6 megawatts, during the first quarter of Fiscal 2010. There were no C600 product shipments in the same period last year. Revenue from C800 product shipments was $1.2 million for two units, or 1.6 megawatts, during the first quarter of Fiscal 2010. There were no C800 product shipments in the same period last year. Revenue from C1000 product shipments was $4.0 million for five units, or 5.0 megawatts, during the first quarter of Fiscal 2010. There were no C1000 product shipments in the same period last year. Revenue from accessories, parts and service during the first quarter of Fiscal 2010 increased $1.0 million to $3.5 million from $2.5 million during the first quarter of Fiscal 2009.

The overall revenue increase for the first quarter of Fiscal 2010 compared to the first quarter of Fiscal 2009 included a $2.8 million increase in revenue from the Asian market, a $2.3 million increase in revenue from the European market, a $0.9 million increase in revenue from the North American market and a $0.2 million increase in revenue from the South American market, all primarily the result of efforts to improve distribution channels. Overall microturbine product shipments decreased during the first quarter of Fiscal 2010 compared to the first quarter of Fiscal 2009, while the revenue for the same period increased as a result of the introduction of our new C200 and C1000 Series product lines. Product shipments decreased to 80 units for the first quarter of Fiscal 2010 compared to 89 units for the first quarter of Fiscal 2009, while megawatts increased to 11.8 megawatts from 5.0 megawatts compared to the same period last year. Average revenue per unit increased for the first quarter of Fiscal 2010 to $0.1 million compared to $56,000 per unit for the first quarter of Fiscal 2009. The timing of shipments is subject to change based on several variables (including customer payments and customer delivery schedules), some of which are not in our control and can affect our quarterly revenue and backlog. Therefore, we evaluate historical revenue in conjunction with backlog to anticipate the growth trend of our revenue.

The following table summarizes our revenue:

                                                Three Months Ended June 30,
                                          2009                              2008
                              Revenue    Megawatts    Units     Revenue    Megawatts    Units
C30                          $     0.6         0.5        16   $     1.0         0.6        21
C60 Series                         3.4         3.5        53         4.0         4.4        68
C200                               0.5         0.6         3           -           -         -
C600                               0.5         0.6         1           -           -         -
C800                               1.2         1.6         2           -           -         -
C1000 Series                       4.0         5.0         5           -           -         -
Total from Microturbine
Products                     $    10.2        11.8        80   $     5.0         5.0        89
Accessories, Parts and
Service                            3.5           -         -         2.5           -         -
Total                        $    13.7        11.8        80   $     7.5         5.0        89

Two customers accounted for 27% and 18% of our revenue, respectively, for the first quarter of Fiscal 2010, totaling approximately 45% of revenue. For the first quarter of Fiscal 2009, two customers accounted for 32% and 13% of our revenue, respectively, totaling approximately 45% of our revenue. Sales to Banking Production Centre ("BPC"), our Russian distributor, accounted for 27% and 32% of our revenue for the first quarter of Fiscal 2010 and 2009, respectively.

Gross Loss.Cost of goods sold includes direct material costs, production overhead, inventory charges and provision for estimated product warranty expenses. The gross loss was $2.8 million, or 21% of revenue, for the first quarter of Fiscal 2010 compared to $1.3 million, or 17% of revenue, for the first quarter of Fiscal 2009. The increase in gross loss reflects increased manufacturing costs of $1.1 million because of the product launch of the C200 and C1000 Series systems and decreased sales of C60 Series systems, resulting in a lower margin product mix of $0.7 million offset by reduced warranty expense of $0.3 million. Warranty expense is a combination of a per-unit warranty accrual recorded at the time revenue is recognized and changes, if any, in estimates for warranty programs. Warranty program estimates are recorded in the period that new information, such as design changes, cost of repair and product enhancements, becomes available. The reduction of warranty expense of $0.3 million consisted of a $0.2 million decrease in the estimated cost of repair and a $0.2 million reduction in warranty programs because of actual repair of units and units subsequently covered by factory protection plans offset by an increase of $0.1 million as a result of warranty expense for unit shipments because of the introduction of the C200 and C1000 Series systems.

We expect to continue to incur gross losses until we are able to achieve higher unit sales volumes to cover our fixed manufacturing costs. We have taken initiatives to further reduce direct material costs and other manufacturing and warranty costs as we work to achieve profitability.

Research and Development Expenses. R&D expenses include compensation, engineering department expenses and materials costs associated with development. R&D expenses for the first quarter of Fiscal 2010 decreased $1.2 million, or 60%, to $0.8 million from $2.0 million for the first quarter of Fiscal 2009. R&D expenses are reported net of benefits from cost-sharing programs, such as the UTCP funding. There were approximately $1.3 million of such benefits for the first quarter of Fiscal 2010 and $2.0 million of such benefits for the first quarter of Fiscal 2009. There were no in-kind services performed by UTCP under the cost-sharing program during the first quarter of Fiscal 2010. In-kind services performed during the first quarter of Fiscal 2009 were valued at $0.2 million and recorded as consulting expense. The overall decrease in R&D expenses of $1.2 million resulted from decreased spending for consulting fees of $0.9 million, supplies of $0.6 million, labor costs of $0.2 million, and facilities expense of $0.1 million offset by reduced UTCP funding benefits of $0.7 million for the cost-sharing program. The UTCP cost-sharing program concluded in June 2009. Cost-sharing programs vary from period to period depending on the phases of the programs. We expect to enter into at least one cost-sharing program in Fiscal 2010. If we do not enter into cost-sharing programs as expected, we will not incur some of the planned costs and, as a result, would expect our spending in Fiscal 2010 to be lower than that in Fiscal 2009.

Selling, General, and Administrative ("SG&A") Expenses. SG&A expenses decreased $0.5 million, or 8%, to $6.2 million for the first quarter of Fiscal 2010 from $6.7 million for the first quarter of Fiscal 2009. The net decrease in SG&A expenses was comprised of a decrease of $0.7 million related to travel expense, $0.1 million in labor expense and $0.1 million of marketing expense offset by an increase of $0.3 million from a reversal of a loss contingency in the first quarter of Fiscal 2009 and an increase of $0.1 million in professional services expense, that includes accounting, legal and insurance expense. We expect SG&A costs in Fiscal 2010 to be slightly lower than in Fiscal 2009.

Interest Income. Interest income for the first quarter of Fiscal 2010 decreased $0.2 million, or 96%, to $8,000 from $0.2 million for the same period last year. The decrease during the period was attributable to lower average cash balances and lower interest rates over the same period last year. We expect interest income to decline for Fiscal 2010 as we continue to use cash to support our operations.

Interest Expense. Interest expense for the first quarter of Fiscal 2010 was $0.1 million. There was no interest expense during the first quarter of Fiscal 2009. Interest expense related to the revolving Credit Facility accounted for the increase in interest expense in Fiscal 2010. As of June 30, 2009, we had total debt of $8.8 million outstanding under the revolving Credit Facility.

Change in Fair Value of Warrant Liability. The change in fair value of the warrant liability was $5.2 million for the first quarter of Fiscal 2010 due to the adoption of EITF No. 07-5 in Fiscal 2010. The change in fair value of the warrant liability reflects the change in the warrant liability during the first quarter of Fiscal 2010.

Income Taxes. Income taxes for the first quarter of Fiscal 2010 increased to $0.1 million from $2,000 for the same period last year. The increase during the period was related to service activity in Mexico that exceeded certain thresholds that did not occur during the first quarter of Fiscal 2009. We do not expect a significant amount of income tax expense for the remainder of Fiscal 2010 as the current agreement with this customer in Mexico expires in August 2009.

Liquidity and Capital Resources

Our cash requirements depend on many factors, including the execution of our plan. We expect to continue to devote substantial capital resources to running our business and creating the strategic changes summarized herein. Our planned capital expenditures for Fiscal 2010 include approximately $3.6 million for rental units and plant and equipment costs related to manufacturing and operations. The majority of the $3.6 million relates to the rental units, which can be built primarily from inventory on hand. We have invested our cash in institutional funds that invest in high quality short-term money market instruments to provide liquidity for operations and for capital preservation.

Our cash and cash equivalent balances increased $5.9 million during the first quarter of Fiscal 2010, compared to a decrease of $9.9 million for the first quarter of Fiscal 2009. The cash was used in:

Operating Activities. During the first quarter of Fiscal 2010, we used $9.9 million in cash in our operating activities, which consisted of a net loss for the period of $15.3 million, and cash used for working capital of $1.9 million offset by non-cash adjustments (primarily change in fair value of warrant liability, depreciation, warranty, stock-based compensation and inventory charges) of $7.1 million. During the same period last year, operating cash usage was $14.0 million, which consisted of a net loss for the period of $9.8 million and cash used for working capital of $5.6 million, offset by non-cash adjustments of $1.4 million. The decrease in working capital cash usage of $3.7 million is primarily attributable to inventory which has decreased by $6.4 million as a result of our initiatives to reduce inventory. Additionally, accounts receivable increased $2.1 million because of higher sales occurring at the end of the period and the timing of collections, net accounts payable . . .