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, 2008.

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, 2008. 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 leader in the development and manufacture of applied energy systems for military and commercial applications. Through our efforts in developing our core technology, Laser Guided Energy (LGE™), we have gained expertise and proprietary knowledge in high performance lasers, high-voltage electronics, advanced dynamic optics and atmospheric and plasma energy interactions. We apply these technologies to deliver innovative solutions to urgent military requirements, including neutralizing improvised explosive devices ("IEDs") and 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 the third quarter of 2009, we initiated a new strategic plan. The objective of this effort was to identify the areas in which our core strengths can be developed to increase our business across new applications in the military, government and commercial sectors. The goals for the strategic plan include increasing revenues, achieving positive cash flow, profitability, development of new products and markets, and controlling costs to improve margins.

On July 30, 2009, we received a $992,000 contract (currently funded in the amount of $600,000) for the design, development and delivery of a laser system to the U.S. Navy. We anticipate that the contract will be fully funded at the beginning of 2010, provided that the objectives of the first phase are met, as the government has allocated the full funding amount to the contracting authority. On August 18, 2009, we received a $3.1 million contract from the U.S. Army's Research, Development and Engineering Command for the continued advancement and development of our LGETM technology. The contract is for a period of three years with a potential contract ceiling of $13.4 million.

During 2009, we received additional funding through contract modifications for our U.S. Marine Corps program for approximately $476,000, of which $224,000 was received in September, to support further development and operational assessment of the technology. We expect additional funding in the fourth quarter of 2009 for this program based upon favorable assessment reports received and positive feedback from our Marine Corps customer.

Our counter-IED technology continues to perform well and receive favorable evaluations by the U.S. Marine Corps. As a result, we expect continued funding will be received for further systems and development activities in the fourth quarter of 2009. The delivery and successful employment of this technology by a customer in a rugged field environment is an important milestone for Applied Energetics, as we believe it validates our ability to transition technologies from the laboratory to the field and provide customer support throughout the product life cycle.

On September 1, 2009, the company and Kenneth M. Wallace entered into a separation agreement (the "Separation Agreement") pursuant to which Mr. Wallace's employment as Chief Financial Officer of the Registrant terminated. Pursuant to the terms of the separation agreement, Mr. Wallace has received lump sum payments of $29,000, and $7,682 as reimbursement for health and medical insurance premiums for six months, and will receive four (4) monthly payments of $28,125.

On September 1, 2009, the company appointed Humberto Astorga, Director of Finance, as its principal financial officer and principal accounting officer for SEC reporting purposes.

RECENT ACCOUNTING PRONOUNCEMENTS

The Financial Accounting Standards Board ("FASB") has issued Accounting Standards Update 2009-01, (Topic 105) Generally Accepted Accounting Principles amendments based on Statement of Financial Accounting Standards ("SFAS") No. 168
- The FASB Accounting Standards Codification ™ and the Hierarchy of Generally Accepted Accounting Principles. Accounting Standards Update 2009-01 amends the Codification for the issuance of Statement No. 168. SFAS 168 was intended to replace Statement 162 "The Hierarchy of Generally Accepted Accounting Principles", and to establish the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative GAAP for SEC registrants. This statement is effective for interim reporting periods ending after September 15, 2009. The adoption of the standard is not expected to have a significant impact on the company's consolidated financial statements.

The FASB has issued Accounting Standards Update ("ASU") 2009-04, Accounting for Redeemable Equity Instruments. ASU 2009-04 updates Topic 480-10-S99 to reflect the SEC staff's view regarding the application of Accounting Series Release No. 268, Presentation in Financial Statements of "Redeemable Preferred Stocks". The adoption of the standard is not expected to have a significant impact on the company's consolidated financial statements.

The FASB has issued Accounting Standards Update ("ASU") 2009-05, Fair Value Measurements and Disclosures (Topic 820) - Measuring Liabilities at Fair Value. ASU 2009-05 amends Subtopic 820-10, Fair Value Measurements and Disclosures - Overall, for the fair value measurement of liabilities and provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the techniques provided for in this update. This statement is effective for interim reporting periods immediately after issuance in August, 2009. The adoption of the standard is not expected to have a significant impact on the company's consolidated financial statements.

The FASB has issued Accounting Standards Update ("ASU") 2009-13, Multiple Deliverable Revenue Arrangements. ASU 2009-13 replaces EITF 00-21, and clarifies the criteria for separating revenue between multiple deliverables. This statement is effective for new revenue arrangements or materially modified arrangements in periods subsequent to adoption. Adoption is required for fiscal years beginning on or after June 15, 2010, but early adoption is allowed. We anticipate adopting ASU 2009-13 as of January 1, 2010 for new commercial revenue arrangements that fall within the scope of this Update. The adoption of the standard is not expected to have a significant impact on the company's consolidated financial statements.

RESULTS OF OPERATIONS

COMPARISON OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008:

                                                2009             2008
            Revenue                         $  1,877,865     $  4,014,302
            Cost of revenue                    1,777,840        3,789,962
               General and administrative      1,083,249        1,647,366
               Settlement expenses               265,197                -
               Selling and marketing             132,386           61,565
               Research and development          210,925          359,807
            Other (expense) income:
               Interest expense                        -             (388 )
               Interest income                     8,388          123,558

            Net loss                        $ (1,583,344 )   $ (1,721,228 )

REVENUE

Revenue decreased approximately $2.1 million for the three months ended September 30, 2009 compared to the three months ended September 30, 2008, which was attributable to the expected decrease in revenue from the Counter-IED product line of approximately $1.6 million, and from the LGE product line of approximately $700,000. The decreases in these two product lines were offset by an increase in our new Laser product line revenue of $100,000.

COST OF REVENUE

Cost of revenue decreased approximately $2.0 million compared for the three months ended September 30, 2009 compared to the three months ended September 30, 2008, which was in line with the decrease in revenues of 53% for the same period. 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 expenses decreased approximately $564,000 for the three months ended September 30, 2009 compared to the three months ended September 30, 2008. Lower revenues in 2009 caused an increase in general and administrative costs of approximately $973,000 due to applied labor and overhead not being allocated to government contracts. Professional services costs increased by approximately $18,000. Offsetting these increases are reductions in salaries, benefits, and temporary help of approximately $713,000 and non-cash employee compensation costs of approximately $424,000 due to the previously reported restructuring and reductions in force. Additional reductions included recruiting and travel related costs of approximately $191,000 operational expenses of approximately $166,000, and depreciation and amortization costs of approximately $60,000.

SETTLEMENT EXPENSES

The settlement of the class action and derivative lawsuits caused an increase of $265,000 for the three months ended September 30, 2009.

SELLING AND MARKETING

Selling and marketing expenses increased approximately $71,000 for the three months ended September 30, 2009 from the same period in 2008, reflecting increased allocation of time of existing personnel and costs associated with business development, professional conferences and exhibitions, marketing literature, and updated web content.

RESEARCH AND DEVELOPMENT

Internal research and development expenses decreased approximately $149,000 during the three months ended September 30, 2009 as compared to the same period in 2008. The decrease is related to cancellation of research and development projects conducted at the St. Louis facility that was closed in the second quarter of 2009. We continue to focus on the development of proprietary high voltage and laser technologies at our Tucson, Arizona location.

Our short-term research and development goals are to develop innovative laser sources, novel high-voltage electrical products, efficient optical systems and to engineer laser hardware to be more compact and rugged as an essential element of maturing our LGE technology to be practical for fielding. Longer-term research objectives include development of tunable and eye safe laser sources to improve safety and utility of LGE, adjunct military and commercial applications for lasers to expand accessible markets for our technology, and integrated weapon and counter-weapon system technologies.

INTEREST INCOME AND INTEREST EXPENSE

Net interest income for the three months ended September 30, 2009 was lower by approximately $115,000 from the same period of 2008 primarily due to the lower balance of invested funds and lower interest rates on our investments in 2009.

NET LOSS

Our operations for the three months ended September 30, 2009 resulted in a net loss of approximately $1.6 million, a decrease of approximately $138,000 compared to the $1.7 million loss for the same period in 2008.

COMPARISON OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008:

                                               2009             2008
              Revenue                      $  6,195,404     $ 11,653,390
              Cost of revenue                 5,810,602       10,719,524
              General and administrative      5,219,034        6,170,107
              Settlement expenses             1,390,197                -
              Selling and marketing             561,410          173,003
              Research and development        1,051,572          965,017
              Other (expense) income:
              Interest expense                      (19 )         (1,940 )
              Interest income                    56,222          539,166
              Other                                   -               10
              Net loss                     $ (7,781,208 )   $ (5,837,025 )

REVENUE

Revenue decreased approximately $5.5 million for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008, which was attributable to a decrease in revenue from the Counter-IED product line of approximately $4.1 million, from the LGE product line of approximately $1.2 million, and from a reduction in revenue on the High Voltage product line of approximately $334,000. The decreases in revenues from these three product lines were offset by an increase in our new Laser product line revenue of $116,000.

COST OF REVENUE

Cost of revenue decreased approximately $4.9 million for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008, which was in line with the decrease in revenues of 47% for the same period. 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 expenses increased by approximately $951,000 for the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008. Lower revenues in 2009 caused an increase in general and administrative costs of approximately $2.414 million due to applied labor and overhead not being allocated to government contracts. Professional services increased approximately $129,000 and disposals of equipment and leasehold improvements increased approximately $92,000 in 2009. Offsetting these increases are reductions in non-cash compensation costs of approximately $1.645 million, salaries, benefits, and temporary help of approximately $1.131 million due to the previously reported restructuring and reductions in our workforce, recruiting and travel related costs of approximately $402,000, operational expenses of approximately $261,000, and depreciation and amortization costs of $151,000.

SETTLEMENT EXPENSES

The settlement of the class action and derivative lawsuits caused an increase of approximately $1.4 million for the nine months ended September 30, 2009.

SELLING AND MARKETING

Selling and marketing expenses increased approximately $388,000 for the nine months ended September 30, 2009 from the same period in 2008, reflecting increased allocation of time of existing personnel and costs associated with business development, professional conferences and exhibitions, marketing literature, and updated web content.

RESEARCH AND DEVELOPMENT

Internal research and development expenses increased approximately $87,000 during the nine months ended September 30, 2009 as compared to the same period in 2008. The increase is related to the continued development of proprietary high voltage and laser technologies.

Our short-term research and development goals are to develop innovative laser sources, novel high-voltage electrical products, efficient optical systems and to engineer laser hardware to be more compact and rugged as an essential element of maturing our LGE technology to be practical for fielding. Longer-term research objectives include development of tunable and eye safe laser sources to improve safety and utility of LGE, adjunct military and commercial applications for lasers to expand accessible markets for our technology, and integrated weapon and counter-weapon system technologies.

INTEREST INCOME AND INTEREST EXPENSE

Net interest income for the nine months ended September 30, 2009 was lower by approximately $483,000 from the same period of 2008 primarily due to the lower balance of invested funds and lower interest rates on our investments in 2009.

NET LOSS

Our operations for the nine months ended September 30, 2009 resulted in a net loss of approximately $7.8 million, an increase of approximately $1.9 million compared to the $5.8 million loss for the same period of 2008.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2009, we had approximately $11.8 million of cash and cash equivalents. Our cash position decreased during the first nine months of 2009 by approximately $3.7 million. During the first nine months of 2009, we used $3.5 million of cash in operating activities, which is comprised of our net loss of $7.8 million, plus adjustments in non-cash share-based compensation expense of $1.3 million, depreciation and amortization of $499,000, loss on equipment disposal of $107,000, and the litigation settlement payable in common shares of $1.2 million. Changes in assets and liabilities that provided cash include decreases in accounts receivable of $1.4 million, prepaid expenses and deposits of $386,000, long-term receivables of $253,000, accrued expenses of $68,000, and billings in excess of costs of $20,000. Changes in assets and liabilities that used cash were a decrease in accounts payable of $558,000, and increases in other receivables of $245,000 and inventory of $219,000.

As part of our total cash use during the first nine months of 2009, investment activities used approximately $9,000. Financing activities used approximately $131,000, primarily from the preferred stock cash dividends paid in February, May, and August, 2009.

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 cash equivalents. We determined that we have sufficient working capital to fulfill existing contracts and expected contracts in 2009 and 2010.

BACKLOG OF ORDERS

At September 30, 2009, we had a backlog (workload remaining on signed contracts) of approximately $4.7 million to be completed within the next twelve months. The backlog does not include proposals and contracts under negotiation.