Table of Contents

(Mark One)

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2003

OR

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                to                                .

Commission file number: 001-15957

CAPSTONE TURBINE CORPORATION

21211 Nordhoff Street, Chatsworth, California 91311
(Address of principal executive offices) (Zip code)

818-734-5300
(Registrant’s telephone number including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Yes x No o

     The number of outstanding shares of the registrant’s common stock as of April 30, 2003 was 81,267,570.

1

Table of Contents

CAPSTONE TURBINE CORPORATION

INDEX

2

Table of Contents

PART I — FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

CAPSTONE TURBINE CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited)

See accompanying notes to consolidated financial statements.

3

Table of Contents

CAPSTONE TURBINE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying notes to consolidated financial statements.

4

Table of Contents

CAPSTONE TURBINE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(Unaudited)

See accompanying notes to consolidated financial statements.

5

Table of Contents

CAPSTONE TURBINE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to consolidated financial statements.

6

Table of Contents

CAPSTONE TURBINE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1.

Business and Organization

     Capstone Turbine Corporation (the “Company”) develops, manufactures and sells microturbine generator sets for use in combined heat and power generation, resource recovery, hybrid electric vehicles and other power, heat and cooling applications in the markets for distributed power generation around the world. The Company was organized in 1988 and has been commercially producing its microturbine generators since 1998.

     The Company has incurred significant operating losses since its inception. Management anticipates incurring additional losses until the Company can produce sufficient revenues to cover costs. To date, the Company has funded its activities primarily through private and public equity offerings.

2.

Basis of Presentation

     The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“generally accepted accounting principles”) for interim financial information and with the instructions to Form 10-Q and Regulation S-X promulgated under the Securities and Exchange Act of 1934. They do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The balance sheet at December 31, 2002 was derived from audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. In the opinion of management the interim financial statements include all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial condition, results of operations, stockholders’ equity and cash flows for such periods. Results of operations for any interim period are not necessarily indicative of results for any other interim period or for the full year. These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

3.

New Accounting Pronouncements

     In January 2003, the Emerging Issues Task Force (“EITF”) released EITF 00-21: “Accounting for Revenue Arrangements with Multiple Deliverables.” EITF 00-21 clarifies the timing and recognition of revenue from certain transactions that include the delivery and performance of multiple products or services. EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Alternatively, entities may elect to report the change in accounting as a cumulative-effect adjustment in accordance with APB Opinion 20, “Accounting Changes.” If so elected, disclosure should be made in periods subsequent to the date of initial application of this consensus of the amount of the recognized revenue that was previously included in the cumulative-effect adjustments. The Company is currently reviewing the impact of EITF 00-21.

     In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment of SFAS No. 123.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the methods used on reported results. The disclosure requirements apply to all companies for fiscal years ended after December 15, 2002. The Company accounts for its employee stock option plans under the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. The Company accounts for equity instruments issued to recipients other than employees using the fair value at the date of grant. The following table is presented in accordance with SFAS No. 148 and illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123.

7

Table of Contents

CAPSTONE TURBINE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)

     In November 2002, FASB Interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” was issued. FIN No. 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. FIN No. 45 also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of this Interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The Company did not issue any guarantees of indebtedness of others during the quarter ended March 31, 2003. Product warranties are excluded from the initial recognition and measurement provisions of FIN No. 45 but are subject to its disclosure requirements. The required disclosures and a roll-forward of product warranty liabilities are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company disclosed its accounting policy on product warranty in its Annual Report on Form 10-K for the year ended December 31, 2002. The required tabular reconciliation of the changes in the aggregate product warranty liability for the quarter ended March 31, 2003 is disclosed in Note 8.

     In July 2002, SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” was issued by the FASB. SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Examples of costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material impact on the Company’s consolidated financial position or results of operations as it has not initiated any exit activities or disposal activities.

4.

Segment Reporting

     The Company is considered to be a single operating segment in conformity with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” The business activities of said operating segment are the development, manufacture and sale of turbine generator sets. Following is a breakdown by geographical area of the Company’s revenues:

8

Table of Contents

CAPSTONE TURBINE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)

     Revenues and margins for the three months ended March 31, 2002 were reported net of $569,000 and $79,000, respectively, that resulted from the repossession of 20 units of our C30 products from a distributor in Africa.

5.

Inventory

     Inventory is stated at the lower of standard cost (which approximates actual cost on the first-in, first-out method) or market and consists of the following:

     The non-current portion of inventory represents that portion of the inventory in excess of amounts expected to be sold or used in the next twelve months.

6.

Intangible Asset

     The intangible asset represents the license granted to the Company to use a former supplier’s intellectual property for the design and manufacture of licensed product for use in microturbines. Additional information is as follows:

     The intangible asset, which was acquired in 2000, is being amortized over its estimated useful life of ten years. The Company recorded $68,000 and $94,000 of amortization expense related to the manufacturing license for the quarters ended March 31, 2003 and 2002, respectively. The manufacturing license is scheduled to be fully amortized by 2010 with corresponding amortization estimated to be $199,000, $267,000, $267,000, $267,000, $267,000 and $694,000, for the remainder of 2003, calendar years 2004, 2005, 2006 and 2007, and thereafter, respectively.

7.

Stock-Based Compensation

     During 1999 and 2000, the Company issued common stock options at less than the fair value of its common stock. Accordingly, the Company recorded stock-based compensation expense based on the vesting of these grants as follows:

     As of March 31, 2003, the Company had $705,000 in deferred employee and director stock-based compensation, which will be amortized through 2004 based on the vesting period.

     On March 20, 2003, the Board of Directors approved an amendment to the 2000 Equity Incentive Plan (the “2000 Plan”) to increase the number of shares of common stock available for grant by 2,500,000 shares. The grants under this increase shall be non-statutory stock options. As a result of this amendment, the 2000 Plan now provides for awards of up to 6,200,000 shares, plus the number of

9

Table of Contents

CAPSTONE TURBINE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(Unaudited)

shares previously authorized and remaining available under the 1993 Incentive Stock Plan (the “1993 Plan”), plus any shares covered by options granted under the 1993 Plan that are forfeited or expire unexercised.

8.

Accrued Warranty Reserve

     The following table represents the changes in the product warranty liability for the quarter ended March 31, 2003:

9.

Commitments and Contingencies

     As of March 31, 2003, the Company had firm commitments to purchase inventories of approximately $4,300,000 and $2,400,000 for non-inventory items.

     In December 2001, a purported shareholder class action lawsuit was filed in the United States District Court for the Southern District of New York against the Company, two of its officers, and the underwriters of our initial public offering. The suit purports to be a class action filed on behalf of purchasers of our common stock during the period from June 28, 2000 to December 6, 2000. An amended complaint was filed on April 19, 2002. No date has been set for the Company to respond to the complaint. Plaintiffs allege that the underwriter defendants agreed to allocate stock in the Company’s June 28, 2000 initial public offering and November 16, 2000 secondary offering to certain investors in exchange for excessive and undisclosed commissions and agreements by those investors to make additional purchases of stock in the aftermarket at pre-determined prices. Plaintiffs allege that the prospectuses for these two public offerings were false and misleading in violation of the securities laws because they did not disclose these arrangements. The Company understands that over three hundred other issuers have been named as defendants in nearly identical lawsuits filed by some of the same plaintiffs’ law firms. We intend to defend these actions vigorously. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of litigation could have a material adverse effect on the Company’s financial position and results of operations.

10.

Related Party Transactions

     Mr. Eliot Protsch became a member of the Company’s Board of Directors in April 2002 and became Chairman of the Company’s Board of Directors in October 2002. Mr. Protsch is President of Alliant Energy-Interstate Power and Light and Executive Vice-President, Energy Delivery at Alliant Energy Corporation. Alliant Energy Resources, Inc., a subsidiary of Alliant Energy Corporation, is a distributor for the Company. Sales to Alliant Energy Resources, Inc. in the quarter ended March 31, 2003 were approximately $11,000. There were no sales to Alliant Energy Resources, Inc. in the quarter ended March 31, 2002.

11.

Selling, General and Administrative Expenses

     As a result of a settlement agreement with a professional services firm, liabilities for $1,099,000 of administrative expenses recorded in prior years were reversed in the first quarter of 2003.

12.

Net Loss Per Common Share

     Basic loss per common share is computed using the weighted-average number of common shares outstanding for the period. The impact of common stock options has not been included in the computation of diluted loss per share as their inclusion would have had an anti-dilutive effect on the per-share amounts for the periods presented; therefore, diluted loss per share is equal to basic loss per share.

10

Table of Contents

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

     The following discussion should be read in conjunction with the Financial Statements and Notes included in this Form 10-Q and within Capstone’s Annual Report on Form 10-K for the year ended December 31, 2002. When used in the following discussion, the words “believes”, “anticipates”, “intends”, “expects”, “plans” 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 “Other Information – Business Risks” in Item 5 of this Form 10-Q. Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date hereof. We undertake no obligation to revise or update publicly any of the forward-looking statements after the filing of this Form 10-Q to conform such statements to actual results or to changes in our expectations.

Critical Accounting Policies

     There were no material changes in the quarter ended March 31, 2003 relating to our critical accounting policies as previously discussed in Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2002.

Results of Operations

Quarters Ended March 31, 2003 and 2002

     Revenues. Revenues for the quarter ended March 31, 2003 decreased $1.8 million to $2.8 million from $4.6 million for the same period last year. Revenues from product shipments for the quarter decreased $2.4 million to $1.4 million from $3.8 million for the same period a year ago. During the quarter ended March 31, 2003, we shipped 1.3 megawatts, or 38 units, consisting of 32 units of our C30 products and 6 units of our C60 products. During the quarter ended March 31, 2002, we shipped 4.7 megawatts, or 127 units, consisting of 99 units of our C30 products and 28 units of our C60 products. Revenues from accessories, parts and service for the quarter ended March 31, 2003 increased $0.6 million to $1.4 million from $0.8 million for the same period last year.

     During the quarter ended March 31, 2003, 50% of our revenues were to two customers in North America as compared to 75% to two customers, a European utility and Sumitomo Corporation in Japan, for the same period last year.

     While our sales of products were low in the first quarter of 2003, we have entered the second quarter with 7 megawatts of orders scheduled for shipment mostly during the second and third quarters of 2003. These orders are not firm. The timing of shipments of these orders may also be changed. We expect our sales for the full year of 2003 will be about the same or lower than the sales of $19.5 million in 2002.

     We currently believe that there close to 600 units in our distributors’ inventories that are available for sale. These inventories, which are owned by our distributors, may adversely impact our sales opportunities in the future.

     Gross Loss. Cost of goods sold includes direct material costs, production overhead, inventory charges and provision for estimated product warranty expenses. We had a gross loss of $2.2 million for the quarter ended March 31, 2003, compared to $3.0 million for the same period last year. The reduction in gross loss was primarily from increased sales of accessories, parts and service, and higher average selling prices of microturbines due to product configuration mix.

     Our cost of goods sold has exceeded revenues each period. We expect this trend to continue until such time that we can sell a sufficient number of units to achieve a break-even margin. Despite our product and market advantages, the rate of adoption for our technology has been slower than initially anticipated. The present economic environment, with tight restrictions for capital expenditures, also makes it significantly more challenging. In our efforts to get to a higher rate of adoption and become profitable, we are working on three focus areas: specific vertical markets, lowering maintenance costs and new product development.

     R&D Expenses. Research and development (“R&D”) expenses include compensation, the engineering department overhead allocations for administration and facilities and material costs associated with development. R&D expenses were $1.0 million for the quarter ended March 31, 2003, compared to $1.4 million for the same period a year ago. R&D expenses are reported net of benefits from cost sharing programs. These benefits were $1.7 million for the quarter ended March 31, 2003 and $1.3 million for the same period last year. Our gross R&D spending was comparable between periods.

11

Table of Contents

     Selling, General, and Administrative Expenses. Selling, general, and administrative (“SG&A”) expenses include compensation and related expenses in support of our general corporate functions, which include human resources, finance and accounting, shareholder relations, quality, information systems and legal services. SG&A expenses for the quarter ended March 31, 2003 decreased $3.6 million to $4.8 million, compared to $8.4 million for the same period last year. The decrease was due to several factors including:

	•		There was no amortization expense from marketing rights in the quarter ended March 31, 2003, compared to $1.3 million in the same period last year. The marketing rights were fully impaired during the second quarter of 2002.
	•		As a result of a settlement agreement with a professional services firm, liabilities for $1.1 million of administrative expenses recorded in prior years were reversed in the first quarter of 2003. We do not expect similar reversals of expenses in future periods.
	•		Spending was lower in 2003 as a result of our actions to reduce our cost structure, resize the business and lower our cash usage.

     Interest Income. Interest income decreased $0.4 million to $0.4 million for the quarter ended March 31, 2003, compared to $0.8 million for the same period a year ago. The decrease was primarily attributable to the lower cash balances and lower interest rates. We expect decreasing cash balances from our use of funds will continue to diminish our interest income.

Liquidity and Capital Resources

     Our cash requirements depend on many factors, including our product development activities and our commercialization efforts. While we are working to reduce our cash usage, we expect to continue to devote substantial capital resources to running our business, including continuing the development of our sales and marketing programs and continuing our R&D activities. We believe that our current cash balance of $132.6 million is sufficient to fund operating losses and our currently projected commitments to reach the point of cash flow positive. We have invested our cash in an institutional fund that invests in high quality short-term money market instruments to provide liquidity for operations and for capital preservation.

     We used cash of $7.7 million during the quarter ended March 31, 2003, compared to $6.5 million for the same period last year.

     Our net cash used in operations, excluding working capital, was $6.1 million for the quarter ended March 31, 2003, compared to $7.2 million for the same period last year. This decrease of $1.1 million was primarily from a lower net loss. We used cash for working capital of $0.8 million for the quarter ended March 31, 2003, compared to generating a source of cash from working capital of $1.3 million for the same period last year. This increase of $2.1 million was largely due to this year’s first quarter having lower collections of accounts receivable as a result of lower sales, and higher inventory purchases.

     Accounts receivable decreased $1.2 million to $3.7 million as of March 31, 2003 from $4.9 million as of December 31, 2002. The decrease was due to lower sales in the first quarter of 2003 compared to sales in the fourth quarter of 2002.

     Total inventory increased $0.6 million to $16.5 million as of March 31, 2003 from $15.9 million as of December 31, 2002. At March 31, 2003, non-current inventory of $4.4 million represents that portion of the inventory in excess of amounts expected to be sold or used in the next twelve months. The increase in total inventory was due to inventory purchases under firm contracts with our suppliers. As of March 31, 2003, the Company had firm commitments to purchase inventories of approximately $4.3 million and $2.4 million for non-inventory items.

     Net cash used in investing activities for acquisition of fixed assets was $0.3 million for the quarter ended March 31, 2003, compared to $0.4 million for the same period last year.

     Our net cash used in financing activities of $0.5 million for the quarter, compared to $0.2 million for the same period a year ago primarily due to purchase of treasury stock of $0.2 million this year. In October 2002, the Company’s Board of Directors approved a stock repurchase program under which the Company may purchase up to $10 million of the Company’s common stock. The Company could purchase shares from time to time through open market and privately negotiated transactions at prices deemed appropriate by management. The program has no termination date. Since the inception of the program, we have repurchased 451,953 shares for an aggregate price of $0.4 million

12

Table of Contents

     There have been no material changes in the Company’s remaining commitments under non-cancelable operating leases and capital leases as disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Impact of Recently Issued Accounting Standards

     In January 2003, the Emerging Issues Task Force (EITF) released EITF 00-21: “Accounting for Revenue Arrangements with Multiple Deliverables.” EITF 00-21 clarifies the timing and recognition of revenue from certain transactions that include the delivery and performance of multiple products or services. EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Alternatively, entities may elect to report the change in accounting as a cumulative-effect adjustment in accordance with APB Opinion 20, “Accounting Changes”. If so elected, disclosure should be made in periods subsequent to the date of initial application of this consensus of the amount of the recognized revenue that was previously included in the cumulative-effect adjustments. We are currently reviewing the impact of this EITF.

Item 3. Qualitative and Quantitative Disclosures About Market Risk

     No material changes have occurred in the quantitative and qualitative market risk disclosure of the Company as presented in its Annual Report on Form 10-K for the year ended December 31, 2002.

Item 4. Controls and Procedures

(a)

Evaluation of disclosure controls and procedures.

     Our Chief Executive Officer and our Chief Financial Officer evaluated our “disclosure controls and procedures” (as defined in Rule 13a-14(c) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of a date within 90 days before the filing date of this quarterly report. They concluded that as of the evaluation date, our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission (“SEC”) rules and forms.

(b)

Changes in internal controls

     Subsequent to the date of their evaluation, there were no significant changes in our internal controls or in other factors that could significantly affect these controls. There were no significant deficiencies or material weaknesses in our internal controls so no corrective actions were taken.

13

Table of Contents

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

     There have been no material developments since the quarter ended December 31, 2002.

Item 5. Other Information-Business Risks

     This document contains certain forward-looking statements (as such term is defined in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) pertaining to, among other things, Capstone’s future results of operations, R&D activities, sales expectations, our ability to develop markets for our products, sources for parts, federal, state and local regulations, and general business, industry and economic conditions applicable to Capstone. These statements are based largely on Capstone’s current expectations, estimates and forecasts and are subject to a number of risks and uncertainties. Actual results could differ materially from these forward-looking statements. Factors that can cause actual results to differ materially include, but are not limited to, those discussed below. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The following factors should be considered in addition to the other information contained herein in evaluating Capstone and its business. We undertake no obligation to revise or update publicly any of the forward-looking statements after the filing of this Form 10-Q to conform such statements to actual results or to changes in our expectations except as required by law.

     Investors should carefully consider the risks described below before making an investment decision. In addition, these risks are not the only ones facing our Company. Additional risks we are not presently aware of or that we currently believe are immaterial may also impair our business operations. Our business could be harmed by any of these risks. The trading price of our common stock has and could continue to decline due to any of these risks, and investors may lose all or part of their investment. In assessing these risks, investors should also refer to the other information contained or incorporated by reference in this Quarterly Report on Form 10-Q, or in our Annual Report on Form 10-K and other documents filed by us from time to time.

We have a limited operating history characterized by net losses, we anticipate continued losses and we may never become profitable.

     Since inception through March 31, 2003, we generated cumulative operating losses of approximately $277 million. We expect this trend to continue until such time that we can sell a sufficient number of units to achieve profitability. We have only been commercially producing Capstone MicroTurbines since December 1998. Our business is such that we have relatively few customers and limited repeat business. While the Company commenced a program to decrease expenses, there can be no assurance that expenses have been, or will be, decreased sufficiently to have adequate cash resources to reach the point of profitability, that the Company will not increase expenses in the future, that the Company will maintain or increase net revenues or that the Company will ever become profitable. Even if we do achieve profitability, we may be unable to increase our sales and sustain or increase our profitability in the future.

Our success depends in significant part upon the service of management and key employees.

     Our success depends in significant part upon the service of our executive officers, senior management, and sales and technical personnel. We have undergone numerous personnel changes in all levels of the organization. In particular, the Board is seeking a permanent CEO. Our inability to find an appropriate person for the CEO position may adversely impact the prospects for the Company. The failure of our personnel to execute our strategy, or our failure to retain management and personnel, could have a material adverse effect on our business. In addition, our interim CEO may make changes in management or our strategy that are not consistent with a new CEO’s strategic plans. If we are unable to develop and implement our strategy in a timely manner, our market penetration may be negatively impacted, which could have a material adverse effect on our business and results of operations. Our success will be dependent on our continued ability to attract, retain and motivate highly skilled employees. There can be no assurance that we can do so.

     Our internal control systems are highly dependent on detective controls performed by specific individuals in key positions at the Company. Detective controls are those designed to detect mistakes that have occurred and correct them. Loss of these key people

14

Table of Contents

or our inability to replace them with similarly skilled individuals or new processes in a timely manner could adversely impact our internal control mechanisms.

     We have reduced our personnel in order to reduce our operating costs. If we have terminated individuals whose skills we subsequently needed or if demand for our product significantly exceeds our expectations, our ability to generate revenues and maintain customer relationships could be adversely affected.

The economic downturn has made potential customers hesitant to make capital expenditures.

     The global economic climate has made potential customers hesitant to make capital expenditures. As a result, we have seen reluctance on the part of customers to buy our products. As a result of the economic uncertainty and the desire by companies to tighten capital expenditures, along with fluctuations in energy prices, political disruptions or the risk of higher interest rates, we may not be able to sustain or expand our customer base and sales, which would negatively impact our financial position and results of operations. The impact of continued lower capital spending may result in increased risk of excess and obsolete inventories, excess facilities and manufacturing capacity and higher overhead costs as a percentage of revenues.

If we do not effectively implement our sales and marketing plans, our sales will not grow and our profitability will suffer.

     Our sales and marketing efforts may not successfully compete against the more extensive and well-funded sales and marketing operations of our current and future competitors and therefore may not generate the net revenues anticipated. We market microturbine technology for use in stationary distributed power generation applications such as CHP, resource recovery and power quality and reliability as well as hybrid electric vehicles. We have decided to focus our resources on select vertical markets we believe have near term potential, such as those where we already have distributors. We may change our focus to other markets or applications in the future. There can be no assurance that our focus or our near term plans will be successful. If we are not able to successfully address markets for our products, we may not be able to grow our business, compete effectively or achieve profitability.

A sustainable market for microturbines may never develop or may take longer to develop than we anticipate, which would adversely impact our revenues and profitability.

     Our products represent an emerging market, and we do not know whether our targeted customers will accept our technology or will purchase our products in sufficient quantities to grow our business. If a sustainable market fails to develop or develops more slowly than we anticipate, we may be unable to recover the losses we have incurred to develop our products, we may have further impairment of assets, we may be unable to meet our operational expenses and we may be unable to achieve profitability. The development of a sustainable market for our systems may be impacted by many factors including some that are out of our control. Examples include:

	•		the cost competitiveness of our microturbines;
	•		costs associated with the installation and commissioning of our microturbines by third parties;
	•		maintenance costs associated with our microturbines;
	•		the future costs and availability of fuels used by our microturbines;
	•		consumer reluctance to try a new product;
	•		consumer perceptions of our microturbines’ safety and quality;
	•		regulatory requirements;
	•		economic downturns and reduction in capital spending; and
	•		the emergence of newer, more competitive technologies and products.

15

Table of Contents

We have limited experience in international sales and may not succeed in growing our international sales.

     We have limited experience in international sales and will depend on our international marketing partners for these sales. If a dispute arises between us and any of our partners, we may not achieve our desired sales results and we may be delayed or completely fail to penetrate some international markets, and our revenue and operations could be materially adversely affected. Any inability to obtain foreign regulatory approvals or quality standard certifications on a timely basis could negatively impact our business and results of operations. Also, as we seek to expand into the international markets, customers may have difficulty or be unable to integrate our products into their existing systems or may have difficulty meeting local standards. As a result, our products may require redesign. Any redesign of the product may delay sales or cause quality issues. In addition, we may be subject to a variety of other risks associated with international business, including:

	•		delays in establishing international distribution channels;
	•		difficulties in collecting international accounts receivables;
	•		difficulties in complying with foreign regulatory and commercial requirements;
	•		difficulties in recruiting and retaining individuals skilled in international business operations;
	•		increased costs associated with maintaining international marketing efforts;
	•		compliance with U.S. Department of Commerce export controls;
	•		increases in duty rates;
	•		the introduction of non-tariff trade barriers;
	•		fluctuations in currency exchange rates;
	•		global political and economic instability; and
	•		difficulties in enforcement of intellectual property rights.

Product quality expectations may not be met causing slower market acceptance.

     As we improve the quality and lower the maintenance costs of our products, we may require engineering changes. Such improvement initiatives may render existing inventories obsolete or excessive. Despite our continuous quality improvement initiatives, if we do not meet customer expectations, we may experience slower market acceptance of our products. Any significant quality issues with our products could have a material adverse effect on our results of operations and financial position. Moreover, as we develop new configurations for our microturbines or as our customers place existing configurations in commercial use, we may experience product malfunctions that cause our products to perform below expectations. Any significant malfunctions could adversely affect our operating results and financial position and affect the marketability of our products.

We depend upon the development of new products and enhancements of existing products.

     Our operating results may depend on our ability to develop and introduce new products, such as the C200 Microturbine, for existing and emerging markets and to reduce the costs to produce existing products. The success of new products is dependent on several factors, including proper new product definition, product cost, timely completion and introduction of new products, differentiation of new products from those of our competitors, meeting changing customer requirements, emerging industry standards and market acceptance of these products. The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation, as well as the accurate anticipation of technological and market trends. There can be no assurance that we will successfully identify new product opportunities, develop and bring new products to market in a timely manner, and achieve market acceptance of our products, or that products and technologies developed by others will not render our products or technologies obsolete or noncompetitive.

16

Table of Contents

     A key element of the Company’s strategy is the development of its C200 Microturbine planned for release in 2004. However, the Company has on occasion experienced delays in the introduction of new products and product enhancements. Such delays have, and any future delays could have, a material adverse effect on the Company’s business, operating results and financial condition. Furthermore, from time to time, the Company may announce new products or product enhancements, capabilities or technologies that have the potential to replace the Company’s existing product offerings and that may cause customers to defer purchasing existing Company products. Any failure to introduce new products or product enhancements on a timely basis, customer delays in purchasing products in anticipation of new product introductions or any inability of the Company to respond effectively to product announcements by competitors, technological changes or emerging industry standards could have a material adverse effect on the Company’s business, operating results and financial condition.

We operate in a highly competitive market and may not be able to compete effectively due to factors affecting the market for our products.

     The market for our products is highly competitive and is changing rapidly. We believe that the primary competitive factors affecting the market for our products include:

	•		operating efficiency;
	•		reliability;
	•		product quality and performance;
	•		life cycle costs;
	•		development of new products and features;
	•		quality and experience of sales, marketing and service organizations;
	•		availability and price of fuel;
	•		product price;
	•		emissions levels;
	•		name recognition; and
	•		quality of distribution channels.

     Several of these factors are outside our control. We cannot assure you that we will be able to compete successfully in the future with respect to these or any other competitive factors.

     In addition, competing technologies may get certain benefits, like governmental subsidies or promotion that we do not enjoy or do not benefit from to the same extent. This could enhance their abilities to fund research or penetrate markets.

Our competitors, who have significantly greater resources than we have, may be able to adapt more quickly to new or emerging technologies or to devote greater resources to the promotion and sale of their products, and we may be unable to compete effectively.

     Our competitors include several well-established companies that have substantially greater resources than we have and worldwide presence. Ingersoll-Rand Company and Elliott Power Systems are competitors of Capstone that benefit from larger corporate resources, including technical and engineering resources, and who have microturbines in various stages of development and commercialization. Ingersoll-Rand Company has commercialized its first line of microturbine units and has announced that it will be commercializing its 250-kilowatt product in 2003 which will directly compete with our C200 product targeted for release in 2004. Many of these companies sell directly to end-users, which we believe may provide some competitive advantages over our sales strategy. Furthermore, many of these companies offer a more comprehensive solution to their customers.

17

Table of Contents

     In addition to these competitors, Turbec, a joint venture in Europe of AB Volvo and ABB Ltd., develops, produces and sells microturbines. Turbec’s first product, a combined heat and power microturbine, is currently available. A number of other major automotive and industrial companies have in-house microturbine development efforts, including Ishikawajima-Harima Heavy Industries, Turbo Genset Inc., Toyota Motor Corporation and Kawasaki Heavy Industries. Furthermore, we believe that all of these companies will eventually have products that will compete with our microturbines. Some of our competitors are currently developing and testing larger microturbines than Capstone’s current MicroTurbine products, ranging up to 280 kilowatts, and which may have longer useful lives than Capstone MicroTurbines.

     Capstone MicroTurbines also compete with other existing technologies, including the electric utility grid, reciprocating engines, fuel cells and photovoltaic systems. Many of the competitors producing these technologies also have greater resources than we have. For instance, reciprocating engine generator sets are produced and sold by, among others, Caterpillar Inc., Interstate Companies, Cummins Inc., Yanmar, Hess and MAN. We cannot assure you that the market for distributed power generation products will not ultimately be dominated by technologies other than ours. Furthermore, electric utility companies may impose fees or other barriers that make microturbines less competitive.

     Because of greater resources, some of our competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements, to devote greater resources to the promotion and sale of their products than we can or introduce governmental regulations and policies to create competitive advantage vis-à-vis our products. We believe that developing and maintaining a competitive advantage will require continued investment by us in product development and quality, as well as attention to product performance, our product prices, our conformance to industry standards, manufacturing capability and sales and marketing.

     Achieving projected development schedules has a significant impact on customer expectations and near-term sales of products for which products under development could serve as a substitute. For example, we have projected that the C200 product will be commercially available in 2004; we cannot assure that we will meet this development schedule and may suffer an adverse impact on revenues if we fail to meet this schedule. In addition, current and potential competitors have established or may in the future establish collaborative relationships among themselves or with third parties, including third parties with whom we have business relationships. Accordingly, new competitors or alliances may emerge and rapidly acquire significant market share.

     There is no assurance that we will be able to successfully compete against either current or potential competitors or that competition will not have a material adverse effect on our business, operating results and financial condition.

Changes in government regulations and the electric utility industry restructuring may affect demand for our microturbines.

     The market for electricity and generation products is heavily influenced by federal and state government regulations and policies. The deregulation and restructuring of the electric industry in the United States and elsewhere may aid the desirability of alternative power sources. However, problems associated with such deregulation and restructuring may cause rule changes that may reduce or eliminate advantages of such deregulation and restructuring. We cannot predict how the deregulation and the restructuring of the electric utility industry will ultimately affect the market for our microturbines. Additional competition from utilities and other power sources that may take advantage of these regulations could diminish the demand for our products. While we have seen some increase in government support for distributed power, we cannot assure that this support will continue or that it will be maintained in its current form or that it will have any near-term impact on our operating results. For example, the California Self Generation Program is due to expire in December 2004. Changes in regulatory standards or policies could reduce the level of investment in the research and development of alternative power sources, including microturbines. Any reduction or termination of such programs can increase the cost to our potential customers, making our systems less desirable and thereby harm our revenue and potential profitability.

We operate in a highly regulated business environment and changes in regulation could impose costs on us or make our products less economical.

     Our products are subject to federal, state, local and foreign laws and regulations, governing, among other things, emissions to air as well as laws relating to occupational health and safety. Regulatory agencies may impose special requirements for implementation and operation of our products (e.g., connection with the electric grid) or may significantly impact or even eliminate some of our target markets. We may incur material costs or liabilities in complying with government regulations. In addition, potentially significant expenditures could be required in order to comply with evolving environmental and health and safety laws, regulations and requirements that may be adopted or imposed in the future. For example, our current products do not comply with the

18

Table of Contents

2007 proposed emission standards of the California Air Resources Board. Furthermore, our potential utility customers must comply with numerous laws and regulations. The deregulation of the utility industry may also create challenges for our marketing efforts. For example, as part of electric utility deregulation, federal, state and local governmental authorities may impose transitional charges or exit fees, which would make it less economical for some potential customers to switch to our products. Further, our ability to penetrate the Japanese market will depend on our receipt of approvals and changes to regulatory requirements surrounding power generation by Japanese regulators. We can provide no assurances that we will be able to obtain these approvals and changes in a timely manner, or at all.

Utility companies could place barriers to our entry into the marketplace and we may not be able to effectively sell our product.

     Utility companies may charge additional fees to industrial customers who install on-site generation, thereby reducing the electricity they take from the utility, or for having the capacity to use power from the grid for back-up or standby purposes. For example, the New York Public Service Commission is currently in the process of adopting new standby charges. These types of fees or charges could increase the cost to our potential customers for using our systems and could make our systems less desirable, thereby harming our revenue and profitability potential. In addition, utility rate reductions can make our products less competitive which will have a material adverse effect on our operations. The California Public Utility Commission will be considering new rate proposals for investor owned utilities.

We may not be able to retain or develop additional strategic partners and distributors in our targeted markets, in which case our sales would not increase as expected.

     In order to expand our customer base, we believe that we must enter into strategic sales and marketing alliances or similar collaborative relationships, in which we ally ourselves with companies that have particular expertise in or more extensive access to desirable markets. We believe that developing strategic partners in our targeted markets can improve the rate of adoption as well as reduce the direct financial burden of introducing a new technology and creating a new market. We may provide volume price discounts or otherwise incur significant costs that may reduce the potential profitability of these relationships. We may not be able to retain or develop appropriate distributors or strategic partners on a timely basis, and we cannot assure you that the partners with which we form alliances will focus adequate resources on selling our products or will be successful in selling them. In addition, some of the relationships may require that we grant exclusive distribution rights in defined territories. These exclusive distribution arrangements could result in us being unable to enter into other arrangements at a time when the distributor or partner with whom we form a relationship is not successful in selling our products or has reduced its commitment to market our products. We cannot assure you that we will be able to negotiate collaborative relationships on favorable terms or at all. The inability of the Company to develop strategic partners or a lack of success of our strategic partners in marketing our products may adversely affect our financial condition and results of operations.

We are subject to risks associated with our strategic alliance with United Technologies Corporation.

     In October 2002, we entered into a strategic alliance with UTC through its UTC Power Division. The strategic alliance between UTC and Capstone is a ten-year agreement that involves the integration, marketing, sales and service of CHP solutions targeted for commercial buildings. The UTC Agreement provides for the combination of our microturbine products with their absorption chillers. We cannot assure that we can complete this integration in a cost effective manner or consistent with UTC’s or our timing expectations. UTC will be the exclusive distributor for the combined Capstone MicroTurbines with UTC absorption chillers, but they will also be a non-exclusive distributor generally for Capstone MicroTurbines. The UTC Agreement is limited to North America and most of Europe. However, this alliance may not be successful and may create channel conflict with our other distributors. If this relationship fails to materialize as expected then this may impede our future growth and a sustainable market may fail to develop. Furthermore, although both parties have certain competitive restrictions, UTC may offer alternative solutions, designed by themselves or third parties. There can be no assurance that UTC will give a high priority to the marketing of the Company’s products as compared to its other products or alternative solutions. Both UTC and Capstone have options to terminate the relationship if the other company fails to meet its development, product purchase or other goals in the UTC Agreement. There can be no assurance that the Company will retain its relationship with UTC. We do not expect short-term operating benefits from the UTC relationship but we have incurred and will incur short-term costs to create this alliance and fulfill our obligations under the UTC Agreement.

     As part of the UTC Agreement, UTC purchased 3,994,817 shares of Capstone’s common stock (the “UTC Shares”) in October 2002 for an aggregate price of approximately $4.0 million. The UTC shares are subject to a lock-up period of nine months subject to certain exceptions provided for in the UTC Agreement. Any sale by UTC of the UTC Shares may be viewed by the

19

Table of Contents

investing public as a drawback to the relationship that could have a material adverse effect on the Company’s stock price and financial condition.

Our ability to identify and develop Authorized Service Providers (“ASPs”) can significantly impact our success.

     Our ability to identify and develop business relationships with ASPs who can provide quality, cost effective installations and service can significantly impact our success. We need to reduce the total installed cost of our microturbines to enhance market opportunities. Our inability to improve our ASPs’ quality of installation and commissioning standards while reducing associated costs could affect the marketability of our products.

Our suppliers and manufacturers may not supply us with a sufficient amount of components or components of adequate quality, and we may not be able to produce our product.

     Although we generally attempt to use standard parts and components for our products, some of our components are currently available only from a single source or limited sources. We may experience delays in production if we fail to identify alternative vendors, or any parts supply is interrupted, each of which could materially adversely affect our business and operations. In order to reduce manufacturing lead times and ensure adequate component supply, we enter into agreements with certain contract manufacturers and supply partners that allow them to procure inventory based upon criteria defined by us. If we fail to anticipate customer demand properly, an oversupply of parts could result in excess or obsolete inventories, which could adversely affect our business. A reduction or interruption in supply, a significant increase in price of one or more components or a decrease in demand of products could materially adversely affect our business and operations and could materially damage our customer relationships. Also, we cannot guarantee that any of the parts or components that we are obligated to purchase will be of adequate quality or that the prices we pay for the parts or components will not increase. Our inability to meet volume commitments with suppliers could affect the availability or pricing of our parts and components. Financial problems of contract manufacturers on whom we rely could limit our supply or increase our costs.

We may not achieve production cost reductions necessary to competitively price our product, which would impair our sales.

     We believe that we will need to reduce the unit production cost of our products over time to maintain our ability to offer competitively priced products. Our ability to achieve cost reductions will depend on our ability to develop low cost design enhancements, to obtain necessary tooling and favorable vendor contracts, as well as to increase sales volumes so we can achieve economies of scale. We cannot assure you that we will be able to achieve any production cost reductions. Our failure to achieve such cost reductions could have a material adverse effect on our business and results of operations.

Our products involve a lengthy sales cycle and we may not anticipate sales levels appropriately, which could impair our profitability.

     The sale of our products typically involves a significant commitment of capital by customers, with the attendant delays frequently associated with large capital expenditures. For these and other reasons, the sales cycle associated with our products is typically lengthy and subject to a number of significant risks over which we have little or no control. We expect to plan our production and inventory levels based on internal forecasts of customer demand, which is highly unpredictable and can fluctuate substantially. If sales in any period fall significantly below anticipated levels, our financial condition and results of operations could suffer. If demand in any period increases well above anticipated levels, we may have difficulties in responding, incur greater costs to respond, or be unable to fulfill the demand in sufficient time to retain the order. In addition, our operating expenses are based on anticipated sales levels, and a high percentage of our expenses are generally fixed in the short term. As a result of these factors, a small fluctuation in timing of sales can cause operating results to vary from period to period.

We may not effectively expand our production capabilities, which would negatively impact our sales.

     We may experience unanticipated growth in our business operations, which may require expansion of our internal and external production capabilities. We may experience delays or problems in expanding production that could significantly impact our business. Several factors could delay or prevent production expansion, including our:

	•		inability to purchase parts or components in adequate quantities or sufficient quality;
	•		failure to increase our assembly and test operations;

20

Table of Contents

	•		failure to hire and train additional personnel;
	•		failure to develop and implement manufacturing processes and equipment;
	•		inability to find and train proper partner companies with whom we can build product distribution, marketing, or development relationships; and
	•		inability to manufacture recuperator cores or air bearings on schedule, in quantities or with the quality that we require.

If we are unable to manufacture recuperator cores internally, our assembly and production of microturbines may suffer delays and interruptions.

     Solar Turbines Incorporated (“Solar”) was our sole supplier of recuperator cores, which are heat exchangers that preheat incoming air before it enters the combustion chamber and are an essential component of our microturbines. In 2001, we started to manufacture recuperator cores under contractual rights to use Solar’s intellectual property. We cannot assure you that we will be able to successfully implement this technology in developing a sustainable manufacturing process at higher volumes. While on a demonstration basis, we have shown the ability to produce 50 cores in one week, this may not be sustainable as we are not experienced in manufacturing recuperator cores. Inherent in the manufacturing process are a number of risks. Manufacturing of the recuperator cores is a complex process requiring high levels of innovation and skill. At present, we are not aware of any other supplier that could produce these cores to our specifications within our time requirements. As a result of recent cost cutting measures, we have fewer people skilled in manufacturing recuperator cores. Our inability to manufacture recuperator cores could have a material adverse effect on the Company’s operating results.

Our business is especially subject to the risk of earthquake.

     Our Company and our manufacturing facilities are located in Southern California, a region known for seismic activity. A significant natural disaster, such as an earthquake, could have a material adverse impact on our business, operating results and financial condition.

We may not be able to effectively manage our growth or improve our operational, financial and management information systems, which would impair our profitability.

     If we are successful in executing our business plan, we will experience growth in our business that could place a significant strain on our management and other resources. Our ability to manage our growth will require us to continue to improve our operational, financial and management information systems, to implement new systems and to motivate and effectively manage our employees. We cannot assure you that our management will be able to effectively manage this growth.

We depend on our intellectual property to make our products competitive and if we are unable to protect our intellectual property, our business will suffer.

     We rely on a combination of patent, trade secret, copyright and trademark law, and nondisclosure agreements to establish and protect our intellectual property rights in our products. In particular, we believe that our patents and patents pending for our air-bearing systems, power electronics and controls and our combustion systems are key to our business. We believe that, due to the rapid pace of technological innovation in turbine products, our ability to establish and maintain a position among the technology leaders in the industry depends on both our patents and other intellectual property and the skills of our development personnel. We cannot assure you that any patent, trademark, copyright or license owned or held by us will not be invalidated, circumvented or challenged, that the rights granted thereunder will provide competitive advantages to us or that any of our future patent applications will be issued with the scope of the claims asserted by us, if at all. Further, we cannot assure you that third parties or competitors will not develop technologies that are similar or superior to our technology, including our air bearing technology, duplicate our technology or design around our patents. Also, another party may be able to reverse engineer our technology and discover our intellectual property and trade secrets. We may be subject to or may initiate proceedings in the U.S. Patent and Trademark Office, which can require significant financial and management resources or require us to develop a non-infringing technology or enter into royalty or license agreements. If we are found to infringe upon the intellectual property rights of others, we may not be able to produce our products or may have to enter into costly license agreements. In addition, the laws of foreign countries in which our products are or may be developed, manufactured or sold may not protect our products and intellectual property rights to the same extent as the laws of the United States.

21

Table of Contents

Our inability to protect our intellectual property adequately could have a material adverse effect on our financial condition or results of operations.

Potential intellectual property, shareholder or other litigation may adversely impact our business.

     Because of the nature of our business, we may face litigation relating to intellectual property matters, labor matters, product liability and shareholder disputes. For example, in December 2001, a purported shareholder class action lawsuit was filed in the United States District Court for the Southern District of New York against the Company, two of its officers, and the underwriters of our initial public offering. The suit purports to be a class action filed on behalf of purchasers of our common stock during the period from June 28, 2000 to December 6, 2000. An amended complaint was filed on April 19, 2002. No date has been set for the Company to respond to the complaint. Plaintiffs allege that the underwriter defendants agreed to allocate stock in the Company’s June 28, 2000 initial public offering and November 16, 2000 secondary offering to certain investors in exchange for excessive and undisclosed commissions and agreements by those investors to make additional purchases of stock in the aftermarket at pre-determined prices. Plaintiffs allege that the prospectuses for these two public offerings were false and misleading in violation of the securities laws because they did not disclose these arrangements. The Company understands that over three hundred other issuers have been named as defendants in nearly identical lawsuits filed by some of the same plaintiffs’ law firms. We intend to defend these actions vigorously. However, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of the litigation. Any unfavorable outcome of litigation could have a material adverse effect on the Company’s financial position and results of operations.

     Our intellectual property is one of our principal assets. A negative outcome in litigation relating to our intellectual property could have a material adverse effect on our business and operating results. An adverse judgment could negatively impact the price of our common stock and our ability to obtain future financing on favorable terms or at all. Any litigation could be costly, divert management attention or result in increased costs of doing business.

We may be unable to fund our future operating requirements, which could force us to curtail our operations.

     We are a capital-intensive company and may need additional financing to fund our operations. Our future capital requirements will depend on many factors, including our ability to successfully market and sell our products. To the extent that the funds we now have on hand are insufficient to fund our future operating requirements, we will need to raise additional funds, through further public or private equity or debt financings. These financings may not be available or, if available, may be on terms that are not favorable to us and could result in further dilution to our stockholders. Downturns in worldwide capital markets may also impede our ability to raise additional capital on favorable terms or at all. If adequate capital were not available to us, we would likely be required to significantly curtail or possibly even cease our operations.

     We may encounter greater business risks in the future as we manage cash resources differently. In 2002, we undertook efforts to lower our cash burn rate. As a result of those and ongoing efforts, we may not spend money in areas that ultimately prove important to the business. We may incur greater risks through lower spending rates for insurance, intellectual property protection, total employee compensation and other areas.

Termination of certain Supply and Distribution Agreements may require us to repurchase parts inventory.

     We have certain Supply and Distribution Agreements and ASP agreements that upon termination under specified conditions require us to repurchase particular elements of their parts inventories. To date, these conditions have never arisen and we believe that the amounts of such inventories currently are not significant. It is possible, however, that in the future such conditions could occur that would require such repurchases. These repurchases could result in higher prices for the repurchased parts inventory than would otherwise be required to secure such quantities or could result in excess quantities of some parts inventory. In addition, certain ASP agreements require us to provide service to the customers of the ASP upon termination of the ASP agreement under specified conditions, until such time that we can identify and transfer the obligation to a new ASP. Since we do not have control over the terms of such third-party service agreements, we may be exposed to significant risks and expenses that we cannot adequately quantify. To date these conditions have not arisen, however, any significant exposure from such third-party service agreements in the future could have a material effect on our results of operations and financial position.

22

Table of Contents

We face potentially significant fluctuations in operating results, which could impact our stock price.

     As a result of variety of factors discussed herein, operating results for a particular quarter are difficult to predict. Given the continued uncertainty surrounding many variables that may impact the industry in which we operate, our visibility into future periods is limited. Our net sales may grow at a slower rate than experienced in the past periods and, in particular periods or overall, may decline. A number of factors could affect our operating results and thereby impact our stock price, including:

	•		the timing of the introduction or enhancement of products by us or our competitors;
	•		quality of installation and commissioning of our products by our ASPs and customers;
	•		our reliance on a small number of customers;
	•		the lack of order backlog;
	•		the size, timing, shipment and pricing of individual orders;
	•		market acceptance of new products;
	•		customers delaying orders of our products because of the anticipated release of new products by us or our competitors;
	•		changes in our operating expenses, the mix of products sold, or product pricing;
	•		the ability of our suppliers to deliver quality parts when we need them;
	•		development of our direct and indirect sales channels;
	•		change in management and loss of key personnel;
	•		political unrest or changes in the trade policies, tariffs or other regulations of countries in which we do business that could lower demand for our products;
	•		changes in environmental regulations; and
	•		changes in market prices for natural resources that could lower the desirability of our products.

     Because we are in the early stages of selling our products, with relatively few customers, we expect our order flow to continue to be uneven from period to period. In addition, we do not have an established base of customers that we can rely on for repeat sales. Because a significant portion of our expenses is fixed, a small variation in the timing of recognition of revenue can cause significant variations in operating results from quarter to quarter. Any of the above factors could have a material adverse effect on our operations and financial results.

The market price of our common stock is highly volatile and may decline regardless of our operating performance.

     The market price of our common stock is highly volatile. Many factors of this volatility are beyond our control. These factors may cause the market price of our common stock to decline, regardless of our operating performance. Factors that could cause fluctuation in our stock price may include, among other things:

	•		actual or anticipated variations in quarterly operating results;
	•		changes in financial estimates by securities analysts;
	•		conditions or trends in our industry or the overall economy;
	•		changes in the market valuations of other technology companies;

23

Table of Contents

	•		the listing for trading of options on our common stock;
	•		announcements by us or our competitors of significant acquisitions, strategic partnerships, divestitures, joint ventures or other strategic initiatives;
	•		capital commitments;
	•		additions or departures of key personnel; and
	•		sales of common stock.

Our announced stock repurchase program may not produce benefits for stockholders.

     Capstone may not purchase the approved maximum $10 million under the repurchase program announced in October 2002 or may not acquire shares at prices that later appear advantageous. We cannot assure stockholders that using cash for this purpose will result in short-term or long-term benefits for our stockholders.

Our NASDAQ National Market listing may be adversely affected if our stock price does not rise and we are unable to meet NASDAQ’s listing requirements through other actions.

     In order to continue to be listed on the NASDAQ National Market, we must meet specific quantitative standards, including a minimum bid price. On March 18, 2003, we received notice from the NASDAQ that the price of our stock had closed below the minimum $1.00 per share requirement for 30 consecutive trading days. Therefore, in accordance with Marketplace Rule 4450(e)(2), we will be provided until September 15, 2003 to regain compliance. In the event that we should fail to meet this listing requirement, we may appeal such determination, we may apply for listing on the NASDAQ SmallCap Market (where we may have up to an additional nine months to comply with the minimum bid price requirements for continued listing) or we may pursue alternative strategies to allow our common stock to continue to be listed. If we fail to meet the continuing listing standards for the NASDAQ National Market (and, should we be listed on the NASDAQ SmallCap Market, if we fail to meet the continuing listing standards for the NASDAQ SmallCap Market), our stock may be delisted. The delisting of our common stock would adversely affect the liquidity and trading price of our securities. In addition, it would make it difficult for investors to obtain accurate quotations of the share price of our common stock.

24

Table of Contents

Item 6. Exhibits and Reports on Form 8-K:

(a)

Index to Exhibits.

               The following exhibits are filed with, or incorporated by reference into, this Quarterly Report on Form 10-Q:

(1)		Filed herewith.
(2)		Incorporated by reference to Capstone Turbine’s Registration Statement on Form S-1 (File No. 333-33024).
(3)		Incorporated by reference to Capstone Turbine’s Registration Statement on Form S-1 (File No. 333-48524).
(4)		Incorporated by reference to Capstone Turbine’s Current Report on Form 8-K filed on October 16, 2000.
(5)		Incorporated by reference to Capstone Turbine’s Registration Statement on Form S-8 (File No. 333-66390).
(6)		Incorporated by reference to Capstone Turbine’s Annual Report on Form 10-K for the year ended December 31, 2001 (File No. 001-15957).
(7)		Incorporated by reference to Capstone Turbine’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2002 (File No. 001-15957).
(8)		Incorporated by reference to Capstone Turbine’s Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 001-15957).

(b)

Reports on Form 8-K. None

25

Table of Contents

SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

26

Table of Contents

CERTIFICATION

I, Emily Liggett, certify that:

1.		I have reviewed this quarterly report on Form 10-Q of Capstone Turbine Corporation;
2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiary, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.

The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.