**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**







**FORM
      10-Q**


**(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, 2006**


**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: 0-15930**







**SOUTHWALL
      TECHNOLOGIES INC.**


(Exact
      name of registrant as specified in its charter)





**Delaware**
            
            **94-2551470**(State
                or other jurisdiction of incorporation or organization)
            
            (I.R.S.
                Employer Identification Number)**3975
                East Bayshore Road, Palo Alto, California**
            
            **94303**(Address
                of principal executive offices)
            
            (Zip
                Code)








Registrant's
      telephone number, including area code: **(650) 962-9111**







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 a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      One).





Large
                accelerated filer ̈
            Accelerated
                filer ̈
            Non-accelerated
                filerx





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).  Yes o No x





Applicable
      only to Issuers Involved in Bankruptcy


Proceeding
      During the Preceding Five Years





Indicate
      by check mark whether the registrant has filed documents and reports required
      to
      be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934
      subsequent to the distribution of securities under a plan confirmed by a
      court.  Yes o No o





As
      of May
      1, 2006, there were 26,949,201 shares of the Registrant's Common Stock
      outstanding.










1





**SOUTHWALLTECHNOLOGIES INC.**





**INDEX**





PagePART
                I - FINANCIAL INFORMATION________Item
                1
            Financial
                StatementsUnaudited
                Condensed Consolidated Balance Sheets - March
                31, 2006 and December 31, 2005
            3Unaudited
                Condensed Consolidated Statements of
                Operations - Three month periods ended March 31, 2006 and April 3,
                2005
            4Unaudited
                Condensed Consolidated Statements of Cash Flows
                - Three month periods ended March 31, 2006 and April 3,
                2005
            5Notes
                to the Unaudited Condensed Consolidated Financial
                StatementsItem
                2
            Management’s
                Discussion and Analysis of Financial Condition
                and Results of Operations
            14Item
                3
            Quantitative
                and Qualitative Disclosures about Market
                Risk
            21Item
                4
            Controls
                and Procedures
            23PART
                II - OTHER INFORMATIONItem
                1
            Legal
                Proceedings
            24Item
                1A
            Risk
                Factors
            24Item
                2
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            27Item
                3
            Defaults
                upon Senior Securities
            27Item
                4
            Submission
                of Matters to a Vote of Security
                Holders
            27Item
                5
            Other
                Information
            27Item
                6
            Exhibits
            27Signatures
            28





2
 *Index*




PARTI.
      FINANCIAL INFORMATION


Item1--Financial
      Statements:


**SOUTHWALLTECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED BALANCE SHEETS**


**(in
      thousands, except per share data)**




March
                31,
              2006
            
            December
                31,
              2005**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            5,117
            
            $
            6,600Restricted
                cash
            
            
            398
            
            
            402Accounts
                receivable, net of allowance for doubtful accounts of $203at
                March 31, 2006 and $208 at December 31, 2005
            
            
            6,293
            
            
            6,780Inventories,
                net
            
            
            7,258
            
            
            5,879Other
                current assets
            
            
            909
            
            
            982Total
                current assets
            
            
            19,975
            
            
            20,643Property,
                plant and equipment, net
            
            
            16,929
            
            
            16,857Restricted
                cash loans
            
            
            1,021
            
            
            995Other
                assets
            
            
            1,126
            
            
            1,146Total
                assets
            
            $
            39,051
            
            $
            39,641**LIABILITIES,
                PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Current
                portion of long term debt
            
            $
            1,171
            
            $
            1,317Line
                of credit
            
            
            2,996
            
            
            2,996Accounts
                payable
            
            
            2,551
            
            
            1,402Accrued
                compensation
            
            
            990
            
            
            1,161Other
                accrued liabilities
            
            
            4,518
            
            
            5,076Total
                current liabilities
            
            
            12,226
            
            
            11,952Term
                debt
            
            
            8,728
            
            
            8,790Government
                grants advanced
            
            
            398
            
            
            396Other
                long term liabilities
            
            
            2,585
            
            
            2,564Total
                liabilities
            
            
            23,937
            
            
            23,702Commitments
                and contingencies (Note 5)Series
                A 10% cumulative convertible preferred stock, $0.001 par value; $1.00
                stated value; 5,000 shares authorized, 4,893 shares outstanding at
                March
                31, 2006 and December 31, 2005, respectively (Liquidation preference:
                $5,505 and $5,383 at March 31, 2006 and December 31, 2005,
                respectively)
            
            
            4,810
            
            
            4,810Stockholders’
                equity:Common
                stock, $0.001 par value per share; 50,000 shares authorized, 26,893
                shares
                and 26,793 shares outstanding at March 31, 2006 and December 31,
                2005,
                respectively
            
            
            27
            
            
            27Capital
                in excess of par value
            
            
            78,007
            
            
            77,828Accumulated
                other comprehensive income:Accumulated
                translation adjustment
            
            
            2,856
            
            
            2,532Accumulated
                deficit
            
            
            (70,586
            )
            
            (69,258
            )Total
                stockholders’ equity
            
            
            10,304
            
            
            11,129Total
                liabilities, preferred stock and stockholders’ equity
            
            $
            39,051
            
            $
            39,641





See
      accompanying notes to unaudited condensed consolidated financial
      statements.





3
 *Index*




**SOUTHWALLTECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**


**(in
      thousands, except per share data)**





Three
                months endedMarch
                31,
              2006
            
            April
                3,
              2005Net
                revenues
            
            $
            10,034
            
            $
            15,647Cost
                of revenues
            
            
            6,366
            
            
            11,270Gross
                profit
            
            
            3,668
            
            
            4,377Operating
                expenses:Research
                and development
            
            
            1,646
            
            
            696Selling,
                general and administrative
            
            
            2,562
            
            
            2,026Impairment
                recoveries for long-lived assets
            
            
            -
            
            
            (170
            )Restructuring
                charges
            
            
            452
            
            
            -Total
                operating expenses
            
            
            4,660
            
            
            2,552Income
                (loss) from operations
            
            
            (992
            )
            
            1,825Interest
                expense, net
            
            
            (192
            )
            
            (271
            )Other
                income (expenses), net
            
            
            150
            
            
            292Income
                (loss) before provision for income taxes
            
            
            (1,034
            )
            
            1,846Provision
                for income taxes
            
            
            293
            
            
            147Net
                income (loss)
            
            
            (1,327
            )
            
            1,699Deemed
                dividend on preferred stock
            
            
            122
            
            
            123Net
                income (loss) attributable to common stockholders
            
            $
            (1,449
            )
            $
            1,576Net
                income (loss) per share:Basic
            
            $
            (0.05
            )
            $
            0.06Diluted
            
            $
            (0.05
            )
            $
            0.05Shares
                used in computing net income (loss) per share:Basic
            
            
            26,825
            
            
            26,613Diluted
            
            
            26,825
            
            
            33,181





See
      accompanying notes to unaudited condensed consolidated financial
      statements.





4
 *Index*





**SOUTHWALLTECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(in
      thousands)**





Three
                months endedMarch
                31,
              2006
            
            April
                3,
              2005Cash
                flows from operating activities:Net
                income (loss)
            
            $
            (1,327
            )
            $
            1,699Adjustments
                to reconcile net income (loss) to net cash (used in) provided by
                operating
                activities:Deferred
                income tax
            
            
            82
            
            
            -Impairment
                recoveries from long-lived assets
            
            
            -
            
            
            (170
            )Depreciation
                and amortization
            
            
            518
            
            
            623Stock
                compensation
            
            
            231
            
            
            91Change
                in assets and liabilities:Deferred
                revenues
            
            
            (8
            )
            
            (8
            )Accounts
                receivable, net
            
            
            487
            
            
            (334
            )Inventories,
                net
            
            
            (1,379
            )
            
            (8
            )Other
                current and non current assets
            
            
            69
            
            
            (570
            )Accrued
                restructuring
            
            
            421
            
            
            -Accrued
                liabilities—deferred rent
            
            
            (1,192
            )
            
            -Accounts
                payable and accrued liabilities
            
            
            1,110
            
            
            (764
            )Net
                cash (used in) provided by operating activities
            
            
            (988
            )
            
            559Cash
                flows from investing activities:Decrease
                in restricted cash
            
            
            5
            
            
            191Proceeds
                from sale of property, plant and equipment
            
            
            -
            
            
            170Expenditures
                for property, plant and equipment
            
            
            (168
            )
            
            (136
            )Net
                cash provided by (used in) investing activities
            
            
            (163
            )
            
            225Cash
                flows from financing activities:Repayments
                under capital lease
            
            
            -
            
            
            (4
            )Proceeds
                from exercise of stock options
            
            
            -
            
            
            19Principal
                payments on borrowings
            
            
            (422
            )
            
            (812
            )Investment
                credit in Germany
            
            
            (9
            )
            
            (5
            )Net
                cash used in financing activities
            
            
            (431
            )
            
            (802
            )Effect
                of foreign exchange rate changes on cash
            
            
            99
            
            
            (10
            )Net
                decrease in cash and cash equivalents
            
            
            (1,483
            )
            
            (28
            )Cash
                and cash equivalents, beginning of period
            
            
            6,600
            
            
            4,547Cash
                and cash equivalents, end of period
            
            $
            5,117
            
            $
            4,519





See
      accompanying notes to unaudited condensed consolidated financial
      statements.





5
 *Index*





**SOUTHWALLTECHNOLOGIES INC.**


**NOTES
      TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**(in
      thousands, except per share data)**




**Note 1--Interim
      Period Reporting:**





The
      accompanying interim condensed consolidated financial statements of Southwall
      Technologies Inc. (“Southwall” or the “Company”) are unaudited and have been
      prepared in accordance with accounting principles generally accepted in the
      United States of America for interim financial information and with the
      instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain
      information and footnote disclosure normally included in financial statements
      prepared in accordance with accounting principles generally accepted in the
      United States of America have been condensed or omitted. In the opinion of
      management, the unaudited condensed consolidated financial statements reflect
      all adjustments, consisting only of normal recurring adjustments, considered
      necessary to present fairly the financial position, results of operations and
      cash flows of Southwall and its subsidiaries for all periods presented. The
      Company suggests that these condensed consolidated financial statements be
      read
      in conjunction with the consolidated financial statements and notes thereto
      contained in the Company's Form 10-K for the year ended December 31,
      2005 filed with the Securities and Exchange Commission on March 29, 2006. The
      results of operations for the interim periods presented are not necessarily
      indicative of the operating results of the full year.





The
      Company uses a 52-week fiscal year ending on December 31. The quarters
      ended March 31, 2006 and April 3, 2005 each included 13 weeks.





**Note 2--Inventories,
      Net:**





Inventories
      are stated at the lower of cost (determined by the first-in, first-out method)
      or market. Cost includes materials, labor and manufacturing overhead. The
      Company establishes provisions for excess and obsolete inventories to reduce
      such inventories to their estimated net realizable value. Such provisions are
      charged to cost of revenues. At March 31, 2006 and December 31, 2005,
      inventories consisted of the following (in thousands):




March
                    31,
                  2006
                
                December
                    31,
                  2005Raw
                    materials
                
                $
                3,754
                
                $
                3,482Work-in-process
                
                
                1,603
                
                
                1,409Finished
                    goods
                
                
                1,901
                
                
                988$
                7,258
                
                $
                5,879


**Note 3--Net
      Income (Loss) Per Share:**





Basic
      net
      income (loss) per share is computed by dividing net income (loss) attributable
      to common stockholders (numerator) by the weighted average number of common
      shares outstanding (denominator) for the period. Diluted net income (loss)
      per
      share gives effect to all dilutive common shares potentially outstanding during
      the period, including stock options, warrants to purchase common stock and
      convertible preferred stock. Preferred stock dividends are added back to net
      income attributable to common stockholders since they would not have been
      accrued if the preferred stock had been converted to common stock at the
      beginning of the period.





6
 *Index*





The
      Company excludes options from the computation of diluted weighted average shares
      outstanding if the exercise price of the options is greater than the average
      market price of the shares because the inclusion of these options would be
      anti-dilutive to earnings per share.  Accordingly, stock options to
      purchase 1,800 shares at a weighted average price of $3.82 per share were
      excluded from the computation of diluted weighted average shares outstanding
      for
      the three-month period ended April 3, 2005.





In
      net
      loss periods, the basic and diluted weighted average shares of common stock
      and
      common stock equivalents are the same because inclusion of common stock
      equivalents would be anti-dilutive. Accordingly, for the three-month period
      ended March 31, 2006, there was no difference between the denominators used
      for
      the calculation of basic and diluted net income (loss) per share. For the
      three-month period ended March 31, 2006, there were 5,680 options outstanding
      and excluded from the net loss per share calculation. Tables
      summarizing net income (loss) attributable to common stockholders, for diluted
      net income (loss) per share, and shares outstanding are shown below (in
      thousands):





Three
                months endedMarch
                31,
              2006
            
            April
                3,
              2005Net
                income (loss) attributable to common stockholders-basic
            
            $
            (1,449
            )
            $
            1,576Add:
                Deemed dividend on preferred stock
            
            
            122
            
            
            123Net
                income (loss) attributable to common stockholders-diluted
            
            $
            (1,327
            )
            $
            1,699Weighted
                average common shares outstanding-basic
            
            
            26,825
            
            
            26,613Dilutive
                effect of warrants
            
            
            -
            
            
            357Dilutive
                effect of performance shares
            
            
            -
            
            
            149Dilutive
                effect of Series A preferred shares
            
            
            -
            
            
            4,893Dilutive
                effect of stock options
            
            
            -
            
            
            1,169Weighted
                average common shares outstanding - diluted
            
            
            26,825
            
            
            33,181





**Note 4
      - Segment Reporting:**





Southwall
      operates in one segment.





The
      total
      net revenues for the automotive glass, electronic display, window film and
      architectural product lines for the three-month periods ended March 31, 2006
      and
      April 3, 2005 were as follows (in thousands):




Three
                months endedMarch
                31,
              2006
            
            April
                3,
              2005Automotive
                glass
            
            $
            2,879
            
            $
            6,385Electronic
                display
            
            
            2,491
            
            
            4,079Window
                film
            
            
            3,452
            
            
            3,646Architectural
            
            
            1,212
            
            
            1,537Total
                net revenues
            
            $
            10,034
            
            $
            15,647





The
      following is a summary of net revenues by geographic area (based on the location
      of the Company's customers) for the three-month periods ended March 31, 2006
      and
      April 3, 2005, respectively (in thousands):





Three
                months endedMarch
                31,
              2006
            
            April
                3,
              2005United
                States
            
            $
            3,647
            
            $
            3,716Japan
            
            
            2,108
            
            
            3,799France
            
            
            142
            
            
            3,323Pacific
                Rim
            
            
            2,915
            
            
            2,562Germany
            
            
            779
            
            
            1,345Rest
                of the world
            
            
            443
            
            
            902Total
                net revenues
            
            $
            10,034
            
            $
            15,647





7
 *Index*





**Note 5--Commitments
      and Contingencies:**





*Commitments*





On
      January 19, 2006, the Company announced its plans to close its Palo Alto
      manufacturing facility. As a result of this decision, the Company is in
      negotiation with its landlords to decommission and surrender these premises.
      The
      Company has recognized $0.2 million of liability on one of its buildings. No
      liability has been recognized with respect to the second building at this time
      because the Company cannot ascertain the fair value of any potential obligation
      to this landlord because the settlement date and method of settlement for our
      obligation have not been specified, and the Company currently does not have
      sufficient information to reasonably estimate any potential obligation. The
      Company believes that it can resolve this issue with this landlord and will
      pay
      for any potential obligations in the second half of 2006. It is possible that
      our estimate of our lease obligation could change in the near term.





On
      February 19, 2004, the Company entered into the second amendment to the lease
      for the second building. The amendment reflected a payment schedule for a rent
      deferral for this legal agreement. In January of 2006, the Company paid off
      approximately $1.2 million of this deferred rent. As of March 31, 2006, there
      was no deferred rent outstanding.





*Contingencies*





The
      Company was named as a defendant, along with Bostik, Inc., in an action
      captioned WASCO Products, Inc. v. Southwall Technologies, Inc. and Bostik,
      Inc.,
      Civ. Action No. C 02 2926 SBA, which was filed in Federal District Court for
      the
      Northern District of California on June 18, 2002. We were served with the
      Complaint in this matter on July 1, 2002. The plaintiff filed the matter as
      a
      class action on behalf of all entities and individuals in the United States
      who
      manufactured and/or sold and warranted the service life of insulated glass
      units
      manufactured between 1989 and 1999, which contained Southwall Heat Mirror film
      and were sealed with a specific type of sealant manufactured by Bostik, Inc.
      The
      plaintiff alleged that the sealant provided by Bostik, Inc. was defective,
      resulting in elevated warranty replacement claims and costs. The plaintiff
      asserted claims against us for breach of an implied warranty of fitness,
      misrepresentation, fraudulent concealment, negligence, negligent interference
      with prospective economic advantage, breach of contract, unfair business
      practices and false or misleading business practices. The plaintiff sought
      recovery on behalf of the class of $100 million for damages allegedly resulting
      from elevated warranty replacement claims, restitution, injunctive relief,
      and
      non-specific compensation for lost profits. By Order entered December 22, 2003,
      the Court dismissed all claims against us. The plaintiff has filed a notice
      of
      appeal to the Ninth Circuit Court of Appeals. On January 13, 2006, the Court
      of
      Appeals affirmed the lower court decision. On January 26, 2006, the plaintiff
      filed a petition for rehearing with the Ninth Circuit Court of Appeals. In
      March
      of 2006, the Ninth Circuit Court of Appeals denied the plaintiff’s petition. A
      percentage of the Company’s defense costs are being paid by its insurance
      carriers under reservation of rights. It is not possible to predict how
      Plaintiff’s claims will be resolved, whether the Company will be found liable,
      or the nature and extent of Plaintiff’s alleged damages.





The
      insurance carriers in some of the litigation related to allege product failures
      and defects in window products manufactured by others in which we were a
      defendant in the past paid the defense and settlement costs related to such
      litigation. Those insurance carriers reserved their rights to recover a portion
      or all of such payments from us. As a result, those insurance carriers could
      seek from us up to an aggregate of $12.9 million plus defense costs,
      although any such recovery would be restricted to claims that were not covered
      by our insurance policies. We intend to vigorously defend any attempts by these
      insurance carriers to seek reimbursement. We are not able to estimate the
      likelihood that these insurance carriers will seek to recover any such payments,
      the amount, if any, they might seek, or the outcome of such
      attempts.





8
 *Index*





On
      June
      13, 2002, Plaintiff Charles Ikekwere (“Plaintiff”) filed a Complaint against the
      Company in the Superior Court of California in and for the County of Santa
      Clara, Case No. CV808644. Mr. Ikekwere is a former employee of the Company.
      Plaintiff’s Complaint alleged claims for race discrimination, national origin
      discrimination, retaliation, medical condition discrimination, breach of
      contract, breach of fiduciary duty, fraud, negligence, intentional infliction
      of
      emotional distress, and punitive damages. The Company challenged the sufficiency
      of certain of Plaintiff’s allegations, which caused him to file a First Amended
      Complaint alleging essentially the same claims. The Company also challenged
      certain of Plaintiff’s allegations in his First Amended Complaint, which caused
      him to file a Second Amended Complaint. Following the Company’s legal challenges
      to Plaintiff’s Second Amended Complaint, the following claims remain at issue in
      the litigation: (1) race discrimination; (2) national origin discrimination;
      (3)
      retaliation; (4) medical condition discrimination; (5) breach of contract;
      (6)
      violation of California Constitution Article I; and (7) fraud and deceit. In
      light of certain deposition testimony given by Plaintiff, the Company removed
      this matter to Federal Court on January 6, 2004. The basis for the Company’s
      removal was that certain of Plaintiff’s allegations were preempted by the
      Employee Retirement Income and Security Act (ERISA). On February 4, 2004,
      Plaintiff filed a Motion to Remand the case to State Court, which the Court
      denied. Plaintiff subsequently amended his Second Amended Complaint to add
      a
      claim under ERISA. The Company has filed a summary judgment motion, which,
      if
      granted, will dispose of the entire action. If Plaintiff defeats the Company’s
      summary judgment motion, trial is scheduled for July 2006. Until discovery
      is
      completed and the Court rules on the Company’s summary judgment motion, it is
      not possible to predict how Plaintiff’s claims will be resolved, whether the
      Company will be found liable, or the nature and extent of Plaintiff’s alleged
      damages.





In
      addition, the Company is involved in certain other legal actions arising in
      the
      ordinary course of business. The Company believes, however, that none of these
      actions, either individually or in the aggregate, will have a material adverse
      effect on its business, consolidated financial position, results of operations
      or cash flows.





**Note 6--Stock-Based
      Compensation:**





The
      Company has a stock-based compensation program that provides its Board of
      Directors broad discretion in creating employee equity incentives. The Company
      has granted stock options under various option plans and agreements in the
      past
      and currently grants stock options under the 1997 Stock Incentive Plan and
      the
      1998 Stock Option Plan for employees, board members and consultants. The Board
      of Directors adopted the 1998 Stock Option Plan for employees and consultants
      on
      August 6, 1998. The Compensation Committee of the Board of Directors
      administers the plans and agreements. The exercise price of options granted
      under the 1997 and 1998 plans must be at least 85% of the fair market value
      of
      the stock at the date of grant. Options granted under the 1998 plan prior to
      October 2004 generally vest at a rate of 25% per year, are non-transferable
      and
      expire over terms not exceeding ten years from the date of grant or three months
      after the optionee terminates his relationship with the Company. Options granted
      under the 1997 plan prior to October 2004 generally vest at a rate of 25% per
      year, are non-transferable and expire over terms not exceeding ten years from
      the date of grant or eighteen months after the optionee terminates his
      relationship with the Company. In October 2004, the board of directors changed
      the vesting. Grants from and after October 2004 under both plans vest at a
      rate
      of 25% after six months and then evenly monthly thereafter for the remaining
      42
      months. The Company also has an Employee Stock Purchase Plan (ESPP) that allows
      employees, subject to certain limitations, to purchase shares at 85% of the
      lower of the fair market value of the Common Stock at the beginning of the
      six-month offering period, or the last day of the purchase period. As of March
      31, 2006, the Company had approximately 2,527 shares of common stock reserved
      for future issuance under our stock option plans and ESPP.





On
      January 1, 2006, the Company adopted the provisions of SFAS 123R, “Shared-Based
      Payment” (SFAS 123R), requiring it to recognize expense related to the fair
      value of our stock-based compensation awards. The Company elected to use the
      modified prospective transition method as permitted by SFAS 123R and therefore
      has not restated its financial results for prior periods. Under this transition
      method, stock-based compensation expense for the three months ended March 31,
      2006 includes compensation expense for all stock-based compensation awards
      granted prior to, but not yet vested as of January 1, 2006, based on the grant
      date fair value estimated in accordance with the original provisions of SFAS
      123. Stock-based compensation expense for all stock-based compensation awards
      granted subsequent to January 1, 2006 was based on the grant-date fair value
      estimated in accordance with the provisions of SFAS 123R. The Company recognized
      compensation expense for stock option awards on a graded vesting basis over
      the
      requisite service period of the award.





9
 *Index*





The
      following table sets forth the total stock-based compensation expense resulting
      from stock options included in the condensed consolidated statements of
      operations (in thousands):


___________________Three
                months ended
              March
                31,
              2006Cost
                of sales
            
            $
            11Research
                and development
            
            
            54Selling,
                general and administrative
            
            
            162Stock-based
                compensation expense before income taxes
            
            
            227Income
                tax benefit
            
            
            -Total
                stock-based compensation expense after income taxes
            
            $
            227





Net
      cash
      proceeds from the exercise of stock options were none and $19 for the three
      months ended March 31, 2006, and April 3, 2005, respectively. No income tax
      benefit was realized from stock option exercises during the three months ended
      March 31, 2006, and April 3, 2005. In accordance with SFAS 123R, the Company
      presents excess tax benefits from the exercise of stock options, if any, as
      financing cash flows rather than operating cash flows.





Prior
      to
      the adoption of SFAS 123R, the Company applied SFAS No. 123, “Accounting for
      Stock-Based Compensation” (SFAS 123), amended by SFAS No. 148, “Accounting for
      Stock-Based Compensation - Transition and Disclosure” (SFAS 148), which allowed
      companies to apply the existing accounting rules under APB 25, “Accounting for
      Stock Issued to Employees” (APB 25), and related Interpretations. In general, as
      the exercise price of options granted under these plans was equal to the market
      price of the underlying common stock on the grant date, no stock-based employee
      compensation cost was recognized in the Company’s net income (loss). As required
      by SFAS 148 prior to the adoption of SFAS 123R, the Company provided pro forma
      net income (loss) and pro forma net income (loss) per common share disclosures
      for stock-based awards, as if the fair-value-based method defined in SFAS 123
      had been applied.





The
      following table illustrates the effect on net income after tax and net income
      per common share as if the Company had applied the fair value recognition
      provisions of SFAS 123 to stock-based compensation during the three-month period
      ended April 3, 2005 (in thousands, except per share amounts):





Three
                months ended
              April
                3,
              2005Net
                income attributable to common stockholders:
            
            ___________________As
                reported
            
            $
            1,576Add:
                Stock-based employee compensation expense included in reported net
                income,
                net of related tax effects
            
            
            91Deduct:
                Total stock-based employee compensation determined under fair value
                based
                method for all awards, net of related tax effects
            
            
            (153
            )Pro
                forma net income attributable to common stockholders
            
            $
            1,514





10
 *Index*








Net
                income attributable to common stockholders per share:As
                reported - basic
            
            $
            0.06Pro
                forma - basic
            
            $
            0.06As
                reported - diluted
            
            $
            0.05Pro
                forma - diluted
            
            $
            0.05





The
      fair
      value of stock-based awards was estimated using the Black-Scholes model with
      the
      following weighted-average assumptions for the three months ended March 31,
      2006, and April 3, 2005, respectively:





Three
                  months endedMarch
                  31,
                2006
              
              April
                  3,
                2005Expected
                  life (in years)
              
              
              1.9
              
              
              1.4Interest
                  value
              
              
              4.63
              %
              
              3.56
              %Volatility
              
              
              109
              %
              
              116
              %Dividend
              
              
              -
              
              
              -Weighted-average
                  fair value at grant date
              
              $
              0.36
              
              $
              0.45





The
      Company’s computation of expected volatility for the quarter ended March 31,
      2006 is based on historical volatility. The Company’s computation of expected
      life is based on historical exercise patterns. The interest rate for periods
      within the expected life of the award is based on the U.S. Treasury yield in
      effect at the time of grant.





Stock
      option activity for the three months ended March 31, 2006, was as follows (in
      thousands, except per share amounts):





Shares
            
            Weighted-Average
              Exercise
                Price
            
            Weighted-Average
              Remaining
              Contractual
                Term
            
            Aggregate
              Intrinsic
                ValueOutstanding
                at December 31, 2005
            
            
            5,572
            
            $
            1.53Grants
            
            
            190
            
            
            0.68Exercises
            
            
            -
            
            
            -Forfeitures
                or expirations
            
            
            82
            
            
            3.70Outstanding
                at March 31, 2006
            
            
            5,680
            
            $
            1.47
            
            
            7.58
            
            $
            899Exercisable
                at March 31, 2006
            
            
            3,098
            
            $
            1.89
            
            
            6.40
            
            $
            428





The
      aggregate intrinsic value in the table above represents the total pretax
      intrinsic value (i.e., the difference between Southwall’s closing stock price on
      the last trading day of its first quarter of fiscal 2006 and the exercise price,
      times the number of shares) that would have been received by the option holders
      had all option holders exercised their options on March 31, 2006. This amount
      changes based on the fair market value of Southwall’s stock. Total intrinsic
      value of options exercised is zero for the three months ended March 31, 2006.
      Total fair value of options vested is $69 for the three months ended March
      31,
      2006.





As
      of
      March 31, 2006, $943 of total unrecognized compensation cost related to stock
      options was expected to be recognized over a weighted-average period of 1.9
      years.





11
 *Index*





**Note
      7 - Restructuring:**





In
      December 2002, we implemented a reduction in force at our Palo Alto
      location and elected to vacate certain buildings in Palo Alto. As a result
      of these actions, we incurred a restructuring charge of $2,624 in 2002 relating
      to employee severance packages and the remaining rents due on excess facilities
      in Palo Alto that we no longer occupy. In 2003, we recorded a credit to
      operating expenses of $65 as a result of modifications to the severance packages
      of certain employees. On
      January 19, 2006, we commenced restructuring actions to improve our cost
      structure. These actions include the closure of our Palo Alto, California
      manufacturing facility and a reduction in force at our Palo Alto site in the
      first half of 2006. As
      a
      result of these actions, we incurred a restructuring charge of $452 during
      the
      first quarter of 2006 relating to employee severance packages, and related
      charges.





The
      following tables set forth the beginning and ending liability balances relating
      to the above described restructuring activities as well as activity during
      the
      three-month periods ended March 31, 2006 and April 3, 2005 (in
      thousands):


Restructuring
                Plan
                  2006
              
              Restructuring
                Plan
                  2002Severance
                and
                Benefits
              
              Facilities
                Related
                and
                  Other
              
              Facilities
                Related
              
              TotalBalance
                  at January 1, 2005
              
              $
              -
              
              $
              -
              
              $
              274
              
              $
              274Provisions
              
              
              -
              
              
              -
              
              
              -
              
              
              -Adjustment
                  to reserve
              
              
              -
              
              
              -
              
              
              -
              
              
              -Cash
                  payments
              
              
              -
              
              
              -
              
              
              -
              
              
              -Balance
                  at April 3, 2005
              
              $
              -
              
              $
              -
              
              $
              274
              
              $
              274Severance
                and
                Benefits
              
              
              Facilities
                Related
                and
                  Other
              
              
              Facilities
                Related
              
              
              TotalBalance
                  at January 1, 2006
              
              $
              -
              
              $
              -
              
              $
              199
              
              $
              199Provisions
              
              
              375
              
              
              77
              
              
              -
              
              
              452Adjustment
                  to reserve
              
              
              -
              
              
              -
              
              
              -
              
              
              -Cash
                  payments
              
              
              (11
              )
              
              (20
              )
              
              -
              
              
              (31
              )Balance
                  at March 31, 2006
              
              $
              364
              
              $
              57
              
              $
              199
              
              $
              620




At
      March
      31, 2006, $5 27
      was
      included in other accrued liabilities, and $93 was included in other long-term
      liabilities on the condensed consolidated balance sheet.





**Note
      8 - Guarantees:**





The
      Company establishes a reserve for sales returns and warranties for specifically
      identified, as well as anticipated sales returns and warranties based on
      experience. The activity in the reserve for sales returns and warranties account
      during the three-month periods ended March 31, 2006 and April 3, 2005 was as
      follows (in thousands):





Balance
                at
              December
                31,
              2004
            
            Provision
            
            Utilized
            
            Balance
                at
              April
                3,
              2005Accrued
                sales returns and warranty
            
            $
            2,701
            
            $
            58
            
            $
            (564
            )
            $
            2,195____________Balance
                at
              December
                31,
              2005
            
            
            Provision
            
            
            Utilized
            
            
            Balance
                at
              March
                31,
              2006Accrued
                sales returns and warranty
            
            $
            1,556
            
            $
            (86
            )
            $
            (166
            )
            $
            1,304





12
 *Index*





These
      amounts are included in other accrued liabilities in the condensed consolidated
      balance sheets.





**Note
      9 - Comprehensive Income:**





The
      Company has adopted the provisions of SFAS No. 130 "Reporting Comprehensive
      Income". SFAS 130 establishes standards for reporting and display in the
      financial statements of total net income and the components of all other
      non-owner changes in equity, referred to as comprehensive income (loss).
      Accordingly, the Company has reported the translation gain (loss) from the
      consolidation of its foreign subsidiary in comprehensive income (loss).





The
      total
      comprehensive income (loss) at March 31, 2006, December 31, 2005, and April
      3,
      2005 was as follows (in thousands):





March
                31,
              2006
            
            December
                31,
              2005
            
            April
                3,
              2005Foreign
                Currency Translation Adjustment
            
            $
            324
            
            $
            (1,826
            )
            $
            (670
            )Net
                Income (Loss)
            
            
            (1,327
            )
            
            3,320
            
            
            1,699Other
                Comprehensive Income (Loss)
            
            $
            (1,003
            )
            $
            1,494
            
            $
            1,029





13
 *Index*





**Item2--Management's
      Discussion and Analysis of Financial Condition
      and Results of Operations:**





The
      following discussion and analysis of our financial condition and results of
      operations should be read in conjunction with our unaudited condensed
      consolidated financial statements and notes thereto appearing elsewhere in
      this
      report. This discussion and analysis contains forward-looking statements that
      involve risks and uncertainties, including those discussed below under
      "Forward-Looking Statements" and "Risk Factors”, set forth in Item 1A, and in
      our Annual Report on Form 10-K for the year ended December 31, 2005.
      You should not place undue reliance on these forward-looking statements. Actual
      results may differ materially from those anticipated in the forward-looking
      statements. These forward-looking statements represent our judgment as of the
      date of the filing of this Form 10-Q.





**Overview**





We
      are a
      global developer, manufacturer and marketer of thin film coatings on flexible
      substrates for the automotive glass, electronic display, architectural glass
      and
      window film markets. We have developed a variety of products that control
      sunlight in automotive glass, reduce light reflection, reduce electromagnetic
      radiation and improve image quality in electronic display products and conserve
      energy in architectural products. Our products consist of transparent
      solar-control films for automotive glass; anti-reflective films for computer
      screens, including flat panel displays, and plasma displays; transparent
      conductive films for use in touch screen and liquid crystal displays; energy
      control films for architectural glass; and various other coatings.




*Restructuring
      and financing activities.* As a
      consequence of the decline in our revenues and negative cash flows in 2003,
      we
      implemented several cost cutting and business restructuring activities during
      2003 and 2004. These activities, which included employee layoffs and the closure
      of several facilities (including the closure of our Tempe manufacturing facility
      in the fourth quarter of 2003), were designed to improve our cash flow from
      operations to allow us to continue as a going concern. During the fourth quarter
      of 2003 and the first quarter of 2004, we agreed to new payment terms with
      all
      of our major creditors and vendors, which extended or reduced our payment
      obligations. We also issued $4.5 million of convertible promissory notes and
      warrants to investors. The convertible promissory notes were converted to Series
      A preferred shares and the warrants were exercised for shares of common stock
      in
      the fourth quarter of 2004. On
      January 19, 2006, we commenced restructuring actions to improve our cost
      structure. These actions include the closure of our Palo Alto, California
      manufacturing facility and a reduction in force at our Palo Alto site in the
      first half of 2006. We expect to reduce its total operating expenses by
      approximately $4 million on an annual basis from these restructuring activities. As
      a
      result of these actions, we incurred a restructuring charge of $452 during
      the
      first quarter of 2006 relating to employee severance packages, and related
      charges (see Note 7 of Notes to Unaudited Condensed Consolidated Financial
      Statements—Restructuring).





*Demand
      for our customers' products.* We
      derive significant benefits from our relationships with a few large customers
      and suppliers. Our revenues and gross profit can increase or decrease rapidly
      reflecting underlying demand for the products of one or a small number of our
      customers. We may also be unable to replace a customer when a relationship
      ends
      or demand for our product declines as a result of evolution of our customers'
      products.





Our
      three
      largest customers in the automotive glass and window film markets include
      Pilkington PLC, Saint Gobain Sekurit and Globamatrix Holdings Pte. Ltd., or
      Globamatrix, which collectively accounted for approximately 45%, 54% and 50% of
      our total revenues during the first three months of 2006, 2005 and 2004,
      respectively.





14
 *Index*





Under
      our
      agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
      purchase commitment of $9.0 million of product **.** For each
      year after 2004 through and including 2011, Globamatrix is required to purchase
      an amount of product equal to 110% of the amount of product it was required
      to
      purchase in the prior year. Globamatrix is obligated to purchase $11.3 million
      of products in 2006. During the first quarter of 2006, Globamatrix purchased
      approximately $3.4 million of product.





*Sales
      returns and allowances.*  Our
      gross
      margins and profitability have been adversely affected from time to time by
      product quality claims. From 2002 to 2005, our sales returns provision has
      averaged approximately 2.8% to 4.5% of gross revenues. During 2005, our sales
      returns provision has averaged approximately 3.4% of our gross revenues due
      to
      fewer quality claims received during the period. During
      the first three months of 2006, our sales returns provision has averaged
      approximately 1.7% of our gross revenues due to fewer quality claims received
      during the period.





**Critical
      Accounting Policies and Estimates**





The
      accompanying discussion and analysis of our financial condition and results
      of
      operations are based upon our condensed consolidated financial statements,
      which
      have been prepared in accordance with generally accepted accounting principles
      in the United States (U.S. GAAP). The preparation of these financial statements
      requires us to make estimates and judgments that affect the reported amounts
      of
      assets, liabilities, revenues and expenses, and related disclosure of contingent
      assets and liabilities. These estimates form the basis for making judgments
      about the carrying values of assets and liabilities that are not readily
      apparent from other sources. We base our estimates and judgments on historical
      experience and on various other assumptions that we believe are reasonable
      under
      the circumstances. However, future events cannot be forecasted with certainty
      and the best estimates and judgments routinely require adjustment. We are
      required to make estimates and judgments in many areas, including those related
      to revenue recognition, allowance for doubtful accounts and sales returns,
      valuation of inventories, assessment of probability of the outcome of current
      litigation, restructuring costs, impairment charge for long-lived assets and
      accounting for income taxes. We believe the policies disclosed are the most
      critical to our financial statements because their application places the most
      significant demands on management’s judgment. Senior management has discussed
      the development, selection and disclosure of these estimates with the Audit
      Committee of our Board of Directors.





We
      believe there have been no significant changes during the first three months
      of
      fiscal 2006 to the items that we disclosed as our critical accounting policies
      and estimates in our discussion and analysis of financial condition and results
      of operations in our 2005 Form 10-K, except as noted below.





*Stock
      Based Compensation Expense*





We
      account for stock-based compensation in accordance with the provisions of SFAS
      123R. Under the fair value recognition provisions of SFAS 123R, stock based
      compensation cost is estimated at the grant date based on the fair value of
      the
      award and is recognized as expense ratably over the requisite service period
      of
      the award. Determining the appropriate fair value model and calculating the
      fair
      value of stock-based awards requires judgment, including estimating stock price
      volatility, forfeiture rates and expected lives.





**Three
      Months Ended March 31, 2006 compared with Three Months Ended April 3,
      2005**





**Results
      of Operations**





*Net
      revenues.* Our net
      revenues for the three months ended March 31, 2006 and April 3, 2005 were $10.0
      million and $15.6 million, respectively. The decline in revenues affected all
      of
      our market segments as described below.





15
 *Index*





Our
      net
      revenues in the window film market decreased by $0.2 million, or 5%, from $3.6
      million in the first quarter of 2005 to $3.4 million in the same period in
      2006. In
      the
      second half of 2005, we stopped converting (cutting the film to the customer’s
      specifications) one of our window film product models and agreed with our
      customers that they would complete this process. This resulted in a
      decline in average sales prices for the TX product line and the decrease in
      window film market net revenues.





Our
      net
      revenues in the electronic display market decreased by $1.6 million, or 39%,
      from $4.1 million in the first quarter of 2005 to $2.5 million in the same
      period of 2006. The decrease was due to the termination of the AR product line
      ($0.4 million), a decline in demand for Silver reflector film for the LCD
      back-light market ($0.6 million) and reduced average sales prices on film sold
      to Mitsui for Plasma Display Panel, or PDP, filters ($0.6 million). An overall
      decrease in the average selling prices for PDP products resulted in price
      pressures on all suppliers in the market.




Our
      net
      revenues in the automotive market decreased by $3.5 million, or 55%, from $6.4
      million in the first quarter of 2005 to $2.9 million in the same period of
      2006.
      The decrease was primarily due to a reduction in demand throughout the first
      quarter by Saint Gobain as a result of their large inventory build-up at 2005
      year end.





Our
      net
      revenues in the architectural market decreased by $0.3 million, or 21%, from
      $1.5 million in the first quarter of 2005 to $1.2 million in the same period
      of
      2006. The decrease was due to softness in the Asian market and a decreased
      demand from our U.S. customers due to inventory build-up at
      year-end.





*Cost
      of revenues* .
      Cost of
      revenues consists of materials and subcontractor services, labor and
      manufacturing overhead. Cost of revenues was $6.4 million in the first quarter
      of 2006 compared to $11.3 million in the same period of 2005. The decrease
      in
      cost of revenues was primarily due to lower revenues, transfer of production
      to
      our lower cost German manufacturing facility, and improved yields for the
      products that were manufactured in Palo Alto.




*Gross
      profit and gross margin* .
      Our
      gross profit decreased $0.7 million from $4.4 million in the first quarter
      of
      2005 to $3.7 million in the same period of 2006. As a percentage of sales,
      gross
      profit increased from 28% in the first quarter of 2005 to 37% in the same period
      in 2006 due to lower overall manufacturing costs as detailed above.





*Operating
      expenses*




*Research
      and development* .
      Research and development expenses increased $1 million from $0.7 million in
      the
      first quarter of 2005 to $1.65 million in the same period of 2006. The 136%
      increase from year to year was due primarily to an increase in labor and
      employee benefits costs as a result of expanding our engineering organization.
      In June 2005, we hired a new Chief Technology Officer and Senior Vice President,
      and a new Director of Engineering for the automotive market. In September 2005,
      we hired a new Director of Engineering for the electronic display market. In
      addition, we spent more on research and development materials in the first
      quarter of 2006 than in the same period in 2005. We expect to continue investing
      into research and development in 2006 at the same level of expenditure as in
      the
      first quarter of 2006. In
      2005,
      we began development and sampling of a new class of films with improved
      performance that we believe will be beneficial across our product lines. We
      also
      initiated significant research and development into thin film technology that
      we
      anticipate will enable Southwall to produce products for new applications and
      markets.





*Selling,
      general and administrative* .
      Selling, general and administrative expenses consist primarily of corporate
      and
      administrative overhead, selling commissions and occupancy costs. Selling,
      general and administrative expenses increased $0.5 million from $2.0 million
      in
      the first quarter of 2005 to $2.56 million in the same period of 2006. The
      increase in general and administrative expenses in 2006 was primarily due to
      the
      stock based compensation expense of $0.2 million, higher legal expense, and
      building decommission expense of $0.2 million recorded in the first quarter
      of
      2006.





16
 *Index*





*Impairment
      recoveries from long-lived assets.* In the
      first quarter of 2005, we recorded the recovery of $0.2 million of previously
      recorded impairment charges related to the final payment from the sale of a
      production machine which was impaired in the third quarter of 2003. There were
      no such recoveries in the first quarter of 2006.





*Restructuring.* On
      January 19, 2006, we commenced restructuring actions to improve our cost
      structure. These actions include the closure of our Palo Alto, California
      manufacturing facility and a reduction in force at our Palo Alto site in the
      first half of 2006. As
      a
      result of these actions, we incurred a restructuring charge of $452 during
      the
      first quarter of 2006 relating to employee severance packages, and related
      charges. We
      don’t
      expect any restructuring activities for the rest of 2006. There was no such
      restructuring charge in the first quarter of 2005.





*Income
      (loss) from operations* .
      Income
      from operations decreased $2.8 million from the income of $1.8 million in the
      first quarter of 2005 to the loss of $1.0 million in the same period of 2006.
      The decrease was primarily due to a decrease in revenue, increase in research
      and development costs, recognition of the stock based employee compensation
      expense, and a restructuring charge in the first quarter of 2006 as detailed
      above.





*Interest
      expense, net.* Interest
      expense, net decreased $0.1 million from $0.3 million in the first quarter
      of
      2005 to $0.2 million in the same period of 2006. The decrease in interest
      expense was primarily attributable to less outstanding debt during the first
      quarter of 2006 compared to the same period in 2005.




*Other
      income, net* .
      In the
      first quarter of 2005 and 2006, other income, net, primarily relates to our
      German subsidiary, Southwall Europe GmBH, or SEG. In the
      first quarter of 2006, SEG received a lower energy and waste rebate refund
      than
      in the same period in 2005. Other income, net, also reflects foreign exchange
      transaction gains and losses in the first quarter
      of 2006 and 2005. Some of our transactions with foreign customers are
      denominated in foreign currencies, principally the Euro. As exchange rates
      fluctuate relative to the U.S. dollar, exchange gains and losses occur. In
      the
      first quarter of 2006, other income, net, was $0.2 million, a decrease of $0.1
      million from $0.3 million in the same period in 2005.





*Income
      (loss) before provision for income taxes* .
      We
      recorded a pre-tax loss of $1.0 million in the first quarter of 2006 and a
      pre-tax income of $1.8 million in the first quarter of 2005. The decrease of
      $2.8 million was primarily due to a decrease in revenue, increase in research
      and development costs, recognition of the stock based employee compensation
      expense, a restructuring charge, and a lower other income, net, in the first
      quarter of 2006.





*Provision
      for income taxes* .
      The
      increase in the provision for income taxes in the first quarter of 2006 compared
      to the same period in 2005 is related to higher taxable income in 2006 in SEG
      as
      this subsidiary no longer has net operating losses to offset net taxable income.





*Net
      income (loss).* In the
      first quarters of 2006 and 2005, we recorded a net loss of $1.3 million and
      a
      net income of $1.7 million, respectively. The decrease of $3.0 million was
      primarily due to a decrease in revenue, an increase in research and development
      costs, recognition of the stock based employee compensation expense, a
      restructuring charge, a lower other income, net, and a higher income tax
      provision in the first quarter of 2006.





*Deemed
      dividend on preferred stock.* We
      accrued $0.1 million of deemed dividend on preferred stock in the first quarter
      of 2006. The holders of our secured convertible promissory notes converted
      those
      notes to shares of Series A preferred stock in December 2004. The Series A
      preferred stock accrues cumulative dividends at the rate of 10% per
      annum.





17
 *Index*





**Liquidity
      and capital resources.**





*Liquidity*




Our
      principal liquidity requirements are for working capital, consisting primarily
      of accounts receivable and inventories. We believe that because of the
      relatively long production cycle of certain of our products, our inventories
      will continue to represent a significant portion of our working
      capital.





Our
      cash
      and cash equivalents decreased $1.5 million from $6.6 million at December 31,
      2005 to $5.1 million at March 31, 2006. Cash used in operating activities of
      $1.0 million for the first three months of 2006 was primarily the result of
      net
      loss of $1.3 million, increase in inventories of $1.4 million, decrease in
      accrued liabilities of $1.2 million due to a deferred rent payment and partially
      offset by non-cash depreciation of $0.5 million, stock compensation of $0.2
      million, decreases in accounts receivable of $0.5 million, increase in accrued
      restructuring of $0.4 million and an increase in accounts payable and accrued
      liabilities of $1.1 million. Cash provided from operations for the first quarter
      of 2005 of $0.6 million was primarily the result of net income of $1.7 million
      and non-cash depreciation of $0.6 million, partially offset by impairment
      recoveries from long-lived assets of $0.2 million and increases in accounts
      receivable of $0.3 million, other current and non-current assets of $0.6 million
      and a decrease in accounts payable and accrued liabilities of $0.8
      million.




Cash
      used
      in investing activities for the first three months of 2006 was $0.2 million
      and
      was the result of capital expenditures. Cash provided by investing activities
      for the first quarter of 2005 of $0.2 million was primarily the result of a
      decrease in restricted cash of $0.2 million and proceeds from the sale of fixed
      asset of $0.2 million, partially offset by capital expenditures of $0.1
      million.





Cash
      used
      in financing activities for the first three months of 2006 was $0.4 million
      and
      was primarily the result of payments of $0.4 million on our borrowings. Cash
      used in financing activities for the first quarter of 2005 of $0.8 million
      was
      the result of repayments under capital leases and repayments of notes
      payable.





We
      entered into an agreement with the Saxony government in May 1999 under
      which we receive investment grants. As of March 31, 2006, we had received
      5.0 million Euros or $5.0 million at historical exchange rate of the grants
      and accounted for these grants by applying the proceeds received to reduce
      the
      cost of our fixed assets in our Dresden manufacturing facility. Additionally,
      as
      of March 31, 2006, we had a balance remaining from the government grants we
      are
      entitled to receive of 0.3 million Euros, or $0.4 million, which has been
      recorded as an advance and held as restricted cash until we receive approval
      from the Saxony government to apply the funds to reduce our capital
      expenditures. If we fail to meet certain requirements in connection with these
      grants, the Saxony government has the right to demand repayment of the grants.
      The total annual amount of investment grants and investment allowances that
      we
      are entitled to seek varies from year to year based upon the amount of our
      capital expenditures that meet certain requirements of the Saxony government.
      Generally, we are not eligible to seek investment grants and allowances in
      the
      aggregate for any year in excess of 33% of our eligible capital expenditures
      in
      Germany for that year. We expect to continue to finance a portion of our capital
      expenditures in Dresden with additional grants from the Saxony government and
      additional loans from German banks, some of which may be guaranteed by the
      Saxony government. However, we cannot guarantee that we will be eligible for
      or
      will receive additional grants in the future from the Saxony
      government.





*Borrowing
      arrangements*





On
      April
      28, 2005, we entered into a credit agreement (the “Credit Agreement”) with Wells
      Fargo HSBC Trade Bank, N.A. (the “Bank”). The Credit Agreement provides for two
      facilities. All amounts borrowed under both facilities under the Credit
      Agreement must be repaid on or before May 31, 2006. It is our intention to
      renew
      this credit facility in May 2006.





18
 *Index*





The
      first
      facility is a revolving line of credit under which we may from time to time
      borrow up to $3 million, subject to satisfaction of certain conditions. Amounts
      borrowed under the first facility bear interest at the prime rate minus 1.75%
      per annum or LIBOR plus 1% per annum, at our option. We borrowed approximately
      $3.0 million from this facility on April 28, 2005 which amount remained
      outstanding as of March 31, 2006.





The
      second facility is a formula line under which we may, from time to time, borrow
      up to $3 million, subject to certain conditions, with advances on up to 80%
      of
      eligible accounts receivable. Amounts borrowed under the second facility bear
      interest at the prime rate minus 0.25% per annum. We may borrow under the second
      facility only if we meet certain financial covenants. As of March 31, 2006,
      we
      met these financial covenants. There is no balance outstanding under the second
      facility.





All
      borrowings under both facilities are collateralized by our inventory,
      receivables, raw material and work in progress. In addition, the first facility
      under the Credit Agreement is collateralized by a letter of credit posted by
      Needham & Company, one of our stockholders.





The
      terms
      of the Credit Agreement, among other things, limit our ability to (i) incur,
      assume or guarantee additional indebtedness in excess of $12.9 million (other
      than pursuant to the Credit Agreement), (ii) pay dividends or repurchase stock
      (except up to $0.6 million per year of dividends on preferred stock), (iii)
      incur liens upon the collateral pledged to the bank, (iv) make any loans or
      advances to, or investments in, any person or entity outside the ordinary course
      of business, (v) merge, consolidate, sell or otherwise dispose of all or a
      substantial or material portion of our assets, (vi) enter into transactions
      with
      affiliates, and (vii) make acquisitions other than up to an aggregate amount
      of
      $3 million and (viii) to make capital expenditures in any fiscal year in excess
      of $1.5 million.





The
      Credit Agreement provides for events of default, which include, among others,
      (a) nonpayment of amounts when due (with no grace periods), (b) the breach
      of
      our representations or covenants or other agreements in the Credit Agreement
      or
      related documents, (c) payment defaults or accelerations of our other
      indebtedness, (d) a failure to pay certain judgments, (e) the occurrence of
      any
      event or condition that the Bank believes impairs or is substantially likely
      to
      impair the prospects of payment or performance by us, and (f) certain events
      of
      bankruptcy, insolvency or reorganization. Generally, if an event of default
      occurs, the Bank may declare all outstanding indebtedness under the Credit
      Agreement to be due and payable.




The
      foregoing description does not purport to be a complete statement of the
      parties' rights and obligations under the Credit Agreement and the transactions
      contemplated thereby or a complete explanation of the material terms
      thereof.





*Capital
      expenditures*





We
      expect
      to spend approximately $1.5 million in 2006 on upgrades and refurbishment of
      our
      production machines and research and development tools. We spent
      approximately $0.2 million in capital expenditures during the first three months
      of 2006.





19
 *Index*





*Future
      payment obligations*





Our
      future payment obligations on our borrowings pursuant to our term debt, line
      of
      credit, non-cancelable operating leases and other non-cancelable contractual
      commitments are as follows at March 31, 2006 (in thousands):


Less
              
              
              
              
              
              GreaterThan
              
              
              
              
              
              ThanTotal
              
              1
                  Year
              
              1-3
                  Years
              
              3-5
                  Years
              
              5
                  YearsContractual
                  Obligations:Term
                  debt (1)
              
              $
              9,899
              
              $
              1,171
              
              $
              1,996
              
              $
              4,160
              
              $
              2,572Line
                  of credit
              
              
              2,996
              
              
              2,996
              
              
              --
              
              
              --
              
              
              --Operating
                  leases (2)
              
              
              593
              
              
              380
              
              
              208
              
              
              5
              
              
              --Total
                  contractual cash obligations
              
              $
              13,488
              
              $
              4,547
              
              $
              2,204
              
              $
              4,165
              
              $
              2,572




(1)
            Represents
                loan agreements with Portfolio Financing Servicing Company, Wells
                Fargo
                Bank and several German banks.





(2)
            Represents
                the remaining rents owed on a building we rent in Palo Alto and Mountain
                View, California.





20
 *Index*





**Item3--Quantitative
      and Qualitative Disclosures about Market
      Risk**





We
      are
      exposed to the impact of interest rate changes, foreign currency fluctuations,
      and changes in the market values of our investments.





Financing
      risk: Our exposure to market rate risk for changes in interest rates relates
      primarily to our line of credit which bears an interest rate equal to 1.0%
      above
      the bank LIBOR rate (which was 4.875% at March 31, 2006) and is calculated
      based
      on amounts borrowed under the facility. In addition, the interest rate on one
      of
      our German loans has been reset to the prevailing market rate of 5.75% and
      another of our German loans will have its interest rate reset to the prevailing
      market rate in 2009. Fluctuations or changes in interest rates may adversely
      affect our expected interest expense. The effect of a 10% fluctuation in the
      interest rate on our line of credit and term debt would have had an effect
      of
      about $21,000 on our interest expense for the first quarter of
      2006.





Investment
      risk: We invest our excess cash in money market accounts and, by practice,
      limit
      the amount of exposure to any one institution. Investments in both fixed rate
      and floating rate interest earning instruments carry a degree of interest rate
      risk. Fixed rate securities may have their fair market value adversely affected
      due to a rise in interest rates, while floating rate securities may produce
      less
      income than expected if interest rates fall. The effect of a 10% fluctuation
      in
      the interest rate of any of our floating rate securities would have had an
      adverse effect of less than $10,000 for the first quarter of 2006.





Foreign
      currency risk: International revenues (defined as sales to customers located
      outside of the United States) accounted for approximately 63% of our total
      sales
      in the first three months of 2006. Approximately 16% of our international
      revenues were denominated in Euros relating to sales from our Dresden operation
      in the first quarter of 2006. The other 84% of our international sales were
      denominated in US dollars. In addition, certain transactions with foreign
      suppliers are denominated in foreign currencies (principally Japanese Yen).
      The
      effect of a 10% fluctuation in the Euro exchange rate would have had an effect
      of approximately $0.3 million on net revenues for the first three months of
      2006 and the effect on expenses of a 10% fluctuation in the Yen exchange rate
      would have been immaterial.





21
 *Index*





**FORWARD-LOOKING
      STATEMENTS**





This
      Quarterly Report contains forward-looking statements, which are subject to
      a
      number of risks and uncertainties. All statements other than statements of
      historical facts are forward-looking statements. These statements are identified
      by terminology such as "may," "will," "could," "should," "expects," "plans,"
      "intends," "seeks," "anticipates," "believes," "estimates," "potential," or
      "continue," or the negative of such terms or other comparable terminology,
      although not all forward-looking statements contain these identifying words.
      Forward-looking statements are only predictions and include statements relating
      to:





·
            our
                ability to remain as a going
                concern;




·
            our
                strategy, future operations and financial plans, including, without
                limitation, our plans to install and commercially produce products
                on new
                machines;




·
            the
                success of our restructuring
                activities;




·
            the
                continued trading of our common stock on the Over-the-Counter Bulletin
                Board;




·
            our
                projected need for, and ability to obtain, additional borrowings
                and our
                future liquidity;




·
            future
                applications of thin-film technologies and our development of new
                products;




·
            our
                competition;




·
            statements
                about the future size of markets;




·
            our
                expectations with respect to future grants, investment allowances
                and bank
                guarantees from the Saxony
                government;




·
            our
                expected results of operations and cash flows;




·
            pending
                and threatened litigation and its outcome; and




·
            our
                projected capital expenditures.







You
      should not place undue reliance on our forward-looking statements. Actual events
      or results may differ materially. In evaluating these statements, you should
      specifically consider various factors, including the risks outlined below under
      "Risk Factors" and
      under “Risk Factors” in our 2005 Form 10-K. These factors may cause our actual
      results to differ materially from any forward-looking statement. Although we
      believe the expectations reflected in our forward-looking statements are
      reasonable as of the date they are being made, we cannot guarantee our future
      results, levels of activity, performance, or achievements. Moreover, neither
      we,
      nor any other person, assume responsibility for the future accuracy and
      completeness of these forward-looking statements.





22
 *Index*





**Item4--Controls
      and Procedures**





(a)
            *Evaluation
                and Disclosure Controls and Procedures*.
                Under the supervision and with the participation of our management,
                including our chief executive officer and vice president of finance,
                we
                conducted an evaluation of the effectiveness of the design and operation
                of our disclosure controls and procedures, as defined in Rules 13a-15(e)
                and 15d-15(e) under the Securities Exchange Act of 1934, as amended,
                as of
                March 31, 2006. Based on this evaluation, our chief executive officer
                and
                vice president of finance concluded as of the Evaluation Date that
                our
                disclosure controls and procedures were effective such that the
                information relating to our company, including our consolidated
                subsidiaries, required to be disclosed in our Securities and Exchange
                Commission (“SEC”) reports (i) is recorded, processed, summarized and
                reported with the time periods specified in SEC rules and forms,
                and (ii)
                is accumulated and communicated to our management, including our
                chief
                executive officer and vice president of finance, as appropriate to
                allow
                timely decisions regarding required
                disclosure.





(b)
            *Report
                on Internal Control Over Financial Reporting*.
                We will be required by the Sarbanes-Oxley Act to include an assessment
                of our internal control over financial reporting and an attestation
                from an independent registered public accounting firm in our Annual
                Report
                on Form 10-K beginning with the filing for our fiscal year ending
                December 31, 2007.





(c)
            *Changes
                in Internal Controls*.
                There were no changes during the first three months of 2006 in our
                internal controls over financial reporting that have materially effected,
                or are reasonably likely to materially affect, the internal controls
                over
                financial reporting.





23
 *Index*




**PARTII--OTHER
      INFORMATION**




**Item1--Legal
      Proceedings**





Litigation
      filed against the Company was described under Item 3 in the Company's Form
      10-K
      filed on March 29, 2006. No other material developments have occurred with
      respect to the litigation described therein.





In
      addition, the Company is involved in certain other legal actions arising in
      the
      ordinary course of business. The Company believes, however, that none of these
      actions, either individually or in the aggregate, will have a material adverse
      effect on Southwall's business, Southwall's consolidated financial position,
      results of operations or cash flows.





**Item1A--Risk
      Factors**





The
      following information updates, and should be read in conjunction with, the
      information disclosed in Item 1A, “Risk Factors,” of our Annual Report on Form
      10K for the year ended December 31, 2005 and filed with the SEC on March 29,
      2006.





**Financial
      Risks**





*Our
      working capital position, financial commitments and historical performance
      may
      raise doubt about our ability to have positive earnings in the
      future.*





We
      incurred net losses in the first quarter of 2006, and in 2004 and 2003 and
      negative cash flows from operations in the first quarter of 2006 and in 2003.
      These factors together with our working capital position and our significant
      debt service and other contractual obligations at December 31, 2005, may raise
      doubt about our ability to restore profitable operations, generate cash flow
      from operating activities and obtain additional financing. These and other
      factors related to our business during recent years, our past failure to comply
      with covenants in our financing agreements and our voluntary delisting from
      NASDAQ in March 2004 may make it difficult for us to secure the required
      additional borrowings on favorable terms or at all. We intend to seek additional
      borrowings or alternative sources of financing; however, difficulties in
      borrowing money or raising financing could have a material adverse effect on
      our
      operations, planned capital expenditures and ability to comply with the terms
      of
      government grants.





*Covenants
      or defaults under our credit and other loan agreements may prevent us from
      borrowing or force us to curtail our operations.*





As
      of
      March 31, 2006, we had total outstanding obligations under our credit and other
      loan agreements of $12.9 million. Our inability to make timely payments of
      interest or principal under these facilities could materially adversely affect
      our ability to borrow money under existing credit facilities, to secure
      additional borrowings or to function as a going concern. Our current credit
      facilities contain financial covenants that require us to meet certain financial
      performance targets and operating covenants that limit our discretion with
      respect to business matters. Among other things, these covenants restrict our
      ability to borrow additional money, create liens or other encumbrances, and
      make
      certain payments including dividends and capital expenditures. Many of these
      loans contain provisions that permit the lender to declare the loans immediately
      due if there is a material adverse change in our business. These credit
      facilities also contain events of default that could require us to pay off
      indebtedness before its maturity . The
      restrictions imposed by these credit facilities or the failure of lenders to
      advance funds under these facilities could force us to curtail our operations
      or
      have a material adverse effect on our liquidity.





24
 *Index*





*We
      expect to be subject to increased foreign currency risk in our international
      operations.*





In
      2003,
      2004, 2005 and during the first quarter of 2006, approximately 34%, 31%, 32%
      and
      23% of our revenues, respectively, were denominated in euros, primarily related
      to sales from our Dresden operation, including sales to one of our largest
      customers, a European automotive glass manufacturer. In addition, other
      customers may request to make payments in foreign currencies. Also, certain
      transactions with foreign suppliers are denominated in foreign currencies,
      primarily Japanese Yen.





A
      strengthening in the dollar relative to the currencies of those countries in
      which we do business would increase the prices of our products as stated in
      those currencies and could hurt our sales in those countries. Significant
      fluctuations in the exchange rates between the U.S. dollar and foreign
      currencies could cause us to lower our prices and thus reduce our profitability
      and cash flows. These fluctuations could also cause prospective customers to
      cancel or delay orders because of the increased relative cost of our products.





**Operational
      Risks**





*We
      depend on a small number of customers for nearly all of our revenues, and the
      loss of a large customer could materially adversely affect our revenues or
      operating results.*





Our
      ten
      largest customers accounted for approximately 79%, 82%, 79% and 84% of net
      revenues during the first quarter 2006 and in 2005, 2004 and 2003, respectively.
      We expect to continue to derive a significant portion of our net sales from
      this
      relatively small number of customers. Accordingly, the loss of a large customer
      could materially hurt our business, and the deferral or loss of anticipated
      orders from a large customer or a small number of customers could materially
      reduce our revenue and operating results in any period. Some of our largest
      automotive glass customers have used a technology — direct-to-glass
      sputtering — as
      an
      alternative to our window films, which in 2003 resulted in a decrease in orders
      from these customers. The continued or expanded use of this technology by our
      automotive glass customers would have a material adverse effect on our results
      of operations and financial position.





*Fluctuations
      or slowdowns in the overall electronic display industry have and may continue
      to
      adversely affect our revenues.*





Our
      business depends in part on sales by manufacturers of products that include
      electronic displays. The markets for electronic display products are highly
      cyclical and have experienced periods of oversupply resulting in significantly
      reduced demand for our products. For example, during the first quarter of 2006,
      we experienced a decrease of 39% from the first quarter of 2005 in our net
      revenues in the electronic display market primarily due to lower demand for
      our
      sputtered thin film filter products for Plasma Display Panel products due to
      increased competition, and we expect this trend to continue. Mitsubishi Electric
      was the only CRT manufacturer that buys our anti-reflective, or AR, film and
      it
      decided to consolidate all of the manufacturing of this product to Japan. In
      connection with that consolidation, Mitsubishi ceased production of the 17"
      AR
      product in its Mexico plant during the third quarter of 2003. In 2005, we
      stopped converting (cutting the film to the customer’s specifications) one of
      our window film product models and agreed with our customers that they would
      complete this process. This resulted in a
      decline in average sales prices for the TX product line and the decrease in
      window film market net revenues.





25
 *Index*





*Our
      business is susceptible to numerous risks associated with international
      operations.*





Revenues
      from international sales amounted to approximately 63%, 74%, 79% and 89% of
      our
      net revenues during the first quarter of 2006 and in 2005, 2004 and 2003,
      respectively. The distance between our two manufacturing sites creates
      logistical and communications challenges. In addition, to achieve acceptance
      in
      international markets, our products must be modified to handle a variety of
      factors specific to each international market as well as local regulations.
      We
      may also be subject to a number of other risks associated with international
      business activities. These risks include:





•
            unexpected
                changes in and the burdens and costs of compliance with a variety
                of
                foreign laws and regulatory requirements;


•
            potentially
                adverse tax consequences; and


•
            global
                economic turbulence and political instability.





26
 *Index*





**Item2--
      Unregistered Sales of Equity Securities and Use
      of Proceeds**





None.




**Item3--Defaults
      upon Senior Securities**





Not
      applicable.




**Item4--Submission
      of Matters to a Vote of
      Stockholders**





None.





**Item5--Other
      Information**





None.




**Item6--Exhibits**





(a)
            Exhibits








Exhibit
              Number
            Item31.1
            Certification
                of Principal Executive Officer pursuant to Exchange Act Rules 13a-14
                and
                15d-1431.2
            Certification
                of Principal Financial Officer pursuant to Exchange Act Rules 13a-14
                and
                15d-1432.1
            Certification
                of Principal Executive Officer pursuant to 18 U.S.C Section
                135032.2
            Certification
                of Principal Financial Officer pursuant to 18 U.S.C Section
                1350





27
 *Index*





**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.




Dated:  May
                15, 2006**Southwall
                Technologies Inc.**By:
            /s/
                Thomas G. HoodThomas
                G. Hood*President
                and Chief Executive Officer*By:
            /s/
                Sylvia KamenskiSylvia
                Kamenski*Vice
                President of Finance*




28