**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 April 3, 2005**
      **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**
      (State
      or other jurisdiction of incorporation or organization)
    
    **94-2551470**
      (I.R.S.
      Employer Identification Number)**3975
      East Bayshore Road, Palo Alto, California**
      (Address
      of principal executive offices)
    
    **94303**
      (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 an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes o No x
 
 As of May
2, 2005, there were 26,778,482 shares of the Registrant's Common Stock
outstanding.
 
 
 1
 *Index*
   **SOUTHWALL
TECHNOLOGIES INC.**
 
 **INDEX**
  
 PagePART
      I - FINANCIAL INFORMATIONItem
      1
    Financial StatementsUnaudited Condensed Consolidated Balance Sheets - April 3, 2005
      And December 31, 2004
    3Unaudited Condensed Consolidated Statements of Operations -
      Three month periods ended April 3, 2005 and March 28,
    2004
    4Unaudited Condensed Consolidated Statements of Cash Flows -
      Three Month period ended April 3, 2005 and March 28,
    2004
    5Notes to the Unaudited Condensed Consolidated Financial
      Statements
    6Item
      2
    Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
    13Item
      3
    Quantitative and Qualitative Disclosures about Market
      Risk
    19Item
      4
    Controls and Procedures
    30PART
      II - OTHER INFORMATIONItem
      1
    Legal Proceedings
    31Item
      2
    Unregistered Sales of Equity Securities and Use of
      Proceeds
    31Item
      3
    Defaults upon Senior Securities
    31Item
      4
    Submission of Matters to a Vote of Security
      Holders
    31Item
      5
    Other Information
    31Item
      6
    Exhibits
    31Signatures
    32
  2
 *Index*
  PART I.
FINANCIAL INFORMATION
 
 Item 1—Financial Statements:
 SOUTHWALL TECHNOLOGIES INC.
 UNAUDITED CONDENSED CONSOLIDATED BALANCE
SHEETS
 (in
thousands, except per share data)
 
 April
      3,
    
    December
      31,ASSETS
    
    2005
    
    2004Current
      assets:Cash
      and cash equivalents
    
    $
    4,519
    
    $
    4,547Restricted
      cash
    
    
    475
    
    
    686Accounts
      receivable, net of allowance for doubtful accounts of$284
      at April 3, 2005 and $292 at December 31, 2004
    
    
    6,401
    
    
    6,186Inventories,
      net
    
    
    8,363
    
    
    8,355Other
      current assets
    
    
    2,354
    
    
    1,757Total
      current assets
    
    
    22,112
    
    
    21,531Property,
      plant and equipment, net
    
    
    19,596
    
    
    21,110Restricted
      cash loans
    
    
    1,093
    
    
    1,149Other
      assets
    
    
    1,130
    
    
    1,157Total
      assets
    
    $
    43,931
    
    $
    44,947LIABILITIES,
      REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITYCurrent
      liabilities:Current
      portion of long term debt and capital leases
    
    $
    1,306
    
    $
    1,463Line
      of credit
    
    
    2,975
    
    
    2,975Accounts
      payable
    
    
    2,536
    
    
    2,544Accrued
      compensation
    
    
    1,001
    
    
    1,378Other
      accrued liabilities
    
    
    6,164
    
    
    6,643Total
      current liabilities
    
    
    13,982
    
    
    15,003Term
      debt and capital leases
    
    
    10,468
    
    
    11,644Government
      grants advanced
    
    
    475
    
    
    505Other
      long term liabilities
    
    
    3,134
    
    
    3,222Total
      liabilities
    
    
    28,059
    
    
    30,374Commitments
      and contingencies (Note 5)Series
      A 10% cumulative preferred stock, $0.001 par value; $1.00stated
      value; 5,000 shares authorized, 4,893 shares outstanding(Liquidation
      preference $4,893)
    
    
    4,810
    
    
    4,810Stockholders’
      equity:Common
      stock, $0.001 par value; 50,000 authorized, 26,778and
      26,488 shares outstanding at April 3, 2005 andDecember
      31, 2004, respectively
    
    
    26
    
    
    26Capital
      in excess of par value
    
    
    78,360
    
    
    77,957Accumulated
      other comprehensive income:Cumulative
      translation adjustment
    
    
    3,687
    
    
    4,358Deferred
      compensation
    
    
    (132
    )
    
    -Accumulated
      deficit
    
    
    (70,879
    )
    
    (72,578
    )Total
      stockholders’ equity
    
    
    11,062
    
    
    9,763Total
      liabilities, redeemable preferred stock and stockholders’
      equity
    
    $
    43,931
    
    $
    44,947
 
 
 See
accompanying notes to unaudited condensed consolidated financial
statements.
  3
 *Index*
   **SOUTHWALL TECHNOLOGIES INC.**
 **UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS**
 **(in
thousands, except per share data)**
 
 Three
      months endedApril
      3,
    
    March
      28,2005
    
    2004Net
      revenues
    
    $
    15,647
    
    $
    11,067Cost
      of revenues
    
    
    11,270
    
    
    8,466Gross
      profit
    
    
    4,377
    
    
    2,601Operating
      expenses:Research
      and development
    
    
    696
    
    
    810Selling,
      general and administrative
    
    
    2,026
    
    
    3,063Impairment
      recoveries for long-lived assets
    
    
    (170
    )
    
    --Total
      operating expense
    
    
    2,552
    
    
    3,873Income
      (loss) from operations
    
    
    1,825
    
    
    (1,272
    )Interest
      expense, net
    
    
    (271
    )
    
    (675
    )Cost
      of warrants issued
    
    
    --
    
    
    (4,818
    )Other
      income, net
    
    
    292
    
    
    430Income
      (loss) before provision for income taxes
    
    
    1,846
    
    
    (6,335
    )Provision
      for income taxes
    
    
    147
    
    
    355Net
      income (loss)
    
    
    1,699
    
    
    (6,690
    )Deemed
      dividend on redeemable preferred stock
    
    
    123
    
    
    --Net
      income (loss) attributable to common stockholders
    
    $
    1,576
    
    $
    (6,690
    )Net
      income (loss) per share:Basic
    
    $
    0.06
    
    $
    (0.53
    )Diluted
    
    $
    0.05
    
    $
    (0.53
    )Shares
      used in computing net income (loss) per share:Basic
    
    
    26,613
    
    
    12,548Diluted
    
    
    33,181
    
    
    12,548
  See
accompanying notes to unaudited condensed consolidated financial
statements.
  4
 *Index*
  **SOUTHWALL TECHNOLOGIES INC.**
 **UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH
FLOWS**
 **(in
thousands)**
 Three
      months endedApril
      3,
    
    March
      28,*Cash
      flows from operating activities:*
    
    2005
    
    2004Net
      income (loss)
    
    $
    1,699
    
    $
    (6,690
    )Adjustments
      to reconcile net income (loss) to net cash provided by (used in)operating
      activities:Impairment
      recoveries from long-lived assets
    
    
    (170
    )
    
    -Depreciation
      and amortization
    
    
    623
    
    
    615Charges
      related to warrants issued to investors and creditors
    
    
    -
    
    
    4,818Amortization
      of debt issuance costs
    
    
    -
    
    
    59Stock
      compensation
    
    
    91
    
    
    -Change
      in assets and liabilities:Deferred
      revenues
    
    
    (8
    )
    
    -Accounts
      receivable, net
    
    
    (334
    )
    
    2,439Inventories,
      net
    
    
    (8
    )
    
    (50
    )Other
      current and non current assets
    
    
    (570
    )
    
    (2,501
    )Accounts
      payable and accrued liabilities
    
    
    (764
    )
    
    (660
    )*Net
      cash provided by (used in) operating activities*
    
    
    559
    
    
    (1,970
    )*Cash
      flows from investing activities*:Decrease
      in restricted cash
    
    
    191
    
    
    -Proceeds
      from sale of property, plant and equipment
    
    
    170
    
    
    -Expenditures
      for property, plant and equipment
    
    
    (136
    )
    
    (347
    )*Net
      cash provided by (used in) investing activities*
    
    
    225
    
    
    (347
    )*Cash
      flows from financing activities*:Repayments
      under capital lease
    
    
    (4
    )
    
    -Proceeds
      from exercise of stock options
    
    
    19
    
    
    -Principal
      payment on borrowings
    
    
    (812
    )
    
    (837
    )Payments
      on line of credit
    
    
    -
    
    
    (1,298
    )Proceeds
      from sale of convertible promissory notes
    
    
    -
    
    
    4,500Investment
      credit in Germany
    
    
    (5
    )
    
    --*Net
      cash provided by (used in) financing activities*
    
    
    (802
    )
    
    2,365Effect
      of foreign exchange rate changes on cash
    
    
    (10
    )
    
    268Net
      increase (decrease) in cash and cash equivalents
    
    
    (28
    )
    
    316Cash
      and cash equivalents, beginning of period
    
    
    4,547
    
    
    1,152Cash
      and cash equivalents, end of period
    
    $
    4,519
    
    $
    1,468Supplemental
      cash flow disclosures:Cash
      paid for interest
    
    $
    234
    
    $
    337Cash
      paid for income taxes
    
    $
    11
    
    $
    90
 
 See
accompanying notes to unaudited condensed consolidated financial
statements.
  5
 *Index*
   **SOUTHWALL TECHNOLOGIES INC.**
 **NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS**
  **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,
2004 filed with the Securities and Exchange Commission on March 30, 2005. 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 April 3, 2005 and March 28, 2004 each included 13 weeks.
 
 **Note 2—Balance
Sheet:**
 
 *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 net revenues. At April 3, 2005 and December 31, 2004,
inventories consisted of the following (in thousands):
 April
      3,
    
    December
      31,2005
    
    2004Raw
      materials
    
    $
    4,048
    
    $
    4,755Work-in-process
    
    
    3,502
    
    
    2,059Finished
      goods
    
    
    813
    
    
    1,541$
    8,363
    
    $
    8,355
 *Other
long-term liabilities*
 
 Other
long-term liabilities consisted of the following at April 3, 2005 and December
31, 2004 (in thousands):
 
 April
      3,
    
    December
      31,2005
    
    2004Liabilities
      associated with settlement agreement
    
    $
    2,354
    
    $
    2,354Deferred
      tax liability
    
    
    331
    
    
    397Long-term
      restructuring costs
    
    
    200
    
    
    200Other
    
    
    249
    
    
    271$
    3,134
    
    $
    3,222
  6
 *Index*
  **Note 3—Net
Income (Loss) Per Share:**
 
 Basic net
income (loss) per share is computed by dividing income 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
redeemable convertible preferred stock. The computation of diluted income (loss)
per share uses the average of the closing prices of the common stock during the
period.  In addition, the preferred stock dividends are added back to net
income attributable to common stockholders since they would not be paid in cash
if the preferred stock was converted to common stock.
 
 In net
loss periods, the basic and diluted weighted average shares of common stock and
common stock equivalents are the same because the inclusion of common stock
equivalents would be anti-dilutive. Accordingly, for the three-month period
ended March 28, 2004, there was no difference between the denominators used for
the calculation of basic and diluted net loss per share. There were 2,870,197
and 14,241,535 options and warrants, respectively, outstanding at March 28, 2004
that were excluded from the diluted net loss per share calculation as reported
because they were anti-dilutive.
 
 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
antidilutive to earnings per share.  Accordingly, stock options to purchase
1,789,755 shares at an average price of  $3.80 per share were excluded from
the computation of diluted weighted average shares outstanding for the three
month period ended April 3, 2005.
 
 Tables
summarizing net income, for diluted net income per share and shares outstanding
are shown below (in thousands):
 Three
      months endedApril
      3,
    
    March
      28,2005
    
    2004Net
      income (loss) attributable to common stockholders-basic
    
    $
    1,576
    
    $
    (6,690
    )Add:
      Deemed dividend on redeemable preferred stock
    
    
    123
    
    
    -Net
      income (loss) attributable to common stockholders-diluted
    
    $
    1,699
    
    $
    (6,690
    )Weighted
      average common shares outstanding-basic
    
    
    26,613
    
    
    12,548Dilutive
      effect of warrants
    
    
    357
    
    
    -Dilutive
      effect of performance shares
    
    
    149
    
    
    -Dilutive
      effect of Series A preferred shares
    
    
    4,893
    
    
    -Dilutive
      effect of stock options
    
    
    1,169
    
    
    -Weighted
      average common shares outstanding - diluted
    
    
    33,181
    
    
    12,548
  **Note 4
- Segment Reporting:**
 
 Southwall
reports segment information using the management approach to determine segment
information. The management approach designates the internal organization that
is used by management for making operating decisions and assessing performance
as the source of its reportable segments. The Company is organized on the basis
of products and services. The total net revenues for the automotive glass,
electronic display, window film and architectural product lines for the first
quarters of 2005 and 2004 were as follows (in thousands):
  April
      3,2005
    
    March
      28,2004Automotive
      glass
    
    $
    6,385
    
    $
    4,401Electronic
      display
    
    
    4,079
    
    
    3,419Window
      film
    
    
    3,646
    
    
    1,844Architectural
    
    
    1,537
    
    
    1,403Total
      net revenues
    
    $
    15,647
    
    $
    11,067
 7
 *Index*
  The
following is a summary of net revenues by geographic area (based on the location
of the Company’s customers) for the first quarters of 2005 and 2004,
respectively (in thousands):
 
 April
      3,
    
    March
      28,2005
    
    2004United
      States
    
    $
    3,716
    
    $
    1,481Japan
    
    
    3,799
    
    
    2,974France
    
    
    3,323
    
    
    2,248Pacific
      Rim
    
    
    2,562
    
    
    1,670Germany
    
    
    1,345
    
    
    1,423Rest
      of the world
    
    
    902
    
    
    1,271Total
      net revenues
    
    $
    15,647
    
    $
    11,067
 
 
 **Note 5—Commitments
and Contingencies:**
 
 The
Company is named as a defendant, along with Bostik, Inc., in an action captioned
WASCO Products, Inc. v. Southwall Technologies, Inc. and Bostik, Inc., Div.
Action No. C 02 2926 SBA, which was filed in Federal District Court for the
Northern District of California on June 18, 2002. The Company was 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 the Company 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 the Company. The
plaintiff has filed a notice of appeal to the Ninth Circuit Court of Appeals.
Southwall’s insurance carriers under reservation of rights are paying a
percentage of the Company’s defense costs.
 
 The
Company is a defendant in the action captioned Four Seasons Solar Products Corp.
v. Black & Decker Corp., Bostik, Inc. and Southwall Technologies Inc., No. 5
CV 1695, in the United States District Court for the Eastern District of New
York. Plaintiff was a manufacturer of insulated glass units, which incorporate
Heat Mirror film. Plaintiff alleged that a sealant produced by a co-defendant is
defective, asserts causes of action for breach of contract, unfair competition,
and fraudulent concealment, and sought monetary damages of approximately $36
million for past and future replacement costs, loss of customer goodwill, and
punitive damages against all defendants. On April 8, 2003, the Court issued an
order granting final judgment in Southwall’s favor. Four Seasons filed a Notice
of Appeal. On appeal, the judgment in Southwall’s favor was affirmed. The
Company’s insurance carriers under reservation of rights paid a percentage of
the Company’s defense costs.
  8
 *Index*
  The
insurance carriers in some of the litigation related to allege product failures
and defects in window products manufactured by others in which the Company was 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 the Company. As a result, those insurance carriers
could seek from the Company 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 the Company’s insurance policies. The Company intends to
vigorously defend any attempts by these insurance carriers to seek
reimbursement. The Company is 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.
 
 In
addition, the Company is involved, from time to time, in certain other legal
actions arising in the ordinary course of business. Southwall believes, however,
that none of these actions, either individually or in the aggregate, will have a
material adverse effect on its business, its consolidated financial position,
results of operations or cash flows.
 
 **Note 6—Stock-Based
Compensation:**
 
 Statement
of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for
Stock-Based Compensation - Transition and Disclosure, an Amendment of FASB
Statement No. 123” amends the disclosure requirements of Statement of Financial
Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based
Compensation,” to require more prominent disclosures in both annual and interim
financial standards regarding the method of accounting for stock-based employee
compensation and the effect of the method used on reported results.
 
 The
Company accounts for stock-based employee compensation arrangements in
accordance with provisions of Accounting Principles Board Opinion No. 25
(“APB25”), “Accounting for Stock Issued to Employees” and related
interpretations. Under APB 25, compensation expense is based on the difference,
if any, on the date of the grant, between the fair value of the Company’s stock
and the exercise price.
 
 The
following table illustrates the effect on net income and earnings per share if
the Company had applied the fair value recognition provisions of SFAS 123 and
SFAS 148 to stock-based employee compensation (in thousands, except per share
amounts):
 
 Three
      months endedApril
      3,
    
    March
      28,2005
    
    2004Net
      income (loss) attributable to common stockholdersAs
      reported
    
    $
    1,576
    
    $
    (6,690
    )Add:
      Stock-based employee compensation expenseincluded
      in reported net income (loss), net ofrelated
      tax effects
    
    
    91
    
    
    --Deduct:
      Total stock-based employee compensationdetermined
      under fair value based methodfor
      all awards, net of related tax effects
    
    
    (153
    )
    
    (9
    )Pro
      forma net income (loss) attributable to commonstockholders
    
    $
    1,514
    
    $
    (6,699
    )Net
      income (loss) attributable to common stockholdersper
      share:As
      reported - basic
    
    $
    0.06
    
    $
    (0.53
    )Pro
      forma - basic
    
    $
    0.06
    
    $
    (0.53
    )As
      reported - diluted
    
    $
    0.05
    
    $
    (0.53
    )Pro
      forma - diluted
    
    $
    0.05
    
    $
    (0.53
    )
  9
 *Index*
  The fair
value of each option grant under the Company’s stock option plans is estimated
on the date of grant using the Black-Scholes option pricing model, multiple
option approach, with the following weighted average assumptions used for grants
in the first quarter of 2005 and 2004, respectively: expected volatility of
116%, and 99%; risk-free interest rate of 3.56% and 2.3%; and expected lives
from vesting date of 1.4 years and 1.89 years. Southwall did not pay dividends
on common stock during these periods and assumed no dividend yield. The weighted
average fair value of stock options granted in the first quarters of 2005 and
2004 was $0.45 and $1.81 per share, respectively. The Company granted 268,361
and 856,001 options during the first quarters of 2005 and 2004,
respectively.
 
 **Note
7 - Restructuring:**
 
 The
Company implemented a reduction in force at its Palo Alto location in December
2002, and elected to vacate certain buildings in Palo Alto. As result of these
actions, the Company incurred a restructuring charge of $2.6 million in 2002
relating to employee severance packages and the remaining rents due on excess
facilities in Palo Alto no longer occupied.
 
 The
following tables set forth the beginning and ending liability balances relating
to the above described restructuring activity as well as activity during the
fiscal quarters ended April 3, 2005 and March 28, 2004 (in
thousands):
 ExcessFacilities
    
    TotalBalance
      at January 1, 2004
    
    $
    1,569
    
    $
    1,569Provisions
    
    
    --
    
    
    --Cash
      payments
    
    
    (244
    )
    
    (244
    )Balance
      at March 28, 2004
    
    $
    1,325
    
    $
    1,325Balance
      at January 1, 2005
    
    $
    274
    
    $
    274Provisions
    
    
    --
    
    
    --Cash
      payments
    
    
    --
    
    
    --Balance
      at April 3, 2005
    
    $
    274
    
    $
    274
 
 **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 reserve for sales returns and warranties at April 3, 2005 and
March 28, 2004 were as follows (in thousands):
  Balance
      atDecember 31,2003
    
    Provision
    
    Utilized
    
    Balance
      atMarch 28,2004Accrued
      sales returns and warranties
    
    $
    1,850
    
    $
    578
    
    $
    (434
    )
    $
    1,994Balance
      at
      December
      31,
      2004
    
    
    Provision
    
    
    Utilized
    
    Balance
      at
      April
      3,
      2005Accrued
      sales returns and warranties
    
    $
    2,701
    
    $
    58
    
    $
    (564
    )
    $
    2,195
 
  10
 *Index*
  **Note
9 - Recent Accounting Pronouncements:**
 
 In April
2005, the Securities and Exchange Commission announced the adoption of a new
rule that amends the effective date of Statement of Financial Accounting
Standard No 123 (revised 2004). The effective date of the new standard under
these new rules for the Company’s consolidated financial statements is January
1, 2006. Adoption of this statement will have a significant impact on the
Company’s consolidated financial statements as the Company will be required to
expense the fair value of the Company’s stock option grants and stock purchases
under the Company’s employee stock purchase plan rather than disclose the impact
on the Company’s consolidated net income (loss) within the Company’s footnotes,
as is the Company’s current practice.
 
 **Note
10 - Subsequent Events:**
 
 On April
28, 2005, Southwall repaid all obligations outstanding under its credit
agreements with PBF dated December 18, 2003, as amended April 29, 2004.
Principal and interest then outstanding under these agreements of approximately
$3.0 million was repaid with amounts borrowed under a new Credit Agreement with
Wells Fargo HSBC Trade Bank, N.A. (the “Bank”). In connection with this
repayment, PBF will release its security interests in Southwall’s
assets.
 
 On April
28, 2005, Southwall entered into a Credit Agreement (the “Credit Agreement”)
with the Bank, which provides for two facilities - a revolving loan facility and
a formula line. 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.
 
 The first
facility is a revolving line of credit under which Southwall 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 Southwall’s option. The Company
borrowed approximately $3.0 million from this facility on April 28,
2005.
 
 The
second facility is a formula line under which Southwall may from time to time
borrow up to $3 million, subject to certain conditions, with advances of up to
80% of eligible accounts receivable. Amounts borrowed under the second facility
bear interest at the prime rate minus 0.25% per annum. Southwall may not borrow
under the second facility until after June 30, 2005, and only if they meet
certain financial covenants.In addition, if Southwall activates the second
facility, all borrowings under both facilities under the Credit Agreement are
subject to the satisfaction of the additional financial covenants.
 
 All
borrowings under both facilities are secured by Southwall’s inventory,
receivables, raw material, works in progress and other assets. In addition, the
first facility under the Credit Agreement is secured by a letter of credit
posted by Needham & Company, one of Southwall’s stockholders.
 
 The terms
of the Credit Agreement, among other things, limit the ability of Southwall to
(i) incur, assume or guarantee additional indebtedness in excess of $13.5
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 substantially all or a substantial or material portion of Southwall’s assets,
(vi) enter into transactions with affiliates, and (vii) make acquisitions other
than up to an aggregate amount of $3 million and (viii) make capital
expenditures in any fiscal year in excess of $1.5 million.
  11
 *Index*
  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
Southwall’s representations or covenants or other agreements in the Credit
Agreement or related documents, (c) payment defaults or accelerations of other
indebtedness of Southwall, (d) a failure to pay certain judgments, (e) the
occurrence of any event or condition that Bank believes impairs or is
substantially likely to impair the prospects of payment or performance by
Southwall, 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.
  12
 *Index*
  **Item 2—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" and in our Annual Report on
Form 10-K for the year ended December 31, 2004. 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, 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 shares and the warrants were exercised for shares of common stock in the
fourth quarter of 2004.
  *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.
 
 In 1999,
we expanded our relationship with customers in the automotive glass market,
including Pilkington PLC, Saint Gobain Sekurit and Globamatrix Holdings
Pte. Ltd., or Globamatrix, which collectively accounted for approximately
54%, 45%, 45% and 37% of our total revenues during the first quarter of 2005 and
in 2004, 2003 and 2002, respectively.
 
 Under our
agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
purchase commitment of $9.0 million of products **.** 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 $10.3 million
of products in 2005. During the first quarter of 2005, Globamatrix purchased
approximately $3.5 million of products.
  13
 *Index*
  *Sales
returns and allowances.* Our
gross margins and profitability have been adversely affected from time to time
by product quality claims. From 2000 to 2004 our sales returns provision has
averaged approximately 3.5% to 4.7% of gross revenues. In 2002, we had certain
quality claims with respect to products produced for Globamatrix, which reduced
our gross profit by approximately $1.5 million. **** During
the first quarter of 2005, our sales returns provision has average approximately
0.4% of our gross revenues due to less quality claims received during the
period.
  
 **Three
Months Ended April 3, 2005 compared with Three Months Ended March 28,
2004**
 
 **Results
of Operations**
 
 *Net
revenues.* Our net
revenues for the three months ended April 3, 2005 and March 28, 2004 were $15.6
million and $11.1 million, respectively.
 
 Our sales
in the electronic display market increased by $0.7 million, or 19.3%, from $3.4
million in the first quarter of 2004 to $4.1 million in the same period of 2005.
The increase was primarily due to higher demand for our sputtered thin film
filter products for Plasma Display Panel products. Mitsui Chemicals is our
primary customer in the electronic display market. Sales to Mitsui increased
$1.5 million from $2.4 million in the first quarter of 2004 to $3.9 million in
the same period in 2005 due to higher demand for our product in the flat panel
display, or FPD market. This increase was partially offset by decreases in sales
from other customers.
 
 Our sales
in the window film market increased by $1.8 million, or 97.7%, from $1.8 million
in the first quarter of 2004 to $3.6 million in the same period in 2005. We sell
our window film products primarily to customers located in the Pacific Rim and
the Middle East. We believe our sales to this market during the first quarter of
2004 were negatively affected by the SARs epidemic and the conflicts in Iraq and
Afghanistan. Our window film sales reflected strong growth among all four of our
window film customers in the first quarter of 2005 due to higher
demand.
 
 Our sales
in the automotive market increased by $2.0 million, or 45.1% from $4.4 million
in the first quarter of 2004 to $6.4 million in the same period in 2005. The
increase resulted from increased sales to our Original Equipment Manufacturer,
or OEM, and Automotive Replacement Glass, or ARG, customers.
 
 Our sales
in the architectural market were $1.5 million in the first quarter of 2005
compared to $1.4 million in the same period of 2004.
 
 *Cost
of revenues* . Cost of
revenues consists of materials and subcontractor services, labor and
manufacturing overhead. Cost of revenues was $11.3 million in the first quarter
of 2005 compared to $8.5 million in the same period of 2004. The increase in
cost of revenues was primarily due to the increase in revenues.
 
 *Gross
profit and gross margin* . Our
gross profit increased $1.8 million from $2.6 million in the first quarter of
2004 to $4.4 million in the same period of 2005. As a percent of sales, gross
profit increased from 23.5% in the first quarter of 2004 to 28.0% in the same
period in 2005. The increase in gross margin was primarily the result of a $3.3
million reduction in our manufacturing costs from the first quarter of 2004 to
the first quarter of 2005 as a result of the restructuring actions taken in 2003
and the first quarter of 2004. Continued improvements in our Dresden operations
combined with stabilized U.S. production have played an important role in the
increase of our gross margin in the first quarter of 2005 when compared to the
same period in 2004.
  *Operating
expenses*
  14
 *Index*
  *Research
and development* .
Research and development expenses decreased $0.1 million from $0.8 million in
the first quarter of 2004 to $0.7 million in the same period of 2005. The 14.1%
decrease from year to year was due in part to a decrease in labor and employee
benefits costs as a result of the reduction in force of 14 employees initiated
in the fourth quarter of 2003 and completed in the second quarter of 2004. We
are currently conducting a national search for a new Chief Technology
Officer/Vice President of Engineering as well as for several new scientific and
engineering positions. We expect our research and development expenses to
increase in the coming months.
 
 *Selling,
general and administrative* .
Selling, general and administrative expenses consist primarily of corporate and
administrative overhead, selling commissions, advertising costs and occupancy
costs. Selling, general and administrative expenses decreased $1.0 million from
$3.1 million in the first quarter of 2004 to $2.0 million in the same period of
2005. The decrease in general and administrative expenses was primarily due to
lower personnel costs in the amount of $0.4 million, as a result of staff
reductions, which took place in the fourth quarter of 2003 and were completed in
the second quarter of 2004. In addition, legal and accounting fees decreased
from approximately $0.6 million in the first quarter of 2004 to approximately
$0.1 million in the same period of 2005. We expect our selling, general and
administrative expenses to increase slightly as we have started our efforts to
comply with Section 404 of the Sarbanes-Oxley Act of 2002.
 
 *Impairment
(recoveries) for long-lived assets.* The
recovery of $0.2 million of previously recorded impairment charges in the first
quarter of 2005 related to the final payment from the sale of a production
machine in the second quarter of 2004 which was impaired in the third quarter of
2003.
 
 *Income
(loss) from operations* . We
earned income from operations of $1.8 million in the first quarter of 2005
compared to incurring a loss from operations in the same period of 2004 of $6.3
million. The income from operations in 2005 was primarily due to higher net
revenues, higher gross margins and lower operating expenses. The loss from
operations in 2004 was primarily due to lower net revenues, lower gross margins
and higher operating expenses for the reasons described above.
 
 *Interest
expense, net.* Interest
expense decreased by $0.4 million from $0.7 million in the first quarter of 2004
to $0.3 million in the same period of 2005. The decrease in interest expense was
primarily attributable to less outstanding debt in 2005. The primary reduction
in outstanding debt was due to the conversion of the Secured Convertible
Promissory Notes into our Series A shares.
 
 *Costs
of warrants issued.* In
the first quarter of 2004, the Company incurred $4.8 million in warrants expense
as a result of the re-measurement of all outstanding warrants and other
financial instruments. There was no warrants expense recorded in the first
quarter of 2005.
 
 *Other
income, net* . Other
income, net, reflects foreign exchange transaction gains and losses in the first
quarter of 2004 and 2005. Some of our transactions with foreign customers and
suppliers are denominated in foreign currencies, principally the Euro and
Japanese yen. As exchange rates fluctuate relative to the U.S. dollar, exchange
gains and losses occur.
 
 *Income
(loss) before provision for income taxes* . We
recorded a pre-tax profit of $1.8 million in the first quarter of 2005 compared
to a pre-tax loss of $6.3 million in the same period of 2004 for the reasons set
forth above.
 
 *Provision
for income taxes* . The
provision for income taxes in 2004 and 2005 was primarily related to our German
subsidiary, Southwall Europe GmBH (SEG). The decrease in the provision for
income taxes during the first quarter of 2005 when compared to the same period
in 2004 was due to lower taxable income in SEG in 2005.
  15
 *Index*
  *Net
income (loss).* Net
income for the first quarter of 2005 was $1.7 million compared to a net loss of
$6.7 million in the same period of 2004 for the reasons set forth
above.
 
 *Deemed
dividend on redeemable preferred stock.* We
incurred $0.1 million of deemed dividend on redeemable preferred stock in the
first quarter of 2005 as a result of the conversion of our Secured Convertible
Promissory Notes to Series A shares in December 2004. The Series A shares carry
a 10% cumulative dividend rate.
 
 *Net
income (loss) attributable to common stockholders.* Net
income attributable to common stockholders for the first quarter of 2005 was
$1.6 million compared to net loss attributable to common stockholders of $6.7
million for the same period in 2004.
 
 **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 slightly during the first quarter of 2005. 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 accounts payable and accrued
liabilities of $0.8 million. Cash used in operating activities for the first
quarter of 2004 of $2.0 million was primarily the result of net loss of $6.7
million and increases in other current and non-current assets of $2.5 million
and accounts payable and accrued liabilities of $0.7 million, partially offset
by non-cash depreciation of $0.6 million, warrants issued to investors and
creditors of $4.8 million and decreases in account receivable of $2.4 million.
 
 Cash
provided by investing activities for the first quarter of 2005 of $0.2 million
was primarily the result of 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 investing activities for the
first quarter of 2004 of $0.3 million was primarily the result of capital
expenditures.
 
 Cash used
in financing activities for the first quarter of 2005 of $0.8 million primarily
the result of repayments under capital leases and repayments of notes payable of
$0.8 million. Cash provided by financing activities for the first quarter of
2004 of $2.4 million was primarily the result of proceeds from the issuance of
convertible promissory notes of $4.5 million, partially offset by principal
payment of borrowings of $0.8 million and repayments on the line of credit of
$1.3 million.
 
 We
entered into an agreement with the Saxony government in May 1999 under
which we receive investment grants. As of December 31, 2004, we had
received 5.0 million Euros or $6.8 million of the grants and accounted for
these grants by applying the proceeds received to reduce the cost of our fixed
assets of our Dresden manufacturing facility. Additionally, as of December 31,
2004, we have a balance remaining from the government grants received in May
1999 of 0.4 million Euros or $0.5 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. We did not receive any
grants during the first quarter of 2005. 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 total
investment grants and allowances for any year in excess of 33% of our eligible
capital expenditures 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.
  16
 *Index*
  *Borrowing
arrangements*
 
 On April
28, 2005, we repaid all obligations outstanding under our credit agreements with
PBF dated December 18, 2003, as amended April 29, 2004. In connection with this
repayment, PBF will release its security interests in our assets.
 
 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.
 
 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.
 
 The
second facility is formula line under which we may from time to time borrow up
to $3 million, subject to certain conditions, with advances of 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 not borrow under the
second facility until after June 30, 2005, and only if they meet certain
financial covenants. In addition, if we activate the second facility, all
borrowings under both facilities under the Credit Agreement are subject to the
satisfaction of the additional financial covenants.
 
 All
borrowings under both facilities are secured by our inventory, receivables, raw
material, works in progress and other assets. In addition, the first facility
under the Credit Agreement is secured 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 $13.5 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 substantially
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 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.
 
 17
 *Index*
 
 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
anticipate spending approximately $1.1 million in capital expenditures in 2005,
primarily to maintain and upgrade our production facilities in Dresden. We spent
approximately $0.1 million in capital expenditures during the first quarter of
2005.
 
 *Future
payment obligations*
 
 Our
future payment obligations on our borrowings pursuant to our term debt, capital
lease obligations, non-cancelable operating leases and other non-cancelable
contractual commitments are as follows at April 3, 2005 (in
thousands):
 
 GreaterLess
      than
    
    
    
    
    
    ThanTotal
    
    1
      Year
    
    1-3
      Year
    
    4-5
      Year
    
    5
      YearContractual
      Obligations:Term
      debt (1)
    
    $
    11,735
    
    $
    1,267
    
    $
    2,279
    
    $
    5,181
    
    $
    3,008Line
      of credit
    
    
    2,975
    
    
    2,975
    
    
    --
    
    
    --
    
    
    --Capital
      lease obligations
    
    
    39
    
    
    39
    
    
    --
    
    
    --
    
    
    --Operating
      leases (2)
    
    
    2,149
    
    
    541
    
    
    1,523
    
    
    85
    
    
    --Total
      contractual cash obligations
    
    $
    16,898
    
    $
    4,822
    
    $
    3,802
    
    $
    5,266
    
    $
    3,008
  (1)
    Represents
      loan agreements with Portfolio Financing Servicing Company, Bank of
      America and Lehman Brothers, and several German
banks.
 (2)
    Represents
      the remaining rents owed on building we rent in Palo Alto,
      California.
  18
 *Index*
  **Item 3—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 1.75% above the bank
base rate (which was 5.75% at April 3, 2005) or 1% above the LIBOR rate (which
was approximately 3.08% at April 3, 2005) and is calculated based on amounts
borrowed under the facility. In addition, the interest rate on one of our German
loans was reset to the prevailing market rate of 5.75% on December 31, 2004 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 would have had an effect of about $21,000 on
our interest expense for the first quarter of 2005.
 
 *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 2005.
 
 *Foreign
currency risk:* International revenues (defined as sales to customers located outside of the
United States) accounted for approximately 76% of our total sales in the first
quarter of 2005. Approximately 47% of our
international revenues were denominated in Euros relating to sales from our
Dresden operation in the first quarter of 2005. The other 53% 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 less than $0.5 million on net revenues for
the first quarter of 2005 and the effect on expenses of a 10% fluctuation in the
Yen exchange rate would have been minimal.
  19
 *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." 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.
  20
 *Index*
  **RISK
FACTORS**
 
 **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 2004, 2003 and 2002 and negative cash flows from
operations in 2003 and 2002. These factors together with our working capital
position and our significant debt service and other contractual obligations at
April 3, 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,
including the restatement in 2000 of our consolidated financial statements for
prior periods, operating losses in 1998, 1999, 2000, 2002 and 2003, 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.
 
 *The
transactions with Needham and Dolphin may have a negative effect on us or our
stock price* .
 
 As a
result of the consummation of the financing transactions in December 2003 and
February 2004 with Needham & Company and its affiliates and Dolphin
Direct Equity Partners, L.P, our shareholders suffered material dilution. As our
largest stockholder and the guarantor of our line of credit, Needham could
prevent us from seeking additional borrowings or alternative sources of
financing that we require for future operations or otherwise control the company
in ways that might have a material adverse effect on the company or our stock
price.
 
 *Covenants
or defaults under our credit and other loan agreements may prevent us from
borrowing or force us to curtail our operations.*
 
 As of
April 3, 2005, we had total outstanding obligations under our credit and other
loan agreements of $14.7 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 will 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.
 
 *Our
ability to borrow is limited by the nature of our equipment and some of our
accounts receivable* .
 
 Our
equipment is custom designed for a special purpose. In addition, a large portion
of our accounts receivable are from foreign sales, which are often more
difficult to collect than domestic accounts receivable. As a result of the
nature of our equipment and accounts receivable, lenders will generally allow us
to borrow less against these items as collateral than they would for other types
of equipment or domestic accounts receivable, or require us to provide
additional credit enhancements.
  21
 *Index*
  *If we
default under our secured credit facilities and financing arrangements, the
lenders could foreclose on the assets we have pledged to them requiring us to
significantly curtail or even cease our operations* .
 
 In
connection with our current borrowing facilities and financing arrangements, we
have granted security interests in and liens on substantially all of our assets,
including our production machines and our Dresden facility, to secure the loans.
If our senior lenders were to repossess one or more of those machines, our
ability to produce product would be materially impaired. Our revenues, gross
margins and operating efficiency would also be materially adversely affected.
Our obligations under our secured credit facilities contain cross-default and
cross-acceleration provisions and provisions that allow the lenders to declare
the loans immediately due if there is a material adverse change in our business.
If we default under the credit facilities or financing arrangements the lenders
could declare all of the funds borrowed thereunder, together with all accrued
interest, immediately due and payable. If we are unable to repay such
indebtedness, the lenders could foreclose on the pledged assets. If the lenders
foreclose on our assets, we would be forced to significantly curtail or even
cease our operations.
 
 *Our
quarterly revenue and operating results are volatile and difficult to predict.
If we fail to meet the expectations of public market analysts or investors, the
market price of our common stock may decrease significantly.*
 
 Our
quarterly revenue and operating results have varied significantly in the past
and will likely vary significantly in the future. Our revenue and operating
results may fall below the expectations of securities analysts or investors in
future periods. Our failure to meet these expectations would likely adversely
affect the market price of our common stock.
 
 Our
quarterly revenue and operating results may vary depending on a number of
factors, including:
 
 l
    fluctuating
      customer demand, which is influenced by a number of factors, including
      market acceptance of our products and the products of our customers and
      end-users, changes in product mix, and the timing, cancellation or delay
      of customer orders and shipments;
 
 l
    the
      timing of shipments of our products by us and by independent
      subcontractors to our customers;
 
 l
    manufacturing
      and operational difficulties that may arise due to, among other things,
      quality control, capacity utilization of our production machines,
      unscheduled equipment maintenance, and the hiring and training of
      additional staff;
 
 l
    our
      ability to introduce new products on a timely basis; and
 
 l
    competition,
      including the introduction or announcement of new products by competitors,
      the adoption of competitive technologies by our customers, the addition of
      new production capacity by competitors and competitive pressures on prices
      of our products and those of our customers.
 
 *We
expect to be subject to increased foreign currency risk in our international
operations.*
 
 In 2003
and 2004 and during the first quarter of 2005, approximately 34%, 31%, and 36%
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.
  22
 *Index*
  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.
 
 *Our
suppliers and subcontractors may impose more onerous payment terms on
us.*
 
 As a
result of our financial performance and voluntary delisting from NASDAQ, our
suppliers and creditors may impose more onerous payment terms on us, which may
have a material adverse effect on our financial performance and our liquidity.
For example, one of our subcontractors has required us to provide it with a
security interest in all of our inventory held by it and has limited the amount
of unpaid invoices we may have outstanding with it at any time.
 
 **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 81%, 79%, 84% and 84% of net
revenues during the first quarter of 2005 and in fiscal years 2004, 2003, and
2002, respectively. We have contracts extending past 2005 with only two of these
customers. We expect to continue to derive a significant portion of our
net revenues 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 2002 and 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.
 
 *We
must continue to develop new products or enhance existing products on a timely
basis to compete successfully in a rapidly changing
marketplace.*
 
 Our
future success depends upon our ability to introduce new products, improve
existing products and processes to keep pace with technological and market
developments, and to address the increasingly sophisticated and demanding needs
of our customers, especially in the electronic display and automotive markets.
Technological changes, process improvements, or operating improvements that
could adversely affect us include:
 
 l
    the
      development of competing technologies to our anti-reflective and silver
      reflector films for liquid crystal displays in the flat panel display
      industry;
  l
    changes
      in the way coatings are applied to alternative substrates such as
      tri-acetate cellulose, or TAC;
  l
    the
      development of new technologies that improve the manufacturing efficiency
      of our competitors;
  l
    the
      development of new materials that improve the performance of products that
      could compete with our products; and
 
 l
    improvements
      in the alternatives to the sputtering technology we use to produce our
      products, such as plasma enhanced chemical vapor deposition, or PECVD.
  23
 *Index*
  Our
research and development efforts may not be successful in developing products in
the time, or with the characteristics, necessary to meet customer needs. If we
do not adapt to technological changes or process or operating improvements, our
competitive position, operations and prospects would be materially adversely
affected.
 
 *Our
ability to successfully identify suitable target companies and integrate
acquired companies or technologies may affect our future
growth.*
 
 A
potential part of our continuing business strategy is to consider acquiring
companies, products, and technologies that complement our current products,
enhance our market coverage, technical capabilities or production capacity, or
offer other growth opportunities. Our ability to successfully complete
acquisitions requires that we identify suitable target companies, agree on
acceptable terms, and obtain acquisition financing on acceptable terms. In
connection with these acquisitions, we could incur debt, amortization expenses
relating to identified intangibles, impairment charges relating to goodwill, or
merger related charges, or could issue stock that would dilute our current
shareholders' percentage of ownership. The success of any acquisitions will
depend upon our ability to integrate acquired operations, retain and motivate
acquired personnel, and increase the customer base of the combined businesses.
We cannot assure you that we will be able to accomplish all of these goals. Any
future acquisitions would involve certain additional risks, including:
 
 l
    difficulty
      integrating the purchased operations, technologies, or products;
 
 l
    unanticipated
      costs, which would reduce our profitability;
 
 l
    diversion
      of management's attention from our core business;
 
 l
    potential
      entrance into markets in which we have limited or no prior experience; and
 
 l
    potential
      loss of key employees, particularly those of the acquired business.
 
 *If
one of our customers is able to enforce a European automotive film patent, we
may be restricted from using the methods present in such patent to produce some
of our products.*
 
 On March
3, 2005, the European Patent Office allowed a European patent owned by
Pilkington Automotive GmBH entitled "Method for producing a laminated glass pane
free of optical obstruction caused by warping, use of a particular carrier film
for the production of the laminated glass pane and carrier films particularly
suitable for the method of use." This European patent covers certain laminated
films and methods of using them which may prevent us from producing certain
films designed for the automotive markets. Our inability to use this technology
could adversely affect our ability to provide a full range of products to the
automotive film market. We participated in opposing the European patent and will
appeal the European Patent Office decision.
 
 *Failure
to meet the volume requirements of our customers may result in a loss of
business or contractual penalties.*
  24
 *Index*
  Our
long-term competitive position will depend to a significant extent on our
manufacturing capacity. The failure to have sufficient capacity, to fully
utilize capacity when needed or to successfully integrate and manage additional
capacity in the future could adversely affect our relationships with customers
and cause customers to buy similar products from our competitors if we are
unable to meet their needs. For example, we believe that we lost substantial
potential architectural products sales in 2001 because we did not have the
capacity to manufacture the required amounts of products. Also, our failure to
produce required amounts of products under some of our contracts will result in
price reductions on future sales under such contracts or penalties under which
we would be required to reimburse the customer for the full cost of any product
not delivered in a timely manner, either of which would reduce our gross
margins.
 
 *We
depend on our OEM customers for the sale of our products.*
 
 We sell a
substantial portion of our products to a relatively small number of original
equipment manufacturers, or OEMs. The timing and amount of sales to these
customers ultimately depend on sales levels and shipping schedules for the OEM
products into which our products are incorporated. We have no control over the
volume of products shipped by our OEM customers or shipping dates, and we cannot
be certain that our OEM customers will continue to ship products that
incorporate our products at current levels or at all. We currently have
long-term contracts with only two of our OEM customers. Failure of our OEM
customers to achieve significant sales of products incorporating our products
and fluctuations in the timing and volume of such sales could be harmful to our
business. Failure of these customers to inform us of changes in their production
needs in a timely manner could also hinder our ability to effectively manage our
business.
 
 *We
rely upon our OEM customers for information relating to the development of new
products so that we are able to meet end-user demands.*
 
 We rely
on our OEM customers to inform us of opportunities to develop new products that
serve end-user demands. If our OEM customers do not present us with market
opportunities early enough for us to develop products to meet end-user needs in
a timely fashion, or if the OEMs fail to anticipate end-user needs at all,
we may fail to develop new products or modify our existing products for the
end-user markets for our products. In addition, if our OEM customers fail to
accurately anticipate end-user demands, we may spend resources on products that
are not commercially successful.
 
 *We
depend on a distributor for the sale of our after-market
products.*
 
 We
primarily use one independent distributor to sell our after-market products. We
have a distribution agreement with Globamatrix Holdings Pte. Ltd., or
Globamatrix, under which we granted an exclusive worldwide license to distribute
our after-market applied film in the automotive and architectural glass markets.
Failure of Globamatrix to achieve significant sales of products incorporating
our products and fluctuations in the timing and volume of such sales could be
harmful to our business. We believe that the success of our after-market
products will continue to depend upon this distributor.
 
 *We
face intense competition, which could affect our ability to increase our
revenue, maintain our margins and increase our market share.*
 
 The
market for each of our products is intensely competitive and we expect
competition to increase in the future. Competitors vary in size and in the scope
and breadth of the products they offer. We compete both with companies using
technology similar to ours and companies using other technologies or developing
improved technologies. Direct-to-glass sputtering represents the principal
alternative technology to our sputter-coated film products. Direct-to-glass is a
mature, well-known process for applying thin film coatings directly to glass,
which is used by some of our current and potential customers to produce products
that compete with our products. This technology is commonly used to manufacture
products that conserve energy in buildings and automobiles. Many of our current
and potential competitors have significantly greater financial, technical,
marketing and other resources than we have. In addition, many of our competitors
have well-established relationships with our current and potential customers and
have extensive knowledge of our industry.
  25
 *Index*
  *We
are dependent on key suppliers of materials, which may prevent us from
delivering product in a timely manner.*
 
 We
manufacture all of our products using materials procured from third-party
suppliers. We do not have long-term contracts with our third-party suppliers.
Certain of the materials we require are obtained from a limited number of
sources. Delays or reductions in product shipments could damage our
relationships with customers. Further, a significant increase in the price of
one or more of the materials used in our products could have a material adverse
effect on our cost of goods sold and operating results.
 
 *We
are dependent on a few qualified subcontractors to add properties to some of our
products.*
 
 We rely
on third-party subcontractors to add properties, such as adhesives, to some of
our products. There are only a limited number of qualified subcontractors that
can provide some of the services we require, and we do not have long-term
contracts with any of those subcontractors. Qualifying alternative
subcontractors could take a great deal of time or cause us to change product
designs. The loss of a subcontractor could adversely affect our ability to meet
our scheduled product deliveries to customers, which could damage our
relationships with customers. If our subcontractors do not produce a quality
product, our yield will decrease and our margins will be lower. Further, a
significant increase in the price charged by one or more of our subcontractors
could force us to raise prices on our products or lower our margins, which could
have a material adverse effect on our operating results.
 
 *We
are dependent on key suppliers of production machines, which may prevent us from
delivering an acceptable product on a timely basis and limit our capacity for
revenue growth.*
 
 Our
production machines are large, complex and difficult to manufacture. It can take
up to a year from the time we order a machine until it is delivered. Following
delivery, it can take us, with the assistance of the manufacturer, up to six
additional months to test and prepare the machine for commercial production.
There are a very limited number of companies that are capable of manufacturing
these machines. Our inability in the future to have new production machines
manufactured and prepared for commercial production in a timely manner would
prevent us from delivering product on a timely basis and limit our capacity for
revenue growth.
 
 *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, due to the deteriorating economic
environment, sales by flat cathode ray tube manufacturers decreased in 2002 and
further in 2003, contributing to our electronic display product revenues
declining by 11% in 2002, and another 3% for 2003. 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.
 
 *Performance,
reliability or quality problems with our products may cause our customers to
reduce or cancel their orders.*
  26
 *Index*
  We
manufacture our products based on specific, technical requirements of each of
our customers. We believe that future orders of our products will depend in part
on our ability to maintain the performance, reliability and quality standards
required by our customers. If our products have performance, reliability or
quality problems, then we may experience:
 
 l
    delays
      in collecting accounts receivable;
 
 l
    higher
      manufacturing costs;
 
 l
    additional
      warranty and service expenses; and
 
 l
    reduced
      or cancelled orders.
 
 *If we
fail to recruit and retain a significant number of qualified technical personnel
we may not be able to develop, enhance and introduce our products on a timely
basis, and our business will be harmed* .
 
 We
require the services of a substantial number of qualified technical personnel.
Intense competition and aggressive recruiting, as well as a high-level of
employee mobility characterize the market for skilled technical personnel. These
characteristics make it particularly difficult for us to attract and retain the
qualified technical personnel we require. We have experienced, and we expect to
continue to experience, difficulty in hiring and retaining highly skilled
employees with appropriate technical qualifications. It is especially difficult
for us to recruit qualified personnel to move to the location of our Palo Alto,
California offices because of the high-cost of living. If we are unable to
recruit and retain a sufficient number of qualified technical employees, we may
not be able to complete the development of, or enhance, our products in a timely
manner. As a result, our business may be harmed and our operating results may
suffer.
 
 *We
may be unable to attract or retain the other highly skilled employees that are
necessary for the success of our business.*
 
 In
addition to our dependence on our technical personnel, our success also depends
on our continuing ability to attract and retain other highly skilled employees.
We depend on the continued services of our senior management, particularly
Thomas G. Hood, our President and Chief Executive Officer. We do not have
employment contracts with any of our officers or key-person life insurance
covering any officer or employee. Our officers have technical and industry
knowledge that cannot easily be replaced. Competition for similar personnel in
our industry where we operate is intense. We have experienced, and we expect to
continue to experience, difficulty in hiring and retaining highly skilled
employees with appropriate qualifications. If we do not succeed in attracting or
retaining the necessary personnel, our business could be adversely
affected.
 
 *If we
are unable to adequately protect our intellectual property, third parties may be
able to duplicate our products or develop functionally equivalent or superior
technology.*
 
 Our
success depends in large part upon our proprietary technology. We rely on our
know-how, as well as a combination of patent, trademark and trade secret
protection, to establish and protect our intellectual property rights. Despite
our efforts to protect our proprietary rights, unauthorized parties may attempt
to copy aspects of our products or to obtain and use information that we regard
as proprietary. Policing unauthorized use of our products is difficult. Our
means of protecting our proprietary rights may not be adequate. In addition, the
laws of some foreign countries do not protect our proprietary rights to as great
an extent as do the laws of the United States. In the next three years, one of
our U.S. patents relating to our architectural products will expire. Expiration
of this patents or our failure to adequately protect our proprietary rights may
allow third parties to duplicate our products or develop functionally equivalent
or superior technology. In addition, our competitors may independently develop
similar technology or design around our proprietary intellectual
property.
  27
 *Index*
  *Our
business is susceptible to numerous risks associated with international
operations.*
 
 Revenues
from international sales amounted to approximately 76%, 79%, 89% and 85% of our
net revenues during the first quarter of 2005 and fiscal years 2004, 2003 and
2002, 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:
 
 l
    unexpected
      changes in and the burdens and costs of compliance with a variety of
      foreign laws and regulatory requirements;
 
 l
    potentially
      adverse tax consequences; and
 
 l
    global
      economic turbulence and political instability.
 
 *If we
fail to comply with environmental regulations, our operations could be
suspended.*
 
 We use
hazardous chemicals in producing our products and have air and water emissions
that require controls. As a result, we are subject to a variety of local, state
and federal governmental regulations relating to the storage, discharge,
handling, emission, generation, manufacture and disposal of toxic or other
hazardous substances used to manufacture our products, compliance with which is
expensive. Our failure to comply with current or future regulations could result
in the imposition of substantial fines on us, suspension of production,
alteration of our manufacturing processes, increased costs or cessation of
operations.
 
 *We
rely on our domestic sales representatives, without whom our architectural
product sales may suffer.*
 
 We use
independent sales representatives to promote our Heat Mirror products to
architects in the United States. If some or all of our sales representatives
experience financial difficulties, or otherwise become unable or unwilling to
promote our products, our business could be harmed. These sales representatives
could reduce or discontinue promotion of our products. They may not devote the
resources necessary to provide effective marketing support to us. In addition,
we depend upon the continued viability and financial resources of these
representatives, many of which are small organizations with limited working
capital. These representatives, in turn, depend substantially on general
economic conditions and other factors affecting the markets for the products
they promote. We believe that our success in this market will continue to depend
upon these sales representatives.
 
 *We
may experience unanticipated warranty or other claims with respect to our
products, which may lead to extensive litigation costs and
expenses.*
 
 In the
ordinary course of business, we have periodically become engaged in litigation
principally as a result of disputes with customers of our architectural
products. We have settled some of these suits and others are pending. We may
become engaged in similar or other lawsuits in the future. Some of our products
that have been the basis for lawsuits against us could be the basis for future
lawsuits. An adverse outcome in the defense of a warranty or other claim could
subject us to significant liabilities to third parties. Any litigation,
regardless of the outcome, could be costly and require significant time and
attention of key members of our management and technical
personnel.
  28
 *Index*
  *We
may face extensive damages or litigation costs if our insurance carriers seek to
have us indemnify them for settlements of past and outstanding
litigation.*
 
 Several
of our insurance carriers have reserved their rights to seek indemnification
from us for substantial amounts paid to plaintiffs by the insurance carriers as
part of settlements of litigation relating to our architectural products. Our
insurance carriers in a case in which the plaintiff alleged we were responsible
for defects in window products manufactured by others have advised us that they
intend to seek reimbursement for settlement and defense costs. Any claims, with
or without merit, could require significant time and attention of key members of
our management and result in costly litigation.
  29
 *Index*
  **I****tem
4—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 chief financial officer, 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
      April 3, 2005. Based on this evaluation, our chief executive officer and
      chief financial officer concluded as of the Evaluation Date that our
      disclosure controls and procedures were effective such that the
      information relating to the 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 chief financial officer, 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, 2006.
 
 *c.*
    *Changes
      in Internal Controls*.
      There were no changes in our internal controls over financial reporting
      identified that are reasonably likely to affect the internal controls over
      financial reporting.
  30
 *Index*
  **PART
II—OTHER INFORMATION**
 
  **Item 1—Legal Proceedings**
 
  Litigation
filed against the Company was described under Item 3 in the Company’s Form 10-K
filed on March 30, 2005. 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.
 
 **Item 2— Unregistered Sales of Equity Securities and Use of
Proceeds.**
 
 None.
 
 **Item 3—Defaults upon Senior Securities**
 
 Not
applicable.
 
  **Item 4—Submission of Matters to a Vote of
Stockholders**
 
 None.
 
  **Item 5—Other Information**
 
 None.
 
  **I****tem
6—Exhibits**
 
 (a)      
 Exhibits
 
 
 ExhibitNumber
    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
      135099.1
    Revolving Credit Loans
      Note-1 in the original principal amount of $3,000,000 dated April 28, 2005
      and issued by the Company to Wells Fargo HSBC Trade Bank99.2
    Revolving Credit Loan
      Note-2 in the original principal amount of $3,000,000 dated April 28, 2005
      and issued by the Company to Wells Fargo HSBC Trade Bank99.3
    Continuing Security
      Agreement Rights to Payment and Inventory dated April 28, 2005 between the
      Company and Wells Fargo HSBC Trade Bank99.4
    Credit Agreement dated
      April 28, 2005 between the Company and Wells Fargo HSBC Trade
    Bank99.5
    Form of Incentive Stock
      option Agreement for the Company's 1997 Stock Incentive Plan99.6
    Form of Non-Qualified
      Stock Option Agreement for the Company's 1997 Stock Incentive
    Plan99.7
    Form of Non-Qualified
      Stock Option Agreement for the Company's 1998 Stock Plan for Employees and
      Consultants
  31
 *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 12, 2005**Southwall
      Technologies Inc.**By:
    /s/
      Thomas G. HoodThomas
      G. Hood*President
      and Chief Executive Officer*By:
    /s/
      Maury AustinMaury
      Austin*Senior
      Vice President and Chief Financial
Officer*
   32