UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549


______________





FORM
10-Q


(MARKONE)


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




For
the quarterly period ended September 30, 2008


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)3788
      Fabian Way, Palo Alto, California
              (Address
      of principal executive offices)
            94303
              (Zip
      Code)








Registrant's
telephone number, including area code:(650) 798-1200


___________________




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. YesxNoo





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





Large
      accelerated filer  ̈
            Accelerated
      filer  ̈
            Non-accelerated
      filer x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange


Act).           Yeso                      Nox





As of
October 31, 2008, there were 28,706,222 shares of the registrant's Common Stock
outstanding.




1


SOUTHWALL
TECHNOLOGIESINC.





INDEX





PagePART
      I – FINANCIAL INFORMATIONItem
      1
                                                            Financial
      StatementsUnaudited Condensed Consolidated Balance Sheets –
      September 30, 2008 and December 31, 2007
                                                            3Unaudited Condensed Consolidated Statements of Operations –
      Three month and nine month periods ended September 30, 2008 and September
      30, 2007
                                                            4Unaudited Condensed Consolidated Statements of Cash Flows -
      nine month periods ended September 30, 2008 and September 30,
      2007
                                                            5Notes to the Unaudited Condensed Consolidated Financial
      Statements
                                                            6Item
      2
                                                            Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                                                            15Item
      3
                                                            Quantitative and Qualitative Disclosures about Market
      Risk
                                                            24Item
      4
                                                            Controls and Procedures
                                                            25PART
      II – OTHER INFORMATIONItem
      1
                                                            Legal Proceedings
                                                            26Item
      1A
                                                            Risk Factors
                                                            26Item
      2
                                                            Unregistered Sales of Equity Securities and Use of
      Proceeds
                                                            27Item
      3
                                                            Defaults upon Senior Securities
                                                            27Item
      4
                                                            Submission of Matters to a Vote of Security
      Holders
                                                            27Item
      5
                                                            Other Information
                                                            27Item
      6
                                                            Exhibits
                                                            27Signatures
                                                            28


2
 Index


PART I.
FINANCIAL INFORMATION





Item
1--Financial Statements:


SOUTHWALLTECHNOLOGIES INC.


UNAUDITED
CONDENSED CONSOLIDATED BALANCE SHEETS


(in
thousands, except per share data)





September
      30,
                
                
                December
      31,2008
                
                
                2007ASSETSCurrent
      assets:Cash
      and cash equivalents
                
                $
                11,673
                
                
                $
                6,492Restricted
      cash
                
                
                286
                
                
                
                294Accounts
      receivable, net of allowance for doubtful accounts of $83 at September 30,
      2008 and $66 at December 31, 2007
                
                
                5,232
                
                
                
                4,346Inventories,
      net
                
                
                5,944
                
                
                
                5,640Restricted
      cash loans
                
                
                1,207
                
                
                
                -Other
      current assets
                
                
                751
                
                
                
                837Total
      current assets
                
                
                25,093
                
                
                
                17,609Property,
      plant and equipment, net
                
                
                15,596
                
                
                
                17,071Restricted
      cash loans
                
                
                -
                
                
                
                1,242Other
      assets
                
                
                659
                
                
                
                1,345Total
      assets
                
                $
                41,348
                
                
                $
                37,267LIABILITIES,
      PREFERRED STOCK AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Current
      portion of long term debt
                
                $
                3,965
                
                
                $
                1,149Accounts
      payable
                
                
                1,304
                
                
                
                964Accrued
      compensation
                
                
                1,478
                
                
                
                1,267Other
      accrued liabilities
                
                
                5,268
                
                
                
                6,350Total
      current liabilities
                
                
                12,015
                
                
                
                9,730Term
      debt
                
                
                4,930
                
                
                
                8,277Other
      long term liabilities
                
                
                2,594
                
                
                
                2,567Total
      liabilities
                
                
                19,539
                
                
                
                20,574Commitments
      and contingencies (Note 6)Series
      A 10% cumulative convertible preferred stock, $0.001 par value; $1.00
      stated value; 5,000 shares authorized, 4,893 shares outstanding at
      September 30, 2008 and December 31, 2007, respectively (Liquidation
      preference: $6,644 and $6,277 at September 30, 2008 and December 31, 2007,
      respectively)
                
                
                4,810
                
                
                
                4,810Stockholders’
      equity:Common
      stock, $0.001 par value per share; 50,000 shares authorized, 28,692 shares
      and 27,820 shares outstanding at September 30, 2008 and December 31, 2007,
      respectively
                
                
                29
                
                
                
                28Capital
      in excess of par value
                
                
                78,376
                
                
                
                78,290Accumulated
      other comprehensive income: Accumulated translation
    adjustment
                
                
                4,405
                
                
                
                4,776Accumulated
      deficit
                
                
                (65,811
                )
                
                
                (71,211
                )Total
      stockholders’ equity
                
                
                16,999
                
                
                
                11,883Total
      liabilities, preferred stock and stockholders’ equity
                
                $
                41,348
                
                
                $
                37,267








See
accompanying notes to unaudited condensed consolidated financial
statements.


3
 Index


SOUTHWALLTECHNOLOGIES INC.


UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(in
thousands, except per share data)







Three
      months ended
                
                
                Nine
      months endedSeptember 30,
                
                
                September 
      30,
                
                
                September 30,
                
                
                September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Net
      revenues
                
                $
                10,632
                
                
                $
                9,249
                
                
                $
                34,887
                
                
                $
                29,005Cost
      of revenues
                
                
                6,383
                
                
                
                6,070
                
                
                
                20,063
                
                
                
                18,673Gross
      profit
                
                
                4,249
                
                
                
                3,179
                
                
                
                14,824
                
                
                
                10,332Operating
      expenses:Research
      and development
                
                
                976
                
                
                
                934
                
                
                
                2,372
                
                
                
                3,173Selling,
      general and administrative
                
                
                1,852
                
                
                
                2,122
                
                
                
                6,170
                
                
                
                6,932Recoveries
      for long-lived assets, net
                
                
                -
                
                
                
                (17
                )
                
                
                -
                
                
                
                (25
                )Total
      operating expenses
                
                
                2,828
                
                
                
                3,039
                
                
                
                8,542
                
                
                
                10,080Income
      from operations
                
                
                1,421
                
                
                
                140
                
                
                
                6,282
                
                
                
                252Interest
      expense, net
                
                
                (170
                )
                
                
                (191
                )
                
                
                (433
                )
                
                
                (471
                )Other
      income (expenses), net
                
                
                (238
                )
                
                
                513
                
                
                
                (123
                )
                
                
                1,561Income
      before provision for income taxes
                
                
                1,013
                
                
                
                462
                
                
                
                5,726
                
                
                
                1,342Provision
      for income taxes
                
                
                5
                
                
                
                212
                
                
                
                326
                
                
                
                398Net
      income
                
                
                1,008
                
                
                
                250
                
                
                
                5,400
                
                
                
                944Deemed
      dividend on preferred stock
                
                
                122
                
                
                
                122
                
                
                
                367
                
                
                
                366Net
      income attributable to common stockholders
                
                $
                886
                
                
                $
                128
                
                
                $
                5,033
                
                
                $
                578Net
      income per share:Basic
                
                $
                0.03
                
                
                $
                0.00
                
                
                $
                0.18
                
                
                $
                0.02Diluted
                
                $
                0.03
                
                
                $
                0.00
                
                
                $
                0.16
                
                
                $
                0.02Shares
      used in computing net income per share:Basic
                
                
                28,409
                
                
                
                27,820
                
                
                
                28,099
                
                
                
                27,493Diluted
                
                
                34,681
                
                
                
                28,867
                
                
                
                34,016
                
                
                
                28,313







See
accompanying notes to unaudited condensed consolidated financial
statements.


4
 Index


SOUTHWALLTECHNOLOGIES INC.


UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(in
thousands)


Nine
      months endedSeptember
      30,
                
                
                September
      30,2008
                
                
                2007Cash
      flows from operating activities:Net
      income
                
                $
                5,400
                
                
                $
                944Adjustments
      to reconcile net income to net cash provided by operating
      activities:Deferred
      income tax
                
                
                (49
                )
                
                
                (56
                )Impairment
      recoveries from long-lived assets
                
                
                -
                
                
                
                (25
                )Depreciation
      and amortization
                
                
                2,054
                
                
                
                2,087Stock-based
      compensation
                
                
                162
                
                
                
                273Changes
      in operating assets and liabilities:Accounts
      receivable, net
                
                
                (840
                )
                
                
                (2,129
                )Inventories,
      net
                
                
                (304
                )
                
                
                (373
                )Other
      current and non-current assets
                
                
                827
                
                
                
                161Accounts
      payable and accrued liabilities
                
                
                (870
                )
                
                
                10Net
      cash provided by operating activities
                
                
                6,380
                
                
                
                892Cash
      flows from investing activities:Restricted
      cash
                
                
                -
                
                
                
                (417
                )Proceeds
      from sale of property, plant and equipment
                
                
                -
                
                
                
                25Expenditures
      for property, plant and equipment
                
                
                (1,047
                )
                
                
                (635
                )Net
      cash used in investing activities
                
                
                (1,047
                )
                
                
                (1,027
                )Cash
      flows from financing activities:Proceeds
      from exercise of stock options
                
                
                293
                
                
                
                357Borrowings
      from equipment financing
                
                
                603
                
                
                
                -Borrowings
      on line of credit
                
                
                -
                
                
                
                3,000Repayments
      on line of credit
                
                
                -
                
                
                
                (2,996
                )Investment
      credit in Germany
                
                
                -
                
                
                
                (3
                )Repayments
      of notes payable
                
                
                (883
                )
                
                
                (837
                )Net
      cash provided by (used in) financing activities
                
                
                13
                
                
                
                (479
                )Effect
      of foreign exchange rate changes on cash
                
                
                (165
                )
                
                
                (135
                )Net
      increase (decrease) in cash and cash equivalents
                
                
                5,181
                
                
                
                (749
                )Cash
      and cash equivalents, beginning of period
                
                
                6,492
                
                
                
                5,524Cash
      and cash equivalents, end of period
                
                $
                11,673
                
                
                $
                4,775Supplemental
      cash flows disclosures:Interest
      paid
                
                $
                569
                
                
                $
                670Income
      taxes paid
                
                $
                291
                
                
                $
                398Supplemental
      schedule of non-cash investing and financing activities:Dividends
      accrued
                
                $
                367
                
                
                $
                366








See
accompanying notes to unaudited condensed consolidated financial
statements.


5
 Index


SOUTHWALLTECHNOLOGIES INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(dollar
and share amounts in thousands, except per share data)




Note 1—Basis
of Presentation:





Southwall
Technologies Inc., including its wholly owned subsidiaries, Southwall Europe
GmbH and Southwall IG Holdings, Inc., are hereafter referred to as the
“Company,” “Registrant,” “We,” “Our” or “Us.”





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 (GAAP) 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
year-end consolidated balance sheet data was derived from audited financial
statements, but does not include all disclosures required by GAAP. 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, 2007
filed with the Securities and Exchange Commission on March 31, 2008. The results
of operations for the interim periods presented are not necessarily indicative
of the operating results to be expected for any future periods.





The
preparation of consolidated financial statements in conformity with GAAP
requires management to make estimates and assumptions, based on all known facts
and circumstances that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of consolidated
financial statements and the reported amounts of revenues and expenses during
the periods.  Management makes these estimates using the best
information available at the time of the estimates.  The estimates
included in preparing our financial statements include:  the accrual
for product returns and warranties, allowance for doubtful accounts, quarterly
taxes, inventory valuations (including reserves for excess and obsolete and
impaired inventories), reserves for decommissioning costs associated with
leasehold asset retirement obligations and valuation of stock-based
compensation.  Actual results could differ from those
estimates.


6
 Index


Note
2–Fair Value Measurement – Cash and Cash Equivalents:





Southwall
invests its cash primarily in money market funds.  We utilize the
market approach to measure fair value of our financial assets.





All cash
equivalents are classified as available-for-sale and are summarized as
follows:





September
      30, 2008Fair Value
                                    
                                    
                                    Book Value
                                    
                                    
                                    UnrealizedGain, netMoney
      Market Funds, Level I
                                    
                                    $
                                    6,538
                                    
                                    
                                    
                                    6,538
                                    
                                    
                                    $
                                    -Money
      Market Funds, Level I
                                    
                                    
                                    928
                                    
                                    
                                    
                                    928
                                    
                                    
                                    
                                    -Certificates
      of Deposit, Level I
                                    
                                    
                                    1,900
                                    
                                    
                                    
                                    1,900
                                    
                                    
                                    
                                    -Total
      cash equivalents
                                    
                                    
                                    9,366
                                    
                                    
                                    
                                    9,366
                                    
                                    
                                    
                                    -Cash
                                    
                                    
                                    2,307
                                    
                                    
                                    
                                    2,307
                                    
                                    
                                    
                                    -Total
      cash, cash equivalents
                                    
                                    $
                                    11,673
                                    
                                    
                                    $
                                    11,673
                                    
                                    
                                    $
                                    -December
      31, 2007Fair Value
                                    
                                    
                                    Book Value
                                    
                                    
                                    UnrealizedGain, netMoney
      Market Funds, Level I
                                    
                                    
                                    400
                                    
                                    
                                    
                                    400
                                    
                                    
                                    $
                                    -Money
      Market Funds, Level I
                                    
                                    
                                    4,682
                                    
                                    
                                    
                                    4,682
                                    
                                    
                                    
                                    -Total
      cash equivalents
                                    
                                    
                                    5,082
                                    
                                    
                                    
                                    5,082
                                    
                                    
                                    
                                    -Cash
                                    
                                    
                                    1,410
                                    
                                    
                                    
                                    1,410
                                    
                                    
                                    
                                    -Total
      cash, cash equivalents
                                    
                                    $
                                    6,492
                                    
                                    
                                    $
                                    6,492
                                    
                                    
                                    $
                                    -





FAS 157
includes a fair value hierarchy that is intended to increase consistency and
comparability in fair value measurements and related disclosures.  The
fair value hierarchy is based on inputs to valuation techniques that are used to
measure fair value that are either observable or
unobservable.  Observable inputs reflect assumptions market
participants would use in pricing an asset or liability based on market data
obtained from independent sources, while unobservable inputs reflect a reporting
entity’s pricing based upon its own market assumptions.





The fair
value hierarchy consists of the following three levels:





Level 1 -
Inputs are quoted prices in active markets for identical assets or
liabilities.


Level 2 -
Inputs are quoted prices for similar assets or liabilities in an active market,
quoted prices for identical or similar assets or liabilities in markets that are
not active, inputs other than quoted prices that are observable and
market-corroborated inputs which are derived principally from or corroborated by
observable market data.


Level 3 –
Inputs are derived from valuation techniques in which one or more significant
inputs or value drivers are unobservable.





Note 3—Inventories,
Net:





Inventories
are stated at the lower of cost (determined by the average cost 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.


7
 Index


Such
provisions are charged to cost of revenues. At September 30, 2008 and December
31, 2007, inventories consisted of the following:








September
      30,
                  
                  
                  December
      31,2008
                  
                  
                  2007Raw
      materials
                  
                  $
                  2,519
                  
                  
                  $
                  3,076Work-in-process
                  
                  
                  1,455
                  
                  
                  
                  787Finished
      goods
                  
                  
                  1,970
                  
                  
                  
                  1,777$
                  5,944
                  
                  
                  $
                  5,640








Note 4--Net
Income Per Share:





Basic net
income per share is computed by dividing net income attributable to common
stockholders (numerator) by the weighted average number of common shares
outstanding (denominator) for the period. Diluted net income per share gives
effect to all dilutive common shares potentially outstanding during the period,
including stock options, warrants to purchase common stock and convertible
preferred stock.  The Company excludes options from the computation of
diluted weighted average shares outstanding if the exercise price of the options
is greater than the average market price of the shares because the inclusion of
these options would be anti-dilutive to earnings per share. The Company
also excludes preferred shares convertible into common stock from the
computation of diluted weighted average shares outstanding, per Statement of
Financial Accounting Standard (“SFAS”) 128, “Earnings Per Share”, when the
effect would be antidilutive.





For the
third quarter of 2008, there were 5,203 options outstanding of which 1,802 were
excluded from the dilutive net income per share calculation, as they were
anti-dilutive because the option prices were higher than the average market
price during the three-month period ended September 30, 2008.  For the
nine months ended September 30, 2008, 2,122 options outstanding were excluded
from the dilutive net income per share calculation.  For the three and
nine month periods ended September 30, 2007, 2,403 and 4,358 options outstanding
were excluded from the dilutive net income per share calculation,
respectively.  In net loss periods, the basic and diluted weighted
average shares of common stock and common stock equivalents are the same because
inclusion of common stock equivalents would be anti-dilutive.





The
Company has accrued a deemed dividend on preferred stock of $122 for each of the
three month periods ended September 30, 2008 and September 30,
2007.  Per SFAS 128, the dilutive effect of convertible securities
shall be reflected in diluted EPS by application of the if-converted method.
Under this method, if an entity has convertible preferred stock outstanding, the
preferred dividends applicable to convertible preferred stock shall be added
back to the numerator unless their effect is antidilutive. For the three and
nine month periods ended September 30, 2007, both the Series A Preferred shares
and the preferred deemed dividend had an antidilutive effect and therefore, were
excluded from the denominator and numerator in the calculation of diluted EPS in
the table below.


8
 Index


Tables
summarizing net income attributable to common stockholders, diluted net income
per share, and shares outstanding are shown below:





Three
      months ended
                
                
                Nine
      months endedSeptember
      30,
                
                
                September
      30,
                
                
                September
      30,
                
                
                September
      30,2008
                
                
                2007
                
                
                2008
                
                
                2007Net
      income attributable to common stockholders-basic
                
                
                886
                
                
                
                128
                
                
                
                5,033
                
                
                
                578Add:Deemed
      dividend on preferred stock
                
                
                122
                
                
                
                122
                
                
                
                367
                
                
                
                366Net
      income attributable to common stockholders-diluted
                
                
                1,008
                
                
                
                250
                
                
                
                5,400
                
                
                
                944Weighted
      average common shares outstanding-basic
                
                
                28,409
                
                
                
                27,820
                
                
                
                28,099
                
                
                
                27,493Dilutive
      effect of warrants
                
                
                -
                
                
                
                356
                
                
                
                -
                
                
                
                355Dilutive
      effect of Series A preferred shares
                
                
                4,893
                
                
                
                -
                
                
                
                4,893
                
                
                
                -Dilutive
      effect of stock options
                
                
                1,379
                
                
                
                691
                
                
                
                1,024
                
                
                
                465Weighted
      average common shares outstanding - diluted
                
                
                34,681
                
                
                
                28,867
                
                
                
                34,016
                
                
                
                28,313Basic
      EPS
                
                
                0.03
                
                
                
                0.00
                
                
                
                0.18
                
                
                
                0.02Dilutive
      EPS
                
                
                0.03
                
                
                
                0.00
                
                
                
                0.16
                
                
                
                0.02








Note 5
– Product Reporting:





Southwall
operates in one segment.  The total net revenues for the automotive
glass, window film, architectural and electronic display product lines for the
three and nine month periods ended September 30, 2008 and September 30, 2007
were as follows:





Three
      months ended
                  
                  
                  Nine
      months endedSeptember
      30,
                  
                  
                  September
      30,
                  
                  
                  September
      30,
                  
                  
                  September
      30,2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Automotive
      glass
                  
                  $
                  4,399
                  
                  
                  $
                  3,763
                  
                  
                  $
                  16,680
                  
                  
                  $
                  11,162Window
      film
                  
                  
                  4,338
                  
                  
                  
                  4,036
                  
                  
                  
                  12,913
                  
                  
                  
                  10,629Architectural
                  
                  
                  1,848
                  
                  
                  
                  1,404
                  
                  
                  
                  4,839
                  
                  
                  
                  4,617Electronic
      display
                  
                  
                  47
                  
                  
                  
                  46
                  
                  
                  
                  455
                  
                  
                  
                  2,597Total
      net revenues
                  
                  $
                  10,632
                  
                  
                  $
                  9,249
                  
                  
                  $
                  34,887
                  
                  
                  $
                  29,005





The
following is a summary of net revenues by geographic area (based on the location
of the Company's customers) for the three and nine months periods ended
September 30, 2008 and September 30, 2007:





Three
      months ended
                  
                  
                  Nine
      months endedSeptember
      30,
                  
                  
                  September
      30,
                  
                  
                  September
      30,
                  
                  
                  September
      30,2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Europe:
      France, Germany
                  
                  $
                  3,907
                  
                  
                  $
                  1,721
                  
                  
                  $
                  13,520
                  
                  
                  $
                  5,847Asia
      Pacific: Japan, Pacific Rim
                  
                  
                  3,771
                  
                  
                  
                  2,867
                  
                  
                  
                  11,076
                  
                  
                  
                  10,299United
      States
                  
                  
                  2,118
                  
                  
                  
                  2,466
                  
                  
                  
                  6,521
                  
                  
                  
                  7,410Rest
      of the world
                  
                  
                  836
                  
                  
                  
                  2,195
                  
                  
                  
                  3,770
                  
                  
                  
                  5,449Total
      net revenues
                  
                  $
                  10,632
                  
                  
                  $
                  9,249
                  
                  
                  $
                  34,887
                  
                  
                  $
                  29,005


9
 Index


Note 6--Commitments
and Contingencies:





Commitments





In
January 2006, we commenced restructuring actions to attempt to improve our cost
structure for 2006 and beyond.  These actions included the closure of
our Palo Alto, California manufacturing facility during 2006.  As
December 2006, we had accrued $1,509 for the closure of our manufacturing
facility and an additional $153 in the fourth quarter of 2007 as a leasehold
asset retirement obligation in connection with the return of our Palo Alto
manufacturing facility to the landlord.  In January 2008, a $1,000
letter of credit and $100 cash security deposit were released to the landlord,
and in February 2008, we entered into a settlement agreement with the landlord
under which we paid the landlord an additional $400, thereby releasing us from
any further rent or building restoration obligations under the lease for that
specific manufacturing facility, leaving only environmental related costs to be
incurred.  During the third quarter ended September 30, 2008, the
environmental issues were resolved and the remaining $99 accrual was
reversed.





The
Company leases a research and development facility in Palo
Alto.  Under this lease agreement, the Company accrued $200 as a
current leasehold retirement obligation in the first quarter of
2006.  In the fourth quarter of 2007, the Company increased the
accrual to $500, which is included in other accrued liabilities in the
accompanying consolidated balance sheet.  The method and timing of
payments associated with this property are not yet finalized and therefore, this
estimate of our liability could differ from the actual future settlement
amount.





Contingencies





In
September 1995, Pilkington filed a patent application in Germany for XIR film
characteristics. Southwall challenged the patent. This patent was revoked by the
German Patent Court on April 20, 2004. A separate patent application had
been filed by Pilkington in the European Patent Office on September 13,
1996, and a patent was granted. A separate opposition was filed by Southwall;
however, the European Patent Office did not allow the opposition and maintained
the patent. While the reasons for the final decision of the European Patent
Office were issued September 9, 2008, the Company is unable to determine the
impact, if any, at this time.




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





Note 7--Stock-Based
Compensation:





The
Company has a stock-based compensation program that provides its Board of
Directors broad discretion in creating employee equity incentives. The Company
has granted stock options under various option plans and agreements in the past
and currently grants stock options under the 2007 Long Term Incentive Plan which
authorizes the granting of up to 10,000 shares of Common Stock. Under the terms
of this plan, the Company can grant both Incentive Stock Options and
Nonstatutory Stock Options.  Grants issued under the 2007 plan vest
and become exercisable at a rate of 25% on each anniversary of the date of grant
and become fully vested on the fourth anniversary of the date of grant provided
that the participant remains an employee or service provider of the Company or a
related company.  Each option granted under the plan is
non-transferable and expires over terms not exceeding ten years from the date of
grant or 30 days after an option holder’s voluntary termination from the
Company.  If an option holder’s employment is terminated involuntarily
for misconduct, the option will terminate immediately and may no longer be
exercised.  Involuntary termination not for misconduct allows for the
option holder to exercise options within a period of six months after such
termination of service occurs.  The plan provides for longer
expiration periods for employees who terminate but who were employed with the
Company in excess of five years.  Pursuant to the provisions set forth
in the 2007 Plan, the option expiration will be extended anywhere from six
months to one year, dependent upon the employee’s years of
service.  These provisions apply to options that expire as the result
of involuntary termination not for misconduct. As of September 30, 2008, there
were 8,734 shares of common stock available for grant under the 2007 stock
option plan.


10
 Index


On
January 1, 2006, the Company adopted the provisions of SFAS 123R, “Share-Based
Payment” (SFAS 123R), requiring it to recognize expense related to the fair
value of its stock-based compensation awards.  The Company elected to
use the modified prospective transition method as permitted by SFAS 123R and
therefore has not restated its financial results for prior
periods.  Stock-based compensation expense for awards granted prior to
January 1, 2006 was based on the fair value estimated in accordance with SFAS
123, “Accounting for Stock-based Compensation.”  Stock-based
compensation expensed for all stock-based compensation awards granted subsequent
to January 1, 2006 was based on the grant-date fair value estimated in
accordance with the provisions of SFAS 123R.  The Company recognizes
compensation expense for stock option awards on a graded vesting basis over the
requisite service period of the award.





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





Three
      months ended
                          
                          
                          Nine
      months endedSeptember
      30,
                          
                          
                          September 30,
                          
                          
                          September
      30,
                          
                          
                          September
      30,2008
                          
                          
                          2007
                          
                          
                          2008
                          
                          
                          2007Cost
      of sales
                          
                          $
                          3
                          
                          
                          $
                          1
                          
                          
                          $
                          10
                          
                          
                          $
                          3Research
      and development
                          
                          
                          20
                          
                          
                          
                          23
                          
                          
                          
                          21
                          
                          
                          
                          68Selling,
      general and administrative
                          
                          
                          62
                          
                          
                          
                          64
                          
                          
                          
                          131
                          
                          
                          
                          202Stock-based
      compensation expense before income taxes
                          
                          
                          85
                          
                          
                          
                          88
                          
                          
                          
                          162
                          
                          
                          
                          273Income
      tax benefit
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Total
      stock-based compensation expense after income taxes
                          
                          $
                          85
                          
                          
                          $
                          88
                          
                          
                          $
                          162
                          
                          
                          $
                          273





There
were $293 and $357 cash proceeds from the exercise of stock options for the
nine-month period ended September 30, 2008 and September 30, 2007.  In
accordance with SFAS 123R, the Company presents excess tax benefits from the
exercise of stock options, if any, as financing cash flows rather than operating
cash flows.





The fair
value of stock-based awards was estimated using the Black-Scholes model with the
following weighted-average assumptions for stock options granted during the
three month and nine month periods ended September 30, 2008 and September 30,
2007, respectively:





Three
      months ended
                  
                  
                  Nine
      months endedSeptember
      30,
                  
                  
                  September 30,
                  
                  
                  September
      30,
                  
                  
                  September
      30,2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Expected
      life (in years)
                  
                  
                  -
                  
                  
                  
                  6.00
                  
                  
                  
                  5.67
                  
                  
                  
                  6.00Risk-free
      interest rate
                  
                  
                  -
                  
                  
                  
                  4.43
                  %
                  
                  
                  3.08
                  %
                  
                  
                  4.70
                  %Volatility
                  
                  
                  -
                  
                  
                  
                  80
                  %
                  
                  
                  81
                  %
                  
                  
                  80
                  %Dividend
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Per
      share weighted-average fair value at grant date
                  
                  $
                  -
                  
                  
                  $
                  0.75
                  
                  
                  $
                  0.53
                  
                  
                  $
                  0.35





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


11
 Index


Stock
option activity for the nine months ended September 30, 2008 was as
follows:





Shares
                  
                  
                  Weighted-AverageExercise Price
                  
                  
                  Weighted-Average
      Remaining Contractual Term(in
      years)
                  
                  
                  AggregateIntrinsic ValueOutstanding
      at December 31, 2007
                  
                  
                  5,209
                  
                  
                  $
                  1.08Grants
                  
                  
                  1,126
                  
                  
                  
                  0.87Exercises
                  
                  
                  (515
                  )
                  
                  
                  0.57Forfeitures
      or expirations
                  
                  
                  (617
                  )
                  
                  
                  2.17Outstanding
      at September 30, 2008
                  
                  
                  5,203
                  
                  
                  
                  0.96
                  
                  
                  
                  6.52
                  
                  
                  $
                  1,582Vested
      and expected to vest at September 30, 2008
                  
                  
                  4,045
                  
                  
                  
                  1.03
                  
                  
                  
                  5.89
                  
                  
                  $
                  1,159Exercisable
      at September 30, 2008
                  
                  
                  2,894
                  
                  
                  
                  1.16
                  
                  
                  
                  4.71
                  
                  
                  $
                  769








The
aggregate intrinsic value in the table above represents the total pretax
intrinsic value (i.e.: the difference between Southwall’s closing stock price on
the last trading day of its third quarter of fiscal 2008 and the exercise price,
times the number of shares) that would have been received by the option holders
had all option holders exercised their options on September 30,
2008.  This amount changes based on the fair market value of
Southwall’s stock.  Total intrinsic value of options exercised was $51
and $269 for the three and nine month periods ended September 30, 2008. Total
fair value of options granted was $0 and $600 for the three and nine month
period ended September 30, 2008.




As of
September 30, 2008, $456 of total unrecognized compensation cost, net of
forfeitures, related to stock options was expected to be recognized over a
weighted-average period of approximately 2.69 years.





Note
8 - Warranties:





The
Company establishes a reserve for sales returns and warranties for specifically
identified, as well as anticipated sales returns and warranties based on
experience. The activity in the reserve for sales returns and warranties account
during the nine month periods ended September 30, 2008 and September 30, 2007
was as follows:





Balance
      at
                        
                        
                        
                        
                        
                        
                        
                        
                        Balance
      atDecember
      31,
                        
                        
                        
                        
                        
                        
                        
                        
                        September
      30,2006
                        
                        
                        Provision
                        
                        
                        Utilized
                        
                        
                        2007Accrued
      sales returns and warranty
                        
                        $
                        1,415
                        
                        
                        $
                        1,156
                        
                        
                        $
                        (1,550
                        )
                        
                        $
                        1,021Balance
      at
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        Balance
      atDecember
      31,
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        September
      30,2007
                        
                        
                        Provision
                        
                        
                        Utilized
                        
                        
                        2008Accrued
      sales returns and warranty
                        
                        $
                        1,102
                        
                        
                        $
                        1,098
                        
                        
                        $
                        (728
                        )
                        
                        $
                        1,472








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


12
 Index


Note
9 – Comprehensive Income:





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





The
components of comprehensive income for the three and nine month periods ended
September 30, 2008 and September 30, 2007 were as follows:





Three
      months ended
                
                
                Nine
      months endedSeptember
      30,
                
                
                September
      30,
                
                
                September
      30,
                
                
                September
      30,2008
                
                
                2007
                
                
                2008
                
                
                2007Foreign
      Currency Translation Adjustment
                
                $
                (1,246
                )
                
                $
                523
                
                
                $
                (371
                )
                
                $
                625Net
      Income
                
                
                1,008
                
                
                
                250
                
                
                
                5,400
                
                
                
                944Other
      Comprehensive Income (Loss)
                
                $
                (238
                )
                
                $
                773
                
                
                $
                5,029
                
                
                $
                1,569








The
components of accumulated other comprehensive income were as follows at
September 30, 2008:








Accumulated
      Other Comprehensive Income at December 31, 2007
                  
                  $
                  4,776Foreign
      Currency Translation Adjustment
                  
                  
                  (371
                  )Accumulated
      Other Comprehensive Income at September 30, 2008
                  
                  $
                  4,405








Note
10 - Income Tax:





For the
three months ended September 30, 2008, the Company’s effective tax rate was 0.5
%.  This rate differs from the statutory federal rate of 35% primarily
due to the impact of the benefit received from a reduction of the valuation
allowance on the Company’s unbenefitted deferred tax asset due to the current
year U.S. income.  The amount of this benefit is approximately 28.5
%.





For the
nine months ended September 30, 2008, the Company’s effective tax rate was a
provision of 5.69%.  As allowed by FASB Interpretation No. 18,
“Accounting for Income Taxes in Interim Periods” (FIN 18), we have used the
actual effective tax rate for the nine months ended September 30, 2008 as our
best estimate for the tax rate for the year ending December 31, 2008, as a
reliable estimate for the full year cannot be made at this time.  In
addition, to the extent our expected profitability changes during the year, the
effective tax rate would be revised to reflect any changes in the projected
profitability.  This rate differs from the statutory federal rate of
35% primarily due to the release of a portion of the Company’s valuation
allowance on the U.S. deferred tax asset due to the income generated by the U.S.
operations through the first nine months of 2008.  The amount of the
benefit related to this decrease in the valuation allowance was approximately
$1,873 or 32.71%.


13
 Index


The
following table represents the reconciliation of the statutory federal income
tax to the Company's effective tax rate:





Nine
      months Ended
                    
                    
                    Nine
      months EndedSeptember 30, 2008
                    
                    
                    September 30, 2007Federal
      Statutory Rate
                    
                    
                    35.00
                    %
                    
                    
                    35.00
                    %State
      Rate
                    
                    
                    3.18
                    %
                    
                    
                    0.00
                    %Permanent
      Items
                    
                    
                    0.06
                    %
                    
                    
                    0.36
                    %R&D
      Credit
                    
                    
                    0.00
                    %
                    
                    
                    (3.40
                    %)Rate
      Differential
                    
                    
                    0.22
                    %
                    
                    
                    (2.12
                    %)Change
      in Valuation Allowance
                    
                    
                    (32.71
                    %)
                    
                    
                    (0.22
                    %)Other
                    
                    
                    (0.06
                    %)
                    
                    
                    0.00
                    %Effective
      Tax Rate
                    
                    
                    5.69
                    %
                    
                    
                    29.62
                    %





Note
11-Joint Venture





On April
8, 2008, Southwall IG Holdings, Inc., a wholly owned subsidiary of Southwall
Technologies Inc. entered into a Joint Venture Agreement with Sound Solutions
Window & Doors, LLC; creating Southwall Insulating Glass, LLC
(“SIG”).  Southwall Technologies Inc. has a 50% interest in the newly
formed entity.  SIG manufactures insulated glass units for the
domestic market.  The joint venture is being accounted for under the equity
method of accounting.  As of September 30, 2008, the results of
operations and the financial position of this joint venture were not material to
the consolidated financial statements of the Company.




Southwall
IG Holdings, Inc.’s net investment in its joint venture is $288 as of September
30, 2008 and is included in other assets in the accompanying condensed
consolidated balance sheet. No dividends or cash distributions have been made to
date. The Company’s 50% share of losses in the joint venture was $131 and $132
for the three and nine months ended September 30, 2008, respectively, and is
included in other income (expense), net in the accompanying condensed
consolidated statement of operations.


Note
12 – Recent Accounting Pronouncements:





In
February 2008, the FASB issued FASB Staff Position No. FAS 157-2, “Effective
Date of FASB Statement No. 157” (“FSP 157-2”), to partially defer FASB Statement
No. 157, “Fair Value Measurements” (“FAS 157”).  FSP 157-2 defers the
effective date of FAS 157 for nonfinancial assets and nonfinancial liabilities,
except those that are recognized or disclosed at fair value in the financial
statements on a recurring basis (at least annually), to fiscal years, and
interim periods within those fiscal years, beginning after November 15,
2008.  We are currently evaluating the impact of adopting the
provisions of FSP 157-2.




In
February 2007, the FASB issued Statement No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities, Including an Amendment of FASB
Statement No. 115” (SFAS 159).  This statement allows entities to
elect to measure many financial instruments and certain other items that are
similar to financial instruments at fair value that are not currently required
to be measured at fair value.  The election is made on an
instrument-by-instrument basis and is irrevocable.  If the fair value
option is elected for an instrument, the statement specifies that all subsequent
changes in fair value for that instrument shall be reported in
earnings.  Upon initial adoption, this statement provides entities
with a one-time chance to elect the fair value option for the eligible
items.  The effect of the first measurement to fair value should be
reported as a cumulative-effect adjustment to the opening balance of retained
earnings (accumulated deficit) in the year the statement is
adopted.  SFAS 159 was effective for the Company beginning January 1,
2008.  The Company did not make any elections for fair value
accounting and therefore, it did not record a cumulative-effect adjustment to
its opening deficit balance.


14
 Index


Item2--Management's Discussion and Analysis of Financial
Condition and Results of Operations (in thousands):





The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our unaudited condensed
consolidated financial statements and notes thereto appearing elsewhere in this
report. This discussion and analysis contains forward-looking statements that
involve risks and uncertainties, including those discussed below under
"Forward-Looking Statements" and "Risk Factors”, set forth in Part I, Item 1A,
of our Annual Report on Form 10-K for the year ended December 31, 2007 and
in Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2008. 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.





Forward Looking
Statements





Cautionary
Statement For the Purpose of the “Safe Harbor” Provisions of the Private
Securities Litigation Reform Act of 1995





As used
in this report, the terms "we," "us," "our," "Southwall" and the "Company" mean
Southwall Technologies Inc. and its subsidiaries, unless the context
indicates another meaning. This report contains forward-looking statements as
that term is defined in the Private Securities Litigation Reform Act of 1995
that 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, or similar terminology, although not all forward-looking
statements contain these identifying words. Forward-looking statements are only
predictions and include, without limitation, statements relating
to:





·
            our
      strategy, future operations and financial plans
  ;





·
            our
      revenue expectations;





·
            our
      expected results of operations and cash
flows;





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





·
            future
      applications of thin film coating
technologies;





·
            our
      development of new technologies and products; including the early stage of
      our development of products for use in solar power
    generation;





·
            the
      properties and functionality of our
products;





·
            our
      expectation for the continued decline in our sales of electronic display
      products due to increased price sensitivity in this
  market;





·
            our
      expectations for future grants, investment allowances and bank guarantees
      from local and federal governments in
Germany;





·
            our
      projected need for additional borrowings and future
    liquidity;


15
 Index


·
            our
      ability to implement and maintain effective internal controls and
      procedures;





·
            size
      of and the markets into which we sell or intend to sell our
      products;





·
            our
      intentions to pursue strategic alliances, acquisitions and business
      transactions;





·
            the
      results of our joint venture
subsidiary;





·
            strategic
      mergers and acquisitions of
competitors;





·
            the
      possibility of patent and other intellectual property
      infringement;





·
            our
      opinions regarding energy consumption and the loss of energy through
      inefficient glass;





·
            pending,
      decided and threatened litigation and its
  outcome;





·
            our
      competition; 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 under "Risk
Factors" below. These and other 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, we do not assume any
responsibility for the future accuracy and completeness of these forward-looking
statements.





XIR®, XUV®, Triangle
Design®,
Superglass®,
Heat Mirror®,
California Series®, Solis®, ETCH-A-FLEX®, and Southwall
are registered trademarks of Southwall. V-KOOL® is a registered
trademark of V-Kool International Holdings Pte. Ltd.  All other trade
names and trademarks referred to in this Quarterly Report on Form 10-Q are the
property of their respective owners.








Overview





We are a
global developer, manufacturer and marketer of thin film coatings on flexible
substrates for the automotive glass, architectural glass, window film and
electronic display 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; transparent conductive films for use
in touch screen, liquid crystal displays and plasma displays; energy control
films for architectural glass; and various other coatings.





On April
8, 2008, Southwall IG Holdings, Inc., a wholly owned subsidiary of Southwall
Technologies Inc. entered into a Joint Venture Agreement with Sound Solutions
Window & Doors, LLC; creating Southwall Insulating Glass, LLC
(“SIG”).  Southwall Technologies Inc. has a 50% interest in the newly
formed entity.  SIG manufactures insulated glass units for the
domestic market.  The joint venture is being accounted for under the equity
method of accounting.  As of September 30, 2008, the results of
operations and the financial position of this joint venture were not material to
the consolidated financial statements of the Company.


16
 Index


Restructuring.On
January 19, 2006, we commenced restructuring actions to improve our cost
structure for 2006 and beyond.  These actions included the closure of
our Palo Alto, California manufacturing facility during 2006.  We
accrued $1,509 for the closure of our manufacturing facility and an additional
$153 in the fourth quarter of 2007 as a leasehold asset retirement obligation in
connection with the return of our Palo Alto manufacturing facility to the
landlord.  In January 2008, a $1,000 letter of credit and $100 cash
security deposit were released to the landlord, and in February 2008, we entered
into a settlement agreement with the landlord under which we paid the landlord
an additional $400, thereby releasing us from any further rent or building
restoration obligations under the lease for that specific manufacturing
facility, leaving only environmental related costs to be incurred. During the
third quarter ended September 30, 2008, the environmental issues were resolved
and the remaining $99 accrued was reversed.





The
Company leases a research and development facility in Palo Alto. Under this
lease agreement, the Company accrued $200 as a current leasehold retirement
obligation in the first quarter of 2006.  In the fourth quarter of
2007, the Company increased the accrual to $500, which is included in other
accrued liabilities in the accompanying consolidated balance
sheet.  The method and timing of payments associated with this
property have not yet been finalized, and therefore, this estimate of our
liability could differ from the actual future settlement amount.





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





Our three
largest customers in the automotive glass and window film market, and
architectural glass markets include Pilkington PLC, Saint Gobain Sekurit and
Globamatrix Holdings Pte. Ltd., or Globamatrix, which collectively
accounted for approximately 66%, 63% and 44% of our total revenues during the
first nine months of 2008, 2007 and 2006, respectively.





Under our
agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
purchase commitment of $9,000 of product.  For each year
after 2004 through the term of the contract, 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 $13,000 of
certain products in 2008. During the first nine months of 2008, Globamatrix
purchased approximately $12,900 of these products.





Sales returns and
allowances. Our gross margins and profitability have been adversely
affected from time to time by product quality claims. During the first nine
months of 2008, our sales returns provision averaged approximately 3.3% of our
gross revenues over a rolling twelve month period. From 2003 to 2007, our sales
returns provision has averaged approximately 3.4% of gross
revenues.





European Patent.In
September 1995, Pilkington filed a patent application in Germany for XIR film
characteristics. Southwall challenged the patent. This patent was revoked by the
German Patent Court on April 20, 2004. A separate patent application had
been filed by Pilkington in the European Patent Office on September 13,
1996, and a patent was granted. A separate opposition was filed by Southwall.
However, the European Patent Office did not allow the opposition and maintained
the patent.  While the reasons for the final decision of the European
Patent Office were issued September 9, 2008, the Company is unable to determine
the impact, if any, at this time.


17
 Index


Critical
Accounting Policies and Estimates





The
accompanying discussion and analysis of our financial condition and results of
operations are based upon our condensed consolidated financial statements, which
have been prepared in accordance with generally accepted accounting principles
in the United States (GAAP). The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. These estimates form the basis for making judgments
about the carrying values of assets and liabilities that are not readily
apparent from other sources. We base our estimates and judgments on historical
experience and on various other assumptions that we believe are reasonable under
the circumstances. However, future events cannot be forecasted with certainty,
and the best estimates and judgments routinely require adjustment. We are
required to make estimates and judgments in many areas, including those related
to:  the accrual for product returns and warranties, allowance for
doubtful accounts, quarterly taxes, inventory valuations (including reserves for
excess and obsolete and impaired inventories), reserves for decommissioning
costs associated with leasehold asset retirement obligations and valuation of
stock-based compensation. We believe these policies are the most critical to our
financial statements because their application places the most significant
demands on management’s judgment. Senior management has discussed the
development, selection and disclosure of these estimates with the Audit
Committee of our Board of Directors.





We
believe there have been no significant changes during the first nine months of
fiscal 2008 to the items that we disclosed as our critical accounting policies
and estimates in our discussion and analysis of financial condition and results
of operations in our 2007 Form 10-K.








Three
Months Ended September 30, 2008 compared with Three Months Ended September 30,
2007





Results
of Operations





Net revenues.Our net
revenues for the quarter ended September 30, 2008 were $10,632, an increase of
$1,383, or 15.0%, compared to $9,249 for the same period ending September 30,
2007 primarily due to an increase in automotive and window film
sales.





Net
revenues in the automotive market increased by $636, or 16.9%, to $4,399
compared to $3,763 for the
third quarter ended September 30, 2008 and 2007, respectively. The increase was
primarily due to increased demand by several of our large customers, and to a
lesser extent the impact of the U.S. Dollar to Euro exchange rate.




Window
film net revenues increased by $302, or 7.5%, to $4,338 from $4,036 in the third
quarter ended September 30, 2008 and 2007, respectively.  This was
primarily due to increased overall demand for the window film
business.





Architectural
net revenues increased by $444, or 31.6%, to $1,848 from $1,404 in the third
quarter ended September 30, 2008 and 2007, respectively.  This was
primarily due to increased worldwide demand.





Revenue
in our electronic display business increased by $1, or 2%, to $47 compared to
$46 for the third quarter ended September 30, 2008 and 2007,
respectively.





Gross profit and gross
margin. Our gross profit increased $1,070, or 33.7%, to $4,249 compared
to $3,179 for the third quarter ended September 30, 2008 and 2007,
respectively.  As a percentage of sales, gross profit increased to 40%
compared to 34% for the third quarter ended September 30, 2008 and 2007,
respectively.  This was due to lower product costs in the third
quarter of 2008, resulting from an increase in production volume primarily
associated with increased customer demand for automotive and window film
products. Other factors contributing to the increase in gross margin were
improved yields in our window film product line and benefits received from the
recycling of precious metals used in the manufacturing process.


18
 Index


Operating
expenses




Research and
development.  Research and development expenses remained materially
unchanged for the third quarter ended September 30, 2008 compared to the
third quarter ended September 30, 2007.





Selling, general and
administrative.  Selling, general and administrative expenses
consist primarily of corporate and administrative overhead, selling commissions
and occupancy costs. Selling, general and administrative expenses decreased
$270, or 12.7% to $1,852 compared to $2,122 for the third quarter ended
September 30, 2008 and 2007, respectively. This decrease was primarily due to
the elimination of rent payments associated with our former manufacturing
facility in Palo Alto, California and reduced administrative expenses incurred
by our German subsidiary.





Income from
operations.  Income from operations improved $1,281 to $1,421
compared to $140 for the third quarter ended September 30, 2008 and 2007,
respectively.  This improvement was primarily due to improved gross
profit margins and lower operating costs.





Interest expense, net.Interest expense remained materially unchanged.





Other income, net. 
Other income, net mainly reflects non operating related income and expenses as
well as foreign exchange transaction gains and losses in the third quarter of
2008 and 2007. Some of our transactions with foreign customers are denominated
in foreign currencies, principally the Euro. As exchange rates fluctuate
relative to the U.S. dollar, exchange gains and losses occur. Other income, net
changed from income of $513 in the third quarter of 2007 to expense of $238
in the third quarter of 2008 primarily due to milestone payments received
in the third quarter of 2007 per the terms set forth in the Technology Transfer
and Services agreement with Sun Film and a foreign exchange loss impacting the
third quarter of 2008.





Income before provision for income
taxes.  Pre-tax income increased $551 to $1,013 in the third
quarter of 2008 compared to $462 for the third quarter ended September 30, 2007.
This increase was primarily due to a significant increase in operating income
resulting from higher gross profit margins and lower operating
expenses.





Provision for income taxes.The decrease in the provision for income taxes in the three months ended
September 30, 2008 compared to the same period in 2007 is primarily related to
timing differences in the payment of trade taxes and lower taxable income at our
foreign subsidiary, Southwall Europe GmbH, or SEG.





For the
three months ended September 30, 2008, the Company’s effective tax rate was 0.5
%.  This rate differs from the statutory federal rate of 35% primarily
due to the impact of the benefit received from a reduction of the valuation
allowance on the Company’s unbenefitted deferred tax asset due to the current
year U.S. income.  The amount of this benefit is approximately 28.5
%.





Deemed dividend on preferred
stock. We accrued $122 of deemed dividend on preferred stock in the third
quarter of 2008 and 2007, respectively.  The holders of our secured
convertible promissory notes converted those notes to shares of Series A
preferred stock in December 2004. The Series A Preferred Stock accrues
cumulative dividends at the rate of 10% per annum.


19
 Index


Nine
Months Ended September 30, 2008 compared with Nine Months Ended September 30,
2007





Results
of Operations





Net revenues.Our net
revenues for the nine months ended September 30, 2008 were $34,887, an increase
of $5,882,
or 20.3%, compared to $29,005 for the same period ending September 30, 2007
primarily due to an increase in automotive and window film sales.





Our net
revenues in the automotive market increased by $5,518, or 49.4%, to $16,680
compared to $11,162
for the nine months ended September 30, 2008 and 2007, respectively. The
increase was primarily due to increased demand by several of our large
customers, and to a lesser extent the impact of the U.S. Dollar to Euro exchange
rate.





Our net
revenues in the window film product line increased $2,284, or 21.5%, to $12,913
from $10,629 in the nine month period ended September 30, 2008 and 2007,
respectively.  This was primarily due to increased overall demand in
the window film business.





Our net
revenues in architectural products increased $222, or 4.8%, to $4,839 from
$4,617 for the nine months ended September 30, 2008 and 2007,
respectively.  This was primarily due to increased worldwide
demand.





Revenue
in our electronic display market continued to show a decline, where sales
decreased by $2,142, or 82.4
%, to $455 compared to $2,597 for the nine month period ended September 30, 2008
and 2007, respectively.  This decrease was due to the loss of a major
customer, Mitsui, and the Company’s decision not to pursue the plasma display
panel market due to the intensively price competitive market for those
products.  Unless pricing for those products improves, it is likely
that the Company will not make significant future sales of plasma display
panels.





Gross profit and gross
margin. Our gross profit increased $4,492, or 43.5%, to $14,824 compared
to $10,332 for the nine month period ended September 30, 2008 and 2007,
respectively. As a percentage of sales, gross profit increased to 42.5% compared
to 35.6% for the nine months ended September 30, 2008 and 2007,
respectively.  This was due to lower product costs in the first three
quarters of 2008, which were the result of an increase in production volume
associated with increased customer demand for automotive and window film
products. Other factors contributing to the increase in gross margin were
improved yields in our window film product line and credits received relating to
the recycling of precious metals used in the manufacturing process.





Operating
expenses




Research and development.
Research and development expenses decreased $801, or 25.2%, to $2,372 compared
to $3,173 for the nine months ended September 30, 2008 and 2007, respectively.
This decrease was primarily due to the reduction in the number of employees,
decreased reliance on outside service providers and lower material
costs.  In the fourth quarter of 2007, the Company initiated a new
program of customer funded development projects and continued to engage
customers in similar projects in 2008.  The fees paid by customers for
these projects offsets research and development costs.  Until all
products and services are delivered to the customers pursuant to the terms set
forth in the respective development agreements, all credits to research and
development expense are deferred.  Upon satisfaction of the agreement
terms, the credits are recognized on a project by project basis.





Selling, general and
administrative. Selling, general and administrative expenses consist
primarily of corporate and administrative overhead, selling commissions and
occupancy costs. Selling, general and administrative expenses decreased $762, or
11%, to $6,170 compared to $6,932 for the nine months ended September 30, 2008
and 2007, respectively.  This decrease was primarily due to a
reduction in the number of employees in the first quarter of 2008 as compared to
the same period in 2007 and to a lesser extent, the elimination of rent payments
associated with our manufacturing facility in Palo Alto,
California.


20
 Index


Income from
operations.  Income from operations improved $6,030 to $6,282
compared to $252 for the nine months ended September 30, 2008 and 2007,
respectively.  This improvement was primarily due to the combination
of improved gross profit margins and lower operating costs.





Interest expense, net.Interest expense from the nine months ended September 30, 2008 to the
same period in 2007 remained materially unchanged.





Other income,
net





Income before provision for income
taxes.  Pre-tax income increased $4,384 to $5,726 in the nine
months ended September 30, 2008 compared to $1,342 for the nine months ended
September 30, 2007. This increase was primarily due to a significant increase in
operating income resulting from higher gross profit margins and lower operating
expenses.





Provision for income taxes.For the nine months ended September 30, 2008, the Company’s effective tax
rate was a provision of 5.69%.  As allowed by FASB Interpretation
No. 18, Accounting for Income Taxes in Interim Periods” (FIN 18), we have
used the actual effective tax rate for the nine months ended September 30, 2008
as our best estimate for the tax rate for the year ending December 31, 2008, as
a reliable estimate for the full year cannot be made at this time.  In
addition, to the extent our expected profitability changes during the year, the
effective tax rate would be revised to reflect any changes in the projected
profitability.





This rate
differs from the statutory federal rate of 35.00% primarily due to the release
of a portion of the Company’s  valuation allowance on the U.S.
deferred tax asset due to the income generate by the U.S. operations through the
first nine months of 2008.  The amount of the benefit related to this
decrease in the valuation allowance was approximately $1,873 or
32.71%.


21
 Index


The
following table represents the reconciliation of the statutory federal income
tax to the Company's effective tax rate:





Nine
      months Ended
                  
                  
                  Nine
      months EndedSeptember 30, 2008
                  
                  
                  September 30, 2007Federal
      Statutory Rate
                  
                  
                  35.00
                  %
                  
                  
                  35.00
                  %State
      Rate
                  
                  
                  3.18
                  %
                  
                  
                  0.00
                  %Permanent
      Items
                  
                  
                  0.06
                  %
                  
                  
                  0.36
                  %R&D
      Credit
                  
                  
                  0.00
                  %
                  
                  
                  (3.40
                  %)Rate
      Differential
                  
                  
                  0.22
                  %
                  
                  
                  (2.12
                  %)Change
      in Valuation Allowance
                  
                  
                  (32.71
                  %)
                  
                  
                  (0.22
                  %)Other
                  
                  
                  (0.06
                  %)
                  
                  
                  0.00
                  %Effective
      Tax Rate
                  
                  
                  5.69
                  %
                  
                  
                  29.62
                  %








Deemed dividend on preferred
stock. We accrued $367 and $366 of deemed dividend on preferred stock in
the first nine months of 2008 and 2007, respectively.  The holders of
our secured convertible promissory notes converted those notes to shares of
Series A preferred stock in December 2004. The Series A Preferred Stock accrues
cumulative dividends at the rate of 10% per annum.








Liquidity
and Capital Resources





Liquidity




Our
principal liquidity requirements are for working capital, consisting primarily
of accounts receivable and inventories, for debt repayments and capital
expenditures. We believe that because of the 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 increased $5,181 from $6,492 at December 31, 2007 to
$11,673 at September 30, 2008. Cash provided by operating activities of $6,380
for the first nine months of 2008 was primarily the result of net income of
$5,400, non-cash depreciation of $2,054, non-cash stock compensation expense of $162, a
decrease in other current and non current assets of $827 offset by an increase
in accounts receivable of $840 resulting from higher sales volume at the end of
the third quarter, an increase in inventories of $304, a decrease in accounts
payable and accrued liabilities of $870 and a decrease in deferred income tax of
$49.





Cash
provided by operating activities for the first nine months of 2007 of $892 was
primarily the result of net income of $944, non-cash depreciation of $2,087,
non-cash stock compensation expense of  $273, a decrease in other
current and non-current assets of $161 and an increase in accounts payable and
accrued liabilities of $10, offset by an increase in inventories of $373, a
decrease in deferred income tax of $56, a decrease in impairment recoveries of
$25 and an increase in accounts receivable of $2,129.





Cash used
in investing activities for the first nine months of 2008 was $1,047 and was the
result of capital
expenditures. Cash used in investing activities for the first nine months of
2007 was $1,027 and was primarily due to capital expenditures of $635, an
increase in restricted cash of $417 in Germany for purchase of precious metals
used in production offset by proceeds from sale of property, plant and equipment
of $25.


22
 Index


Cash
provided by financing activities for the first nine months of 2008 was $13 and
was the result of proceeds from exercise of stock options of $293, borrowings
from equipment financing of $603 offset by payments on borrowings of $883. Net
cash used in financing activities for the first nine months of 2007 of $479 was
primarily the result of payments on borrowings of $837, offset by proceeds from
exercise of stock options of $357.





We
entered into an agreement with the Saxony government in May 1999 under
which we receive investment grants. As of September 30, 2008, we had received
grants of 5,000 Euros or $5,000 at the historical exchange rate and accounted
for these grants by applying the proceeds received to reduce the cost of our
fixed assets in our Dresden manufacturing facility. As of September 30, 2008,
all government grants had been applied for or repaid.





Borrowing
arrangements





Credit
Agreement with Wells Fargo Bank





On May
19, 2008, Southwall Technologies Inc. (“Southwall”) entered into a new Credit
Agreement with Wells Fargo Bank (“Bank”).  The Credit Agreement
provides for a $3 million revolving line of credit, under which we may, from
time to time, borrow up to 85% of eligible accounts
receivables.  Amounts borrowed under the facility bear interest at
prime plus 0.75% annualized on the average daily financed amount
outstanding.  All borrowings under the facilities are collateralized
by our assets in the United States and are subject to certain covenants
including minimum cumulative quarterly net income, minimum net worth and a
maximum annual cap on unfinanced capital expenditures.





The terms
of the Credit Agreement, among other things, limit our ability to (i) incur,
assume or guarantee additional indebtedness (other than pursuant to the Credit
Agreement), (ii) incur liens upon the collateral pledged to the bank , and (iii)
merge, consolidate, sell or otherwise dispose of substantially all or a
substantial or material portion of our assets.





The
Credit Agreement provides for events of default, which include, among others:
(a) nonpayment of amounts when due, (b) the breach of our representations or
covenants or other agreements in the Credit Agreement of related documents, (c)
defaults or acceleration of our other indebtedness, (d) the occurrence of any
events or condition that the Bank believes impairs or is substantially likely to
impair the prospects of payment of performance by us, and (e) certain events of
bankruptcy, insolvency or reorganization.  Generally, if any event of
default occurs, the Bank may declare all outstanding indebtedness under the
Credit Agreement to be due and payable.  The maturity date of the
facility is May 19, 2009.





The
foregoing 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 material terms thereof.





Capital
expenditures





We expect
to spend approximately $1,500 in 2008 on upgrades and refurbishment of our
production machines and research and development tools. We spent approximately
$1,047 in capital expenditures during the first nine months of
2008.  In addition, we expect to finance approximately $600 on
manufacturing equipment to be used by Southwall Insulating Glass, LLC (“SIG”) to
automate the incorporation of Heat Mirror into insulated glass units during the
manufacturing process.


23
 Index


Future
payment obligations





Our
future payment obligations on our borrowings pursuant to our term debt,
non-cancelable operating leases and other non-cancelable contractual commitments
are as follows at September 30, 2008:





Less
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  GreaterThan
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  ThanTotal
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  1
      Year
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  1-3
      Years
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  3-5
      Years
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  5
      YearsContractual
      Obligations:Term
      debt (1)
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  8,895
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  3,965
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  1,999
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  785
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  2,146Term
      debt Interest (1)
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  1,695
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  492
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  489
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  330
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  384Operating
      leases (2)
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  1,269
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  450
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  819
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  -
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  -Other
      Obligations (3)
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  1,835
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  -
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  -
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  -
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  1,835Total
      contractual cash obligations
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  13,694
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  4,907
      10
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  3,307
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  1,115
                                                                                                                                                                                  
                                                                                                                                                                                  
                                                                                                                                                                                  $
                                                                                                                                                                                  4,365





(1)
                Represents
      the principal and interest allocations of loan agreements with Portfolio
      Financing Servicing
      Company and several German
banks.





(2)
              Represents the remaining rents
      owed on buildings we rent in Palo Alto,
  California.





(3)
              Represents accumulated dividends
      accrual on Series A 10% cumulative convertible preferred stock (greater
      than five years).





Interest
expense relating to term debt decreased for the nine month period ending
September 30, 2007 to September 30, 2008 from $471 to $433,
respectively.  The reason for the decrease is mainly due to lower debt
levels and fluctuations in the Euro exchange rate.





As of
September 30, 2008, we maintained 30,174 square feet of office and warehouse
space at 3780-3788 Fabian Way, Palo Alto, California 94303.  The terms
of the leases for these facilities continue through June 30,
2011.  The monthly rent expense for this facility was $27 through May
31, 2008.  The monthly payment increased to $28 for the remainder of
2008.  In 2009, the monthly rent payments will increase to $38 and
increase annually at a rate of 3% through the expiration of the
lease.





As of
September 30, 2008, we also had a lease obligation for 9,200 square feet at 3961
East Bayshore Road, Palo Alto, California 94303.  This manufacturing
space is currently being subleased to another party.  The monthly rent
payments for this facility are $9.





Item3--Quantitative and Qualitative Disclosures about Market
Risk





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





Financing
risk: The interest rate on one of our German loans has been reset to the
prevailing market rate of 5.75% and another of our German loans will have its
interest rate reset to the prevailing market rate in 2009. Fluctuations or
changes in interest rates may adversely affect our expected interest expense.
The effect of a 10% fluctuation in the interest rate on our line of credit and
term debt would have had an immaterial effect on our interest expense for the
first nine months of 2008.


24
 Index


Investment
risk: We invest our excess cash in money market accounts and, by
practice, make every effort to limit the amount of exposure by investing with
strong, well-known institutions. 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 on our excess cash investments would not have had a material
effect on our interest income in the first nine months of 2008.


.


Foreign currency
risk: International revenues (defined as sales to customers located
outside of the United States) accounted for approximately 80% of our total sales
in the third quarter of 2008. Approximately 53%
of our international revenues were denominated in Euros in the third quarter of
2008. The other 47% of our international sales were denominated in US dollars.
In addition, certain transactions with foreign suppliers are denominated in
foreign currencies. The effect of a 10% fluctuation in the Euro exchange rate
would have had an effect of approximately $756 on net revenues for the third
quarter of 2008.







Item4--Controls and Procedures





(a)
            Evaluation
      and Disclosure Controls and Procedures.  Under the
      supervision and with the participation of our management, including our
      Principal Executive Officer and Principal 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.  Based on this evaluation, our Principal Executive
      Officer and Principal Financial Officer concluded as of the end of the
      period covered by this report, that our disclosure controls and procedures
      were effective, such that the information relating to our company,
      including our consolidated subsidiaries, required to be disclosed in our
      Securities and Exchange Commission (“SEC”) reports (i) is recorded,
      processed, summarized and reported within the time periods specified in
      SEC rules and forms, and (ii) is accumulated and communicated to our
      management, including our principal executive officer and principal
      financial officer, as appropriate to allow timely decisions regarding
      required disclosure.








(b)
            Changes
      in Internal Controls.  There were no changes during the
      first nine months of 2008 in our internal controls over financial
      reporting that have materially affected, or are reasonably likely to
      materially affect, the internal controls over financial
      reporting.




Internal
control systems, no matter how well designed and operated, have inherent
limitations.  Consequently, even a system which is determined to be
effective cannot provide absolute assurance that all control issues have been
detected or prevented.  Our systems of internal controls are designed
to provide reasonable assurance with respect to financial statement preparation
and presentation.


25
 Index


PART
II--OTHER INFORMATION




Item1--Legal Proceedings




In
September 1995, Pilkington filed a patent application in Germany for XIR film
characteristics. Southwall challenged thepatent.
This patent was revoked by the German Patent Court on April 20, 2004. A
separate patent application had been filed by Pilkington in the European Patent
Office on September 13, 1996, and a patent was granted. A separate
opposition was filed by Southwall. However, the European Patent Office did not
allow the opposition and maintained the patent.  While the reasons for
the final decision of the European Patent Office were issued September 9, 2008,
the Company is unable to determine the impact, if any, at this
time.




We are a
party to various pending judicial and administrative proceedings arising in the
ordinary course of business.  While the outcome of the pending
proceedings cannot be predicted with certainty, based on our review, we believe
that any unrecorded liability that may result is not likely to have a material
effect on our liquidity, financial condition or results of
operations.





Item 1A—Risk Factors





The
following information updates should be read in conjunction with the information
disclosed in Item 1A, “Risk Factors,” of our Annual Report on Form 10-K for the
year ended December 31, 2007, filed with the SEC on March 31, 2008.





Financial
Risks





There
have been no significant changes in financial risk factors for the three month
period ended September 30, 2008.  See information set forth in the
section entitled “Risk Factors” in our Annual Report on Form 10-K for the fiscal
year ended December 31, 2007, except (1) with respect to the Pilkington patent
and (2) the current global economic environment. In
September 1995, Pilkington filed a patent application in Germany for XIR film
characteristics. Southwall challenged the patent. This patent was revoked by the
German Patent Court on April 20, 2004. A separate patent application had
been filed by Pilkington in the European Patent Office on September 13,
1996, and a patent was granted. A separate opposition was filed by Southwall.
However, the European Patent Office did not allow the opposition and maintained
the patent.  While the reasons for the final decision of the European
Patent Office were issued September 9, 2008, the Company is unable to determine
the impact, if any, at this time.




Operational
Risks





There
have been no significant changes in operational risk factors for the three month
period ended September 30, 2008.  See information set forth in the
section entitled “Risk Factors” in our Annual Report on Form 10-K for the fiscal
year ended December 31, 2007, except (1) with respect to the Pilkington patent
and (2) the current global economic environment.  In September 1995,
Pilkington filed a patent application in Germany for XIR film characteristics.
Southwall challenged the patent. This patent was revoked by the German Patent
Court on April 20, 2004. A separate patent application had been filed by
Pilkington in the European Patent Office on September 13, 1996, and a
patent was granted. A separate opposition was filed by Southwall. However, the
European Patent Office did not allow the opposition and maintained the
patent.  While the reasons for the final decision of the European
Patent Office were issued September 9, 2008, the Company is unable to determine
the impact, if any, at this time.


26
 Index


In recent
months, worldwide economic conditions have deteriorated significantly in the
United States and other countries and may remain depressed for the foreseeable
future.These
conditions make it difficult for our customers and potential customers to
accurately forecast and plan future business activities and could cause our
customers and potential customers to slow or reduce spending on our
products.  Furthermore, during challenging economic times, our
customers’ ability to make timely payments to us could be
impaired.  If that were to occur, accounts receivable collection time
may increase, and we may be required to increase our allowance for doubtful
accounts accordingly.  We cannot predict the timing, strength or
duration of any economic slowdown or subsequent economic
recovery.  However, these and other economic factors could have a
material adverse effect on demand for our products which would impact our
financial condition and operating results.





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





None.





Item3--Defaults upon Senior Securities





None




Item4--Submission of Matters to a Vote of
Stockholders





None





Item5--Other Information





None





Item6--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
      1350




27
 Index


SIGNATURES




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




Dated:  November
      13, 2008Southwall
      Technologies Inc.By:
            /s/
      Dennis F. CapovillaDennis
      F. CapovillaChief
      Executive OfficerBy:
            /s/
      Mallorie BurakMallorie
      BurakChief
      Accounting Officer