**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


__________________





**FORM
      10-Q**


**(MARK
      ONE)**


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





**For
      the quarterly period ended October 2, 2005**


**or**


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





**For
      the transition period from to**








**Commission
      File Number: 0-15930**


___________________




**SOUTHWALL
      TECHNOLOGIES INC.**


(Exact
      name of registrant as specified in its charter)





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











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


___________________





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





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





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


Act).  Yes o No x





As
      of
      November 1, 2005, there were 26,787,881 shares of the Registrant's Common Stock
      outstanding.







1




**SOUTHWALL
      TECHNOLOGIES INC.**





**INDEX**





PagePART
                I - FINANCIAL INFORMATIONItem
                1
            Financial
                StatementsUnaudited
                Condensed Consolidated Balance Sheets - October
                2, 2005 and December 31, 2004
            3Unaudited
                Condensed Consolidated Statements of
                Operations - Three and nine month periods ended October 2, 2005 and
                September 26, 2004
            4Unaudited
                Condensed Consolidated Statements of Cash
                Flows - Nine month periods ended October 2, 2005 and September 26,
                2004
            5Notes
                to the Unaudited Condensed Consolidated Financial
                Statements
            6Item
                2
            Management’s
                Discussion and Analysis of Financial Condition
                and Results of Operations
            11Item
                3
            Quantitative
                and Qualitative Disclosures about Market
                Risk
            17Item
                4
            Controls
                and Procedures
            25PART
                II - OTHER INFORMATIONItem
                1
            Legal
                Proceedings
            26Item
                2
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            26Item
                3
            Defaults
                upon Senior Securities
            26Item
                4
            Submission
                of Matters to a Vote of Security
                Holders
            26Item
                5
            Other
                Information
            26Item
                6
            Exhibits
            26Signatures
            27


2
 *Index*


PART
      I. FINANCIAL INFORMATION


Item
      1--Financial Statements:


**SOUTHWALL
      TECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED BALANCE SHEETS**


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




October
                2,
              2005
            
            December
                31,
              2004**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            8,066
            
            $
            4,547Restricted
                cash
            
            
            417
            
            
            686Accounts
                receivable, net of allowance for doubtful accounts of $261at
                October 2, 2005 and $292 at December 31, 2004
            
            
            4,739
            
            
            6,186Inventories,
                net
            
            
            7,243
            
            
            8,355Other
                current assets
            
            
            1,056
            
            
            1,757Total
                current assets
            
            
            21,521
            
            
            21,531Property,
                plant and equipment, net
            
            
            17,523
            
            
            21,110Restricted
                cash loans
            
            
            1,016
            
            
            1,149Other
                assets
            
            
            1,135
            
            
            1,157Total
                assets
            
            $
            41,195
            
            $
            44,947**LIABILITIES,
                REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS’
                EQUITY**Current
                liabilities:Current
                portion of long term debt and capital leases
            
            $
            1,327
            
            $
            1,463Line
                of credit
            
            
            2,996
            
            
            2,975Accounts
                payable
            
            
            930
            
            
            2,544Accrued
                compensation
            
            
            1,280
            
            
            1,378Other
                accrued liabilities
            
            
            5,873
            
            
            6,643Total
                current liabilities
            
            
            12,406
            
            
            15,003Term
                debt and capital leases
            
            
            9,188
            
            
            11,644Government
                grants advanced
            
            
            417
            
            
            505Other
                long term liabilities
            
            
            3,073
            
            
            3,222Total
                liabilities
            
            
            25,084
            
            
            30,374Commitments
                and contingencies (Note 5)Series
                A 10% cumulative preferred stock, $0.001 par value; $1.00stated
                value; 5,000 shares authorized, 4,893 shares outstanding(Liquidation
                preference $5,256)
            
            
            4,810
            
            
            4,810Stockholders’
                equity:Common
                stock, $0.001 par value per share; 50,000 shares authorized, 26,788
                shares
                and 26,488 shares outstanding at October 2, 2005 and December 31,
                2004,
                respectively
            
            
            27
            
            
            26Capital
                in excess of par value
            
            
            77,953
            
            
            77,957Accumulated
                other comprehensive income:Accumulated
                translation adjustment
            
            
            2,790
            
            
            4,358Accumulated
                deficit
            
            
            (69,469
            )
            
            (72,578
            )Total
                stockholders’ equity
            
            
            11,301
            
            
            9,763Total
                liabilities, redeemable preferred stock and stockholders’ equity
            
            $
            41,195
            
            $
            44,947





See
      accompanying notes to unaudited condensed consolidated financial
      statements.


3
 *Index*


**SOUTHWALL
      TECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**


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




Three
                months ended
            
            Nine
                months endedOctober
                2,
              2005
            
            September
                26,
              2004
            
            October
                2,
              2005
            
            September
                26,
              2004Net
                revenues
            
            $
            12,025
            
            $
            15,932
            
            $
            42,844
            
            $
            41,547Cost
                of revenues
            
            
            7,921
            
            
            10,152
            
            
            28,979
            
            
            27,554Gross
                profit
            
            
            4,104
            
            
            5,780
            
            
            13,865
            
            
            13,993Operating
                expenses:Research
                and development
            
            
            1,334
            
            
            841
            
            
            3,047
            
            
            2,422Selling,
                general and administrative
            
            
            2,104
            
            
            2,308
            
            
            6,461
            
            
            7,891Impairment
                recoveries for long-lived assets
            
            
            -
            
            
            (85
            )
            
            (170
            )
            
            (1,513
            )Total
                operating expenses
            
            
            3,438
            
            
            3,064
            
            
            9,338
            
            
            8,800Income
                from operations
            
            
            666
            
            
            2,716
            
            
            4,527
            
            
            5,193Interest
                expense, net
            
            
            (210
            )
            
            (444
            )
            
            (778
            )
            
            (1,754
            )Cost
                of warrants issued
            
            
            -
            
            
            (491
            )
            
            -
            
            
            (6,782
            )Other
                income (expenses), net
            
            
            9
            
            
            53
            
            
            142
            
            
            371Income
                (loss) before provision for income taxes
            
            
            465
            
            
            1,834
            
            
            3,891
            
            
            (2,972
            )Provision
                (benefit) for income taxes
            
            
            450
            
            
            (298
            )
            
            782
            
            
            400Net
                income (loss)
            
            
            15
            
            
            2,132
            
            
            3,109
            
            
            (3,372
            )Deemed
                dividend on redeemable preferred stock
            
            
            120
            
            
            -
            
            
            363
            
            
            -Net
                income (loss) attributable to common stockholders
            
            $
            (105
            )
            $
            2,132
            
            $
            2,746
            
            $
            (3,372
            )Net
                income (loss) per share:Basic
            
            $
            0.00
            
            $
            0.17
            
            $
            0.10
            
            $
            (0.27
            )Diluted
            
            $
            0.00
            
            $
            0.07
            
            $
            0.09
            
            $
            (0.27
            )Shares
                used in computing net income (loss) per share:Basic
            
            
            26,788
            
            
            12,550
            
            
            26,727
            
            
            12,550Diluted
            
            
            32,720
            
            
            31,218
            
            
            32,999
            
            
            12,550





See
      accompanying notes to unaudited condensed consolidated financial
      statements.


4
 *Index*




**SOUTHWALL
      TECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(in
      thousands)**





Nine
                months endedOctober
                2,
              2005
            
            September
                26,
              2004Cash
                flows from operating activities:Net
                income (loss)
            
            $
            3,109
            
            $
            (3,372
            )Adjustments
                to reconcile net income (loss) to net cash provided byoperating
                activities:Impairment
                recoveries from long-lived assets
            
            
            (170
            )
            
            (1,513
            )Depreciation
                and amortization
            
            
            1,677
            
            
            1,843Charges
                related to warrants issued to investors and creditors
            
            
            -
            
            
            6,782Amortization
                of debt issuance costs
            
            
            -
            
            
            274Unamortized
                debt discount
            
            
            -
            
            
            78Stock
                compensation
            
            
            45
            
            
            -Change
                in assets and liabilities:Deferred
                revenues
            
            
            (26
            )
            
            (32
            )Accounts
                receivable, net
            
            
            1,456
            
            
            1,354Inventories,
                net
            
            
            1,112
            
            
            507Other
                current and non current assets
            
            
            723
            
            
            (1,339
            )Accounts
                payable and accrued liabilities
            
            
            (2,627
            )
            
            (3,097
            )Net
                cash provided by operating activities
            
            
            5,299
            
            
            1,485Cash
                flows from investing activities:Restricted
                cash
            
            
            244
            
            
            107Proceeds
                from sale of property, plant and equipment
            
            
            170
            
            
            1,614Expenditures
                for property, plant and equipment
            
            
            (535
            )
            
            (75
            )Net
                cash provided by (used in) investing activities
            
            
            (121
            )
            
            1,646Cash
                flows from financing activities:Repayments
                under capital lease
            
            
            (5
            )
            
            -Proceeds
                from exercise of stock options
            
            
            20
            
            
            -Principal
                payments on borrowings
            
            
            (1,354
            )
            
            (2,458
            )Payments
                on line of credit
            
            
            (2,975
            )
            
            (3,649
            )Borrowings
                on line of credit
            
            
            2,996
            
            
            -Proceeds
                from sale of convertible promissory notes
            
            
            -
            
            
            4,500Investment
                credit in Germany
            
            
            (30
            )
            
            -Net
                cash used in financing activities
            
            
            (1,348
            )
            
            (1,607
            )Effect
                of foreign exchange rate changes on cash
            
            
            (311
            )
            
            (16
            )Net
                increase in cash and cash equivalents
            
            
            3,519
            
            
            1,508Cash
                and cash equivalents, beginning of period
            
            
            4,547
            
            
            1,152Cash
                and cash equivalents, end of period
            
            $
            8,066
            
            $
            2,660





See
      accompanying notes to unaudited condensed consolidated financial
      statements.


5
 *Index*


**SOUTHWALL
      TECHNOLOGIES INC.**


**NOTES
      TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





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





The
      accompanying interim condensed consolidated financial statements of Southwall
      Technologies Inc. (“Southwall” or the “Company”) are unaudited and have been
      prepared in accordance with accounting principles generally accepted in the
      United States of America for interim financial information and with the
      instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain
      information and footnote disclosure normally included in financial statements
      prepared in accordance with accounting principles generally accepted in the
      United States of America have been condensed or omitted. In the opinion of
      management, the unaudited condensed consolidated financial statements reflect
      all adjustments, consisting only of normal recurring adjustments, considered
      necessary to present fairly the financial position, results of operations and
      cash flows of Southwall and its subsidiaries for all periods presented. The
      Company suggests that these condensed consolidated financial statements be
      read
      in conjunction with the consolidated financial statements and notes thereto
      contained in the Company's Form 10-K for the year ended December 31,
      2004 filed with the Securities and Exchange Commission on March 30, 2005. The
      results of operations for the interim periods presented are not necessarily
      indicative of the operating results of the full year.





The
      Company uses a 52-week fiscal year ending on December 31. The quarters
      ended October 2, 2005 and September 26, 2004 each included
      13 weeks.





**Note 2—Inventories,
      Net:**





Inventories
      are stated at the lower of cost (determined by the first-in, first-out method)
      or market. Cost includes materials, labor and manufacturing overhead. The
      Company establishes provisions for excess and obsolete inventories to reduce
      such inventories to their estimated net realizable value. Such provisions are
      charged to cost of revenues. At October 2, 2005 and December 31, 2004,
      inventories consisted of the following (in thousands):





October
                2,
              2005
            
            December
                31,
              2004Raw
                materials
            
            $
            4,441
            
            $
            4,755Work-in-process
            
            
            1,852
            
            
            2,059Finished
                goods
            
            
            950
            
            
            1,541$
            7,243
            
            $
            8,355





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





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





The
      Company excludes options from the computation of diluted weighted average shares
      outstanding if the exercise price of the options is greater than the average
      market price of the shares because the inclusion of these options would be
      anti-dilutive to earnings per share.  Accordingly, stock options to
      purchase 2,415,005 and 1,737,505 shares at a weighted average price of $2.74
      and
      $3.35 per share, respectively, were excluded from the computation of diluted
      weighted average shares outstanding for the three and nine-month periods ended
      October 2, 2005, respectively. Stock options to purchase 2,489,535 shares at
      a
      weighted average price of $3.28 per share were excluded from the computation
      of
      diluted weighted average shares outstanding for the three-month period ended
      September 26, 2004.





In
      net
      loss periods, the basic and diluted weighted average shares of common stock
      and
      common stock equivalents are the same because inclusion of common stock
      equivalents would be anti-dilutive. Accordingly, for the nine-month period
      ended
      September 26, 2004, there was no difference between the denominators used for
      the calculation of basic and diluted net income (loss) per share. For the
      nine-month period ended September 26, 2004, there were 2,559,535 and 14,241,535
      anti-dilutive options and warrants outstanding, respectively, excluded from
      the
      net loss per share calculation. Tables
      summarizing net loss attributable to common stockholders, for diluted net income
      (loss) per share, and shares outstanding are shown below (in
      thousands):


6
 *Index*




Three
                  months ended
              
              Nine
                  months endedOctober
                  2,
                2005
              
              September
                  26,
                2004
              
              October
                  2,
                2005
              
              September
                  26,
                2004Net
                  income (loss) attributable to common stockholders-basic
              
              $
              (105
              )
              $
              2,132
              
              $
              2,746
              
              $
              (3,372
              )Add:
                  Interest expense on convertible promissory notes
              
              
              -
              
              
              154
              
              
              -
              
              
              -Add:
                  Deemed dividend on redeemable preferred stock
              
              
              120
              
              
              -
              
              
              363
              
              
              -Net
                  income (loss) attributable to common stockholders-diluted
              
              $
              15
              
              $
              2,286
              
              $
              3,109
              
              $
              (3,372
              )Weighted
                  average common shares outstanding-basic
              
              
              26,788
              
              
              12,550
              
              
              26,727
              
              
              12,550Dilutive
                  effect of warrants
              
              
              356
              
              
              14,241
              
              
              357
              
              
              -Dilutive
                  effect of performance shares
              
              
              -
              
              
              -
              
              
              50
              
              
              -Dilutive
                  effect of Series A preferred shares
              
              
              4,893
              
              
              4,500
              
              
              4,893
              
              
              -Dilutive
                  effect of stock options
              
              
              683
              
              
              -
              
              
              972
              
              
              -Directors’
                  common stock
              
              
              -
              
              
              153
              
              
              -
              
              
              -Number
                  of warrants repurchased
              
              
              -
              
              
              (226
              )
              
              -
              
              
              -Weighted
                  average common shares outstanding - diluted
              
              
              32,720
              
              
              31,218
              
              
              32,999
              
              
              12,550





**Note 4
      - Segment Reporting:**





Southwall
      reports segment information using the management approach to determine segment
      information. The management approach designates the internal organization that
      is used by management for making operating decisions and assessing performance
      as the source of its reportable segments. The Company is organized on the basis
      of products and services. The total net revenues for the automotive glass,
      electronic display, window film and architectural product lines for the three
      and nine-month periods ended October 2, 2005 and September 26, 2004 were as
      follows (in thousands):





Three
                months ended
            
            Nine
                months endedOctober
                2,
              2005
            
            September
                26,
              2004
            
            October
                2,
              2005
            
            September
                26,
              2004Automotive
                glass
            
            $
            3,857
            
            $
            4,586
            
            $
            15,179
            
            $
            14,614Electronic
                display
            
            
            3,049
            
            
            6,498
            
            
            10,425
            
            
            15,713Window
                film
            
            
            3,907
            
            
            2,856
            
            
            13,034
            
            
            6,505Architectural
            
            
            1,212
            
            
            1,992
            
            
            4,206
            
            
            4,715Total
                net revenues
            
            $
            12,025
            
            $
            15,932
            
            $
            42,844
            
            $
            41,547





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-month periods ended October
      2, 2005 and September 26, 2004, respectively (in thousands):





Three
                months ended
            
            Nine
                months endedOctober
                2,
              2005
            
            September
                26,
              2004
            
            October
                2,
              2005
            
            September
                26,
              2004United
                States
            
            $
            3,290
            
            $
            3,602
            
            $
            11,001
            
            $
            8,049Japan
            
            
            2,822
            
            
            5,997
            
            
            9,252
            
            
            14,256France
            
            
            1,955
            
            
            2,290
            
            
            8,448
            
            
            7,009Pacific
                Rim
            
            
            2,713
            
            
            1,896
            
            
            8,798
            
            
            5,086Germany
            
            
            693
            
            
            1,469
            
            
            3,406
            
            
            4,365Rest
                of the world
            
            
            552
            
            
            678
            
            
            1,939
            
            
            2,782Total
                net revenues
            
            $
            12,025
            
            $
            15,932
            
            $
            42,844
            
            $
            41,547






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




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


7
 *Index*


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





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





Statement
      of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for
      Stock-Based Compensation - Transition and Disclosure, an Amendment of FASB
      Statement No. 123” amends the disclosure requirements of Statement of Financial
      Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based
      Compensation,” to require more prominent disclosures in both annual and interim
      financial statements regarding the method of accounting for stock-based employee
      compensation and the effect of the method used on reported results.





The
      Company accounts for stock-based employee compensation arrangements in
      accordance with provisions of Accounting Principles Board Opinion No. 25 (“APB
      25”), “Accounting for Stock Issued to Employees” and related interpretations.
      Under APB 25, compensation expense is based on the difference, if any, on the
      date of the grant, between the fair value of the Company's stock and the
      exercise price.




The
      following table illustrates the effect on net income (loss) attributable to
      common stockholders and net income (loss) attributable to common stockholders
      per share if the Company had applied the fair value recognition provisions
      of
      SFAS 123 and SFAS 148 to stock-based employee compensation (in thousands, except
      per share amounts):





Three
                months ended
            
            Nine
                months endedOctober
                2,
              2005
            
            September
                26,
              2004
            
            October
                2,
              2005
            
            September
                26,
              2004Net
                income (loss) attributable tocommon stockholders:As
                reported
            
            $
            (105
            )
            $
            2,132
            
            $
            2,746
            
            $
            (3,372
            )Add:
                Stock-based employee compensation expense included in reported net
                income
                (loss), net of related tax effects
            
            
            -
            
            
            -
            
            
            45
            
            
            -Deduct:
                Total stock-based employee compensation determined under fair value
                based
                method for all awards, net of related tax effects
            
            
            (200
            )
            
            (57
            )
            
            (502
            )
            
            (259
            )Pro
                forma net income (loss) attributable to common
                stockholders
            
            $
            (305
            )
            $
            2,075
            
            $
            2,289
            
            $
            (3,631
            )Net
                income (loss) attributable to common stockholders per
                share:As
                reported - basic
            
            $
            0.00
            
            $
            0.17
            
            $
            0.10
            
            $
            (0.27
            )Pro
                forma - basic
            
            $
            (0.01
            )
            $
            0.16
            
            $
            0.09
            
            $
            (0.30
            )As
                reported - diluted
            
            $
            0.00
            
            $
            0.07
            
            $
            0.09
            
            $
            (0.27
            )Pro
                forma - diluted
            
            $
            (0.01
            )
            $
            0.07
            
            $
            0.08
            
            $
            (0.30
            )




The
      fair
      value of each option grant under the Company's stock option plans is estimated
      on the date of grant using the Black-Scholes option pricing model, multiple
      option approach, with the following weighted average assumptions used for grants
      in the third quarters of 2005 and 2004, respectively: expected volatility of
      116% and 99%; risk-free interest rate of 4.01% and 2.8%; and expected lives
      from
      vesting date of 2.24 years and 2.75 years. The weighted average fair value
      of
      stock options granted in the third quarters of 2005 and 2004 was $0.70 and
      $0.29
      per share, respectively. The Company did not pay dividends on common stock
      during these periods and assumed no dividend yield. The Company granted 395,000
      and 95,000 options during the third quarters of 2005 and 2004,
      respectively.





The
      following weighted average assumptions were used for grants during the
      nine-month periods of 2005 and 2004, respectively: expected volatility of 116%
      for each period; risk-free interest rate of 3.82% and 2.37%; and expected lives
      from vesting date of 1.94 years and 2.14 years. The weighted average fair value
      of stock options granted during the nine-month periods of 2005 and 2004 was
      $0.65 and $0.97 per share, respectively. The Company did not pay dividends
      on
      common stock during these periods and assumed no dividend yield. The Company
      granted 763,361 and 841,001 options during the first nine months of 2005 and
      2004, respectively.


8
 *Index*


**Note
      7 - Restructuring:**





The
      Company implemented a reduction in force at its Palo Alto location in December
      2002, and elected to vacate certain buildings in Palo Alto. As result of these
      actions, the Company incurred a restructuring charge of $2.6 million in 2002
      relating to employee severance packages and the remaining rents due on excess
      facilities in Palo Alto no longer occupied.





The
      following tables set forth the beginning and ending liability balances relating
      to the above described restructuring activity as well as activity during
      nine-month periods ended October 2, 2005 and September 26, 2004 (in
      thousands):




Excess
                FacilitiesBalance
                  at January 1, 2004
              
              $
              1,569Provisions
              
              
              431Adjustment
                  to reserve
              
              
              (646
              )Cash
                  payments
              
              
              (609
              )Balance
                  at September 26, 2004
              
              $
              745
    Excess
                FacilitiesBalance
                  at January 1, 2005
              
              $
              274Provisions
              
              
              -Adjustment
                  to reserve
              
              
              -Cash
                  payments
              
              
              (21
              )Balance
                  at October 2, 2005
              
              $
              253





At
      October 2, 2005, $106,000 was included in other accrued liabilities, and
      $147,000 was included in other long-term liabilities on the condensed
      consolidated balance sheet.





**Note
      8 - Guarantees:**





The
      Company establishes a reserve for sales returns and warranties for specifically
      identified, as well as anticipated sales returns and warranties based on
      experience. The activity in the reserve for sales returns and warranties account
      during the nine-month periods ended October 2, 2005 and September 26, 2004
      were
      as follows (in thousands):




Balance
                at
              December
                31,
              2003
            
            Provision
            
            Utilized
            
            Balance
                at
              September
                26,
              2004Accrued
                sales returns and warranty
            
            $
            1,850
            
            $
            1,812
            
            $
            (1,020
            )
            $
            2,642





Balance
                at
              December
                31,
              2004
            
            Provision
            
            Utilized
            
            Balance
                at
              October
                2,
              2005Accrued
                sales returns and warranty
            
            $
            2,701
            
            $
            21
            
            $
            (1,137
            )
            $
            1,585





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


9
 *Index*


**Note
      9 - Recent Accounting Pronouncements:**





In
      April
      2005, the Securities and Exchange Commission approved a rule that delayed the
      effective date of Statement of Financial Accounting Standards No. 123 (revised
      2004) to the first annual reporting period beginning after June 15, 2005.
      Adoption of this statement will have an impact on the Company's consolidated
      financial statements as the Company will be required to expense the fair value
      of the Company's stock option grants and stock purchases under the Company's
      employee stock purchase plan rather than disclose the impact on the Company's
      consolidated net income (loss) within the Company's footnotes, as is the
      Company's current practice. The Company is currently evaluating the impact
      that
      adoption of this standard will have on its consolidated results of operations
      and financial condition beginning January 1, 2006 when it becomes
      effective.


10
 *Index*




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





The
      following discussion and analysis of our financial condition and results of
      operations should be read in conjunction with our unaudited condensed
      consolidated financial statements and notes thereto appearing elsewhere in
      this
      report. This discussion and analysis contains forward-looking statements that
      involve risks and uncertainties, including those discussed below under
      "Forward-Looking Statements" and "Risk Factors" and in our Annual Report on
      Form 10-K for the year ended December 31, 2004. You should not place
      undue reliance on these forward-looking statements. Actual results may differ
      materially from those anticipated in the forward-looking statements. These
      forward-looking statements represent our judgment as of the date of the filing
      of this Form 10-Q.





**Overview**





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




*Restructuring
      and financing activities.* As a
      consequence of the decline in our revenues and negative cash flows in 2003,
      we
      implemented several cost cutting and business restructuring activities during
      2003 and 2004. These activities, which included employee layoffs and the closure
      of several facilities (including the closure of our Tempe manufacturing facility
      in the fourth quarter of 2003), were designed to improve our cash flow from
      operations to allow us to continue as a going concern. During the fourth quarter
      of 2003 and the first quarter of 2004, we agreed to new payment terms with
      all
      of our major creditors and vendors, which extended or reduced our payment
      obligations. We also issued $4.5 million of convertible promissory notes and
      warrants to investors. The convertible promissory notes were converted to Series
      A preferred shares and the warrants were exercised for shares of common stock
      in
      the fourth quarter of 2004. There were no restructuring activities in
      2005.




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





In
      1999,
      we expanded our relationship with customers in the automotive glass and window
      film markets, including Pilkington PLC, Saint Gobain Sekurit and Globamatrix
      Holdings Pte. Ltd., or Globamatrix, which collectively accounted for
      approximately 56%, 45%, 45% and 37% of our total revenues during the first
      nine
      months of 2005 and in 2004, 2003 and 2002, respectively.





Under
      our
      agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
      purchase commitment of $9.0 million of product **.** For each
      year after 2004 through and including 2011, Globamatrix is required to purchase
      an amount of product equal to 110% of the amount of product it was required
      to
      purchase in the prior year. Globamatrix is obligated to purchase $10.3 million
      of products in 2005. During the third quarter and the first nine months of
      2005,
      Globamatrix purchased approximately $3.5 and $12.1 million of product,
      respectively.





*Sales
      returns and allowances.* Our
      gross margins and profitability have been adversely affected from time to time
      by product quality claims. From 2000 to 2004 our sales returns provision has
      averaged between 3.5% to 4.7% of gross revenues. In 2002, we had certain quality
      claims with respect to products produced for Globamatrix, which reduced our
      gross profit by approximately $1.5 million. **** During
      the first nine months of 2005, our sales returns provision has averaged
      approximately 2.7% of our gross revenues due to fewer quality claims received
      during the period.





**Three
      Months Ended October 2, 2005 compared with Three Months Ended September 26,
      2004**





**Results
      of Operations**





*Net
      revenues.* Our net
      revenues for the three months ended October 2, 2005 and September 26, 2004
      were
      $12.0 million and $15.9 million, respectively.





Our
      net
      revenues in the window film market increased by $1.1 million, or 36.8%, from
      $2.9 million in the third quarter of 2004 to $3.9 million in the same period
      in
      2005. Revenues from our Solis products for the third quarter of 2005 increased
      to $3.5 million from $2.0 million in the same period of 2004 due to higher
      demand for this product due to customers replenishing their inventory. Revenues
      from our TX products for the third quarter of 2005 decreased to $0.4 million
      from $0.8 million in the same period of 2004 due to the fact that we are only
      supplying sputtered film instead of new window film.





Our
      net
      revenues in the electronic display market decreased by $3.4 million, or 53.1%,
      from $6.5 million in the third quarter of 2004 to $3.0 million in the same
      period of 2005. The decrease was primarily due to lower demand for our sputtered
      thin film filter products for Plasma Display Panel products due to increased
      competition. Mitsui Chemicals is our primary customer in the electronic display
      market. Sales to Mitsui decreased $3.0 million from $5.7 million in the third
      quarter of 2004 to $2.7 million in the same period in 2005 due to increased
      competition from reduced prices in the flat panel display, or FPD market.
 In addition, we phased out our unprofitable anti-reflective product lines
      and stopped selling these products in 2005. We sold $0.3 million anti-reflective
      products in the third quarter of 2004.


11
 *Index*


Our
      net
      revenues in the automotive market decreased by $0.7 million, or 15.9%, from
      $4.6
      million in the third quarter of 2004 to $3.9 million in the same period of
      2005.
      The decrease was primarily due to a decrease in sales volume in the automotive
      market.





Our
      net
      revenues in the architectural market decreased by $0.8 million, or 39.2%, from
      $2.0 million in the third quarter of 2004 to $1.2 million in the same period
      of
      2005. The decrease was primarily due to a decrease in sales volume in
      architectural market.





*Cost
      of revenues* .
      Cost of
      revenues consists of materials and subcontractor services, labor and
      manufacturing overhead. Cost of revenues was $7.9 million in the third quarter
      of 2005 compared to $10.2 million in the same period of 2004. The decrease
      in
      cost of revenues was primarily due to a decrease in materials cost related
      to
      our decreased sales.




*Gross
      profit and gross margin* .
      Our
      gross profit decreased $1.7 million from $5.8 million in the third quarter
      of
      2004 to $4.1 million in the same period of 2005. As a percentage of sales,
      gross
      profit decreased from 36.3% in the third quarter of 2004 to 34.1% in the same
      period in 2005. The decrease related to lower average selling prices in all
      product lines in the third quarter of 2005 due to increased competition, which
      we expect to continue, partially offset by $0.6 million of sale of previously
      written off inventory.





*Operating
      expenses*




*Research
      and development* .
      Research and development expenses increased $0.5 million from $0.8 million
      in
      the third quarter of 2004 to $1.3 million in the same period of 2005. The 58.6%
      increase from year to year was due primarily to an increase in labor and
      employee benefits costs as a result of expanding our engineering organization.
      In June 2005, we hired a new Chief Technology Officer and Senior Vice President,
      and a new Director of Engineering for the automotive market. In September 2005,
      we hired a new Director of Engineering for the electronic display market. In
      addition, we spent more on research and development materials in the third
      quarter of 2005 than in the same period in 2004. We expect to continue to hire
      new scientific and engineering employees in the fourth quarter of 2005, which
      we
      expect will increase our research and development expense.





*Selling,
      general and administrative* .
      Selling, general and administrative expenses consist primarily of corporate
      and
      administrative overhead, selling commissions, advertising costs and occupancy
      costs. Selling, general and administrative expenses decreased $0.2 million
      from
      $2.3 million in the third quarter of 2004 to $2.1 million in the same period
      of
      2005. The decrease in general and administrative expenses in 2005 was primarily
      due to higher legal, consulting, and outside services in the third quarter
      of
      2004.





*Impairment
      recoveries from long-lived assets.* In the
      third quarter of 2004, we recorded $0.1 million of proceeds received from
      miscellaneous sales of long-lived assets that the company wrote off in the
      third
      quarter of 2003. There were no such recoveries in the third quarter of
      2005.





*Income
      from operations* .
      Income
      from operations decreased $2.1 million from $2.7 million in the third quarter
      of
      2004 to $0.7 million in the same period of 2005. The decrease was primarily
      due
      to a decrease in revenue due to lower sales volume in the third quarter of
      2005.





*Interest
      expense, net.* Interest
      expense decreased by $0.2 million from $0.4 million in the third quarter of
      2004
      to $0.2 million in the same period of 2005. The decrease in interest expense
      was
      primarily attributable to less outstanding debt during the third quarter of
      2005
      compared to 2004.




*Costs
      of warrants issued.* In
      the third quarter of 2004, the Company incurred $0.5 million in warrants expense
      as a result of the re-measurement of all outstanding warrants and other
      financial instruments. There was no warrants expense recorded in the third


quarter
      of 2005.





*Other
      income, net* .
      Other
      income, net, reflects foreign exchange transaction gains and losses in the
      third quarter
      of 2004 and 2005. Some of our transactions with foreign customers are
      denominated in foreign currencies, principally the Euro. As exchange rates
      fluctuate relative to the U.S. dollar, exchange gains and losses occur. In
      the
      third quarter of 2005, the net exchange gain due to Euro fluctuation was $9,100,
      a decrease from $42,300 in the same period in 2004.





*Income
      before provision for income taxes* .
      We
      recorded a pre-tax profit of $0.5 million in the third quarter of 2005 versus
      $1.8 million in the third quarter of 2004.





*Provision
      for income taxes* .
      The
      provision for income taxes in the third quarter of 2005 primarily relates to
      our
      German subsidiary, Southwall Europe GmBH (SEG). The increase was due to a
      deferred tax provision in SEG’s books as we now have a higher taxable profit in
      SEG. During the third quarter of 2004, we incurred a benefit from income taxes
      of $0.3 million. The benefit from income taxes in the third quarter of 2004
      was
      due to an adjustment in our year-to-date calculation of our provision for income
      taxes for SEG. Our taxable income for such period was lowered by an adjustment
      to our fixed assets basis as a result of government grants and allowances
      received from the Saxony government.


12
 *Index*


*Net
      income (loss).* Net
      income for the third quarter of 2005 was $15,000 and $2.1 million for the same
      period of 2004.





*Deemed
      dividend on redeemable preferred stock.* We
      incurred $0.1 million of deemed dividend on redeemable preferred stock in the
      third quarter of 2005. 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.





*Net
      income (loss) attributable to common stockholders.* We
      incurred a net loss of $0.1 million attributable to common stockholders for
      the
      third quarter of 2005 compared to net income of $2.1 million for the third
      quarter of 2004.








**Nine
      Months Ended October 2, 2005 compared with Nine Months Ended September 26,
      2004**





**Results
      of Operations**





*Net
      revenues.* Our net
      revenues for the nine months ended October 2, 2005 and September 26, 2004 were
      $42.8 million and $41.5 million, respectively.





Our
      net
      revenues in the window film market increased by $6.5 million, or 100.4%, from
      $6.5 million in the first nine months of 2004 to $13.0 million in the same
      period in 2005. Revenues from our Solis products for the first nine months
      of
      2005 increased to $9.9 million from $4.1 million in the same period of 2004.
      Revenues from our TX products for the first nine months of 2005 increased to
      $2.9 million from $2.5 million in the first nine months of 2004. In 2005, we
      stopped converting our window film products and agreed with our customers to
      own
      this process. This resulted in higher revenues on our TX products as our
      customers bought more products to fill their production lines. We sell our
      window film products primarily to customers located in the Pacific Rim and
      the
      Middle East. We believe our sales to this market during the first quarter of
      2004 were negatively affected by the SARs epidemic and the conflicts in Iraq
      and
      Afghanistan.





Our
      net
      revenues in the automotive market increased by $0.6 million, or 3.9%, from
      $14.6
      million in the first nine months of 2004 to $15.2 million in the same period
      in
      2005. The increase was due to higher demand from both our OEM and Automotive
      Replacement Glass accounts in the first quarter of 2005.





Our
      net
      revenues in the electronic display market decreased by $5.3 million, or 33.7%,
      from $15.7 million in the first nine months of 2004 to $10.4 million in the
      same
      period of 2005. The decrease was primarily due to lower demand for our sputtered
      thin film filter products for Plasma Display Panel products due to increased
      competition. Sales to Mitsui, our primary customer in the electronic display
      market, decreased $4.7 million from $13.5 million in the first nine months
      of
      2004 to $8.8 million in the same period in 2005 due to increased competition
      from reduced prices in the FPD market.  In addition, we phased out our
      unprofitable anti-reflective product lines and stopped selling these products
      in
      2005. We sold $0.6 million anti-reflective products in the first nine months
      of
      2004.





Our
      net
      revenues in the architectural markets were $4.2 million in the first nine months
      of 2005 compared to $4.7 million in the same period of 2004. The decrease was
      due to softness in the Asian market and a decrease in business from one of
      our
      largest accounts in Europe and the Middle East.





*Cost
      of revenues* .
      Cost of
      revenues was $29.0 million in the first nine months of 2005 compared to $27.6
      million in the same period of 2004. The increase in cost of revenues was due
      to
      an increase in materials cost related to our increased sales and higher
      manufacturing costs due to lower volumes.




*Gross
      profit margin* .
      Our
      gross profit decreased $0.1 million from $14.0 million in the first nine months
      of 2004 to $13.9 million in the same period of 2005. As a percent of sales,
      gross profit decreased from 33.7% in the first nine months of 2004 to 32.4%
      in
      the same period in 2005. The decrease related to lower average selling prices
      in
      automotive, electronic display and architecture products lines in first nine
      months of 2005 due to increased competition, which we expect to continue,
      partially offset by $0.6 million of sale of previously written off
      inventory.





*Operating
      expenses*




*Research
      and development* .
      Research and development expenses increased $0.6 million from $2.4 million
      in
      the first nine months of 2004 to $3.0 million in the same period of 2005. The
      25.8% increase from year to year was due in part to an increase in labor and
      employee benefits costs as a result of expanding our engineering organization.
      In June 2005, we hired a new Chief Technology Officer and Senior Vice President,
      and a new Director of Engineering for the automotive market. In September 2005,
      we hired a new Director of Engineering for the electronic display market. We
      expect to continue to hire new scientific and engineering employees in the
      fourth quarter of 2005, which will increase our research and development
      expense.


13
 *Index*


*Selling,
      general and administrative* .
      Selling, general and administrative expenses decreased $1.4 million from $7.9
      million in the first nine months of 2004 to $6.5 million in the same period
      of
      2005. The decrease in general and administrative expenses in 2005 was primarily
      due to higher legal and accounting fees of $0.9 million, outside services
      expense of $0.5 million and compensation expense of $0.2 million in the first
      nine months of 2004, partially offset by higher Sarbanes-Oxley compliance
      expenses of $0.2 million in the first nine months of 2005.





*Impairment
      recoveries from long-lived assets.* In June
      2004, we sold
      a
      production machine, which was impaired in the third quarter of 2003, from our
      Tempe manufacturing facility to a third party. The sales price was $1.7 million,
      which included the price of the production machine, other miscellaneous
      hardware, training to be provided by us and operating software to run the
      machine. By June 27, 2004, all of our obligations were completed and we
      recognized a gain in the second quarter of 2004 of $1.4 million, representing
      90% of the sale value less the book value of $0.1 million. There was $0.2
      million impairment recoveries from long-lived assets in the first quarter of
      2005.





*Income
      from operations* .
      Income
      from operations decreased $0.7 million from $5.2 million in the first nine
      months of 2004 to $4.5 million in the same period of 2005. The decrease was
      a
      result of lower revenues and lower recoveries for long-lived assets.





*Interest
      expense, net.* Interest
      expense decreased by $1.0 million from $1.8 million in the first nine months
      of
      2004 to $0.8 million in the same period of 2005. The decrease in interest
      expense was primarily attributable to less outstanding debt in the first nine
      months of 2005 compared to same period in 2004.




*Costs
      of warrants issued.* In
      the first nine months of 2004, the Company incurred $6.8 million in warrants
      expense as a result of the re-measurement of all outstanding warrants and other
      financial instruments. There was no warrants expense recorded in the first
      nine
      months of 2005.





*Other
      income, net* .
      Other
      income, net, reflects foreign exchange transaction gains and losses in the
      first
      nine months of 2004
      and 2005. Some of our transactions with foreign customers are denominated in
      foreign currencies, principally the Euro. As exchange rates fluctuate relative
      to the U.S. dollar, exchange gains and losses occur. For the first nine months
      of 2005, the net exchange loss due to Euro fluctuation was $0.3 million in
      comparison to the net exchange gain of $0.1 million for the nine-month period
      in
      2004. Other income, net for the first nine months of 2005 included an energy
      rebate from our German subsidiary of approximately $0.4 million.





*Income
      (loss) before provision for income taxes* .
      We
      recorded a pre-tax profit of $3.9 million in the first nine months of 2005
      compared to a pre-tax loss of $3.0 million in the same period of
      2004.





*Provision
      for income taxes* .
      The
      provisions for income taxes in the first nine months of 2005 and 2004 were
      primarily related to SEG. The increase in the provision for income taxes during
      the first nine months of 2005 when compared to the same period in 2004 was
      primarily due to a $0.3 million income tax benefit recorded in the third quarter
      of 2004 in SEG’s books.





*Net
      income (loss).* Net
      income for the first nine months of 2005 was $3.1 million compared to net loss
      of $3.4 million in the same period of 2004.





*Deemed
      dividend on redeemable preferred stock.* We
      incurred $0.4 million of deemed dividend on redeemable preferred stock in the
      first nine months of 2005 as a result of the conversion of our secured
      convertible promissory notes into shares of Series A preferred stock in December
      2004. The Series A preferred stock carries a 10% cumulative dividend rate.
      There
      was no such dividend in the same period of 2004.





*Net
      income (loss) attributable to common stockholders.* Net
      income attributable to common stockholders for the first nine months of 2005
      was
      $2.7 million compared to a net loss of $3.4 million during the same period
      in
      2004.





**Liquidity
      and capital resources.**





*Liquidity*




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





Our
      cash
      and cash equivalents increased $3.5 million during the first nine months of
      2005. Cash provided from operations of $5.3 million for the first nine months
      of
      2005 was primarily the result of net income of $3.1 million, non-cash
      depreciation of $1.7 million, and decreases in accounts receivable of $1.5
      million, in inventories of $1.1 million and in other current and non-current
      assets of $0.7 million partially offset by impairment recoveries from long-lived
      assets of $0.2 million and a decrease in accounts payable and accrued
      liabilities of $2.6 million. Cash
      provided by
      operating activities of $1.5 million for the first nine months of 2004 was
      primarily the result of cost of warrants issued of $6.8 million, non-cash
      depreciation of $1.8 million and a decrease in accounts receivable of $1.4
      million, offsetting the net loss of $3.4 million, a decrease in accounts payable
      and accrued liabilities of $3.1 million, as well as an increase in other current
      and non-current assets of $1.3 million and gain from impairment recoveries
      from
      long lived assets and the change in assets and liabilities.


14
 *Index*


Cash
      used
      in investing activities for the first nine months of 2005 was $0.1 million
      and
      was primarily of a decrease in restricted cash of $0.2 million and proceeds
      from
      the sale of a fixed asset of $0.2 million. Cash
      provided from investing activities during the nine months ended September 26,
      2004 was $1.6 million, primarily from the proceeds from the sale of fixed assets
      offset by capital expenditures during the first half of 2004.





Cash
      used
      in financing activities for the first nine months of 2005 was $1.3 million
      and
      resulted primarily the result of repayments under capital leases and principal
      payments on borrowings of $1.4 million. Net
      cash
      used in financing activities was $1.6 million during the first nine months
      of
      2004, primarily as a result of issuing $4.5 million in convertible promissory
      notes during the first quarter of 2004, offset by payments on our line of credit
      of $3.6 million and payments on our borrowings of $2.5 million.





We
      entered into an agreement with the Saxony government in May 1999 under
      which we receive investment grants. As of December 31, 2004, we had
      received 5.0 million Euros, or $6.8 million, of the grants and accounted
      for these grants by applying the proceeds received to reduce the cost of our
      fixed assets of our Dresden manufacturing facility. Additionally, as of December
      31, 2004, we had a balance remaining from the government grants received in
      May
      1999 of 0.4 million Euros, or $0.5 million, which has been recorded as an
      advance and held as restricted cash until we receive approval from the Saxony
      government to apply the funds to reduce our capital expenditures. We did not
      receive any grants during the first nine months of 2005. If we fail to meet
      certain requirements in connection with these grants, the Saxony government
      has
      the right to demand repayment of the grants. The total annual amount of
      investment grants and investment allowances that we are entitled to seek varies
      from year to year based upon the amount of our capital expenditures that meet
      certain requirements of the Saxony government. Generally, we are not eligible
      to
      seek total investment grants and allowances for any year in excess of 33% of
      our
      eligible capital expenditures in Germany for that year. We expect to continue
      to
      finance a portion of our capital expenditures in Dresden with additional grants
      from the Saxony government and additional loans from German banks, some of
      which
      may be guaranteed by the Saxony government. However, we cannot guarantee that
      we
      will be eligible for or will receive additional grants in the future from the
      Saxony government.





*Borrowing
      arrangements*





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





The
      first
      facility is a revolving line of credit under which we may from time to time
      borrow up to $3 million, subject to satisfaction of certain conditions. Amounts
      borrowed under the first facility bear interest at the prime rate minus 1.75%
      per annum or LIBOR plus 1% per annum, at our option. We borrowed approximately
      $3.0 million from this facility on April 28, 2005 which amount remained
      outstanding as of October 2, 2005.




The
      second facility is a formula line under which we may, from time to, time
      borrow up to $3 million, subject to certain conditions, with advances of up
      to
      80% of eligible accounts receivable. Amounts borrowed under the second facility
      bear interest at the prime rate minus 0.25% per annum. We may borrow under
      the
      second facility only if we meet certain financial covenants. As of October
      2,
      2005, we met these financial covenants. All borrowings under both facilities
      are
      subject to the satisfaction of the additional financial covenants under the
      Credit Agreement which prohibit our capital expenditures from exceeding $1.5
      million per year.  There is no balance outstanding under the second
      facility.





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





The
      terms
      of the Credit Agreement, among other things, limit our ability to (i) incur,
      assume or guarantee additional indebtedness in excess of $13.5 million (other
      than pursuant to the Credit Agreement), (ii) pay dividends or repurchase stock
      (except up to $0.6 million per year of dividends on preferred stock), (iii)
      incur liens upon the collateral pledged to the bank, (iv) make any loans or
      advances to, or investments in, any person or entity outside the ordinary course
      of business, (v) merge, consolidate, sell or otherwise dispose of substantially
      all or a substantial or material portion of our assets, (vi) enter into
      transactions with affiliates, and (vii) make acquisitions other than up to
      an
      aggregate amount of $3 million and (viii) to make capital expenditures in any
      fiscal year in excess of $1.5 million.





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




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


15
 *Index*


*Capital
      expenditures*





We
      anticipate spending less than $1.0 million in capital expenditures in 2005,
      primarily to maintain and upgrade our production facilities. We spent
      approximately $0.5 million in capital expenditures during the first nine months
      of 2005.




*Future
      payment obligations*





Our
      future payment obligations on our borrowings pursuant to our term debt, capital
      lease obligations, non-cancelable operating leases and other non-cancelable
      contractual commitments are as follows at October 2, 2005 (in
      thousands):





GreaterLess
                than
            
            
            
            
            
            ThanTotal
            
            1
                Year
            
            1-3
                Year
            
            4-5
                Year
            
            5
                YearContractual
                Obligations:Term
                debt (1)
            
            $
            10,477
            
            $
            1,288
            
            $
            1,988
            
            $
            4,666
            
            $
            2,535Line
                of credit
            
            
            2,996
            
            
            2,996
            
            
            --
            
            
            --
            
            
            --Capital
                lease obligations
            
            
            38
            
            
            38
            
            
            --
            
            
            --
            
            
            --Operating
                leases (2)
            
            
            2,049
            
            
            1,683
            
            
            350
            
            
            16
            
            
            --Total
                contractual cash obligations
            
            $
            15,560
            
            $
            6,005
            
            $
            2,338
            
            $
            4,682
            
            $
            2,535




(1)
            Represents
                loan agreements with Portfolio Financing Servicing Company, Bank
                of
                America and Lehman Brothers, and several German
                banks.





(2)
            Represents
                the remaining rents owed on a building we rent in Palo Alto, California.
                On July 14, 2005, we moved our warehouse from 210 Littlefield, So.
                San
                Francisco, CA into 2629B Terminal Blvd., Mountain View, CA. The term
                of
                this lease is a period of one year, commencing on August 1, 2005
                and
                terminating on July 31, 2006, with monthly rent payments of
                $5,655.




16
 *Index*


**Item
      3--Quantitative and Qualitative Disclosures about Market
      Risk**




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





*Financing
      risk:* Our
      exposure to market rate risk for changes in interest rates relates primarily
      to
      our line of credit which bears an interest rate equal to 1.0% above the bank
      LIBOR rate (which was 4.875% at October 2, 2005) and is calculated based on
      amounts borrowed under the facility. In addition, the interest rate on one
      of
      our German loans was reset to the prevailing market rate of 5.75% on December
      31, 2004 and another of our German loans will have its interest rate reset
      to
      the prevailing market rate in 2009. Fluctuations or changes in interest rates
      may adversely affect our expected interest expense. The effect of a 10%
      fluctuation in the interest rate on our line of credit would have had an effect
      of about $21,000 on our interest expense for the third quarter of
      2005.





*Investment
      risk:* We
      invest our excess cash in money market accounts and, by practice, limit the
      amount of exposure to any one institution. Investments in both fixed rate and
      floating rate interest earning instruments carry a degree of interest rate
      risk.
      Fixed rate securities may have their fair market value adversely affected due
      to
      a rise in interest rates, while floating rate securities may produce less income
      than expected if interest rates fall. The effect of a 10% fluctuation in the
      interest rate of any of our floating rate securities would have had an adverse
      effect of less than $10,000 for the third quarter of 2005.





*Foreign
      currency risk:* International revenues (defined as sales to customers located outside of the
      United States) accounted for approximately 73% of our total sales in the third
      quarter of 2005. Approximately 31% of our international revenues were
      denominated in Euros relating to sales from our Dresden operation in the third
      quarter of 2005. The other 69% of our international sales were denominated
      in US
      dollars. In addition, certain transactions with foreign suppliers are
      denominated in foreign currencies (principally Japanese Yen). The effect of
      a
      10% fluctuation in the Euro exchange rate would have had an effect of less
      than
      $0.5 million on net revenues for the third quarter of 2005 and the effect
      on expenses of a 10% fluctuation in the Yen exchange rate would have been
      minimal.


17
 *Index*




**FORWARD-LOOKING
      STATEMENTS**





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





·
            our
                ability to remain as a going
                concern;




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




·
            the
                success of our restructuring
                activities;




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




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




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




·
            our
                competition;




·
            statements
                about the future size of markets;




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




·
            our
                expected results of operations and cash flows;




·
            pending
                and threatened litigation and its outcome; and




·
            our
                projected capital expenditures.





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


18
 *Index*


**RISK
      FACTORS**





**Financial
      Risks**





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





We
      incurred net losses in 2004, 2003 and 2002 and negative cash flows from
      operations in 2003 and 2002. These factors together with our working capital
      position and our significant debt service and other contractual obligations
      at
      October 2, 2005, may raise doubt about our ability to restore profitable
      operations, generate cash flow from operating activities and obtain additional
      financing. These and other factors related to our business during recent years,
      including the restatement in 2000 of our consolidated financial statements
      for
      prior periods, operating losses in 1998, 1999, 2000, 2002 and 2003, our past
      failure to comply with covenants in our financing agreements and our voluntary
      delisting from NASDAQ in March 2004 may make it difficult for us to secure
      the
      required additional borrowings on favorable terms or at all. We may seek
      additional borrowings or alternative sources of financing; however, difficulties
      in borrowing money or raising financing could have a material adverse effect
      on
      our operations, planned capital expenditures and ability to comply with the
      terms of government grants.





*The
      transactions with Needham and Dolphin may have a negative effect on us or our
      stock price* .





As
      a
      result of the consummation of the financing transactions in December 2003 and
      February 2004 with Needham & Company and its affiliates and Dolphin
      Direct Equity Partners, L.P, our shareholders suffered material dilution. As
      our
      largest stockholder and the guarantor of our line of credit, Needham could
      prevent us from seeking additional borrowings or alternative sources of
      financing that we may require for future operations or otherwise control the
      company in ways that might have a material adverse effect on the company or
      our
      stock price.





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





As
      of
      October 2, 2005, we had total outstanding obligations under our credit and
      other
      loan agreements and capital leases of $13.5 million. Our inability to make
      timely payments of interest or principal under these arrangements could
      materially adversely affect our ability to borrow money under existing
      credit facilities, to secure additional borrowings or to function as a going
      concern. Our current credit facilities contain financial covenants that will
      require us to meet certain financial performance targets and operating covenants
      that limit our discretion with respect to business matters. Among other things,
      these covenants restrict our ability to borrow additional money, create liens
      or
      other encumbrances, and make certain payments including dividends and capital
      expenditures. Many of these loans contain provisions that permit the lender
      to
      declare the loans immediately due if there is a material adverse change in
      our
      business. These credit facilities also contain events of default that could
      require us to pay off indebtedness before its maturity. The restrictions imposed
      by these credit facilities or the failure of lenders to advance funds under
      these facilities could force us to curtail our operations or have a material
      adverse effect on our liquidity.





*Our
      ability to borrow is limited by the nature of our equipment and some of our
      accounts receivable* .





Our
      equipment is custom designed for a special purpose. In addition, a large portion
      of our accounts receivable are from foreign sales, which are often more
      difficult to collect than domestic accounts receivable. As a result of the
      nature of our equipment and accounts receivable, lenders will generally allow
      us
      to borrow less against these items as collateral than they would for other
      types
      of equipment or domestic accounts receivable, or require us to provide
      additional credit enhancements.





*If
      we
      default under our secured credit facilities and financing arrangements, the
      lenders could foreclose on the assets we have pledged to them requiring us
      to
      significantly curtail or even cease our operations* .





In
      connection with our current borrowing facilities and financing arrangements,
      we
      have granted security interests in and liens on substantially all of our assets,
      including our production machines and our Dresden facility, to secure the loans.
      If our senior lenders were to repossess one or more of those machines, our
      ability to produce product would be materially impaired. Our revenues, gross
      margins and operating efficiency would also be materially adversely affected.
      Our obligations under our secured credit facilities contain cross-default and
      cross-acceleration provisions and provisions that allow the lenders to declare
      the loans immediately due if there is a material adverse change in our business.
      If we default under the credit facilities or financing arrangements the lenders
      could declare all of the funds borrowed thereunder, together with all accrued
      interest, immediately due and payable. If we are unable to repay such
      indebtedness, the lenders could foreclose on the pledged assets. If the lenders
      foreclose on our assets, we would be forced to significantly curtail or even
      cease our operations.





*Our
      quarterly revenue and operating results are volatile and difficult to predict.
      If we fail to meet the expectations of public market analysts or investors,
      the
      market price of our common stock may decrease significantly.*





Our
      quarterly revenue and operating results have varied significantly in the past
      and will likely vary significantly in the future. Our revenue and operating
      results may fall below the expectations of securities analysts or investors
      in
      future periods. Our failure to meet these expectations would likely adversely
      affect the market price of our common stock.


19
 *Index*


Our
      quarterly revenue and operating results may vary depending on a number of
      factors, including:





·
            fluctuating
                customer demand, which is influenced by a number of factors, including
                market acceptance of our products and the products of our customers
                and
                end-users, changes in product mix, and the timing, cancellation or
                delay
                of customer orders and shipments;




·
              the
                  timing of shipments of our products by us and by independent
                  subcontractors to our customers;





·
            manufacturing
                and operational difficulties that may arise due to, among other things,
                quality control, capacity utilization of our production machines,
                unscheduled equipment maintenance, and the hiring and training of
                additional staff;





·
            our
                ability to introduce new products on a timely basis; and





·
            competition,
                including the introduction or announcement of new products by competitors,
                the adoption of competitive technologies by our customers, the addition
                of
                new production capacity by competitors and competitive pressures
                on prices
                of our products and those of our customers.





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





In
      2003
      and 2004 and during the first nine months of 2005, approximately 34%, 34%,
      and
      29% of our revenues, respectively, were denominated in Euros, primarily related
      to sales from our Dresden operation, including sales to one of our largest
      customers, a European automotive glass manufacturer. In addition, other
      customers may request to make payments in foreign currencies. Also, certain
      transactions with foreign suppliers are denominated in foreign currencies,
      primarily Japanese Yen.





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





*Our
      suppliers and subcontractors may impose more onerous payment terms on
      us.*





As
      a
      result of our financial performance and voluntary delisting from NASDAQ, our
      suppliers and creditors may impose more onerous payment terms on us, which
      may
      have a material adverse effect on our financial performance and our liquidity.
      For example, one of our subcontractors has required us to provide it with a
      security interest in all of our inventory held by it and has limited the amount
      of unpaid invoices we may have outstanding with it at any time.





**Operational
      Risks**





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





Our nine
      largest customers accounted for approximately 80%, 80%, 76% and 84% of net
      revenues during the first nine months of 2005 and in fiscal years 2004, 2003,
      and 2002, respectively. We have contracts extending past 2005 with only two
      of
      these customers. We expect to continue to derive a significant portion of our
      net revenues from this relatively small number of customers. Accordingly,
      the loss of a large customer could materially hurt our business, and the
      deferral or loss of anticipated orders from a large customer or a small number
      of customers could materially reduce our revenue and operating results in any
      period.





*We
      must continue to develop new products or enhance existing products on a timely
      basis to compete successfully in a rapidly changing
      marketplace.*





Our
      future success depends upon our ability to introduce new products, improve
      existing products and processes to keep pace with technological and market
      developments, and to address the increasingly sophisticated and demanding needs
      of our customers, especially in the electronic display and automotive markets.
      Technological changes, process improvements, or operating improvements that
      could adversely affect us include:





·
            the
                development of competing technologies to our anti-reflective and
                silver
                reflector films for liquid crystal displays in the flat panel display
                industry;





·
            changes
                in the way coatings are applied to alternative substrates such as
                tri-acetate cellulose, or TAC;


20
 *Index*


·
            the
                development of new technologies that improve the manufacturing efficiency
                of our competitors;





·
            the
                development of new materials that improve the performance of products
                that
                could compete with our products; and





·
            improvements
                in the alternatives to the sputtering technology we use to produce
                our
                products, such as plasma enhanced chemical vapor deposition, or PECVD.





Our
      research and development efforts may not be successful in developing products
      in
      the time, or with the characteristics, necessary to meet customer needs. If
      we
      do not adapt to technological changes or process or operating improvements,
      our
      competitive position, operations and prospects would be materially adversely
      affected.





*Our
      ability to successfully identify suitable target companies and integrate
      acquired companies or technologies may affect our future
      growth.*





A
      potential part of our continuing business strategy is to consider acquiring
      companies, products, and technologies that complement our current products,
      enhance our market coverage, technical capabilities or production capacity,
      or
      offer other growth opportunities. Our ability to successfully complete
      acquisitions requires that we identify suitable target companies, agree on
      acceptable terms, and obtain acquisition financing on acceptable terms. In
      connection with these acquisitions, we could incur debt, amortization expenses
      relating to identified intangibles, impairment charges relating to goodwill,
      or
      merger related charges, or could issue stock that would dilute our current
      shareholders' percentage of ownership. The success of any acquisitions will
      depend upon our ability to integrate acquired operations, retain and motivate
      acquired personnel, and increase the customer base of the combined businesses.
      We cannot assure you that we will be able to accomplish all of these goals.
      Any
      future acquisitions would involve certain additional risks,
      including:





·
            difficulty
                integrating the purchased operations, technologies, or products;





·
            unanticipated
                costs, which would reduce our profitability;





·
            diversion
                of management's attention from our core business;





·
            potential
                entrance into markets in which we have limited or no prior experience;
                and





·
            potential
                loss of key employees, particularly those of the acquired business.





*If
      one of our customers is able to enforce a European automotive film patent,
      we
      may be restricted from using the methods present in such patent to produce
      some
      of our products.*




On
      March
      3, 2005, the European Patent Office allowed a European patent owned by
      Pilkington Automotive GmBH entitled "Method for producing a laminated glass
      pane
      free of optical obstruction caused by warping, use of a particular carrier
      film
      for the production of the laminated glass pane and carrier films particularly
      suitable for the method of use." This European patent covers certain laminated
      films and methods of using them which may prevent us from producing certain
      films designed for the automotive markets. Our inability to use this technology
      could adversely affect our ability to provide a full range of products to the
      automotive film market. We participated in opposing the European patent and
      have
      appealed the European Patent Office decision.




*Failure
      to meet the volume requirements of our customers may result in a loss of
      business or contractual penalties.*





Our
      long-term competitive position will depend to a significant extent on our
      manufacturing capacity. The failure to have sufficient capacity, to fully
      utilize capacity when needed or to successfully integrate and manage additional
      capacity in the future could adversely affect our relationships with customers
      and cause customers to buy similar products from our competitors if we are
      unable to meet their needs. For example, we believe that we lost substantial
      potential architectural products sales in 2001 because we did not have the
      capacity to manufacture the required amounts of products. Also, our failure
      to
      produce required amounts of products under some of our contracts will result
      in
      price reductions on future sales under such contracts or penalties under which
      we would be required to reimburse the customer for the full cost of any product
      not delivered in a timely manner, either of which would reduce our gross
      margins.





*We
      depend on our OEM customers for the sale of our products.*





We
      sell a
      substantial portion of our products to a relatively small number of original
      equipment manufacturers, or OEMs. The timing and amount of sales to these
      customers ultimately depend on sales levels and shipping schedules for the
      OEM
      products into which our products are incorporated. We have no control over
      the
      volume of products shipped by our OEM customers or shipping dates, and we cannot
      be certain that our OEM customers will continue to ship products that
      incorporate our products at current levels or at all. We currently have
      long-term contracts with only two of our OEM customers. Failure of our OEM
      customers to achieve significant sales of products incorporating our products
      and fluctuations in the timing and volume of such sales could be harmful to
      our
      business. Failure of these customers to inform us of changes in their production
      needs in a timely manner could also hinder our ability to effectively manage
      our
      business.


21
 *Index*


*We
      rely upon our OEM customers for information relating to the development of
      new
      products so that we are able to meet end-user demands.*





We
      rely
      on our OEM customers to inform us of opportunities to develop new products
      that
      serve end-user demands. If our OEM customers do not present us with market
      opportunities early enough for us to develop products to meet end-user needs
      in
      a timely fashion, or if the OEMs fail to anticipate end-user needs at all,
      we may fail to develop new products or modify our existing products for the
      end-user markets for our products. In addition, if our OEM customers fail to
      accurately anticipate end-user demands, we may spend resources on products
      that
      are not commercially successful.





*We
      depend on a distributor for the sale of our after-market
      products.*





We
      primarily use one independent distributor to sell our after-market products.
      We
      have a distribution agreement with Globamatrix Holdings Pte. Ltd., or
      Globamatrix, under which we granted an exclusive worldwide license to distribute
      our after-market applied film in the automotive and architectural glass markets.
      Failure of Globamatrix to achieve significant sales of products incorporating
      our products and fluctuations in the timing and volume of such sales could
      be
      harmful to our business. We believe that the success of our after-market
      products will continue to depend upon this distributor.





*We
      face intense competition, which could affect our ability to increase our
      revenue, maintain our margins and increase our market share.*





The
      market for each of our products is intensely competitive and we expect
      competition to increase in the future. Competitors vary in size and in the
      scope
      and breadth of the products they offer. We compete both with companies using
      technology similar to ours and companies using other technologies or developing
      improved technologies. Direct-to-glass sputtering represents the principal
      alternative technology to our sputter-coated film products. Direct-to-glass
      is a
      mature, well-known process for applying thin film coatings directly to glass,
      which is used by some of our current and potential customers to produce products
      that compete with our products. This technology is commonly used to manufacture
      products that conserve energy in buildings and automobiles. Many of our current
      and potential competitors have significantly greater financial, technical,
      marketing and other resources than we have. In addition, many of our competitors
      have well-established relationships with our current and potential customers
      and
      have extensive knowledge of our industry.





*We
      are dependent on key suppliers of materials, which may prevent us from
      delivering product in a timely manner.*





We
      manufacture all of our products using materials procured from third-party
      suppliers. We do not have long-term contracts with our third-party suppliers.
      Certain of the materials we require are obtained from a limited number of
      sources. Delays or reductions in product shipments could damage our
      relationships with customers. Further, a significant increase in the price
      of
      one or more of the materials used in our products could have a material adverse
      effect on our cost of goods sold and operating results.





*We
      are dependent on a few qualified subcontractors to add properties to some of
      our
      products.*





We
      rely
      on third-party subcontractors to add properties, such as adhesives, to some
      of
      our products. There are only a limited number of qualified subcontractors that
      can provide some of the services we require, and we do not have long-term
      contracts with any of those subcontractors. Qualifying alternative
      subcontractors could take a great deal of time or cause us to change product
      designs. The loss of a subcontractor could adversely affect our ability to
      meet
      our scheduled product deliveries to customers, which could damage our
      relationships with customers. If our subcontractors do not produce a quality
      product, our yield will decrease and our margins will be lower. Further, a
      significant increase in the price charged by one or more of our subcontractors
      could force us to raise prices on our products or lower our margins, which
      could
      have a material adverse effect on our operating results.





*We
      are dependent on key suppliers of production machines, which may prevent us
      from
      delivering an acceptable product on a timely basis and limit our capacity for
      revenue growth.*





Our
      production machines are large, complex and difficult to manufacture. It can
      take
      up to a year from the time we order a machine until it is delivered. Following
      delivery, it can take us, with the assistance of the manufacturer, up to six
      additional months to test and prepare the machine for commercial production.
      There are a very limited number of companies that are capable of manufacturing
      these machines. Our inability in the future to have new production machines
      manufactured and prepared for commercial production in a timely manner would
      prevent us from delivering product on a timely basis and limit our capacity
      for
      revenue growth.





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





Our
      business depends in part on sales by manufacturers of products that include
      electronic displays. The markets for electronic display products are highly
      cyclical and have experienced periods of oversupply resulting in significantly
      reduced demand for our products. For example, during the first nine months
      of
      2005, we experienced a decrease of 33.7% from the same period in 2004 in our
      net
      revenues in the electronic display market primarily due to lower demand for
      our
      sputtered thin film filter products for Plasma Display Panel products due to
      increased competition, and we expect this trend to continue. Mitsubishi Electric
      was the only CRT manufacturer that buys our anti-reflective, or AR, film and
      it
      decided to consolidate all of the manufacturing of this product to Japan. In
      connection with that consolidation, Mitsubishi ceased production of the 17"
      AR
      product in its Mexico plant during the third quarter of 2003. In 2005, we
      stopped converting our window film products and agreed with our customers to
      own
      this process. This resulted in higher revenues on our TX products as our
      customers bought more products to fill their production lines.


22
 *Index*


*Performance,
      reliability or quality problems with our products may cause our customers to
      reduce or cancel their orders.*





We
      manufacture our products based on specific, technical requirements of each
      of
      our customers. We believe that future orders of our products will depend in
      part
      on our ability to maintain the performance, reliability and quality standards
      required by our customers. If our products have performance, reliability or
      quality problems, then we may experience:





·
            delays
                in collecting accounts receivable;





·
            higher
                manufacturing costs;





·
            additional
                warranty and service expenses; and





·
            reduced
                or cancelled orders.





*If
      we
      fail to recruit and retain a significant number of qualified technical personnel
      we may not be able to develop, enhance and introduce our products on a timely
      basis, and our business will be harmed* .





We
      require the services of a substantial number of qualified technical personnel.
      Intense competition and aggressive recruiting, as well as a high-level of
      employee mobility characterize the market for skilled technical personnel.
      These
      characteristics make it particularly difficult for us to attract and retain
      the
      qualified technical personnel we require. We have experienced, and we expect
      to
      continue to experience, difficulty in hiring and retaining highly skilled
      employees with appropriate technical qualifications. It is especially difficult
      for us to recruit qualified personnel to move to the location of our Palo Alto,
      California offices because of the high-cost of living. If we are unable to
      recruit and retain a sufficient number of qualified technical employees, we
      may
      not be able to complete the development of, or enhance, our products in a timely
      manner. As a result, our business may be harmed and our operating results may
      suffer.





*We
      may be unable to attract or retain the other highly skilled employees that
      are
      necessary for the success of our business.*





In
      addition to our dependence on our technical personnel, our success also depends
      on our continuing ability to attract and retain other highly skilled employees.
      We depend on the continued services of our senior management, particularly
      Thomas G. Hood, our President and Chief Executive Officer. We do not have
      employment contracts with any of our officers or key-person life insurance
      covering any officer or employee. Our officers have technical and industry
      knowledge that cannot easily be replaced. Competition for similar personnel
      in
      our industry where we operate is intense. We have experienced, and we expect
      to
      continue to experience, difficulty in hiring and retaining highly skilled
      employees with appropriate qualifications. If we do not succeed in attracting
      or
      retaining the necessary personnel, our business could be adversely
      affected.





*If
      we
      are unable to adequately protect our intellectual property, third parties may
      be
      able to duplicate our products or develop functionally equivalent or superior
      technology.*





Our
      success depends in large part upon our proprietary technology. We rely on our
      know-how, as well as a combination of patent, trademark and trade secret
      protection, to establish and protect our intellectual property rights. Despite
      our efforts to protect our proprietary rights, unauthorized parties may attempt
      to copy aspects of our products or to obtain and use information that we regard
      as proprietary. Policing unauthorized use of our products is difficult. Our
      means of protecting our proprietary rights may not be adequate. In addition,
      the
      laws of some foreign countries do not protect our proprietary rights to as
      great
      an extent as do the laws of the United States. In the next three years, one
      of
      our U.S. patents relating to our architectural products will expire. Expiration
      of this patents or our failure to adequately protect our proprietary rights
      may
      allow third parties to duplicate our products or develop functionally equivalent
      or superior technology. In addition, our competitors may independently develop
      similar technology or design around our proprietary intellectual
      property.





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





Revenues
      from international sales amounted to approximately 74%, 79%, 89% and 85% of
      our
      net revenues during the first nine months of 2005 and fiscal years 2004, 2003
      and 2002, respectively. The distance between our two manufacturing sites creates
      logistical and communications challenges. In addition, to achieve acceptance
      in
      international markets, our products must be modified to handle a variety of
      factors specific to each international market as well as local regulations.
      We
      may also be subject to a number of other risks associated with international
      business activities. These risks include:





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


23
 *Index*


·
            potentially
                adverse tax consequences; and


·
            global
                economic turbulence and political
                instability.





*If
      we
      fail to comply with environmental regulations, our operations could be
      suspended.*





We
      use
      hazardous chemicals in producing our products and have air and water emissions
      that require controls. As a result, we are subject to a variety of local, state
      and federal governmental regulations relating to the storage, discharge,
      handling, emission, generation, manufacture and disposal of toxic or other
      hazardous substances used to manufacture our products, compliance with which
      is
      expensive. Our failure to comply with current or future regulations could result
      in the imposition of substantial fines on us, suspension of production,
      alteration of our manufacturing processes, increased costs or cessation of
      operations.





*We
      rely on our domestic sales representatives, without whom our architectural
      product sales may suffer.*





We
      use
      independent sales representatives to promote our Heat Mirror products to
      architects in the United States. If some or all of our sales representatives
      experience financial difficulties, or otherwise become unable or unwilling
      to
      promote our products, our business could be harmed. These sales representatives
      could reduce or discontinue promotion of our products. They may not devote
      the
      resources necessary to provide effective marketing support to us. In addition,
      we depend upon the continued viability and financial resources of these
      representatives, many of which are small organizations with limited working
      capital. These representatives, in turn, depend substantially on general
      economic conditions and other factors affecting the markets for the products
      they promote. We believe that our success in this market will continue to depend
      upon these sales representatives.





*We
      may experience unanticipated warranty or other claims with respect to our
      products, which may lead to extensive litigation costs and
      expenses.*





In
      the
      ordinary course of business, we have periodically become engaged in litigation
      principally as a result of disputes with customers of our architectural
      products. We have settled some of these suits and others are pending. We may
      become engaged in similar or other lawsuits in the future. Some of our products
      that have been the basis for lawsuits against us could be the basis for future
      lawsuits. An adverse outcome in the defense of a warranty or other claim could
      subject us to significant liabilities to third parties. Any litigation,
      regardless of the outcome, could be costly and require significant time and
      attention of key members of our management and technical personnel.





*We
      may face extensive damages or litigation costs if our insurance carriers seek
      to
      have us indemnify them for settlements of past and outstanding
      litigation.*





Several
      of our insurance carriers have reserved their rights to seek indemnification
      from us for substantial amounts paid to plaintiffs by the insurance carriers
      as
      part of settlements of litigation relating to our architectural products. Our
      insurance carriers in a case in which the plaintiff alleged we were responsible
      for defects in window products manufactured by others have advised us that
      they
      intend to seek reimbursement for settlement and defense costs. Any claims,
      with
      or without merit, could require significant time and attention of key members
      of
      our management and result in costly litigation.


24
 *Index*




**Item
      4--Controls and Procedures**


*a.*
            *Evaluation
                and Disclosure Controls and Procedures*.
                Under the supervision and with the participation of our management,
                including our chief executive officer and acting chief financial
                officer,
                we conducted an evaluation of the effectiveness of the design and
                operation of our disclosure controls and procedures, as defined in
                Rules
                13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934,
                as
                amended, as of October 2, 2005 (the “Evaluation Date”). Based on this
                evaluation, our chief executive officer and acting chief financial
                officer
                concluded as of the Evaluation Date that our disclosure controls
                and
                procedures were effective such that the information relating to the
                Company, including our consolidated subsidiaries, required to be
                disclosed
                in our Securities and Exchange Commission ("SEC") reports (i) is
                recorded,
                processed, summarized and reported with the time periods specified
                in SEC
                rules and forms, and (ii) is accumulated and communicated to our
                management, including our chief executive officer and acting chief
                financial officer, as appropriate to allow timely decisions regarding
                required disclosure.








*b.*
            *Report
                on Internal Control Over Financial Reporting*.
                We will be required by the Sarbanes-Oxley Act to include an assessment
                of our internal control over financial reporting and an attestation
                from an independent registered public accounting firm in our Annual
                Report
                on Form 10-K beginning with the filing for our fiscal year ending
                December 31, 2007. This may be due beginning with our fiscal year
                ending
                December 31, 2006 if our market capitalization increases above $75
                million
                at the determining date on June 30,
                2006.








*c.*
            *Changes
                in Internal Controls*.
                There were no changes during the quarter ended October 2, 2005 in
                our
                internal controls over financial reporting that have materially effected,
                or are reasonably likely to materially affect, the internal controls
                over
                financial reporting.


25
 *Index*




**PART
      II--OTHER INFORMATION**




**Item
      1--Legal Proceedings**





Litigation
      filed against the Company was described under Item 3 in the Company's Form
      10-K
      filed on March 30, 2005. No other material developments have occurred with
      respect to the litigation described therein.





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




**Item
      2-- Unregistered Sales of Equity Securities and Use of
      Proceeds**





None.




**Item
      3--Defaults upon Senior Securities**





Not
      applicable.




**Item
      4--Submission of Matters to a Vote of
      Stockholders**





None.





**Item
      5--Other Information**





None.




**Item
      6--Exhibits**





(a)
            Exhibits








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


26
 *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 15, 2005**Southwall
                Technologies Inc.**By:
            /s/
                Thomas G. HoodThomas
                G. Hood*President
                and Chief Executive Officer*By:
            /s/
                Sylvia KamenskiSylvia
                Kamenski*Acting
                Chief Financial Officer*




27