**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
 __________________
 
 **FORM
        10-Q**
 **(MARK
        ONE)**
 x
              **QUARTERLY
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                  OF 1934**
  **For
        the quarterly period ended June 30, 2006**
 **or**
  o
                **TRANSITION
                    REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                    OF 1934**
  **For
        the transition period from to**
   **Commission
        File Number: 0-15930**
 ___________________
 
 
 **SOUTHWALL
        TECHNOLOGIES INC.**
 (Exact
        name of registrant as specified in its charter)
 
 **Delaware**
                (State
                  or other jurisdiction of incorporation or organization)
              
              **94-2551470**
                (I.R.S.
                  Employer Identification Number)**3788
                  Fabian Way, Palo Alto, California**
                (Address
                  of principal executive offices)
              
              **94303**
                (Zip
                  Code)
 
 Registrant's
        telephone number, including area code: **(650) 798-1200**
 ___________________
  Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
        during the preceding 12 months (or for such shorter period that the
        registrant was required to file such reports), and (2) has been subject to
        such filing requirements for the past 90 days. Yes x No o
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
        One).
 
 Large
                  accelerated filer ̈
              
              Accelerated
                  filer ̈
              
              Non-accelerated
                  filerx
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act).
        Yes o No x
 
 As
        of
        August 1, 2006, there were 26,957,001 shares of the registrant's Common Stock
        outstanding.
  
 
 1
 **SOUTHWALL
          TECHNOLOGIES INC.**
 
 **INDEX**
 
 PagePART
                    I - FINANCIAL INFORMATIONItem
                    1
                Financial
                    StatementsUnaudited
                    Condensed Consolidated Balance Sheets - June 30, 2006
                    and December 31, 2005
                3Unaudited
                    Condensed Consolidated Statements of Operations -
                    Three and six month periods ended June 30, 2006 and July 3,
                    2005
                4Unaudited
                    Condensed Consolidated Statements of Cash Flows - Six
                    month periods ended June 30, 2006 and July 3, 2005
                5Notes
                    to the Unaudited Condensed Consolidated Financial
                    Statements
                6Item
                    2
                Management’s
                    Discussion and Analysis of Financial Condition and
                    Results of Operations
                15Item
                    3
                Quantitative
                    and Qualitative Disclosures about Market
                    Risk
                24Item
                    4
                Controls
                    and Procedures
                26PART
                    II - OTHER INFORMATIONItem
                    1
                Legal
                    Proceedings
                27Item
                    1A
                Risk
                    Factors
                28Item
                    2
                Unregistered
                    Sales of Equity Securities and Use of
                    Proceeds
                30Item
                    3
                Defaults
                    upon Senior Securities
                30Item
                    4
                Submission
                    of Matters to a Vote of Security
                    Holders
                30Item
                    5
                Other
                    Information
                30Item
                    6
                Exhibits
                31Signatures
                32
  2
 *Table
              of Contents*
 
 PART
          I. FINANCIAL INFORMATION
 Item
          1--Financial Statements:
 **SOUTHWALL
          TECHNOLOGIES INC.**
 **UNAUDITED
          CONDENSED CONSOLIDATED BALANCE SHEETS**
 **(in
          thousands, except per share data)**
 June
                    30,
                  2006
                
                December
                    31,
                  2005**ASSETS**Current
                    assets:Cash
                    and cash equivalents
                
                $
                4,211
                
                $
                6,600Restricted
                    cash
                
                
                342
                
                
                402Accounts
                    receivable, net of allowance for doubtful accounts of $133 at
                    June 30,
                    2006 and $208 at December 31, 2005
                
                
                5,961
                
                
                6,780Inventories,
                    net
                
                
                5,067
                
                
                5,879Other
                    current assets
                
                
                866
                
                
                982Total
                    current assets
                
                
                16,447
                
                
                20,643Property,
                    plant and equipment, net
                
                
                17,338
                
                
                16,857Restricted
                    cash loans
                
                
                1,073
                
                
                995Other
                    assets
                
                
                1,162
                
                
                1,146Total
                    assets
                
                $
                36,020
                
                $
                39,641**LIABILITIES,
                    PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**Current
                    liabilities:Current
                    portion of long term debt
                
                $
                1,214
                
                $
                1,317Line
                    of credit
                
                
                2,996
                
                
                2,996Accounts
                    payable
                
                
                992
                
                
                1,402Accrued
                    compensation
                
                
                670
                
                
                1,161Other
                    accrued liabilities
                
                
                4,195
                
                
                5,076Total
                    current liabilities
                
                
                10,067
                
                
                11,952Term
                    debt
                
                
                8,832
                
                
                8,790Government
                    grants advanced
                
                
                342
                
                
                396Other
                    long term liabilities
                
                
                2,480
                
                
                2,564Total
                    liabilities
                
                
                21,721
                
                
                23,702Commitments
                    and contingencies (Note 5)Series
                    A 10% cumulative convertible preferred stock, $0.001 par value;
                    $1.00
                    stated value; 5,000 shares authorized, 4,893 shares outstanding
                    at June
                    30, 2006 and December 31, 2005, respectively (Liquidation preference:
                    $5,626 and $5,383 at June 30, 2006 and December 31, 2005,
                    respectively)
                
                
                4,810
                
                
                4,810Stockholders’
                    equity:Common
                    stock, $0.001 par value per share; 50,000 shares authorized,
                    26,957 shares
                    and 26,793 shares outstanding at June 30, 2006 and December 31,
                    2005,
                    respectively
                
                
                27
                
                
                27Capital
                    in excess of par value
                
                
                78,057
                
                
                77,828Accumulated
                    other comprehensive income:Accumulated
                    translation adjustment
                
                
                3,377
                
                
                2,532Accumulated
                    deficit
                
                
                (71,972
                )
                
                (69,258
                )Total
                    stockholders’ equity
                
                
                9,489
                
                
                11,129Total
                    liabilities, preferred stock and stockholders’ equity
                
                $
                36,020
                
                $
                39,641
 
 See
          accompanying notes to unaudited condensed consolidated financial
          statements.
  3
 *Table
              of Contents*
 
 **SOUTHWALL
          TECHNOLOGIES INC.**
 **UNAUDITED
          CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**
 **(in
          thousands, except per share data)**
  Three
                    months ended
                
                Six
                    months endedJune
                    30,
                  2006
                
                July
                    3,
                  2005
                
                June
                    30,
                  2006
                
                July
                    3,
                  2005Net
                    revenues
                
                $
                11,337
                
                $
                15,172
                
                $
                21,371
                
                $
                30,819Cost
                    of revenues
                
                
                7,268
                
                
                9,788
                
                
                13,634
                
                
                21,058Gross
                    profit
                
                
                4,069
                
                
                5,384
                
                
                7,737
                
                
                9,761Operating
                    expenses:Research
                    and development
                
                
                2,071
                
                
                1,017
                
                
                3,717
                
                
                1,713Selling,
                    general and administrative
                
                
                2,525
                
                
                2,331
                
                
                5,087
                
                
                4,357Impairment
                    charge (recoveries) for long-lived assets
                
                
                208
                
                
                -
                
                
                208
                
                
                (170
                )Restructuring
                    charges
                
                
                259
                
                
                -
                
                
                711
                
                
                -Total
                    operating expenses
                
                
                5,063
                
                
                3,348
                
                
                9,723
                
                
                5,900Income
                    (loss) from operations
                
                
                (994
                )
                
                2,036
                
                
                (1,986
                )
                
                3,861Interest
                    expense, net
                
                
                (189
                )
                
                (297
                )
                
                (381
                )
                
                (568
                )Other
                    income (expenses), net
                
                
                29
                
                
                (159
                )
                
                179
                
                
                133Income
                    (loss) before provision for income taxes
                
                
                (1,154
                )
                
                1,580
                
                
                (2,188
                )
                
                3,426Provision
                    for income taxes
                
                
                233
                
                
                185
                
                
                526
                
                
                332Net
                    income (loss)
                
                
                (1,387
                )
                
                1,395
                
                
                (2,714
                )
                
                3,094Deemed
                    dividend on preferred stock
                
                
                122
                
                
                120
                
                
                244
                
                
                243Net
                    income (loss) attributable to common stockholders
                
                $
                (1,509
                )
                $
                1,275
                
                $
                (2,958
                )
                $
                2,851Net
                    income (loss) per share:Basic
                
                $
                (0.06
                )
                $
                0.05
                
                $
                (0.11
                )
                $
                0.11Diluted
                
                $
                (0.06
                )
                $
                0.04
                
                $
                (0.11
                )
                $
                0.09Shares
                    used in computing net income (loss) per share:Basic
                
                
                26,939
                
                
                26,782
                
                
                26,882
                
                
                26,697Diluted
                
                
                26,939
                
                
                33,094
                
                
                26,882
                
                
                33,138
 
 See
          accompanying notes to unaudited condensed consolidated financial
          statements.
 
 4
 *Table
              of Contents*
 
 **SOUTHWALL
          TECHNOLOGIES INC**
 **UNAUDITED
          CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(in
          thousands)**
  Six
                      months endedJune
                      30,
                    2006
                  
                  July
                      3,
                    2005Cash
                      flows from operating activities:Net
                      income (loss)
                  
                  $
                  (2,714
                  )
                  $
                  3,094Adjustments
                      to reconcile net income (loss) to net cash (used in) provided
                      by operating
                      activities:Deferred
                      income tax
                  
                  
                  61
                  
                  
                  -Impairment
                      charge (recoveries) from long-lived assets
                  
                  
                  208
                  
                  
                  (170
                  )Depreciation
                      and amortization
                  
                  
                  1,124
                  
                  
                  1,134Stock
                      compensation
                  
                  
                  372
                  
                  
                  45Change
                      in assets and liabilities:Deferred
                      revenues
                  
                  
                  (16
                  )
                  
                  (17
                  )Accounts
                      receivable, net
                  
                  
                  859
                  
                  
                  246Inventories,
                      net
                  
                  
                  812
                  
                  
                  1,274Other
                      current and non current assets
                  
                  
                  80
                  
                  
                  443Accrued
                      restructuring
                  
                  
                  83
                  
                  
                  -Accrued
                      liabilities—deferred rent
                  
                  
                  (1,192
                  )
                  
                  -Accounts
                      payable and accrued liabilities
                  
                  
                  (958
                  )
                  
                  (1,850
                  )Net
                      cash (used in) provided by operating activities
                  
                  
                  (1,281
                  )
                  
                  4,199Cash
                      flows from investing activities:Decrease
                      in restricted cash
                  
                  
                  53
                  
                  
                  237Proceeds
                      from sale of property, plant and equipment
                  
                  
                  97
                  
                  
                  170Expenditures
                      for property, plant and equipment
                  
                  
                  (644
                  )
                  
                  (406
                  )Net
                      cash (used in) provided by investing activities
                  
                  
                  (494
                  )
                  
                  1Cash
                      flows from financing activities:Repayments
                      under capital lease
                  
                  
                  -
                  
                  
                  (5
                  )Proceeds
                      from exercise of stock options
                  
                  
                  32
                  
                  
                  19Principal
                      payments on borrowings
                  
                  
                  (697
                  )
                  
                  (986
                  )Payments
                      on line of credit
                  
                  
                  -
                  
                  
                  (2,975
                  )Borrowings
                      on line of credit
                  
                  
                  -
                  
                  
                  2,996Investment
                      credit in Germany
                  
                  
                  (84
                  )
                  
                  (22
                  )Net
                      cash used in financing activities
                  
                  
                  (749
                  )
                  
                  (973
                  )Effect
                      of foreign exchange rate changes on cash
                  
                  
                  135
                  
                  
                  (146
                  )Net
                      (decrease) increase in cash and cash equivalents
                  
                  
                  (2,389
                  )
                  
                  3,081Cash
                      and cash equivalents, beginning of period
                  
                  
                  6,600
                  
                  
                  4,547Cash
                      and cash equivalents, end of period
                  
                  $
                  4,211
                  
                  $
                  7,628
 See
            accompanying notes to unaudited condensed consolidated financial
            statements.
  5
 *Table
              of Contents*
  **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
          year-end condensed balance sheet data was derived from audited financial
          statements, but does not include all disclosures required by accounting
          principles generally accepted in the United States of America. The Company
          suggests that these condensed consolidated financial statements be read
          in
          conjunction with the consolidated financial statements and notes thereto
          contained in the Company's Form 10-K for the year ended December 31,
          2005 filed with the Securities and Exchange Commission on March 29, 2006.
          The
          results of operations for the interim periods presented are not necessarily
          indicative of the operating results of the full year.
 
 In
          2005,
          the Company used a 52-week fiscal year ending on December 31. In 2006, the
          Company changed to a fiscal calendar year ending on December 31 with fiscal
          quarters ending on March 31, June 30, and September 30. The second fiscal
          quarters of 2006 and 2005 ended on June 30, 2006 and July 3, 2005, respectively.
          The July 3, 2005 quarter included 13 weeks.
 
 **Note 2—Inventories,
          Net:**
 
 In
          January 2006, the Company changed its inventory valuation method from the
          first-in, first-out method to the average cost method. With the closing
          of the
          Company’s Palo Alto, California manufacturing facility and all production now
          being performed in our German subsidiary’s facility, the use of the average cost
          method was deemed preferable as it both accommodates our German subsidiary’s
          statutory reporting requirements and fairly approximates actual costs.
          In
          addition, the impact of the change was $0.3 million which the Company considers
          immaterial.
 
 Inventories
          are stated at the lower of cost (determined by the average 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 June 30, 2006 and December 31, 2005, inventories
          consisted of the following (in thousands):
 
 June
                    30,
                  2006
                
                December
                    31,
                  2005Raw
                    materials
                
                $
                3,033
                
                $
                3,482Work-in-process
                
                
                799
                
                
                1,409Finished
                    goods
                
                
                1,235
                
                
                988$
                5,067
                
                $
                5,879
  6
 *Table
              of Contents*
 
 **Note 3--Net
          Income (Loss) Per Share:**
 
 Basic
          net
          income (loss) per share is computed by dividing net income (loss) attributable
          to common stockholders (numerator) by the weighted average number of common
          shares outstanding (denominator) for the period. Diluted net income (loss)
          per
          share gives effect to all dilutive common shares potentially outstanding
          during
          the period, including stock options, warrants to purchase common stock
          and
          convertible preferred stock. Preferred stock dividends are added back to
          net
          income attributable to common stockholders since they would not have been
          accrued if the preferred stock had been converted to common stock at the
          beginning of the period.
 
 The
          Company excludes options from the computation of diluted weighted average
          shares
          outstanding if the exercise price of the options is greater than the average
          market price of the shares because the inclusion of these options would
          be
          anti-dilutive to earnings per share.  Accordingly, stock options to
          purchase 1,844,000 shares at an average price of $4.61 per share were
          excluded from the computation of diluted weighted average shares outstanding
          for
          the three and six-month periods ended July 3, 2005.
  In
          net
          loss periods, the basic and diluted weighted average shares of common stock
          and
          common stock equivalents are the same because inclusion of common stock
          equivalents would be anti-dilutive. Accordingly, for the three and six-month
          periods ended June 30, 2006, there was no difference between the denominators
          used for the calculation of basic and diluted net income (loss) per share.
          For
          the three and six-month periods ended June 30, 2006, there were 5,994,000
          options, 360,000 warrants, and 4,893,000 preferred shares outstanding and
          excluded from the net loss per share calculation. Tables
          summarizing net income (loss) attributable to common stockholders, for
          diluted
          net income (loss) per share, and shares outstanding are shown below (in
          thousands):
 
 Three
                    months ended
                
                Six
                    months endedJune
                    30,
                
                July
                    3,
                
                June
                    30,
                
                July
                    3,2006
                
                2005
                
                2006
                
                2005Net
                    income (loss) attributable to common stockholders-basic
                
                $
                (1,509
                )
                $
                1,275
                
                $
                (2,958
                )
                $
                2,851Add:
                    Deemed dividend on preferred stock
                
                
                122
                
                
                120
                
                
                244
                
                
                243Net
                    income (loss) attributable to common stockholders-diluted
                
                $
                (1,387
                )
                $
                1,395
                
                $
                (2,714
                )
                $
                3,094Weighted
                    average common shares outstanding-basic
                
                
                26,939
                
                
                26,782
                
                
                26,882
                
                
                26,697Dilutive
                    effect of warrants
                
                
                -
                
                
                357
                
                
                -
                
                
                357Dilutive
                    effect of performance shares
                
                
                -
                
                
                -
                
                
                -
                
                
                75Dilutive
                    effect of Series A preferred shares
                
                
                -
                
                
                4,893
                
                
                -
                
                
                4,893Dilutive
                    effect of stock options
                
                
                -
                
                
                1,062
                
                
                -
                
                
                1,116Weighted
                    average common shares outstanding - diluted
                
                
                26,939
                
                
                33,094
                
                
                26,882
                
                
                33,138
  **Note 4
          - Segment Reporting:**
 
 Southwall
          operates in one segment.
 
 The
          total
          net revenues for the automotive glass, electronic display, window film
          and
          architectural product lines for the three and
          six-month periods ended June 30, 2006 and July 3, 2005 were as follows
          (in
          thousands):
  Three
                      months ended
                  
                  Six
                      months endedJune
                      30,
                    2006
                  
                  July
                      3,
                    2005
                  
                  June
                      30,
                    2006
                  
                  July
                      3,
                    2005Automotive
                      glass
                  
                  $
                  3,828
                  
                  $
                  4,937
                  
                  $
                  6,707
                  
                  $
                  11,322Electronic
                      display
                  
                  
                  3,270
                  
                  
                  3,297
                  
                  
                  5,761
                  
                  
                  7,376Window
                      film
                  
                  
                  3,004
                  
                  
                  5,481
                  
                  
                  6,456
                  
                  
                  9,127Architectural
                  
                  
                  1,235
                  
                  
                  1,457
                  
                  
                  2,447
                  
                  
                  2,994Total
                      net revenues
                  
                  $
                  11,337
                  
                  $
                  15,172
                  
                  $
                  21,371
                  
                  $
                  30,819
  7
 *Table
              of Contents*
  The
          following is a summary of net revenues by geographic area (based on the
          location
          of the Company's customers) for the three and six-month periods ended June
          30,
          2006 and July 3, 2005, respectively (in thousands):
  Three
                    months ended
                
                Six
                    months endedJune
                    30,
                  2006
                
                July
                    3,
                  2005
                
                June
                    30,
                  2006
                
                July
                    3,
                  2005United
                    States
                
                $
                3,532
                
                $
                3,995
                
                $
                7,179
                
                $
                7,711Japan
                
                
                3,201
                
                
                2,631
                
                
                5,309
                
                
                6,430France
                
                
                1,286
                
                
                3,170
                
                
                1,428
                
                
                6,493Pacific
                    Rim
                
                
                1,786
                
                
                3,523
                
                
                4,701
                
                
                6,085Germany
                
                
                1,166
                
                
                1,368
                
                
                1,945
                
                
                2,713Rest
                    of the world
                
                
                366
                
                
                485
                
                
                809
                
                
                1,387Total
                    net revenues
                
                $
                11,337
                
                $
                15,172
                
                $
                21,371
                
                $
                30,819
 
 **Note 5--Commitments
          and Contingencies:**
 
 *Commitments*
 
 On
          January 19, 2006, the Company announced its plans to close its Palo Alto
          manufacturing facility. As a result of this decision, the Company is in
          negotiation with its landlord to decommission and surrender these premises.
          The
          Company has recognized $0.2 million of liability on one of its buildings.
          No
          liability has been recognized with respect to decommissioning of the second
          building at this time because the Company cannot ascertain the fair value
          of any
          potential obligation to this landlord because the settlement date and method
          of
          settlement for our decommissioning obligation have not been specified,
          and the
          Company currently does not have sufficient information to reasonably estimate
          any potential obligation. The Company believes that it can resolve this
          issue
          with this landlord and will pay for any potential obligations in the second
          half
          of 2006. It is possible that our estimate of our lease decommissioning
          obligation could change in the near term.
 
 On
          February 19, 2004, the Company entered into the second amendment to the
          lease
          for the second building. The amendment reflected a payment schedule for
          a rent
          deferral. In January of 2006, the Company paid off approximately $1.2 million
          in
          deferred rent. As of June 30, 2006, there was no deferred rent outstanding.
 
 *Contingencies*
 
 The
          Company was named as a defendant, along with Bostik, Inc., in an action
          captioned WASCO Products, Inc. v. Southwall Technologies, Inc. and Bostik,
          Inc.,
          Civ. Action No. C 02 2926 SBA, which was filed in Federal District Court
          for the
          Northern District of California on June 18, 2002. The Company was served
          with
          the Complaint in this matter on July 1, 2002. The plaintiff filed the matter
          as
          a class action on behalf of all entities and individuals in the United
          States
          who manufactured and/or sold and warranted the service life of insulated
          glass
          units manufactured between 1989 and 1999, which contained Southwall Heat
          Mirror
          film and were sealed with a specific type of sealant manufactured by Bostik,
          Inc. The plaintiff alleged that the sealant provided by Bostik, Inc. was
          defective, resulting in elevated warranty replacement claims and costs.
          The
          plaintiff asserted claims against the Company for breach of an implied
          warranty
          of fitness, misrepresentation, fraudulent concealment, negligence, negligent
          interference with prospective economic advantage, breach of contract, unfair
          business practices and false or misleading business practices. The plaintiff
          sought recovery on behalf of the class of $100 million for damages allegedly
          resulting from elevated warranty replacement claims, restitution, injunctive
          relief, and non-specific compensation for lost profits. By Order entered
          December 22, 2003, the Court dismissed all claims against the Company.
          The
          plaintiff appealed to the Ninth Circuit Court of Appeals. On January 13,
          2006,
          the Court of Appeals affirmed the lower court decision. On January 26,
          2006, the
          plaintiff filed a petition for rehearing with the Ninth Circuit Court of
          Appeals. In March of 2006, the Ninth Circuit Court of Appeals denied the
          plaintiff’s petition. On May 26, 2006 the plaintiff filed a petition for writ of
          certiorari to the United States Supreme Court. The Supreme Court has not
          ruled
          on the petition. A percentage of the Company’s defense costs are being paid by
          its insurance carriers under reservation of rights. It
          is not
          possible to predict how Plaintiff’s claims will be resolved or whether the
          Company will be found liable at this time.
  8
 *Table
              of Contents*
 
 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 us up to an aggregate of $12.9 million plus defense costs,
          although any such recovery would be restricted to claims that were not
          covered
          by 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.
 
 On
          June
          13, 2002, Plaintiff Charles Ikekwere (“Plaintiff”) filed a Complaint against the
          Company in the Superior Court of California in and for the County of Santa
          Clara, Case No. CV808644. Mr. Ikekwere is a former employee of the Company.
          Plaintiff’s Complaint alleged claims for race discrimination, national origin
          discrimination, retaliation, medical condition discrimination, breach of
          contract, breach of fiduciary duty, fraud, negligence, intentional infliction
          of
          emotional distress, and punitive damages. The Company challenged the sufficiency
          of certain of Plaintiff’s allegations, which caused him to file a First Amended
          Complaint alleging essentially the same claims. The Company also challenged
          certain of Plaintiff’s allegations in his First Amended Complaint, which caused
          him to file a Second Amended Complaint. Following the Company’s legal challenges
          to Plaintiff’s Second Amended Complaint, the following claims remain at issue in
          the litigation: (1) race discrimination; (2) national origin discrimination;
          (3)
          retaliation; (4) medical condition discrimination; (5) breach of contract;
          (6)
          violation of California Constitution Article I; and (7) fraud and deceit.
          In
          light of certain deposition testimony given by Plaintiff, the Company removed
          this matter to Federal Court on January 6, 2004. The basis for the Company’s
          removal was that certain of Plaintiff’s allegations were preempted by the
          Employee Retirement Income and Security Act (ERISA). On February 4, 2004,
          Plaintiff filed a Motion to Remand the case to State Court, which the Court
          denied. Plaintiff subsequently amended his Second Amended Complaint to
          add a
          claim under ERISA. The Company filed a summary judgment motion in March
          of 2006.
          In June of 2006 the judge granted in part and denied in part Southwall's
          motion
          for summary judgment. Southwall and Plaintiff were scheduled to go to trial
          in
          July; however, plaintiff filed a motion for a continuance, which was granted
          by
          the judge. The trial is now scheduled for December 1, 2006. Also, Southwall
          and
          Plaintiff have a Settlement Conference that is scheduled to take place
          in
          September 2006. It is not possible to predict how Plaintiff’s claims will be
          resolved, whether the Company will be found liable, or the nature and extent
          of
          Plaintiff’s alleged damages at this time.
 
 In
          addition, the Company is involved in certain other legal actions arising
          in the
          ordinary course of business. The Company believes, however, that none of
          these
          actions, either individually or in the aggregate, will have a material
          adverse
          effect on its business, consolidated financial position, results of operations
          or cash flows.
 
 **Note 6--Stock-Based
          Compensation:**
 
 The
          Company has a stock-based compensation program that provides its Board
          of
          Directors broad discretion in creating employee equity incentives. The
          Company
          has granted stock options under various option plans and agreements in
          the past
          and currently grants stock options under the 1997 Stock Incentive Plan
          and the
          1998 Stock Option Plan for employees, board members and consultants. The
          Board
          of Directors adopted the 1997 and 1998 Stock Option Plans on May 12, 1997
          and
          August 6, 1998, respectively. The Compensation Committee of the Board of
          Directors administers the plans and agreements. The exercise price of options
          granted under the 1997 and 1998 plans must be at least 85% of the fair
          market
          value of the stock at the date of grant. Options granted under the 1998
          plan
          prior to October 2004 generally vest at a rate of 25% per year, are
          non-transferable and expire over terms not exceeding ten years from the
          date of
          grant or three months after the optionee terminates his relationship with
          the
          Company. Options granted under the 1997 plan prior to October 2004 generally
          vest at a rate of 25% per year, are non-transferable and expire over terms
          not
          exceeding ten years from the date of grant or eighteen months after the
          optionee
          terminates his relationship with the Company. Grants from and after October
          2004
          until April 2006 under both plans vest at a rate of 25% after six months
          and
          then evenly monthly thereafter for the remaining 42 months. From and after
          April
          2006 grants under both plans vest at a rate of 25% per year on each anniversary
          of the grant date.
  9
 *Table
              of Contents*
 
 The
          Company also has an Employee Stock Purchase Plan (ESPP) that allows employees,
          subject to certain limitations, to purchase shares at 85% of the lower
          of the
          fair market value of the Common Stock at the beginning of the six-month
          offering
          period, or the last day of the purchase period. The Company has decided
          to
          discontinue its ESPP in the second half of 2006.
 
 As
          of
          June 30, 2006, the Company had approximately 2,149,000 shares of common
          stock
          reserved for future issuance under its stock option plans and ESPP.
 
 On
          January 1, 2006, the Company adopted the provisions of SFAS 123R, “Shared-Based
          Payment” (SFAS 123R), requiring it to recognize expense related to the fair
          value of its stock-based compensation awards. The Company elected to use
          the
          modified prospective transition method as permitted by SFAS 123R and therefore
          has not restated its financial results for prior periods. Under this transition
          method, stock-based compensation expense for the three and six-month periods
          ended June 30, 2006 includes compensation expense for all stock-based
          compensation awards granted prior to, but not yet vested as of January
          1, 2006,
          based on the grant date fair value estimated in accordance with the original
          provisions of SFAS 123. Stock-based compensation expense for all stock-based
          compensation awards granted subsequent to January 1, 2006 was based on
          the
          grant-date fair value estimated in accordance with the provisions of SFAS
          123R.
          The Company recognized compensation expense for stock option awards on
          a graded
          vesting basis over the requisite service period of the award.
 
 The
          following table sets forth the total stock-based compensation expense resulting
          from stock options included in the condensed consolidated statements of
          operations (in thousands):
 
 Three
                    months ended
                
                Six
                    months endedJune
                    30,
                  2006
                
                June
                    30,
                  2006Cost
                    of sales
                
                $
                -
                
                $
                11Research
                    and development
                
                
                34
                
                
                88Selling,
                    general and administrative
                
                
                78
                
                
                240Stock-based
                    compensation expense before income taxes
                
                
                112
                
                
                339Income
                    tax benefit
                
                
                -
                
                
                -Total
                    stock-based compensation expense after income taxes
                
                $
                112
                
                $
                339
 
 Net
          cash
          proceeds from the exercise of stock options were immaterial for the three
          months
          ended June 30, 2006 and July 3, 2005, respectively, and immaterial for
          the six
          months ended June 30, 2006 and July 3, 2005, respectively. No income tax
          benefit
          was realized from stock option exercises during the three and six-month
          periods
          ended June 30, 2006, and July 3, 2005. In accordance with SFAS 123R, the
          Company
          presents excess tax benefits from the exercise of stock options, if any,
          as
          financing cash flows rather than operating cash flows.
 
 10
 *Table
              of Contents*
 
 Prior
          to
          the adoption of SFAS 123R, the Company applied SFAS No. 123, “Accounting for
          Stock-Based Compensation” (SFAS 123), amended by SFAS No. 148, “Accounting for
          Stock-Based Compensation - Transition and Disclosure” (SFAS 148), which allowed
          companies to apply the existing accounting rules under APB 25, “Accounting for
          Stock Issued to Employees” (APB 25), and related Interpretations. In general, as
          the exercise price of options granted under these plans was equal to the
          market
          price of the underlying common stock on the grant date, no stock-based
          employee
          compensation cost was recognized in the Company’s net income (loss). As required
          by SFAS 148 prior to the adoption of SFAS 123R, the Company provided pro
          forma
          net income (loss) and pro forma net income (loss) per common share disclosures
          for stock-based awards, as if the fair-value-based method defined in SFAS
          123
          had been applied.
 
 The
          following table illustrates the effect on net income after tax and net
          income
          per common share as if the Company had applied the fair value recognition
          provisions of SFAS 123 to stock-based compensation during the three and
          six-month periods ended July 3, 2005 (in thousands, except per share amounts):
 
 Three
                    months ended
                
                Six
                    months endedJuly
                    3,
                  2005
                
                July
                    3,
                  2005Net
                    income attributable to common stockholders:As
                    reported
                
                $
                1,275
                
                $
                2,851Add: 
                    Stock-based employee compensation expense included in reported
                    net income,
                    net of related tax effects
                
                
                -
                
                
                45Deduct: 
                    Total stock-based employee compensation determined under fair
                    value based
                    method for all awards, net of related tax effects
                
                
                (149
                )
                
                (302
                )Pro
                    forma net income attributable to common stockholders
                
                $
                1,126
                
                $
                2,594Net
                    income attributable to common stockholders per share:As
                    reported - basic
                
                $
                0.05
                
                $
                0.11Pro
                    forma - basic
                
                $
                0.04
                
                $
                0.10As
                    reported - diluted
                
                $
                0.04
                
                $
                0.09Pro
                    forma - diluted
                
                $
                0.04
                
                $
                0.09
  The
          fair
          value of stock-based awards was estimated using the Black-Scholes model
          with the
          following weighted-average assumptions for the three and six-month periods
          ended
          June 30, 2006, and July 3, 2005, respectively:
 
 Three
                    months ended
                
                Six
                    months endedJune
                    30,
                  2006
                
                July
                    3,
                  2005
                
                June
                    30,
                  2006
                
                July
                    3,
                  2005Expected
                    life (in years)
                
                
                2.58
                
                
                2.25
                
                
                2.40
                
                
                1.63Risk-free
                    interest rate
                
                
                4.98
                %
                
                3.75
                %
                
                4.88
                %
                
                3.61
                %Volatility
                
                
                109
                %
                
                116
                %
                
                109
                %
                
                116
                %Dividend
                
                
                -
                
                
                -
                
                
                -
                
                
                -Weighted-average
                    fair value at grant date
                
                $
                0.44
                
                $
                0.97
                
                $
                0.42
                
                $
                0.59
  11
 *Table
              of Contents*
  The
          Company’s computation of expected volatility for the quarter ended June 30, 2006
          is based on historical volatility. The Company’s computation of expected life is
          based on historical exercise patterns. The interest rate for periods within
          the
          expected life of the award is based on the U.S. Treasury yield in effect
          at the
          time of grant.
 
 Stock
          option activity for the six months ended June 30, 2006 was as follows (in
          thousands, except per share amounts):
  Shares
                
                Weighted-AverageExercise
                    Price
                
                Weighted-Average
                    Remaining Contractual Term(in
                    years)
                
                AggregateIntrinsic
                    ValueOutstanding
                    at December 31, 2005
                
                
                5,572
                
                $
                1.53Grants
                
                
                698
                
                
                0.70Exercises
                
                
                (57
                )
                
                0.50Forfeitures
                    or expirations
                
                
                (219
                )
                
                2.55Outstanding
                    at June 30, 2006
                
                
                5,994
                
                $
                1.40
                
                
                7.57
                
                $
                214Vested
                    and expected to vest at June 30, 2006
                
                
                5,239
                
                $
                1.48
                
                
                7.34
                
                $
                197Exercisable
                    at June 30, 2006
                
                
                3,424
                
                $
                1.78
                
                
                6.52
                
                $
                156
 
 The
          aggregate intrinsic value in the table above represents the total pretax
          intrinsic value (i.e., the difference between Southwall’s closing stock price on
          the last trading day of its second quarter of fiscal 2006 and the exercise
          price, times the number of shares) that would have been received by the
          option
          holders had all option holders exercised their options on June 30, 2006.
          This
          amount changes based on the fair market value of Southwall’s stock. Total
          intrinsic value of options exercised was immaterial for the three and six-month
          periods ended June 30, 2006. Total fair value of options vested is $0.2
          million
          and $0.3 million for the three and six-month periods ended June 30, 2006,
          respectively.
 
 As
          of
          June 30, 2006, $1.0 million of total unrecognized compensation cost related
          to
          stock options was expected to be recognized over a weighted-average period
          of
          approximately 1.68 years.
 
 On
          May
          11, 2006, the Company granted 515,000 Performance Stock Units (“PSUs”) to
          certain employees under the 2006 Long Term Incentive Program. In accordance
          with
          SFAS 123R, the PSUs have been valued on the date of grant based on their
          fair
          value determined under the Black-Scholes valuation model. Under the Plan,
          the
          PSUs will vest when certain milestones are met and the participants will
          then
          have immediate ownership of the PSUs, which convert to common stock of
          the
          Company on a 1:1 basis. The PSUs have no purchase price/cost to the participants
          and the participants must be employed with the Company on the date the
          milestone
          is achieved in order to vest. As of June 30, 2006, the milestones have
          not been
          achieved and thus no PSUs had vested. For the quarter ended June 30, 2006,
          an
          immaterial amount of compensation was recognized. The PSUs are expected
          to vest
          over a 23 month period and had a weighted average grant date fair value
          of $0.71
          and an aggregate intrinsic value of $0.3 million as of June 30, 2006. As
          of June
          30, 2006, $0.3 million of unrecognized compensation cost related to the
          PSUs is
          expected to be recognized over the remaining expected service period of
          21
          months.
 
 **Note
          7 - Restructuring:**
 
 In
          December 2002, we implemented a reduction in force at our Palo Alto
          location and elected to vacate certain buildings in Palo Alto. As a result
          of these actions, we incurred a restructuring charge of $2.6 million in
          2002
          relating to employee severance packages and the remaining rents due on
          excess
          facilities in Palo Alto that we no longer occupy. In 2003, we recorded a
          credit to operating expenses of $0.1 million as a result of modifications
          to the
          severance packages of certain employees. On
          January 19, 2006, we commenced restructuring actions to improve our cost
          structure. These actions include the closure of our Palo Alto, California
          manufacturing facility and a reduction in force at our Palo Alto site in
          the
          first half of 2006. As
          a
          result of these actions, we incurred a restructuring charge of $0.7 million
          during the first half of 2006 relating to employee severance packages,
          and
          related charges.
  12
 *Table
              of Contents*
 
 The
          following tables set forth the beginning and ending liability balances
          relating
          to the above described restructuring activities as well as activity during
          the
          six month periods ended  June
          30,
          2006 and July 3, 2005 (in thousands):
  Restructuring
                        
                        RestructuringPlan 
                            2006
                        
                        Plan 
                            2002Severance
                          and
                            Benefits
                        
                        Facilities
                            Related
                          and
                            Other
                        
                        Facilities
                            Related
                        
                        TotalBalance
                            at January 1, 2005
                        
                        $
                        -
                        
                        $
                        -
                        
                        $
                        274
                        
                        $
                        274Provisions
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -Adjustment
                            to reserve
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -Cash
                            payments
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (21
                        )
                        
                        (21
                        )Balance
                            at July 3, 2005
                        
                        $
                        -
                        
                        $
                        -
                        
                        $
                        253
                        
                        $
                        253Severanceand
                            Benefits
                        
                        Facilities
                            Related
                          and
                            Other
                        
                        Facilities
                            Related
                        
                        TotalBalance
                            at January 1, 2006
                        
                        $
                        -
                        
                        $
                        -
                        
                        $
                        199
                        
                        $
                        199Provisions
                        
                        
                        375
                        
                        
                        359
                        
                        
                        -
                        
                        
                        734Adjustment
                            to reserve
                        
                        
                        -
                        
                        
                        (23
                        )
                        
                        -
                        
                        
                        (23
                        )Cash
                            payments
                        
                        
                        (314
                        )
                        
                        (262
                        )
                        
                        (53
                        )
                        
                        (629
                        )Balance
                            at June 30, 2006
                        
                        $
                        61
                        
                        $
                        74
                        
                        $
                        146
                        
                        $
                        281
 At
          June
          30, 2006, $ 0.2
          million was included in other accrued liabilities, and a minimal amount
          was
          included in other long-term liabilities in 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 six month periods ended June 30, 2006 and July 3, 2005 was as
          follows
          (in thousands):
 
 Balance
                    at December 31,
                  2004
                
                Provision
                
                Utilized
                
                Balance
                    at July 3,
                  2005Accrued
                    sales returns and warranty
                
                $
                2,701
                
                $
                242
                
                $
                (808
                )
                $
                2,135
 
 
 Balance
                    at December 31,
                  2005
                
                Provision
                
                Utilized
                
                Balance
                    at June 30,
                  2006Accrued
                    sales returns and warranty
                
                $
                1,556
                
                $
                (68
                )
                $
                (333
                )
                $
                1,155
 
 These
          amounts are included in other accrued liabilities in the condensed consolidated
          balance sheets.
  13
 *Table
              of Contents*
 
 **Note
          9 - Comprehensive Income (Loss):**
 
 The
          Company has adopted the provisions of SFAS No. 130 "Reporting Comprehensive
          Income". SFAS 130 establishes standards for reporting and display in the
          financial statements of total net income (loss)
          and the components of all other non-owner changes in equity, referred to
          as
          comprehensive income (loss). Accordingly, the Company has reported the
          translation gain (loss) from the consolidation of its foreign subsidiary
          in
          comprehensive income (loss).
 
 The
          components of comprehensive income (loss) for the three and six-month periods
          ended June 30, 2006 and July 3, 2005 were as follows (in
          thousands):
  Three
                      months ended
                  
                  Six
                      months endedJune
                      30,
                    2006
                  
                  July
                      3,
                    2005
                  
                  June
                      30,
                    2006
                  
                  July
                      3,
                    2005Foreign
                      Currency Translation Adjustment
                  
                  $
                  521
                  
                  $
                  (869
                  )
                  $
                  845
                  
                  $
                  (1,540
                  )Net
                      Income (Loss)
                  
                  
                  (1,387
                  )
                  
                  1,395
                  
                  
                  (2,714
                  )
                  
                  3,094Other
                      Comprehensive Income (Loss)
                  
                  $
                  (866
                  )
                  $
                  526
                  
                  $
                  (1,869
                  )
                  $
                  1,554
 
 The
          components of accumulated other comprehensive income were as follows at
          June 30,
          2006 (in thousands):
 
 
 Accumulated
                    Other Comprehensive Income at December 31, 2005
                
                $
                2,532Foreign
                    Currency Translation Adjustment
                
                
                845Accumulated
                    Other Comprehensive Income at June 30, 2006
                
                $
                3,377
  14
 *Table
              of Contents*
 
 **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”, set forth in Part I, Item 1A,
          and in our Annual Report on Form 10-K for the year ended December 31,
          2005 and in Part II, Item 1A of our Quarterly Report on Form 10-Q for the
          quarter ended March 31, 2006. You should not place undue reliance on these
          forward-looking statements. Actual results may differ materially from those
          anticipated in the forward-looking statements. These forward-looking statements
          represent our judgment as of the date of the filing of this
          Form 10-Q.
 
 **Overview**
 
 We
          are a
          global developer, manufacturer and marketer of thin film coatings on flexible
          substrates for the automotive glass, electronic display, architectural
          glass and
          window film markets. We have developed a variety of products that control
          sunlight in automotive glass, reduce light reflection, reduce electromagnetic
          radiation and improve image quality in electronic display products and
          conserve
          energy in architectural products. Our products consist of transparent
          solar-control films for automotive glass; anti-reflective films for computer
          screens, including flat panel displays, and plasma displays; transparent
          conductive films for use in touch screen and liquid crystal displays; energy
          control films for architectural glass; and various other coatings.
  *Restructuring
          and financing activities.* As a
          consequence of the decline in our revenues and negative cash flows in 2003,
          we
          implemented several cost cutting and business restructuring activities
          during
          2003 and 2004. These activities, which included employee layoffs and the
          closure
          of several facilities (including the closure of our Tempe manufacturing
          facility
          in the fourth quarter of 2003), were designed to improve our cash flow
          from
          operations to allow us to continue as a going concern. During the fourth
          quarter
          of 2003 and the first quarter of 2004, we agreed to new payment terms with
          all
          of our major creditors and vendors, which extended or reduced our payment
          obligations. We also issued $4.5 million of convertible promissory notes
          and
          warrants to investors. The convertible promissory notes were converted
          to Series
          A preferred shares and the warrants were exercised for shares of common
          stock in
          the fourth quarter of 2004. On
          January 19, 2006, we commenced restructuring actions to improve our cost
          structure. These actions include the closure of our Palo Alto, California
          manufacturing facility and a reduction in force at our Palo Alto site in
          the
          first half of 2006. We are targeting a reduction in our total operating
          expenses
          of approximately $4 million on an annual basis from these restructuring
          activities. As
          a
          result of these actions, we incurred a restructuring charge of $0.7 million
          during the first half of 2006 relating to employee severance packages and
          facility related charges (see Note 7 of Notes to Unaudited Condensed
          Consolidated Financial Statements—Restructuring).
 
 *Demand
          for our customers' products.* We
          derive significant benefits from our relationships with a few large customers
          and suppliers. Our revenues and gross profit can increase or decrease rapidly
          reflecting underlying demand for the products of one or a small number
          of our
          customers. We may also be unable to replace a customer when a relationship
          ends
          or demand for our product declines as a result of evolution of our customers'
          products.
 
 Our
          three
          largest customers in the automotive glass and window film markets include
          Pilkington PLC, Saint Gobain Sekurit and Globamatrix Holdings Pte. Ltd., or
          Globamatrix, which collectively accounted for approximately 47%, 54% and
          45% of
          our total revenues during the first six months of 2006, fiscal year 2005
          and
          fiscal year 2004, respectively.
  15
 *Table
              of Contents*
  Under
          our
          agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
          purchase commitment of $9.0 million of product **.** For each
          year after 2004 through and including 2011, Globamatrix is required to
          purchase
          an amount of product equal to 110% of the amount of product it was required
          to
          purchase in the prior year. Globamatrix is obligated to purchase $11.3
          million
          of products in 2006. During the first six months of 2006, Globamatrix purchased
          approximately $6.4 million of product.
 
 During
          the first six months of 2006, our revenues in the automotive market decreased
          due to a reduction in demand from Saint Gobain. The reduction in demand
          was due
          to the ongoing “de-contenting” (a change by auto manufacturers to make the parts
          in which our products are found optional features rather than standard
          features
          to control their costs) trend in the automotive industry.
 
 *Sales
          returns and allowances.*  Our
          gross
          margins and profitability have been adversely affected from time to time
          by
          product quality claims. From 2003 to 2005, our sales returns provision
          has
          averaged approximately 2.5% to 4.5% of gross revenues. D uring
          the
          first six months of 2006, our sales returns provision has averaged approximately
          1.6% of our gross revenues due to fewer quality claims received during
          the
          period.
 
 **Critical
          Accounting Policies and Estimates**
 
 The
          accompanying discussion and analysis of our financial condition and results
          of
          operations are based upon our condensed consolidated financial statements,
          which
          have been prepared in accordance with generally accepted accounting principles
          in the United States (U.S. GAAP). The preparation of these financial statements
          requires us to make estimates and judgments that affect the reported amounts
          of
          assets, liabilities, revenues and expenses, and related disclosure of contingent
          assets and liabilities. These estimates form the basis for making judgments
          about the carrying values of assets and liabilities that are not readily
          apparent from other sources. We base our estimates and judgments on historical
          experience and on various other assumptions that we believe are reasonable
          under
          the circumstances. However, future events cannot be forecasted with certainty
          and the best estimates and judgments routinely require adjustment. We are
          required to make estimates and judgments in many areas, including those
          related
          to revenue recognition, allowance for doubtful accounts and sales returns,
          valuation of inventories, assessment of probability of the outcome of current
          litigation, restructuring costs, stock-based compensation expense, impairment
          charge for long-lived assets and accounting for income taxes. We believe
          the
          policies disclosed are the most critical to our financial statements because
          their application places the most significant demands on management’s judgment.
          Senior management has discussed the development, selection and disclosure
          of
          these estimates with the Audit Committee of our Board of Directors.
 
 We
          believe there have been no significant changes during the first six months
          of
          fiscal 2006 to the items that we disclosed as our critical accounting policies
          and estimates in our discussion and analysis of financial condition and
          results
          of operations in our 2005 Form 10-K, except as noted below.
 
 *Valuation
          of Inventories*
 
 In
          January 2006, we changed our inventory valuation method from the first-in,
          first-out method to the average cost method. With the closing of our Palo
          Alto,
          California manufacturing facility and all production now being performed
          in our
          German subsidiary’s facility, the use of the average cost method was deemed
          preferable as it both accommodates our German subsidiary’s statutory reporting
          requirements and fairly approximates actual costs. In addition, the impact
          of
          the change was $0.3 million which we consider immaterial.
 
 *Stock
          Based Compensation Expense*
 
 We
          account for stock-based compensation in accordance with the provisions
          of SFAS
          123R. Under the fair value recognition provisions of SFAS 123R, stock based
          compensation cost is estimated at the grant date based on the fair value
          of the
          award and is recognized as expense ratably over the requisite service period
          of
          the award. Determining the appropriate fair value model and calculating
          the fair
          value of stock-based awards requires judgment, including estimating stock
          price
          volatility, forfeiture rates and expected lives.
  16
 *Table
              of Contents*
 
 **Three
          Months Ended June 30, 2006 compared with Three Months Ended July 3,
          2005**
 
 **Results
          of Operations**
 
 *Net
          revenues.* Our
          net
          revenues for the three months ended June 30, 2006 and July 3, 2005 were
          $11.3
          million and $15.2 million, respectively. The decline in revenues affected
          all of
          our markets as described below.
 
 Our
          net
          revenues in the window film product line decreased by $2.5 million, or
          45%, from
          $5.5 million in the second quarter of 2005 to $3.0 million in the same
          period in
          2006. In the second half of 2005, we ceased converting (processing the
          sputtered
          film into finished applied window film) for one of our window film product
          models and agreed with our customer that they would take over responsibility
          for
          this process. This resulted in a decline in average sales prices for the
          TX
          product line and the decrease in window film market net revenues. In addition,
          revenues for our other window film product lines were higher in the second
          quarter of 2005 due to the fact that the last shipment from the first quarter
          of
          2005 was rescheduled into the beginning of the second quarter of 2005 at
          the
          customer’s request, resulting in unusually high sales for this product line in
          the second quarter of 2005.
 
 Our
          net
          revenues in the electronic display market remained relatively unchanged
          in the
          second quarter of 2005 compared to the same period of 2006.
  Our
          net
          revenues in the automotive market decreased by $1.1 million, or 22%, from
          $4.9
          million in the second quarter of 2005 to $3.8 million in the same period
          of
          2006. The decrease was primarily due to a reduction in demand in 2006 by
          Saint
          Gobain as a result of the ongoing “de-contenting” (a change by auto
          manufacturers to make the parts in which our products are found optional
          features rather than standard features to control their costs) trend in
          the
          automotive industry, partially offset by increases from some of our Automotive
          Replacement Glass customers.
 
 Our
          net
          revenues in the architectural market decreased by approximately $0.2 million,
          or
          15%, from $1.5 million in the second quarter of 2005 to $1.2 million in
          the same
          period of 2006. The decrease was due primarily to softness in the Asian
          market
          due to competitive pressures, particularly in the refrigeration
          business.
 
 *Cost
          of revenues.* Cost of
          revenues consists of materials and subcontractor services, labor and
          manufacturing overhead. Cost of revenues was $7.3 million in the second
          quarter
          of 2006 compared to $9.8 million in the same period of 2005.  The decrease
          in cost of revenues was primarily due to lower revenues, transfer of production
          to our lower cost German manufacturing facility, and favorable variances
          related
          to the shutdown of our manufacturing facility in Palo Alto offset by inventory
          reserves for the window film products.
 
 *Gross
          profit and gross margin.* Our
          gross profit decreased $1.3 million from $5.4 million in the second quarter
          of
          2005 to $4.1 million in the same period of 2006. As a percentage of sales,
          gross
          profit increased from 35% in the second quarter of 2005 to 36% in the same
          period in 2006 due to lower overall manufacturing costs as detailed above,
          offset by lower margins in our electronic display products and inventory
          reserves for the window film products. The lower electronic display margins
          in
          2006 when compared to 2005 were due to lower average selling prices due
          to
          increased competition in this market.
  17
 *Table
              of Contents*
  *Operating
          expenses*
 
 *Research
          and development* .
          Research and development expenses increased $1.1 million from $1.0 million
          in
          the second quarter of 2005 to $2.1 million in the same period of 2006.
          The 104%
          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 second quarter of 2006 than in
          the
          same period in 2005. We expect expenditures relating to research and development
          for the remainder of 2006 to continue at the same level as in the first
          half of
          2006. In
          2005,
          we began development and sampling of a new class of films with improved
          performance that we believe will be beneficial across our product lines.
          We also
          initiated significant research and development into thin film technology
          that we
          anticipate will enable Southwall to produce new products for new applications
          and new markets.
 
 *Selling,
          general and administrative* .
          Selling, general and administrative expenses consist primarily of corporate
          and
          administrative overhead, selling commissions and occupancy costs. Selling,
          general and administrative expenses increased $0.2 million from $2.3 million
          in
          the second quarter of 2005 to $2.5 million in the same period of 2006.
          The
          increase in general and administrative expenses in the second quarter of
          2006
          was primarily due to the stock based compensation expense of $0.1 million
          and an
          increase in legal fees of $0.1 million.
 
 *Impairment
          charge (recoveries) for long-lived assets.* In the second quarter
          of 2006, we ceased manufacturing in Palo Alto. As a result of this action,
          we
          recorded a $0.3 million impairment charge related to a production machine
          which
          was decommissioned in the second quarter of 2006. There was no such charge
          in
          the second quarter
          of 2005. In addition, in the second quarter
          of 2006, we recorded the recovery of $0.1 million of previously recorded
          impairment charges related to impaired long-lived assets which were sold
          in the
          second quarter of 2006. There were no such recoveries in the second quarter
          of 2005.
 
 *Restructuring.* On
          January 19, 2006, we commenced restructuring actions to improve our cost
          structure. These actions include the closure of our Palo Alto, California
          manufacturing facility and a reduction in force at our Palo Alto site in
          the
          first half of 2006. As
          a
          result of these actions, we incurred additional restructuring charges of
          $0.3
          million during the second quarter of 2006 primarily relating to outside
          services
          to decommission our manufacturing equipment and scrapped production materials. There
          was
          no such restructuring charge in the second quarter of 2005.
 
 *Income
          (loss) from operations* .
          Income
          from operations decreased $3.0 million from income of $2.0 million in the
          second
          quarter of 2005 to a loss of $1.0 million in the same period of 2006. The
          decrease was primarily due to a decrease in revenue, increase in research
          and
          development costs, recognition of the stock based employee compensation
          expense,
          and restructuring charges and impairment charges in the second quarter
          of 2006
          as detailed above.
 
 *Interest
          expense, net.* Interest
          expense, net decreased $0.1 million from $0.3 million in the first quarter
          of
          2005 to $0.2 million in the same period of 2006. The decrease in interest
          expense was primarily attributable to less outstanding debt during the
          second
          quarter of 2006 compared to the same period in 2005.
  *Other
          income, net* .
          Other
          income, net, mainly reflects foreign exchange transaction gains and losses
          in
          the second  quarter
          of 2006 and 2005. Some of our transactions with foreign customers are
          denominated in foreign currencies, principally the Euro. As exchange rates
          fluctuate relative to the U.S. dollar, exchange gains and losses occur.
          In the
          second quarter of 2006, the net exchange gain due to Euro fluctuation was
          not
          material compared to the net exchange loss of $0.2 million in the same
          period in
          2005.
 
 *Income
          (loss) before provision for income taxes* .
          We
          recorded a pre-tax loss of $1.2 million in the second quarter of 2006 and
          a
          pre-tax income of $1.6 million in the second quarter of 2005. The decrease
          of
          $2.7 million was primarily due to a decrease in revenue, increase in research
          and development costs, recognition of the stock based employee compensation
          expense, and restructuring and impairment charges in the second quarter
          of
          2006.
  18
 *Table
              of Contents*
 
 *Provision
          for income taxes* .
          The
          increase in the provision for income taxes in the second quarter of 2006
          compared to the same period in 2005 is related to higher taxable income
          in 2006
          in our foreign subsidiary, Southwall Europe GmBH, or SEG, as this subsidiary
          no
          longer has net operating losses to offset net taxable income. In addition,
          our
          foreign subsidiary completed an income tax audit for years 1999 to 2002
          and
          incurred additional income tax expense of $0.1 million in the second quarter
          of
          2006.
 
 *Net
          income (loss).* In the
          second quarters of 2006 and 2005, we recorded a net loss of $1.4 million
          and net
          income of $1.4 million, respectively. The decrease of $2.8 million was
          primarily
          due to a decrease in revenue, an increase in research and development costs,
          recognition of the stock based employee compensation expense, restructuring
          and
          impairment charges, and a higher income tax provision in the second quarter
          of
          2006.
 
 *Deemed
          dividend on preferred stock.* We
          accrued $0.1 million of deemed dividend on preferred stock in each of the
          second
          quarters of 2006 and 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.
 
 **Six
          Months Ended June 30, 2006 compared with Six Months Ended July 3,
          2005**
 
 **Results
          of Operations**
 
 *Net
          revenues.* Our net
          revenues for the six months ended June 30, 2006 and July 3, 2005 were $21.4
          million and $30.8 million, respectively.
 
 Our
          net
          revenues in the window film market decreased by $2.7 million, or 29%, from
          $9.1
          million in the first six months of 2005 to $6.5 million in the same period
          in
          2006. In the second half of 2005, we ceased converting (processing the
          sputtered
          film into finished applied window film) for one of our window film product
          models and agreed with our customer that they would take over responsibility
          for
          this process. This resulted in a decline in average sales prices for one
          TX
          product line. In addition, revenues for our other window film product lines
          were
          higher in the first half of 2005 due to the fact that the last shipment
          from the
          fourth quarter of 2004 was rescheduled into the beginning of the first
          quarter
          of 2005 at the customer’s request, resulting in unusually high sales for this
          product line in the first six months of 2005.
 
 Our
          net
          revenues in the electronic display market decreased by $1.6 million, or
          22%,
          from $7.4 million in the first six months of 2005 to $5.8 million in the
          same
          period of 2006. The decrease was due to the termination of the AR product
          line,
          a decline in demand for Silver reflector film for the LCD back-light market
          and
          reduced average sales prices on film sold to Mitsui for Plasma Display
          Panel, or
          PDP, filters. An overall decrease in the average selling prices for PDP
          products
          resulted in price pressures on all suppliers in the market.
  Our
          net
          revenues in the automotive market decreased by $4.6 million, or 41%, from
          $11.3
          million in the first six months of 2005 to $6.7 million in the same period
          of
          2006. The decrease was primarily due to a reduction in demand throughout
          the
          first six months of 2006 by Saint Gobain as a result of their large inventory
          build-up at 2005 year end and the ongoing “de-contenting” (a change by auto
          manufacturers to make the parts in which our products are found optional
          features rather than standard features to control their costs) trend in
          the
          automotive industry.
 
 Our
          net
          revenues in the architectural market decreased by $0.5 million, or 18%,
          from
          $3.0 million in the first six months of 2005 to $2.4 million in the same
          period
          of 2006. The decrease was due to softness in the Asian market and a decreased
          demand from our U.S. customers due to inventory build-up at 2005
          year-end.
  19
 *Table
              of Contents*
 
 *Cost
          of revenues* .
          Cost of
          revenues was $13.6 million in the first six months of 2006 compared to
          $21.1
          million in the same period of 2005.  The decrease in cost of revenues was
          primarily due to lower revenues, transfer of production to our lower cost
          German
          manufacturing facility, offset by inventory reserves for the window film
          products.
 
 *Gross
          profit and gross margin* .
          Our
          gross profit decreased $2.0 million from $9.8 million in the first six
          months of
          2005 to $7.7 million in the same period of 2006. As a percentage of sales,
          gross
          profit increased from 32% in the first six months of 2005 to 36% in the
          same
          period in 2006 due to lower overall manufacturing costs as detailed above,
          offset by lower margins in our electronic display products and inventory
          reserves for the window film products.
 
 *Operating
          expenses*
  *Research
          and development* .
          Research and development expenses increased $2.0 million from $1.7 million
          in
          the first six months of 2005 to $3.7 million in the same period of 2006.
          The
          117% increase from year to year was due primarily to an increase in labor
          and
          employee benefits costs as a result of expanding our engineering organization.
          In June 2005, we hired a new Chief Technology Officer and Senior Vice President,
          and a new Director of Engineering for the automotive market. In September
          2005,
          we hired a new Director of Engineering for the electronic display market.
          In
          addition, we spent more on research and development materials in the first
          six
          months of 2006 than in the same period in 2005. We expect expenditures
          relating
          to research and development for the remainder of 2006 to continue at the
          same
          level as in the first half of 2006. In
          2005,
          we began development and sampling of a new class of films with improved
          performance that we believe will be beneficial across our product lines.
          We also
          initiated significant research and development into thin film technology
          that we
          anticipate will enable Southwall to produce new products for new applications
          and new markets.
 
 *Selling,
          general and administrative* .
          Selling, general and administrative expenses increased $0.7 million from
          $4.4
          million in the first six months of 2005 to $5.1 million in the same period
          of
          2006. The increase in general and administrative expenses in the first
          six
          months of 2006 was primarily due to the stock based compensation expense
          of $0.3
          million and an increase in legal fees of $0.2 million.
 
 *Impairment
          charge (recoveries) for long-lived assets.* As a
          result of our decision to cease manufacturing in Palo Alto, we recorded
          a $0.3
          million impairment charge related to a production machine which was
          decommissioned in the second quarter of 2006. There was no such charge
          in the first
          six
          months of 2005.
          In addition, in the first
          six
          months of 2006,
          we recorded the recovery of $0.1 million of previously recorded impairment
          charges related to long-lived assets which were impaired in prior and current
          years. In the first
          six
          months of 2005,
          we recorded the recovery of $0.2 million of previously recorded impairment
          charges related to the final payment from the sale of a production machine
          which
          was impaired in the third quarter of 2003.
 
 *Restructuring.* On
          January 19, 2006, we commenced restructuring actions to improve our cost
          structure. These actions include the closure of our Palo Alto, California
          manufacturing facility and a reduction in force at our Palo Alto site in
          the
          first half of 2006. As
          a
          result of these actions, we incurred a restructuring charge of $0.7 million
          during the first six months of 2006 relating to employee severance packages,
          outside services relating to decommissioning our production machine and
          scrapping some of our production materials. There
          was
          no such restructuring charge in the first
          six
          months of 2005.
 
 *Income
          (loss) from operations* .
          Income
          from operations decreased $5.8 million from income of $3.9 million in the
          first
          six months of 2005 to a loss of $2.0 million in the same period of 2006.
          The
          decrease was primarily due to a decrease in revenue, increase in research
          and
          development costs, recognition of the stock based employee compensation
          expense,
          and restructuring charges and impairment charges in the first six months
          of 2006
          as detailed above.
  20
 *Table
              of Contents*
 
 *Interest
          expense, net.* Interest
          expense, net, decreased $0.2 million from $0.6 million in the first six
          months
          of 2005 to $0.4 million in the same period of 2006. The decrease in interest
          expense was primarily attributable to less outstanding debt during the
          first six
          months of 2006 compared to the same period in 2005.
  *Other
          income, net* .
          Other
          income, net, reflects foreign exchange transaction gains and losses .
          Some of
          our transactions with foreign customers are denominated in foreign currencies,
          principally the Euro. As exchange rates fluctuate relative to the U.S.
          dollar,
          exchange gains and losses occur. In the first
          six
          months of 2006,
          the net exchange gain due to Euro fluctuation was $0.1 million compared
          to the
          net exchange loss of $0.3 million in the same period in 2005. In addition
          to the
          exchange recognized in the first six months of 2006, our German subsidiary,
          Southwall Europe GmBH, or SEG, received $0.1 million of energy and waste
          rebate
          refund. The exchange loss incurred in the first six months of 2005 was
          offset by
          the energy and waste rebate refund of $0.4 million received by SEG.
 
 *Income
          (loss) before provision for income taxes* .
          We
          recorded a pre-tax loss of $2.2 million in the first
          six
          months of 2006
          and a pre-tax income of $3.4 million in the first
          six
          months of 2005.
          The decrease of $5.6 million was primarily due to a decrease in revenue,
          increase in research and development costs, recognition of the stock based
          employee compensation expense, and restructuring and impairment charges
          in the
          second quarter of 2006.
 
 *Provision
          for income taxes* .
          The
          increase in the provision for income taxes in the first
          six
          months of 2006
          compared to the same period in 2005 is related to higher taxable income
          in 2006
          in SEG as this subsidiary no longer has net operating losses to offset
          net
          taxable income. In addition, SEG completed an income tax audit for years
          1999 to
          2002 and recognized an additional $0.1 million in the first six months
          of
          2006.
 
 *Net
          income (loss).* In the first
          six
          months of 2006
          and 2005, we recorded a net loss of $2.7 million and net income of $3.1
          million,
          respectively. The decrease of $5.8 million was primarily due to a decrease
          in
          revenue, an increase in research and development costs, recognition of
          the stock
          based employee compensation expense, restructuring and impairment charges,
          and a
          higher income tax provision in the first
          six
          months of
          2006.
 
 *Deemed
          dividend on preferred stock.* We
          accrued $0.2 million of deemed dividend on preferred stock in the first
          six
          months of 2006
          and 2005.
 
 **Liquidity
          and capital resources.**
 
 *Liquidity*
  Our
          principal liquidity requirements are for working capital, consisting primarily
          of accounts receivable and inventories. We believe that because of the
          relatively long production cycle of certain of our products, our inventories
          will continue to represent a significant portion of our working
          capital.
 
 Our
          cash
          and cash equivalents decreased $2.4 million from $6.6 million at December
          31,
          2005 to $4.2 million at June 30, 2006. Cash used in operating activities
          of $1.3
          million for the first six months of 2006 was primarily the result of a
          net loss
          of $2.7 million, a decrease in accrued liabilities of $1.2 million due
          to a
          deferred rent payment and a decrease in accounts payable and accrued liabilities
          of $1.0 million, partially offset by non-cash depreciation of $1.1 million,
          a
          decrease in inventories of $0.8 million, non-cash stock compensation expense
          of
          $0.4 million, and decreases in accounts receivable of $0.9 million. Cash
          provided from operations for the first six months of 2005 of $4.2 million
          was
          primarily the result of net income of $3.1 million, non-cash depreciation
          of
          $1.1 million, and decreases in accounts receivable of $0.2 million, in
          inventories of $1.3 million and in other current and non-current assets
          of $0.4
          million, partially offset by impairment recoveries from long-lived assets
          of
          $0.2 million and a decrease in accounts payable and accrued liabilities
          of $1.8
          million.
  21
 *Table
              of Contents*
 
 Cash
          used
          in investing activities for the first six months of 2006 was $0.5 million
          and
          was primarily the result of capital expenditures of $0.6 million. Cash
          provided
          by investing activities for the first six months of 2005 was negligible,
          primarily the result of a decrease in restricted cash of $0.2 million and
          proceeds from the sale of fixed assets of $0.2 million, offset by capital
          expenditures of $0.4 million.
 
 Cash
          used
          in financing activities for the first six months of 2006 was $0.7 million
          and
          was primarily the result of payments of $0.7 million on our borrowings.
          Cash
          used in financing activities for the first six months of 2005 of $1.0 million
          was primarily the result of repayments under capital leases and principal
          payments on borrowings.
 
 We
          entered into an agreement with the Saxony government in May 1999 under
          which we receive investment grants. As of June 30, 2006, we had received
          5.0 million Euros or $5.0 million at historical exchange rate of the grants
          and accounted for these grants by applying the proceeds received to reduce
          the
          cost of our fixed assets in our Dresden manufacturing facility. Additionally,
          as
          of June 30, 2006, we had a balance remaining from the government grants
          that we
          are entitled to receive of 0.3 million Euros, or $0.3 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. The total annual amount of investment grants and investment
          allowances that we are entitled to seek varies from year to year based
          upon the
          amount of our capital expenditures that meet certain requirements of the
          Saxony
          government. Generally, we are not eligible to seek investment grants and
          allowances in the aggregate for any year in excess of 33% of our eligible
          capital expenditures in Germany for that year. The measurement date of
          these
          requirements was June 30, 2006, at which time we did not meet some of these
          requirements. If we fail to meet certain requirements in connection with
          these
          grants, the Saxony government has the right to demand repayment of the
          grants.
          In June 2006, we re-filed to amend our agreement with the Saxony government.
          In
          this amendment, we sought to modify the amount of capital spending required
          to
          have been spent through June 30, 2006, to reflect the actual amount spent
          and to
          count workstations instead of employees. We expect a Saxony government
          audit at
          SEG in the latter part of 2006. We expect to negotiate with the State of
          Saxony
          to reach an agreement on our requested amendment by the end of 2006 or
          early
          2007. No assurance can be given, however, that such negotiations will be
          successful or what the outcome will be.
 
 *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 provided for two
          facilities. All amounts borrowed under both facilities under the Credit
          Agreement had to be repaid on or before May 31, 2006. We renewed the first
          credit facility in May 2006. We did not renew the second facility of the
          Credit
          Agreement.
 
 The
          credit 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 credit 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 June 30, 2006.
 
 All
          borrowings under the Credit Agreement are collateralized by a letter of
          credit
          posted by Needham & Company, one of our stockholders. There are no financial
          covenants to this Credit Agreement.
 
 The
          terms
          of the Credit Agreement, limit our ability to (i) merge into or consolidate
          with
          any other entity, (ii) make any substantial change in the nature of our
          business
          as conducted as of the date hereof, (iii) acquire all or substantially
          all of
          the assets of any other entity with the exception that we may acquire all
          or
          substantially all of the assets of any other entity up to an amount of
          $3
          million, (iv) sell, lease, transfer or otherwise dispose of all or a substantial
          or material portion of our assets except in the ordinary course of its
          business.
  22
 *Table
              of Contents*
 
 The
          foregoing description does not purport to be a complete statement of the
          parties' rights and obligations under the Credit Agreement and the transactions
          contemplated thereby or a complete explanation of the material terms
          thereof.
 
 *Capital
          expenditures*
 
 We
          expect
          to spend approximately $1.9 million in 2006 on upgrades and refurbishment
          of our
          production machines and research and development tools. We spent
          approximately $0.6 million in capital expenditures during the first six
          months
          of 2006.
  *Future
          payment obligations*
 
 Our
          future payment obligations on our borrowings pursuant to our term debt,
          line of
          credit, non-cancelable operating leases and other non-cancelable contractual
          commitments are as follows at June 30, 2006 (in thousands):
  Less
                  
                  
                  
                  
                  
                  GreaterThan
                  
                  
                  
                  
                  
                  ThanTotal
                  
                  1
                      Year
                  
                  1-3
                      Years
                  
                  3-5
                      Years
                  
                  5
                      YearsContractual
                      Obligations:Term
                      debt (1)
                  
                  $
                  10,046
                  
                  $
                  1,214
                  
                  $
                  2,067
                  
                  $
                  4,064
                  
                  $
                  2,701Line
                      of credit
                  
                  
                  2,996
                  
                  
                  2,996
                  
                  
                  --
                  
                  
                  --
                  
                  
                  --Operating
                      leases (2)
                  
                  
                  2,190
                  
                  
                  464
                  
                  
                  791
                  
                  
                  935
                  
                  
                  --Total
                      contractual cash obligations
                  
                  $
                  15,232
                  
                  $
                  4,674
                  
                  $
                  2,858
                  
                  $
                  4,999
                  
                  $
                  2,701
 
 (1)
                Represents
                    loan agreements with Portfolio Financing Servicing Company, Wells
                    Fargo
                    Bank and several German banks.
 
 (2)
                Represents
                    the remaining rents owed on a building we rent in Palo Alto,
                    California.
 
 On
          June
          13, 2006, we signed a sublease agreement with Maxspeed to sublease 3782-3788
          Fabian Way, Palo Alto, California 94303. The term of this sublease commenced
          on
          June 16, 2006 and will continue until December 31, 2008, with monthly rent
          payments of $17,920 through May 31, 2007, $18,368 through May 31, 2008,
          and
          $19,040 through December 31, 2008.
 
 On
          June
          21, 2006, we amended our lease with Richard Christina to extend our original
          lease through June 30, 2011 for the facilities at 3780 Fabian Way, Palo
          Alto,
          California 94303. Also, on June 21, 2006, we entered into a lease agreement
          with
          Richard Christina to lease 3782-3788 Fabian Way, Palo Alto, California.
          The term
          of this lease extends the rental term for all premises (3780 and 3782-3788
          Fabian Way, Palo Alto, California) to June 30, 2011 at a Base Rent of $37,717.50
          per month. On January 1, 2010 and 2011, the Base Rent shall increase by
          3%.
  23
 *Table
              of Contents*
 
 **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 5.25% at June 30, 2006) and is calculated based on
          amounts
          borrowed under the facility. In addition, the interest rate on one of our
          German
          loans has been reset to the prevailing market rate of 5.75% and another
          of our
          German loans will have its interest rate reset to the prevailing market
          rate in
          2009. Fluctuations or changes in interest rates may adversely affect our
          expected interest expense. The effect of a 10% fluctuation in the interest
          rate
          on our line of credit and term debt would have had an immaterial effect
          on our
          interest expense for the second quarter of 2006.
 
 ***Investment
          risk:*** We
          invest our excess cash in money market accounts and, by practice, limit
          the
          amount of exposure to any one institution. Investments in both fixed rate
          and
          floating rate interest earning instruments carry a degree of interest rate
          risk.
          Fixed rate securities may have their fair market value adversely affected
          due to
          a rise in interest rates, while floating rate securities may produce less
          income
          than expected if interest rates fall. The effect of a 10% fluctuation in
          the
          interest rate on our line of credit and term debt would not have a material
          effect on our interest expense in the second quarter of 2006.
 
 ***Foreign
          currency risk:*** International revenues (defined as sales to customers located outside of
          the
          United States) accounted for approximately 69% of our total sales in the
          second
          quarter of 2006. Approximately 31% of our international revenues were
          denominated in Euros relating to sales from our Dresden operation in the
          second
          quarter of 2006. 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
          approximately $0.5 million on net revenues for the second quarter of 2006
          and the effect on expenses of a 10% fluctuation in the Yen exchange rate
          would
          have been immaterial.
  24
 *Table
              of Contents*
  **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 and our expectations
                    as to expense
                    reductions;
  ·
                the
                    continued trading of our common stock on the Over-the-Counter
                    Bulletin
                    Board;
  ·
                our
                    projected need for, and ability to obtain, additional borrowings
                    and our
                    future liquidity;
  ·
                future
                    applications of thin-film technologies and our development of
                    new
                    products;
  ·
                our
                    competition;
  ·
                statements
                    about the future size of markets;
  ·
                our
                    expectations with respect to future grants, investment allowances
                    and bank
                    guarantees from the Saxony
                    government;
  ·
                our
                    expected results of operations and cash flows;
  ·
                pending
                    and threatened litigation and its outcome; and
  ·
                our
                    projected capital expenditures.
 
 You
          should not place undue reliance on our forward-looking statements. Actual
          events
          or results may differ materially. In evaluating these statements, you should
          specifically consider various factors, including the risks outlined below
          under
          "Risk Factors" and under “Risk Factors” in our 2005 Form 10-K and in
          our Form 10-Q for the first quarter of 2006. 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.
  25
 *Table
              of Contents*
  **** **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 vice president of finance,
                    we
                    conducted an evaluation of the effectiveness of the design and
                    operation
                    of our disclosure controls and procedures, as defined in Rules
                    13a-15(e)
                    and 15d-15(e) under the Securities Exchange Act of 1934, as amended,
                    as of
                    June 30, 2006. Based on this evaluation, our chief executive
                    officer and
                    vice president of finance concluded as of the Evaluation Date
                    that our
                    disclosure controls and procedures were effective such that the
                    information relating to our company, including our consolidated
                    subsidiary, required to be disclosed in our Securities and Exchange
                    Commission (“SEC”) reports (i) is recorded, processed, summarized and
                    reported with the time periods specified in SEC rules and forms,
                    and (ii)
                    is accumulated and communicated to our management, including
                    our chief
                    executive officer and vice president of finance, as appropriate
                    to allow
                    timely decisions regarding required
                    disclosure.
 
 (b)
                *Report
                    on Internal Control Over Financial Reporting*.
                    We will be required by the Sarbanes-Oxley Act to include an assessment
                    of our internal control over financial reporting and an attestation
                    from an independent registered public accounting firm in our
                    Annual Report
                    on Form 10-K beginning with the filing for our fiscal year ending
                    December 31, 2007.
 
 (c)
                *Changes
                    in Internal Controls*.
                    There were no changes during the first six months of 2006 in
                    our internal
                    controls over financial reporting that have materially effected,
                    or are
                    reasonably likely to materially affect, the internal controls
                    over
                    financial reporting.
  26
 *Table
              of Contents*
  **PART
          II--OTHER INFORMATION**
  **Item
          1--Legal Proceedings**
 
 The
          Company was named as a defendant, along with Bostik, Inc., in an action
          captioned WASCO Products, Inc. v. Southwall Technologies, Inc. and Bostik,
          Inc.,
          Civ. Action No. C 02 2926 SBA, which was filed in Federal District Court
          for the
          Northern District of California on June 18, 2002. The Company was served
          with
          the Complaint in this matter on July 1, 2002. The plaintiff filed the matter
          as
          a class action on behalf of all entities and individuals in the United
          States
          who manufactured and/or sold and warranted the service life of insulated
          glass
          units manufactured between 1989 and 1999, which contained Southwall Heat
          Mirror
          film and were sealed with a specific type of sealant manufactured by Bostik,
          Inc. The plaintiff alleged that the sealant provided by Bostik, Inc. was
          defective, resulting in elevated warranty replacement claims and costs.
          The
          plaintiff asserted claims against the Company for breach of an implied
          warranty
          of fitness, misrepresentation, fraudulent concealment, negligence, negligent
          interference with prospective economic advantage, breach of contract, unfair
          business practices and false or misleading business practices. The plaintiff
          sought recovery on behalf of the class of $100 million for damages allegedly
          resulting from elevated warranty replacement claims, restitution, injunctive
          relief, and non-specific compensation for lost profits. By Order entered
          December 22, 2003, the Court dismissed all claims against the Company.
          The
          plaintiff appealed to the Ninth Circuit Court of Appeals. On January 13,
          2006,
          the Court of Appeals affirmed the lower court decision. On January 26,
          2006, the
          plaintiff filed a petition for rehearing with the Ninth Circuit Court of
          Appeals. In March of 2006, the Ninth Circuit Court of Appeals denied the
          plaintiff’s petition. On May 26, 2006 the plaintiff filed a petition for writ of
          certiorari to the United Sates Supreme Court. The Supreme Court has not
          ruled on
          the petition. A percentage of the Company’s defense costs are being paid by its
          insurance carriers under reservation of rights. It
          is not
          possible to predict how Plaintiff’s claims will be resolved or whether the
          Company will be found liable at this time.
 
 On
          June
          13, 2002, Plaintiff Charles Ikekwere (“Plaintiff”) filed a Complaint against the
          Company in the Superior Court of California in and for the County of Santa
          Clara, Case No. CV808644. Mr. Ikekwere is a former employee of the Company.
          Plaintiff’s Complaint alleged claims for race discrimination, national origin
          discrimination, retaliation, medical condition discrimination, breach of
          contract, breach of fiduciary duty, fraud, negligence, intentional infliction
          of
          emotional distress, and punitive damages. The Company challenged the sufficiency
          of certain of Plaintiff’s allegations, which caused him to file a First Amended
          Complaint alleging essentially the same claims. The Company also challenged
          certain of Plaintiff’s allegations in his First Amended Complaint, which caused
          him to file a Second Amended Complaint. Following the Company’s legal challenges
          to Plaintiff’s Second Amended Complaint, the following claims remain at issue in
          the litigation: (1) race discrimination; (2) national origin discrimination;
          (3)
          retaliation; (4) medical condition discrimination; (5) breach of contract;
          (6)
          violation of California Constitution Article I; and (7) fraud and deceit.
          In
          light of certain deposition testimony given by Plaintiff, the Company removed
          this matter to Federal Court on January 6, 2004. The basis for the Company’s
          removal was that certain of Plaintiff’s allegations were preempted by the
          Employee Retirement Income and Security Act (ERISA). On February 4, 2004,
          Plaintiff filed a Motion to Remand the case to State Court, which the Court
          denied. Plaintiff subsequently amended his Second Amended Complaint to
          add a
          claim under ERISA. The Company filed a summary judgment motion in March
          of 2006.
          In June of 2006 the judge granted in part and denied in part Southwall's
          motion
          for summary judgment. Southwall and Plaintiff were scheduled to go to trial
          in
          July; however, plaintiff filed a motion for a continuance, which was granted
          by
          the judge. The trial is now scheduled for December 1, 2006. Also, Southwall
          and
          Plaintiff have a Settlement Conference that is scheduled to take place
          in
          September 2006. It is not possible to predict how Plaintiff’s claims will be
          resolved, whether the Company will be found liable, or the nature and extent
          of
          Plaintiff’s alleged damages at this time.
 
 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.
  27
 *Table
              of Contents*
 
 **Item
          1A—Risk Factors**
 
 The
          following information updates, and should be read in conjunction with,
          the
          information disclosed in Item 1A, “Risk Factors,” of our Annual Report on Form
          10K for the year ended December 31, 2005 and filed with the SEC on March
          29,
          2006 and in Part II Item 1A of our Quarterly Report on Form 10-Q for the
          quarter
          ended March 31, 2006.
 
 **Financial
          Risks**
 
 *Our
          working capital position, financial commitments and historical performance
          may
          raise doubt about our ability to have positive earnings in the
          future.*
 
 We
          incurred net losses in the first six months of 2006, and in 2005 and 2004
          and
          negative cash flows from operations in the first six months of 2006 and
          in 2003.
          These factors together with our working capital position and our significant
          debt service and other contractual obligations at June 30, 2006, may raise
          doubt
          about our ability to restore profitable operations, generate cash flow
          from
          operating activities and obtain additional financing. These and other factors
          related to our business during recent years, our past failure to comply
          with
          covenants in our financing agreements and our voluntary delisting from
          NASDAQ in
          March 2004 may make it difficult for us to secure the required additional
          borrowings on favorable terms or at all. We intend to seek additional borrowings
          or alternative sources of financing; however, difficulties in borrowing
          money or
          raising financing could have a material adverse effect on our operations,
          planned capital expenditures and ability to comply with the terms of government
          grants.
 
 *Restrictions
          or defaults under our credit and other loan agreements may prevent us from
          borrowing or force us to curtail our operations.*
 
 As
          of
          June 30, 2006, we had total outstanding obligations under our credit and
          other
          loan agreements of $13.0 million. Our inability to make timely payments
          of
          interest or principal under these facilities could materially adversely
          affect
          our ability to borrow money under existing credit facilities, to secure
          additional borrowings or to function as a going concern. 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.
 
 *We
          expect to be subject to increased foreign currency risk in our international
          operations.*
 
 In
          2003,
          2004, 2005 and during the first six months of 2006, approximately 34%,
          31%, 32%
          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.
  28
 *Table
              of Contents*
 
 *Failure
          to meet requirements under our investment grant agreements with the Saxony
          government may require us to repay grants or force us to curtail our
          operations.*
 
 We
          entered into an agreement with the Saxony government in May 1999 under
          which we receive investment grants. As of June 30, 2006, we had received
          5.0 million Euros or $5.0 million at historical exchange rate of the grants
          and accounted for these grants by applying the proceeds received to reduce
          the
          cost of our fixed assets in our Dresden manufacturing facility. 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 measurement date of
          these
          requirements was June 30, 2006, at which time we did not meet some of these
          requirements. We are currently seeking an amendment to our agreement with
          the
          Saxony Government which would bring us into compliance with the requirements.
          If
          such negotiations are unsuccessful, we could be required to repay the grants
          which would adversely effect our operations.
 
 **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%, 82%, 79% and 84% of
          net
          revenues during the first six months of 2006 and in 2005, 2004 and 2003,
          respectively. We expect to continue to derive a significant portion of
          our net
          sales from this relatively small number of customers. Accordingly, the
          loss of a
          large customer could materially hurt our business, and the deferral or
          loss of
          anticipated orders from a large customer or a small number of customers
          could
          materially reduce our revenue and operating results in any period. Some
          of our
          largest automotive glass customers have used a technology — direct-to-glass
          sputtering — as
          an
          alternative to our window films, which in 2003 resulted in a decrease in
          orders
          from these customers. The continued or expanded use of this technology
          by our
          automotive glass customers would have a material adverse effect on our
          results
          of operations and financial position.
 
 *Fluctuations
          or slowdowns in the overall electronic display industry have and may continue
          to
          adversely affect our revenues.*
 
 Our
          business depends in part on sales by manufacturers of products that include
          electronic displays. The markets for electronic display products are highly
          cyclical and have experienced periods of oversupply resulting in significantly
          reduced demand for our products. For example, during the first six months
          of
          2006, we experienced a decrease of 22% from the first six months of 2005
          in our
          net revenues in the electronic display market primarily due to lower demand
          for
          our sputtered thin film filter products for Plasma Display Panel products
          due to
          increased competition, and we expect this trend to continue. Mitsubishi
          Electric
          was the only CRT manufacturer that buys our anti-reflective, or AR, film
          and it
          decided to consolidate all of the manufacturing of this product to Japan.
          In
          connection with that consolidation, Mitsubishi ceased production of the
          17" AR
          product in its Mexico plant during the third quarter of 2003. In 2005,
          we
          stopped converting (cutting the film to the customer’s specifications) one of
          our window film product models and agreed with our customers that they
          would
          complete this process. This resulted in a
          decline in average sales prices for the TX product line and the decrease
          in
          window film market net revenues.
  29
 *Table
              of Contents*
 
 *Our
          business is susceptible to numerous risks associated with international
          operations.*
 
 Revenues
          from international sales amounted to approximately 66%, 74%, 79% and 89%
          of our
          net revenues during the first six months of 2006 and in 2005, 2004 and
          2003,
          respectively. The distance between our two manufacturing sites creates
          logistical and communications challenges. In addition, to achieve acceptance
          in
          international markets, our products must be modified to handle a variety
          of
          factors specific to each international market as well as local regulations.
          We
          may also be subject to a number of other risks associated with international
          business activities. These risks include:
 
 •
                unexpected
                    changes in and the burdens and costs of compliance with a variety
                    of
                    foreign laws and regulatory requirements;
 •
                potentially
                    adverse tax consequences; and
 •
                global
                    economic turbulence and political instability.
 
 **Item
          2-- Unregistered Sales of Equity Securities and Use of
          Proceeds**
 
 None.
  **Item3--Defaults
          upon Senior Securities**
 
 Not
          applicable.
  **Item
          4--Submission of Matters to a Vote of
          Stockholders**
 
 On
          June
          5, 2006, we held our Annual Meeting of Stockholders. The
          number of shares outstanding and eligible to vote as of June 5, 2006, the
          record
          date, were 26,900,091 shares. The following matters were voted
          upon:
 
 1.
                Our
                    stockholders elected William A. Berry, George Boyadjieff, Thomas
                    G. Hood,
                    Jami K. Nachtsheim, R. Eugene Goodson, Andre R. Horn and Peter
                    E. Salas as
                    directors to serve until the 2007 Annual Meeting of Stockholders
                    and until
                    their successors are elected.
 
 The
          vote
          for each director was as follows:
  Director
                
                For
                WithheldWilliam
                    A. Berry
                
                24,119,788
                65,240George
                    Boyadjieff
                
                24,024,871
                160,157Thomas
                    G. Hood
                
                24,119,188
                65,840Jami
                    K. Nachtsheim
                
                24,119,288
                65,740R.
                    Eugene Goodson
                
                24,115,288
                69,740Andre
                    R. Horn
                
                24,119,288
                65,740Peter
                    E. Salas
                
                24,115,288
                69,740
  There
          were 5,000 votes abstaining and n o
          broker
          non-votes, in the election of directors.
  2.
                Our
                    stockholders ratified the selection of Burr, Pilger & Mayer LLP, our
                    independent registered public accounting firm, for the fiscal
                    year ending
                    December 31, 2006.On
                    the matter, there were 24,128,843 votes "FOR", 51,185 votes "AGAINST",
                    5,000 votes "ABSTAINING", and no broker non-votes.
 
 **Item
          5--Other Information**
 
 None.
  30
 *Table
              of Contents*
 
 **Item
          6--Exhibits**
  (a)
                Exhibits
  ExhibitNumber
                Item31.1
                Certification
                    of Principal Executive Officer pursuant to Exchange Act Rules
                    13a-14 and
                    15d-1431.2
                Certification
                    of Principal Financial Officer pursuant to Exchange Act Rules
                    13a-14 and
                    15d-1432.1
                Certification
                    of Principal Executive Officer pursuant to 18 U.S.C Section
                    135032.2
                Certification
                    of Principal Financial Officer pursuant to 18 U.S.C Section
                    135099.1
                Sublease
                    agreement for the facilities at 3782-3788 Fabian Way, Palo Alto,
                    CA, dated
                    June 13, 2006, between Maxspeed Corporation and Southwall Technologies
                    Inc.99.2
                Amendment
                    to lease agreement for the facilities at 3780 Fabian Way, Palo
                    Alto, CA,
                    dated June 21, 2006 between the Company, Richard Christina and
                    Diane
                    Christina.99.3
                Credit
                    Agreement dated May 30, 2006, between the Company and Wells Fargo
                    HSBC
                    Trade Bank, N.A.99.4
                Revolving
                    Credit Loans Note dated May 30, 2006 and issued by the Company
                    and Wells
                    Fargo HSBC Trade Bank, N.A.
  31
 *Table
              of Contents*
  **SIGNATURES**
  Pursuant
          to the requirements of the Securities Exchange Act of 1934, the registrant
          has
          duly caused this report to be signed on its behalf by the undersigned thereunto
          duly authorized.
  Dated:  
                    August 11, 2006**Southwall
                    Technologies Inc.**By:
                /s/
                    George BoyadjieffGeorge
                    Boyadjieff*Chairman
                    and Interim Chief Executive Officer*By:
                /s/
                    Sylvia KamenskiSylvia
                    Kamenski*Vice
                    President of Finance*






32