**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

----

** **

**FORM 10-Q**

 
|   | **(MARK ONE)** |
|--------|----------------|

 

| ý | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]** |
|--------|----------------------------------------------------------------------------------------------------------------|

 

**For thequarterly period ended September 30, 2001**

** **

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

**EXCHANGE ACT OF 1934 [NO FEE  REQUIRED]** |
|---|-----------------------------------------------------------------------------------------------------------------------|

 

**For thetransition period from ______ to ______**

 

**Commission FileNumber: 0-15930**

 

----

 

**SOUTHWALL TECHNOLOGIES INC.**

(Exact name of registrant asspecified in its charter)

 

| **DELAWARE**                                                           |   | **94–2551470**                      |
|------------------------------------------------------------------------|--------|------------------------------------------|
|  (State  or other jurisdiction of

incorporation or organization) |   | (I.R.S. Employer

Identification Number) |
|                                                                   |   |                                     |
| **1029 Corporation Way, Palo Alto, California**                        |   | **94303**                                |
| (Address of principal executive offices)                               |   | (Zip Code)                               |
|                                                                   |   |                                     |
| **(650) 962-9111**                                                |
| Registrant's telephone number, including area code                     |

 

 

----

 

                Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý  No o

 

                As of October 11, 2001 therewere 8,247,924 shares of the Registrant's Common Stock outstanding

 

 

**SOUTHWALLTECHNOLOGIES INC.**

 

**INDEX**

 
|        | **PART I FINANCIAL  INFORMATION**                                                                                                      |
|-------------|----------------------------------------------------------------------------------------------------------------------------------------|
| **Item 1**  | **Financial Statements:**                                                                                                              |
|        | Unaudited Consolidated Balance  Sheets—September 30, 2001 and December 31, 2000                                              |
|        | Unaudited  Consolidated Statements of Operations—Three month and nine month periods  ended September 30, 2001 and October 1, 2000 |
|        | Unaudited  Consolidated Statements of Cash Flows—Three month and nine month periods  ended September 30, 2001 and October 1, 2000 |
|        | Notes  to Unaudited Consolidated Financial Statements                                                                                  |
| **Item 2**  | Management's  Discussion and Analysis of Financial Condition and Results of Operations                                                 |
| **Item 3**  | Quantitative  and Qualitative Disclosures about Market Risk                                                                            |
|        | **PART II OTHER INFORMATION**                                                                                                          |
| **Item 1**  | Legal Proceedings  and Other Matters                                                                                                   |
| **Item 2**  | Changes in Securities                                                                                                                  |
| **Item 3**  | Defaults upon  Senior Securities                                                                                                       |
| **Item  4** | Submission  of Matters to a Vote of Stockholders                                                                                       |
| **Item 5**  | Other  Information                                                                                                                     |
| **Item 6**  | Exhibits and Reports on Form 8-K                                                                                                       |
|        | Signatures                                                                                                                             |
|        |                                                                                                                                   |

 

**PART I FINANCIALINFORMATION**

 

**Item 1****-FinancialStatements:**

 

**SOUTHWALLTECHNOLOGIES INC.**

**CONSOLIDATED BALANCE SHEETS**

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

 

 
|                                                                                               |   |              |          |              |          |
|----------------------------------------------------------------------------------------------------|--------|-------------------|---------------|-------------------|---------------|
|                                                                                               |   | **September 30,** | ** **    | **December  31,** |          |
|                                                                                               |   | **2001**          | ** **    | **2000**          |          |
|                                                                                               |   | **(Unaudited)**   | ** **    |              |          |
| ASSETS                                                                                             |   |              |          |              |          |
| Current Assets                                                                                     |   |              |          |              |          |
| Cash and cash  equivalents                                                                         |   | $                 | 3,145         |              | $             | 61 |   |
| Restricted cash                                                                                    |   | 1,195             |          | 1,849             |          |
| Accounts  receivable, net of allowance for bad debts of $584 and $640                              |   | 12,118            |          | 13,317            |          |
| Inventories, net                                                                                   |   | 5,716             |          | 10,174            |          |
| Other current  assets                                                                              |   | 1,606             |          | 2,008             |          |
| Total current  assets                                                                              |   | $                 | 23,780        |              | $             | 27,409 |   |
|                                                                                               |   |              |          |              |          |
| Property, plant  and equipment, net                                                                |   | 48,026            |          | 49,884            |          |
| Other assets                                                                                       |   | 3,226             |          | 3,169             |          |
| Total assets                                                                                       |   | $                 | 75,032        |              | $             | 80,462 |   |
|                                                                                               |   |              |          |              |          |
| LIABILITIES AND  STOCKHOLDERS' EQUITY                                                              |   |              |          |              |          |
| Current  liabilities:                                                                              |   |              |          |              |          |
| Bank line of  credit                                                                               |   | $                 | 5,498         |              | $             | 8,719 |   |
| Accounts payable                                                                                   |   | 11,643            |          | 16,857            |          |
| Accrued  compensation                                                                              |   | 2,029             |          | 1,915             |          |
| Other accrued  liabilities                                                                         |   | 5,220             |          | 4,551             |          |
| Government  grants advanced                                                                        |   | 976               |          | 1,085             |          |
| Current portion  long-term debt                                                                    |   | 8,204             |          | 5,806             |          |
| Long-term debt  reclassified to current                                                            |   | 17,022            |          | 20,624            |          |
| Total current  liabilities                                                                         |   | 50,592            |          | 59,557            |          |
|                                                                                               |   |              |          |              |          |
| Other                                                                                              |   | 744               |          | 767               |          |
| Total  liabilities                                                                                 |   | 51,336            |          | 60,324            |          |
|                                                                                               |   |              |          |              |          |
| Stockholders'  equity:                                                                             |   |              |          |              |          |
| Common stock,  $0.001 par value, 20,000 shares authorized; issued and outstanding 8,311 and  7,889 |   | 8                 |     | 8                 |     |
| Capital in  excess of par value                                                                    |   | 52,549            |          | 51,764            |          |
| Less cost of  treasury stock, 123 and 166 shares outstanding                                       |   | (312              | )             | (839              | )             |
| Notes receivable                                                                                   |   | (107              | )             | (99               | )             |
| Cumulative  translation adjustment                                                                 |   | (359              | )             | (151              | )             |
| Accumulated  deficit                                                                               |   | (28,083           | )             | (30,545           | )             |
| Total  stockholders' equity                                                                        |   | 23,696            |          | 20,138            |          |
| Total  liabilities and stockholders' equity                                                        |   | $                 | 75,032        |              | $             | 80,462 |   |

 

See accompanying notes toconsolidated financial statements.

**SOUTHWALLTECHNOLOGIES INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

**(Unaudited)**

** **
|                                                                            |   | **Three Months Ended** |   | **Nine Months Ended** |   |
|---------------------------------------------------------------------------------|--------|------------------------|--------|-----------------------|--------|
|                                                                            |   |                   |   |                  |   |   |   |   |   |
|                                                                            |   | **September 30,**      |   | **October  1,**       |   | **September  30,** |   | **October  1,** |   |
|                                                                            |   | **2001**               |   | **2000**              |   | **2001** |   | **2000** |   |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Net revenues                                                                    |   | $                      | 22,777 |                  | $      | 26,361 |   | $ | 62,436 |   | $ | 64,398 |   |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Costs and expenses                                                              |   |                   |   |                  |   |   |   |   |   |
| Cost of sales                                                                   |   | 15,629                 |   | 19,399                |   | 46,798 |   | 51,104 |   |
| Research and  development                                                       |   | 1,386                  |   | 1,921                 |   | 3,995 |   | 5,010 |   |
| Selling, general  and administrative                                            |   | 2,688                  |   | 5,621                 |   | 8,401 |   | 10,715 |   |
| Legal settlement                                                                |   | -                      |   | 0                     |   | - |   | 402 |   |
| Total costs and  expenses                                                       |   | 19,703                 |   | 26,941                |   | 59,194 |   | 67,231 |   |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Income (loss)  from operations                                                  |   | 3,074                  |   | (580                  | )      | 3,242 |   | (2,833 | ) |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Interest  (expense), net                                                        |   | (618                   | )      | (946                  | )      | (2,156 | ) | (1,966 | ) |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Other income  (expense), net                                                    |   | (36                    | )      | (4                    | )      | 1,328 |   | 16 |   |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Income (loss)  before provision for income taxes                                |   | 2,420                  |   | (1,530                | )      | 2,414 |   | (4,783 | ) |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Provision for  income taxes                                                     |   | 11                     |   | (18                   | )      | (48 | ) | (95 | ) |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Net income  (loss)                                                              |   | $                      | 2,409  |                  | $      | (1,548 | ) | $ | 2,462 |   | $ | (4,878 | ) |
|                                                                            |   |                   |   |                  |   |   |   |   |   |
| Net income  (loss) per share:                                                   |   |                   |   |                  |   |   |   |   |   |
| Basic                                                                           |   | $                      | 0.29   |                  | $      | (0.20 | ) | $ | 0.31 |   | $ | (0.64 | ) |
| Diluted                                                                         |   | $                      | 0.28   |                  | $      | (0.20 | ) | $ | 0.30 |   | $ | (0.64 | ) |
|                                                                            |   |                   |   |                  |   |   |   |   |   |   |   |   |   |
| Weighted average  shares of common stock and dilutive common stock equivalents: |   |                   |   |                  |   |   |   |   |   |
| Basic                                                                           |   | 8,220                  |   | 7,680                 |   | 8,010 |   | 7,614 |   |
| Diluted                                                                         |   | 8,466                  |   | 7,680                 |   | 8,084 |   | 7,614 |   |

 

See accompanying notes toconsolidated financial statements.

 

**SOUTHWALLTECHNOLOGIES INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**

**(Unaudited)**

**Increase(Decrease) in cash**

 
|                                                                                      |   | **Nine Months Ended,** |   |
|-------------------------------------------------------------------------------------------|--------|------------------------|--------|
|                                                                                      |   | **September 30,**      |   | **October  1,** |   |
|                                                                                      |   | **2001**               |   | **2000** |   |
| Cash flows (used  in) or provided by operating activities:                                |   |                   |   |   |   |
| Net income  (loss)                                                                        |   | $                      | 2,462  |   | $ | (4,878 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |   |                   |   |   |   |
| Depreciation and  amortization                                                            |   | 4,359                  |   | 3,836 |   |
| Change in assets  and liabilities:                                                        |   |                   |   |   |   |
| Accounts  receivable, net                                                                 |   | 1,199                  |   | (4,547 | ) |
| Inventories, net                                                                          |   | 4,459                  |   | (3,969 | ) |
| Other current  and non-current assets                                                     |   | 310                    |   | 479 |   |
| Accounts  payable, and accrued liabilities                                                |   | (4,454                 | )      | 9,257 |   |
|                                                                                      |   |                   |   |   |   |
| Cash provided by  operating activities                                                    |   | 8,335                  |   | 178 |   |
|                                                                                      |   |                   |   |   |   |
| Cash flows from  investing activities:                                                    |   |                   |   |   |   |
| Restricted cash                                                                           |   | 654                    |   | (898 | ) |
| Expenditures for  property, plant and equipment and other assets                          |   | (4,679                 | )      | (10,499 | ) |
|                                                                                      |   |                   |   |   |   |
| Net cash used in  investing activities                                                    |   | (4,025                 | )      | (11,397 | ) |
|                                                                                      |   |                   |   |   |   |
| Cash flows from  financing activities:                                                    |   |                   |   |   |   |
| Proceeds from  foreign government grants                                                  |   | -                      |   | 945 |   |
| Proceeds from  investment allowances                                                      |   | 2,101                  |   | - |   |
| Proceeds from  borrowings                                                                 |   | 1,055                  |   | 8,521 |   |
| Proceeds from  sale of stock                                                              |   | 970                    |   | - |   |
| Principal  payments on borrowings                                                         |   | (5,480                 | )      | (1,413 | ) |
| Repayment of  stockholder's note receivable                                               |   | (7                     | )      | 805 |   |
| Issuance  (purchase) of treasury stock, net                                               |   | 342                    |   | 721 |   |
|                                                                                      |   |                   |   |   |   |
| Net cash  provided by (used in) financing activities                                      |   | (1,019                 | )      | 9,579 |   |
|                                                                                      |   |                   |   |   |   |
| Effect of  foreign exchange rate changes on cash                                          |   | (208                   | )      | - |   |
|                                                                                      |   |                   |   |   |   |
| Net increase  (decrease) in cash and cash equivalents                                     |   | 3,083                  |   | (1,640 | ) |
| Cash and cash  equivalents, beginning of year                                             |   | 61                     |   | 1,772 |   |
|                                                                                      |   |                   |   |   |   |
| Cash and cash  equivalents, end of period                                                 |   | $                      | 3,144  |   | $ | 132 |   |

 

See accompanying notes toconsolidated financial statements.

 

SOUTHWALL TECHNOLOGIES INC. NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (in thousands)

(Unaudited)

 

**Note 1—InterimPeriod Reporting:**

 

                While the information presentedin the accompanying consolidated financial statements is unaudited, it includesall adjustments (consisting only of normal recurring adjustments) which, in theopinion of management, are necessary to present fairly the Company's financialposition and results of operations, and changes in financial position as of thedates and for the periods indicated.

 

                Certain information and footnotedisclosures normally contained in financial statements prepared in accordancewith generally accepted accounting principles have been condensed or omitted.It is suggested that these consolidated financial statements be read inconjunction with the financial statements contained in the Company'sForm 10-K/A for the year ended December 31, 2000 filed onApril 11, 2001. The results of operations for the interim periodspresented are not necessarily indicative of the operating results of the fullyear.

 

**Note 2—BalanceSheet:**

 

*Restricted Cash*

 

                Restricted cash consists of theunapplied portion of grants received from the German government to co-financethe costs of the construction of the Company's German facility. In the eventthe Company fails to meet certain conditions related to the grants, the Germangovernment has the right to reclaim the grant. (See Note 6)

 

*Inventories, net*

 

                Inventories are stated at thelower of cost (determined by the first-in- first-out method) or market.Inventories consisted of the following: 

 
|               |   | **September 30, 2001** |   | **December 31, 2000** |   |
|--------------------|--------|------------------------|--------|-----------------------|--------|
| Raw Materials      |   | $                      | 3,573  |                  | $      | 4,394 |   |
| Work-in-progress   |   | 1,645                  |   | 4,799                 |   |
| Finished goods     |   | 489                    |   | 981                   |   |
| Total  inventories |   | $                      | 5,707  |                  | $      | 10,174 |   |

# * *

*Government Grants Advanced*

 

                Government grants advancedconsists of grant monies received from the German government that are subjectto certain conditions (see Note 5 – Government Grant). Upon approval andreceipt of the grants from the government, the funds are applied as a reductionof the costs of the German manufacturing facility. In the event the Companyfails to meet these conditions, the grants the government has the right toreclaim the grants.

 

**Note 3—Netincome (loss) per share:**

 

                Basic net income (loss) pershare is computed by dividing income available to common shareholders(numerator) by the weighted average number of common shares outstanding(denominator) for the period. Diluted net income (loss) per share gives effectto all dilutive potential common shares outstanding during the period. Thecomputation of diluted earnings per share uses the average market prices duringthe period. During each of the periods presented there were no differencesbetween the numerators used for calculation of basic and diluted net income(loss) per share. The total amount of the difference in the basic and dilutedweighted average shares of common stock and common stock equivalents in theperiods where there is net income is attributable to the effect of dilutivestock options. In net loss periods, the basic and diluted weighted averageshares of common stock and common stock equivalents are the same becauseinclusion of stock options would be anti-dilutive.

 

**Note 4—FinancingLine of Credit:**

 

                The Company has a$10 million receivable financing line of credit with a bank. Availabilityunder the line of credit is based on 80% of the approved accounts receivablebalance and bears a finance fee of 0.088% per month of the average dailyaccount balance outstanding during the settlement period. In connection withthe line of credit, the Company has granted the bank a continuing lien upon andsecurity interest in, and right of set off with respect to all of the Company'srights, title and interest in all accounts receivable, inventory, monies,remittances and fixed assets. There were $5.5 million of borrowingsoutstanding under this line of credit at September 30, 2001. (SeeNote 9-Going Concern and Loan Covenants)

 

**Note 5—Long-termdebt:**

 

                The Company's long-term debtconsisted of the following at September 30, 2001: 

 
| **Description**                                   |   | **Rate**     |   | **Balance at**

**September 30, 2001** |   | **Scheduled**

**Principal Payments**

**Remaining for**

**2001** |   |
|---------------------------------------------------|--------|--------------|--------|----------------------------------------|--------|--------------------------------------------------------------------|--------|
| Financing Line of Credit                          |   | $            | 5,498  |                                   |   |                                                               |   |   |
|                                              |   |         |   |                                   |   |                                                               |   |
| Long-term debt                                    |   |         |   |                                   |   |                                                               |   |
| Promissory note  dated May 6, 1997                |   | LIBOR +.4375 |   | 8,750                                  |   | $                                                                  | 1,250  |   |
| Sales-leaseback  agreement dated July 19, 1999    |   | 13.0         | %      | 2,321                                  |   | 711                                                                |   |
| Sales-leaseback  agreement dated October 19, 1999 |   | 13.0         | %      | 2,446                                  |   | 1,374                                                              |   |
| German bank loan  dated May 12, 1999              |   | 6.1          | %      | 2,568                                  |   | 78                                                                 |   |
| German bank loan  dated May 28, 1999              |   | 7.1          | %      | 2,284                                  |   | -                                                                  |   |
| German bank loan  dated May 28, 1999              |   | 3.8          | %      | 1,303                                  |   | -                                                                  |   |
| German bank loan  dated December 1, 1999          |   | 7.2          | %      | 1,937                                  |   | 54                                                                 |   |
| German bank loan  dated August 14, 1999           |   | 5.8          | %      | 1,541                                  |   | -                                                                  |   |
| German bank loan  dated June 29, 2000             |   | 5.8          | %      | 552                                    |   | 52                                                                 |   |
| German bank loan  dated July 20, 2000             |   | 7.1          | %      | 389                                    |   | 39                                                                 |   |
| German bank loan  dated December 19, 2000         |   | 7.5          | %      | 236                                    |   | -                                                                  |   |
| Note Payable  dated September 21, 2001            |   | -            |   | 820                                    |   | 150                                                                |   |
| Other equipment  financings                       |   |         |   | 79                                     |   | 8                                                                  |   |
| Total long-term  debt                             |   | -            |   | 25,226                                 |   | 3,716                                                              |   |
| Less current  portion                             |   |         |   | 8,204                                  |   |                                                               |   |
| Less long-term  portion-reclassified to current   |   |         |   | 17,022                                 |   |                                                               |   |
| Long-Term Debt                                    |   |         |   | $                                      | 0      |                                                               |   |   |
|                                                   |        |              |        |                                        |        |                                                                    |        |  |  |  |

 

                The promissory note datedMay 6, 1997 is payable to Sanwa Bank. The note payments are guaranteed byTeijin Limited in Japan (Teijin), a stockholder and supplier of the Company.The Teijin guarantee is collateralized by certain equipment located in theCompany's Tempe manufacturing facility and inventory, to the extent necessaryto provide 120% net book value coverage of the outstanding loan balance. Theinterest rate on the loan is re-set semi-annually at LIBOR plus 0.4375% (5.25%and 7.45% at September 30, 2001 and October 1, 2000 respectively). The Companyis also subject to certain financial covenants. A loan guarantee service fee ispayable to Teijin semi-annually on the outstanding balance at the rate of0.5625%. The note provides for semi-annual payments of interest only during thefirst four years, followed by semi-annual installments, plus interest for thefour year term beginning in May, 2001. The remaining scheduled principalpayments for 2001 are $1.25 million. Teijin also received warrants in 1997to purchase 158,000 shares of the Company's common stock at $9 per share. Thesewarrants were not exercised and expired on May 30, 2000. At September 30,2001 the Company was not in compliance with certain of the financial covenantswith Teijin, the guarantor, pertaining to this promissory note. The Companyreceived a waiver from Teijin through October 1, 2001. Teijin did notagree to extend the waiver beyond this date. Accordingly, the Company hasreclassified the balance of the note from long-term debt to current liabilitiesin the balance sheet. (See Note 9—GOING CONCERN AND LOAN COVENANTS) The Company has begundiscussions with the guarantor regarding amending the financial covenants ofthis loan agreement, or waiving the financial covenants of this loan agreementas of December 31, 2000. However, the Company can make no assurances regardingthe successful outcome of those discussions

 

                During1999, the Company entered into two equipment sale-leaseback agreements with aleasing company ("Lessor"). Because the Company has an option topurchase the equipment at a price to be determined between the Company and theLessor at the end of the lease period, the sale-leaseback agreements have beentreated as financing. One lease agreement has a lease term of three years andthe other lease agreement has an initial lease term of two years with an optionto extend it for an additional year. At September 30, 2001, the Company had atotal of $4.8 million outstanding under these leases. The leases arecollateralized by the leased equipment and certain other production equipmentof the Company. The effective interest rate of both leases is approximately 13%per annum and they are repayable over their lease term commencing inMay 2000. Additionally, the Company has provided the Lessor an irrevocablestandby letter of credit in the amount of $0.5 million to collateralizeall of the Company's obligations under these agreements. The letter of creditshall not expire before January 1, 2002. In addition, $1 million ofthe amounts due from the Lessor was not funded, but will be released upon theCompany satisfying certain financial conditions. Due to the uncertainty ofcompliance with these financial conditions, the Company has classified thisamount under non-current "Other Assets." However, the amount payableto the Lessor under the capitalized leases includes the unfunded amount of$1.0 million. (See Note 9—GOINGCONCERN AND LOAN COVENANTS)

 

                On May 12, 1999, theCompany entered into a loan agreement with a German bank that provides forborrowings up to $2.9 million (DM 6.0 million). Under the terms ofthis agreement, the funds were used solely for the purpose of capitalinvestment by the Company’s German subsidiary. The term of the loan is 10 yearsand the principal is repayable in Deutschemarks after the end of one year in 36quarterly payments. The loan bears interest at 6.1% per annum for the firstfive years, and will be adjusted to the prevailing rate at the end of the fifthyear. At September 30, 2001, the amount outstanding under this bank loan was$2.6 million. (See Note 9—GOINGCONCERN AND LOAN COVENANTS)

 

                On May 28, 1999, theCompany entered into a general loan agreement with a German bank. Under theterms of the loan agreement, funds are available in three tranches, and shallbe used solely for the purpose of capital investment by the German subsidiary.The first tranche provides for borrowings of $2.2 million (DM4.89 million) for a term of twenty years. The principal is repayable afterten years in twenty equal, semi-annual payments. The loan bears fixed interestof 7.1% per annum for the first ten years. At September 30, 2001, the amountoutstanding was $2.3 million. The second tranche provides for borrowingsof $1.5 million (DM 3.35 million) for a term of seven years and theprincipal is repayable after one year in twelve equal, semi-annual payments.The loan bears fixed interest at 3.8% per annum for the period of seven years.At September 30, 2001, the amount outstanding was $1.3 million. The thirdtranche, dated December 1, 1999, provides for borrowings of$1.87 million (EURO 2.121 million) for a term of ten years, and theprincipal is repayable after one year, in thirty six equal quarterly payments.The loan bears fixed interest of 7.15% per annum for the first five years. AtSeptember 30, 2001, the amount outstanding was $1.9 million. All of theproceeds from the loans were received during 1999. (See Note 9—GOING CONCERN AND LOANCOVENANTS)

 

                On August 14, 1999, theCompany entered into a loan agreement with a German bank that provides forborrowings up to $1.7 million (DM 3.3 million). Under the terms ofthis agreement, the funds will be used solely for the purpose of capitalinvestment by the German subsidiary. The principal balance is due in a singlepayment on June 30, 2009 and bears interest at a rate of 5.8% per annum.The interest is payable quarterly in Deutschemarks. 50% of the loan proceedsare restricted in an escrow account for the duration of the loan period and areclassified as non-current "Other Assets." At September 30, 2001, theamount outstanding under this bank loan was $1.5 million. (See Note 9—GOING CONCERN AND LOANCOVENANTS)

 

                On June 29, 2000, theCompany entered into a loan agreement with a German bank that provides for borrowingsup to $0.5 million (DM 1.0 million). Under the terms of this agreement,the funds will be used solely for the purpose of capital investment by theGerman subsidiary. The principal balance is repayable in 12 equal quarterlypayments beginning June 2001 and bears interest at a rate of 5.8% perannum. The interest is payable quarterly in Deutschemarks. At September 30,2001, the amount outstanding under this bank loan was $0.5 million. (SeeNote 9—GOINGCONCERN AND LOAN COVENANTS)

 

                On July 20, 2000, theCompany entered into a loan agreement with a German bank that provides forborrowings up to $0.5 million (EURO 0.5 million). Under the terms of thisagreement, the funds will be used solely for the purpose of capital investmentby the German subsidiary. The principal balance is repayable in 12 quarterlypayments beginning June 2001 and bears interest at a rate of 7.1% perannum. The interest is payable quarterly in EURO dollars. At September 30,2001, the amount outstanding under this bank loan was $0.4 million. (SeeNote 9—GOINGCONCERN AND LOAN COVENANTS)

 

                On December 19, 2000 the Companyentered into a loan agreement with a German bank that provides for borrowingsup to $0.2 million (EURO 0.3 million). Under the terms of this agreement,the funds will be used solely for the purpose of capital investment by theGerman subsidiary. The principal balance is repayable in 12 quarterly paymentsbeginning March 2002 and bears interest at a rate of 7.5% per annum. Theinterest is payable quarterly in EURO dollars. At September 30, 2001, theamount outstanding under this bank loan was $0.2 million. (See Note 9—GOING CONCERN AND LOANCOVENANTS)

 

                The preceding German bank loansare collateralized by the production equipment, building and land owned by theGerman subsidiary.

 

                On September 21, 2001, theCompany entered into a note payable agreement with the manufacturer of theCompany’s PM7, located at its Tempe facility, for the remaining balance owed onthe machine, in the amount of $0.96 million. The first installment on the notewas paid on September 26, 2001 in the amount of $0.14 million. The remainingbalance of the note will be paid in 16 monthly installments.

 

                Other long-term debt consists ofcapitalized leases related primarily to certain computer equipment used by theCompany.

 

                Scheduled principal reductionsof long-term debt for the balance of 2001 and the fours years following andthereafter, are as follows: 

 
| **Year**               |   | **Amount** |   |
|------------------------|--------|------------|--------|
| 2001 - fourth  quarter |   | $          | 3,715  |   |
| 2002 - annual          |   | 6,394      |   |
| 2003 - annual          |   | 4,479      |   |
| 2004 - annual          |   | 3,512      |   |
| 2005 - annual          |   | 787        |   |
| Thereafter             |   | 6,339      |   |
| Total                  |   | $          | 25,226 |   |

 

                The Company incurred totalinterest expense of $0.6 million and $1.2 million in third quarter of 2001and 2000, respectively, and $2.2 million and $3.6 million for the first ninemonths of 2001 and 2000 respectively. Of these amounts, the Company capitalized$0.0 million and $0.2 million in the third quarter of 2001 and 2000,respectively, and $0.04 million and $1.67 million for the first nine months of2001 and 2000 respectively as part of the costs related to the construction ofnew production machines and facilities.

 

**Note 6—GovernmentGrant:**

 

                The Company received a grantaward (the "Grant"), from the State Government of Saxony in Germany(the "Grantor") in May 1999. The Grant provides for investmentgrants to a maximum amount of $9.9 million (DM 20.3 million). As ofSeptember 30, 2001, the Company had received approximately $4.9 million(DM 9.7 million) under this Grant and accounted for the Grant by applyingthe proceeds received against the cost of the German manufacturing facility.Additionally, the Company has received $0.9 million of government grantsthat have been recorded as an advance until the Company earns the grant throughfuture expenditures. In addition, during 2000, the Company also received$1.0 million (DM 2.1 million) in investment allowances from theGerman government and those proceeds were applied as a reduction of the cost ofthe German manufacturing facility. The Company has received an additional$2.1 million (DM 4.4 million) in investment allowances from the Germangovernment in 2001. Those funds were applied as a reduction of the cost of theGerman manufacturing facility. The Company's total investment in the Germanoperations at September 30, 2001 was $24.8 million (DM 52.2 million).

 

                The Grant is subject to thefollowing requirements:

 

                a)             The grant is earmarked to co–financethe costs of the construction of a facility to manufacture XIR® film for the automotiveglass industry, located at Grossroehrsdorf, Germany.

 

                b)            The construction period for theproject is from March 15, 1999 to March 14, 2002.

 

                c)             The total investment should be atleast $39.2 million (DM 80.3 million) excluding grants received.

 

                d)            The project must create at least 143permanent jobs and 7 apprenticeships by March 15, 2002.

 

                In the event that the Companyfails to meet the above requirements, the Grantor has the right to reclaim theGrant. Presently, the Company cannot determine the total investment that willbe made in the German facility and is in the process of reviewing the totalinvestment and timing thereof with the Grantor. The Company believes that itwill not meet all of the conditions of the Grant due to the inability of theequipment manufacturer to provide the equipment in time to meet the mandatedschedule, and the availability of financing to the Company. The Company hasbegun informal discussions with the Saxony government regarding amending thegrant conditions, but is unable to predict the outcome and the impact, if any,on the Company's obligations under the grant.

 

                The Company is eligible foradditional investment allowances from the German government amounting to$3.7 million (DM 7.7 million) calculated based on a capitalinvestment of $39.2 million (DM 80.3 million), subject to EuropeanUnion regulatory approval.

 

                The investment allowance issubject to the following requirements:

 

                a)             The movable and immovable assetswhich acquisition costs are taken into account in determining the investmentallowance shall be employed within the subsidized territory for a period of atleast five years following the acquisition or production.

 

                b)            The movable assets which acquisitioncosts are taken into account in determining the increased investment allowanceshall remain in a business that is engaged in the processing industry, or in asimilar production industry for a period of at least five years following theacquisition or production.

 

                In the event that the Companyfails to meet the above requirements, the investment allowance must be paidback, with interest.

 

**Note 7—SegmentReporting:**

 

                The Company operates in onesegment, the advanced film coatings segment, and is organized for operatingdecision-making and performance assessment on the basis of products andservices. It derives revenues from three product lines – Electronic Display,Automotive Glass and Architectural Products, as follows:

 
|                |   | **Three Months Ended** |       | **Nine Months Ended** |       |
|---------------------|--------|------------------------|------------|-----------------------|------------|
|                |   | **September 30,**      |       | **October 1,**        |       | **September 30,** |   | **October 1,** |   |
|                |   | **2001**               | ** ** | **2000**              | ** ** | **2001** | ** ** | **2000** | ** ** |
| Electronic  display |   | $                      | 7,318      |                  | $          | 15,343 |   | $ | 22,824 |   | $ | 36,017 |   |
| Automotive glass    |   | 10,817                 |       | 5,866                 |       | 28,191 |   | 15,639 |   |
| Architectural       |   | 4,642                  |       | 5,152                 |       | 11,421 |   | 12,742 |   |
| Total net  revenues |   | $                      | 22,777     |                  | $          | 26,361 |   | $ | 62,436 |   | $ | 64,398 |   |

 

                The following is a summary ofnet revenues by geographic area for the third quarter of 2001 and 2000, and thefirst nine months of 2001 and 2000 respectively.

 
|                |   | **Three Months Ended** |       | **Nine Months Ended** |       |
|---------------------|--------|------------------------|------------|-----------------------|------------|
|                |   | **September 30,**      |       | **October 1,**        |       | **September 30,** |   | **October 1,** |   |
|                |   | **2001**               | ** ** | **2000**              | ** ** | **2001** | ** ** | **2000** | ** ** |
| United States       |   | $                      | 4,643      |                  | $          | 4,607 |   | $ | 10,070 |   | $ | 9,987 |   |
| South America       |   | 137                    |       | 149                   |       | 454 |   | 452 |   |
| Pacific Rim         |   | 2,429                  |       | 5,448                 |       | 7,873 |   | 11,543 |   |
| Japan               |   | 5,526                  |       | 10,291                |       | 17,897 |   | 25,943 |   |
| Europe              |   | 9,971                  |       | 5,605                 |       | 25,834 |   | 15,633 |   |
| Canada              |   | 71                     |       | 261                   |       | 308 |   | 840 |   |
| Total net  revenues |   | $                      | 22,777     |                  | $          | 26,361 |   | $ | 62,436 |   | $ | 64,398 |   |

 

Four customers accounted for 23.8%, 23.4%, 13.4% and  0.0%, respectively, of net sales in the ninemonths ended September 30, 2001, and 14.3%, 40.4%, 5.7% and 13.3%,respectively, in the comparable period ended October 1, 2000.

 

**Note 8—Contingencies:**

 

The company is a defendant in an action filed on April 5, 1996, *Four Seasons Solar Products Corp vs. Black &Decker, Bostik, Inc. and Southwall Technologies, Inc.*,No. 5 CV 1695, pending in the United States District Court for the EasternDistrict of New York. Plaintiff is a manufacturer of insulated glass unitswhich incorporate the Company's Heat Mirror® film. Plaintiff alleges that a sealantprovided by co-defendant is defective, asserts causes of action for breach ofcontract, unfair competition, and fraudulent concealment, and seeks monetarydamages of approximately $36.0 million for past and future replacementcosts, loss of customer goodwill, and punitive damages against all defendants.The Company has filed a motion to dismiss. The Court has dismissed the unfaircompetition and fraudulent concealment claims against the Company. It still hasunder advisement the Company's motion to dismiss the breach of contract claim.The Company believes the claim to be without merit and will vigorously defendthe action, should the breach of contract claim survive the motion to dismiss.

 

                The Company was named adefendant in a class action lawsuit filed on March 9, 1998 by RichardMcKernan in the Superior Court of California, County of Santa Clara. TheCompany has reached a settlement with plaintiffs in the amount of$3.75 million, which will be funded by the Company’s insurance carrierTheinsurance carrier has not indicated whether it intends to pursue the Companyfor reimbursement of the settlement amount. The cost of the defense of theMcKernan action is being paid by the Company's insurer.

 

                The Company's German subsidiaryis a defendant in a lawsuit filed by one of its suppliers on March 21,2000 in a German court to seek payment of $0.9 million for engineeringservices rendered in connection with developing the initial plans for theGerman facility. The Company issued letters of award to the plaintiff amountingto $0.3 million prior to terminating plaintiff's services for not meetingthe Company's expectations. The plaintiff claims fees for services rendered,including the costs of significant modifications and revisions requested by theCompany calculated in accordance with the German Federal Schedule ofArchitects' fees. The plaintiff further alleges that the Company utilizedplaintiff's planning work in further developing the plant. The Company believesthat the suit is without merit and intends to vigorously defend its position.The Company has accrued $0.8 million as a liability on the balance sheetat September 30, 2001 in the event this amount will be awarded to theplaintiff.

 

                In August 2000, theCompany, its Chief Executive Officer, Thomas G. Hood, and former ChiefFinancial Officer, Bill R. Finley, were named as defendants in seven lawsuits,all filed in the United States District Court for the Northern District ofCalifornia (Docket Nos: C-00-2792-MMC; C-00-2795-BZ; C-00-2834-SC;C-00-20856-EAI; C-00-3007-EDL; C-00-3027-JCS; and C-00-3079-MMC) (the"Actions") all alleging violations of the federal securities laws.Each of the plaintiffs in the Actions alleges that he purchased shares of theCompany's common stock and seeks to represent a class of shareholders who purchasedshares during the period July 26, 2000 through August 1, 2000, suchdates constituting the period from the Company's release of its financialresults for the first quarter of FY 2000, to the date that it issued its pressrelease announcing that it would be restating its financial statements for thatquarter. The substantive allegations in each of the Actions are essentially thesame, i.e., that the defendants knew, or were reckless in not knowing, that theCompany's first quarter financial statements were in error and violatedgenerally accepted accounting principles, and that as a result the putativeclass members purchased stock at artificially inflated prices and were damaged.In the third quarter of 2001, the parties reached agreement on a settlement, inthe amount of $4.2 million, which has received final approval from thecourt. The negotiated settlement was paid entirely by the Company's insurers.

 

                In October 2000, theCompany was served with a complaint entitled *HurdMillwork, Inc. v. Southwall Technologies, Inc.*, et. al.,United States District Court, Northern District of California, Case No.C00-3820 (CRB). Hurd is a manufacturer of insulated glass units whichincorporate Heat Mirror®film. Hurd alleges that various failures and deficiencies associated with theinsulated glass units give rise to warranty and other consumer claims. Hurd isseeking monetary damages for past and future replacement costs, litigationexpenses, and punitive damages. The complaint alleges $32 million in damagesand $25 million in restitution. The Company believes Hurd's action to bewithout merit and intends to strenuously defend against it. The Hurd action isstill in the early discovery phase and the Company is awaiting receipt ofHurd's production of relevant documents to support the suit. The Court hasscheduled the trial for March 4, 2002. The defense of the Hurd action isbeing paid, in part, by the Company's insurers. The Company has agreed to paythe difference between its legal fees and the insurance company's legal fees.The Company believes the difference in legal fees is immaterial, therefore noamount has been accrued at September 30, 2001.

 

                In addition, the Company isinvolved in certain other legal actions arising in the ordinary course ofbusiness. The Company believes, however, that none of these actions, eitherindividually or in the aggregate, will have a material adverse effect on theCompany's business or its consolidated financial position or results ofoperations.

 

**Note 9—GoingConcern and Loan Covenants**

 

*Loan Covenants*

 

                Pursuant to the Teijin guaranty,the German bank loans, and lease agreements described in Note 5, and relatedterms, conditions and covenants, the Company requested waivers from TeijinLimited, the German banks and the leasing company as discussed below, relatedto the Company's default, or event of default pursuant to these respectiveagreements or otherwise arising in connection with the Company's requirement torestate prior financial periods, the financial position of the Companyreflected in such restated financial statements, the Company's failure to fileits Form 10-Q for the second quarter of 2000 in a timely manner andtrading halts or other actions taken or threatened to be taken by NASDAQ, orany law suits filed or threatened to be filed in connection with suchrestatements or late filings.

 

                On September 7, 2000,Teijin provided Southwall with a letter waiving any defaults throughOctober 1, 2001 arising out of the Company's failure to comply with theMinimum Quick Ratio and Maximum Debt-To-Tangible Net Worth financial covenants.Further, Teijin waived any event of default related to the Company'srequirement to restate prior financial periods, the financial position of theCompany to be reflected in such restated financial statements, the Company'sfailure to file its Form 10-Q for the second quarter of 2000 in a timelymanner, any trading halts or other actions taken or threatened by NASDAQ, orany lawsuits filed or threatened in connection with such restatements or latefilings or otherwise. Teijin has not agreed to extend this waiver beyond theOctober 1, 2001 date. As a result, the Company has reclassified the SanwaLoan, to which this guaranty applies, from long-term to current liabilities inthe September 30, 2001 balance sheet. The Company has begun discussions withTeijin regarding amending, or waiving the financial covenants as of December31, 2000. However, the Company can make no assurances regarding the successfuloutcome of those discussions.

 

                The Company received in October,2000 from the German banks a waiver of the events of default pursuant to theGerman bank agreements but the German banks did not provide a waiver of theevents of default or any rights it may have with respect to any furthermaterial adverse change in the financial condition of the Company resultingfrom the events of default and the German banks have reserved the right toterminate the loan agreements if the expectations relating to turnover andprofit as provided by the Company do not occur and provide a cause fortermination. The Company cannot currently determine with reasonable certaintywhether it will be able to comply with these provisions and accordingly hasreclassified these loans from long-term to current liabilities in the balancesheet.

 

                In November, 2000, the Companyreceived from the leasing company for the sale-leaseback agreements datedJuly 19, 1999 and October 19, 1999 a partial waiver of the events ofdefault pursuant to the agreements. However it reserved its right to declare anevent of default based on the Company's financial condition. Accordingly, theCompany has reclassified these agreements from long-term to current liabilitiesin the balance sheet.

 

*Going Concern*

 

                These consolidated financialstatements have been prepared assuming that the Company will continue as agoing concern. The Company has significant current and long-term debtcontaining certain covenants, with which the Company has not complied,requiring the Company to obtain waivers and to classify, as a currentliability, the debt for which waivers have not been obtained. The Company mustmeet certain commitments for debt service payments that raise substantial doubtabout its ability to continue as a going concern. The financial statements donot include any adjustments that might result from the outcome of thisuncertainty. As a result of this uncertainty, the Company may not be able tomeet its debt service obligations without additional financing. However, theCompany can give no assurances it will be successful in obtaining the requiredadditional financing on favorable terms, or upon any terms.

 

**Item 2****—Management'sDiscussion and Analysis of Financial Condition and Results of Operations:**

 

                Except for the historicalinformation contained herein, certain matters discussed in this Form 10-QReport are forward–looking statements that involve risks anduncertainties, including those discussed below under "Risk Factors"and in the Company's Annual Report on Form 10-K/A. Actual results maydiffer materially from those projected. These forward–looking statementsrepresent the Company's judgment as of the date of the filing of thisForm 10-Q Report. The Company disclaims, however, any intent or obligationto update these forward–looking statements.

 

*General*

 

                We are a designer andmanufacturer of technologically advanced thin-film coatings that selectivelyabsorb, reflect or transmit light and electromagnetic and infrared emissions.Our products are used in a number of electronic, automotive and building productsto enhance optical and thermal performance characteristics, improve usercomfort and reduce energy costs. From our founding in 1979 through the early1990's, we developed and produced thin-film coated substrates primarily forresidential and commercial buildings, and for military applications. In theearly 1990's, we began to develop products for the electronic display andautomotive markets.

 

                In 1996, we realized our firstmaterial revenue from the electronic display and automotive markets. For the ninemonths ended September 30, 2001 the automotive sector accounted for 45.2% ofour revenues, with the electronic display products contributing 36.6% of ourrevenues and the architectural market accounting for the balance.

 

                Several factors affect our grossmargins, including manufacturing efficiencies, product mix, productdifferentiation, inventory management, volume pricing, and the start-up ofequipment and new plants. Over the past several years, each of these factorshas contributed to margin volatility as we have added new capacity to meet thedemand of our electronics and automotive markets.

 

**Three Months Ended September 30, 2001 Compared with ThreeMonths Ended October 1, 2000**

 

*Net revenues*

 

                Net revenues decreased by$3.6 million, or 13.6%, to $22.8 million for the third quarter of2001, from $26.4 million for the third quarter of 2000. Sales to theautomotive market increased by $4.9 million, or 83.1%, to$10.8 million for third quarter of 2001, from $5.9 million for thethird quarter of 2000. This increase was primarily attributable to increasedproduction from the Company’s German operations. Sales to the electronicdisplay market decreased by $8.0 million, or 52.3%, to $7.3 million forthe third quarter of 2001, from $15.3 million for the third quarter of2000. The decrease was the result of an on-going, worldwide slowdown in thesale and manufacture of personal computers. Sales to the architectural marketdecreased $0.6 million, or 11.5%, to $4.6 million for the thirdquarter of 2001, from $5.2 million for the third quarter of 2000. The decreasewas primarily the result of the diversion of manufacturing capacity, previouslyused to produce products for the architectural market, to manufacture productsfor the automotive market.

 

*Cost and expenses*

 

*                Cost ofsales.*  Cost of sales expense consists primarily ofmaterials, production labor and machine overhead. Cost of sales decreased$3.8 million, or 19.6%, to $15.6 million for the third quarter of2001, from $19.4 million in the third quarter of 2000. As a percentage of netrevenues, cost of sales decreased to 68.4% of net revenues for the thirdquarter of 2001, from 73.5% of net revenues in the third quarter of 2000. Thehigher costs in 2000, as a percentage of revenues, was due to greater start-up costsin the Company's Tempe and German operations, higher Electronic Display productrevenues, which have higher costs. Additionally, cost savings resulting fromthe reduction in force of the Tempe and Palo Alto operations effected duringthe first quarter of 2001, and manufacturing yield improvements realized duringthe third quarter of 2001 further contributed to the improvement in margin.

 

*                Researchand development expenses.*  Research and development spending decreased$0.5 million, or 26.3%, to $1.4 million in the third quarter of 2001,from $1.9 million in the third quarter of 2000. Research and developmentexpenses decreased to 6.1% of net revenues for the third quarter of 2001, from7.2% of net revenues for the third quarter of 2000. The reduction was theresult of cost containment measures taken by the Company.

 

*                Selling,general and administrative expenses.*  Selling, general andadministrative expenses normally consist primarily of corporate andadministrative overhead, selling commissions, advertising costs and occupancycosts. These expenses decreased $2.9 million, or 51.8%, to $2.7 million in thethird quarter of 2001, from $5.6 million for the same period in 2000. Selling,general and administrative expenses decreased to 11.8% of net revenues for thethird quarter of 2001, from 21.2% of net revenues for the third quarter of2000. The higher costs in 2000 were the result of accounting, legal andconsulting costs incurred relating to the restatement of the Company’sfinancial results for 1999 and the first quarter of 2000.

 

*Income (loss) from operations*

 

                The Company realized a profit of$3.1 million for the third quarter of 2001, compared to a loss of$0.6 million for the third quarter of 2000. The increase in the Company’sprofitability in the third quarter of 2001, compared to the same period lastyear, was attributable to professional fees incurred during the third quarterof 2000 related to the restatement of the Company’s financial results, and,during the third quarter of 2001, improved manufacturing efficiency, revenue from the Company's Germanoperations, in addition to cost savings resulting from the reduction in forceof the Tempe and Palo Alto operations effected during the first quarter of2001.

 

*Interest (expense), net*

 

                The Company incurred interestexpense on borrowings of $0.6 million and $0.9 million in the thirdquarter of 2001 and 2000, respectively. The decrease in interest expenseprincipally results from a reduction in borrowings under the Company’srevolving line of credit, and lower interest rates on bank debt.

 

*Other income (expense), net*

 

                Other income (expense), netincludes rental income, interest income and foreign exchange transaction gainsand losses. The Company recorded other expense of $35,800in the third quarterof 2001 compared with other expense of $3,800 in the corresponding 2000 period.Certain transactions with foreign suppliers are denominated in foreigncurrencies rather than U.S. dollars. As exchange rates fluctuate relative tothe U.S. dollar, exchange gains and losses occur.

 

*Income (loss) before provision for income taxes*

 

                The Company reported a pre-taxprofit of $2.4 million for the third quarter of 2001, compared to apre-tax loss of $1.5 million for the third quarter of 2000. Theimprovement in performance was primarily due to additional revenue generated bythe Company's German operations, tighter cost controls and improvedmanufacturing efficiency.

 

**Nine Months Ended September 30, 2001 Compared with NineMonths Ended October 1, 2000**

 

*Net revenues*

 

                Net revenues decreased$2.0 million, or 3.1%, to $62.4 million for the first nine months of2001, from $64.4 million for the first nine months of 2000. Sales to theAutomotive market increased by $12.6 million, or 80.8%, to$28.2 million for the first nine months of 2001, from $15.6 millionfor the first nine months of 2000. This increase is primarily attributable tothe increased revenue in the first nine months of 2001, from the Company’sGerman operations, which began limited production of commercial automotiveproduct in December 2000. Sales to the Electronic Display market decreasedby $13.2 million, or 36.7%, to $22.8 million for the first ninemonths of 2001, from $36.0 million for the first nine months of 2000. Thedecrease was the result of the worldwide slowdown in the sale and manufactureof personal computers. Sales to the Architectural market decreased$1.3 million, or 10.2%, to $11.4 million for the first nine months of2001, from $12.7 million for the first nine months of 2000. The decrease wasprimarily the result of the loss of a North American manufacturer thatrepresented approximately 6% of the Company's Heat Mirror sales, and thediversion of manufacturing capacity previously used to produce products for theArchitectural market, to manufacture products for the Automotive market.

 

*Costand Expenses*

* *

*                Cost ofsales.*  Cost of sales decreased $4.3 million,or 8.4%, to $46.8 million for the first nine months of 2001, from$51.1 million in the first nine months of 2000. As a percentage of netrevenues, cost of sales decreased to 75.0% of net revenues for the first ninemonths of 2001, from 79.3% of net revenues in the first nine months of 2000.The higher costs in 2000, as a percentage of revenues, were due to greaterstart-up costs in the Company's Tempe and German operations, and higherElectronic Display revenues during 2000, which generally yield lower margins asa result of outside processing costs. Additionally, cost savings resulting fromthe reduction in force of the Tempe and Palo Alto operations effected duringthe first quarter of 2001 and manufacturing yield improvements realized in thefirst nine months of 2001 further contributed to the improvement in margin.

 

*                Researchand development expenses.*  Our research and development spending decreased$1.0 million, or 20.0%, to $4.0 million in the first nine months of2001, from $5.0 million in the first nine months of 2000. Research anddevelopment expenses decreased to 6.4% of net revenues for the first ninemonths of 2001, from 7.8% of net revenues for the first nine months of 2000.The decrease in the first nine months of 2001 was primarily attributable toreduced headcount and cost control measures introduced by the Company.

 

*                Selling,general and administrative expenses.*  These expenses decreased$2.3 million, or 21.5%, to $8.4 million in the first nine months of2001, from $10.7 million in the first nine months of 2000. Selling,general and administrative expenses, as percentage of revenue, decreased to13.5% for the first nine months of 2001, from 16.6% for the first nine monthsof 2000. The higher costs in 2000 were the result of accounting, legal andconsulting costs incurred relating to the Company’s restated financial results.

 

*Legal Settlement.*

 

                In the second quarter of 2000,the Company accrued $0.4 million in settlement of a legal matter.

 

*Income (loss) from operations*

 

                Income from operations was$3.2 million for the first nine months of 2001 compared to a loss of$2.8 million for the first nine months of 2000. The improvement was due toimproved manufacturing efficiency cost reduction programs put in place in thePalo Alto and Tempe operations, and a reduction in professional fees incurredduring the third quarter of 2000.

 

*Interest (expense), net*

 

                The Company incurred netinterest expense on borrowings of $2.2 million and $2.0 million forthe first nine months of 2001 and 2000, respectively, and capitalized interestincurred in connection with construction in process of $0.04 million and $2.6million for the first nine months of 2001 and 2000, respectively. The increasein net interest expense principally results from the completion of constructionin process related to the German and Tempe plants in late 2000.

 

*Other income (expense), net*

 

                Other income (expense), netincludes rental income, interest income and foreign exchange transaction gainsand losses. The Company recorded other income of $1.3 million for thefirst nine months of 2001, compared with $0.02 million in thecorresponding 2000 period. Certain transactions with foreign suppliers aredenominated in foreign currencies (principally Japanese Yen) rather than U.S.dollars. As exchange rates fluctuate relative to the U.S. dollar, exchangegains and losses occur.

 

*Income (Loss) before provision for income taxes*

 

                The Company recorded a pre-taxprofit of  $2.4 million for thefirst nine months of 2001, compared to a pre-tax loss of $4.8 million forthe first nine months of 2000, due to additional revenue generated by theCompany's German operations, and higher revenues from the Automotive market,partially offset by a decrease in revenue from the Electronic Display market.

 

**Liquidity and Capital Resources**

 

*Capital expenditures*

 

                Since 1998, we have usedborrowings, German government grants and cash from operations to fund our capitalexpenditures. During 1999, we invested approximately $24.0 million incapital expenditures, including approximately $13.5 million of progresspayments for our new manufacturing facility and first production machine (PM8)in Germany, approximately $7.5 million for two new production machines(PM6 and PM7) and leasehold improvements for our Tempe facility, andapproximately $2.5 million for the upgrade of two production machines (PM1and PM2) in Palo Alto. These investments were financed by $13.6 million ofshort and long-term debt, $4.9 million in German government grants,$4.5 million of cash from operations, and cash on hand. The Germangovernment grants subject us to a number of covenants. (See Note 5 toNotes to Consolidated Financial Statements.)

 

                We spent approximately$12.9 million for capital expenditures in 2000, including$9.8 million in our German facility, of which $7.0 millionrepresented final progress payments on our two new production machines (PM8 andPM9) in Germany and the completion of our German facility. We financed ourcapital expenditures in Germany primarily through the receipt of$4.0 million of additional bank loans and $1.0 million of subsidiesfrom the German government and the release of $2.6 million of cashrestricted by the German government to use in financing the completion of ourGerman facility. The German government may reclaim the grants if we fail tomeet any of the covenants. (See Note 6 to Notes of the ConsolidatedFinancial Statements.) We invested an additional $3.1 million in our Tempeand Palo Alto operations for leasehold improvements, computer equipment andimprovements on our production machines.

 

                In the first quarter of 2000,our second machine at Tempe (PM6) began to produce limited amounts of film forcommercial use. An additional machine (PM7) was delivered to Tempe in the thirdquarter of 2000, and it has been partially funded by a note payable to themanufacturer of the machine . Additionally, we took possession of our newfacility in Germany in May 2000, where PM8 was installed in the thirdquarter and PM9 was installed in 2001. PM8 commenced production of commercialproduct in December of 2000, and PM9 began limited commercial production in thesecond quarter of 2001. The Company expects that the remaining installments onthe machines will be paid from committed German bank loans. Presently, theCompany can not predict the total investment that will be made in the Germanfacility and is in the process of reviewing the total investment and timingthereof. The Company believes that it will not meet all of the conditions tothe Grant. The Company has begun discussions with the Saxony governmentregarding amending the conditions associated with the grants, however, theCompany is unable to predict the outcome of these discussions, and the impact,if any, on the Company's obligations under the grant. See "Risk Factors—Our ability to meet futurecash requirements may depend on our ability to retain grants received to datefrom the German Government."

 

                In the first nine months of2001, the Company spent approximately $2.6 million in capital expenditures,primarily in its German operations on PM9. The $2.6 million in capitalexpenditures made during the first nine months of 2001, is net of $2.1 millionin investment allowances received during the third quarter of 2001, whichrelates to capital expenditures made by the Company during 2000.  (See Note 6 - Government Grant)  The Company's total capital expenditures in2001 are expected to be less than $4.0 million, and the expenditures areexpected to be used to expand production capacity, acquire personal computersfor additional employees and upgrade the Company's computer network.

 

*Liquidity*

 

                Operating activities generated$0.2 million during the first nine months of 2000. In the first nine months of2001, operating activities generated $8.3 million in cash. Included in capitallease obligations on the balance sheets are $1.0 million of proceeds froma sale-leaseback transaction in 1999. This amount was withheld by the lessorand classified in "Other Assets", and will not be released until theCompany meets certain financial covenants. Furthermore, 50% of the proceedsfrom a $1.6 million loan from a German bank are restricted in an escrowaccount for the duration of the loan period and are classified in "OtherAssets." The Company has reclassified to "Restricted Cash" thatportion of cash, $1.2 million, which is restricted to payments for thefacility in Germany.

 

                Thefollowing table sets forth the material terms of our short and long-termindebtedness at September 30, 2001:

 
| **Description**                                     |   | **Rate**     |   | **Maturity** |   | **Balance at**

**September 30, 2001** |   | **Scheduled**

**Principal Payments**

**Remaining for**

**2001** |   | **Start Date** |     |
|-----------------------------------------------------|--------|--------------|--------|--------------|--------|----------------------------------------|--------|--------------------------------------------------------------------|--------|----------------|----------|
| Financing Line of Credit                            |   |         |   |         |   | $                                      | 5,498  |                                                               |   |           |     |   |
| Long-term debt                                      |   |         |   |         |   |                                   |   |                                                               |   |           |     |
| Promissory note  dated May 6, 1997                  |   | LIBOR +.4375 |   | (1           | )      | 8,750                                  |   | $                                                                  | 1,250  |           | May 2001 |   |
| Sales-leaseback  agreement dated   July 19, 1999    |   | 13.0         | %      | (2           | )      | 2,321                                  |   | 711                                                                |   | April 2000     |     |
| Sales-leaseback  agreement dated   October 19, 1999 |   | 13.0         | %      | (3           | )      | 2,446                                  |   | 1,374                                                              |   | March 2000     |     |
| German bank loan  dated May 12, 1999                |   | 6.1          | %      | (4           | )      | 2,568                                  |   | 78                                                                 |   | March 2001     |     |
| German bank loan  dated May 28, 1999                |   | 7.1          | %      | (5           | )      | 2,284                                  |   | -                                                                  |   | December 2009  |     |
| German bank loan  dated May 28, 1999                |   | 3.8          | %      | (6           | )      | 1,303                                  |   | -                                                                  |   | March 2001     |     |
| German bank loan  dated December 1, 1999            |   | 7.2          | %      | (7           | )      | 1,937                                  |   | 54                                                                 |   | December 2001  |     |
| German bank loan  dated August 14, 1999             |   | 5.8          | %      | (8           | )      | 1,541                                  |   | -                                                                  |   | June 2009      |     |
| German bank loan  dated June 29, 2000               |   | 5.8          | %      | (9           | )      | 552                                    |   | 52                                                                 |   | June 2001      |     |
| German bank loan  dated July 20, 2000               |   | 7.1          | %      | (10          | )      | 389                                    |   | 39                                                                 |   | June 2001      |     |
| German bank loan  dated December 19, 2000           |   | 7.5          | %      | (11          | )      | 236                                    |   | -                                                                  |   | March 2002     |     |
| Note Payable  dated September 21, 2001              |   | -            |   | (12          | )      | 820                                    |   | 150                                                                |   | September 2001 |     |
| Other equipment  financings                         |   |         |   |         |   | 79                                     |   | 8                                                                  |   |           |     |
| Total long-term  debt                               |   | -            |   | -            |   | 25,226                                 |   | 3,716                                                              |   |           |     |
| Less current  portion                               |   |         |   |         |   | 8,204                                  |   |                                                               |   |           |     |
| Less long-term  portion-reclassified to current     |   |         |   |         |   | 17,022                                 |   |                                                               |   |           |     |
| Long-Term Debt                                      |   |         |   |         |   | $                                      | 0      |                                                               |   |           |     |   |
|                                                     |        |              |        |              |        |                                        |        |                                                                    |        |                |          |  |  |

 

___________

 

(1)           We are required to make equal semi–annual repaymentsfrom May 2001 through November 2004.

 

(2)           We are required to make equal monthly principal paymentsover the 36–month term of this financing.

 

(3)           We are required to make equal monthly principal paymentsover the 24–month term of this financing.

 

(4)           We are required to make equal quarterly principal paymentsover the 9–year repayment term of this financing starting March 31, 2001.

 

(5)           We are required to make equal semi–annual principalpayments for ten years from December 2009 through June 2019.

 

(6)           We are required to make semi–annual principalpayments for six years from March 2001 through September 2006.

 

(7)           We are required to make equal quarterly principal paymentsfor nine years from December 2001 through September 2010.

 

(8)           We are required to make one principal payment on June2009.

 

(9)           We are required to make equalquarterly principal payments for three years from July 2001 through June 2005.

 

(10)         We are required to make equal quarterlyprincipal payments for three years from June 2001 through July 2004.

 

(11)         We made a payment of $139.8 thousand inSeptember 2001. We will make equal monthly payments of $50.0 thousand fromOctober 2001 through December 2002, and a final payment of $69.8 thousand inJanuary 2003.

 

(12)         Represents the portion of long–term debt that has beenreclassified into current liabilities as a result of lenders not grantingwaivers for failure to meet certain covenants.

 

                We have granted the lender ofthe financing line of credit a security interest in our receivables, inventoryand other assets not otherwise collateralized. Our loans from German banks alsosubject us to covenants, including covenants relating to the progress of andinvestment in the development of our Dresden facility and the minimum number ofour employees at Dresden by 2002. We have granted the German banks securityinterests in our Dresden facility and the assets located at the facility.

 

                The promissory note datedMay 6, 1997 is payable to a bank and guaranteed by Teijin Limited, astockholder and one of our suppliers. The Teijin guarantee is collateralized bycertain equipment in the Company's Tempe manufacturing facility, and ourinventory to the extent necessary to cover 120% of the outstanding loan balancebased on the net book value of the inventory. The guarantee subjects us tocertain financial and other covenants, including covenants relating to ourtangible net worth, our debt to tangible net worth, profitability and the ratioof our cash, cash equivalents and short term investments to our total current liabilities.At December 31, 2000, we were not in compliance with the financialcovenants relating to our minimum net worth, the ratio of our debt to equity,the ratio of our cash, cash equivalents and short-term investments to currentliabilities, and the requirement that Company be profitable. The Companyreceived a waiver for failure to comply with these covenants throughOctober 1, 2001. Teijin did not extend the waiver. Accordingly, theCompany has reclassified the long-term balance from long-term debt to currentliabilities in the balance sheet. The Company has begun discussions with Teijinregarding amending the financial covenants of this loan agreement. However, theCompany can make no assurances regarding the successful outcome of the thosediscussions. Beginning in 2001, the Company is obligated to make two principalpayments of $1.25 million each in May and November. The Company made thefirst principal payment of $1.25 million on May 7, 2001, and will paythe second installment of $1.25 million in November 2001. The Companywill also make principal payments of $2.5 million each in 2002, 2003 and2004.

 

                Wehave provided the lessor under our sales–leaseback financings a$0.5 million irrevocable standby letter of credit to collateralize ourobligations under the sales–leaseback agreements. The letter of creditwill not expire before January 1, 2002. In addition, $1.0 million ofthe amount to be received from the lessor was withheld pending our meetingcertain financial conditions.

 

*Loan Covenants*

 

                Pursuant to the guaranty, theGerman bank loans, and lease agreements listed above, and related terms,conditions and covenants the Company requested waivers from Teijin Limited, theGerman banks and the leasing company as discussed below, related to the Company'sdefault, or event of default pursuant to these respective agreements orotherwise arising in connection with the Company's requirement to restate priorfinancial periods, the financial position of the Company reflected in suchrestated financial statements, the Company's failure to file its Form 10-Qfor the second quarter of 2000 in a timely manner and trading halts or otheractions taken or threatened to be taken by NASDAQ, or any law suits filed orthreatened to be filed in connection with such restatements or late filings.

 

                On September 7, 2000,Teijin provided Southwall with a letter waiving any defaults throughOctober 1, 2001 arising out of the Company's failure to comply with theMinimum Quick Ratio and Maximum Debt-to-Tangible Net Worth financial covenants.Further, Teijin waived any Event of Default related to the Company'srequirement to restate prior financial periods, the financial position of theCompany to be reflected in such restated financial statements, the Company'sfailure to file its Form 10-Q for the second quarter of 2000 in a timelymanner, any trading halts or other actions taken or threatened by NASDAQ, orany lawsuits filed or threatened in connection with such restatements or latefilings or otherwise. Teijin has not agreed to extend this waiver beyond theOctober 1, 2001 date. As a result, the Company has reclassified the SanwaLoan, to which this guaranty applies, from long-term to current liabilities inthe balance sheet.

 

                The Company received inOctober 2000 from the German banks a waiver of the Events of Defaultpursuant to the agreements but the German banks did not provide a waiver of theEvents of Default or any rights it may have with respect to any furthermaterial adverse change in the financial condition of the Company resultingfrom the Events of Default and the German banks have reserved the right toterminate the loan agreements after the third and fourth quarter of 2000 if theexpectations relating to turnover and profit as provided by the Company do notoccur and provide a cause for termination. The Company cannot currentlydetermine with reasonable certainty whether it will be able to comply withthese provisions and accordingly has reclassified these loans from long-term tocurrent liabilities in the balance sheet.

 

                In November 2000, theCompany received from the leasing company for the sale-leaseback agreementsdated July 19, 1999 and October 19, 1999 a partial waiver of theEvents of Default pursuant to the agreements. However it reserved its right todeclare an Event of Default based on the company's financial condition.Accordingly, the Company has reclassified these agreements from long-term tocurrent liabilities in the balance sheet.

 

**Going Concern**

 

                These consolidated financialstatements have been prepared assuming that the Company will continue as agoing concern. The Company has significant current and long-term debtcontaining certain covenants, with which the Company has not complied,requiring the Company to obtain waivers and to classify, as a currentliability, the debt for which waivers have not been obtained. The Company mustmeet certain commitments for debt service payments that raise substantial doubtabout its ability to continue as a going concern. These consolidated financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty. As a result of this uncertainty, the Company may not be ableto meet its debt service obligations without additional financing. However, theCompany can give no assurances it will be successful in obtaining the requiredadditional financing .

 

**Item 3****—Quantitativeand Qualitative Disclosures about Market Risk**

 

                The Company is exposed to theimpact of interest rate changes, foreign currency fluctuations, and changes inthe market values of its investments.

 

 **FINANCINGRISK.**  The Company's exposureto market rate risk for changes in interest rates relates primarily to theCompany's term loans which are tied to the London Interbank Offered Rate("LIBOR") and bank line of credit which is tied to the prime rate.The Company's German subsidiary also has several fixed-rate term loans that aredenominated and repayable in Deutschemarks. Fluctuations in interest rates mayadversely impact the interest expense expected for the Company. At September30, 2001, the Company had one loan with a variable interest rate. The effect ofa 10% fluctuation in the interest rate for this loan would have an impact ofless than $75,000. The effect of interest rate fluctuations on the Companyduring the first nine months of 2001 was not material.

 

 **INVESTMENTRISK.**  The Company investsits excess cash in certificates of deposit and money market accounts and, bypolicy, limits the amount of exposure to any one institution. Investments inboth fixed rate and floating rate interest earning instruments carries a degreeof interest rate risk. Fixed rate securities may have their fair market valueadversely impacted due to a rise in interest rates, while floating ratesecurities may produce less income than expected if interest rates fall. Theeffect of a 10% fluctuation in the interest rate of any floating ratesecurities would have an adverse impact of less than $100,000.

 

 **FOREIGNCURRENCY RISK.**  Internationalrevenues amounted to 83.9% of the Company's total sales in the first ninemonths of 2001 and, by policy, the Company limits foreign currency risk byrequiring all sales to be denominated in U.S. dollars. Sales from the Germansubsidiary are currently denominated in U.S. dollars, but will likely be denominatedin EUROs beginning in 2002. Certain transactions with foreign suppliers aredenominated in foreign currencies (principally Japanese Yen), rather than U.S.dollars. The Company's international business is subject to risks typical of aninternational business, including, but not limited to differing economicconditions, changes in political climate, differing tax structures, otherregulations and restrictions, and foreign exchange rate volatility.Accordingly, the Company's future results could be materially adverselyimpacted by changes in these or other factors.

 

**RISK FACTORS**

 

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

 

                Our quarterly revenue andoperating results have varied significantly in the past and will likely varysignificantly in the future. Our revenue and operating results may fall belowthe expectations of securities analysts or investors in future periods. Ourfailure to meet these expectations would likely adversely affect the marketprice of our common stock.

 

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

 

                •              manufacturing andoperational difficulties that may arise due to, among other things, expansionof our production capacity, the transfer of equipment and personnel to ourinternational manufacturing facility, and the hiring and training of additionalstaff;

 

                •              our possible abilityto introduce new products and technologies on a timely basis, and the increasedresearch, development and engineering costs and marketing expenses associatedwith new product introductions;

 

                •              fluctuating customerdemand, which is influenced by a number of factors, including general economicconditions in the sputtered thin–film coatings industry, marketacceptance of our products and the products of our customers and end–users,changes in the product mix demanded and offered, and the timing, cancellationor delay of customer orders and shipments;

 

                •              competition,including the introduction or announcement of new products by competitors, theadoption of competitive technologies by our customers, the addition of newproduction capacity by competitors and competitive pressures on prices of ourproducts and those of our customers; and

 

                •              the timing of ourrecognition of revenues from product orders which can materially affect ouroperating results on a quarterly basis due to the size of a particular order.

 

**Future growth of our business may place a strain on ourfinancial, management and production resources.**

 

                In order to grow, we must expandour manufacturing capacity by adding additional production machines, which willplace a strain on our financial resources. Unless the Company securesadditional financing, it will not be able to expand its manufacturing capacity.We will need to finance a large portion of these future expenditures throughexternal sources, including borrowings. We do not have credit facilities inplace to provide this financing. We cannot assure you that we will be able tosecure credit facilities or other sources of financing that will address ourfuture capital needs or that such credit facilities will not be on terms lessfavorable to us than we have budgeted.

 

                In addition, growth of ourbusiness will increase the work load and responsibilities of our existingmanagement and require us to expand our management team. We cannot assure youthat the present size of our management team will enable us to expand ourbusiness or that we will be able to recruit enough experienced managers.

 

                Many of our machines are theonly manufacturing sources for certain of our products and are running at ornear capacity. We do not have plans to develop redundancy for much of ourproduction capability. Therefore, a breakdown or catastrophic damage to certainmachines would severely and adversely affect our business. In addition, it cantake up to 12-18 months to replace certain production machines. If ourplans to expand our manufacturing capacity are not implemented on a timelybasis, we could face production shortfalls. Rapid increases in productionlevels to meet unanticipated demand could result in higher costs and otherexpenses. These higher expenditures could lower our profit margins. Further, ifproduction is increased rapidly, there may be decreased manufacturing yields,which may also lower our margins.

 

**Our ability to meet our future cash requirements may dependon our ability to retain grants received to date from the German government.**

 

                The Company has an agreement toreceive a grant award (the "Grant"), which was approved by the StateGovernment of Saxony in Germany (the "Grantor") in May 1999. Theagreement provides for investment grants to a maximum amount of$9.9 million (DM 20.3 million). As of September 30, 2001, the Companyhad received approximately $4.9 million (DM 9.7 million) under thisGrant and accounted for the Grant by applying the proceeds received against thecost of the German manufacturing facility. The Company has received$0.9 million of Grants that has been recorded as an advance until theCompany earns this portion of the Grant through future expenditures.

 

                The Company believes that it mayfail to meet certain requirements in connection with the grants (seeNote 6—GovernmentGrant), in which event the Grantor would have the right to reclaim the Grant.In particular, the Company can not determine whether the total investment thatwill be made in the German facility will satisfy the condition to the Grant,but expects that it will not and is in the process of reviewing the totalinvestment and timing thereof with the Grantor. The Company has had informaldiscussions with the Saxony government, but is unable to predict the outcome ofthese discussions, and the impact, if any, on the Company's obligations underthe grant. If the Company breaches the covenants under the Grant, the Grantormay withhold the remaining portions of the Grant, or seek repayment of amountspreviously granted. Either event would have a material, adverse effect on theCompany.

 

**We may not be able to bring new machines online effectivelyin our manufacturing operations to meet increasing capacity requirements.**

 

                We expanded our manufacturingcapacity through the purchase of two new productions machines for our Tempefacility in 1999, one of which began production in the first quarter of 2000and the other of which is scheduled to begin production in the first half of2002. The first machine in our new Dresden manufacturing facility begancommercial production in the fourth quarter of 2000. The second machine beganproduction in the second quarter of 2001. In the past, we have experiencedsignificant problems during the initial phases of operating a new machine. Wehave taken substantial write-offs of inventory and incurred substantialexpenses in connection with the resolution of these problems. If we encountersimilar problems with new machines, our production capability and our operatingresults will suffer.

 

**Our success will depend on our ability to service ourborrowings and maintain credit facilities.**

 

                We have financed a large portionof our capital expenditures through borrowings and expect to continue to do so.Our inability to make timely payments of interest or principal under thesefacilities could materially adversely affect our ability to borrow money underexisting credit facilities or to secure additional borrowings. In addition, ourcurrent credit facilities contain, and our future credit facilities willcontain, financial and operating covenants that will limit our discretion withrespect to business matters. Among other things, these covenants will restrictour ability to incur additional indebtedness, create liens or otherencumbrances, and make certain payments including dividends and investments.These credit facilities will also contain financial covenants and events ofdefault that could require us to pay off indebtedness before its maturity. Therestrictions imposed by these credit facilities or the failure of lenders toadvance funds under these facilities could adversely affect us. You should readthe sections entitled "Loan Covenants"; "Liquidity"; and"Going Concern" in the "Management's Discussion and Analysis ofFinancial Condition and Results of Operations" for more information.

 

**We depend on a small number of customers for a substantialportion of our sales, and the loss of a large customer could hurt our revenuesor operating results.**

 

                Our ten largest customersaccounted for approximately 74%, 69% and 85% of net product sales in 1998, 1999and 2000, respectively. During 2000, our three largest customers wereMitsubishi Electric Corporation, Sekurit St. Gobain and Samsung, each of whichaccounted for more than 10% of our net product sales. We expect to continue toderive a significant portion of our net product sales from a relatively smallnumber of customers. Accordingly, the loss of a large customer could materiallyhurt our business, and the deferral or loss of anticipated orders from a smallnumber of customers could materially damage our revenue and operating resultsin any period. In addition, we do not have long-term contracts or purchaseorders with many of our customers, and customers may cancel their orders,change production quantities from forecast volumes or delay production for anyreason.

 

**We depend on our OEM customers for the sale of our productsand for information relating to the development of new products.**

 

                We sell a substantial portion ofour products to a relatively small number of original equipment manufacturers,or OEMs. The timing and amount of sales to these customers ultimatelydepend on sales levels and shipping schedules for the OEM products into whichour products are incorporated. We have no control over the shipping dates orvolume of products shipped by our OEM customers, and we cannot be certain thatour OEM customers will continue to ship products that incorporate our productsat current levels or at all. Failure of our OEM customers to achievesignificant sales of products incorporating our products and fluctuations inthe timing and volume of such sales could be harmful to our business. Failureof these customers to inform us of changes in their production needs in atimely manner could also hinder our ability to effectively manage our business.

 

                In addition, we rely on our OEMcustomers to inform us of opportunities to develop new products that serveend-user demands. If our OEM customers do not present us with market opportunitiesearly enough for us to develop products to meet end-user needs in a timelyfashion, or if the OEMs fail to anticipate end-user needs at all, we mayfail to develop new products or modify our existing products for our end-usermarkets. In addition, if our OEM customers fail to accurately anticipateend-user demands, we may spend resources on products that are not commerciallysuccessful.

 

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

 

                We manufacture all of ourproducts using materials procured from third–party suppliers. Certain ofthese materials are obtained from a limited number of sources. For example, thesubstrates we use in the manufacture of our Heat Mirror product is only currentlyavailable only from one qualified source, Teijin, holder of approximately 8.1%of our common stock. The substrates used in the manufacture of ouranti-reflective film is currently available from only two qualified sources,Teijin and Di Nippon Printing. The loss of either of these current sourcescould adversely affect our ability to meet our scheduled product deliveries tocustomers. In addition, any interruption in the operations of vendors ofcertain other materials could also adversely affect our ability to meet ourscheduled product deliveries to customers. If we are unable to obtain asufficient supply of materials from our current sources, we could experiencedifficulties in obtaining alternative sources quickly or in altering productdesigns to use alternative materials. In the case of several materials, ittakes a great deal of time to qualify new suppliers. Delays or reductions inproduct shipments could damage our relationships with our customers. Further, asignificant increase in the price of one or more of these materials could havea material adverse effect on our operating results.

 

**We are dependent on key suppliers of production machineswhich may prevent us from delivering an acceptable product on a timely basis.**

 

                Our production machines arelarge, complex and difficult to manufacture. It can take up to a year from thetime we order a machine until it is delivered. Following delivery, it can takeus, with the assistance of the manufacturer, up to six additional months totest and prepare the machine for commercial production. There are a verylimited number of companies that are capable of manufacturing these machines.Our inability in the future to have new production machines manufactured andprepared for commercial production in a timely manner would have a materialadverse effect on our business.

 

**We must continue to develop new products or enhance existingproducts on a timely basis to compete successfully in a rapidly changingmarketplace.**

 

                The market for thin-film coatedglass and coating equipment is characterized by rapid change, especially in theelectronic display market. Our future success depends upon our ability tointroduce new products, improve existing products and processes to keep pacewith technological and market developments, and to address the increasinglysophisticated and demanding needs of our customers. Technological changes,process improvements, or operating improvements that could adversely affect usinclude:

 

                •              the development ofnew technologies that improve the manufacturing efficiency of our competitors;

 

                •              changes in productrequirements of our customers;

 

                •              changes in the waycoatings are applied to alternative substrates such as tetra acetate cellulose,or TAC;

 

                •              the development ofnew materials that improve the performance of thin–film coated glass; and

 

                •              improvements in thealternatives to the sputtering technology we use to produce our products, suchas plasma enhanced chemical vapor deposition, or PECVD.

 

                We may not have sufficient fundsto devote to research and development, or our research and development effortsmay not be successful in developing products in the time, or with thecharacteristics, necessary to meet customer needs. If we do not adapt totechnological changes, or process or operating improvements, our competitiveposition, operations and prospects would be materially adversely affected.

 

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

 

                The market for each of ourproducts is intensely competitive and we expect competition to increase in thefuture. Competitors vary in size and in the scope and breadth of the productsthey offer. Many of our current and potential competitors have significantlygreater financial, technical, marketing and other resources than we have. Inaddition, many of our competitors have well-established relationships with ourcurrent and potential customers and have extensive knowledge of our industry.Current and potential competitors have established or may establish cooperativerelationships among themselves or with third parties to increase the ability oftheir products to address customer needs.

 

 *ElectronicInformation Display Market.* Competitors in the anti-reflective coatings market include customers whohave the capability to use wet coating technology, as well as competitors, whosupply sputter coated films similar to those produced by us. One of the largestmanufacturers of flat-face computer display tubes, or CDTs, Sony Corporation ofJapan, has its own sputter coating film technology which is used to provideanti-reflective characteristics on its own CDTs. Customers' selection ofanti-reflective products is driven by quality, price and capacity.

 

 *AutomotiveGlass Market.*  Solar controlproducts in the automotive OEM market are provided by large, worldwide glasslaminators who typically have divisions also selling products to the commercialflat glass industry. Several of these companies, such as PPG, Pilkington PLC,Sekurit St. Gobain, Asahi, Guardian, and Glaverbel, have direct to glasssputtering capability. In the applied film segment of the automotive market,companies such as 3M, Material Sciences Corporation, CP Films, and CourtauldsPLC produce competitive solar control products that are widely accepted in themarket.

 

 *Residentialand Commercial Window Market.* Products that provide solar control and energy conservation have beenavailable to this market for almost 20 years. Since our introduction ofour Heat Mirror suspended film product in 1979, large glass producers likeGuardian, PPG, Viracon, Glaverbel, and Asahi, have produced their owndirect-to-glass sputtered products that perform similarly to our Heat Mirrorproduct.

 

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

 

                We require the services of asubstantial number of qualified technical personnel. The market for skilledtechnical personnel is characterized by intense competition and aggressiverecruiting, as well as a high-level of employee mobility. These characteristicsmake it particularly difficult for us to attract and retain the qualifiedtechnical personnel we require. We have experienced, and we expect to continueto experience, difficulty in hiring and retaining highly skilled employees withappropriate technical qualifications. It is especially difficult to recruitqualified personnel to move to the location of our in Palo Alto, California,offices because of the high-cost of living. If we are unable to recruit andretain a sufficient number of qualified technical employees, we may not be ableto complete the development of, or enhance, our products in a timely manner. Asa result, our business may be harmed and our operating results may suffer.

 

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

 

                In addition to our dependence onour technical personnel, our success also depends on our continuing ability toattract and retain other highly skilled employees. We depend on the continuedservices of our senior management, particularly Thomas G. Hood, our President andChief Executive Officer, and Robert Freeman, our Chief Financial Officer, andother personnel. We do not have any key person life insurance covering anyofficer or employee. Competition for personnel in our industry where we operateis intense. We have experienced, and we expect to continue to experiencedifficulty in hiring and retaining highly skilled employees with appropriatequalifications. If we do not succeed in attracting or retaining the necessarypersonnel, our business could be adversely affected.

 

**Our success depends in part upon our ability to protect ourintellectual property, but we may not be able to do so adequately.**

 

                Our success depends in largepart upon our proprietary technology. We rely on our know-how, as well as acombination of patent, trademark and trade secret protection, to establish andprotect our intellectual property rights. In addition, we seek to avoiddisclosure of our know-how and trade secrets through a number of means,including requiring those persons with access to our proprietary information toexecute nondisclosure agreements with us. We seek to protect our technology,documentation and other written materials under trade secret and copyrightlaws, which afford only limited protection. We have 28 patents and 6 patentapplications pending in the United States that cover materials, processes,products and production equipment. We also have patents and patent applicationspending in various foreign countries covering the same technology. Some foreigncountries in which we may do business provide significantly less patent andproprietary rights protection than the United States.

 

                Despite our efforts to protectour proprietary rights, unauthorized parties may attempt to copy aspects of ourproducts or to obtain and use information that we regard as proprietary.Policing unauthorized use of our products is difficult. In addition, the lawsof some foreign countries do not protect our proprietary rights to as great anextent as do the laws of the United States. Our means of protecting ourproprietary rights may not be adequate. In addition, our competitors mayindependently develop similar technology, duplicate our products, or designaround our proprietary intellectual property.

 

**Our business is susceptible to numerous risks associated withinternational operations.**

 

                We have expanded our operationsand hired additional personnel to address international markets for thethin-film coatings industry. International revenues amounted to 68%, 77% and86% of our net revenues during 1998, 1999 and 2000, respectively. The distancebetween California and Dresden create logistical and communications challenges.In addition, to achieve acceptance in international markets, our products mustbe modified to handle a variety of factors specific to each internationalmarket as well as local regulations. We may also be subject to a number ofother risks associated with international business activities. These risksinclude:

 

                •              unexpected changes inand the burdens and costs of compliance with a variety or foreign laws andregulatory requirements;

 

                •              currency exchangerate fluctuations;

 

                •              tariffs, exportcontrols and other trade barriers;

 

                •              longer accountsreceivable payment cycles and difficulties in collecting accounts receivable;

 

                •              difficulties inmanaging and staffing international operations;

 

                •              potentially adversetax consequences, including restrictions on the repatriation of earnings; and

 

                •              global economicturbulence and political instability.

 

                Our international sales arecurrently invoiced and collected in U.S. dollars. A strengthening in the dollarrelative to the currencies of those countries in which we do business wouldincrease the prices of our products as stated in those currencies and couldhurt our sales in those countries. Significant fluctuations in the exchangerates between the U.S. dollar and foreign currencies could cause us to lowerour prices and thus reduce our profitability. These fluctuations could alsocause prospective customers to delay orders because of the increased relativecost of our products.

 

                We expect that, within the nexttwelve months, the customers of our Dresden operation will begin to makepayments in EUROs or other foreign currencies. In addition, in the future,other of our customers may also make payments in foreign currencies. Suchtransactions may require us to begin to hedge foreign currencies in order toreduce the risk to us of fluctuating exchange rates.

 

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

 

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

 

                •              delays in collectingaccounts receivable;

 

                •              reduced orders;

 

                •              additional warrantyand service expenses; and

 

                •              higher manufacturingcosts.

 

**We may face costly damages or litigation costs if a thirdparty claims that we infringe its intellectual property.**

 

                It is possible that thirdparties may claim that we or our current or potential future products infringeupon their intellectual property. Any claims, with or without merit, could betime consuming, result in costly litigation, cause product shipment delays orrequire us to enter into royalty or licensing agreements. Royalty or licensingagreements, if required, may not be available on terms acceptable to us or atall, which could seriously harm our business.

 

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

                We use hazardous chemicals in producingour products. As a result, we are subject to a variety of local, state andfederal governmental regulations relating to the storage, discharge, handling,emission, generation, manufacture and disposal of toxic or other hazardoussubstances used to manufacture our products, compliance with which isexpensive. Our failure to comply with current or future regulations couldresult in the imposition of substantial fines on us, suspension of production,alteration of our manufacturing processes or cessation of operations.

 

**We rely on our international and domestic salesrepresentatives, without whom our sales may suffer.**

 

                We sell our products in Japan,China and Korea through sales representatives. We also market and sell our HeatMirror products in North America primarily through sales representatives. Thesesales representatives could reduce or discontinue sales of our products. Theymay not devote the resources necessary to provide effective sales and marketingsupport to us. In addition, we depend upon the continued viability andfinancial resources of these representatives, many of which are smallorganizations with limited working capital. These representatives, in turn,depend substantially on general economic conditions and other factors affectingthe markets for the products they sell. We believe that our success willcontinue to depend upon these sales representatives. If some or all of oursales representatives experience financial difficulties, or otherwise becomeunable or unwilling to promote and sell our products, our business could beharmed.

 

**Poweroutages which currently impact companies with facilities in California mayadversely affect our California facilities.**

** **

**               **Part of our facilities are located in the State ofCalifornia, and we rely on a continuous power supply to conduct operations.California's current energy crisis could substantially disrupt our operationsand increase our expenses. In the event of an acute power shortage, that is,when power reserves for the State of California fall below 1.5%, California hason some occasions implemented, and may in the future continue to implement,rolling blackouts throughout the state. Blackouts could intermittently andtemporarily affect our ability to continue operations at our facilities. Furthermore,the deregulation of the energy industry instituted in 1996 by the Californiagovernment and shortages in wholesale electricity supplies have caused powerprices to increase. If wholesale prices continue to increase, our operatingexpenses will likely increase, which will have a negative effect on ouroperating results.

**Our stock price could fluctuate widely in response to variousfactors, many of which are beyond our control.**

 

                The trading price of our commonstock may be highly volatile. Our stock price could fluctuate widely inresponse to factors such as the following:

 

                •              actual or anticipatedvariations in our quarterly revenues or operating results;

 

                •              announcements of newproducts or services by us or our competitors, or new competing technologies;

 

                •              our addition or lossof significant customers;

 

                •              changes in financialestimates or recommendations by securities analysts;

 

                •              announcements by usof significant acquisitions or strategic partnerships;

 

                •              additions ordepartures of our key personnel;

 

                •              future equity or debtofferings by us or our announcements of such offerings; and

 

                •              general market andeconomic conditions.

 

                In addition, in recent years thestock markets in general, and the Nasdaq National Market and the market for technologycompanies in particular, have experienced large price and volume fluctuations.These fluctuations have often been seemingly unrelated or disproportionate tothe operating performance of these technology companies. These market andindustry factors may materially and adversely affect our stock price,regardless of our operating performance. In the past, securities class actionlitigation has often been brought against a company following periods ofvolatility in the market price of its stock. Securities litigation could resultin substantial costs or large judgments against us and divert management'sattention and resources.

 

**Recentaccounting pronouncements**

** **

**               **In October2001, the FASB issued Statement of Financial Accounting Standards No. 144("SFAS No. 144"), "Accounting for the impairment, or Disposal ofLong-Lived Assets" which required it to be applied starting with yearsbeginning after December 15, 2001. SFAS 144 requires, amongst other things, theapplication model for long-lived assets that are impaired, or to be disposed ofby sales. The adoption of SFAS 144 is not expected to have a significant impacton the Company's financial statements.

** **

**PART II OTHER INFORMATION**

 

**Item 1—LegalProceedings and Other Matters**

 

                Litigation filed against the Companywas described under Item 3 in the Company's Form 10-K/A filed onApril 11, 2001. Subsequent to such filing, the Company received finalapproval from the Court on the settlement of the shareholder in the amount of$4.2 million. The negotiated settlement was paid entirely by the Company’sinsurers. No other material developments have occurred with respect to thelitigation described therein. See Note 8 - Contingencies.

 

                In addition, the Company isinvolved in certain other legal actions arising in the ordinary course ofbusiness. The Company believes, however, that none of these actions, eitherindividually or in the aggregate, will have a material adverse effect on theCompany's business or its consolidated financial position or results ofoperations.

 

**Item 2—Changes in Securities**

 

                None

 

**Item 3—Defaultsupon Senior Securities**

 

                Not applicable

 

**Item 4—Submissionof Matters to a Vote of Stockholders**

 

                No matters were submitted to avote of security holders during the quarter ended September 30, 2001.

 

**Item 5—Other Information**

 

                Not applicable

 

**Item 6—Exhibitsand Reports on Form 8–K**

 

                (a)           Exhibits

 

**                    Exhibit**

**                    Number             Item**

 

                                10.96       Digeo, Inc. sublease agreement

 

                                10.97       Energy Conversion Devices note payable

 

                (b)           Reports on Form 8-K

 

                None

 

**SIGNATURES**

 

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

 

 

 
| Dated:  November 12, 2001 | Southwall  Technologies Inc |
|---------------------------|----------------------------------|
|                      |                             |   |
|                      | By:                              |   |
|                      |                             |   |
|                      |                             | /s/  Thomas G. Hood |
|                      |                             | Thomas  G. Hood |
|                      |                             | *President and Chief Executive Officer* |
|                      |                             |   |
|                      | By:                              |   |
|                      |                             |   |
|                      |                             | /s/  Robert R. Freeman |
|                      |                             | Robert  R. Freeman |
|                      |                             | *Senior Vice President and Chief Financial Officer* |