**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
  
 
 **FORM
        10-Q**
 **(MARK
        ONE)**
 x
              **QUARTERLY
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                  OF 1934**
  **For
        the quarterly period ended June 30, 2007**
 **or**
 o
              **TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                  OF 1934**
  **For
        the transition period from to**
  
 **Commission
        File Number: 0-15930**
  
 
 **SOUTHWALL
        TECHNOLOGIES INC.**
 (Exact
        name of registrant as specified in its charter)
 
 **Delaware**
              
              **94-2551470**(State
                  or other jurisdiction of incorporation or organization)
              
              (I.R.S.
                  Employer Identification Number)**3788
                  Fabian Way, Palo Alto, California**
              
              **94303**(Address
                  of principal executive offices)
              
              (Zip
                  Code)
 
  Registrant's
        telephone number, including area code:**(650) 798-1200**
  
  Indicate
        by check mark whether the
        registrant (1) has filed all reports required to be filed by
        Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
        preceding 12 months (or for such shorter period that the registrant was
        required to file such reports), and (2) has been subject to such filing
        requirements for the past 90 days. YesxNoo
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
        One).
 
 Large
                  accelerated filer  ̈
              
              Accelerated
                  filer  ̈
              
              Non-accelerated
                  filer x
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act).YesoNox
 
 As
        of
        August 7, 2007, there were 27,819,622 shares of the registrant's Common Stock
        outstanding.
  
 1
  **SOUTHWALL
          TECHNOLOGIES INC.**
 
 **INDEX**
 
 PagePART
                    I – FINANCIAL INFORMATIONItem
                    1
                
                Financial
                    StatementsUnaudited
                    Condensed Consolidated Balance Sheets – June 30, 2007
                    and December 31, 2006
                
                3Unaudited
                    Condensed Consolidated Statements of Operations –
                    Three and six month periods ended June 30, 2007 and June 30,
                    2006
                
                4Unaudited
                    Condensed Consolidated Statements of Cash Flows – Six
                    month periods ended June 30, 2007 and June 30, 2006
                
                5Notes
                    to the Unaudited Condensed Consolidated Financial
                    Statements
                
                6Item
                    2
                
                Management’s
                    Discussion and Analysis of Financial Condition and
                    Results of Operations
                
                13Item
                    3
                
                Quantitative
                    and Qualitative Disclosures about Market
                    Risk
                
                23Item
                    4T
                
                Controls
                    and Procedures
                
                24PART
                    II – OTHER INFORMATIONItem
                    1
                
                Legal
                    Proceedings
                
                25Item
                    1A
                
                Risk
                    Factors
                
                25Item
                    2
                
                Unregistered
                    Sales of Equity Securities and Use of
                    Proceeds
                
                25Item
                    3
                
                Defaults
                    upon Senior Securities
                
                25Item
                    4
                
                Submission
                    of Matters to a Vote of Security
                    Holders
                
                26Item
                    5
                
                Other
                    Information
                
                26Item
                    6
                
                Exhibits
                
                27Signatures
                
                28
  2
 *Index*
 
 PART I.
          FINANCIAL INFORMATION
 
 Item
          1--Financial Statements:
 **SOUTHWALL
          TECHNOLOGIES INC.**
 **UNAUDITED
          CONDENSED CONSOLIDATED BALANCE SHEETS**
 **(in
          thousands, except per share data)**
 
 June
                    30,
                
                
                December
                    31,2007
                
                
                2006**ASSETS**Current
                    assets:Cash
                    and cash equivalents
                
                $
                2,937
                
                
                $
                5,524Restricted
                    cash
                
                
                625
                
                
                
                209Accounts
                    receivable, net of allowance for doubtful accounts of $103 at
                    June 30,
                    2007 and $102 at December 31, 2006
                
                
                6,529
                
                
                
                3,608Inventories,
                    net
                
                
                6,107
                
                
                
                5,598Other
                    current assets
                
                
                809
                
                
                
                1,064Total
                    current assets
                
                
                17,007
                
                
                
                16,003Property,
                    plant and equipment, net
                
                
                16,720
                
                
                
                17,232Restricted
                    cash loans
                
                
                1,139
                
                
                
                1,111Other
                    assets
                
                
                1,321
                
                
                
                1,155Total
                    assets
                
                $
                36,187
                
                
                $
                35,501**LIABILITIES,
                    PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**Current
                    liabilities:Current
                    portion of long term debt
                
                $
                1,079
                
                
                $
                1,059Line
                    of credit
                
                
                3,000
                
                
                
                2,996Accounts
                    payable
                
                
                1,426
                
                
                
                955Accrued
                    compensation
                
                
                629
                
                
                
                859Government
                    grants advanced
                
                
                223
                
                
                
                -Other
                    accrued liabilities
                
                
                6,095
                
                
                
                6,448Total
                    current liabilities
                
                
                12,452
                
                
                
                12,317Term
                    debt
                
                
                8,214
                
                
                
                8,568Government
                    grants advanced
                
                
                -
                
                
                
                220Other
                    long term liabilities
                
                
                2,581
                
                
                
                2,550Total
                    liabilities
                
                
                23,247
                
                
                
                23,655Commitments
                    and contingencies (Note 5)Series
                    A 10% cumulative convertible preferred stock, $0.001 par value;
                    $1.00
                    stated value; 5,000 shares authorized, 4,893 shares outstanding
                    at June
                    30, 2007 and December 31, 2006, respectively (Liquidation preference:
                    $6,032 and $5,788 at June 30, 2007 and December 31, 2006,
                    respectively)
                
                
                4,810
                
                
                
                4,810Stockholders’
                    equity:Common
                    stock, $0.001 par value per share; 50,000 shares authorized,
                    27,513 shares
                    and 27,139 shares outstanding at June 30, 2007 and December 31,
                    2006,
                    respectively
                
                
                28
                
                
                
                27Capital
                    in excess of par value
                
                
                78,378
                
                
                
                78,081Accumulated
                    other comprehensive income:Accumulated
                    translation adjustment
                
                
                3,798
                
                
                
                3,696Accumulated
                    deficit
                
                
                (74,074
                )
                
                
                (74,768
                )Total
                    stockholders’ equity
                
                
                8,130
                
                
                
                7,036Total
                    liabilities, preferred stock and stockholders’ equity
                
                $
                36,187
                
                
                $
                35,501
  See
          accompanying notes to unaudited condensed consolidated financial
          statements.
 
 3
 *Index*
  **SOUTHWALL
          TECHNOLOGIES INC.**
 **UNAUDITED
          CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**
 **(in
          thousands, except per share data)**
  Three
                    months ended
                
                
                Six
                    months endedJune
                    30,
                
                
                June
                    30,
                
                
                June
                    30,
                
                
                June
                    30,2007
                
                
                2006
                
                
                2007
                
                
                2006Net
                    revenues
                
                $
                9,250
                
                
                $
                11,337
                
                
                $
                19,756
                
                
                $
                21,371Cost
                    of revenues
                
                
                6,507
                
                
                
                7,268
                
                
                
                12,603
                
                
                
                13,634Gross
                    profit
                
                
                2,743
                
                
                
                4,069
                
                
                
                7,153
                
                
                
                7,737Operating
                    expenses:Research
                    and development
                
                
                870
                
                
                
                2,071
                
                
                
                2,239
                
                
                
                3,717Selling,
                    general and administrative
                
                
                2,282
                
                
                
                2,525
                
                
                
                4,810
                
                
                
                5,087Impairment
                    charge (recoveries) for long-lived assets
                
                
                -
                
                
                
                208
                
                
                
                (8
                )
                
                
                208Restructuring
                    charges
                
                
                -
                
                
                
                259
                
                
                
                -
                
                
                
                711Total
                    operating expenses
                
                
                3,152
                
                
                
                5,063
                
                
                
                7,041
                
                
                
                9,723Income
                    (loss) from operations
                
                
                (409
                )
                
                
                (994
                )
                
                
                112
                
                
                
                (1,986
                )Interest
                    expense, net
                
                
                (167
                )
                
                
                (189
                )
                
                
                (280
                )
                
                
                (381
                )Other
                    income, net
                
                
                1,043
                
                
                
                29
                
                
                
                1,048
                
                
                
                179Income
                    (loss) before provision for income taxes
                
                
                467
                
                
                
                (1,154
                )
                
                
                880
                
                
                
                (2,188
                )Provision
                    for income taxes
                
                
                5
                
                
                
                233
                
                
                
                186
                
                
                
                526Net
                    income (loss)
                
                
                462
                
                
                
                (1,387
                )
                
                
                694
                
                
                
                (2,714
                )Deemed
                    dividend on preferred stock
                
                
                122
                
                
                
                122
                
                
                
                244
                
                
                
                244Net
                    income (loss) attributable to common stockholders
                
                $
                340
                
                
                $
                (1,509
                )
                
                $
                450
                
                
                $
                (2,958
                )Net
                    income (loss) per share:Basic
                
                $
                0.01
                
                
                $
                (0.06
                )
                
                $
                0.02
                
                
                $
                (0.11
                )Diluted
                
                $
                0.01
                
                
                $
                (0.06
                )
                
                $
                0.02
                
                
                $
                (0.11
                )Shares
                    used in computing net income (loss) per share:Basic
                
                
                27,513
                
                
                
                26,939
                
                
                
                27,327
                
                
                
                26,882Diluted
                
                
                28,498
                
                
                
                26,939
                
                
                
                28,033
                
                
                
                26,882
  See
          accompanying notes to unaudited condensed consolidated financial
          statements.
  4
 *Index*
  **SOUTHWALL
          TECHNOLOGIES INC.**
 **UNAUDITED
          CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(in
          thousands)**
  Six
                    months endedJune
                    30,
                
                
                June
                    30,2007
                
                
                2006Cash
                    flows from operating activities:Net
                    income (loss)
                
                $
                694
                
                
                $
                (2,714
                )Adjustments
                    to reconcile net income (loss) to net cash (used in) provided
                    by operating
                    activities:Deferred
                    income tax
                
                
                (66
                )
                
                
                61Impairment
                    charge (recoveries) from long-lived assets
                
                
                (8
                )
                
                
                208Depreciation
                    and amortization
                
                
                1,370
                
                
                
                1,124Stock
                    compensation
                
                
                185
                
                
                
                372Change
                    in assets and liabilities:Deferred
                    revenues
                
                
                (198
                )
                
                
                (16
                )Accounts
                    receivable, net
                
                
                (2,874
                )
                
                
                859Inventories,
                    net
                
                
                (509
                )
                
                
                812Other
                    current and non current assets
                
                
                142
                
                
                
                80Accrued
                    restructuring
                
                
                (60
                )
                
                
                83Accrued
                    liabilities—deferred rent
                
                
                -
                
                
                
                (1,192
                )Accounts
                    payable and accrued liabilities
                
                
                (56
                )
                
                
                (958
                )Net
                    cash used in  operating activities
                
                
                (1,380
                )
                
                
                (1,281
                )Cash
                    flows from investing activities:Restricted
                    cash
                
                
                (406
                )
                
                
                53Proceeds
                    from sale of property, plant and equipment
                
                
                8
                
                
                
                97Expenditures
                    for property, plant and equipment
                
                
                (438
                )
                
                
                (644
                )Net
                    cash used in investing activities
                
                
                (836
                )
                
                
                (494
                )Cash
                    flows from financing activities:Proceeds
                    from exercise of stock options
                
                
                357
                
                
                
                32Repayments
                    of notes payable
                
                
                (539
                )
                
                
                (697
                )Payments
                    on line of credit
                
                
                (2,996
                )
                
                
                -Borrowings
                    on line of credit
                
                
                3,000
                
                
                
                -Investment
                    credit in Germany
                
                
                (3
                )
                
                
                (84
                )Net
                    cash used in financing activities
                
                
                (181
                )
                
                
                (749
                )Effect
                    of foreign exchange rate changes on cash
                
                
                (190
                )
                
                
                135Net
                    decrease in cash and cash equivalents
                
                
                (2,587
                )
                
                
                (2,389
                )Cash
                    and cash equivalents, beginning of period
                
                
                5,524
                
                
                
                6,600Cash
                    and cash equivalents, end of period
                
                $
                2,937
                
                
                $
                4,211Supplemental
                    cash flow disclosures:Interest
                    paid
                
                $
                375
                
                
                $
                507Income
                    taxes paid
                
                $
                186
                
                
                $
                527Supplemental
                    schedule of non-cash investing and financing activities:Dividends
                    accrued
                
                $
                244
                
                
                $
                244
 
 See
          accompanying notes to unaudited condensed consolidated financial
          statements.
  5
 *Index*
  **SOUTHWALL
          TECHNOLOGIES INC.**
 **NOTES
          TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**
  **Note 1--Interim
          Period Reporting:**
 
 The
          accompanying interim condensed consolidated financial statements of Southwall
          Technologies Inc. (“Southwall” or the “Company”) are unaudited and have been
          prepared in accordance with accounting principles generally accepted in
          the
          United States of America for interim financial information and with the
          instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly,
          certain
          information and footnote disclosure normally included in financial statements
          prepared in accordance with accounting principles generally accepted in
          the
          United States of America have been condensed or omitted. In the opinion
          of
          management, the unaudited condensed consolidated financial statements reflect
          all adjustments, consisting only of normal recurring adjustments, considered
          necessary to present fairly the financial position, results of operations
          and
          cash flows of Southwall and its subsidiaries for all periods presented.
          The
          year-end condensed balance sheet data was derived from audited financial
          statements, but does not include all disclosures required by accounting
          principles generally accepted in the United States of America. The Company
          suggests that these condensed consolidated financial statements be read
          in
          conjunction with the consolidated financial statements and notes thereto
          contained in the Company's Form 10-K for the year ended December 31,
          2006 filed with the Securities and Exchange Commission on April 2, 2007.
          The
          results of operations for the interim periods presented are not necessarily
          indicative of the operating results of the full year.
 
 **Note 2—Inventories,
          Net:**
 
 Inventories
          are stated at the lower of cost (determined by the average method) or market.
          Cost includes materials, labor and manufacturing overhead. The Company
          establishes provisions for excess and obsolete inventories to reduce such
          inventories to their estimated net realizable value. Such provisions are
          charged
          to cost of revenues. At June 30, 2007 and December 31, 2006, inventories
          consisted of the following (in thousands):
 
 June
                    30,
                
                
                December
                    31,2007
                
                
                2006Raw
                    materials
                
                $
                3,001
                
                
                $
                3,850Work-in-process
                
                
                1,486
                
                
                
                221Finished
                    goods
                
                
                1,620
                
                
                
                1,527$
                6,107
                
                
                $
                5,598
 
 **Note 3--Net
          Income (Loss) Per Share:**
 
 Basic
          net
          income (loss) per share is computed by dividing net income (loss) attributable
          to common stockholders (numerator) by the weighted average number of common
          shares outstanding (denominator) for the period. Diluted net income (loss)
          per
          share gives effect to all dilutive common shares potentially outstanding
          during
          the period, including stock options, warrants to purchase common stock
          and
          convertible preferred stock. The
          Company excludes options from the computation of diluted weighted average
          shares
          outstanding if the exercise price of the options is greater than the average
          market price of the shares because the inclusion of these options would
          be
          anti-dilutive to earnings per share. The company also excludes preferred
          shares convertible into common stock from the computation of diluted weighted
          average shares outstanding per SFAS 128.
 
 In
          net
          loss periods, the basic and diluted weighted average shares of common stock
          and
          common stock equivalents are the same because inclusion of common stock
          equivalents would be anti-dilutive. For the second quarter of 2007, a net
          income
          period, there were 5,250 options outstanding of which 2,282 were excluded
          from
          the net income per share calculation as they were anti-dilutive because
          the
          option prices were higher than the average market value during the three-month
          period ended June 30, 2007.
  6
 *Index*
  The
          company had accrued a deemed dividend on preferred stock of $122 thousand
          and
          $244 thousand for the three and six-month periods ended June 30, 2007 and
          June
          30, 2006, respectively. Per SFAS 128, the dilutive effect of convertible
          securities shall be reflected in diluted EPS by application of the if-converted
          method. Under this method, if an entity has convertible preferred stock
          outstanding, the preferred dividends applicable to convertible preferred
          stock
          shall be added back to the numerator. Tables summarizing net income (loss)
          attributable to common stockholders, for diluted net income (loss) per
          share,
          and shares outstanding are shown below (in thousands):
 
 Three
                    months ended
                
                
                Six
                    months endedJune
                    30,
                
                
                June
                    30,
                
                
                June
                    30,
                
                
                June
                    30,2007
                
                
                2006
                
                
                2007
                
                
                2006Net
                    income (loss) attributable to common stockholders-basic
                
                $
                340
                
                
                $
                (1,509
                )
                
                $
                450
                
                
                $
                (2,958
                )Add:  Deemed
                    dividend on preferred stock
                
                
                122
                
                
                
                122
                
                
                
                244
                
                
                
                244Net
                    income (loss) attributable to common stockholders-diluted
                
                $
                462
                
                
                $
                (1,387
                )
                
                $
                694
                
                
                $
                (2,714
                )Weighted
                    average common shares outstanding-basic
                
                
                27,513
                
                
                
                26,939
                
                
                
                27,327
                
                
                
                26,882Dilutive
                    effect of warrants
                
                
                985
                
                
                
                -
                
                
                
                706
                
                
                
                -Dilutive
                    effect of performance shares
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Dilutive
                    effect of Series A preferred shares
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Dilutive
                    effect of stock options
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Weighted
                    average common shares outstanding - diluted
                
                
                28,498
                
                
                
                26,939
                
                
                
                28,033
                
                
                
                26,882
 
 **Note 4
          - Segment Reporting:**
 
 Southwall
          operates in one segment.
 
 The
          total
          net revenues for the automotive glass, electronic display, window film
          and
          architectural product lines for the three and six-month periods ended June
          30,
          2007 and June 30, 2006 were as follows (in thousands):
  Three
                    months ended
                
                
                Six
                    months endedJune
                    30,
                
                
                June
                    30,
                
                
                June
                    30,
                
                
                June
                    30,2007
                
                
                2006
                
                
                2007
                
                
                2006Automotive
                    glass
                
                $
                3,532
                
                
                $
                3,828
                
                
                $
                7,399
                
                
                $
                6,707Electronic
                    display
                
                
                442
                
                
                
                3,270
                
                
                
                2,551
                
                
                
                5,761Window
                    film
                
                
                3,600
                
                
                
                3,004
                
                
                
                6,593
                
                
                
                6,456Architectural
                
                
                1,676
                
                
                
                1,235
                
                
                
                3,213
                
                
                
                2,447Total
                    net revenues
                
                $
                9,250
                
                
                $
                11,337
                
                
                $
                19,756
                
                
                $
                21,371
 
 The
          following is a summary of net revenues by geographic area (based on the
          location
          of the Company's customers) for the three and six-month periods ended June
          30,
          2007 and June 30, 2006, respectively (in thousands):
  7
 *Index*
  Three
                    months ended
                
                
                Six
                    months endedJune
                    30,
                
                
                June
                    30,
                
                
                June
                    30,
                
                
                June
                    30,2007
                
                
                2006
                
                
                2007
                
                
                2006United
                    States
                
                $
                2,570
                
                
                $
                3,532
                
                
                $
                4,944
                
                
                $
                7,179Japan
                
                
                486
                
                
                
                3,201
                
                
                
                2,558
                
                
                
                5,309France
                
                
                1,079
                
                
                
                1,286
                
                
                
                2,163
                
                
                
                1,428Pacific
                    Rim
                
                
                2,253
                
                
                
                1,786
                
                
                
                4,874
                
                
                
                4,701Germany
                
                
                893
                
                
                
                1,166
                
                
                
                1,963
                
                
                
                1,945Rest
                    of the world
                
                
                1,969
                
                
                
                366
                
                
                
                3,254
                
                
                
                809Total
                    net revenues
                
                $
                9,250
                
                
                $
                11,337
                
                
                $
                19,756
                
                
                $
                21,371
 
 **Note 5--Commitments
          and Contingencies:**
 
 *Commitments*
 
 On
          January 19, 2006, we commenced restructuring actions with the intention
          of
          improving our cost structure for 2006 and beyond. These actions have included
          the closure of our Palo Alto, California manufacturing facility and a reduction
          in force at our Palo Alto site during the first half of 2006. We accrued
          $1.5
          million in third quarter of 2006 as a leasehold asset retirement obligation
          in
          connection with this plan.
 
 On
          February 19, 2004, the Company entered into the second amendment to the
          lease
          for one of its Palo Alto, California facilities. The amendment reflected
          a
          payment schedule for a rent deferral for this lease agreement. In January
          of
          2006, the Company paid off approximately $1.2 million in deferred rent.
          As of
          June 30, 2007, there was no deferred rent outstanding.
 
 *Contingencies*
 
 The
          insurance carriers in some of the litigation related to alleged product
          failures
          and defects in window products manufactured by others in which the Company
          was a
          defendant in the past paid the defense and settlement costs related to
          such
          litigation. Those insurance carriers reserved their rights to recover a
          portion
          or all of such payments from the Company. As a result, those insurance
          carriers
          could seek from us up to an aggregate of $12.9 million plus defense costs,
          although any such recovery would be restricted to claims that were not
          covered
          by the Company’s insurance policies.  In the case where the insurance
          carriers might seek reimbursement, the Company would vigorously defend
          any
          attempts by these insurance carriers to seek reimbursement. The Company
          is not
          able to estimate the likelihood that these insurance carriers will seek
          to
          recover any such payments, the amount, if any, they might seek, or the
          outcome
          of such attempts.
 
 In
          addition, the Company is involved in certain other legal actions arising
          in the
          ordinary course of business. The Company believes, however, that none of
          these
          actions, either individually or in the aggregate, will have a material
          adverse
          effect on its business, consolidated financial position, results of operations
          or cash flows.
 
 **Note 6--Stock-Based
          Compensation:**
 
 The
          Company has a stock-based compensation program that provides its Board
          of
          Directors broad discretion in creating employee equity incentives. The
          Company
          has granted stock options under various option plans and agreements in
          the past
          and currently grants stock options under the 1997 Stock Incentive Plan
          and the
          1998 Stock Option Plan for employees, board members and consultants. The
          Board
          of Directors adopted the 1998 Stock Option Plans on August 6, 1998. The
          Compensation Committee of the Board of Directors administers the plans
          and
          agreements. The exercise price of options granted under the 1997 and 1998
          plans
          must be at least 85% of the fair market value of the stock at the date
          of grant.
          Options granted under the 1998 plan prior to October 2004 generally vest
          at a
          rate of 25% per year, are non-transferable and expire over terms not exceeding
          ten years from the date of grant or three months after the optionee terminates
          his relationship with the Company. Options granted under the 1997 plan
          prior to
          October 2004 generally vest at a rate of 25% per year, are non-transferable
          and
          expire over terms not exceeding ten years from the date of grant or eighteen
          months after the optionee terminates his relationship with the Company.
          In
          October 2004, the board of directors changed the vesting. Grants from and
          after
          October 2004 under both plans vest at a rate of 25% after six months and
          then
          evenly monthly thereafter for the remaining 42 months. In March 1997 the
          Company
          adopted the 1997 Employee Stock Purchase Plan (“ESPP”) under the terms of the
          ESPP, employees, subject to certain limitations, may purchase shares at
          85% of
          the lower of the fair market value of the Common Stock at the beginning
          of the
          six-month offering period, or the last day of the purchase period. As of
          June
          30, 2007, the Company had approximately 10,103 shares of common stock reserved
          for future issuance under these stock option plans. On May 24, 2007 the
          Company’s Shareholders approved the Company’s 2007 Long Term Incentive Plan
          which authorizes the granting of up to 10 million shares of Common
          Stock.
  8
 *Index*
  On
          January 1, 2006, the Company adopted the provisions of SFAS 123R, “Shared-Based
          Payment” (SFAS 123R), requiring it to recognize expense related to the fair
          value of its stock-based compensation awards. The Company elected to use
          the
          modified prospective transition method as permitted by SFAS 123R and therefore
          has not restated its financial results for prior periods. Under this transition
          method, stock-based compensation expense for the three and six-month periods
          ended June 30, 2007 and June 30, 2006 includes compensation expense for
          all
          stock-based compensation awards granted prior to, but not yet vested as
          of
          January 1, 2006, based on the grant date fair value estimated in accordance
          with
          the original provisions of SFAS 123. Stock-based compensation expense for
          all
          stock-based compensation awards granted subsequent to January 1, 2006 was
          based
          on the grant-date fair value estimated in accordance with the provisions
          of SFAS
          123R. The Company recognized compensation expense for stock option awards
          on a
          graded vesting basis over the requisite service period of the
          award.
 
 The
          following table sets forth the total stock-based compensation expense resulting
          from stock options included in the condensed consolidated statements of
          operations (in thousands):
 
 Three
                    months ended
                
                
                Six
                    months endedJune
                    30,
                
                
                June
                    30,
                
                
                June
                    30,
                
                
                June
                    30,2007
                
                
                2006
                
                
                2007
                
                
                2006Cost
                    of sales
                
                $
                1
                
                
                $
                -
                
                
                $
                2
                
                
                $
                11Research
                    and development
                
                
                18
                
                
                
                34
                
                
                
                45
                
                
                
                88Selling,
                    general and administrative
                
                
                53
                
                
                
                78
                
                
                
                138
                
                
                
                240Stock-based
                    compensation expense before income taxes
                
                
                72
                
                
                
                112
                
                
                
                185
                
                
                
                339Income
                    tax benefit
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Total
                    stock-based compensation  expense after income
                    taxes
                
                $
                72
                
                
                $
                112
                
                
                $
                185
                
                
                $
                339
 
 There
          were $357 thousand and $32 thousand cash proceeds from the exercise of
          stock
          options for the six-month period ended June 30, 2007 and June 30, 2006.
          No
          income tax benefit was realized from stock option exercises during the
          six-month
          periods ended June 30, 2007, and June 30, 2006. In accordance with SFAS
          123R,
          the Company presents excess tax benefits from the exercise of stock options,
          if
          any, as financing cash flows rather than operating cash flows.
  The
          fair
          value of stock-based awards was estimated using the Black-Scholes model
          with the
          following weighted-average assumptions for the three and six-month periods
          ended
          June 30, 2007, and June 30, 2006, respectively:
 
 Three
                    months ended
                
                
                Six
                    months endedJune
                    30,
                
                
                June
                    30,
                
                
                June
                    30,
                
                
                June
                    30,2007
                
                
                2006
                
                
                2007
                
                
                2006Expected
                    life (in years)
                
                
                -
                
                
                
                2.58
                
                
                
                6.00
                
                
                
                2.40Risk-free
                    interest rate
                
                
                -
                
                
                
                4.98
                %
                
                
                4.71
                %
                
                
                4.88
                %Volatility
                
                
                -
                
                
                
                109
                %
                
                
                80
                %
                
                
                109
                %Dividend
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Weighted-average
                    fair value at grant date
                
                $
                -
                
                
                $
                0.44
                
                
                $
                0.33
                
                
                $
                0.42
  9
 *Index*
  The
          Company’s computation of expected volatility was based on historical volatility.
          The Company’s computation of expected life was based on historical exercise
          patterns. The interest rate for periods within the expected life of the
          award is
          based on the U.S. Treasury yield in effect at the time of grant.
 
 Stock
          option activity for the six months ended June 30, 2007 was as follows (in
          thousands, except per share amounts):
 
 Shares
                
                
                Weighted-Average
                  Exercise
                    Price
                
                
                Weighted-Average
                  Remaining
                  Contractual
                    Term
                  (in
                    years)
                
                
                Aggregate
                  Intrinsic
                    ValueOutstanding
                    at December 31, 2006
                
                
                5,837
                
                
                $
                1.28Grants
                
                
                1,333
                
                
                
                0.47Exercises
                
                
                (678
                )
                
                
                0.53Forfeitures
                    or expirations
                
                
                (1,242
                )
                
                
                1.47Outstanding
                    at June 30, 2007
                
                
                5,250
                
                
                $
                1.13
                
                
                
                7.38
                
                
                $
                1,865Vested
                    and expected to vest at June 30, 2007
                
                
                4,579
                
                
                $
                1.21
                
                
                
                7.11
                
                
                $
                1,495Exercisable
                    at June 30, 2007
                
                
                3,050
                
                
                $
                1.52
                
                
                
                6.24
                
                
                $
                724
 
 The
          aggregate intrinsic value in the table above represents the total pretax
          intrinsic value (i.e., the difference between Southwall’s closing stock price on
          the last trading day of its second quarter of fiscal 2007 and the exercise
          price, times the number of shares) that would have been received by the
          option
          holders had all option holders exercised their options on June 30, 2007.
          This
          amount changes based on the fair market value of Southwall’s stock. Total
          intrinsic value of options exercised was immaterial for the three and six-month
          periods ended June 30, 2007. Total fair value of options granted is $0.0
          million
          and $0.4 million for the three and six-month periods ended June 30, 2007,
          respectively.
  As
          of
          June 30, 2007, $0.9 million of total unrecognized compensation cost related
          to
          stock options was expected to be recognized over a weighted-average period
          of
          approximately 1.63 years.
 
 **Note
          7 - Restructuring:**
 
 On
          January 19, 2006, we commenced restructuring actions to improve our cost
          structure. These actions include the closure of our Palo Alto, California
          manufacturing facility and a reduction in force at our Palo Alto site in
          the
          first half of 2006. As a result of these actions, we incurred a restructuring
          charge of $0.7 million during the first half of 2006 relating to employee
          severance packages, and related charges.
 
 In
          December 2002, we implemented a reduction in force at our Palo Alto
          location and elected to vacate certain buildings in Palo Alto. As a result
          of these actions, we incurred a restructuring charge of $2.6 million in
          2002
          relating to employee severance packages and the remaining rents due on
          excess
          facilities in Palo Alto that we no longer occupy.
  The
          following tables set forth the beginning and ending liability balances
          relating
          to the above described restructuring activities as well as activity during
          the
          six month periods endedJune 30, 2007 and
          June 30,
          2006 (in thousands):
 
 Restructuring
                
                
                RestructuringPlan
                    2006
                
                
                Plan
                    2002Severance
                
                
                Facilitiesand
                
                
                Related
                
                
                FacilitiesBenefits
                
                
                and
                    Other
                
                
                Related
                
                
                TotalBalance
                    at December 31, 2005
                
                $
                -
                
                
                $
                -
                
                
                $
                199
                
                
                $
                199Provisions
                
                
                375
                
                
                
                359
                
                
                
                -
                
                
                
                734Adjustment
                    to reserve
                
                
                -
                
                
                
                (23
                )
                
                
                -
                
                
                
                (23
                )Cash
                    payments
                
                
                (314
                )
                
                
                (262
                )
                
                
                (53
                )
                
                
                (629
                )Balance
                    at June 30, 2006
                
                $
                61
                
                
                $
                74
                
                
                $
                146
                
                
                $
                281
 
 10
 *Index*
 
 Severance
                
                
                Facilitiesand
                
                
                Related
                
                
                FacilitiesBenefits
                
                
                and
                    Other
                
                
                Related
                
                
                TotalBalance
                    at December 31, 2006
                
                $
                19
                
                
                $
                9
                
                
                $
                93
                
                
                $
                121Provisions
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Adjustment
                    to reserve
                
                
                -
                
                
                
                (2
                )
                
                
                -
                
                
                
                (2
                )Cash
                    payments
                
                
                -
                
                
                
                (7
                )
                
                
                (52
                )
                
                
                (59
                )Balance
                    at June 30, 2007
                
                $
                19
                
                
                $
                0
                
                
                $
                41
                
                
                $
                60
 
 At
          June
          30, 2007, $0.06 million was included in other accrued liabilities in the
          condensed consolidated balance sheet.
 
 **Note
          8 - Guarantees:**
 
 The
          Company establishes a reserve for sales returns and warranties for specifically
          identified, as well as anticipated sales returns and warranties based on
          experience. The activity in the reserve for sales returns and warranties
          account
          during the six month periods ended June 30, 2007 and June 30, 2006 was
          as
          follows (in thousands):
 
 Balance
                    at
                  December
                    31,
                  2005
                
                
                Provision
                
                
                Utilized
                
                
                Balance
                    at
                  June
                    30,
                  2006Accrued
                    sales returns and warranty
                
                $
                1,556
                
                
                $
                (68
                )
                
                $
                (333
                )
                
                $
                1,155
 
 
 Balance
                    at December 31,
                  2006
                
                
                Provision
                
                
                Utilized
                
                
                Balance
                    at
                  June
                    30,
                  2007Accrued
                    sales returns and warranty
                
                $
                1,415
                
                
                $
                844
                
                
                $
                (1,349
                )
                
                $
                910
  These
          amounts are included in other accrued liabilities in the condensed consolidated
          balance sheets.
 
 **Note
          9 – Comprehensive Income (Loss):**
 
 The
          Company has adopted the provisions of SFAS No. 130 "Reporting Comprehensive
          Income". SFAS 130 establishes standards for reporting and display in the
          financial statements of total net income (loss) and the components of all
          other
          non-owner changes in equity, referred to as comprehensive income (loss).
          Accordingly, the Company has reported the translation gain (loss) from
          the
          consolidation of its foreign subsidiary in comprehensive income
          (loss).
 
 The
          components of comprehensive income (loss) for the three and six-month periods
          ended June 30, 2007 and June 30, 2006 were as follows (in
          thousands):
 
 Three
                    months ended
                
                
                Six
                    months endedJune
                    30,
                
                
                June
                    30,
                
                
                June
                    30,
                
                
                June
                    30,2007
                
                
                2006
                
                
                2007
                
                
                2006Foreign
                    Currency Translation Adjustment
                
                $
                85
                
                
                $
                521
                
                
                $
                102
                
                
                $
                845Net
                    Income (Loss)
                
                
                462
                
                
                
                (1,387
                )
                
                
                694
                
                
                
                (2,714
                )Other
                    Comprehensive Income (Loss)
                
                $
                547
                
                
                $
                (866
                )
                
                $
                796
                
                
                $
                (1,869
                )
  11
 *Index*
  The
          components of accumulated other comprehensive income were as follows at
          June 30,
          2007 (in thousands):
 
 Accumulated
                    Other Comprehensive Income at December 31, 2006
                
                $
                3,696Foreign
                    Currency Translation Adjustment
                
                
                102Accumulated
                    Other Comprehensive Income at June 30, 2007
                
                $
                3,798
  **Note
          10 – Recent Accounting Pronouncements:**
 
 In
          June
          2006, the Financial Accounting Standards Board issued Interpretation No.
          48,
“Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement
          No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income
          taxes recognized in an enterprise’s financial statements in accordance with SFAS
          109. It prescribes a recognition threshold and measurement attribute for
          the
          financial statements recognition and measurement of a tax taken or expected
          to
          be taken in a tax return. FIN 48 also provides guidance on derecognition,
          classification, interest and penalties, accounting in interim periods and
          disclosures. We adopted FIN 48 on January 1, 2007. The impact of FIN 48
          did not
          have a material effect on our financial statements.
 
 In
          September 2006, the Financial Accounting Standards Board (“FASB”) issued
          Statement of Financial Accounting Standards No. 157, “Fair Value Measurements”
(“SFAS 157”). This statement defines fair value, establishes a framework for
          measuring fair value in generally accepted accounting principles and expands
          disclosures about fair value measurements. SFAS 157 is effective for financial
          statements issued for fiscal years beginning after November 15, 2007, and
          interim periods within those fiscal years. We are currently evaluating
          the
          effect that the adoption of SFAS 157 will have on our financial position
          and
          results of operations.
 
 On
          September 13, 2006, the Securities and Exchange Commission (“SEC”) issued Staff
          Accounting Bulletin No. 108 (“SAB 108”). The interpretations in SAB 108 were
          issued to address diversity in practice in quantifying financial statement
          misstatement and the potential under current practice for the build up
          of  improper amounts on the balance sheet. The adoption of SAB 108 did
          not have a significant impact on our position and results of operations
          in the
          second quarter of 2007.
 
 In
          February 2007, the Financial Accounting Standards Board (“FASB”) issued
          Statement of Financial Accounting Standards No. 159, “The Fair Value Option for
          Financial Assets and Financial Liabilities-Including an amendment of FASB
          Statement No. 115” (“SFAS 159”). The objective of this statement is to improve
          financial reporting by providing entities with the opportunity to mitigate
          volatility in reported earnings caused by measuring related assets and
          liabilities differently without having to apply complex hedge accounting
          provisions. SFAS 159 is effective as of the beginning of an entity’s first
          fiscal year that begins after November 15, 2007. We are currently evaluating
          the
          effect that the adoption of SFAS 159 will have on our financial positions
          and
          results of operations.
 
 In
          addition, the Company is reviewing the Emerging Issues Task Force 06-03
          (“EITF
          06-03”) issued in June 2006, effective to financial reporting for interim and
          annual reporting periods beginning after December 15, 2006. This EITF applies
          to
          taxes assessed by various governmental authorities on many different types
          of
          transactions. These taxes range from sales taxes that are applied to a
          broad
          class of transactions involving a wide range of goods and services to excise
          taxes that are applied only to specific types of transactions or items.
          We are
          currently evaluating the effect that the adoption of EITF 06-3 will have
          on our
          financial position and results of operations.
  12
 *Index*
  **Item
          2--Management's Discussion and Analysis of Financial Condition
          and Results of Operations:**
 
 The
          following discussion and analysis of our financial condition and results
          of
          operations should be read in conjunction with our unaudited condensed
          consolidated financial statements and notes thereto appearing elsewhere
          in this
          report. This discussion and analysis contains forward-looking statements
          that
          involve risks and uncertainties, including those discussed below under
          "Forward-Looking Statements" and "Risk Factors”, set forth in Part I, Item 1A,
          and in our Annual Report on Form 10-K for the year ended December 31,
          2006 and in Part II, Item 1A of our Quarterly Report on Form 10-Q for the
          quarter ended March 31, 2007. You should not place undue reliance on these
          forward-looking statements. Actual results may differ materially from those
          anticipated in the forward-looking statements. These forward-looking statements
          represent our judgment as of the date of the filing of this
          Form 10-Q.
 
 **Forward
          Looking Statements**
 
 Certain
          statements contained in this section, in quantitative and Qualitative Disclosure
          About Market Risk and elsewhere in this report are intended to be covered
          by the
          Safe Harbor provided for under Section 27A of the Securities Act of 1933,
          as amended, and Section 21E of the Securities Act of 1934, as amended.
          This
          Quarterly Report contains forward-looking statements, which are subject
          to a
          number of risks and uncertainties. All statements other than statements
          of
          historical facts are forward-looking statements. These statements are identified
          by terminology such as but not limited to "may," "will," "could," "should,"
          "expects," "plans," "intends," "seeks," "anticipates," "believes," "estimates,"
          "potential," or "continue," or the negative of such terms or other comparable
          terminology, although not all forward-looking statements contain these
          identifying words. Forward-looking statements are only predictions and
          include
          statements relating to:
 
 ·
                our
                    ability to remain as a going
                    concern;
  ·
                our
                    strategy, future operations and financial plans, including, without
                    limitation, our plans to install and commercially produce products
                    on new
                    machines;
  ·
                the
                    success of our restructuring activities and our expectations
                    as to expense
                    reductions;
  ·
                the
                    continued trading of our common stock on the Over-the-Counter
                    Bulletin
                    Board;
  ·
                our
                    projected need for, and ability to obtain, additional borrowings
                    and our
                    future liquidity;
  ·
                future
                    applications of thin-film technologies and our development of
                    new
                    products;
  ·
                our
                    competition;
  ·
                statements
                    about the future size of markets;
  ·
                our
                    expectations with respect to future grants, investment allowances
                    and bank
                    guarantees from the Saxony
                    government;
  ·
                our
                    expected results of operations and cash
                    flows;
  ·
                pending
                    and threatened litigation and its outcome;
                    and
  ·
                Our
                    projected capital expenditures.
  You
          should not place undue reliance on our forward-looking statements. Actual
          events
          or results may differ materially. In evaluating these statements, you should
          specifically consider various factors, including the risks outlined below
          under
          "Risk Factors" and under “Risk Factors” in our 2006 Form 10-K and in our Form
          10-Q for the first quarter of 2007. These factors may cause our actual
          results
          to differ materially from any forward-looking statement. Although we believe
          the
          expectations reflected in our forward-looking statements are reasonable
          as of
          the date they are being made, we cannot guarantee our future results, levels
          of
          activity, performance, or achievements. Moreover, neither we, nor any other
          person, assume responsibility for the future accuracy and completeness
          of these
          forward-looking statements.
  13
 *Index*
  **Overview**
 
 We
          are a
          global developer, manufacturer and marketer of thin film coatings on flexible
          substrates for the automotive glass, electronic display, architectural
          glass and
          window film markets. We have developed a variety of products that control
          sunlight in automotive glass, reduce light reflection, reduce electromagnetic
          radiation and improve image quality in electronic display products and
          conserve
          energy in architectural products. Our products consist of transparent
          solar-control films for automotive glass; transparent conductive films
          for use
          in touch screen, liquid crystal displays and plasma displays; energy control
          films for architectural glass; and various other coatings.
  *Restructuring
          and financing activities.* As a consequence of the decline in our revenues
          and negative cash flows in 2003, we implemented several cost cutting and
          business restructuring activities during 2003 and 2004. These activities,
          which
          included employee layoffs and the closure of several facilities (including
          the
          closure of our Tempe manufacturing facility in the fourth quarter of 2003),
          were
          designed to improve our cash flow from operations to allow us to continue
          as a
          going concern. During the fourth quarter of 2003 and the first quarter
          of 2004,
          we agreed to new payment terms with all of our major creditors and vendors,
          which extended or reduced our payment obligations. We also issued $4.5
          million
          of convertible promissory notes and warrants to investors. The convertible
          promissory notes were converted to Series A preferred shares and the warrants
          were exercised for shares of common stock in the fourth quarter of 2004.
          In
          January 2006, we commenced further restructuring actions to improve our
          cost
          structure for 2006 and beyond. These actions included the closure of our
          Palo
          Alto, California manufacturing facility and a reduction in force at our
          Palo
          Alto site in the first half of 2006. Also during the first half of 2006,
          we
          transferred our U.S. manufacturing operations to the European site located
          near
          Dresden, Germany. As a result of these actions, we incurred a restructuring
          charge of $0.9 million in 2006 relating to employee severance packages
          and
          facility related charges (see Note 7 of Notes to Unaudited Condensed
          Consolidated Financial Statements—Restructuring).
 
 *Demand
          for our customers' products.* We derive significant benefits from our
          relationships with a few large customers and suppliers. Our revenues and
          gross
          profit can increase or decrease rapidly, reflecting underlying demand for
          the
          products of one or a small number of our customers. We may also be unable
          to
          replace a customer when a relationship ends or demand for our product declines
          as a result of evolution of our customers' products.
 
 Our
          three
          largest customers in the automotive glass and window film markets include
          Pilkington PLC, Saint Gobain Sekurit and Globamatrix Holdings Pte. Ltd., or
          Globamatrix, which collectively accounted for approximately 63%, 47% and
          54% of
          our total revenues during the first six months of 2007, fiscal year 2006
          and
          fiscal year 2005, respectively.
 
 Under
          our
          agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
          purchase commitment of $9.0 million of product**.** For each year
          after 2004 through and including 2011, Globamatrix is required to purchase
          an
          amount of product equal to 110% of the amount of product it was required
          to
          purchase in the prior year. Globamatrix is obligated to purchase $12.0
          million
          of certain products in 2007. During the first six months of 2007, Globamatrix
          purchased approximately $6.9 million of these products.
 
 *Sales
          returns and allowances.* Our gross margins and profitability have been
          adversely affected from time to time by product quality
          claims.  During the first six months of 2007, our sales returns
          provision has averaged approximately 4.6% of our gross revenues due to
          higher
          quality claims received during the period.   From 2002 to 2006,
          our sales returns provision has averaged approximately 1.7% to 4.5% of
          gross
          revenues.
 
  14
 *Index*
  **Critical
          Accounting Policies and Estimates**
 
 The
          accompanying discussion and analysis of our financial condition and results
          of
          operations are based upon our condensed consolidated financial statements,
          which
          have been prepared in accordance with generally accepted accounting principles
          in the United States (U.S. GAAP). The preparation of these financial statements
          requires us to make estimates and judgments that affect the reported amounts
          of
          assets, liabilities, revenues and expenses, and related disclosure of contingent
          assets and liabilities. These estimates form the basis for making judgments
          about the carrying values of assets and liabilities that are not readily
          apparent from other sources. We base our estimates and judgments on historical
          experience and on various other assumptions that we believe are reasonable
          under
          the circumstances. However, future events cannot be forecasted with certainty,
          and the best estimates and judgments routinely require adjustment. We are
          required to make estimates and judgments in many areas, including those
          related
          to revenue recognition, allowance for doubtful accounts and sales returns,
          valuation of inventories, assessment of probability of the outcome of current
          litigation, restructuring costs, stock-based compensation expense, impairment
          charge for long-lived assets and accounting for income taxes. We believe
          the
          policies disclosed are the most critical to our financial statements because
          their application places the most significant demands on management’s judgment.
          Senior management has discussed the development, selection and disclosure
          of
          these estimates with the Audit Committee of our Board of Directors.
 
 We
          believe there have been no significant changes during the first six months
          of
          fiscal 2007 to the items that we disclosed as our critical accounting policies
          and estimates in our discussion and analysis of financial condition and
          results
          of operations in our 2006 Form 10-K, except as noted below.
 
 *Stock
          Based Compensation Expense*
 
 We
          account for stock-based compensation in accordance with the provisions
          of SFAS
          123R. Under the fair value recognition provisions of SFAS 123R, stock based
          compensation cost is estimated at the grant date based on the fair value
          of the
          award and is recognized as expense ratably over the requisite service period
          of
          the award. Determining the appropriate fair value model and calculating
          the fair
          value of stock-based awards requires judgment, including estimating stock
          price
          volatility, forfeiture rates and expected lives.
 
 **Three
          Months Ended June 30, 2007 compared with Three Months Ended June 30,
          2006**
 
 **Results
          of Operations**
 
 *Net
          revenues.*Our net revenues for the second quarter ended June 30, 2007 and
          June 30, 2006 were $9.250 million and $11.337 million, respectively. The
          largest
          component of the revenue decline was reduced demand for our electronic
          display
          products and to a lesser degree our automotive glass products. Revenues
          increased from our window film and architectural products.
 
 Our
          net
          revenues from our electronic display products decreased by $2.818 million,
          86.4%, to $0.442 million  compared to $3.260 million for the second
          quarter ended June 30, 2007 and 2006 respectively.  This decrease was
          due to the decreased demand from our major display product customer as
          a result
          of price sensitivity in the electronic display industry.  Due to the
          competitive nature of pricing in this market, going forward we expect to
          see
          significantly decreased revenues from our electronic display product line
          compared to fiscal 2006.  In 2006 our electronic display business
          comprised approximately 25% of our total sales.
 
 Our
          net
          revenues in the automotive market decreased by $.295 million, 7.7%, to
          $3.532
          million compared to $3.827 million for the second quarter ended June 30,
          2007
          and 2006 respectively. The decrease was primarily due to a reduction in
          demand
          in 2007 as a result of the ongoing “de-contenting” (a change by auto
          manufacturers to make the parts in which our products are found optional
          features rather than standard features to control their costs) trend in
          the
          automotive industry, partially offset by increases from some of our Automotive
          Replacement Glass customers.
 15
 *Index*
  Our
          net
          revenues in the window film product line increased by $0.596 million, 19.8%,
          to
          $3.600 million compared to $3.004 million in the second quarter ended June
          30,
          2007 and 2006 respectively.  This increase was primary due to an
          increased demand under the Globamatrix contract.
 
 Our
          net
          revenues in architectural products increased by $0.441 million, 35.7%,
          to $1.676
          million compared to $1.235 million for the second quarter ended June 30,
          2007
          and 2006 respectively.  This increase is due to strengthening demand
          for our solar control and insulting glass products worldwide.
 
 *Cost
          of revenues.* Cost of revenues consists of materials and subcontractor
          services, labor and manufacturing overhead. Cost of revenues was $6.507
          million
          in the second quarter ended June 30, 2007 compared to $7.268 million in
          the same
          period of 2006.  The decrease in cost of revenues was primarily due to
          lower revenues and transfer of production to our lower cost German manufacturing
          facility, and was partially offset by inventory reserves for the window
          film
          products.
 
 *Gross
          profit and gross margin.* Our gross profit decreased $1.326 million to
          $2.743 million compared to $4.069 million for the second quarter ended
          June 30,
          2007 and 2006 respectively.  As a percentage of sales, gross profit
          decreased to 29.7% compared to 35.9% for the second quarter ended June
          30, 2007
          and 2006 respectively. This was primarily due to the lower sales volumes
          and an
          increase in inventory reserves for the window film products as a result
          of a
          quality and yield issue at one of our subcontractors.
 
 *Operating
          expenses*
  *Research
          and development*. Research and development expenses decreased $1.201 million
          to $0.870 million compared to $2.071 million for the second quarter ended
          June
          30, 2007 and 2006 respectively. The 58% decrease from year to year was
          due
          primarily to the timing of test runs in the second quarter of 2007 compared
          to
          the same period last year and the consumption of the associated
          materials.  Also the decrease is partially due to lower labor and
          employee benefit costs, due to a workforce reduction and the resignation
          of our
          Chief Technology Officer effective April 2, 2007.  We do not intend to
          replace this position in the near future as we believe our current R&D staff
          is sufficient for our R&D needs.  We expect expenditures relating
          to research and development for the remainder of 2007 to be slightly higher
          in
          the second half of 2007 as compared with the first half of 2007.  In
          the second quarter of 2007 we delivered the first order for a new class
          of
          window film, which we believe, will strengthen our window film
          line.
 
 *Selling,
          general and administrative*. Selling, general and administrative expenses
          consist primarily of corporate and administrative overhead, selling commissions
          and occupancy costs. Selling, general and administrative expenses decreased
          $0.243 million to $2.282 million compared to $2.525 million for the second
          quarter ended June 30, 2007 and 2006 respectively.  This decrease was
          primarily due to the transitioning of the Vice President of Business Development
          and our Managing Director of Southwall Europe to Sunfilm AG in April 2007,
          partially offset by the promotion of Dennis Capovilla to President and
          Michael
          Vargas to Vice President of Administration & HR.
 
 *Impairment
          charge (recoveries) for long-lived assets.* In the second quarter of 2006,
          we ceased manufacturing in Palo Alto. As a result of this action, we recorded
          a
          $0.208 million impairment charge related to a production machine, which
          was
          decommissioned in the second quarter ended June 30, 2006. There was no
          such
          charge in the second quarter ended June 30, 2007.  In addition, in the
          second quarter ended June 30, 2006, we recorded the recovery of $0.1 million
          of
          previously recorded impairment charges related to impaired long-lived assets,
          which were sold in the second quarter of 2006. There were no such recoveries
          in
          the second quarter ended June 30, 2007.
  16
 *Index*
  *Restructuring.*On January 19, 2006, we commenced restructuring actions to improve
          our cost
          structure. These actions include the closure of our Palo Alto, California
          manufacturing facility and a reduction in force at our Palo Alto site in
          the
          first half of 2006. As a result of these actions, we incurred additional
          restructuring charges of $0.259 million during the second quarter ended
          June 30,
          2006, primarily relating to outside services to decommission our manufacturing
          equipment and scrapped production materials. There was no such restructuring
          charge in the second quarter ended June 30, 2007.
 
 *Income
          (loss) from operations*.  Loss from operations improved $0.585
          million to a loss of $0.409 million compared to a loss of $0.994 million
          for the
          second quarter ended June 30, 2007 and 2006 respectively.  This
          improvement was due to a decrease of total operating expenses attributable
          to a
          reduction of  $1.201 million in research and development
          expenses,  $0.259 million in restructuring charges, $0.208 million in
          impairment charges, and  $0.243 million in selling, general and
          administrative expenses, partially offset by a decline in revenue and the
          related margin decline.
 
 *Interest
          expense, net.*There was no material change in interest expense from second
          quarter ended June 30, 2006 to the same period in 2007.
 
 *Other
          income, net*.  Other income, net, includes the receipt of $1.500
          million received for milestones met under a Technology Transfer and Service
          Agreement with Sunfilm AG.  This income was partially offset by a
          cancellation charge on a machinery order of $0.470 million.  The
          remaining other income  mainly reflects foreign exchange transaction
          gains and losses in the secondquarter of 2007 and 2006. Some of our transactions
          with foreign customers are denominated in foreign currencies, principally
          the
          Euro. As exchange rates fluctuate relative to the U.S. dollar, exchange
          gains
          and losses occur.  Other income increased $1.014 million to $1.043
          million compared to $.029 million for the second quarter ended June 30,
          2006 and
          2007 respectively.
 
 *Income
          (loss) before provision for income taxes*. We recorded pre-tax income of
          $0.467 million in the second quarter of 2007 compared to a pre-tax loss of
          $1.154 million for the second quarter ended June 30, 2006
          respectively.  This increase was the result of other income of $1.043
          million, a decrease in total operating expenses attributable to a reduction
          of
          $1.201 million in research and development expenses, $0.259 million in
          restructuring charges, $0.208 million in impairment charges, and a $0.243
          million in selling, general and administrative expenses, partially offset
          by
          lower margin from reduced sales.
 
 *Provision
          for income taxes*. The decrease in the provision for income taxes in the
          second quarter ended June 30, 2007  compared to the same period in
          2006 is related to lower taxable income in 2007 in our foreign subsidiary,
          Southwall Europe GmbH, or SEG.  In addition, our foreign subsidiary
          completed an income tax audit for years 1999 to 2002 and incurred additional
          income tax expense of $0.1 million in the second quarter ended June 30,
          2006.
 
 *Deemed
          dividend on preferred stock.* We accrued $0.122 million of deemed dividend
          on preferred stock in each of the second quarters of 2007 and
          2006.  The holders of our secured convertible promissory notes
          converted those notes to shares of Series A preferred stock in December
          2004.
          The Series A preferred stock accrues cumulative dividends at the rate of
          10% per
          annum.
 
 **Six
          Months Ended June 30, 2007 compared with Six Months Ended June 30,
          2006**
 
 *Net
          revenues.*Our net revenues for thesix months
          ended June 30,
          2007 and June 30, 2006 were $19.756 million and $21.371 million, respectively.
          The decline in revenues was the result of a decreased demand for our electronic
          display products, partially offset by an increase in revenue from our
          architectural products, automotive glass and window film product
          lines.
  17
 *Index*
  Our
          net
          revenues from our electronic display products decreased by $3.210 million,
          55.7%, to $2.551 million compared to $5.761 million for the six months
          ended
          June 30, 2007 and 2006 respectively.  This decrease was primarily due
          to the decreased demand from our major display product customer as a result
          of
          price sensitivity in the electronic display industry. Due to the competitive
          nature of pricing in this market, going forward we expect to see significantly
          decreased revenues from our electronic display product line compared to
          fiscal
          2006.  In 2006 our electronic display business comprised approximately
          25% of our total sales.
 
 Our
          net
          revenues in the architectural product line increased by $0.766 million,
          31.3%,
          to $3.213 million compared to $2.447 million for the six months ended June
          30,
          2007 and 2006 respectively.  This improvement is due to increased
          demand for Southwall's energy efficient building products.
 
 Our
          net
          revenues in the automotive market increased by $0.692 million, 10.3%, to
          $7.399
          million compared to $6.707 million for the six months ended June 30, 2007
          and
          2006 respectively. The increase was primarily due to additional revenue
          from
          some of our Automotive Replacement Glass customers partially offset by
          a
          reduction in demand in 2007 as a result of the ongoing “de-contenting” (a change
          by auto manufacturers to make the parts in which our products are found
          optional
          features rather than standard features to control their costs) trend in
          the
          automotive industry.
 
 Our
          net
          revenues in the window film product line increased by $0.137 million, 2.1
          %, to
          $6.593 million compared to $6.456 million in the six months ended June
          30, 2007
          and 2006 respectively.  This increase was due to increased demand from
          Globamatrix.
 
 *Cost
          of revenues.* Cost of revenues consists of materials and subcontractor
          services, labor and manufacturing overhead. Cost of revenues was $12.603
          million
          in the six months ended June 30, 2007 compared to $13.634 million in the
          same
          period of 2006.  The decrease in cost of revenues was primarily due to
          lower revenues, and transfer of production to our lower cost German
          manufacturing facility, partially offset by inventory reserves for the
          window
          film products.
 
 *Gross
          profit and gross margin.* Our gross profit decreased $0.584 million to
          $7.153 million compared to $7.737 million for the six months ended June
          30, 2007
          and 2006 respectively.  As a percentage of sales, gross profit was
          36.2% for each of the six month periods ended June 30.  The decline in
          gross profit dollars is due to sales volume decline.
 
 *Operating
          expenses*
  *Research
          and development*. Research and development expenses decreased $1.478 million
          to $2.239 compared to $3.717 million for the six months ended June 30,
          2007 and
          2006 respectively. The 39.8% decrease from year to year was due primarily
          to the
          timing of test runs in  2007 compared to the same period last
          year  and the consumption of the associated materials.  Also
          the decrease is partially due to lower labor and employee benefits costs,
          due to
          a workforce  reduction and the resignation of our Chief Technology
          Officer effective April 2, 2007.  We expect expenditures relating to
          research and development for the remainder of 2007 to be slightly higher
          in the
          second half of 2007 as compared with the first half of 2007.  In the
          second quarter of 2007 we delivered the first order for a new class of
          window
          film, which we believe, will strengthen our window film line.
 
 *Selling,
          general and administrative*. Selling, general and administrative expenses
          consist primarily of corporate and administrative overhead, selling commissions
          and occupancy costs. Selling, general and administrative expenses decreased
          $0.277 to $4.810 million compared to $5.087 million for
          the six
          months ended June 30, 2007 and 2006 respectively. This decrease was primarily
          due to the transitioning of the Vice President of Business Development
          and our
          Managing Director of Southwall Europe to Sunfilm AG in April
          2007,  partially offset by the promotion of Dennis Capovilla to
          President and Michael Vargas to Vice President of Administration &
HR.
  18
 *Index*
  *Impairment
          charge (recoveries) for long-lived assets.* In the second quarter of 2006,
          we ceased manufacturing in Palo Alto. As a result of this action, we recorded
          a
          $0.208 million impairment charge related to a production machine, which
          was
          decommissioned in the six months  ended June 30, 2006. There was no
          such charge in the six months ended June 30, 2007. In addition, in the
          six
          months ended June 30, 2006, we recorded the recovery of $0.1 million of
          previously recorded impairment charges related to impaired long-lived assets,
          which were sold in the six months ended June 30, 2006. There were no
          material  recoveries in the six months  ended June 30,
          2007.
 
 *Restructuring.*On January 19, 2006, we commenced restructuring actions to improve
          our cost
          structure. These actions include the closure of our Palo Alto, California
          manufacturing facility and a reduction in force at our Palo Alto site in
          the
          first half of 2006. As a result of these actions, we incurred additional
          restructuring charges of $0.711 million during the six months ended June
          30,
          2006 primarily relating to outside services to decommission our manufacturing
          equipment and scrapped production materials. There was no such restructuring
          charge in the second quarter ended June 30, 2007.
 
 *Income
          (loss) from operations*.  Income from operations increased $2.098
          million to $0.112 million compared to a loss of $1.986 million for the
          six
          months ended June 30, 2007 and 2006 respectively.  This improvement
          was due to a decrease of total operating expenses attributable to a reduction
          of
          $1.478 million in research and development expenses, $0.711 million in
          restructuring charges, $0.216 million in impairment charges, and a
          $0.277 million in selling, general and administrative
          expenses.
 
 *Interest
          expense, net.*Interest expense decrease $0.101 million to $0.280 million
          from $0.381 million in the six months ended June 30, 2006
          and  2007.  The difference was due to payments on
          outstanding debt.
 
 *Other
          income, net*.  Other income, net, includes the receipt of $1.500
          million received for milestones met under a Technology Transfer and Service
          Agreement with Sunfilm AG.  This income was partially offset by a
          cancellation charge of $0.470 million on a machinery order.  The
          balance reflects foreign exchange transaction gains and losses in the
          secondquarter of 2007 and 2006. Some of our transactions with foreign customers
          are denominated in foreign currencies, principally the Euro. As exchange
          rates
          fluctuate relative to the U.S. dollar, exchange gains and losses
          occur.  Other income increased $0.869 million to $1.048 million
          compared to $.179 million for the second quarter ended June 30, 2006 and
          2007
          respectively.
 
 *Income
          (loss) before provision for income taxes*. We recorded pre-tax income of
          $0.880 million compared to a pre-tax loss of $2.188 million for the six
          months ended June 30, 2007 and 2006 respectively.  This increase was
          the result of other income of $1.048 million and to a decrease in total
          operating expenses attributable to a reduction of $1.478 million in research
          and
          development expenses, $0.711 million in restructuring charges,
          $0.216 million in impairment charges, and $0.277 million in selling,
          general and administrative expenses.
 
 *Provision
          for income taxes*. The decrease in the provision for income taxes in the six
          months ended June 30, 2007 compared to the same period in 2006 is related
          to
          lower taxable income in 2007 in our foreign subsidiary, Southwall Europe
          GmbH,
          or SEG.  In addition, our foreign subsidiary completed an income tax
          audit for years 1999 to 2002 and incurred additional income tax expense
          of $0.1
          million in the six months ended June 30, 2006.
 
 *Deemed
          dividend on preferred stock.* We accrued $0.244 million of deemed dividend
          on preferred stock in each of the first six months of 2007 and
          2006.  The holders of our secured convertible promissory notes
          converted those notes to shares of Series A preferred stock in December
          2004.
          The Series A preferred stock accrues cumulative dividends at the rate of
          10% per
          annum.
 19
 *Index*
  **Results
          of Operations**
 
 **Liquidity
          and capital resources.**
 
 *Liquidity*
  Our
          principal liquidity requirements are for working capital, consisting primarily
          of accounts receivable and inventories, for debt repayments and capital
          expenditures. We believe that because of the relatively long production
          cycle of
          certain of our products, our inventories will continue to represent a
          significant portion of our working capital.
 
 Our
          cash
          and cash equivalents decreased $2.6 million from $5.5 million at December
          31,
          2006 to $2.9 million at June 30, 2007. Cash used in operating activities
          of $1.4
          million for the first six months of 2007 was primarily the result of an
          increase
          in accounts receivable of $2.9 million, which are due for collection in
          the
          third quarter of 2007, increase in inventories of $0.5 million, partially
          offset
          by net income of $0.7 million, non-cash depreciation of $1.4 million and
          non-cash stock compensation expense of $0.2 million. Cash used in operations
          for
          the first six months of 2006 of $1.3 million was primarily the result of
          net
          loss of $2.7 million, a decrease in accrued liabilities of $1.2 million
          due to a
          deferred rent payment and a decrease in accounts payable and accrued liabilities
          of $1.0 million, partially offset by non-cash depreciation of $1.1 million,
          a
          decrease in inventories of $0.8 million and non-cash stock compensation
          expense
          of $0.4 million and decrease in accounts receivable of $0.9
          million.
 
 Cash
          used
          in investing activities for the first six months of 2007 was $0.8 million
          and
          was primarily the result of capital expenditures of $0.4 million and an
          increase
          in restricted cash of $0.4 million in Germany for purchase of precious
          metals
          used in production. Cash used in investing activities for the first six
          months
          of 2006 was $0.5 million and was primarily the result of capital
          expenditures.
 
 Cash
          used
          in financing activities for the first six months of 2007 was $0.2 million
          and
          was primarily the result of repayments under capital lease of $0.5 million
          offset by $0.3 million proceeds received from exercise of stock options.
          Cash
          used in financing activities for the first six months of 2006 of $0.7 million
          was primarily the result of repayments under capital leases and principal
          payments on borrowings.
 
 We
          entered into an agreement with the Saxony government in May 1999 under
          which we receive investment grants. As of June 30, 2007, we had received
          5.0 million Euros or $5.0 million at historical exchange rate of the grants
          and accounted for these grants by applying the proceeds received to reduce
          the
          cost of our fixed assets in our Dresden manufacturing facility. Additionally,
          as
          of June 30, 2007, we had a balance remaining from the government grants
          that we
          are entitled to receive of $0.2 million, which has been recorded as an
          advance
          and held as restricted cash until we receive approval from the Saxony government
          to apply the funds to reduce our capital expenditures. The total annual
          amount
          of investment grants and investment allowances that we are entitled to
          seek
          varies from year to year based upon the amount of our capital expenditures
          that
          meet certain requirements of the Saxony government. The measurement date
          of
          these requirements was June 30, 2006. We believe we met the requirements
          at June
          30, 2006. Currently we are in audit meetings with the Saxony government
          with
          regard to $0.2 million unused grants that we have previously received and
          currently hold as restricted cash. We expect to close these grants in the
          third
          quarter of 2007. However, we cannot guarantee that we will be eligible
          for or
          will receive additional grants in the future from the Saxony
          government.
 
  20
 *Index*
  *Borrowing
          arrangements*
 
 On
          March
          29, 2007, we entered into a new Credit Agreement (“Credit Agreement”) with
          Bridge Bank, N.A. (“Bank”), replacing our credit agreement with Wells Fargo HSBC
          Trade Bank, N.A. The Credit Agreement provides for two facilities. The
          first
          facility is a revolving line of credit for the lesser of $3 million or
          the face
          value of the letter of credit used to support the facility. The Proceeds
          of the
          facility were used to pay off Wells Fargo HSBC Trade Bank. Amounts borrowed
          under the first facility bear interest at the prime rate minus 1.75% and
          are
          collateralized by a $3 million standby letter of credit from Needham &
Company (“Needham”). At December 31, 2006, Needham and its affiliates owned
          41.7% of our outstanding common stock and series A 10% Cumulative Convertible
          Preferred Stock convertible into another 5% of our outstanding common stock.
          Unless released from the Letter of Credit, beginning August 1,
          2007  Needham will begin receiving quarterly interest payments on the
          $3 million supporting the letter of credit at the rate of 12.8% per annum.
          We
          are pursuing various options to reduce this interest charge, but can provide
          no
          assurances we will be successful
 
 The
          second facility is a $3 million revolving line of credit line under which
          we
          may, from time to time, borrow up to 80% of eligible accounts receivables
          (net
          of pre-paid deposits, pre-billed invoices, deferred revenue, offsets, and
          contras related to each specific account debtor and other requirements
          in the
          lender’s discretion). Amounts borrowed under the second facility bear interest
          at the prime plus 1.75% annualized on the average daily finance amount
          outstanding. The second facility also provides for a $2 million letter
          of credit
          sub facility. All borrowings under the facilities will be collateralized
          by all
          our assets and are subject to certain covenants. These covenants include
          that
          while the second facility is outstanding (a) we will maintain a minimum
          current
          ratio of 1.00 to 1.00 for the months through May 31, 2007; thereafter,
          starting
          with month ending June 30, 2007, we need to maintain a current ratio of
          1.25 to
          1.00 on a monthly basis; and (b) our quarterly net loss to shareholders
          (including deemed dividend) will not exceed $0.4 million for any quarter
          after
          September 30, 2007.
 
 The
          terms
          of the Credit Agreement, among other things, limit our ability to (i) incur,
          assume or guarantee additional indebtedness (other than pursuant to the
          Credit
          Agreement), (ii) incur liens upon the collateral pledged to the bank, and
          (iii)
          merge, consolidate, sell or otherwise dispose of substantially all or a
          substantial or material portion of our assets.
 
 The
          Credit Agreement provides for events of default, which include, among others,
          (a) nonpayment of amounts when due (with no grace periods), (b) the breach
          of
          our representations or covenants or other agreements in the Credit Agreement
          or
          related documents, (c) defaults or accelerations of our other indebtedness,
          (d)
          a failure to pay certain judgments, (e) the occurrence of any event or
          condition
          that the Bank believes impairs or is substantially likely to impair the
          prospects of payment or performance by us, and (f) certain events of bankruptcy,
          insolvency or reorganization. Generally, if an event of default occurs,
          the Bank
          may declare all outstanding indebtedness under the Credit Agreement to
          be due
          and payable.
 
 The
          maturity date of the facilities is March 28, 2008.  The Company is in
          compliance with all financial covenants.
 
 The
          foregoing description does not purport to be a complete statement of the
          parties’ rights and obligations under the Credit Agreement and the transactions
          contemplated thereby or a complete explanation of the material terms
          thereof.
 
 *Capital
          expenditures*
 
 We
          expect
          to spend approximately $1.4 million in 2007 on upgrades and refurbishment
          of our
          production machines and research and development tools. We spent approximately
          $0.4 million in capital expenditures during the first six months of
          2007.
 21
 *Index*
  *Future
          payment obligations*
 
 Our
          future payment obligations on our borrowings pursuant to our term debt,
          line of
          credit, non-cancelable operating leases and other non-cancelable contractual
          commitments are as follows at June 30, 2007 (in thousands):
 
 
 Less
                
                
                
                
                
                
                
                
                GreaterThan
                
                
                
                
                
                
                
                
                ThanTotal
                
                
                1
                    Year
                
                
                1-3
                    Years
                
                
                3-5
                    Years
                
                
                5
                    YearsContractual
                    Obligations:Term
                    debt (1)
                
                $
                9,293
                
                
                $
                1,078
                
                
                $
                4,578
                
                
                $
                1,105
                
                
                $
                2,532Line
                    of credit (1)
                
                
                3,000
                
                
                
                3,000
                
                
                
                --
                
                
                
                --
                
                
                
                --Operating
                    leases (2)
                
                
                1,875
                
                
                
                473
                
                
                
                812
                
                
                
                590
                
                
                
                --Total
                    contractual cash obligations
                
                $
                14,168
                
                
                $
                4,551
                
                
                $
                5,390
                
                
                $
                1,695
                
                
                $
                2,532
  (1)
                Represents
                    loan agreements with Portfolio Financing Servicing Company, Bridge
                    Bank
                    and several German banks.
 
 (2)
                Represents
                    the remaining rents
                    owed on buildings we rent in Palo Alto and Mountain View,
                    California.
 
 On
          June
          13, 2006, we signed a sublease agreement  to sublease 3782-3788 Fabian
          Way, Palo Alto, California 94303.  The term of this sublease commenced
          on June 16, 2006 and will continue until December 31, 2008, with monthly
          rent
          payments of $18,000 through May 31, 2008, and $19,000 through December
          31,
          2008.
 
 On
          June 21, 2006, we amended our lease
          with Richard Christina to extend our original lease through June 30, 2011
          for
          the facilities at 3780 Fabian Way, Palo Alto, California 94303. Also, on
          June
          21, 2006, we entered into a lease agreement with Richard Christina to lease
          3782-3788 Fabian Way, Palo Alto, California. The term of this lease extends
          the
          rental term for all premises (3780 and 3782-3788 Fabian Way, Palo Alto,
          California) to June 30, 2011 at a Base Rent of $38,000 per month. On January
          1,
          2010 and 2011, the Base Rent shall increase by 3%.
  22
 *Index*
  **Item
          3--Quantitative and Qualitative Disclosures about Market
          Risk**
 
 We
          are
          exposed to the impact of interest rate changes, foreign currency fluctuations,
          and changes in the market values of our investments.
 
 ***Financing
          risk:*** Our exposure to market rate risk for changes in interest
          rates relates primarily to our line of credit which bears an interest rate
          equal
          to prime rate minus 1.75% (which was 6.50% at June 30, 2007) and is calculated
          based on amounts borrowed under the facility. In addition, the interest
          rate on
          one of our German loans has been reset to the prevailing market rate of
          5.75%
          and another of our German loans will have its interest rate reset to the
          prevailing market rate in 2009. Fluctuations or changes in interest rates
          may
          adversely affect our expected interest expense. The effect of a 10% fluctuation
          in the interest rate on our line of credit and term debt would have had
          an
          immaterial effect on our interest expense for the first six months of
          2007.
 
 ***Investment
          risk:*** We invest our excess cash in money market accounts and,
          by
          practice, limit the amount of exposure to any one institution. Investments
          in
          both fixed rate and floating rate interest earning instruments carry a
          degree of
          interest rate risk. Fixed rate securities may have their fair market value
          adversely affected due to a rise in interest rates, while floating rate
          securities may produce less income than expected if interest rates fall.
          The
          effect of a 10% fluctuation in the interest rate on our excess cash investments
          would not have had a material effect on our interest expense in the first
          six
          months of 2007.
 
 ***Foreign
          currency risk:*** International revenues (defined as sales to
          customers located outside of the United States) accounted for approximately
          72%
          of our total sales in the second quarter of 2007. Approximately 51% of
          our
          international revenues were denominated in Euros relating to sales from
          our
          Dresden operation in the second quarter of 2007. The other 49% of our
          international sales were denominated in US dollars. In addition, certain
          transactions with foreign suppliers are denominated in foreign currencies
          (principally Japanese Yen). The effect of a 10% fluctuation in the Euro
          exchange
          rate would have had an effect of approximately $0.5 million on net revenues
          for the second quarter of 2007 and the effect on expenses of a 10% fluctuation
          in the Yen exchange rate would have been immaterial.
  23
 *Index*
  **Item4T--Controls
          and Procedures**
 
 (a)
                *Evaluation
                    and Disclosure Controls and Procedures*.  Under the
                    supervision and with the participation of our management, including
                    our
                    chief executive officer and acting principal financial officer,
                    we
                    conducted an evaluation of the effectiveness of the design and
                    operation
                    of our disclosure controls and procedures, as defined in Rules
                    13a-15(e)
                    and 15d-15(e) under the Securities Exchange Act of 1934, as amended,
                    as of
                    June 30, 2007.  Based on this evaluation, our chief executive
                    officer and acting principal financial officer concluded as of
                    the
                    Evaluation Date that our disclosure controls and procedures were
                    effective, such that the information relating to our company,
                    including
                    our consolidated subsidiary, required to be disclosed in our
                    Securities
                    and Exchange Commission (“SEC”) reports (i) is recorded, processed,
                    summarized and reported with the time periods specified in SEC
                    rules and
                    forms, and (ii) is accumulated and communicated to our management,
                    including our chief executive officer and principal financial
                    officer, as
                    appropriate to allow timely decisions regarding required
                    disclosure.
 
 (b)
                *Report
                    on Internal Control Over Financial Reporting*. We will be required by
                    the Sarbanes-Oxley Act to include an assessment of our internal
                    control over financial reporting in our Annual Report on Form
                    10-K
                    beginning with the filing for our fiscal year ending December 31,
                    2007.
 
 (c)
                *Changes
                    in Internal Controls*.  There were no changes during the
                    first six months of 2007 in our internal controls over financial
                    reporting
                    that have materially affected, or are reasonably likely to materially
                    affect, the internal controls over financial
                    reporting.
  24
 *Index*
  **PART
          II--OTHER INFORMATION**
  **Item
          1--Legal Proceedings**
 
 Not
          applicable.
 
 **Item
          1A—Risk Factors**
 
 The
          following information updates, and should be read in conjunction with,
          the
          information disclosed in Item 1A, “Risk Factors,” of our Annual Report on Form
          10K for the year ended December 31, 2006 and filed with the SEC on April
          2, 2007
          and in Part II Item 1A of our Quarterly Report on Form 10-Q for the quarter
          ended March 31, 2007.
 
 **Financial
          Risks**
 
 There
          have been no significant changes in financial risk factors for the second
          quarter ended June 30, 2007.  See information set forth in the section
          entitled “Risk Factors” in our Annual Report on From 10-k for the fiscal years
          ended December 31, 2006.
 
 **Operational
          Risks**
 
 *We
          depend on a small number of customers for nearly all of our revenues, and
          the
          loss of a large customer could materially adversely affect our revenues
          or
          operating results.*
 
 Our
          nine
          largest customers accounted for approximately 80%, 80%, 82% and 79% of
          net
          revenues during the first six months of 2007 and in 2006, 2005 and 2004,
          respectively. We expect to continue to derive a significant portion of
          our net
          sales from this relatively small number of customers. Accordingly, the
          loss of a
          large customer could materially hurt our business, and the deferral or
          loss of
          anticipated orders from a large customer or a small number of customers
          could
          materially reduce our revenue and operating results in any period. Some
          of our
          largest automotive glass customers have used a technology—direct-to-glass
          sputtering—as an alternative to our window films, which in 2003 resulted in a
          decrease in orders from these customers. The continued or expanded use
          of this
          technology by our automotive glass customers would have a material adverse
          effect on our results of operations and financial position.
 
 *Fluctuations
          or slowdowns in the overall electronic display industry have and may continue
          to
          adversely affect our revenues.*
 
 Our
          business depends in part on sales by manufacturers of products that include
          electronic displays. The markets for electronic display products are highly
          cyclical and have experienced periods of oversupply resulting in significantly
          reduced demand for our products. In addition, the continuing cost-down
          pressure
          in the Display markets, particularly in PDPs, limits the applications for
          our
          film-based filters due to increased competition, and we expect this trend
          to
          continue. We are also dependent on our marketing partner to successfully
          promote
          film-based filters.
 
 **Item
          2-- Unregistered Sales of Equity Securities and Use of
          Proceeds**
 
 None.
  **Item
          3--Defaults upon Senior Securities**
 
 Not
          applicable.
  25
 *Index*
  
 **Item
          4--Submission of Matters to a Vote of
          Stockholders**
 
  On
          May
          24, 2007, we held our Annual Meeting of Stockholders.  The number of
          shares outstanding and eligible to vote as of May 24, 2007, the record
          date,
          were 27,139,035 shares.  The following matters were voted
          upon:
   1.
                Our
                    stockholders elected William A. Berry, George Boyadjieff, Jami
                    K.
                    Nachtsheim, R. Eugene Goodson, Andre R. Horn and Peter E. Salas
                    as
                    directors to serve until the 2007 Annual Meeting of Stockholders
                    and until
                    their successors are elected.
  The
          vote
          for each director was as follows:
 
  Director
                
                For
                
                WithheldWilliam
                    A. Berry
                
                20,824,715
                
                122,649George
                    Boyadjieff
                
                20,407,996
                
                539,368Jami
                    K. Nachtsheim
                
                20,480,514
                
                466,850R.
                    Eugene Goodson
                
                20,863,615
                
                83,749Andre
                    R. Horn
                
                20,821,715
                
                125,649Peter
                    E. Salas
                
                20,821,115
                
                126,249
   2.
                Approval
                    of the Company’s 2007 Long-Term Incentive Plan.  On the matter
                    there were 13,440,632 votes “FOR”, 844,233 votes “AGAINST” and 69,268
                    votes “ABSTAINING”.
  3.
                Our
                    stockholders ratified the selection of Burr, Pilger & Mayer LLP, our
                    independent registered public accounting firm, for the fiscal
                    year ending
                    December 31, 2007. On the matter, there were 20,448,031 votes
                    "FOR",
                    51,400 votes "AGAINST", 411,069 votes "ABSTAINING", and no broker
                    non-votes.
 
 **Item
          5--Other Information**
 
 Over
          the
          past four years the Company has sold a highly specialized EMI filtering
          film for
          use in Plasma Display Panels under an exclusive Manufacturing and Supply
          Agreement to one of our customers, Mitsui Chemicals, this agreement expires
          at
          the end of 2007.   Mitsui does not plan to purchase film in sufficient
          quantities for the balance of the year to meet their 2007 binding contract
          commitment. The Company and Mitsui are currently in the process of
          negotiating a mutually agreeable settlement.
 
 On
          July
          2, 2007 Dr. R. Eugene Goodson was appointed Executive Chairman, relinquishing
          the title of chief executive officer.  In his position of Executive
          Chairman Dr. Goodson’s annual salary is $150,000  plus a $625 per
          month car allowance, and employee benefits.
 
 On
          May
          30, 2007 Michael Vargas was promoted to Vice President of General Administration
          & HR,  Mr. Vargas’s  annual salary is
          $143,000.  In addition Mr. Vargas receives a car allowance of $950.00
          per month plus employee benefits.
  26
 *Index*
  **Item
          6--Exhibits**
  (a)
                Exhibits
 
 
 ExhibitNumber
                
                Item31.1
                
                Certification
                    of Principal Executive Officer pursuant to Exchange Act Rules
                    13a-14 and
                    15d-1431.2
                
                Certification
                    of Principal Financial Officer pursuant to Exchange Act Rules
                    13a-14 and
                    15d-1432.1
                
                Certification
                    of Principal Executive Officer pursuant to 18 U.S.C Section
                    135032.2
                
                Certification
                    of Principal Financial Officer pursuant to 18 U.S.C Section
                    1350
  27
 *Index*
  **SIGNATURES**
  Pursuant
          to the requirements of the Securities Exchange Act of 1934, the registrant
          has
          duly caused this report to be signed on its behalf by the undersigned thereunto
          duly authorized.
  Dated:  
                    August 10, 2007**Southwall
                    Technologies Inc.**By:Dr.
                    R. Eugene Goodson*Executive
                    Chairman*By:Don
                    Stichler*Chief
                    Accounting Officer*
   28