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, 2008


or




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





For
the transition period from to





Commission
File Number: 0-15930


___________________





SOUTHWALL
TECHNOLOGIES INC.


(Exact
name of registrant as specified in its charter)





Delaware
            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
July 28, 2008, there were 28,250,961 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, 2008 and December 31, 2007
            3Unaudited Condensed Consolidated Statements
      of Operations – Three month
      and six month periods ended June 30, 2008 and June 30,
      2007
            4Unaudited Condensed Consolidated Statements of
      Cash Flows – six month periods ended June 30, 2008 and June 30,
      2007
            5Notes to the Unaudited Condensed Consolidated
      Financial Statements
            6Item
      2
            Management’s Discussion and Analysis of Financial
      Condition and Results of Operations
            14Item
      3
            Quantitative and Qualitative Disclosures about Market
      Risk
            24Item
      4
            Controls and Procedures
            25PART
      II – OTHER INFORMATIONItem
      1
            Legal Proceedings
            26Item
      1A
            Risk Factors
            26Item
      2
            Unregistered Sales of Equity Securities and Use of
      Proceeds
            27Item
      3
            Defaults upon Senior Securities
            27Item
      4
            Submission of Matters to a Vote of Security
      Holders
            27Item
      5
            Other Information
            27Item
      6
            Exhibits
            27Signatures
            28


2
 Index




PART I. FINANCIAL
INFORMATION





Item 1--Financial Statements:


SOUTHWALL TECHNOLOGIES
INC.


UNAUDITED CONDENSEDCONSOLIDATED BALANCE
SHEETS


(in
thousands, except per share data)





June
      30,
            
            
            December 31,2008
            
            
            2007ASSETSCurrent
      assets:Cash
      and cash equivalents
            
            $
            7,524
            
            
            $
            6,492Restricted
      cash
            
            
            315
            
            
            
            294Accounts
      receivable, net of allowance for doubtful accounts of $126 at June 30,
      2008 and $66 at December 31, 2007
            
            
            8,077
            
            
            
            4,346Inventories,
      net
            
            
            6,527
            
            
            
            5,640Restricted
      cash loans
            
            
            1,330
            
            
            
            -Other
      current assets
            
            
            854
            
            
            
            837Total
      current assets
            
            
            24,627
            
            
            
            17,609Property,
      plant and equipment, net
            
            
            17,623
            
            
            
            17,071Restricted
      cash loans
            
            
            -
            
            
            
            1,242Other
      assets
            
            
            700
            
            
            
            1,345Total
      assets
            
            $
            42,950
            
            
            $
            37,267LIABILITIES,
      PREFERRED STOCK AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Current
      portion of long term debt
            
            $
            4,040
            
            
            $
            1,149Accounts
      payable
            
            
            2,293
            
            
            
            964Accrued
      compensation
            
            
            1,239
            
            
            
            1,267Other
      accrued liabilities
            
            
            4,989
            
            
            
            6,350Total
      current liabilities
            
            
            12,561
            
            
            
            9,730Term
      debt
            
            
            5,831
            
            
            
            8,277Other
      long term liabilities
            
            
            2,587
            
            
            
            2,567Total
      liabilities
            
            
            20,979
            
            
            
            20,574Commitments
      and contingencies (Note 6)Series
      A 10% cumulative convertible preferred stock, $0.001 par value; $1.00
      stated value; 5,000 shares authorized, 4,893 shares outstanding at June
      30, 2008 and December 31, 2007, respectively (Liquidation preference:
      $6,521 and $6,277 at June 30, 2008 and December 31, 2007,
      respectively)
            
            
            4,810
            
            
            
            4,810Stockholders’
      equity:Common
      stock, $0.001 par value per share; 50,000 shares authorized, 28,222 shares
      and 27,820 shares outstanding at June 30, 2008 and December 31, 2007,
      respectively
            
            
            28
            
            
            
            28Capital
      in excess of par value
            
            
            78,301
            
            
            
            78,290Accumulated
      other comprehensive income: Accumulated translation
    adjustment
            
            
            5,651
            
            
            
            4,776Accumulated
      deficit
            
            
            (66,819
            )
            
            
            (71,211
            )Total
      stockholders’ equity
            
            
            17,161
            
            
            
            11,883Total liabilities,
      preferred stock and stockholders’ equity
            
            $
            42,950
            
            
            $
            37,267




See
accompanying notes to unaudited condensed consolidated financial
statements.


3
 Index


SOUTHWALL TECHNOLOGIES
INC.


UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF
OPERATIONS


(in
thousands, except per share data)




Three
      months ended
              
              
              Six
      months endedJune
      30,
              
              
              June 30,
              
              
              June
      30,
              
              
              June
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Net
      revenues
              
              $
              13,685
              
              
              $
              9,250
              
              
              $
              24,255
              
              
              $
              19,756Cost
      of revenues
              
              
              7,960
              
              
              
              6,507
              
              
              
              13,679
              
              
              
              12,603Gross
      profit
              
              
              5,725
              
              
              
              2,743
              
              
              
              10,576
              
              
              
              7,153Operating
      expenses:Research
      and development
              
              
              688
              
              
              
              870
              
              
              
              1,397
              
              
              
              2,239Selling,
      general and administrative
              
              
              2,280
              
              
              
              2,282
              
              
              
              4,318
              
              
              
              4,810Recoveries
      for long-lived assets, net
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (8
              )Total
      operating expenses
              
              
              2,968
              
              
              
              3,152
              
              
              
              5,715
              
              
              
              7,041Income
      (loss) from operations
              
              
              2,757
              
              
              
              (409
              )
              
              
              4,861
              
              
              
              112Interest
      expense, net
              
              
              (123
              )
              
              
              (167
              )
              
              
              (262
              )
              
              
              (280
              )Other
      income (expenses), net
              
              
              (79
              )
              
              
              1,043
              
              
              
              114
              
              
              
              1,048Income
      before provision for income taxes
              
              
              2,555
              
              
              
              467
              
              
              
              4,713
              
              
              
              880Provision
      for income taxes
              
              
              207
              
              
              
              5
              
              
              
              320
              
              
              
              186Net
      income
              
              
              2,348
              
              
              
              462
              
              
              
              4,393
              
              
              
              694Deemed
      dividend on preferred stock
              
              
              122
              
              
              
              122
              
              
              
              244
              
              
              
              244Net
      income attributable to common stockholders
              
              $
              2,226
              
              
              $
              340
              
              
              $
              4,149
              
              
              $
              450Net
      income per share:Basic
              
              $
              0.08
              
              
              $
              0.01
              
              
              $
              0.15
              
              
              $
              0.02Diluted
              
              $
              0.07
              
              
              $
              0.01
              
              
              $
              0.13
              
              
              $
              0.02Shares
      used in computing net income per share:Basic
              
              
              28,065
              
              
              
              27,513
              
              
              
              27,943
              
              
              
              27,327Diluted
              
              
              34,555
              
              
              
              28,498
              
              
              
              34,037
              
              
              
              28,033




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
      30,2008
              
              
              2007Cash
      flows from  operating activities:Net
      income
              
              $
              4,393
              
              
              $
              694Adjustments
      to reconcile net income to net cash provided
      by (used in) operating activities:Deferred
      income tax
              
              
              (16
              )
              
              
              (66
              )Impairment
      recoveries from long-lived assets
              
              
              -
              
              
              
              (8
              )Depreciation
      and amortization
              
              
              1,515
              
              
              
              1,370Stock-based
      compensation
              
              
              77
              
              
              
              185Changes
      in operating assets and liabilities:Accounts
      receivable, net
              
              
              (3,908
              )
              
              
              (2,874
              )Inventories,
      net
              
              
              (887
              )
              
              
              (509
              )Accrued
      restructuring
              
              
              -
              
              
              
              (60
              )Other
      current and non-current assets
              
              
              616
              
              
              
              142Accounts
      payable and accrued liabilities
              
              
              (291
              )
              
              
              (254
              )Net
      cash provided by (used in) operating activities
              
              
              1,499
              
              
              
              (1,380
              )Cash
      flows from investing activities:Restricted
      cash
              
              
              -
              
              
              
              (406
              )Proceeds
      from sale of property, plant and equipment
              
              
              -
              
              
              
              8Expenditures
      for property, plant and equipment
              
              
              (898
              )
              
              
              (438
              )Net
      cash used in investing activities
              
              
              (898
              )
              
              
              (836
              )Cash
      flows from financing activities:Proceeds
      from exercise of stock options
              
              
              179
              
              
              
              357Borrowings
      from equipment financing
              
              
              473
              
              
              
              -Borrowings
      on line of credit
              
              
              -
              
              
              
              3,000Repayments
      on line of credit
              
              
              -
              
              
              
              (2,996
              )Investment
      credit in Germany
              
              
              -
              
              
              
              (3
              )Repayments
      of notes payable
              
              
              (596
              )
              
              
              (539
              )Net
      cash provided by (used in) financing activities
              
              
              56
              
              
              
              (181
              )Effect
      of foreign exchange rate changes on cash
              
              
              375
              
              
              
              (190
              )Net
      increase (decrease) in cash and cash equivalents
              
              
              1,032
              
              
              
              (2,587
              )Cash
      and cash equivalents, beginning of period
              
              
              6,492
              
              
              
              5,524Cash
      and cash equivalents, end of period
              
              $
              7,524
              
              
              $
              2,937Supplemental
      cash flows disclosures:Interest
      paid
              
              $
              426
              
              
              $
              375Income
      taxes paid
              
              $
              223
              
              
              $
              186Supplemental
      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 CONDENSEDCONSOLIDATED FINANCIAL
STATEMENTS


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




Note
1—Basis of Presentation:




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




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




The
accompanying interim condensed consolidated financial statements of Southwall
Technologies Inc. (“Southwall” or the “Company”) are unaudited and have been
prepared in accordance with accounting principles generally accepted in the
United States of America (GAAP) for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain
information and footnote disclosure normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States of America have been condensed or omitted. In the opinion of
management, the unaudited condensed consolidated financial statements reflect
all adjustments, consisting only of normal recurring adjustments, considered
necessary to present fairly the financial position, results of operations and
cash flows of Southwall and its subsidiaries for all periods presented. The
year-end consolidated balance sheet data was derived from audited financial
statements, but does not include all disclosures required by GAAP. The Company
suggests that these condensed consolidated financial statements be read in
conjunction with the consolidated financial statements and notes thereto
contained in the Company's Form 10-K for the year ended December 31, 2007 filed
with the Securities and Exchange Commission on March 31, 2008. The results of
operations for the interim periods presented are not necessarily indicative of
the operating results to be expected for any future periods.




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


6
 Index


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




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




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




June
      30, 2008Fair Value
              
              
              Book Value
              
              
              UnrealizedGain, netMoney
      Market Funds, Level I
              
              $
              2,005
              
              
              $
              2,005
              
              
              $
              -Money
      Market Funds, Level I
              
              
              1,653
              
              
              
              1,653
              
              
              
              -Certificates
      of Deposit, Level I
              
              
              1,000
              
              
              
              1,000
              
              
              
              -Money
      Market Funds, Level I
              
              
              522
              
              
              
              522
              
              
              
              -Total
      cash equivalents and marketable securities
              
              
              5,180
              
              
              
              5,180
              
              
              
              -Cash
              
              
              2,344
              
              
              
              2,344
              
              
              
              -Total
      cash, cash equivalents and marketable securities
              
              $
              7,524
              
              
              $
              7,524
              
              
              $
              -December
      31, 2007Fair Value
              
              
              Book Value
              
              
              Unrealized
      Gain, netMoney
      Market Funds, Level I
              
              $
              400
              
              
              $
              400
              
              
              $
              -Money
      Market Funds, Level I
              
              
              4,682
              
              
              
              4,682
              
              
              
              -Total
      cash equivalents and marketable securities
              
              
              5,082
              
              
              
              5,082
              
              
              
              -Cash
              
              
              1,410
              
              
              
              1,410
              
              
              
              -Total
      cash, cash equivalents and marketable securities
              
              $
              6,492
              
              
              $
              6,492
              
              
              $
              -




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




The fair
value hierarchy consists of the following three levels:




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


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


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




Note
3—Inventories, Net:




Inventories
are stated at the lower of cost (determined by the average cost method) or
market. Cost includes materials, labor and manufacturing overhead. The Company
establishes provisions for excess and obsolete inventories to reduce such
inventories to their estimated net realizable value. Such provisions are charged
to cost of revenues. At June 30, 2008 and December 31, 2007, inventories
consisted of the following:


7
 Index




June
      30,
            
            
            December
      31,2008
            
            
            2007Raw
      materials
            
            $
            2,999
            
            
            $
            3,076Work-in-process
            
            
            2,093
            
            
            
            787Finished
      goods
            
            
            1,435
            
            
            
            1,777$
            6,527
            
            
            $
            5,640




Note
4--Net Income Per Share:




Basic net
income per share is computed by dividing net income attributable to common
stockholders (numerator) by the weighted average number of common shares
outstanding (denominator) for the period. Diluted net income per share gives
effect to all dilutive common shares potentially outstanding during the period,
including stock options, warrants to purchase common stock and convertible
preferred stock.




The
Company excludes options from the computation of diluted weighted average shares
outstanding if the exercise price of the options is greater than the average
market price of the shares because the inclusion of these options would be
anti-dilutive to earnings per share. The Company also excludes preferred shares
convertible into common stock from the computation of diluted weighted average
shares outstanding, per Statement of Financial Accounting Standard (“SFAS”) 128,
“Earnings Per Share”, when the effect would be antidilutive.




For the
second quarter of 2008, there were 5,328 options outstanding of which 2,150 were
excluded from the dilutive net income per share calculation, as they were
anti-dilutive because the option prices were higher than the average market
value during the three-month period ended June 30, 2008.  For the six
months ended June 30, 2008, 2,240 options outstanding were excluded from the
dilutive net income per share calculation.  For the three and six
month periods ended June 30, 2007, 2,282 and 4,586 options outstanding were
excluded from the dilutive net income per share calculation,
respectively.  In net loss periods, the basic and diluted weighted
average shares of common stock and common stock equivalents are the same because
inclusion of common stock equivalents would be anti-dilutive.




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


8
 Index




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




Three
      months ended
            
            Six
      months endedJune
      30,
            
            
            June
      30,
            
            
            June
      30,
            
            
            June
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Net
      income attributable to common stockholders-basic
            
            $
            2,226
            
            
            $
            340
            
            
            $
            4,149
            
            
            $
            450Add:
      Deemed dividend on preferred stock
            
            
            122
            
            
            
            122
            
            
            
            244
            
            
            
            244Net
      income attributable to common stockholders-diluted
            
            $
            2,348
            
            
            $
            462
            
            
            $
            4,393
            
            
            $
            694Weighted
      average common shares outstanding-basic
            
            
            28,065
            
            
            
            27,513
            
            
            
            27,943
            
            
            
            27,327Dilutive
      effect of warrants
            
            
            357
            
            
            
            985
            
            
            
            355
            
            
            
            706Dilutive
      effect of Series A preferred shares
            
            
            4,893
            
            
            
            -
            
            
            
            4,893
            
            
            
            -Dilutive
      effect of stock options
            
            
            1,240
            
            
            
            -
            
            
            
            846
            
            
            
            -Weighted
      average common shares outstanding – diluted
            
            
            34,555
            
            
            
            28,498
            
            
            
            34,037
            
            
            
            28,033Basic
      EPS
            
            $
            0.08
            
            
            $
            0.01
            
            
            $
            0.15
            
            
            $
            0.02Dilutive
      EPS
            
            $
            0.07
            
            
            $
            0.01
            
            
            $
            0.13
            
            
            $
            0.02




Note
5 – Product Reporting:




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




Three months ended
            
            
            Six months endedJune
      30,
            
            
            June
      30,
            
            
            June
      30,
            
            
            June
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Automotive
      glass
            
            $
            6,312
            
            
            $
            3,532
            
            
            $
            12,281
            
            
            $
            7,399Window
      film
            
            
            5,618
            
            
            
            3,600
            
            
            
            8,574
            
            
            
            6,593Architectural
            
            
            1,469
            
            
            
            1,676
            
            
            
            2,991
            
            
            
            3,213Electronic
      display
            
            
            286
            
            
            
            442
            
            
            
            409
            
            
            
            2,551Total net
      revenues
            
            $
            13,685
            
            
            $
            9,250
            
            
            $
            24,255
            
            
            $
            19,756




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 months periods ended June 30,
2008 and June 30, 2007:




Three
      months ended
            
            Six
      months endedJune
      30,
            
            
            June
      30,
            
            
            June
      30,
            
            
            June
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Europe:
      France, Germany
            
            $
            5,404
            
            
            $
            1,972
            
            
            $
            9,613
            
            
            $
            4,126Asia
      Pacific: Japan, Pacific Rim
            
            
            5,146
            
            
            
            2,739
            
            
            
            7,305
            
            
            
            7,432United
      States
            
            
            1,997
            
            
            
            2,570
            
            
            
            4,403
            
            
            
            4,944Rest
      of the world
            
            
            1,138
            
            
            
            1,969
            
            
            
            2,934
            
            
            
            3,254Total
      net revenues
            
            $
            13,685
            
            
            $
            9,250
            
            
            $
            24,255
            
            
            $
            19,756


9
 Index




Note
6--Commitments and Contingencies:




Commitments




On
January 19, 2006, we commenced restructuring actions to attempt to improve our
cost structure for 2006 and beyond.  These actions included the
closure of our Palo Alto, California manufacturing facility during
2006.  We accrued $1,509 for the closure of our manufacturing facility
and an additional $153 in the fourth quarter of 2007 as a leasehold asset
retirement obligation in connection with the return of our Palo Alto
manufacturing facility to the landlord.  In January 2008, a $1,000
letter of credit and $100 cash security deposit were released to the landlord,
and in February 2008, we entered into a settlement agreement with the landlord
under which we paid the landlord an additional $400, thereby releasing us from
any further rent or building restoration obligations under the lease for that
specific manufacturing facility, leaving only environmental related costs to be
incurred.  The remaining accrued obligation of $110 represents
additional environmental sampling costs and legal fees estimated to be incurred
in 2008.




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




Contingencies




In
September 1995, Pilkington filed a patent application in Germany for XIR film
characteristics. Southwall challenged the patent. This patent was revoked by the
German Patent Court on April 20, 2004. A separate patent application had been
filed by Pilkington in the European Patent Office on September 13, 1996, and a
patent was granted. A separate opposition was filed by Southwall. However, the
European Patent Office did not allow the opposition and maintained the patent.
The reasons for the final decision of the European Patent Office will be issued
within the next few weeks. The Company cannot assess the impact at this
time.




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




Note
7--Stock-Based Compensation:




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


10
 Index




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




Three
      months ended
            
            Six
      months endedJune
      30,
            
            
            June
      30,
            
            
            June
      30,
            
            
            June
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Cost
      of sales
            
            $
            5
            
            
            $
            1
            
            
            $
            7
            
            
            $
            2Research
      and development
            
            
            (12
            )
            
            
            18
            
            
            
            1
            
            
            
            45Selling,
      general and administrative
            
            
            36
            
            
            
            53
            
            
            
            69
            
            
            
            138Stock-based
      compensation expense before
      income taxes
            
            
            29
            
            
            
            72
            
            
            
            77
            
            
            
            185Income
      tax benefit
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Total stock-based
      compensation expense
      after income taxes
            
            $
            29
            
            
            $
            72
            
            
            $
            77
            
            
            $
            185




There
were $179 and $357 cash proceeds from the exercise of stock options for the
six-month period ended June 30, 2008 and June 30, 2007.  In accordance
with SFAS 123R, the Company presents excess tax benefits from the exercise of
stock options, if any, as financing cash flows rather than operating cash
flows.




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




Three
      months ended
              
              
              Six
      months endedJune
      30,
              
              
              June
      30,
              
              
              June
      30,
              
              
              June
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Expected
      life (in years)
              
              
              5.4
              
              
              
              -
              
              
              
              5.67
              
              
              
              6.0Risk-free
      interest rate
              
              
              3.16
              %
              
              
              -
              
              
              
              3.08
              %
              
              
              4.71
              %Volatility
              
              
              79
              %
              
              
              -
              
              
              
              81
              %
              
              
              80
              %Dividend
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Per
      share weighted-average fair value at grant date
              
              $
              0.79
              
              
              $
              -
              
              
              $
              0.53
              
              
              $
              0.33




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


11
 Index




Stock
option activity for the six months ended June 30, 2008 was as
follows:




Weighted - AverageRemainingWeighted-Average
            
            
            Contractual
      Term
            
            
            AggregateShares
            
            
            Exercise
      Price
            
            
            (in
      years)
            
            
            Intrinsic
      ValueOutstanding
      at December 31, 2007
            
            
            5,209
            
            
            $
            1.08Grants
            
            
            1,126
            
            
            
            0.87Exercises
            
            
            (401
            )
            
            
            0.45Forfeitures
      or expirations
            
            
            (605
            )
            
            
            2.20Outstanding
      at June 30, 2008
            
            
            5,329
            
            
            
            0.96
            
            
            
            6.67
            
            
            $
            3,182Vested
      and expected to vest at June 30, 2008
            
            
            4,121
            
            
            
            1.04
            
            
            
            6.01
            
            
            $
            2,328Exercisable
      at June 30, 2008
            
            
            2,885
            
            
            
            1.17
            
            
            
            4.73
            
            
            $
            1,487




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 2008 and the exercise
price, times the number of shares) that would have been received by the option
holders had all option holders exercised their options on June 30,
2008.  This amount changes based on the fair market value of
Southwall’s stock. Total intrinsic value of options exercised was $219 for the
three month period ended June 30, 2008. Total fair value of options granted was
$79 and $600 for the three and six month period ended June 30,
2008.




As of
June 30, 2008, $528 of total unrecognized compensation cost, net of forfeitures,
related to stock options was expected to be recognized over a weighted-average
period of approximately 2.83 years.





Note
8 - Warranties:




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




Balance
      at
            
            
            
            
            
            
            
            
            Balance
      atDecember
      31,
            
            
            
            
            
            
            
            
            June
    30,2006
            
            
            Provision
            
            
            Utilized
            
            
            2007Accrued sales
      returns and warranty
            
            $
            1,415
            
            
            $
            844
            
            
            $
            (1,349
            )
            
            $
            910Balance
      at
            
            
            
            
            
            
            
            
            
            
            Balance
      atDecember
      31,
            
            
            
            
            
            
            
            
            
            
            June
    30,2007
            
            
            Provision
            
            
            Utilized
            
            
            2008Accrued
      sales returns and warranty
            
            $
            1,102
            
            
            $
            850
            
            
            $
            (667
            )
            
            $
            1,285




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


12
 Index




Note
9 – Comprehensive Income:




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




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




Three
      months ended
            
            
            Six
      months endedJune
      30,
            
            
            June
      30,
            
            
            June
      30,
            
            
            June
      30,2008
            
            
            2007
            
            
            2008
            
            
            2007Foreign
      Currency Translation Adjustment
            
            $
            (111
            )
            
            $
            85
            
            
            $
            875
            
            
            $
            102Net
      Income
            
            
            2,348
            
            
            
            462
            
            
            
            4,393
            
            
            
            694Other
      Comprehensive Income
            
            $
            2,237
            
            
            $
            547
            
            
            $
            5,268
            
            
            $
            796




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




Accumulated
      Other Comprehensive Income at December 31, 2007
            
            $
            4,776Foreign
      Currency Translation Adjustment
            
            
            875Accumulated
      Other Comprehensive Income at June 30, 2008
            
            $
            5,651




Note
10 - Income Tax:




The
increase in the provision for income taxes in the six months ended June 30, 2008
compared to the same period in 2007 is primarily related to higher taxable
income in 2008 in our foreign subsidiary, Southwall Europe GmbH, or
SEG.




For the
three months ended June 30, 2008, the Company’s effective tax rate was
8.1%.  This rate differs from the statutory federal rate of 35%
primarily due to the impact of the benefit received from a reduction of the
valuation allowance on the Company’s deferred tax asset due to the current year
U.S. income.  The amount of this reduction is approximately $731 or
29%.




For the
six months ended June 30, 2008, the Company’s effective tax rate was a provision
of 6.75%.  As allowed by FASB Interpretation No. 18, “ Accounting for
Income Taxes in Interim Periods” (FIN 18), we have used the actual effective tax
rate for the six months ended June 30, 2008 as our best estimate for the tax
rate for the year ending December 31, 2008, as a reliable estimate for the full
year cannot be made at this time.  In addition, to the extent our
expected profitability changes during the year, the effective tax rate would be
revised to reflect any changes in the projected profitability.  This
rate differs from the statutory federal rate of 35% primarily due to the release
of a portion of the Company’s valuation allowance on the U.S. deferred tax asset
against the income generated by the U.S. operations through the first six months
of 2008.  The amount of the benefit related to this decrease in
valuation allowance was approximately $1,388 or 29.4%.  Additionally,
the Company had an expense of 1.1% primarily related to a valuation
allowance being established against losses generated by our new subsidiary
holding the Company’s investment in the joint venture.




13
 Index




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




Six months Ended
            
            Six months EndedJune
      30, 2008
            
            June
      30, 2007Federal
      Statutory Rate
            
            
            35.00
            %
            
            
            35.00
            %Permanent
      Items
            
            
            0.00
            %
            
            
            0.00
            %R&D
      Credit
            
            
            0.08
            %
            
            
            (6.25
            %)Foreign
      Rate Differential
            
            
            0.00
            %
            
            
            (8.40
            %)Change
      in Valuation Allowance
            
            
            (29.44
            %)
            
            
            (4.17
            %)Other
            
            
            1.11
            %
            
            
            4.97
            %Effective
      Tax Rate
            
            
            6.75
            %
            
            
            21.15
            %




Note
11 – Recent Accounting Pronouncements:




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




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




Item 2--Management's Discussion and Analysis of Financial
Condition and Results of Operations (in thousands):




The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our unaudited condensed
consolidated financial statements and notes thereto appearing elsewhere in this
report. This discussion and analysis contains forward-looking statements that
involve risks and uncertainties, including those discussed below under
"Forward-Looking Statements" and "Risk Factors”, set forth in Part I, Item 1A,
of our Annual Report on Form 10-K for the year ended December 31, 2007 and in
Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended June
30, 2008. You should not place undue reliance on these forward-looking
statements. Actual results may differ materially from those anticipated in the
forward-looking statements. These forward-looking statements represent our
judgment as of the date of the filing of this Form 10-Q.


14
 Index


Forward
Looking Statements




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




As used
in this report, the terms "we," "us," "our," "Southwall" and the "Company" mean
Southwall Technologies Inc. and its subsidiaries, unless the context indicates
another meaning. This report contains forward-looking statements as that term is
defined in the Private Securities Litigation Reform Act of 1995 that are subject
to a number of risks and uncertainties. All statements other than statements of
historical facts are forward-looking statements. These statements are identified
by terminology such as "may," "will," "could," "should," "expects," "plans,"
"intends," "seeks," "anticipates," "believes," "estimates," "potential," or
"continue," or the negative of such terms or other comparable terminology, or
similar terminology, although not all forward-looking statements contain these
identifying words. Forward-looking statements are only predictions and include,
without limitation, statements relating to:




●
            our
      strategy, future operations and financial plans
  ;




●
            our
      revenue expectations;




●
            our
      expected results of operations and cash
flows;




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




●
            future
      applications of thin film coating
technologies;




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




●
            the
      properties and functionality of our
products;




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




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




●
            our
      projected need for additional borrowings and future
    liquidity;




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




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




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




●
            strategic
      mergers and acquisitions of
competitors


15
 Index


●
            the
      possibility of patent and other intellectual property
      infringement;




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




●
            pending,
      decided and threatened litigation and its
  outcome;




●
            our
      competition; and




●
              our
      projected capital
expenditures.




You
should not place undue reliance on our forward-looking statements. Actual events
or results may differ materially. In evaluating these statements, you should
specifically consider various factors, including the risks outlined under "Risk
Factors" below. These and other factors may cause our actual results to differ
materially from any forward-looking statement. Although we believe the
expectations reflected in our forward-looking statements are reasonable as of
the date they are being made, we cannot guarantee our future results, levels of
activity, performance or achievements. Moreover, we do not assume any
responsibility for the future accuracy and completeness of these forward-looking
statements.




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




Overview




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




Restructuring.On
January 19, 2006, we commenced restructuring actions to improve our cost
structure for 2006 and beyond.  These actions included the closure of
our Palo Alto, California manufacturing facility during 2006.  We
accrued $1,509 for the closure of our manufacturing facility and an additional
$153 in the fourth quarter of 2007 as a leasehold asset retirement obligation in
connection with the return of our Palo Alto manufacturing facility to the
landlord.  In January 2008, a $1,000 letter of credit and $100 cash
security deposit were released to the landlord, and in February 2008, we entered
into a settlement agreement with the landlord under which we paid the landlord
an additional $400, thereby releasing us from any further rent or building
restoration obligations under the lease for that specific manufacturing
facility, leaving only environmental related costs to be
incurred.  The remaining accrued obligation of $110 represents
additional environmental sampling costs and legal fees estimated to be incurred
in 2008.




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




16
 Index


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




Our three
largest customers in the automotive glass and window film market, and
architectural glass markets include Pilkington PLC, Saint Gobain Sekurit and
Globamatrix Holdings Pte. Ltd., or Globamatrix, which collectively accounted for
approximately 69%, 63% and 47% of our total revenues during the first six months
of 2008, 2007 and 2006, respectively.




Under our
agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
purchase commitment of $9,000 of product.  For
each year after 2004 through the term of the contract, Globamatrix is required
to purchase an amount of product equal to 110% of the amount of product it was
required to purchase in the prior year. Globamatrix is obligated to purchase
$13,000 of certain products in 2008. During the first six months of 2008,
Globamatrix purchased approximately $8,575 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 2008, our sales returns
provision averaged approximately 3.4 % of our gross revenues over a rolling
twelve month period. From 2003 to 2007, our sales returns provision has averaged
approximately 2.8% of gross revenues.




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




European
Patent.In
September 1995, Pilkington filed a patent application in Germany for XIR film
characteristics. Southwall challenged the patent. This patent was revoked by the
German Patent Court on April 20, 2004. A separate patent application had been
filed by Pilkington in the European Patent Office on September 13, 1996, and a
patent was granted. A separate opposition was filed by Southwall. However, the
European Patent Office did not allow the opposition and maintained the patent.
The reasons for the final decision of the European Patent Office will be issued
within the next few weeks. The Company cannot assess the impact at this
time.




Critical
Accounting Policies and Estimates




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


17
 Index


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




Three
months Ended June 30, 2008 compared with Three months Ended June 30,
2007




Results
of Operations




Net
revenues.Our net revenues for the quarter ended June 30, 2008 were
$13,685, an increase of $4,435, or 48%, compared to $9,250 for the same period
ending June 30, 2007 primarily due to an increase in automotive and window film
sales partially offset by a decrease in architectural film and electronic
display revenues.




Net
revenues in the automotive market increased by $2,780, or 78.7%, to $6,312
compared to $3,532 for the
second quarter ended June 30, 2008 and 2007, respectively. The increase was
primarily due to increased demand by several of our large customers, and to a
lesser extent the impact of the U.S. Dollar to Euro exchange rate.  It
is uncertain whether the increased demand seen in the first six months of 2008
will continue into the second half of the year.  It is possible that
we may experience a decline from the revenue levels seen in the second quarter
of 2008.




Window
film net revenues increased $2,018, or 56.06%, to $5,618 from $3,600 in the
second quarter ended June 30, 2008 and 2007, respectively.  This was
primarily due to increased overall demand for the window film
business.




Architectural
net revenues decreased $207, or 12.35%, to $1,469 from $1,676 in the second
quarter ended June 30, 2008 and 2007, respectively.  This was
primarily due to a decline in sales to the European market.




Revenue
in our electronic display business continued to show a decline.  Sales
decreased by $156, or 35.3%, to $286 compared to $442 for the second quarter
ended June 30, 2008 and 2007, respectively.  This decrease was due to
the loss of a major customer in 2007, Mitsui, and the Company’s decision not to
pursue the plasma display panel market due to the intensively price competitive
market for those products.  Unless pricing for those products
improves, it is likely that the Company will not make significant future sales
of plasma display panels.




Gross
profit and gross margin. Our gross profit increased $2,982 to $5,725
compared to $2,743 for the second quarter ended June 30, 2008 and 2007,
respectively.  As a percentage of sales, gross profit increased to
41.8% compared to 29.7% for the second quarter ended June 30, 2008 and 2007,
respectively.  This was due to lower product costs in the second
quarter of 2008, resulting from an increase in production volume primarily
associated with increased customer demand for automotive and window film
products. Other factors contributing to the increase in gross margin were
improved yields in our window film product line and credits received relating to
the recycling of precious metals used in the manufacturing
process.


18
 Index


Operating
expenses




Research
and development. Research and development expenses decreased $182, or
21%, to $688 compared to $870 for the second quarter ended June 30, 2008 and
2007, respectively. This decrease was primarily due to a reduction in the number
of employees, decreased reliance on outside service providers and lower material
costs.  In the fourth quarter of 2007, the Company initiated a new
program of customer funded development projects and continued to engage
customers in similar projects in the first and second quarters of
2008.  The fees paid by customers for these projects offsets research
and development costs.  Until all products and services are delivered
to the customers pursuant to the terms set forth in the respective development
agreements, all credits to research and development expense are
deferred.  Upon satisfaction of the agreement terms, the credits are
recognized on a project by project basis.




Selling,
general and administrative. Selling, general and administrative expenses
consist primarily of corporate and administrative overhead, selling commissions
and occupancy costs. Selling, general and administrative expenses remained
materially unchanged for the second quarters ended June 30, 2008 and 2007,
respectively.




Income
from operations.  Income from operations improved $3,166 to
$2,757 compared to a loss of $409 for the second quarter ended June 30, 2008 and
2007, respectively.  This improvement was primarily due to improved
gross profit margins and lower operating costs.




Interest
expense, net.Interest expense decreased $44, or 26.4%, to $123 compared
to $167 for the second quarter ended June 30, 2008 and 2007, respectively. This
decrease was primarily the result of repaying the Bridge Bank line of credit in
December 2007.




Other
income, net.   Other income, net mainly reflects non
operating related income and expenses as well as foreign exchange transaction
gains and losses in the second quarter of 2008 and 2007.  Some of our
transactions with foreign customers are denominated in foreign currencies,
principally the Euro. As exchange rates fluctuate relative to the U.S. dollar,
exchange gains and losses occur. Other income, net changed from income of $1,043
in the second quarter of 2007 to a loss of $79 in the second quarter of 2008
mainly due to milestone payments received in the second quarter of 2007 per the
terms set forth in the Technology Transfer and Services agreement with Sun
Film.




Income
before provision for income taxes.  Pre-tax income increased
$2,088 to $2,555 in the second quarter of 2008 compared to $467 for the second
quarter ended June 30, 2007. This increase was primarily due to a significant
increase in operating income resulting from higher gross profit margins and
lower operating expenses.




Provision
for income taxes. The increase in the provision for income
taxes in the three months ended June 30, 2008 compared to the same period in
2007 is primarily related to higher taxable income in 2008 in our foreign
subsidiary, Southwall Europe GmbH, or SEG.




For the
three months ended June 30, 2008, the Company’s effective tax rate was
8.1%.  This rate differs from the statutory federal rate of 35%
primarily due to the impact of the benefit received from a reduction of the
valuation allowance on the Company’s deferred tax asset due to the current year
U.S. income.  The amount of this reduction is approximately $731 or
29%.




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


19
 Index


Six
months Ended June 30, 2008 compared with Six months Ended June 30,
2007




Results
of Operations




Net
revenues.Our net revenues for the six months ended June 30, 2008 were
$24,255, an increase of $4,499, or 23%, compared to $19,756 for the same period
ending June 30, 2007 primarily due to an increase in automotive and window film
sales partially offset by a decrease in architectural film and electronic
display revenues.




Our net
revenues in the automotive market increased by $4,882, or 66%, to $12,281
compared to $7,399
for the six months ended June 30, 2008 and 2007, respectively. The increase was
primarily due to increased demand by several of our large customers, and to a
lesser extent the impact of the U.S. Dollar to Euro exchange rate.  It
is uncertain whether the increased demand seen in the first six months of 2008
will continue into the second half of the year.  It is possible that
we may experience a decline from the revenue levels seen in the second quarter
of 2008.




Our net
revenues in the window film product line increased $1,981, or 30%, to $8,574
from $6,593 in the six month period ended June 30, 2008 and 2007,
respectively.  This was primarily due to increased overall demand in
the window film business.




Our net
revenues in architectural products decreased $222, or 6.9%, to $2,991 from
$3,213 for the six months ended June 30, 2008 and 2007,
respectively.  This was primarily due to a decline in sales to the
European market, partially offset by strong sales results in North
America.




Revenue
in our electronic display market continued to show a decline, where sales
decreased by $2,142, or 84%, to $409 compared to $2,551 for the six month period
ended June 30, 2008 and 2007, respectively.  This decrease was due to
the loss of a major customer, Mitsui, and the Company’s decision not to pursue
the plasma display panel market due to the intensively price competitive market
for those products.  Unless pricing for those products improves, it is
likely that the Company will not make significant future sales of plasma display
panels.




Gross
profit and gross margin. Our gross profit increased $3,423 to $10,576
compared to $7,153 for the six month period ended June 30, 2008 and 2007,
respectively. As a percentage of sales, gross profit increased to 43.6%
compared to 36.2% for the six months ended June 30, 2008 and 2007,
respectively.  This was due to lower product costs in the first
quarter of 2008, which were the result of an increase in production volume
associated with increased customer demand for automotive and window film
products. Other factors contributing to the increase in gross margin were
improved yields in our window film product line and credits received relating to
the recycling of precious metals used in the manufacturing process.




Operating
expenses




Research
and development. Research and development expenses decreased $842, or
37.6%, to $1,397 compared to $2,239 for the six months ended June 30, 2008 and
2007, respectively. This decrease was primarily due to the reduction in the
number of employees, decreased reliance on outside service providers and lower
material costs.  In the fourth quarter of 2007, the Company initiated
a new program of customer funded development projects and continued to engage
customers in similar projects in the first and second quarters of
2008.  The fees paid by customers for these projects offsets research
and development costs.  Until all products and services are delivered
to the customers pursuant to the terms set forth in the respective development
agreements, all credits to research and development expense are
deferred.  Upon satisfaction of the agreement terms, the credits are
recognized on a project by project basis.


20
 Index




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
$492, or 10.2%, to $4,318 compared to $4,810 for the six months ended June 30,
2008 and 2007, respectively.  This decrease was primarily due to a
reduction in the number of employees in the first quarter of 2008 as compared to
the same period in 2007 and to a lesser extent, the elimination of rent payments
associated with our manufacturing facility in Palo Alto,
California.




Income
from operations.  Income from operations improved $4,749 to
$4,861 compared to $112 for the six months ended June 30, 2008 and 2007,
respectively.  This improvement was primarily due to improved gross
profit margins and lower operating costs.




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




Other
income, net.   Other income, net mainly reflects non
operating related income and expenses as well as foreign exchange transaction
gains and losses in the second quarter of 2008 and 2007.  Some of our
transactions with foreign customers are denominated in foreign currencies,
principally the Euro. As exchange rates fluctuate relative to the U.S. dollar,
exchange gains and losses occur. Other income, net changed from income of $1,048
in the first six months of 2007 to $114 in the first six months of 2008 mainly
due to milestone payments received in the first half of 2007 per the terms set
forth in the Technology Transfer and Services agreement with Sun
Film.




Income
before provision for income taxes.  Pre-tax income increased
$3,833 to $4,713 in the six months ended June 30, 2008 compared to $880 for the
six months ended June 30, 2007. This increase was primarily due to a significant
increase in operating income resulting from higher gross profit margins and
lower operating expenses.




Provision
for income taxes. For the six months ended June 30, 2008, the
Company’s effective tax rate was a provision of 6.75%.  As allowed by
FASB Interpretation No. 18, “ Accounting for Income Taxes in Interim Periods”
(FIN 18), we have used the actual effective tax rate for the six months ended
June 30, 2008 as our best estimate for the tax rate for the year ending December
31, 2008, as a reliable estimate for the full year cannot be made at this
time.  In addition, to the extent our expected profitability changes
during the year, the effective tax rate would be revised to reflect any changes
in the projected profitability.




This rate
differs from the statutory federal rate of 35% primarily due to the release of a
portion of the Company’s valuation allowance on the U.S. deferred tax asset
against the income generate by the U.S. operations through the first six months
of 2008.  The amount of the benefit related to this decrease in
valuation allowance was approximately $1,388 or 29.4%.  Additionally,
the Company had an expense of 1.1% primarily related to a valuation
allowance being established against the losses of our new subsidiary holding the
Company’s investment in the joint venture.


21
 Index




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




Six months Ended
            
            
            Six months EndedJune
      30, 2008
            
            
            June
      30, 2007Federal
      Statutory Rate
            
            
            35.00
            %
            
            
            35.00
            %Permanent
      Items
            
            
            0.00
            %
            
            
            0.00
            %R&D
      Credit
            
            
            0.08
            %
            
            
            (6.25
            %)Foreign
      Rate Differential
            
            
            0.00
            %
            
            
            (8.40
            %)Change
      in Valuation Allowance
            
            
            (29.44
            %)
            
            
            (4.17
            %)Other
            
            
            1.11
            %
            
            
            4.97
            %Effective
      Tax Rate
            
            
            6.75
            %
            
            
            21.15
            %




Deemed
dividend on preferred stock. We accrued $244 of deemed dividend on
preferred stock in the first six months of 2008 and 2007,
respectively.  The holders of our secured convertible promissory notes
converted those notes to shares of Series A preferred stock in December 2004.
The Series A Preferred Stock accrues cumulative dividends at the rate of 10% per
annum.




Liquidity
and Capital Resources.  (in thousands)




Liquidity




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




Our cash
and cash equivalents increased $1,032 from $6,492 at December 31, 2007 to $7,524
at June 30, 2008. Cash provided by operating activities of $1,499 for the first
six months of 2008 was primarily the result of net income of $4,393, non-cash
depreciation of $1,515, non-cash stock compensation expense of $77, a decrease
in other current and non current assets of $616 offset by an increase in
accounts receivable of $3,908 resulting from higher sales volume at the end of
the second quarter, an increase in inventories of $887, a decrease in accounts
payable and accrued liabilities of $291 and a decrease in deferred income tax of
$16. Cash used in operations for the first six months of 2007 of $1,380 was
primarily the result of an increase in accounts receivable of $2,874, an
increase in inventories of $509, a decrease in deferred income tax of $66, a
decrease in accounts payable and accrued liabilities of $254, decrease in
accrued restructuring and impairment recoveries of $68 partially offset by net
income of $694, non-cash depreciation of $1,370 and non-cash stock compensation
expense of $185 and a decrease in other current and non-current assets of
$142.




Cash used
in investing activities for the first six months of 2008 was $898 and was the
result of capital
expenditures. Cash used in investing activities for the first six months of 2007
was $836 and was primarily due to capital expenditures of $438 and an increase
in restricted cash of $406.




Cash
provided by financing activities for the first six months of 2008 was $56 and
was the result of proceeds from exercise of stock options of $179, borrowings
from equipment financing of $473 offset by payments on borrowings of $596. Net
cash used in financing activities for the first six months of 2007 of $181 was
primarily the result of payments on borrowings of $539, offset by proceeds from
exercise of stock options of $357.


22
 Index


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




Borrowing
arrangements




Credit
Agreement with Wells Fargo Bank




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




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




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




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




Capital
expenditures




We expect
to spend approximately $1,500 in 2008 on upgrades and refurbishment of our
production machines and research and development tools. We spent approximately
$898 in capital expenditures during the first six months of 2008.  In
addition, we expect to spend approximately $600 on manufacturing equipment to be
used by Southwall Insulating Glass, LLC to insert Heat Mirror into insulated
glass units during the manufacturing process.


23
 Index


Future
payment obligations




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




Less
            
            
            
            
            
            GreaterThan
            
            
            
            
            
            ThanTotal
            
            1
      Year
            
            1-3
      Years
            
            3-5
      Years
            
            5
      YearsContractual
      Obligations:Term
      debt (1)
            
            $
            9,871
            
            
            $
            4,040
            
            
            $
            2,398
            
            
            $
            871
            
            
            $
            2,562Term
      debt Interest (1)
            
            $
            2,016
            
            
            $
            596
            
            
            $
            524
            
            
            $
            392
            
            
            $
            504Operating
      leases (2)
            
            $
            1,259
            
            
            $
            447
            
            
            $
            812
            
            
            $
            -
            
            
            $
            -Other
      Obligations (3)
            
            $
            1,712
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            1,712Total
      contractual cash obligations
            
            $
            14,858
            
            
            $
            5,083
            
            
            $
            3,734
            
            
            $
            1,263
            
            
            $
            4,778





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




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




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




Interest
expense relating to term debt decreased for the six month period ending June 30,
2007 to June 30, 2008 from $280 to $262, respectively.  The reason for
the decrease is mainly due to fluctuations in the Euro exchange
rate.




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




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





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: 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 2008.


24
 Index


Investment
risk: We invest our excess cash in money market accounts and, by
practice, make every effort to limit the amount of exposure by investing with
strong, well-known institutions. Investments in both fixed rate and floating
rate interest earning instruments carry a degree of interest rate risk. Fixed
rate securities may have their fair market value adversely affected due to a
rise in interest rates, while floating rate securities may produce less income
than expected if interest rates fall. The effect of a 10% fluctuation in the
interest rate on our excess cash investments would not have had a material
effect on our interest income in the first six months of
2008.


.


Foreign
currency risk: International revenues (defined as sales to customers
located outside of the United States) accounted for approximately 85% of our
total sales in the second quarter of 2008. Approximately 51%
of our international revenues were denominated in Euros in the second quarter of
2008. The other 49% of our international sales were denominated in US dollars.
In addition, certain transactions with foreign suppliers are denominated in
foreign currencies. The effect of a 10% fluctuation in the Euro exchange rate
would have had an effect of approximately $969 on net revenues for the second
quarter of 2008.




Item
4-Controls and Procedures




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






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




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


25
 Index


PART
II—OTHER INFORMATION




Item 1—Legal Proceedings




In
September 1995, Pilkington filed a patent application in Germany for XIR film
characteristics. Southwall challenged thepatent.
This patent was revoked by the German Patent Court on April 20, 2004. A separate
patent application had been filed by Pilkington in the European Patent Office on
September 13, 1996, and a patent was granted. A separate opposition was filed by
Southwall. However, the European Patent Office did not allow the opposition and
maintained the patent. The reasons for the final decision of the European Patent
Office will be issued within the next few weeks. The Company cannot assess the
impact at this time.




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




Item 1A—Risk Factors




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




Financial
Risks




There
have been no significant changes in financial risk factors for the three month
period ended June 30, 2008.  See information set forth in the section
entitled “Risk Factors” in our Annual Report on Form 10-K for the fiscal year
ended December 31, 2007, except with respect to the Pilkington patent. In
September 1995, Pilkington filed a patent application in Germany for XIR film
characteristics. Southwall challenged the patent. This patent was revoked by the
German Patent Court on April 20, 2004. A separate patent application had been
filed by Pilkington in the European Patent Office on September 13, 1996, and a
patent was granted. A separate opposition was filed by Southwall. However, the
European Patent Office did not allow the opposition and maintained the patent.
The reasons for the final decision of the European Patent Office will be issued
within the next few weeks. The Company cannot assess the impact at this
time.




Operational
Risks




There
have been no significant changes in operational risk factors for the three month
period ended June 30, 2008.  See information set forth in the section
entitled “Risk Factors” in our Annual Report on Form 10-K for the fiscal year
ended December 31, 2007, except with respect to the Pilkington
patent.  In September 1995, Pilkington filed a patent application in
Germany for XIR film characteristics. Southwall challenged the patent. This
patent was revoked by the German Patent Court on April 20, 2004. A separate
patent application had been filed by Pilkington in the European Patent Office on
September 13, 1996, and a patent was granted. A separate opposition was filed by
Southwall. However, the European Patent Office did not allow the opposition and
maintained the patent. The reasons for the final decision of the European Patent
Office will be issued within the next few weeks. The Company cannot assess the
impact at this time.


26
 Index




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




None.




Item 3--Defaults upon Senior Securities




None




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




None




Item 5--Other Information




None




Item 6--Exhibits




(a)
Exhibits






ExhibitNumber
            Item10.1
            Credit
      Agreement with Wells Fargo Bank31.1
            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
      13, 2008Southwall
      Technologies Inc.By:
            /s/
      DennisCapovillaDennis
      CapovillaChief
      Executive OfficerBy:
            /s/
      Mallorie BurakMallorie
      BurakChief
      Accounting Officer






28