**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 March 31, 2007**


**or**


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





**For
      the transition period from to**





**Commission
      File Number: 0-15930**


___________________




**SOUTHWALL
      TECHNOLOGIES INC.**


(Exact
      name of registrant as specified in its charter)





**Delaware**
            **94-2551470**(State
                or other jurisdiction of incorporation or organization)
            (I.R.S.
                Employer Identification Number)





**3788
                Fabian Way, Palo Alto, California**
            **94303**(Address
                of principal executive offices)
            (Zip
                Code)




Registrant's
      telephone number, including area code:**(650)
      798-1200**


___________________





Indicate
      by check mark whether the
      registrant (1)has
      filed all reports required to be
      filed by Section13
      or 15(d) of the Securities Exchange
      Act of 1934 during the preceding 12months
      (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 90days.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 May
      1, 2007, there were 27,139,035 shares of the Registrant's Common Stock
      outstanding.













**SOUTHWALL
      TECHNOLOGIES INC.**





**INDEX**




PagePART
                I – FINANCIAL INFORMATIONItem
                1
            Financial
                StatementsUnaudited
                Condensed Consolidated Balance Sheets – March 31,
                2007 and December 31, 2006
            3Unaudited
                Condensed Consolidated Statements of Operations –
                Three month periods ended March 31, 2007 and March 31,
                2006
            4Unaudited
                Condensed Consolidated Statements of Cash Flows –
                Three month periods ended March 31, 2007 and March 31,
                2006
            5Notes
                to the Unaudited Condensed Consolidated Financial
                Statements
            6Item
                2
            Management’s
                Discussion and Analysis of Financial Condition
                and Results of Operations
            13Item
                3
            Quantitative
                and Qualitative Disclosures about Market
                Risk
            19Item
                4T
            Controls
                and Procedures
            21PART
                II – OTHER INFORMATIONItem
                1
            Legal
                Proceedings
            22Item
                1A
            Risk
                Factors
            22Item
                2
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            23Item
                3
            Defaults
                upon Senior Securities
            24Item
                4
            Submission
                of Matters to a Vote of Security
                Holders
            24Item
                5
            Other
                Information
            24Item
                6
            Exhibits
            24Signatures
            25





2
 *Index*





PART I.
      FINANCIAL INFORMATION





Item
      1--Financial Statements:


**SOUTHWALL
      TECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED BALANCE
      SHEETS**


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





March
                31,
            
            
            December 31,2007
            
            
            2006**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            3,387
            
            
            $
            5,524Restricted
                cash
            
            
            222
            
            
            
            209Accounts
                receivable, net of allowance for doubtful accounts of $86 at March
                31,
                2007 and $102 at December 31, 2006
            
            
            5,488
            
            
            
            3,608Inventories,
                net
            
            
            5,715
            
            
            
            5,598Other
                current assets
            
            
            893
            
            
            
            1,064Total
                current assets
            
            
            15,705
            
            
            
            16,003Property,
                plant and equipment, net
            
            
            17,020
            
            
            
            17,232Restricted
                cash loans
            
            
            1,124
            
            
            
            1,111Other
                assets
            
            
            1,296
            
            
            
            1,155Total
                assets
            
            $
            35,145
            
            
            $
            35,501





**LIABILITIES,
                PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Current
                portion of long term debt
            
            $
            1,068
            
            
            $
            1,059Line
                of credit
            
            
            3,000
            
            
            
            2,996Accounts
                payable
            
            
            1,155
            
            
            
            955Accrued
                compensation
            
            
            772
            
            
            
            859Government
                grants advanced
            
            
            222
            
            
            
            -Other
                accrued liabilities
            
            
            5,896
            
            
            
            6,448Total
                current liabilities
            
            
            12,113
            
            
            
            12,317Term
                debt
            
            
            8,383
            
            
            
            8,568Government
                grants advanced
            
            
            220
            
            
            
            -Other
                long term liabilities
            
            
            2,564
            
            
            
            2,550Total
                liabilities
            
            
            23,060
            
            
            
            23,655Commitments
                and contingencies (Note 5)Series
                A 10% cumulative convertible preferred stock, $0.001 par value; $1.00
                stated
                value; 5,000 shares authorized, 4,893 shares outstanding at March
                31, 2007
                and December
                31, 2006, respectively (Liquidation preference: $5,910 and $5,788
                at March
                31, 2007 and December 31, 2006,
                respectively)
            
            
            4,810
            
            
            
            4,810Stockholders’
                equity:Common
                stock, $0.001 par value per share; 50,000 shares authorized, 27,139
                shares
                outstanding at March 31, 2007 and December 31, 2006
            
            
            27
            
            
            
            27Capital
                in excess of par value
            
            
            78,071
            
            
            
            78,081Accumulated
                other comprehensive income:Accumulated
                translation adjustment
            
            
            3,713
            
            
            
            3,696Accumulated
                deficit
            
            
            (74,536
            )
            
            
            (74,768
            )Total
                stockholders’ equity
            
            
            7,275
            
            
            
            7,036Total
                liabilities, preferred stock and stockholders’ equity
            
            $
            35,145
            
            
            $
            35,501





See
      accompanying notes to unaudited condensed consolidated financial
      statements.





3
 *Index*





**SOUTHWALL
      TECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF
      OPERATIONS**


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





Three
                months endedMarch
                31,
            
            
            March
                31,2007
            
            
            2006Net
                revenues
            
            $
            10,505
            
            
            $
            10,034Cost
                of revenues
            
            
            6,095
            
            
            
            6,366Gross
                profit
            
            
            4,410
            
            
            
            3,668Operating
                expenses:Research
                and development
            
            
            1,369
            
            
            
            1,646Selling,
                general and administrative
            
            
            2,529
            
            
            
            2,562Impairment
                recoveries for long-lived assets
            
            
            (8
            )
            
            
            -Restructuring
                charges
            
            
            -
            
            
            
            452Total
                operating expenses
            
            
            3,890
            
            
            
            4,660Income
                (loss) from operations
            
            
            520
            
            
            
            (992
            )Interest
                expense, net
            
            
            (113
            )
            
            
            (192
            )Other
                income, net
            
            
            6
            
            
            
            150Income
                (loss) before provision for income taxes
            
            
            413
            
            
            
            (1,034
            )Provision
                for income taxes
            
            
            181
            
            
            
            293Net
                income (loss)
            
            
            232
            
            
            
            (1,327
            )Deemed
                dividend on preferred stock
            
            
            122
            
            
            
            122Net
                income (loss) attributable to common stockholders
            
            $
            110
            
            
            $
            (1,449
            )Net
                income (loss) per share:Basic
            
            $
            0.00
            
            
            $
            (0.05
            )Diluted
            
            $
            0.00
            
            
            $
            (0.05
            )Shares
                used in computing net income (loss) per share:Basic
            
            
            27,139
            
            
            
            26,825Diluted
            
            
            27,566
            
            
            
            26,825




See
      accompanying notes to unaudited condensed consolidated financial
      statements.




4
 *Index*





**SOUTHWALL
      TECHNOLOGIES INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH
      FLOWS**


**(in
      thousands)**


Three
                months endedMarch
                31,
            
            
            March
                31,2007
            
            
            2006Cash
                flows from operating activities:Net
                income (loss)
            
            $
            232
            
            
            $
            (1,327
            )Adjustments
                to reconcile net income (loss) to net cash (used in) provided by
                operating
                activities:Deferred
                income tax
            
            
            (36
            )
            
            
            82Impairment
                recoveries from long-lived assets
            
            
            (8
            )
            
            
            -Depreciation
                and amortization
            
            
            696
            
            
            
            518Stock
                compensation
            
            
            113
            
            
            
            231Change
                in assets and liabilities:Deferred
                revenues
            
            
            (99
            )
            
            
            (8
            )Accounts
                receivable, net
            
            
            (1,872
            )
            
            
            487Inventories,
                net
            
            
            (117
            )
            
            
            (1,379
            )Other
                current and non current assets
            
            
            57
            
            
            
            69Accrued
                restructuring
            
            
            (10
            )
            
            
            421Accrued
                liabilities—deferred rent
            
            
            -
            
            
            
            (1,192
            )Accounts
                payable and accrued liabilities
            
            
            (431
            )
            
            
            1,110Net
                cash used in operating activities
            
            
            (1,475
            )
            
            
            (988
            )Cash
                flows from investing activities:Restricted
                cash
            
            
            (13
            )
            
            
            5Proceeds
                from sale of property, plant and equipment
            
            
            8
            
            
            
            -Expenditures
                for property, plant and equipment
            
            
            (299
            )
            
            
            (168
            )Net
                cash used in investing activities
            
            
            (304
            )
            
            
            (163
            )Cash
                flows from financing activities:Borrowings
                on line of credit
            
            
            3,000
            
            
            
            -Repayments
                on line of credit
            
            
            (2,996
            )
            
            
            -Repayments
                of notes payable
            
            
            (267
            )
            
            
            (422
            )Proceeds
                from investment credit in Germany
            
            
            -
            
            
            
            (9
            )Net
                cash used in financing activities
            
            
            (263
            )
            
            
            (431
            )Effect
                of foreign exchange rate changes on cash
            
            
            (95
            )
            
            
            99Net
                decrease in cash and cash equivalents
            
            
            (2,137
            )
            
            
            (1,483
            )Cash
                and cash equivalents, beginning of period
            
            
            5,524
            
            
            
            6,600Cash
                and cash equivalents, end of period
            
            $
            3,387
            
            
            $
            5,117Supplemental
                cash flow disclosures:Interest
                paid
            
            $
            176
            
            
            $
            269Income
                taxes paid
            
            $
            181
            
            
            $
            293Supplemental
                schedule of non-cash investing and financing activities:Dividends
                accrued
            
            $
            122
            
            
            $
            122




See
      accompanying notes to unaudited condensed consolidated financial
      statements.





5
 *Index*





**SOUTHWALL
      TECHNOLOGIES INC.**


**NOTES
      TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
      STATEMENTS**


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





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





The
      accompanying interim condensed consolidated financial statements of Southwall
      Technologies Inc. (“Southwall” or the “Company”) are unaudited and have been
      prepared in accordance with accounting principles generally accepted in the
      United States of America for interim financial information and with the
      instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain
      information and footnote disclosure normally included in financial statements
      prepared in accordance with accounting principles generally accepted in the
      United States of America have been condensed or omitted. In the opinion of
      management, the unaudited condensed consolidated financial statements reflect
      all adjustments, consisting only of normal recurring adjustments, considered
      necessary to present fairly the financial position, results of operations and
      cash flows of Southwall and its subsidiaries for all periods presented. The
      Company suggests that these condensed consolidated financial statements be
      read
      in conjunction with the consolidated financial statements and notes thereto
      contained in the Company's Form 10-K for the year ended December 31,
      2006 filed with the Securities and Exchange Commission on April 2, 2007.
      The results of operations for the interim periods presented are not necessarily
      indicative of the operating results of the full year.





**Note 2—Inventories,
      Net:**





Inventories
      are stated at the lower of cost (determined by the average cost method) or
      market (net realizable value). 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 March 31, 2007 and December
      31,
      2006, inventories consisted of the following (in thousands):





March 31,
            
            
            December 31,2007
            
            
            2006Raw
                materials
            
            $
            3,343
            
            
            $
            3,850Work-in-process
            
            
            1,322
            
            
            
            221Finished
                goods
            
            
            1,050
            
            
            
            1,527$
            5,715
            
            
            $
            5,598





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





Basic
      net
      income (loss) per share is computed by dividing net income (loss) attributable
      to common stockholders (numerator) by the weighted average number of common
      shares outstanding (denominator) for the period. Diluted net income (loss)
      per
      share gives effect to all dilutive common shares potentially outstanding during
      the period, including stock options, warrants to purchase common stock and
      convertible preferred stock. The
      Company excludes options from the computation of diluted weighted average shares
      outstanding if the exercise price of the options is greater than the average
      market price of the shares because the inclusion of these options would be
      anti-dilutive to earnings per share. The Company also excludes preferred shares
      convertible into common stock from the computation of diluted weighted average
      shares outstanding per SFAS 128 paragraph 13, 14 and 27.





6
 *Index*





In
      net
      loss periods, the basic and diluted weighted average shares of common stock
      and
      common stock equivalents are the same because inclusion of common stock
      equivalents would be anti-dilutive. For the first quarter of 2007, a net income
      period, there were 7,078 options outstanding of which 6,001 were excluded from
      the net income per share calculation as they were anti-dilutive because the
      option prices were higher than the average market value during the three- month
      period ended March 31, 2007.





The
      Company had accrued a deemed dividend on preferred stock of $122 in the first
      quarter of 2007. The deemed dividends were not added back to the net income
      in
      the current quarter because of the anti-dilutive nature of the results. Per
      SFAS
      128, paragraph 27, convertible preferred stock is anti-dilutive whenever the
      amounts of the deemed dividend in or accumulated for the current period per
      common share obtainable on conversion exceed basic EPS. Tables summarizing
      net
      income (loss) attributable to common stockholders, for diluted net income (loss)
      per share, and shares outstanding are shown below (in thousands):





Three
                months endedMarch
                31,
            
            
            March
                31,2007
            
            
            2006Net
                income (loss) attributable to common stockholders-basic
            
            $
            110
            
            
            $
            (1,449
            )Add:  Deemed
                dividend on preferred stock
            
            
            -
            
            
            
            122Net
                income (loss) attributable to common stockholders-diluted
            
            $
            110
            
            
            $
            (1,327
            )Weighted
                average common shares outstanding-basic
            
            
            27,139
            
            
            
            26,825Dilutive
                effect of warrants
            
            
            354
            
            
            
            -Dilutive
                effect of performance shares
            
            
            -
            
            
            
            -Dilutive
                effect of Series A preferred shares
            
            
            -
            
            
            
            -Dilutive
                effect of stock options
            
            
            73
            
            
            
            -Weighted
                average common shares outstanding - diluted
            
            
            27,566
            
            
            
            26,825





**Note 4
      - Segment Reporting:**





Southwall
      operates in one segment.





The
      total
      net revenues for the automotive glass, electronic display, window film and
      architectural product lines for the three-month periods ended March 31, 2007
      and
      March 31, 2006 were as follows (in thousands):





Three
                months endedMarch
                31,
            
            
            March
                31,2007
            
            
            2006Automotive
                glass
            
            $
            3,866
            
            
            $
            2,879Electronic
                display
            
            
            2,109
            
            
            
            2,491Window
                film
            
            
            2,993
            
            
            
            3,452Architectural
            
            
            1,537
            
            
            
            1,212Total
                net revenues
            
            $
            10,505
            
            
            $
            10,034





The
      following is a summary of net revenues by geographic area (based on the location
      of the Company's customers) for the three-month periods ended March 31, 2007
      and
      March 31, 2006, respectively (in thousands):





Three
                months endedMarch
                31,
            
            
            March
                31,2007
            
            
            2006United
                States
            
            $
            2,374
            
            
            $
            3,647Japan
            
            
            2,071
            
            
            
            2,108France
            
            
            1,084
            
            
            
            142Pacific
                Rim
            
            
            2,621
            
            
            
            2,915Germany
            
            
            1,070
            
            
            
            779Rest
                of the world
            
            
            1,285
            
            
            
            443Total
                net revenues
            
            $
            10,505
            
            
            $
            10,034





7
 *Index*





**Note 5--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 have included the closure
      of
      our Palo Alto, California manufacturing facility and a reduction in force at
      our
      Palo Alto site during the first half of 2006. We accrued $1.5 million in third
      quarter of 2006 as a leasehold asset retirement obligation in connection with
      this surrender plan. We expect to complete our surrender of this building to
      our
      landlord in the second quarter of 2007.





On
      February 19, 2004, the Company entered into the second amendment to the lease
      for one of its Palo Alto, California facilities. The amendment reflected a
      payment schedule for a rent deferral for this lease agreement. In January of
      2006, the Company paid off approximately $1.2 million of this deferred
      rent.  As of March 31, 2007, there was no deferred rent
      outstanding.





*Contingencies*





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





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





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





The
      Company has a stock-based compensation program that provides its Board of
      Directors broad discretion in creating employee equity incentives. The Company
      has granted stock options under various option plans and agreements in the
      past
      and currently grants stock options under the 1997 Stock Incentive Plan and
      the
      1998 Stock Option Plan for employees, board members and consultants. The Board
      of Directors adopted the 1998 Stock Option Plan for employees and consultants
      on
      August 6, 1998. The Compensation Committee of the Board of Directors administers
      the plans and agreements. The exercise price of options granted under the 1997
      and 1998 plans must be at least 85% of the fair market value of the stock at
      the
      date of grant. Options granted under the 1998 plan prior to October 2004
      generally vest at a rate of 25% per year, are non-transferable and expire over
      terms not exceeding ten years from the date of grant or three months after
      the
      optionee terminates his relationship with the Company. Options granted under
      the
      1997 plan prior to October 2004 generally vest at a rate of 25% per year, are
      non-transferable and expire over terms not exceeding ten years from the date
      of
      grant or eighteen months after the optionee terminates his relationship with
      the
      Company.  In October 2004, the board of directors changed the vesting.
      Grants from and after October 2004 under both plans vest at a rate of 25% after
      six months and then evenly monthly thereafter for the remaining 42 months.
      The
      Company also has an Employee Stock Purchase Plan (ESPP) that allows employees,
      subject to certain limitations, to purchase shares at 85% of the lower of the
      fair market value of the Common Stock at the beginning of the six-month offering
      period, or the last day of the purchase period. As of March 31, 2007, the
      Company had approximately 883 shares of common stock reserved for future
      issuance under our stock option plans and ESPP.





8
 *Index*





On
      January 1, 2006, the Company adopted the provisions of SFAS 123R, “Shared-Based
      Payment” (SFAS 123R), requiring it to recognize expense related to the fair
      value of our stock-based compensation awards. The Company elected to use the
      modified prospective transition method as permitted by SFAS 123R and therefore
      has not restated its financial results for prior periods. Under this transition
      method, stock-based compensation expense for the three months ended March 31,
      2007 includes compensation expense for all stock-based compensation awards
      granted prior to, but not yet vested as of January 1, 2006, based on the grant
      date fair value estimated in accordance with the original provisions of SFAS
      123. Stock-based compensation expense for all stock-based compensation awards
      granted subsequent to January 1, 2006 was based on the grant-date fair value
      estimated in accordance with the provisions of SFAS 123R. The Company recognized
      compensation expense for stock option awards on a straight line vesting basis
      over the requisite service period of the award.





The
      following table sets forth the total stock-based compensation expense resulting
      from stock options included in the condensed consolidated statements of
      operations (in thousands):





Three
                months endedMarch
                31,
            
            
            March
                31,2007
            
            
            2006Cost
                of sales
            
            $
            1
            
            
            $
            11Research
                and development
            
            
            27
            
            
            
            54Selling,
                general and administrative
            
            
            85
            
            
            
            166Stock-based
                compensation expense before income  taxes
            
            
            113
            
            
            
            231Income
                tax benefit
            
            
            -
            
            
            
            -Total
                stock-based compensation expense after income taxes$
            113
            
            
            $
            231





There
      were no cash proceeds from the exercise of stock options for the three months
      ended March 31, 2007, and March 31, 2006. No income tax benefit was realized
      from stock option exercises during the three months ended March 31, 2007, and
      March 31, 2006. In accordance with SFAS 123R, the Company presents excess tax
      benefits from the exercise of stock options, if any, as financing cash flows
      rather than operating cash flows.





The
      fair
      value of stock-based awards was estimated using the Black-Scholes model with
      the
      following weighted-average assumptions for the three months ended March 31,
      2007, and March 31, 2006, respectively:





Three
                months endedMarch
                31,
            
            
            March
                31,2007
            
            
            2006Expected
                life (in years)
            
            
            6.0
            
            
            
            1.9Interest
                value
            
            
            4.71
            %
            
            
            4.63
            %Volatility
            
            
            80
            %
            
            
            109
            %Dividend
            
            
            -
            
            
            
            -Weighted-average
                fair value at grant date
            
            $
            0.33
            
            
            $
            0.36





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
      was based on the U.S. Treasury yield in effect at the time of
      grant.





9
 *Index*





Stock
      option activity for the three months ended March 31, 2007, was as
      follows:





Shares
            
            
            Weighted-Average
                Exercise Price
            
            
            Weighted-Average
                Remaining Contractual Term
            
            
            Aggregate
                Intrinsic ValueOutstanding
                at December 31, 2006
            
            
            5,837
            
            
            $
            1.28Grants
            
            
            1,332
            
            
            
            0.47Exercises
            
            
            -
            
            
            
            -Forfeitures
                or expirations
            
            
            91
            
            
            
            4.66Outstanding
                at March 31, 2007
            
            
            7,078
            
            
            $
            1.08
            
            
            
            7.74
            
            
            $
            517Exercisable
                at March 31, 2007
            
            
            3,470
            
            
            $
            1.55
            
            
            
            6.34
            
            
            $
            155





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 first quarter of fiscal 2007 and the exercise price,
      times the number of shares) that would have been received by the option holders
      had all option holders exercised their options on March 31, 2007. This amount
      changes based on the fair market value of Southwall’s stock. Total intrinsic
      value of options exercised is zero for the three months ended March 31, 2007.
      Total fair value of options granted is $444 for the three months ended March
      31,
      2007.





As
      of
      March 31, 2007, $599 of total unrecognized compensation cost related to stock
      options, net of forfeitures, was expected to be recognized over a
      weighted-average period of 1.64 years.





**Note
      7--Restructuring:**





In
      December 2002, we implemented a reduction in force at our Palo Alto
      location and elected to vacate certain buildings in Palo Alto. As a result
      of these actions, we incurred a restructuring charge of $2,624 in 2002 relating
      to employee severance packages and the remaining rents due on excess facilities
      in Palo Alto that we no longer occupy. In 2003, we recorded a credit to
      operating expenses of $65 as a result of modifications to the severance packages
      of certain employees. On January 19, 2006, we commenced restructuring actions
      to
      improve our cost structure. These actions include the closure of our Palo Alto,
      California manufacturing facility and a reduction in force at our Palo Alto
      site
      in the first half of 2006. As a result of these actions, we incurred a
      restructuring charge of $452 during the first quarter of 2006 relating to
      employee severance packages, and related charges.





The
      following tables set forth the beginning and ending liability balances relating
      to the above described restructuring activities as well as activity during
      the
      three-month periods ended March 31, 2007 and March 31, 2006 (in
      thousands):





Restructuring
            
            
            RestructuringPlan
                2006
            
            
            Plan
                2002Severance
                and Benefits
            
            
            Facilities
                Related and Other
            
            
            Facilities
                Related
            
            
            TotalBalance
                at January 1, 2006
            
            $
            -
            
            
            $
            -
            
            
            $
            199
            
            
            $
            199Provisions
            
            
            375
            
            
            
            77
            
            
            
            -
            
            
            
            452Adjustment
                to reserve
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Cash
                payments
            
            
            (11
            )
            
            
            (20
            )
            
            
            -
            
            
            
            (31
            )Balance
                at March 31, 2006
            
            $
            364
            
            
            $
            57
            
            
            $
            199
            
            
            $
            620




10
 *Index*





Severance
                and Benefits
            
            
            Facilities
                Related and Other
            
            
            Facilities
                Related
            
            
            TotalBalance
                at January 1, 2007
            
            $
            19
            
            
            $
            9
            
            
            $
            93
            
            
            $
            121Provisions
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Adjustment
                to reserve
            
            
            -
            
            
            
            (2
            )
            
            
            -
            
            
            
            (2
            )Cash
                payments
            
            
            -
            
            
            
            (7
            )
            
            
            -
            
            
            
            (7
            )Balance
                at March 31, 2007
            
            $
            19
            
            
            $
            0
            
            
            $
            93
            
            
            $
            112




At
      March
      31, 2007, $112 was included in other accrued liabilities on the condensed
      consolidated balance sheet.





**Note
      8--Guarantees:**





The
      Company establishes a reserve for sales returns and warranties for specifically
      identified, as well as anticipated sales returns and warranties based on
      experience. The activity in the reserve for sales returns and warranties account
      during the three-month periods ended March 31, 2007 and March 31, 2006 was
      as
      follows


(in
      thousands):





Balance
                at
            
            
            
            
            
            
            
            
            Balance
                atDecember 31,
            
            
            
            
            
            
            
            
            March 31,2005
            
            
            Provision
            
            
            Utilized
            
            
            2006Accrued
                sales returns and warranty
            
            $
            1,556
            
            
            $
            (86
            )
            
            $
            (166
            )
            
            $
            1,304





Balance
                at
            
            
            
            
            
            
            
            
            Balance
                atDecember 31,
            
            
            
            
            
            
            
            
            March 31,2006
            
            
            Provision
            
            
            Utilized
            
            
            2007Accrued
                sales returns and warranty
            
            $
            1,415
            
            
            $
            (305
            )
            
            $
            (262
            )
            
            $
            848





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





**Note
      9 – Comprehensive Income (Loss):**





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





The
      total
      comprehensive income (loss) for the three-month period ended March 31, 2007
      and March 31, 2006 was as follows (in thousands):





March
                31,
            
            
            March
                31,2007
            
            
            2006Foreign
                Currency Translation Adjustment
            
            $
            17
            
            
            $
            324Net
                Income (Loss)
            
            
            232
            
            
            
            (1,327
            )Other
                Comprehensive Income (Loss)
            
            $
            249
            
            
            $
            (1,003
            )





The
      components of accumulated other comprehensive income was as follows at March
      31,
      2007 (in thousands):





Accumulated
                Other Comprehensive Income at December 31, 2006
            
            $
            3,696Foreign
                Currency Translation Adjustment
            
            
            17Accumulated
                Other Comprehensive Income at March 31, 2007
            
            $
            3,713





**Note
      10 – Recent Accounting Pronouncements:**





In
      June
      2006, the Financial Accounting Standards Board issued Interpretation No. 48,
      “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement
      No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income
      taxes recognized in an enterprise’s financial statements in accordance with SFAS
      109. It prescribes a recognition threshold and measurement attribute for the
      financial statements recognition and measurement of a tax taken or expected
      to
      be taken in a tax return. FIN 48 also provides guidance on derecognition,
      classification, interest and penalties, accounting in interim periods and
      disclosures. We adopted FIN 48 on January 1, 2007. The impact of FIN 48 did
      not
      have a material effect on our financial statements.





11
 *Index*





In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 157, “Fair Value Measurements”
(“SFAS 157”). This statement defines fair value, establishes a framework for
      measuring fair value in generally accepted accounting principles and expands
      disclosures about fair value measurements. SFAS 157 is effective for financial
      statements issued for fiscal years beginning after November 15, 2007, and
      interim periods within those fiscal years. We are currently evaluating the
      effect that the adoption of SFAS 157 will have on our financial position and
      results of operations.





On
      September 13, 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108 (“SAB 108”). The interpretations in SAB 108 were
      issued to address diversity in practice in quantifying financial statement
      misstatement and the potential under current practice for the build up
      of  improper amounts on the balance sheet. The adoption of SAB 108 did
      not have a significant impact on our position and results of operations in
      the
      first quarter of 2007.





In
      February 2007, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities-Including an amendment of FASB
      Statement No. 115” (“SFAS 159”). The objective of this statement is to improve
      financial reporting by providing entities with the opportunity to mitigate
      volatility in reported earnings caused by measuring related assets and
      liabilities differently without having to apply complex hedge accounting
      provisions. SFAS 159 is effective as of the beginning of an entity’s first
      fiscal year that begins after November 15, 2007. We are currently evaluating
      the
      effect that the adoption of SFAS 159 will have on our financial positions and
      results of operations.





In
      addition, the Company is reviewing the Emerging Issues Task Force 06-03 (“EITF
      06-03”) issued in June 2006, effective to financial reporting for interim and
      annual reporting periods beginning after December 15, 2006. This EITF applies
      to
      taxes assessed by various governmental authorities on many different types
      of
      transactions. These taxes range from sales taxes that are applied to a broad
      class of transactions involving a wide range of goods and services to excise
      taxes that are applied only to specific types of transactions or items. We
      are
      currently evaluating the effect that the adoption of EITF 06-3 will have on
      our
      financial position and results of operations.





12
 *Index*





**Item2--Management's
      Discussion and Analysis of Financial
      Condition and Results of Operations:**





The
      following discussion and analysis of our financial condition and results of
      operations should be read in conjunction with our unaudited condensed
      consolidated financial statements and notes thereto appearing elsewhere in
      this
      report. This discussion and analysis contains forward-looking statements that
      involve risks and uncertainties, including those discussed below under
      "Forward-Looking Statements" and "Risk Factors”, set forth in Item 1A, and in
      our Annual Report on Form 10-K for the year ended December 31, 2006. You
      should not place undue reliance on these forward-looking statements. Actual
      results may differ materially from those anticipated in the forward-looking
      statements. These forward-looking statements represent our judgment as of the
      date of the filing of this Form 10-Q.





**Overview**





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





*Restructuring
      and financing activities.* As a consequence of the decline in our revenues
      and negative cash flows in 2003, we implemented several cost cutting and
      business restructuring activities during 2003 and 2004. These activities, which
      included employee layoffs and the closure of several facilities (including
      the
      closure of our Tempe manufacturing facility in the fourth quarter of 2003),
      were
      designed to improve our cash flow from operations to allow us to continue as
      a
      going concern. During the fourth quarter of 2003 and the first quarter of 2004,
      we agreed to new payment terms with all of our major creditors and vendors,
      which extended or reduced our payment obligations. We also issued $4.5 million
      of convertible promissory notes and warrants to investors. The convertible
      promissory notes were converted to Series A preferred shares and the warrants
      were exercised for shares of common stock in the fourth quarter of 2004. On
      January 19, 2006, we commenced restructuring actions to improve our cost
      structure for 2006 and beyond. These actions include the closure of our Palo
      Alto, California manufacturing facility and a reduction in force at our Palo
      Alto site in the first half of 2006. Also during the first half of 2006, we
      transferred our U.S manufacturing operations to the European site located near
      Dresden, Germany. As a result of these actions, we incurred a restructuring
      charge of $0.9 million in 2006 relating to employee severance packages, and
      related charges (see Note 7 of Notes to Unaudited Condensed Consolidated
      Financial Statements—Restructuring).





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





Our
      three
      largest customers in the automotive glass and window film markets include
      Pilkington PLC, Saint Gobain Sekurit and Globamatrix Holdings Pte. Ltd., or
      Globamatrix, which collectively accounted for approximately 60%, 45% and 54%
      of
      our total revenues during the first three months of 2007, 2006 and 2005,
      respectively.





Under
      our
      agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
      purchase commitment of $9.0 million of product**.** For each year
      after 2004 through and including 2011, Globamatrix is required to purchase
      an
      amount of product equal to 110% of the amount of product it was required to
      purchase in the prior year. Globamatrix is obligated to purchase $12.0 million
      of products in 2007. During the first quarter of 2007, Globamatrix purchased
      approximately $4.9 million of product.





13
 *Index*





*Sales
      returns and allowances.* Our gross margins and profitability have been
      adversely affected from time to time by product quality claims. From 2002 to
      2006, our sales returns provision has averaged between 1.7% and 4.5% of gross
      revenues. During 2006, our sales returns provision averaged approximately 1.7%
      of our gross revenues. During the first three months of 2007, our sales returns
      provision averaged approximately 2.5% of our gross revenues due to fewer quality
      claims received during the period.





**Critical
      Accounting Policies and Estimates**





The
      accompanying discussion and analysis of our financial condition and results
      of
      operations are based upon our condensed consolidated financial statements,
      which
      have been prepared in accordance with generally accepted accounting principles
      in the United States (U.S. GAAP). The preparation of these financial statements
      requires us to make estimates and judgments that affect the reported amounts
      of
      assets, liabilities, revenues and expenses, and related disclosure of contingent
      assets and liabilities. These estimates form the basis for making judgments
      about the carrying values of assets and liabilities that are not readily
      apparent from other sources. We base our estimates and judgments on historical
      experience and on various other assumptions that we believe are reasonable
      under
      the circumstances. However, future events cannot be forecasted with certainty
      and the best estimates and judgments routinely require adjustment. We are
      required to make estimates and judgments in many areas, including those related
      to revenue recognition, allowance for doubtful accounts and sales returns,
      valuation of inventories, assessment of probability of the outcome of current
      litigation, restructuring costs, impairment charge for long-lived assets and
      accounting for income taxes. We believe the policies disclosed are the most
      critical to our financial statements because their application places the most
      significant demands on management’s judgment. Senior management has discussed
      the development, selection and disclosure of these estimates with the Audit
      Committee of our Board of Directors.





We
      believe there have been no significant changes during the first three months
      of
      fiscal 2007 to the items that we disclosed as our critical accounting policies
      and estimates in our discussion and analysis of financial condition and results
      of operations in our 2006 Form 10-K.





**Three
      Months Ended March 31, 2007 compared with Three Months Ended March 31,
      2006**





**Results
      of Operations**





*Net
      revenues.* Our net revenues for the three months ended March 31, 2007 and
      March 31, 2006 were $10.5 million and $10.0 million, respectively. The
      increase in revenues was primarily due to higher revenues in the automotive
      and
      architectural markets which were partially offset by decrease in revenues in
      electronic display and window film markets.





Our
      net
      revenues in the window film market decreased by $0.5 million, or 14%, from
      $3.4
      million in the first quarter of 2006 to $3.0 million in the same period in
      2007.
      The decrease was primarily due to the transition of our manufacturing operations
      from Palo Alto to Germany which we successfully completed in Q3 2006. This
      resulted in supply chain issues and we were not able to completely fulfill
      the
      customer demands.





Our
      net
      revenues in the electronic display market decreased by $0.4 million, or 16%,
      from $2.5 million in the first quarter of 2006 to $2.1 million in the same
      period of 2007. The decrease was due to lower sales of both the TCP and
      Silver reflective films as a result of increased competition and pricing
      pressure in the markets served.





Our
      net
      revenues in the automotive market increased by $1.0 million, or 34%, from $2.9
      million in the first quarter of 2006 to $3.9 million in the same period of
      2007.
      The increase was due to increased demand from our OEM customers.





14
 *Index*





Our
      net
      revenues in the architectural market increased by $0.3 million, or 25%, from
      $1.2 million in the first quarter of 2006 to $1.5 million in the same period
      of
      2007. The increase was due to strengthening of the market demand for these
      products.





*Cost
      of revenues*. Cost of revenues consists of materials and subcontractor
      services, labor and manufacturing overhead. Cost of revenues was $6.1 million
      in
      the first quarter of 2007 compared to $6.4 million in the same period of
      2006.  The decrease in cost of revenues was primarily due to transfer
      of production to our lower cost German manufacturing facility, and improved
      yields for the products. The cost of revenues decreased from 63% of net revenues
      in the first quarter of 2006 to 58% of net revenues in the same period in
      2007.





*Gross
      profit and gross margin*. Our gross profit increased $0.7 million from $3.7
      million in the first quarter of 2006 to $4.4 million in the same period of
      2007.
      As a percentage of sales, gross profit increased from 37% in the first quarter
      of 2006 to 42% in the same period in 2007 due to lower overall manufacturing
      costs as detailed above.





*Operating
      expenses*





*Research
      and development*. Research and development expenses decreased $0.3 million
      from $1.7 million in the first quarter of 2006 to $1.4 million in the same
      period of 2007. The decrease in research and development expenses was due
      primarily to decrease in labor and employee benefits costs, stock based
      compensation expense, travel, consulting and occupancy costs.





*Selling,
      general and administrative*. Selling, general and administrative expenses
      consist primarily of corporate and administrative overhead, selling
      commissions and occupancy costs. There was no significant change in
      selling, general and administrative expenses from the first quarter of 2006
      to
      the same period in 2007.





*Restructuring.*In 2006, we recorded a charge to operating expenses of $0.9 million as
      a
      result of further reductions in workforce at our Palo Alto manufacturing
      facility and the relocation of the company’s headquarters office to Fabian way,
      Palo Alto, California. There was no such restructuring charge in the first
      quarter of 2007.





*Income
      (loss) from operations*.  Income from operations increased $1.5
      million from a loss of $1.0 million in the first quarter of 2006 to an
      income of $0.5 million in the same period of 2007.  The increase was
      primarily due to an increase in revenue, decrease in cost of revenues, decrease
      in research and development costs, decrease in stock based employee compensation
      expense, and no restructuring charge in the first quarter of 2007.





*Interest
      expense, net.*Interest expense, net, decreased $0.1 million from $0.2
      million in the first quarter of 2006 to $0.1 million in the same period of
      2007.
      The decrease in interest expense was primarily attributable to less outstanding
      debt during the first quarter of 2007 compared to the same period in
      2006.





*Other
      income, net*. Other income, net, primarily reflects foreign exchange
      transaction gains and losses since some of our transactions with foreign
      customers are denominated in foreign currencies, principally the Euro. As
      exchange rates fluctuate relative to the U.S. dollar, exchange gains and losses
      occur.  In the first quarter of 2006, other income, net, also included
      a refund of $0.1 million for energy and waste water rebate received at SEG.
      Other income, net, was minimal in the same period in 2007.





*Income
      (loss) before provision for income taxes*. We recorded a pre-tax income of
      $0.4 million in the first quarter of 2007 and a pre-tax loss of $1.0 million
      in
      the first quarter of 2006. The increase of $1.4 million was primarily due to
      an
      increase in revenue, decrease in research and development costs, decrease in
      stock based employee compensation expense and no restructuring charges in the
      first quarter of 2007.





15
 *Index*





*Provision
      for income taxes*. The decrease in the provision for income taxes in the
      first quarter of 2007 compared to the same period in 2006 is due to lower
      taxable income in 2007 at our German subsidiary, Southwall Europe GmBH, or
      SEG. In 2006 we included an accrual of $132,000 for taxes relating to the
      income tax audit for years 1999 to 2002 at SEG.





*Net
      income (loss).* In the first quarters of 2007 and 2006, we recorded a net
      income of $0.2 million and a net loss of $1.3 million, respectively. The
      increase of $1.5 million was primarily due to an increase in revenue, decrease
      in research and development costs, decrease in stock based employee compensation
      expense, no restructuring charges and lower income tax provision in the first
      quarter of 2007.





*Deemed
      dividend on preferred stock.* We accrued $0.1 million of deemed dividend on
      preferred stock in the first quarter of 2007 and the first quarter of 2006.
      The
      holders of our secured convertible promissory notes converted those notes to
      shares of Series A preferred stock in December 2004. The Series A preferred
      stock accrues cumulative dividends at the rate of 10% per annum.





**Liquidity
      and capital resources.**





*Liquidity*





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





Our
      cash
      and cash equivalents decreased $2.1 million from $5.5 million at December 31,
      2006 to $3.4 million at March 31, 2007. Cash used in operating activities of
      $1.5 million for the first three months of 2007 was primarily the result of
      an
      increase in accounts receivable of $1.9 million due to increase in revenue
      in
      the first quarter of 2007, which are not due for collection until the second
      quarter of 2007, increase in inventories of $0.1 million, decrease in deferred
      revenue of $0.1 million, decrease in accounts payable and accrued liabilities
      of
      $0.4 million and partially offset by net income of $0.2 million, non-cash
      depreciation of $0.7 million and stock compensation of $0.1 million. Cash used
      in operating activities for the first quarter of 2006 of $1.0 million was
      primarily the result of net loss of $1.3 million, increase in inventories of
      $1.4 million, decrease in accrued liabilities of $1.2 million due to a deferred
      rent payment and partially offset by non-cash depreciation of $0.5 million,
      stock compensation of $0.2 million, decreases in accounts receivable of $0.5
      million, increase in accrued restructuring of $0.4 million and an increase
      in
      accounts payable and accrued liabilities of $1.1 million.





Cash
      used
      in investing activities for the first three months of 2007 was $0.3 million
      and
      was the result of capital expenditures. Cash used in investing activities for
      the three months of 2006 of $0.2 million was primarily the result of capital
      expenditures.





Cash
      used
      in financing activities for the first three months of 2007 was $0.3 million
      and
      was primarily the result of payments of $0.3 million on our borrowings. Cash
      used in financing activities for the three months of 2006 of $0.4 million was
      the result of payments on our borrowings.





We
      entered into an agreement with the Saxony government in May 1999 under which
      we
      receive investment grants. As of March 31, 2007, we had received 5.0 million
      Euros or $5.0 million at historical exchange rate of the grants and accounted
      for these grants by applying the proceeds received to reduce the cost of our
      fixed assets in our Dresden manufacturing facility. As of March 31, 2007, we
      had
      a balance remaining from the government grants of $0.2 million, which has been
      recorded as an advance and held as restricted cash until we receive approval
      from the Saxony government to apply the funds to reduce our capital
      expenditures. If we fail to meet certain requirements in connection with these
      grants, the Saxony government has the right to demand repayment of the grants.
      The total annual amount of investment grants and investment allowances that
      we
      are entitled to seek varies from year to year based upon the amount of our
      capital expenditures that meet certain requirements of the Saxony government.
      Generally, we are not eligible to seek investment grants and allowances in
      the
      aggregate for any year in excess of 33% of our eligible capital expenditures
      in
      Germany for that year. The measurement dates of these requirements was June 30,
      2006. We believe we met the requirements at June 30, 2006. In addition, we
      are
      in discussions with the Saxony government with regard to $0.2 million unused
      grants that we have previously received and currently hold as restricted cash.
      We expect to close these grants in the second quarter of 2007. However, we
      cannot guarantee that we will be eligible for or will receive additional grants
      in the future from the Saxony government.





16
 *Index*





*Borrowing
      arrangements*





On
      March
      29, 2007, we entered into a new Credit Agreement (“Credit Agreement”) with
      Bridge Bank, N.A. (“Bank”), replacing our credit agreement with Wells Fargo HSBC
      Trade Bank, N.A. The Credit Agreement provides for two facilities. The first
      facility is a revolving line of credit for the lesser of $3 million or the
      face
      value of the letter of credit used to support the facility. The Proceeds of
      the
      facility will be used to pay off Wells Fargo HSBC Trade Bank. Amounts borrowed
      under the first facility bear interest at the prime rate minus 1.75% and are
      collateralized by a $3 million standby letter of credit from Needham &
Company (“Needham”). At December 31, 2006, Needham and its affiliates owned
      41.7% of our outstanding common stock and series A 10% Cumulative Convertible
      Preferred Stock convertible into another 5% of our outstanding common stock.
      If
      the letter of credit being provided by Needham is not released by August 1,
      2007, Needham will begin receiving from us quarterly interest payments on the
      $3
      million supporting the letter of credit at the rate of 12.8% per
      annum.





The
      second facility is a $3 million revolving line of credit line under which we
      may, from time to time, borrow up to 80% of eligible accounts receivables (net
      of pre-paid deposits, pre-billed invoices, deferred revenue, offsets, contras
      related to each specific account debtor and other requirements in the lender’s
      discretion). Amounts borrowed under the second facility bear interest at the
      prime plus 1.75% annualized on the average daily finance amount outstanding.
      The
      second facility also provides for a $2 million letter of credit subfacility.
      All
      borrowings under the facilities will be collateralized by all our assets and
      are
      subject to certain covenants. These covenants include that while the second
      facility is outstanding (a) we will maintain a minimum current ratio of 1.00
      to
      1.00 for the months through May 31, 2007 (thereafter, starting with month ending
      June 30, 2007, we need to maintain a current ratio of 1.25 to 1.00 on a monthly
      basis); and (b) our quarterly net loss to shareholders (including deemed
      dividend) will not exceed $0.4 million for any quarter after September 30,
      2007.





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





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





17
 *Index*





The
      maturity date of the facilities is March 28, 2008.





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





*Capital
      expenditures*





We
      expect
      to spend approximately $1.8 million in 2007 on upgrades and refurbishment of
      our
      production machines and research and development tools. We spent approximately
      $0.3 million in capital expenditures during the first three months of
      2007.





*Future
      payment obligations*





Our
      future payment obligations on our borrowings pursuant to our term debt, line
      of
      credit, non-cancelable operating leases and other non-cancelable contractual
      commitments are as follows at March 31, 2007 (in thousands):





Less
            
            
            
            
            
            
            
            
            GreaterThan
            
            
            
            
            
            
            
            
            ThanTotal
            
            
            1
                Year
            
            
            1-3
                Years
            
            
            3-5
                Years
            
            
            5
                YearsContractual
                Obligations:Term
                debt (1)
            
            $
            9,451
            
            
            $
            1,068
            
            
            $
            4,638
            
            
            $
            1,248
            
            
            $
            2,497Line
                of credit (1)
            
            
            3,000
            
            
            
            3,000
            
            
            
            --
            
            
            
            --
            
            
            
            --Operating
                leases (2)
            
            
            2,049
            
            
            
            621
            
            
            
            838
            
            
            
            590
            
            
            
            --Total
                contractual cash obligations
            
            $
            14,500
            
            
            $
            4,689
            
            
            $
            5,476
            
            
            $
            1,838
            
            
            $
            2,497




(1)
            Represents
                loan agreements with Portfolio Financing Servicing Company, Bridge
                Bank
                and several German banks.





(2)
            Represents
                the remaining rents
                owed on a building we rent in Palo Alto and Mountain View,
                California.




On
      June
      13, 2006, we signed a sublease agreement with Maxspeed to sublease 3782-3788
      Fabian Way, Palo Alto, California 94303. The term of this sublease commenced
      on
      June 16, 2006 and will continue until December 31, 2008, with monthly rent
      payments of $18,000 through May 31, 2008, and $19,000 through December 31,
      2008





On
      June
      21, 2006, we amended our lease with Richard Christina to extend our original
      lease through June 30, 2011 for the facilities at 3780 Fabian Way, Palo Alto,
      California 94303. Also, on June 21, 2006, we entered into a lease agreement
      with
      Richard Christina to lease 3782-3788 Fabian Way, Palo Alto, California. The
      term
      of this lease extend the rental term for all premises (3780 and 3782-3788 Fabian
      Way, Palo Alto, California) to June 30, 2011 at a base rent of $38,000 per
      month. On January 1, 2010 and 2011, the base rent shall increase by
      3%.





18
 *Index*





**Item3--Quantitative
      and Qualitative Disclosures about Market
      Risk**





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





Financing
      risk: Our exposure to market rate risk for changes in interest rates relates
      primarily to our line of credit which bears an interest rate equal to prime
      rate
      minus 1.75% (which was 6.50% at March 31, 2007) and is calculated based on
      amounts borrowed under the facility. In addition, the interest rate on one
      of
      our German loans has been reset to the prevailing market rate of 5.75% and
      another of our German loans will have its interest rate reset to the prevailing
      market rate in 2009. Fluctuations or changes in interest rates may adversely
      affect our expected interest expense. The effect of a 10% fluctuation in the
      interest rate on our line of credit and term debt would have had an immaterial
      effect on our interest expense for the first three months of 2007.





Investment
      risk: We invest our excess cash in money market accounts and, by practice,
      limit
      the amount of exposure to any one institution. Investments in both fixed rate
      and floating rate interest earning instruments carry a degree of interest rate
      risk. Fixed rate securities may have their fair market value adversely affected
      due to a rise in interest rates, while floating rate securities may produce
      less
      income than expected if interest rates fall. The effect of a 10% fluctuation
      in
      the interest rate on our excess cash investments would not have had a material
      effect on our interest expense in the first three months of 2007.





Foreign
      currency risk: International revenues (defined as sales to customers located
      outside of the United States) accounted for approximately 77% of our total
      sales
      in the first three months of 2007. Approximately 44% of our international
      revenues were denominated in Euros relating to sales from our Dresden operation
      in the first quarter of 2007. The other 56% of our international sales were
      denominated in US dollars. In addition, certain transactions with foreign
      suppliers are denominated in foreign currencies (principally Japanese Yen).
      The
      effect of a 10% fluctuation in the Euro exchange rate would have had an effect
      of approximately $0.6 million on net revenues for the first three months of
      2007
      and the effect on expenses of a 10% fluctuation in the Yen exchange rate would
      have been immaterial.





19
 *Index*





**FORWARD-LOOKING
      STATEMENTS**





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





·
            our
                ability to remain as a going
                concern;




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




·
            the
                success of our restructuring
                activities;




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




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




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




·
            our
                competition;




·
            statements
                about the future size of markets;




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




·
            our
                expected results of operations and cash
                flows;




·
            pending
                and threatened litigation and its outcome;
                and




·
            our
                projected capital expenditures.




You
      should not place undue reliance on our forward-looking statements. Actual events
      or results may differ materially. In evaluating these statements, you should
      specifically consider various factors, including the risks outlined below under
      "Risk Factors" and under “Risk Factors” in our 2006 Form 10-K. These factors may
      cause our actual results to differ materially from any forward-looking
      statement. Although we believe the expectations reflected in our forward-looking
      statements are reasonable as of the date they are being made, we cannot
      guarantee our future results, levels of activity, performance, or achievements.
      Moreover, neither we, nor any other person, assume responsibility for the future
      accuracy and completeness of these forward-looking statements.





20
 *Index*





**Item4T--Controls and Procedures**





(a)
            *Evaluation
                and Disclosure Controls and Procedures*.  Under the
                supervision and with the participation of our management, including
                our
                chief executive officer and vice president of finance, we conducted
                an
                evaluation of the effectiveness of the design and operation of our
                disclosure controls and procedures, as defined in Rules 13a-15(e)
                and
                15d-15(e) under the Securities Exchange Act of 1934, as amended,
                as of
                March 31, 2007.  Based on this evaluation, our chief executive
                officer and vice president of finance concluded as of the Evaluation
                Date
                that our disclosure controls and procedures were effective such that
                the
                information relating to our company, including our consolidated
                subsidiaries, required to be disclosed in our Securities and Exchange
                Commission (“SEC”) reports (i) is recorded, processed, summarized and
                reported with the time periods specified in SEC rules and forms,
                and (ii)
                is accumulated and communicated to our management, including our
                chief
                executive officer and vice president of finance, as appropriate to
                allow
                timely decisions regarding required
                disclosure.





(b)
            *Report
                on Internal Control Over Financial Reporting*. We will be required by
                the Sarbanes-Oxley Act to include an assessment of our internal control
                over financial reporting and in our Annual Report on Form 10-K beginning
                with the filing for our fiscal year ending December 31,
                2007.





(c)
            *Changes
                in Internal Controls*.  There were no changes during the
                first three months of 2007 in our internal controls over financial
                reporting that have materially effected, or are reasonably likely
                to
                materially affect, the internal controls over financial
                reporting.





21
 *Index*





**PART
      II--OTHER INFORMATION**




**Item
      1--Legal Proceedings**





Not
      applicable.





**Item
      1A—Risk Factors**





The
      following information updates, and should be read in conjunction with, the
      information disclosed in Item 1A, “Risk Factors,” of our Annual Report on Form
      10K for the year ended December 31, 2006 and filed with the SEC on April 2,
      2007.





**Financial
      Risks**





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





We
      incurred net losses in 2006, 2004 and 2003 and negative cash flows from
      operations in the first quarter of 2007 and in 2003. These factors together
      with
      our working capital position and our significant debt service and other
      contractual obligations at December 31, 2006 and March 31, 2007, may raise
      doubt
      about our ability to restore profitable operations, generate cash flow from
      operating activities and obtain additional financing. These and other factors
      related to our business during recent years, our past failure to comply with
      covenants in our financing agreements and our voluntary delisting from NASDAQ
      in
      March 2004 may make it difficult for us to secure the required additional
      borrowings on favorable terms or at all. We intend to seek additional borrowings
      or alternative sources of financing; however, difficulties in borrowing money
      or
      raising financing could have a material adverse effect on our operations,
      planned capital expenditures and ability to comply with the terms of government
      grants.





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





As
      of
      March 31, 2007, we had total outstanding obligations under our credit and other
      loan agreements of $12.5 million. Our inability to make timely payments of
      interest or principal under these facilities could materially adversely affect
      our ability to borrow money under existing credit facilities, to secure
      additional borrowings or to function as a going concern. Our current credit
      facilities contain financial covenants that require us to meet certain financial
      performance targets and operating covenants that limit our discretion with
      respect to business matters. Among other things, these covenants restrict our
      ability to borrow additional money, create liens or other encumbrances, and
      make
      certain payments including dividends and capital expenditures. Many of these
      loans contain provisions that permit the lender to declare the loans immediately
      due if there is a material adverse change in our business. These credit
      facilities also contain events of default that could require us to pay off
      indebtedness before its maturity.  The restrictions imposed by these
      credit facilities or the failure of lenders to advance funds under these
      facilities could force us to curtail our operations or have a material adverse
      effect on our liquidity.





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





In
      2004,
      2005, 2006 and during the first quarter of 2007, approximately 31%, 32%, 30%
      and
      41% of our revenues, respectively, were denominated in euros, primarily related
      to sales from our Dresden operation, including sales to one of our largest
      customers, a European automotive glass manufacturer. In addition, other
      customers may request to make payments in foreign currencies. Also, certain
      transactions with foreign suppliers are denominated in foreign currencies,
      primarily Japanese Yen.





22
 *Index*





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





**Operational
      Risks**





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





Our
      ten
      largest customers accounted for approximately 83%, 77%, 81% and 79% of net
      revenues during the first quarter 2007 and in 2006, 2005 and 2004, respectively.
      We expect to continue to derive a significant portion of our net sales from
      this
      relatively small number of customers. Accordingly, the loss of a large customer
      could materially hurt our business, and the deferral or loss of anticipated
      orders from a large customer or a small number of customers could materially
      reduce our revenue and operating results in any period. Some of our largest
      automotive glass customers have used a technology—direct-to-glass sputtering—as
      an alternative to our window films, which in 2003 resulted in a decrease in
      orders from these customers. The continued or expanded use of this technology
      by
      our automotive glass customers would have a material adverse effect on our
      results of operations and financial position.





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





Our
      business depends largely on sales by manufacturers of products that include
      electronic displays. The markets for electronic display products are highly
      cyclical and have experienced periods of oversupply resulting in significantly
      reduced demand for our products.  In addition, the continuing
      cost-down pressure in the Display markets particularly in PDPs limits the
      applications for our film-based filters due to increased competition, and we
      expect this trend to continue. We are also dependent on our marketing partner
      to
      successfully promote film-based filters.





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





Revenues
      from international sales amounted to approximately 77%, 68%, 74% and 79% of
      our
      net revenues during the first quarter of 2007 and in 2006, 2005 and 2004,
      respectively. The distance between our two manufacturing sites creates
      logistical and communications challenges. In addition, to achieve acceptance
      in
      international markets, our products must be modified to handle a variety of
      factors specific to each international market as well as local regulations.
      We
      may also be subject to a number of other risks associated with international
      business activities. These risks include:





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


•
            potentially
                adverse tax consequences; and


•
            global
                economic turbulence and political
                instability.





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





None.





23
 *Index*





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





Not
      applicable.




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





None.





**Item
      5--Other Information**





None.




**Item
      6--Exhibits**





(a)
            Exhibits








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





24
 *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:   May
                11, 2007**Southwall
                Technologies Inc.**By:
            /s/
                Dr. Eugene GoodsonDr.
                Eugene Goodson*President
                and Chief Executive Officer*By:
            /s/
                Sylvia KamenskiSylvia
                Kamenski*Vice
                President of Finance*






25