**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 September 30, 2006**


**or**


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




**For
      the transition period from to**







**Commission
      File Number: 0-15930**


___________________








**SOUTHWALL
      TECHNOLOGIES INC.**


(Exact
      name of registrant as specified in its charter)





**Delaware**
            
            **94-2551470**(State
                or other jurisdiction of incorporation or organization)
            
            (I.R.S.
                Employer Identification Number)**3788
                Fabian Way, Palo Alto, California**
              (Address
                of principal executive offices)
            
            **94303**
              (Zip
                Code)








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


___________________




Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months (or for such shorter period that the
      registrant was required to file such reports), and (2) has been subject to
      such filing requirements for the past 90 days. Yes x No o





Indicate
      by check mark whether the registrant is an accelerated filer (as defined in
      Rule
      12b-2 of the Exchange Act). Yes o No x





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).  Yes o No x





As
      of
      November 1, 2006, there were 26,957,001 shares of the Registrant's Common Stock
      outstanding.







1





**SOUTHWALL
      TECHNOLOGIES INC.**





**INDEX**





PagePART
                I - FINANCIAL INFORMATIONItem
                1
            Financial
                StatementsUnaudited
                Condensed Consolidated Balance Sheets - September
                30, 2006 and December 31, 2005
            3Unaudited
                Condensed Consolidated Statements of Operations -
                Three and nine month periods ended September 30, 2006 and October
                2,
                2005
            4Unaudited
                Condensed Consolidated Statements of Cash Flows -
                Nine month periods ended September 30, 2006 and October 2,
                2005
            5Notes
                to the Unaudited Condensed Consolidated Financial
                Statements
            6Item
                2
            Management’s
                Discussion and Analysis of Financial Condition and
                Results of Operations
            14Item
                3
            Quantitative
                and Qualitative Disclosures about Market
                Risk
            24Item
                4
            Controls
                and Procedures
            25PART
                II - OTHER INFORMATIONItem
                1
            Legal
                Proceedings
            26Item
                1A
            Risk
                Factors
            27Item
                2
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            29Item
                3
            Defaults
                upon Senior Securities
            29Item
                4
            Submission
                of Matters to a Vote of Security
                Holders
            29Item
                5
            Other
                Information
            29Item
                6
            Exhibits
            29Signatures
            30





2
 *Index*




PART
      I.
      FINANCIAL INFORMATION




Item
      1--Financial Statements:


**SOUTHWALL
                TECHNOLOGIES INC.****UNAUDITED
                CONDENSED CONSOLIDATED BALANCE SHEETS****(in
                thousands, except per share data)**September
                30,
              2006
            
            December
                31,
              2005**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            5,032
            
            $
            6,600Restricted
                cash
            
            
            206
            
            
            402Accounts
                receivable, net of allowance for doubtful accounts of $170at
                September 30, 2006 and $208 at December 31, 2005
            
            
            4,804
            
            
            6,780Inventories,
                net
            
            
            5,241
            
            
            5,879Other
                current assets
            
            
            1,492
            
            
            982Total
                current assets
            
            
            16,775
            
            
            20,643Property,
                plant and equipment, net
            
            
            16,689
            
            
            16,857Restricted
                cash loans
            
            
            1,063
            
            
            995Other
                assets
            
            
            1,161
            
            
            1,146Total
                assets
            
            $
            35,688
            
            $
            39,641**LIABILITIES,
                PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Current
                portion of long term debt
            
            $
            1,030
            
            $
            1,317Line
                of credit
            
            
            2,996
            
            
            2,996Accounts
                payable
            
            
            1,543
            
            
            1,402Accrued
                compensation
            
            
            1,109
            
            
            1,161Other
                accrued liabilities
            
            
            6,300
            
            
            5,076Total
                current liabilities
            
            
            12,978
            
            
            11,952Term
                debt
            
            
            8,544
            
            
            8,790Government
                grants advanced
            
            
            206
            
            
            396Other
                long term liabilities
            
            
            2,531
            
            
            2,564Total
                liabilities
            
            
            24,259
            
            
            23,702Commitments
                and contingencies (Note 5)Series
                A 10% cumulative convertible preferred stock, $0.001 par value; $1.00
                stated value; 5,000 shares authorized, 4,893 shares outstanding at
                September 30, 2006 and December 31, 2005, respectively (Liquidation
                preference: $5,749 and $5,383 at September 30, 2006 and December
                31, 2005,
                respectively)
            
            
            4,810
            
            
            4,810Stockholders’
                equity:Common
                stock, $0.001 par value per share; 50,000 shares authorized, 26,957
                shares
                and 26,793 shares outstanding at September 30, 2006 and December
                31, 2005,
                respectively
            
            
            27
            
            
            27Capital
                in excess of par value
            
            
            78,050
            
            
            77,828Accumulated
                other comprehensive income:Accumulated
                translation adjustment
            
            
            3,236
            
            
            2,532Accumulated
                deficit
            
            
            (74,694
            )
            
            (69,258
            )Total
                stockholders’ equity
            
            
            6,619
            
            
            11,129Total
                liabilities, preferred stock and stockholders’ equity
            
            $
            35,688
            
            $
            39,641




See
      accompanying notes to unaudited condensed consolidated financial
      statements.





3
 *Index*




**SOUTHWALL
                TECHNOLOGIES INC.****UNAUDITED
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS****(in
                thousands, except per share data)**Three
                months ended
            
            Nine
                months endedSeptember
                30,
              2006
            
            October
                2,
              2005
            
            September
                30,
              2006
            
            October
                2,
              2005Net
                revenues
            
            $
            9,597
            
            $
            12,025
            
            $
            30,968
            
            $
            42,844Cost
                of revenues
            
            
            5,667
            
            
            7,921
            
            
            19,301
            
            
            28,979Gross
                profit
            
            
            3,930
            
            
            4,104
            
            
            11,667
            
            
            13,865Operating
                expenses:Research
                and development
            
            
            1,659
            
            
            1,334
            
            
            5,376
            
            
            3,047Selling,
                general and administrative
            
            
            4,674
            
            
            2,104
            
            
            9,761
            
            
            6,461Impairment
                recoveries for long-lived assets, net
            
            
            (325
            )
            
            -
            
            
            (117
            )
            
            (170
            )Restructuring
                charges
            
            
            263
            
            
            -
            
            
            974
            
            
            -Total
                operating expenses
            
            
            6,271
            
            
            3,438
            
            
            15,994
            
            
            9,338Income
                (loss) from operations
            
            
            (2,341
            )
            
            666
            
            
            (4,327
            )
            
            4,527Interest
                expense, net
            
            
            (169
            )
            
            (210
            )
            
            (550
            )
            
            (778
            )Other
                income (expenses), net
            
            
            (18
            )
            
            9
            
            
            161
            
            
            142Income
                (loss) before provision for income tax
            
            
            (2,528
            )
            
            465
            
            
            (4,716
            )
            
            3,891Provision
                for income taxes
            
            
            193
            
            
            450
            
            
            719
            
            
            782Net
                income (loss)
            
            
            (2,721
            )
            
            15
            
            
            (5,435
            )
            
            3,109Deemed
                dividend on preferred stock
            
            
            123
            
            
            120
            
            
            367
            
            
            363Net
                income (loss) attributable to common stockholders
            
            $
            (2,844
            )
            $
            (105
            )
            $
            (5,802
            )
            $
            2,746Net
                income (loss) per share:Basic
            
            $
            (0.11
            )
            $
            0.00
            
            $
            (0.22
            )
            $
            0.10Diluted
            
            $
            (0.11
            )
            $
            0.00
            
            $
            (0.22
            )
            $
            0.09Shares
                used in computing net income (loss) per share:Basic
            
            
            26,957
            
            
            26,788
            
            
            26,907
            
            
            26,727Diluted
            
            
            26,957
            
            
            32,720
            
            
            26,907
            
            
            32,999





See
      accompanying notes to unaudited condensed consolidated financial
      statements.





4
 *Index*




**SOUTHWALL
                TECHNOLOGIES INC.****UNAUDITED
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS****(in
                thousands)**Nine
                months endedSeptember
                30,
              2006
            
            October
                2,
              2005Cash
                flows from operating activities:Net
                income (loss)
            
            $
            (5,435
            )
            $
            3,109Adjustments
                to reconcile net income (loss) to net cash (used in) provided by
                operating activities:Deferred
                income tax
            
            
            54
            
            
            -Impairment
                recoveries from long-lived assets, net
            
            
            (117
            )
            
            (170
            )Depreciation
                and amortization
            
            
            1,836
            
            
            1,677Stock
                compensation
            
            
            487
            
            
            45Change
                in assets and liabilities:Deferred
                revenues
            
            
            (26
            )
            
            (26
            )Accounts
                receivable, net
            
            
            1,982
            
            
            1,456Inventories,
                net
            
            
            638
            
            
            1,112Accrued
                restructuring
            
            
            124
            
            
            -Other
                current and non current assets
            
            
            (524
            )
            
            723Accrued
                liabilities - deferred rent
            
            
            (1,192
            )
            
            -Accounts
                payable and accrued liabilities
            
            
            2,025
            
            
            (2,627
            )Net
                cash (used in) provided by operating activities
            
            
            (148
            )
            
            5,299Cash
                flows from investing activities:Restricted
                cash
            
            
            181
            
            
            244Proceeds
                from sale of property, plant and equipment
            
            
            422
            
            
            170Expenditures
                for property, plant and equipment
            
            
            (781
            )
            
            (535
            )Net
                cash used in investing activities
            
            
            (178
            )
            
            (121
            )Cash
                flows from financing activities:Repayments
                under capital lease
            
            
            -
            
            
            (5
            )Proceeds
                from exercise of stock options
            
            
            32
            
            
            20Principal
                payments on borrowings
            
            
            (1,133
            )
            
            (
                1,354
            )Payments
                on line of credit
            
            
            -
            
            
            (2,975
            )Borrowings
                on line of credit
            
            
            -
            
            
            2,996Investment
                credit in Germany
            
            
            (219
            )
            
            (30
            )Net
                cash used in financing activities
            
            
            (1,320
            )
            
            (1,348
            )Effect
                of foreign exchange rate changes on cash
            
            
            78
            
            
            (311
            )Net
                (decrease) increase in cash and cash equivalents
            
            
            (1,568
            )
            
            3,519Cash
                and cash equivalents, beginning of period
            
            
            6,600
            
            
            4,547Cash
                and cash equivalents, end of period
            
            $
            5,032
            
            $
            8,066





See
      accompanying notes to unaudited condensed consolidated financial
      statements.





5
 *Index*





**SOUTHWALL
      TECHNOLOGIES INC.**


**NOTES
      TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**




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





The
      accompanying interim condensed consolidated financial statements of Southwall
      Technologies Inc. (“Southwall” or the “Company”) are unaudited and have been
      prepared in accordance with accounting principles generally accepted in the
      United States of America for interim financial information and with the
      instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain
      information and footnote disclosure normally included in financial statements
      prepared in accordance with accounting principles generally accepted in the
      United States of America have been condensed or omitted. In the opinion of
      management, the unaudited condensed consolidated financial statements reflect
      all adjustments, consisting only of normal recurring adjustments, considered
      necessary to present fairly the financial position, results of operations and
      cash flows of Southwall and its subsidiaries for all periods presented. The
      year-end condensed balance sheet data was derived from audited financial
      statements, but does not include all disclosures required by accounting
      principles generally accepted in the United States of America. The Company
      suggests that these condensed consolidated financial statements be read in
      conjunction with the consolidated financial statements and notes thereto
      contained in the Company's Form 10-K for the year ended December 31, 2005
      filed with the Securities and Exchange Commission on March 29, 2006. The results
      of operations for the interim periods presented are not necessarily indicative
      of the operating results of the full year.





In
      2005,
      the Company used a 52-week fiscal year ending on December 31. In 2006, the
      Company changed to a fiscal calendar year ending on December 31 with fiscal
      quarters ending on March 31, June 30, and September 30. The third fiscal
      quarters of 2006 and 2005 ended on September 30, 2006 and October 2, 2005,
      respectively. The October 2, 2005 quarter included 13 weeks.





**Note 2—Inventories,
      Net:**





In
      January 2006, the Company changed its inventory valuation method from the
      first-in, first-out method to the average cost method. With the closing of
      the
      Company’s Palo Alto, California manufacturing facility and all production now
      being performed in our German subsidiary’s facility, the use of the average cost
      method was deemed preferable as it both accommodates our German subsidiary’s
      statutory reporting requirements and fairly approximates actual costs. In
      addition, the impact of the change was $0.3 million which the Company considers
      immaterial.





Inventories
      are stated at the lower of cost (determined by the average method) or market.
      Cost includes materials, labor and manufacturing overhead. The Company
      establishes provisions for excess and obsolete inventories to reduce such
      inventories to their estimated net realizable value. Such provisions are charged
      to cost of revenues. At September 30, 2006 and December 31, 2005, inventories
      consisted of the following (in thousands):





September
                30,
              2006
            
            December
                31,
              2005Raw
                materials
            
            $
            3,165
            
            $
            3,482Work-in-process
            
            
            791
            
            
            1,409Finished
                goods
            
            
            1,285
            
            
            988$
            5,241
            
            $
            5,879





**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
      redeemable convertible preferred stock. Preferred stock dividends are added
      back
      to net income attributable to common stockholders since they would not have
      been
      accrued if the preferred stock had been converted to common stock at the
      beginning of the period.





6
 *Index*





The
      Company excludes options from the computation of diluted weighted average shares
      outstanding if the exercise price of the options is greater than the average
      market price of the shares because the inclusion of these options would be
      anti-dilutive to earnings per share.  Accordingly, stock options to
      purchase 5,985,000 and 5,806,963 shares were excluded from the computation
      of
      diluted weighted average shares outstanding for the three and nine-month periods
      ended September 30, 2006, respectively. Stock options to purchase 2,415,005
      and
      1,737,505 shares at a weighted average price of $2.74 and $3.35 per share,
      respectively, were excluded from the computation of diluted weighted average
      shares outstanding for the three and nine-month periods ended October 2, 2005
      respectively.





In
      net
      loss periods, the basic and diluted weighted average shares of common stock
      and
      common stock equivalents are the same because inclusion of common stock
      equivalents would be anti-dilutive. Accordingly, for the three and nine-month
      periods ended September 30, 2006, there was no difference between the
      denominators used for the calculation of basic and diluted net income (loss)
      per
      share. Tables
      summarizing net income/(loss) attributable to common stockholders, for diluted
      net income (loss) per share, and shares outstanding are shown below (in
      thousands):





Three
                months ended
            
            Nine
                months endedSeptember
                30,
              2006
            
            October
                2,
              2005
            
            September
                30,
              2006
            
            October
                2,
              2005Net
                income (loss) attributable to common stockholders-basic
            
            $
            (2,844
            )
            $
            (105
            )
            $
            (5,802
            )
            $
            2,746Add:
                Deemed dividend on preferred stock
            
            
            123
            
            
            120
            
            
            367
            
            
            363Net
                income (loss) attributable to common stockholders-diluted
            
            $
            (2,721
            )
            $
            15
            
            $
            (5,435
            )
            $
            3,109Weighted
                average common shares outstanding-basic
            
            
            26,957
            
            
            26,788
            
            
            26,907
            
            
            26,727Dilutive
                effect of warrants
            
            
            -
            
            
            356
            
            
            -
            
            
            357Dilutive
                effect of performance shares
            
            
            -
            
            
            -
            
            
            -
            
            
            50Dilutive
                effect of Series A preferred shares
            
            
            -
            
            
            4,893
            
            
            -
            
            
            4,893Dilutive
                effect of stock options
            
            
            -
            
            
            683
            
            
            -
            
            
            972Weighted
                average common shares outstanding - diluted
            
            
            26,957
            
            
            32,720
            
            
            26,907
            
            
            32,999








**Note 4
      - Segment Reporting:**





Southwall
      reports segment information using the management approach to determine segment
      information. The management approach designates the internal organization that
      is used by management for making operating decisions and assessing performance
      as the source of its reportable segments. The Company is organized on the basis
      of products and services. The total net revenues for the automotive glass,
      electronic display, window film and architectural product lines for the three
      and nine-month periods ended September 30, 2006 and October 2, 2005 were as
      follows (in thousands):




Three
                  months ended
              
              Nine
                  months endedSeptember
                  30,
                2006
              
              October
                  2,
                2005
              
              September
                  30,
                2006
              
              October
                  2,
                2005Automotive
                  glass
              
              $
              3,019
              
              $
              3,857
              
              $
              9,726
              
              $
              15,179Electronic
                  display
              
              
              2,564
              
              
              3,049
              
              
              8,325
              
              
              10,425Window
                  film
              
              
              2,424
              
              
              3,907
              
              
              8,880
              
              
              13,034Architectural
              
              
              1,590
              
              
              1,212
              
              
              4,037
              
              
              4,206Total
                  net revenues
              
              $
              9,597
              
              $
              12,025
              
              $
              30,968
              
              $
              42,844
 
 The
        following is a summary of net revenues by geographic area (based on the location
        of the Company's customers) for the three and nine-month periods ended September
        30, 2006 and October 2, 2005, respectively (in thousands):
  7
 *Index*
 
 Three
                  months ended
              
              Nine
                  months endedSeptember
                  30,
                2006
              
              October
                  2,
                2005
              
              September
                  30,
                2006
              
              October
                  2,
                2005United
                  States
              
              $
              3,231
              
              $
              3,290
              
              $
              10,408
              
              $
              11,001Japan
              
              
              2,639
              
              
              2,822
              
              
              7,948
              
              
              9,252France
              
              
              855
              
              
              1,955
              
              
              2,283
              
              
              8,448Pacific
                  Rim
              
              
              1,916
              
              
              2,713
              
              
              6,617
              
              
              8,798Germany
              
              
              667
              
              
              693
              
              
              2,612
              
              
              3,406Rest
                  of the world
              
              
              289
              
              
              552
              
              
              1,100
              
              
              1,939Total
                  net revenues
              
              $
              9,597
              
              $
              12,025
              
              $
              30,968
              
              $
              42,844


**Note 5--Commitments
      and Contingencies:**





*Commitments*





On
      January 19, 2006, the Company announced its plans to close its Palo Alto
      manufacturing facility consisting of two buildings. As a result of this
      decision, the Company is in negotiation with its landlords to decommission
      and
      surrender these premises. During the quarter ended September 30, 2006, the
      Company has accrued $1.7 million for the estimated costs for decommissioning
      and
      surrender of these buildings, which may require an adjustment in the fourth
      quarter. This amount is included in accrued liabilities in the accompanying
      balance sheet. The Company believes that it can resolve all issues with its
      landlords and will complete any potential obligations in the fourth quarter
      of
      2006.





On
      February 19, 2004, the Company entered into the second amendment to the lease
      for one of the buildings. The amendment reflected a payment schedule for a
      rent
      deferral. In January of 2006, the Company paid off approximately $1.2 million
      in
      deferred rent. As of September 30, 2006, there was no deferred rent
      outstanding.





*Contingencies*





The
      Company was named as a defendant, along with Bostik, Inc., in an action
      captioned WASCO Products, Inc. v. Southwall Technologies, Inc. and Bostik,
      Inc.,
      Civ. Action No. C 02 2926 SBA, which was filed in Federal District Court for
      the
      Northern District of California on June 18, 2002. The Company was served with
      the Complaint in this matter on July 1, 2002. The plaintiff filed the matter
      as
      a class action on behalf of all entities and individuals in the United States
      who manufactured and/or sold and warranted the service life of insulated glass
      units manufactured between 1989 and 1999, which contained Southwall Heat Mirror
      film and were sealed with a specific type of sealant manufactured by Bostik,
      Inc. The plaintiff alleged that the sealant provided by Bostik, Inc. was
      defective, resulting in elevated warranty replacement claims and costs. The
      plaintiff asserted claims against the Company for breach of an implied warranty
      of fitness, misrepresentation, fraudulent concealment, negligence, and negligent
      interference with prospective economic advantage, breach of contract, unfair
      business practices and false or misleading business practices. The plaintiff
      sought recovery on behalf of the class of $100 million for damages allegedly
      resulting from elevated warranty replacement claims, restitution, injunctive
      relief, and non-specific compensation for lost profits. By Order entered
      December 22, 2003, the Court dismissed all claims against the Company. The
      plaintiff appealed to the Ninth Circuit Court of Appeals. On January 13, 2006,
      the Court of Appeals affirmed the lower court decision. On January 26, 2006,
      the
      plaintiff filed a petition for rehearing with the Ninth Circuit Court of
      Appeals. In March of 2006, the Ninth Circuit Court of Appeals denied the
      plaintiff's petition. On May 26, 2006 the plaintiff filed a petition for writ
      of
      certiorari to the United States Supreme Court. On
      October 2, 2006, the Supreme Court denied Wasco’s petition for writ of
      certiorari.





The
      insurance carriers in some of the litigation related to alleged product failures
      and defects in window products manufactured by others in which the Company
      was a
      defendant in the past paid the defense and settlement costs related to such
      litigation. Certain of those insurance carriers reserved their rights to recover
      a portion or all of such payments from the Company. As a result, those insurance
      carriers could seek from us up to an aggregate of $2 million plus defense
      costs, although any such recovery would be restricted to claims that were not
      covered by the Company's insurance policies. The Company intends to vigorously
      defend any attempts by these insurance carriers to seek reimbursement. The
      Company is not able to estimate the likelihood that these insurance carriers
      will seek to recover any such payments, the amount, if any, they might seek,
      or
      the outcome of such attempts.





8
 *Index*





On
      June
      13, 2002, Plaintiff Charles Ikekwere (“Plaintiff”) filed a Complaint against the
      Company in the Superior Court of California in and for the County of Santa
      Clara, Case No. CV808644. Mr. Ikekwere is a former employee of the Company.
      Plaintiff's Complaint alleged claims for race discrimination, national origin
      discrimination, retaliation, medical condition discrimination, breach of
      contract, breach of fiduciary duty, fraud, negligence, intentional infliction
      of
      emotional distress, and punitive damages. In October of 2006 the Company settled
      this suit with the Plaintiff for an amount not considered material to the
      financial statements of the Company. The Company has accrued for this settlement
      in its accompanying financial statements as of September 30, 2006.





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





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





The
      Company has a stock-based compensation program that provides its Board of
      Directors broad discretion in creating employee equity incentives. The Company
      has granted stock options under various option plans and agreements in the
      past
      and currently grants stock options under the 1997 Stock Incentive Plan and
      the
      1998 Stock Option Plan for employees, board members and consultants. The Board
      of Directors adopted the 1997 and 1998 Stock Option Plans on May 12, 1997 and
      August 6, 1998, respectively. The Compensation Committee of the Board of
      Directors administers the plans and agreements. The exercise price of options
      granted under the 1997 and 1998 plans must be at least 85% of the fair market
      value of the stock at the date of grant. Options granted under the 1998 plan
      prior to October 2004 generally vest at a rate of 25% per year, are
      non-transferable and expire over terms not exceeding ten years from the date
      of
      grant or three months after the optionee terminates his relationship with the
      Company. Options granted under the 1997 plan prior to October 2004 generally
      vest at a rate of 25% per year, are non-transferable and expire over terms
      not
      exceeding ten years from the date of grant or eighteen months after the optionee
      terminates his relationship with the Company. Grants from and after October
      2004
      until April 2006 under both plans vest at a rate of 25% after six months and
      then evenly monthly thereafter for the remaining 42 months. From and after
      April
      2006 grants under both plans vest at a rate of 25% per year on each anniversary
      of the grant date.




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
      September 30, 2006, the Company had approximately 2,158,000 shares of common
      stock reserved for future issuance under its stock option plans and
      ESPP.





On
      January 1, 2006, the Company adopted the provisions of SFAS 123R, “Shared-Based
      Payment” (SFAS 123R), requiring it to recognize expense related to the fair
      value of its stock-based compensation awards. The Company elected to use the
      modified prospective transition method as permitted by SFAS 123R and therefore
      has not restated its financial results for prior periods. Under this transition
      method, stock-based compensation expense for the three and nine-month periods
      ended September 30, 2006 includes compensation expense for all stock-based
      compensation awards granted prior to, but not yet vested as of January 1, 2006,
      based on the grant date fair value estimated in accordance with the original
      provisions of SFAS 123, “Accounting for Stock-Based Compensation” (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 is recognizing
      compensation expense for stock option awards on a graded vesting basis over
      the
      requisite service period of the award.





9
 *Index*





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





Three
                months ended
              September
                30,
              2006
            
            Nine
                months ended
              September
                30,
              2006Cost
                of sales
            
            $
            -
            
            $
            11Research
                and development
            
            
            21
            
            
            109Selling,
                general and administrative
            
            
            56
            
            
            296Stock-based
                compensation expense before income taxes
            
            
            77
            
            
            416Income
                tax benefit
            
            
            -
            
            
            -Total
                stock-based compensation expense after income taxes
            
            $
            77
            
            $
            416





There
      were no cash proceeds from the exercise of stock options for the three months
      ended September 30, 2006 and October 2, 2005, respectively, and the amounts
      were
      immaterial for the nine months ended September 30, 2006 and October 2, 2005,
      respectively. No income tax benefit was realized from stock option exercises
      during the three and nine-month periods ended September 30, 2006, and October
      2,
      2005. In accordance with SFAS 123R, the Company presents excess tax benefits
      from the exercise of stock options, if any, as financing cash flows rather
      than
      operating cash flows.




Prior
      to
      the adoption of SFAS 123R, the Company applied SFAS 123, amended by SFAS No.
      148, “Accounting for Stock-Based Compensation - Transition and Disclosure” (SFAS
      148), which allowed companies to apply the existing accounting rules under
      APB
      25, “Accounting for Stock Issued to Employees” (APB 25), and related
      Interpretations. In general, as the exercise price of options granted under
      these plans was equal to the market price of the underlying common stock on
      the
      grant date, no stock-based employee compensation cost was recognized in the
      Company's net income (loss). As required by SFAS 148 prior to the adoption
      of
      SFAS 123R, the Company provided pro forma net income (loss) and pro forma net
      income (loss) per common share disclosures for stock-based awards, as if the
      fair-value-based method defined in SFAS 123 had been applied.




The
      following table illustrates the effect on net income after tax and net income
      per common share as if the Company had applied the fair value recognition
      provisions of SFAS 123 to stock-based compensation during the three and
      nine-month periods ended October 2, 2005 (in thousands, except per share
      amounts):





Three months
                ended
              October
                2,
              2005
            
            Nine
                months ended
              October
                2,
              2005Net
                income attributable to common stockholders:As
                reported
            
            $
            (105
            )
            $
            2,746Add: 
                Stock-based employee compensation expense included in reported net
                income,
                net of related tax effects
            
            
            -
            
            
            45Deduct: 
                Total stock-based employee compensation determined under fair value
                based
                method for all awards, net of related tax effects
            
            
            (200
            )
            
            (502
            )Pro
                forma net income attributable to common stockholders
            
            $
            (305
            )
            $
            2,289Net
                income attributable to common stockholders per share:As
                reported - basic
            
            $
            0.00
            
            $
            0.10Pro
                forma - basic
            
            $
            (0.01
            )
            $
            0.09As
                reported - diluted
            
            $
            0.00
            
            $
            0.09Pro
                forma - diluted
            
            $
            (0.01
            )
            $
            0.08




10
 *Index*








The
      fair
      value of stock-based awards was estimated using the Black-Scholes model with
      the
      following weighted-average assumptions for the three and nine-month periods
      ended September 30, 2006, and October 2, 2005, respectively:





Three
                months ended
            
            Nine
                months endedSeptember
                30,
              2006
            
            October
                2,
              2005
            
            September
                30,
              2006
            
            October,
                2,
              2005Expected
                life (in years)
            
            
            2.59
            
            
            2.24
            
            
            2.44
            
            
            1.94Risk-free
                interest rate
            
            
            4.84
            %
            
            4.01
            %
            
            4.87
            %
            
            3.82
            %Volatility
            
            
            109
            %
            
            116
            %
            
            109
            %
            
            116
            %Weighted-average
                fair value at grant date
            
            $
            0.38
            
            $
            0.70
            
            $
            0.41
            
            $
            0.65




The
      Company's computation of expected volatility for the quarter ended September
      30,
      2006 is based on historical volatility. The Company's computation of expected
      life is based on historical exercise patterns. The interest rate for periods
      within the expected life of the award is based on the U.S. Treasury yield in
      effect at the time of grant.





Stock
      option activity for the nine months ended September 30, 2006 was as follows
      (in
      thousands, except per share amounts):




Shares
              
              Weighted-Average
                  Exercise Price
              
              Weighted-Average
                  Remaining Contractual Term (in years)
              
              Aggregate
                  Intrinsic ValueOutstanding
                  at December 31, 2005
              
              
              5,572
              
              $
              1.53Grants
              
              
              905
              
              
              0.68Exercises
              
              
              (57
              )
              
              0.50Forfeitures
                  or expirations
              
              
              (435
              )
              
              2.59Outstanding
                  at September 30, 2006
              
              
              5,985
              
              $
              1.33
              
              
              7.55
              
              $
              -Vested
                  and expected to vest at September 30, 2006
              
              
              5,109
              
              $
              1.41
              
              
              7.29
              
              $
              -Exercisable
                  at September 30, 2006
              
              
              3,449
              
              $
              1.66
              
              
              6.58
              
              $
              -


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 third quarter of fiscal 2006 and the exercise price,
      times the number of shares) that would have been received by the option holders
      had all option holders exercised their options on September 30, 2006. This
      amount changes based on the fair market value of Southwall's stock. Total
      intrinsic value of options exercised was immaterial for the three and nine-month
      periods ended September 30, 2006. Total fair value of options vested is $0.1
      million and $0.4 million for the three and nine-month periods ended September
      30, 2006, respectively.





11
 *Index*





As
      of
      September 30, 2006, $0.4 million of total unrecognized compensation cost related
      to stock options, net of forfeitures, was expected to be recognized over a
      weighted-average period of approximately 1.63 years.




On
      May
      11, 2006, the Company granted 515,000 Performance Stock Units (“PSUs”) to
      certain employees under the 2006 Long Term Incentive Program. In accordance
      with
      SFAS 123R, the PSUs have been valued on the date of grant based on their fair
      value determined under the Black-Scholes valuation model. Under the Plan, the
      PSUs will vest when certain milestones are met and the participants will then
      have immediate ownership of the PSUs, which convert to common stock of the
      Company on a 1:1 basis. The PSUs have no purchase price/cost to the participants
      and the participants must be employed with the Company on the date the milestone
      is achieved in order to vest. As of September 30, 2006, the milestones have
      not
      been achieved and thus no PSUs had vested. For the quarter ended September
      30,
      2006, an immaterial amount of compensation was recognized. The PSUs are expected
      to vest over a 23 month period and had a weighted average grant date fair value
      of $0.71 and an aggregate intrinsic value of $0.2 million as of September 30,
      2006. As of September 30, 2006, $0.3 million of unrecognized compensation cost
      related to the PSUs is expected to be recognized over the remaining expected
      service period of 18 months.




**Note
      7 - Restructuring:**





In
      December 2002, we implemented a reduction in force at our Palo Alto
      location and elected to vacate certain buildings in Palo Alto. As a result
      of these actions, we incurred a restructuring charge of $2.6 million in 2002
      relating to employee severance packages and the remaining rents due on excess
      facilities in Palo Alto that we no longer occupy. In 2003, we recorded a
      credit to operating expenses of $0.1 million as a result of modifications to
      the
      severance packages of certain employees. On January 19, 2006, we commenced
      restructuring actions to improve our cost structure. These actions include
      the
      closure of our Palo Alto, California manufacturing facility and a reduction
      in
      force at our Palo Alto site in the first half of 2006. As a result of these
      actions, we incurred a restructuring charge of $1.0 million during the first
      nine months of 2006 relating to employee severance packages and related facility
      closure 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
      nine month periods ended September 30, 2006 and October 2, 2005 (in
      thousands):




Restructuring
              Plan 
                2006
            
            Restructuring
              Plan 
                2002Severance
              and
                Benefits
            
            Facilities
                Related
              and
                Other
            
            Facilities
                Related
            
            TotalBalance
                at January 1, 2005
            
            $
            -
            
            $
            -
            
            $
            274
            
            $
            274Provisions
            
            
            -
            
            
            -
            
            
            -
            
            
            -Adjustment
                to reserve
            
            
            -
            
            
            -
            
            
            -
            
            
            -Cash
                payments
            
            
            -
            
            
            -
            
            
            (21
            )
            
            (21
            )Balance
                at October 2, 2005
            
            $
            -
            
            $
            -
            
            $
            253
            
            $
            253





Severance
                 and Benefits
            
            Facilities
                Related
              and
                Other
            
            Facilities
                Related
            
            TotalBalance
                at January 1, 2006
            
            $
            -
            
            $
            -
            
            $
            199
            
            $
            199Provisions
            
            
            375
            
            
            753
            
            
            -
            
            
            1,128Adjustment
                to reserve
            
            
            (5
            )
            
            (149
            )
            
            -
            
            
            (154
            )Cash
                payments
            
            
            (349
            )
            
            (449
            )
            
            (53
            )
            
            (851
            )Balance
                at September 30, 2006
            
            $
            21
            
            $
            155
            
            $
            146
            
            $
            322




12
 *Index*





At
      September 30, 2006, $0.3 million was included in other accrued liabilities,
      and
      a minimal amount was included in other long-term liabilities in the condensed
      consolidated balance sheet.





**Note
      8 - Guarantees:**





The
      Company establishes a reserve for sales returns and warranties for specifically
      identified, as well as anticipated sales returns and warranties based on
      experience. The activity in the reserve for sales returns and warranties account
      during the nine-month periods ended September 30, 2006 and October 2, 2005
      were
      as follows (in thousands):







Balance
                at December 31,2005
            
            Provision
            
            Utilized
            
            Balance
                at September30,2006Accrued
                sales returns and warranty
            
            $
            1,556
            
            $
            571
            
            $
            (570
            )
            $
            1,557





Balance
                at December 31,2004
            
            Provision
            
            Utilized
            
            Balance
                at October 2,2005Accrued
                sales returns and warranty
            
            $
            2,701
            
            $
            21
            
            $
            (1,137
            )
            $
            1,585




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





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





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





The
      components of comprehensive income (loss) for the three and nine-month periods
      ended September 30, 2006 and October 2, 2005 were as follows (in
      thousands):




Three
                  months ended
              
              Nine
                  months endedSeptember
                  30,
                2006
              
              October
                  2,
                2005
              
              September
                  30,
                2006
              
              October
                  2,
                2005Foreign
                  Currency Translation Adjustment
              
              $
              (141
              )
              $
              (28
              )
              $
              704
              
              $
              (1,568
              )Net
                  Income (Loss)
              
              
              (2,721
              )
              
              15
              
              
              (5,435
              )
              
              3,109Other
                  Comprehensive Income (Loss)
              
              $
              (2,862
              )
              $
              (13
              )
              $
              (4,731
              )
              $
              1,541
 The
        components of accumulated other comprehensive income were as follows at
        September 30, 2006 (in thousands):





Accumulated
                Other Comprehensive Income at December 31, 2005
            
            $
            2,532Foreign
                Currency Translation Adjustment
            
            
            704Accumulated
                Other Comprehensive Income at September 30, 2006
            
            $
            3,236





13
 *Index*





**Note
      10 - Recent Accounting Pronouncements**





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. We are currently evaluating the effect
      that the adoption of SAB 108 will have on our financial position and results
      of
      operations.





14
 *Index*





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





The
      following discussion and analysis of our financial condition and results of
      operations should be read in conjunction with our unaudited condensed
      consolidated financial statements and notes thereto appearing elsewhere in
      this
      report. This discussion and analysis contains forward-looking statements that
      involve risks and uncertainties, including those discussed below under
      "Forward-Looking Statements" and "Risk Factors" and in our Annual Report on
      Form 10-K for the year ended December 31, 2005. 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 10% Cumulative Preferred Stock and the warrants were exercised for shares
      of
      common stock in the fourth quarter of 2004. On January 19, 2006, we commenced
      restructuring actions to improve our cost structure. These actions included
      the
      closure of our Palo Alto, California manufacturing facility and a reduction
      in
      force at our Palo Alto site in the first half of 2006. We are targeting a
      reduction in our total operating expenses of approximately $4 million on an
      annual basis from these restructuring activities. As a result of these actions,
      we incurred a restructuring charge of $1.0 million during the first nine months
      of 2006 relating to employee severance packages and facility related charges
      (see Note 7 of Notes to Unaudited Condensed Consolidated Financial
      Statements--Restructuring).




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





Our
      three
      largest customers in the automotive glass and window film markets include
      Pilkington PLC, Saint Gobain Sekurit and Globamatrix Holdings Pte. Ltd., or
      Globamatrix, which collectively accounted for approximately 45%, 54% and 45%
      of
      our total revenues during the first nine months of 2006, and during fiscal
      year
      2005 and fiscal year 2004, respectively.





Under
      our
      agreement with Globamatrix, as amended, Globamatrix agreed to an annual minimum
      purchase commitment which was $9.0 million of product in 2004 **.** 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 $10.9 million
      of product in 2006. During the first nine months of 2006, Globamatrix purchased
      approximately $8.8 million of product.





15
 *Index*





During
      the first nine months of 2006, our revenues in the automotive market decreased
      due to a reduction in demand from Saint Gobain. The reduction in demand was
      due
      to the ongoing “de-contenting” (a change by auto manufacturers to make the parts
      in which our products are found optional features rather than standard features
      to control their costs) trend in the automotive industry.





*Sales
      returns and allowances.* Our
      gross margins and profitability have been adversely affected from time to time
      by product quality claims. From 2003 to 2005, our sales returns provision has
      averaged approximately 2.5% to 4.5% of gross revenues. During the first nine
      months of 2006, our sales returns provision has averaged approximately 4.2%
      of
      our gross revenues due to quality claims received during the
      period.





**Critical
      Accounting Policies and Estimates**





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





We
      believe there have been no significant changes during the first nine months
      of
      fiscal 2006 to the items that we disclosed as our critical accounting policies
      and estimates in our discussion and analysis of financial condition and results
      of operations in our 2005 Form 10-K, except as noted below.





*Valuation
      of Inventories*





In
      January 2006, we changed our inventory valuation method from the first-in,
      first-out method to the average cost method. With the closing of our Palo Alto,
      California manufacturing facility and all production now being performed in
      our
      German subsidiary's facility, the use of the average cost method was deemed
      preferable as it both accommodates our German subsidiary's statutory reporting
      requirements and fairly approximates actual costs. In addition, the impact
      of
      the change was $0.3 million which we consider immaterial.





*Stock
      Based Compensation Expense*





We
      account for stock-based compensation in accordance with the provisions of SFAS
      123R. Under the fair value recognition provisions of SFAS 123R, stock based
      compensation cost is estimated at the grant date based on the fair value of
      the
      award and is recognized as expense ratably over the requisite service period
      of
      the award. Determining the appropriate fair value model and calculating the
      fair
      value of stock-based awards requires judgment, including estimating stock price
      volatility, forfeiture rates and expected lives.





16
 *Index*





**Three
      Months Ended September 30, 2006 compared with Three Months Ended October 2,
      2005**





**Results
      of Operations**





*Net
      revenues.* Our
      net
      revenues for the three months ended September 30, 2006 and October 2, 2005
      were
      $9.6 million and $12.0 million, respectively. The decline in revenues affected
      all of our product lines, except for our architectural products.





Our
      net
      revenues in our window film product line decreased by $1.5 million, or 38%,
      from
      $3.9 million in the third quarter of 2005 to $2.4 million in the same period
      in
      2006. In the second half of 2005, we ceased converting (processing the sputtered
      film into finished applied window film) for one of our window film product
      models and agreed with our customer that they would take over responsibility
      for
      this process. This resulted in a decline in average sales prices for our TX
      product line and a majority of the decrease in window film market net revenues.
      In addition, the returns and allowances provision for window film was $0.6
      million higher in the third quarter of 2006 as compared to the same period
      of
      2005. The higher allowance was a result of supplier quality problems. Shipments
      of the product have been stopped until the exact cause of the defect is
      identified. Resolution of this defect is expected to occur during the fourth
      quarter.





Our
      net
      revenues in the automotive market decreased by $0.8 million, or 22%, from $3.9
      million in the third quarter of 2005 to $3.0 million in the same period of
      2006.
      The decrease was primarily due to a reduction in demand in 2006 by Saint Gobain
      as a result of the ongoing “de-contenting” (a change by auto manufacturers to
      make the parts in which our products are found optional features rather than
      standard features to control their costs) trend in the automotive industry,
      partially offset by increases in demand from some of our Automotive Replacement
      Glass customers.





Our
      net
      revenues in the electronic display market decreased by $0.5 million, or 16%,
      from $3.0 million in the third quarter of 2005 to $2.6 million for the same
      period of 2006. The decrease was due to lower shipments to our major customer
      in
      the electronic display market which was the result of using our limited machine
      capabilities for research and development of a potential new product for this
      customer. In addition, we encountered yield issues with one electronic display
      product as we transferred the manufacture of this product from our Palo Alto
      facility to our German facility. We are focused on improving the yield for
      this
      product at our German plant..





Our
      net
      revenues in the architectural market increased by approximately $0.4 million,
      or
      31%, from $1.2 million in the third quarter of 2005 to $1.6 million in the
      same
      period of 2006. The increase was due primarily to an increase in sales in the
      U.S. region due to higher demand for energy efficient products.





*Cost
      of revenues.* Cost of
      revenues consists of materials, subcontractor services, labor and manufacturing
      overhead. Cost of revenues was $5.7 million in the third quarter of 2006
      compared to $7.9 million in the same period of 2005.  The decrease in cost
      of revenues was primarily due to lower revenues, transfer of production to
      our
      lower cost German manufacturing facility, and savings related to the shutdown
      of
      our manufacturing facility in Palo Alto.





*Gross
      profit.* Our
      gross profit decreased $0.2 million from $4.1 million in the third quarter
      of
      2005 to $3.9 million in the same period of 2006. As a percentage of sales,
      gross
      profit increased from 34% in the third quarter of 2005 to 41% in the same period
      in 2006. As a result of shutting down our Palo Alto operation most of our
      manufacturing is now performed in Germany resulting in full overhead absorption
      at that location. The combination of eliminating cost at Palo Alto and full
      utilization in Germany accounted for the entire gross profit percentage
      improvement from 34% during the third quarter 2005 to 41% during the third
      quarter of 2006.





17
 *Index*





*Operating
      expenses*




*Research
      and development* .
      Research and development expenses increased $0.3 million from $1.3 million
      in
      the third quarter of 2005 to $1.7 million in the same period of 2006. The
      increase from year to year was due the cost associated with the development
      of a
      potential new display product for our largest electronic display customer and
      to
      an increase in employees involved in research and development year over
      year.




*Selling,
      general and administrative* .
      Selling, general and administrative expenses consist primarily of corporate
      and
      administrative overhead, selling commissions and occupancy costs. Selling,
      general and administrative expenses increased $2.6 million from $2.1 million
      in
      the third quarter of 2005 to $4.7 million in the same period of 2006. The
      increase in general and administrative expenses in the third quarter of 2006
      was
      primarily due to the accrual of leasehold retirement obligations and other
      expenses of approximately $1.7 million related to the closure of our Palo Alto
      manufacturing facility, a severance cost of approximately $0.3 million,
      approximately $0.2 million for legal fees and settlement cost on an employee
      lawsuit and higher legal, consulting and accounting fees of approximately $0.4
      million.





*Impairment
      charge (recoveries) for long-lived assets.* In the third quarter
      of 2006, we sold certain machinery for $0.3 million from our recently closed
      Palo Alto manufacturing location. No such sales occurred in the third quarter
      of
      2005.





*Restructuring.* On
      January ** 10,
      2006,
      we commenced restructuring actions to improve our cost structure. These actions
      include the closure of our Palo Alto, California manufacturing plant and a
      reduction in force at our Palo Alto site in the first half of 2006. As a result
      of these actions, we incurred an additional $0.3 million during the third
      quarter of 2006 primarily relating to outside services to decommission our
      manufacturing equipment and scrapped production materials. There was no such
      restructuring charge in the third quarter of 2005.





*Income
      (loss) from operations* .
      Loss
      from operations was $2.3 million in the third quarter of 2006 as compared to
      income of approximately $0.7 million in same period of 2005. The decrease was
      primarily due to a decrease in revenue, an increase in research and development
      costs, recognition of stock based employee compensation expenses, and
      restructuring charges and impairment charges in the third quarter of 2006 as
      detailed above.





*Interest
      expense, net.* Interest
      expense, net remained unchanged at $0.2 million in the third quarter of 2006,
      which is the same amount as during the third quarter of 2005.




*Other
      income (expense), net* .
      Other
      income (expense), net, mainly reflects foreign exchange transaction gains and
      losses. Some
      of
      our transactions with foreign customers and suppliers are denominated in foreign
      currencies, principally the Euro. As exchange rates fluctuate relative to the
      U.S. dollar, exchange gains and losses occur. We incurred $34,000 of exchange
      loss during the third quarter of 2006 compared to an exchange gain of $9,000
      during the third quarter of 2005.





*Income
      (loss) before provision for income taxes* .
      We
      recorded a pre-tax loss of $2.5 million in the third quarter of 2006 compared
      to
      pre-tax income of $0.5 million in the third quarter of 2005. The 2006 loss
      of
      $2.5 million was primarily due to an increase in selling, general and
      administrative expenses, lower revenue, and increase in research and development
      costs as discussed above.





*Provision
      for income taxes* .
      The
      decrease of approximately $0.3 million from $0.5 million to $0.2 million in
      the provision for income taxes in the third quarter of 2006 compared to the
      same
      period in 2005 is related to lower taxable income in 2006 in our foreign
      subsidiary, Southwall Europe GmBH, or SEG. There are no United States income
      taxes included in the provision as the Company has a net operating loss carry
      forward for U.S. tax purposes.





*Net
      income (loss)* .
      In the
      third quarters of 2006 and 2005, we recorded a net loss of $2.7 million and
      net
      income of $15,000, respectively. The decrease of $2.7 million was primarily
      due
      to a decrease in revenue, an increase in research and development costs, an
      increase in selling, general and administrative costs, leasehold retirement
      obligation costs, recognition of a stock based employee compensation
      expense and restructuring charges.





18
 *Index*





*Deemed
      dividend on preferred stock.* We
      accrued $0.1 million of deemed dividend on preferred stock in each of the third
      quarters of 2006 and 2005. The holders of our secured convertible promissory
      notes converted those notes to shares of Series A preferred stock in December
      2004. The Series A preferred stock accrues cumulative dividends at the rate
      of
      10% per annum.





**Nine
      Months Ended September 30, 2006 compared with Nine Months Ended October 2,
      2005**





**Results
      of Operations**





*Net
      revenues.* Our net
      revenues for the nine months ended September 30, 2006 and October 2, 2005 were
      $31.0 million and $42.8 million, respectively.





Our
      net
      revenues in the automotive market decreased by $5.5 million, or 36%, from $15.2
      million in the first nine months of 2005 to $9.7 million in the same period
      of
      2006. The decrease was primarily due to a reduction in demand throughout the
      first nine months of 2006 by a major customer as a result of their large
      inventory build-up at 2005 year end and the ongoing “de-contenting” (a change by
      auto manufacturers to make the parts in which our products are found optional
      features rather than standard features to control their costs) trend in the
      automotive industry.





Our
      net
      revenues in the window film market decreased by $4.2 million, or 32%, from
      $13.0
      million in the first nine months of 2005 to $8.9 million in the same period
      in
      2006. In the second half of 2005, we ceased converting (processing the sputtered
      film into finished applied window film) for one of our window film product
      models and agreed with our customer that they would take over responsibility
      for
      this process. This resulted in a decline in average sales prices for one TX
      product line. In addition, revenues for our other window film product lines
      were
      higher in the first half of 2005 due to the fact that the last shipment from
      the
      fourth quarter of 2004 was rescheduled into the beginning of the first quarter
      of 2005 at the customer's request, resulting in unusually high sales for this
      product line in the first nine months of 2005. In addition, the returns and
      allowances provision for window film was $0.6 million higher in the first nine
      months of 2006 as compared to the same period of 2005. The higher allowance
      was
      a result of supplier quality problems. Shipments of the product have been
      stopped until the exact cause of the defect is identified. Resolution of this
      defect is expected to occur during the fourth quarter.





Our
      net
      revenues in the electronic display market decreased by $2.1 million, or 20%,
      from $10.4 million in the first nine months of 2005 to $8.3 million in the
      same
      period of 2006. The decrease was due to the termination of the AR product line,
      a decline in demand for Silver reflector film for the LCD back-light market
      and
      reduced average sales prices on film sold to Mitsui for Plasma Display Panel,
      or
      PDP, filters. An overall decrease in the average selling prices for PDP products
      resulted in price pressures on all suppliers in the market. In addition, we
      encountered yield issues with one electronic display product as we transferred
      the manufacture of this product from our Palo Alto facility to our German
      facility. We are focused on improving the yield for this product at our German
      plant.





Our
      net
      revenues in the architectural market were essentially flat year over year with
      $4.0 million in revenue for the first nine months of 2006 as compared to $4.2
      million for the first nine months of 2005.





*Cost
      of revenues* .
      Cost of
      revenues was $19.3 million in the first nine months of 2006 compared to $29.0
      million in the same period of 2005.  The decrease in cost of revenues was
      primarily due to lower revenues, transfer of production to our lower cost German
      manufacturing facility, manufacturing savings as a result of closing our Palo
      Alto manufacturing location, partially offset by inventory reserves for our
      window film products.





19
 *Index*





*Gross
      profit and gross margin* .
      Our
      gross profit decreased $2.2 million from $13.9 million in the first nine months
      of 2005 to $11.7 million in the same period of 2006. As a percentage of sales,
      gross profit increased from 32% in the first nine months of 2005 to 38% in
      the
      same period in 2006. As a result of shutting down our Palo Alto operation,
      most
      of our manufacturing is now performed in Germany resulting in full overhead
      absorption at that location. The combination of eliminating unabsorbed cost
      at
      Palo Alto and full utilization in Germany accounted for the entire gross profit
      percentage improvement from 32% during the first nine months of 2005 to 38%
      during the first nine months of 2006. This benefit was partially reduced by
      lower margins in our electronic display products and inventory reserves for
      the
      window film products.





*Operating
      expenses*





*Research
      and development* .
      Research and development expenses increased $2.3 million from $3.0 million
      in
      the first nine months of 2005 to $5.4 million in the same period of 2006. The
      increase from year to year was due primarily to an increase in labor and
      employee benefits costs as a result of expanding our engineering organization.
      In June 2005, we hired a new Chief Technology Officer and Senior Vice President,
      and a new Director of Engineering for the automotive market. In September 2005,
      we hired a new Director of Engineering for the electronic display market. In
      addition, we spent more on research and development materials in the first
      nine
      months of 2006 than in the same period in 2005. We expect expenditures relating
      to research and development for the remainder of 2006 to be lower than their
      average for the first nine months of 2006.





*Selling,
      general and administrative* .
      Selling, general and administrative expenses increased $3.3 million from $6.5
      million in the first nine months of 2005 to $9.8 million in the same period
      of
      2006. The increase in general and administrative expenses in the first nine
      months of 2006 as compared to the same period 2005 was primarily due to a
      severance package and leasehold retirement obligations on the closure of two
      Palo Alto facilities of approximately $2.0 million. Additional increases to
      selling, general and administrative expenses were due to stock based
      compensation expense, and higher legal, accounting and consulting costs in
      2006.





*Impairment
      charge (recoveries) for long-lived assets.* As a
      result of our decision to cease manufacturing in Palo Alto, we recorded a $0.3
      million impairment charge related to a production machine which was
      decommissioned in the second quarter of 2006. There was no such charge in the first
      nine months of 2005.
      In addition, in the first
      nine months of 2006,
      we recorded the recovery of $0.2 million of previously recorded impairment
      charges related to long-lived assets which were impaired in prior and current
      years. In the first
      nine months of 2005,
      we recorded the recovery of $0.2 million of previously recorded impairment
      charges related to the final payment from the sale of a production machine
      which
      was impaired in the third quarter of 2003. Also, in the third quarter 2006,
      we
      sold two machines for $0.3 million that were previously written
      down.





*Restructuring.* On
      January 19, 2006, we commenced restructuring actions to improve our cost
      structure. These actions include the closure of our Palo Alto, California
      manufacturing facility and a reduction in force at our Palo Alto site in the
      first half of 2006. As
      a
      result of these actions, we incurred a restructuring charge of $1.0 million
      during the first nine months of 2006 relating to employee severance packages,
      outside services relating to decommissioning our production machine and
      scrapping some of our production materials. There
      was
      no such restructuring charge in the first
      nine months of 2005.





*Income
      (loss) from operations* .
      The
      loss from operations for the first nine months of 2006 was $4.3 million as
      compared to an operating income of $4.5 million in the first nine months of
      2005. The loss was primarily due to a decrease in revenue, an increase in
      selling, general and administrative expenses, an increase in research and
      development costs, recognition of a stock based employee compensation expense,
      and restructuring charges in the first nine months of 2006 as detailed above.





*Interest
      expense, net.* Interest
      expense, net, decreased $0.2 million from $0.8 million in the first nine months
      of 2005 to $0.6 million in the same period of 2006. The decrease in interest
      expense was primarily attributable to less outstanding debt during the first
      nine months of 2006 compared to the same period in 2005.





20
 *Index*





*Other
      income, net* . In
      the first
      nine months of 2006,
      the net exchange gain due to Euro fluctuation was $0.1 million compared to
      a net
      exchange loss of $0.3 million in the same period in 2005. In addition to the
      exchange gain recognized in the first nine months of 2006, our German
      subsidiary, Southwall Europe GmBH, or SEG, received a $0.1 million energy and
      waste rebate refund from the German government. The exchange loss incurred
      in
      the first nine months of 2005 was offset by an energy and waste rebate refund
      of
      $0.4 million received by SEG from the German government.





*Income
      (loss) before provision for income taxes* .
      We
      recorded a pre-tax loss of $4.7 million in the first
      nine months of 2006
      and pre-tax income of $3.9 million in the first
      nine months of 2005.
      The decrease of $8.6 million was primarily due to a decrease in revenue, an
      increase in selling, general and administrative expenses, increase in research
      and development costs, recognition of stock based employee compensation expense,
      and restructuring charges in the first nine months of 2006.





*Provision
      for income taxes* .
      The
      provision for income taxes of $0.7 million and $0.8 million for the first nine
      months of 2006 and 2005 respectively, primarily relate to SEG our German
      subsidiary. There are no United States income taxes included in the provision
      as
      we have a net operating loss carry-forward for U.S. tax purposes.





*Net
      income (loss).* In the first
      nine months of 2006
      and 2005, we recorded a net loss of $5.4 million and net income of $3.1 million,
      respectively. The decrease was primarily due to a decrease in revenue, an
      increase in selling, general and administrative expenses, an increase in
      research and development costs, recognition of stock based employee compensation
      expense, and restructuring charges.





*Deemed
      dividend on preferred stock.* We
      accrued $0.4 million of deemed dividend on the Series A preferred stock in
      the first
      nine months of 2006
      and 2005. 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 $1.6 million from $6.6 million at December 31,
      2005 to $5.0 million at September 30, 2006. Cash used in operating activities
      of
      $0.1 million for the first nine months of 2006 was primarily the result of
      a net
      loss of $5.4 million and a deferred rent payment of $1.2 million, partially
      offset by non-cash depreciation of $1.8 million, decreases in accounts
      receivable of $2.0 million, a decrease in inventories of $0.6 million, an
      increase in accounts payable and accrued liabilities of $2.0 million and a
      non-cash stock compensation expense of $0.5 million. Cash provided from
      operations for the first nine months of 2005 of $5.3 million was primarily
      the
      result of net income of $3.1 million, non-cash depreciation of $1.7 million,
      and
      decreases in accounts receivable of $1.5 million, in inventories of $1.1 million
      and in other current and non-current assets of $0.7 million, partially offset
      by
      impairment recoveries from long-lived assets of $0.2 million and a decrease
      in
      accounts payable and accrued liabilities of $2.6 million.




Cash
      used
      in investing activities for the first nine months of 2006 was $0.2 million
      and
      was primarily the result of capital expenditures of $0.8 million reduced by
      the
      proceeds of $0.4 million from the sale of assets and a decrease in restricted
      cash of $0.2 million. Cash used in investing activities for the first nine
      months of 2005 was $0.1 million, primarily the result of a decrease in
      restricted cash of $0.2 million and proceeds from the sale of fixed assets
      of
      $0.2 million, offset by capital expenditures of $0.5 million.





21
 *Index*





Cash
      used
      in financing activities for the first nine months of 2006 was $1.3 million
      and
      was primarily the result of payments of $1.1 million on our borrowings. Cash
      used in financing activities for the first nine months of 2005 of $1.3 million
      was primarily the result of principal payments on borrowings.





We
      entered into an agreement with the Saxony government in May 1999 under
      which we receive investment grants. As of September 30, 2006, we had
      received 5.0 million Euros or $5.0 million at historical exchange rate of
      the grants and accounted for these grants by applying the proceeds received
      to
      reduce the cost of our fixed assets in our Dresden manufacturing facility.
      Additionally, as of September 30, 2006, we had a balance remaining from the
      government grants that we are entitled to receive of $0.2 million, which has
      been recorded as an advance and held as restricted cash until we receive
      approval from the Saxony government to apply the funds to reduce our capital
      expenditures. The total annual amount of investment grants and investment
      allowances that we are entitled to seek varies from year to year based upon
      the
      amount of our capital expenditures that meet certain requirements of the Saxony
      government. Generally, we are not eligible to seek investment grants and
      allowances in the aggregate for any year in excess of 33% of our eligible
      capital expenditures in Germany for that year. The measurement date of these
      requirements was June 30, 2006, at which time we did not meet some of these
      requirements. If we fail to meet certain requirements in connection with these
      grants, the Saxony government has the right to demand repayment of the grants.
      In June 2006, we re-filed to amend our agreement with the Saxony government.
      In
      this amendment, we sought to modify the amount of capital spending required
      to
      have been spent through June 30, 2006, to reflect the actual amount spent and
      to
      count workstations instead of employees. We expect a Saxony government audit
      at
      SEG in the latter part of 2006. We expect to negotiate with the State of Saxony
      to reach an agreement on our requested amendment by the end of 2006 or early
      2007. No assurance can be given, however, that such negotiations will be
      successful or what the outcome will be.





*Borrowing
      arrangements*





On
      April
      28, 2005, we entered into a credit agreement (the “Credit Agreement”) with Wells
      Fargo HSBC Trade Bank, N.A. (the “Bank”). The Credit Agreement provided for two
      facilities. All amounts borrowed under both facilities under the Credit
      Agreement had to be repaid on or before May 31, 2006. We renewed the first
      credit facility for another year in May 2006. We did not renew the second
      facility of the Credit Agreement.





The
      credit facility includes a revolving line of credit under which we may from
      time
      to time borrow up to $3 million, subject to satisfaction of certain conditions.
      Amounts borrowed under the credit facility bear interest at the prime rate
      minus
      1.75% per annum or LIBOR plus 1% per annum, at our option. We borrowed
      approximately $3.0 million from this facility on April 28, 2005 which amount
      remained outstanding as of September 30, 2006.





All
      borrowings under the Credit Agreement are collateralized by a letter of credit
      posted by Needham & Company, one of our stockholders. There are no financial
      covenants to this Credit Agreement.





The
      terms
      of the Credit Agreement, limit our ability to (i) merge into or consolidate
      with
      any other entity, (ii) make any substantial change in the nature of our business
      as conducted as of the date hereof, (iii) acquire all or substantially all
      of
      the assets of any other entity for an amount greater than $3 million, (iv)
      sell,
      lease, transfer or otherwise dispose of all or a substantial or material portion
      of our assets except in the ordinary course of business.





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.





22
 *Index*





*Capital
      expenditures*





We
      expect
      to spend approximately $1.5 million in 2006 on upgrades and refurbishment of
      our
      production machines and research and development tools. We spent
      approximately $0.8 million in capital expenditures during the first nine months
      of 2006.




*Future
      payment obligations*





Our
      future payment obligations on our borrowings pursuant to our term debt, line
      of
      credit, non-cancelable operating leases and other non-cancelable contractual
      commitments are as follows at September 30, 2006 (in thousands):




Less
              
              
              
              
              
              GreaterThan
              
              
              
              
              
              ThanTotal
              
              1
                  Year
              
              1-3
                  Years
              
              3-5
                  Years
              
              5
                  YearsContractual
                  Obligations:Term
                  debt (1)
              
              $
              9,574
              
              $
              1,030
              
              $
              2,061
              
              $
              3,793
              
              $
              2,690Line
                  of credit
              
              
              2,996
              
              
              2,996
              
              
              --
              
              
              --
              
              
              --Operating
                  leases (2)
              
              
              2,136
              
              
              482
              
              
              835
              
              
              819
              
              
              --Total
                  contractual cash obligations
              
              $
              14,706
              
              $
              4,508
              
              $
              2,896
              
              $
              4,612
              
              $
              2,690








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




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





On
      June
      13, 2006, we signed a sublease agreement with Maxspeed to sublease 3782-3788
      Fabian Way, Palo Alto, California 94303. The term of this sublease commenced
      on
      June 16, 2006 and will continue until December 31, 2008, with monthly rent
      payments of $17,920 through May 31, 2007, $18,368 through May 31, 2008, and
      $19,040 through December 31, 2008.





On
      June
      21, 2006, we amended our lease with Richard Christina to extend our original
      lease through June 30, 2011 for the facilities at 3780 Fabian Way, Palo Alto,
      California 94303. Also, on June 21, 2006, we entered into a lease agreement
      with
      Richard Christina to lease 3782-3788 Fabian Way, Palo Alto, California. The
      term
      of this lease extends the rental term for all premises (3780 and 3782-3788
      Fabian Way, Palo Alto, California) to June 30, 2011 at a Base Rent of $37,717.50
      per month. On January 1, 2010 and 2011, the Base Rent shall increase by
      3%.





23
 *Index*





**I** **tem
      3--Quantitative and Qualitative Disclosures about Market
      Risk**





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





***Financing
      risk:*** Our
      exposure to market rate risk for changes in interest rates relates primarily
      to
      our line of credit which bears an interest rate equal to 1.0% above the bank
      LIBOR rate (which was 5.25% at September 30, 2006) and is calculated based
      on
      amounts borrowed under the facility. In addition, the interest rate on one
      of
      our German loans has been reset to the prevailing market rate of 5.75% and
      another of our German loans will have its interest rate reset to the prevailing
      market rate in 2009. Fluctuations or changes in interest rates may adversely
      affect our expected interest expense. The effect of a 10% fluctuation in the
      interest rate on our line of credit and term debt would have had an immaterial
      effect on our interest expense for the third quarter of 2006.





***Investment
      risk:*** We
      invest our excess cash in money market accounts and, by practice, limit the
      amount of exposure to any one institution. Investments in both fixed rate and
      floating rate interest earning instruments carry a degree of interest rate
      risk.
      Fixed rate securities may have their fair market value adversely affected due
      to
      a rise in interest rates, while floating rate securities may produce less income
      than expected if interest rates fall. The effect of a 10% fluctuation in the
      interest rate on our excess cash investments would not have had a material
      effect on our interest expense in the third quarter of 2006.





***Foreign
      currency risk:*** International revenues (defined as sales to customers located outside of the
      United States) accounted for approximately 66% of our total sales in the third
      quarter of 2006. Approximately 43% of our international revenues were
      denominated in Euros relating to sales from our Dresden operation in the third
      quarter of 2006. The other 64% 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 $0.2 million on net revenues for the third quarter of 2006 and
      the
      effect on expenses of a 10% fluctuation in the Yen exchange rate would have
      been
      immaterial.




**FORWARD-LOOKING
      STATEMENTS**





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





·
            our
                ability to remain as a going
                concern;




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





·
            the
                success of our restructuring activities and our expectations as to
                expense
                reductions;





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





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





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





·
            our
                competition;





24
 *Index*





·
            statements
                about the future size of markets;





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





·
            our
                expected results of operations and cash
                flows;





·
            pending
                and threatened litigation and its outcome;
                and





·
            our
                projected capital expenditures.





You
      should not place undue reliance on our forward-looking statements. Actual events
      or results may differ materially. In evaluating these statements, you should
      specifically consider various factors, including the risks outlined below under
      "Risk Factors" and under “Risk Factors” in our 2005 Form 10-K and in our Form
      10-Qs for the first and second quarters of 2006. These factors may cause our
      actual results to differ materially from any forward-looking statement. Although
      we believe the expectations reflected in our forward-looking statements are
      reasonable as of the date they are being made, we cannot guarantee our future
      results, levels of activity, performance, or achievements. Moreover, neither
      we,
      nor any other person, assume responsibility for the future accuracy and
      completeness of these forward-looking statements.





**I** **tem
      4--Controls and Procedures**





(a)
            *Evaluation
                and Disclosure Controls and Procedures.*Under the supervision and with the participation of our management,
                including our chief executive office 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
                September 30, 2006. Based on this evaluation, our chief executive
                officer
                and vice president of finance concluded as of the Evaluation Date
                that our
                disclosure controls and procedures were effective such that the
                information relating to our Company, including our consolidated
                subsidiary, required to be disclosed in our Securities and Exchange
                Commission (“SEC”) reports (i) is recorded, processed, summarized and
                reported with the time period specified in the SEC rules and forms,
                and
                (ii) is accumulated and communicated to our management, including
                our
                chief executive officer and vice president of finance, as appropriate
                to
                allow timely decisions regarding required
                disclosure.





(b)
            *Report
                on Internal Control Over Financial Reporting*.
                We will be required by the Sarbanes-Oxley Act to include an assessment
                of
                our internal control over financial reporting and an attestation
                from
                management in our annual report on Form 10-K beginning with the filing
                for
                our fiscal year ending December 31, 2007. In addition, we will need
                an
                attestation of our internal control from an independent registered
                public
                accounting firm in our Annual Report on Form 10-K beginning with
                the
                filing for our fiscal year ending December 31,
                2008.





(c)
            *Changes
                in Internal Controls*.
                There were no changes during the first nine months of 2006 in our
                internal
                controls over financial reporting that have materially affected,
                or are
                reasonably likely to materially affect, the internal controls over
                financial reporting.





25
 *Index*





**P** **ART
      II--OTHER INFORMATION**




**It** **em
      1--Legal Proceedings**





The
      Company was named as a defendant, along with Bostik, Inc., in an action
      captioned WASCO Products, Inc. v. Southwall Technologies, Inc. and Bostik,
      Inc.,
      Civ. Action No. C 02 2926 SBA, which was filed in Federal District Court for
      the
      Northern District of California on June 18, 2002. The Company was served with
      the Complaint in this matter on July 1, 2002. The plaintiff filed the matter
      as
      a class action on behalf of all entities and individuals in the United States
      who manufactured and/or sold and warranted the service life of insulated glass
      units manufactured between 1989 and 1999, which contained Southwall Heat Mirror
      film and were sealed with a specific type of sealant manufactured by Bostik,
      Inc. The plaintiff alleged that the sealant provided by Bostik, Inc. was
      defective, resulting in elevated warranty replacement claims and costs. The
      plaintiff asserted claims against the Company for breach of an implied warranty
      of fitness, misrepresentation, fraudulent concealment, negligence, and negligent
      interference with prospective economic advantage, breach of contract, unfair
      business practices and false or misleading business practices. The plaintiff
      sought recovery on behalf of the class of $100 million for damages allegedly
      resulting from elevated warranty replacement claims, restitution, injunctive
      relief, and non-specific compensation for lost profits. By Order entered
      December 22, 2003, the Court dismissed all claims against the Company. The
      plaintiff appealed to the Ninth Circuit Court of Appeals. On January 13, 2006,
      the Court of Appeals affirmed the lower court decision. On January 26, 2006,
      the
      plaintiff filed a petition for rehearing with the Ninth Circuit Court of
      Appeals. In March of 2006, the Ninth Circuit Court of Appeals denied the
      plaintiff's petition. On May 26, 2006 the plaintiff filed a petition for writ
      of
      certiorari to the United Sates Supreme Court. On October 2, 2006, the Supreme
      Court denied Wasco’s petition for writ certiorari.





The
      insurance carriers in some of the litigation related to alleged product failures
      and defects in window products manufactured by others in which the Company
      was a
      defendant in the past paid the defense and settlement costs related to such
      litigation. Certain of those insurance carriers reserved their rights to recover
      a portion or all of such payments from the Company. As a result, those insurance
      carriers could seek from us up to an aggregate of $2 million plus defense
      costs, although any such recovery would be restricted to claims that were not
      covered by the Company's insurance policies. The Company intends to vigorously
      defend any attempts by these insurance carriers to seek reimbursement. The
      Company is not able to estimate the likelihood that these insurance carriers
      will seek to recover any such payments, the amount, if any, they might seek,
      or
      the outcome of such attempts.





On
      June
      13, 2002, Plaintiff Charles Ikekwere (“Plaintiff”) filed a Complaint against the
      Company in the Superior Court of California in and for the County of Santa
      Clara, Case No. CV808644. Mr. Ikekwere is a former employee of the Company.
      Plaintiff's Complaint alleged claims for race discrimination, national origin
      discrimination, retaliation, medical condition discrimination, breach of
      contract, breach of fiduciary duty, fraud, negligence, intentional infliction
      of
      emotional distress, and punitive damages. The Company settled this suit in
      October 2006 for an amount not considered to be material to the financial
      statements of the Company.





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





26
 *Index*





**Item
      1A--Risk Factors**





The
      following information updates, and should be read in conjunction with, the
      information disclosed in Item 1A, “Risk Factors,” of our Annual Report on Form
      10K for the year ended December 31, 2005 and filed with the SEC on March 29,
      2006 and in Part II Item 1A of our Quarterly Reports on Form 10-Q for the
      quarters ended March 31, 2006 and June 30, 2006.





**Financial
      Risks**





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





We
      incurred net losses in the first nine months of 2006, and in 2005 and 2004
      and
      negative cash flows from operations in the first nine months of 2006 and in
      2003. These factors together with our working capital position and our
      significant debt service and other contractual obligations at September 30,
      2006, may raise doubt about our ability to restore profitable operations,
      generate cash flow from operating activities and obtain additional financing.
      These and other factors related to our business during recent years, our past
      failure to comply with covenants in our financing agreements and our voluntary
      delisting from NASDAQ in March 2004 may make it difficult for us to secure
      the
      required additional borrowings on favorable terms or at all. We intend to seek
      additional borrowings or alternative sources of financing; however, difficulties
      in borrowing money or raising financing could have a material adverse effect
      on
      our operations, planned capital expenditures and ability to comply with the
      terms of government grants.





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





As
      of
      September 30, 2006, we had total outstanding obligations under our credit and
      other loan agreements of $12.6 million. Our inability to make timely payments
      of
      interest or principal under these facilities could materially adversely affect
      our ability to borrow money under existing credit facilities, to secure
      additional borrowings or to function as a going concern. Many of these loans
      contain provisions that permit the lender to declare the loans immediately
      due
      if there is a material adverse change in our business. These credit facilities
      also contain events of default that could require us to pay off indebtedness
      before its maturity. The restrictions imposed by these credit facilities or
      the
      failure of lenders to advance funds under these facilities could force us to
      curtail our operations or have a material adverse effect on our
      liquidity.





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





In
      2003,
      2004, 2005 and during the first nine months of 2006, approximately 34%, 31%,
      32%
      and 43 % of our revenues, respectively, were denominated in Euros, primarily
      related to sales from our Dresden operation, including sales to one of our
      largest customers, a European automotive glass manufacturer. In addition, other
      customers may request to make payments in foreign currencies. Also, certain
      transactions with foreign suppliers are denominated in foreign currencies,
      primarily Japanese Yen.





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




27
 *Index*




*Failure
      to meet requirements under our investment grant agreements with the Saxony
      government may require us to repay grants or force us to curtail our
      operations.*




We
      entered into an agreement with the Saxony government in May 1999 under
      which we receive investment grants. As of September 30, 2006, we had
      received 5.0 million Euros or $5.0 million at historical exchange rate of
      the grants and accounted for these grants by applying the proceeds received
      to
      reduce the cost of our fixed assets in our Dresden manufacturing facility.
      If we
      fail to meet certain requirements in connection with these grants, the Saxony
      government has the right to demand repayment of the grants. The measurement
      date
      of these requirements was June 30, 2006, at which time we did not meet some
      of
      these requirements. We are currently seeking an amendment to our agreement
      with
      the Saxony Government which would bring us into compliance with the
      requirements. If such negotiations are unsuccessful, we could be required to
      repay the grants which would adversely effect our operations.





**Operational
      Risks**





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





Our
      nine
      largest customers accounted for approximately 79%, 82%, 79% and 84% of net
      revenues during the first nine months of 2006 and in 2005, 2004 and 2003,
      respectively. We expect to continue to derive a significant portion of our
      net
      sales from this relatively small number of customers. Accordingly, the loss
      of a
      large customer could materially hurt our business, and the deferral or loss
      of
      anticipated orders from a large customer or a small number of customers could
      materially reduce our revenue and operating results in any period. Some of
      our
      largest automotive glass customers have used a technology--direct-to-glass
      sputtering--as an alternative to our window films, which in 2003 resulted in
      a
      decrease in orders from these customers. The continued or expanded use of this
      technology by our automotive glass customers would have a material adverse
      effect on our results of operations and financial position.





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





Our
      business depends in part on sales by manufacturers of products that include
      electronic displays. The markets for electronic display products are highly
      cyclical and have experienced periods of oversupply resulting in significantly
      reduced demand for our products. For example, during the first nine months
      of
      2006, we experienced a decrease of 20% from the first nine months of 2005 in
      our
      net revenues in the electronic display market primarily due to lower demand
      for
      our sputtered thin film filter products for Plasma Display Panel products due
      to
      increased competition, and we expect this trend to continue. Mitsubishi Electric
      was the only CRT manufacturer that buys our anti-reflective, or AR, film and
      it
      decided to consolidate all of the manufacturing of this product to Japan. In
      connection with that consolidation, Mitsubishi ceased production of the 17"
      AR
      product in its Mexico plant during the third quarter of 2003. In 2005, we
      stopped converting (cutting the film to the customer's specifications) one
      of
      our window film product models and agreed with our customers that they would
      complete this process. This resulted in a decline in average sales prices for
      the TX product line and the decrease in window film market net
      revenues.





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





Revenues
      from international sales amounted to approximately 66%, 74%, 79% and 89% of
      our
      net revenues during the first nine months of 2006 and in 2005, 2004 and 2003,
      respectively. The distance between our two manufacturing sites creates
      logistical and communications challenges. In addition, to achieve acceptance
      in
      international markets, our products must be modified to handle a variety of
      factors specific to each international market as well as local regulations.
      We
      may also be subject to a number of other risks associated with international
      business activities. These risks include:





28
 *Index*




**·**
            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.





**I** **tem
      2-- Unregistered Sales of Equity Securities and Use of
      Proceeds**





None.




**It** **em
      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




Exhibit
              Number
            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




29
 *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:  
                November 13, 2006**Southwall
                Technologies Inc.**By:
            /s/
                Dr. Eugene GoodsonDr.
                Eugene Goodson*President
                and  Chief Executive Officer*By:
            /s/
                Sylvia KamenskiSylvia
                Kamenski*Vice
                President of Finance*






30