**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 July 3, 2005**
                  **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**
                  (State
                    or other jurisdiction of incorporation or organization)
                
                **94-2551470**
                  (I.R.S.
                    Employer Identification Number)**3975
                    East Bayshore Road, Palo Alto, California**
                  (Address
                    of principal executive offices)
                
                **94303**
                  (Zip
                    Code)
 
 
 
 Registrant's
          telephone number, including area code: **(650) 962-9111**
 ___________________
  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
 
 As
          of
          August 1, 2005, there were 26,787,881 shares of the Registrant's Common
          Stock
          outstanding.
 
 
 1
 
 **SOUTHWALL
          TECHNOLOGIES INC.**
 
 **INDEX**
  PagePART
                      I - FINANCIAL INFORMATIONItem
                      1
                  Financial
                      StatementsUnaudited
                      Condensed Consolidated Balance Sheets - July 3, 2005
                      and December 31, 2004
                  3Unaudited
                      Condensed Consolidated Statements of Operations -
                      Three and six month periods ended July 3, 2005 and June 27,
                      2004
                  4Unaudited
                      Condensed Consolidated Statements of Cash
                      Flows - Six month periods ended July 3, 2005 and June 27,
                      2004
                  5Notes
                      to the Unaudited Condensed Consolidated Financial
                      Statements
                  6Item
                      2
                  Management’s
                      Discussion and Analysis of Financial Condition
                      andResults
                      of Operations
                  11Item
                      3
                  Quantitative
                      and Qualitative Disclosures about Market
                      Risk
                  17Item
                      4
                  Controls
                      and Procedures
                  25PART
                      II - OTHER INFORMATIONItem
                      1
                  Legal
                      Proceedings
                  26Item
                      2
                  Unregistered
                      Sales of Equity Securities and Use of
                      Proceeds
                  26Item
                      3
                  Defaults
                      upon Senior Securities
                  26Item
                      4
                  Submission
                      of Matters to a Vote of Security
                      Holders
                  26Item
                      5
                  Other
                      Information
                  26Item
                      6
                  Exhibits
                  27Signatures
                  28
 
 2
 *Table
                of Contents*
 
 PART
          I. FINANCIAL INFORMATION
 Item
          1--Financial Statements:
 **SOUTHWALL
          TECHNOLOGIES INC.**
 **UNAUDITED
          CONDENSED CONSOLIDATED BALANCE SHEETS**
 **(in
          thousands, except per share data)**
  July
                    3,
                
                December
                    31,2005
                
                2004**ASSETS**Current
                    assets:Cash
                    and cash equivalents
                
                $
                7,628
                
                $
                4,547Restricted
                    cash
                
                
                426
                
                
                686Accounts
                      receivable, net of allowance for doubtful accounts of $221
                      at July 3, 2005and $292 at December 31, 2004
                
                
                5,772
                
                
                6,186Inventories,
                    net
                
                
                7,081
                
                
                8,355Other
                    current assets
                
                
                1,337
                
                
                1,757Total
                    current assets
                
                
                22,244
                
                
                21,531Property,
                    plant and equipment, net
                
                
                18,007
                
                
                21,110Restricted
                    cash loans
                
                
                1,020
                
                
                1,149Other
                    assets
                
                
                1,134
                
                
                1,157Total
                    assets
                
                $
                42,405
                
                $
                44,947**LIABILITIES,
                    REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS’
                    EQUITY**Current
                    liabilities:Current
                    portion of long term debt and capital leases
                
                $
                1,280
                
                $
                1,463Line
                    of credit
                
                
                2,996
                
                
                2,975Accounts
                    payable
                
                
                1,984
                
                
                2,544Accrued
                    compensation
                
                
                952
                
                
                1,378Other
                    accrued liabilities
                
                
                5,940
                
                
                6,643Total
                    current liabilities
                
                
                13,152
                
                
                15,003Term
                    debt and capital leases
                
                
                9,637
                
                
                11,644Government
                    grants advance
                
                
                426
                
                
                505Other
                    long term liabilities
                
                
                2,947
                
                
                3,222Total
                    liabilities
                
                
                26,162
                
                
                30,374Commitments
                    and contingencies (Note 5)Series
                      A 10% cumulative preferred stock, $0.001 par value; $1.00 stated
                      value;
                      5,000 shares authorized, 4,810 shares outstanding  (Liquidation
                      preference $4,893)
                
                
                4,810
                
                
                4,810Stockholders’
                    equity:Common
                        stock, $0.001 par value per share; 50,000 shares authorized,
                        26,788 shares
                        and 26,488 shares outstanding at July 3, 2005 and December
                        31, 2004,
                        respectively
                
                
                27
                
                
                26Capital
                    in excess of par value
                
                
                78,072
                
                
                77,957Accumulated
                    other comprehensive income:Cumulated
                    translation adjustment
                
                
                2,818
                
                
                4,358Accumulated
                    deficit
                
                
                (69,484
                )
                
                (72,578
                )Total
                    stockholders’ equity
                
                
                11,433
                
                
                9,763Total
                    liabilities, redeemable preferred stock and stockholders’ equity
                
                $
                42,405
                
                $
                44,947
 
 See
          accompanying notes to unaudited condensed consolidated financial
          statements.
 
 3
 *Table
                of Contents*
 
 **SOUTHWALL
          TECHNOLOGIES INC.**
 **UNAUDITED
          CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**
 **(in
          thousands, except per share data)**
  Three
                    months ended
                
                Six
                    months endedJuly
                    3,
                
                June
                    27,
                
                July
                    3,
                
                June
                    27,2005
                
                2004
                
                2005
                
                2004Net
                    revenues
                
                $
                15,172
                
                $
                14,548
                
                $
                30,819
                
                $
                25,615Cost
                    of revenues
                
                
                9,788
                
                
                8,936
                
                
                21,058
                
                
                17,402Gross
                    profit
                
                
                5,384
                
                
                5,612
                
                
                9,761
                
                
                8,213Operating
                    expenses:Research
                    and development
                
                
                1,017
                
                
                771
                
                
                1,713
                
                
                1,581Selling,
                    general and administrative
                
                
                2,331
                
                
                2,520
                
                
                4,357
                
                
                5,583Impairment
                    recoveries for long-lived assets
                
                
                -
                
                
                (1,428
                )
                
                (170
                )
                
                (1,428
                )Total
                    operating expenses
                
                
                3,348
                
                
                1,863
                
                
                5,900
                
                
                5,736Income
                    from operations
                
                
                2,036
                
                
                3,749
                
                
                3,861
                
                
                2,477Interest
                    expense, net
                
                
                (297
                )
                
                (635
                )
                
                (568
                )
                
                (1,240
                )Cost
                    of warrants issued
                
                
                -
                
                
                (1,473
                )
                
                -
                
                
                (6,291
                )Other
                    income (expenses), net
                
                
                (159
                )
                
                (112
                )
                
                133
                
                
                248Income
                    (loss) before provision for income taxes
                
                
                1,580
                
                
                1,529
                
                
                3,426
                
                
                (4,806
                )Provision
                    for income taxes
                
                
                185
                
                
                343
                
                
                332
                
                
                698Net
                    income (loss)
                
                
                1,395
                
                
                1,186
                
                
                3,094
                
                
                (5,504
                )Deemed
                    dividend on redeemable preferred stock
                
                
                120
                
                
                -
                
                
                243
                
                
                -Net
                    income (loss) attributable to common stockholders
                
                $
                1,275
                
                $
                1,186
                
                $
                2,851
                
                $
                (5,504
                )Net
                    income (loss) per share:Basic
                
                $
                0.05
                
                $
                0.09
                
                $
                0.11
                
                $
                (0.44
                )Diluted
                
                $
                0.04
                
                $
                0.04
                
                $
                0.09
                
                $
                (0.44
                )Shares
                    used in computing net income (loss) per share:Basic
                
                
                26,782
                
                
                12,548
                
                
                26,697
                
                
                12,548Diluted
                
                
                33,094
                
                
                31,416
                
                
                33,138
                
                
                12,548
 
 See
          accompanying notes to unaudited condensed consolidated financial
          statements.
 
 4
 *Table
                of Contents*
 
 **SOUTHWALL
          TECHNOLOGIES INC.**
 **UNAUDITED
          CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(in
          thousands)**
 
 Six
                    months endedJuly
                    3,
                
                June
                    27,2005
                
                2004Cash
                    flows from operating activities:Net
                    income (loss)
                
                $
                3,094
                
                $
                (5,504
                )Adjustments
                      to reconcile net income (loss) to net cash provided by(used
                      in)operating activities:Impairment
                    recoveries from long-lived assets
                
                
                (170
                )
                
                (1,428
                )Depreciation
                    and amortization
                
                
                1,134
                
                
                1,218Charges
                    related to warrants issued to investors and creditors
                
                
                -
                
                
                6,291Amortization
                    of debt issuance costs
                
                
                -
                
                
                59Unamortized
                    debt discount
                
                
                -
                
                
                116Stock
                    compensation
                
                
                45
                
                
                -Change
                    in assets and liabilities:Deferred
                    revenues
                
                
                (17
                )
                
                -Accounts
                    receivable, net
                
                
                246
                
                
                1,381Inventories,
                    net
                
                
                1,274
                
                
                159Other
                    current and non current assets
                
                
                443
                
                
                (1,316
                )Accounts
                    payable and accrued liabilities
                
                
                (1,850
                )
                
                (2,556
                )Net
                    cash provided by (used in) operating activities
                
                
                4,199
                
                
                (1,580
                )Cash
                    flows from investing activities:Restricted
                    cash
                
                
                237
                
                
                147Proceeds
                    from sale of property, plant and equipment
                
                
                170
                
                
                1,180Expenditures
                    for property, plant and equipment
                
                
                (406
                )
                
                (512
                )Net
                    cash provided by investing activities
                
                
                1
                
                
                815Cash
                    flows from financing activities:Repayments
                    under capital lease
                
                
                (5
                )
                
                -Proceeds
                    from exercise of stock options
                
                
                19
                
                
                -Principal
                    payment on borrowings
                
                
                (986
                )
                
                (1,600
                )Payments
                    on line of credit
                
                
                (2,975
                )
                
                (2,295
                )Borrowings
                    on line of credit
                
                
                2,996
                
                
                -Proceeds
                    from sale of convertible promissory notes
                
                
                -
                
                
                4,500Investment
                    credit in Germany
                
                
                (22
                )
                
                -Net
                    cash provided by (used in) financing activities
                
                
                (973
                )
                
                605Effect
                    of foreign exchange rate changes on cash
                
                
                (146
                )
                
                433Net
                    increase in cash and cash equivalents
                
                
                3,081
                
                
                273Cash
                    and cash equivalents, beginning of period
                
                
                4,547
                
                
                1,152Cash
                    and cash equivalents, end of period
                
                $
                7,628
                
                $
                1,425
 
 See
          accompanying notes to unaudited condensed consolidated financial
          statements.
 
 5
 *Table
                of Contents*
 
 **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
          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,
          2004 filed with the Securities and Exchange Commission on March 30, 2005.
          The
          results of operations for the interim periods presented are not necessarily
          indicative of the operating results of the full year.
 
 The
          Company uses a 52-week fiscal year ending on December 31. The quarters
          ended July 3, 2005 and June 27, 2004 each included 13 weeks.
 
 **Note 2--Balance
          Sheet:**
 
 *Inventories,
          net*
 
 Inventories
          are stated at the lower of cost (determined by the first-in, first-out
          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 July 3, 2005 and December 31, 2004, inventories
          consisted of the following (in thousands):
 
 July
                    3,
                
                December
                    31,2005
                
                2004Raw
                    materials
                
                $
                3,727
                
                $
                4,755Work-in-process
                
                
                1,829
                
                
                2,059Finished
                    goods
                
                
                1,525
                
                
                1,541$
                7,081
                
                $
                8,355
 
 *Other
          long-term liabilities*
 
 Other
          long-term liabilities consisted of the following at July 3, 2005 and December
          31, 2004 (in thousands):
 
 July
                    3,
                
                December
                    31,2005
                
                2004Liabilities
                    associated with Settlement Agreement
                
                
                2,354
                
                
                2,354Deferred
                    tax liability
                
                
                219
                
                
                397Long-term
                    restructuring costs
                
                
                147
                
                
                200Other
                
                
                227
                
                
                271$
                2,947
                
                $
                3,222
 
 **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 was converted to common stock at the beginning
          of
          the period.
 
 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 1,844,255 shares at an average price of  $4.61 per share were
          excluded from the computation of diluted weighted average shares outstanding
          for
          the three and six-month periods ended July 3, 2005. Stock options to purchase
          2,972,571 shares at an average price of $4.43 per share were excluded from
          the
          computation of diluted weighted average shares outstanding for the three-month
          period ended June 27, 2004.
 
 6
 *Table
                of Contents*
 
 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 six-month period
          ended
          June 27, 2004 there was no difference between the denominators used for
          the
          calculation of basic and diluted net income (loss) per share. For the six-month
          period ended June 27, 2004, there were 24,400 and 18,741,500 anti-dilutive
          options and warrants outstanding, respectively, excluded from the net loss
          per share calculation. Tables
          summarizing net income (loss) attributable to common stockholders, for
          diluted
          net income per share and shares outstanding are shown below (in
          thousands):
 
 Three
                    months ended
                
                Six
                    months endedJuly
                    3,
                
                June
                    27,
                
                July
                    3,
                
                June
                    27,2005
                
                2004
                
                2005
                
                2004Net
                    income (loss) attributable to common stockholders-basic
                
                $
                1,275
                
                $
                1,186
                
                $
                2,851
                
                $
                (5,504
                )Add:
                    Interest expense on convertible promissory notes
                
                
                -
                
                
                147
                
                
                -
                
                
                -Add:
                    Deemed dividend on redeemable preferred stock
                
                
                120
                
                
                -
                
                
                243
                
                
                -Net
                    income (loss) attributable to common stockholders-diluted
                
                $
                1,395
                
                $
                1,333
                
                $
                3,094
                
                $
                (5,504
                )Weighted
                    average common shares outstanding-basic
                
                
                26,782
                
                
                12,548
                
                
                26,697
                
                
                12,548Dilutive
                    effect of warrants
                
                
                357
                
                
                14,241
                
                
                357
                
                
                -Dilutive
                    effect of performance shares
                
                
                -
                
                
                -
                
                
                75
                
                
                -Dilutive
                    effect of Series A preferred shares
                
                
                4,893
                
                
                4,500
                
                
                4,893
                
                
                -Dilutive
                    effect of stock options
                
                
                1,062
                
                
                127
                
                
                1,116
                
                
                -Weighted
                    average common shares outstanding - diluted
                
                
                33,094
                
                
                31,416
                
                
                33,138
                
                
                12,548
 
 **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 six month periods ended July 3, 2005 and June 27, 2004 were as follows
          (in
          thousands):
  Three
                    months ended
                
                Six
                    months endedJuly
                    3,
                
                June
                    27,
                
                July
                    3,
                
                June
                    27,2005
                
                2004
                
                2005
                
                2004Automotive
                    glass
                
                $
                4,937
                
                $
                5,627
                
                $
                11,322
                
                $
                10,028Electronic
                    display
                
                
                3,297
                
                
                5,796
                
                
                7,376
                
                
                9,215Window
                    film
                
                
                5,481
                
                
                1,805
                
                
                9,127
                
                
                3,649Architectural
                
                
                1,457
                
                
                1,320
                
                
                2,994
                
                
                2,723Total
                    net revenues
                
                $
                15,172
                
                $
                14,548
                
                $
                30,819
                
                $
                25,615
 
 The
          following is a summary of net revenues by geographic area (based on the
          location
          of the Company's customers) for the second quarters and the first six months
          of
          2005 and 2004, respectively (in thousands):
 
 
 Three
                    months ended
                
                Six
                    months endedJuly
                    3,
                
                June
                    27,
                
                July
                    3,
                
                June
                    27,2005
                
                2004
                
                2005
                
                2004United
                    States
                
                $
                3,995
                
                $
                2,966
                
                $
                7,711
                
                $
                4,447Japan
                
                
                2,631
                
                
                5,285
                
                
                6,430
                
                
                8,259France
                
                
                3,170
                
                
                2,471
                
                
                6,493
                
                
                4,719Pacific
                    Rim
                
                
                3,523
                
                
                1,520
                
                
                6,085
                
                
                3,190Germany
                
                
                1,368
                
                
                1,473
                
                
                2,713
                
                
                2,896Rest
                    of the world
                
                
                485
                
                
                833
                
                
                1,387
                
                
                2,104Total
                    net revenues
                
                $
                15,172
                
                $
                14,548
                
                $
                30,819
                
                $
                25,615
 
 **Note 5--Commitments
          and Contingencies:**
  The
          insurance carriers in some of the litigation related to alleged product
          failures
          and defects in window products manufactured by others in which the Company
          was a
          defendant in the past paid the defense and settlement costs related to
          such
          litigation. Those insurance carriers reserved their rights to recover a
          portion
          or all of such payments from the Company. As a result, those insurance
          carriers
          could seek from the Company up to an aggregate of $12.9 million plus
          defense costs, although any such recovery would be restricted to claims
          that
          were not covered by the Company's insurance policies. 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.
 
 7
 *Table
                of Contents*
 
 In
          addition, the Company is involved, from time to time, in certain other
          legal
          actions arising in the ordinary course of business. Southwall believes,
          however,
          that none of these actions, either individually or in the aggregate, will
          have a
          material adverse effect on its business, its consolidated financial position,
          results of operations or cash flows.
 
 **Note 6--Stock-Based
          Compensation:**
 
 Statement
          of Financial Accounting Standards No. 148 (“SFAS 148”), “Accounting for
          Stock-Based Compensation - Transition and Disclosure, an Amendment of FASB
          Statement No. 123” amends the disclosure requirements of Statement of Financial
          Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based
          Compensation,” to require more prominent disclosures in both annual and interim
          financial standards regarding the method of accounting for stock-based
          employee
          compensation and the effect of the method used on reported results.
 
 The
          Company accounts for stock-based employee compensation arrangements in
          accordance with provisions of Accounting Principles Board Opinion No. 25
          (“APB25”), “Accounting for Stock Issued to Employees” and related
          interpretations. Under APB 25, compensation expense is based on the difference,
          if any, on the date of the grant, between the fair value of the Company's
          stock
          and the exercise price.
  The
          following table illustrates the effect on net income (loss) attributable
          to
          common stockholders and net income (loss) attributable to common stockholders
          per share if the Company had applied the fair value recognition provisions
          of
          SFAS 123 and SFAS 148 to stock-based employee compensation (in thousands,
          except
          per share amounts):
 
 Three
                    months ended
                
                Six
                    months endedJuly
                    3,
                
                June
                    27,
                
                July
                    3,
                
                June
                    27,2005
                
                2004
                
                2005
                
                2004Net
                    income (loss) attributable to common stockholders:As
                    reported
                
                $
                1,275
                
                $
                1,186
                
                $
                2,851
                
                $
                (5,504
                )Add:
                        Stock-based employee compensationexpense included in reported net
                        income (loss), net of related tax effects
                
                
                -
                
                
                -
                
                
                45
                
                
                -Deduct:
                          Total stock-based employee compensation determined under
                          fair value based
                          method for all awards, net of related tax
                          effects
                
                
                (149
                )
                
                (194
                )
                
                (302
                )
                
                (202
                )Pro
                      forma net income (loss) attributable to common
                      stockholders
                
                $
                1,126
                
                $
                992
                
                $
                2,594
                
                $
                (5,706
                )Net
                    income (loss) attributable to common stockholders per
                    share:As
                    reported - basic
                
                $
                0.05
                
                $
                0.09
                
                $
                0.11
                
                $
                (0.44
                )Pro
                    forma - basic
                
                $
                0.04
                
                $
                0.08
                
                $
                0.10
                
                $
                (0.46
                )As
                    reported - diluted
                
                $
                0.04
                
                $
                0.04
                
                $
                0.09
                
                $
                (0.44
                )Pro
                    forma - diluted
                
                $
                0.04
                
                $
                0.04
                
                $
                0.09
                
                $
                (0.46
                )
 
 The
          fair
          value of each option grant under the Company's stock option plans is estimated
          on the date of grant using the Black-Scholes option pricing model, multiple
          option approach, with the following weighted average assumptions used for
          grants
          in the second quarter of 2005 and 2004, respectively: expected volatility
          of
          116%, and 99%; risk-free interest rate of 3.75% and 3.8%; and expected
          lives
          from vesting date of 2.25 years and 2.89 years. The weighted average fair
          value
          of stock options granted in the second quarters of 2005 and 2004 was $0.97
          and
          $1.81 per share, respectively. The Company did not pay dividends on common
          stock
          during these periods and assumed no dividend yield. The Company granted
          100,000
          and no options during the second quarters of 2005 and 2004,
          respectively.
 
 8
 *Table
                of Contents*
 
 The
          following weighted average assumptions were used for grants during the
          first six
          months of 2005 and 2004, respectively: expected volatility of 116%, and
          116%;
          risk-free interest rate of 3.61% and 2.28%; and expected lives from vesting
          date
          of 1.63 years and 2.05 years. The weighted average fair value of stock
          options
          granted during the first six months of 2005 and 2004 was $0.59 and $1.05
          per
          share, respectively. The Company did not pay dividends on common stock
          during
          these periods and assumed no dividend yield. The Company granted 368,361
          and
          746,001 options during the first six months of 2005 and 2004,
          respectively.
 
 **Note
          7 - Restructuring:**
 
 The
          Company implemented a reduction in force at its Palo Alto location in December
          2002, and elected to vacate certain buildings in Palo Alto. As result of
          these
          actions, the Company 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 no longer occupied.
 
 The
          following tables set forth the beginning and ending liability balances
          relating
          to the above described restructuring activity as well as activity during
          the
          fiscal quarters ended July 3, 2005 and June 27, 2004 (in
          thousands):
 
 
 ExcessFacilitiesBalance
                    at January 1, 2004
                
                $
                1,569Provisions
                
                
                -Adjustment
                    to reserve
                
                
                (144
                )Cash
                    payments
                
                
                (569
                )Balance
                    at June 27, 2004
                
                $
                856
 
 
 ExcessFacilitiesBalance
                    at January 1, 2005
                
                $
                274Provisions
                
                
                -Adjustment
                    to reserve
                
                
                -Cash
                    payments
                
                
                (21
                )Balance
                    at July 3, 2005
                
                $
                253
 
 
 **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 reserve for sales returns and warranties at June 27, 2004
          and
          July 3, 2005 were as follows (in thousands):
  Balance
                      at
                  
                  
                  
                  
                  
                  Balance
                      atDecember
                      31,
                  
                  
                  
                  
                  
                  June
                      27,2003
                  
                  Provision
                  
                  Utilized
                  
                  2004Accrued
                      sales returns and warranty
                  
                  $
                  1,850
                  
                  $
                  578
                  
                  $
                  (434
                  )
                  $
                  1,994
  Balance
                      at
                  
                  
                  
                  
                  
                  Balance
                      atDecember
                      31,
                  
                  
                  
                  
                  
                  July
                      3,2004
                  
                  Provision
                  
                  Utilized
                  
                  2005Accrued
                      sales returns and warranty
                  
                  $
                  2,701
                  
                  $
                  242
                  
                  $
                  (808
                  )
                  $
                  2,135
 
 9
 *Table
                of Contents*
 
 **Note
          9 - Recent Accounting Pronouncements:**
 
 In
          April
          2005, the Securities and Exchange Commission approved a new rule that delays
          the
          effective date of Statement of Financial Accounting Standards No. 123 (revised
          2004) to the first annual reporting period beginning after June 15, 2005.
          Adoption of this statement will have an impact on the Company's consolidated
          financial statements as the Company will be required to expense the fair
          value
          of the Company's stock option grants and stock purchases under the Company's
          employee stock purchase plan rather than disclose the impact on the Company's
          consolidated net income (loss) within the Company's footnotes, as is the
          Company's current practice. The Company is currently evaluating the impact
          that
          adoption of this standard will have on its consolidated results of operations
          and financial condition beginning January 1, 2006 when it becomes
          effective.
 
 10
 *Table
                of Contents*
  **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, 2004. 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, plasma displays; transparent conductive
          films for use in touch screen and liquid crystal displays; energy control
          films
          for architectural glass; and various other coatings.
  *Restructuring
          and financing activities.* As a
          consequence of the decline in our revenues and negative cash flows in 2003,
          we
          implemented several cost cutting and business restructuring activities
          during
          2003 and 2004. These activities, which included employee layoffs and the
          closure
          of several facilities (including the closure of our Tempe manufacturing
          facility
          in the fourth quarter of 2003), were designed to improve our cash flow
          from
          operations to allow us to continue as a going concern. During the fourth
          quarter
          of 2003 and the first quarter of 2004, we agreed to new payment terms with
          all
          of our major creditors and vendors, which extended or reduced our payment
          obligations. We also issued $4.5 million of convertible promissory notes
          and
          warrants to investors. The convertible promissory notes were converted
          to Series
          A preferred shares and the warrants were exercised for shares of common
          stock in
          the fourth quarter of 2004.
  *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.
 
 In
          1999,
          we expanded our relationship with customers in the automotive glass and
          window
          film markets, including Pilkington PLC, Saint Gobain Sekurit and Globamatrix
          Holdings Pte. Ltd., or Globamatrix, which collectively accounted for
          approximately 58%, 45%, 45% and 37% of our total revenues during the first
          six
          months of 2005 and in 2004, 2003 and 2002, respectively.
 
 Under
          our
          agreement with Globamatrix, as amended, Globamatrix agreed to a 2004 minimum
          purchase commitment of $9.0 million of products **.** 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 $10.3
          million
          of products in 2005. During the second quarter and the first six months
          of 2005,
          Globamatrix purchased approximately $5.5 and $8.9 million of products,
          respectively.
 
 *Sales
          returns and allowances.* Our
          gross margins and profitability have been adversely affected from time
          to time
          by product quality claims. From 2000 to 2004 our sales returns provision
          has
          averaged approximately 3.5% to 4.7% of gross revenues. In 2002, we had
          certain
          quality claims with respect to products produced for Globamatrix, which
          reduced
          our gross profit by approximately $1.5 million. **** During
          the first six months of 2005, our sales returns provision has average
          approximately 2.6% of our gross revenues due to fewer quality claims received
          during the period.
 
 
 **Three
          Months Ended July 3, 2005 compared with Three Months Ended June 27,
          2004**
 
 **Results
          of Operations**
 
 *Net
          revenues.* Our net
          revenues for the three months ended July 3, 2005 and June 27, 2004 were
          $15.2
          million and $14.5 million, respectively.
 
 Our
          net
          revenues in the window film market increased by $3.7 million, or 203.7%,
          from
          $1.8 million in the second quarter of 2004 to $5.5 million in the same
          period in
          2005. Revenues from our Solis products for the second quarter of 2005 increased
          to $3.8 million from $1.4 million in the same period of 2004 due to higher
          demand for this product. In addition, revenues from our TX products for
          the
          second quarter of 2005 increased to $1.7 million from $0.4 million in the
          same
          period of 2004 as a result of a change in the supply chain to improve the
          company’s profitability. We expect future revenues from TX products to be at the
          same level as 2004.
 
 11
 *Table
                of Contents*
 
 Our
          net
          revenues in the electronic display market decreased by $2.5 million, or
          43.1%,
          from $5.8 million in the second quarter of 2004 to $3.3 million in the
          same
          period of 2005. The decrease was primarily due to lower demand for our
          sputtered
          thin film filter products for Plasma Display Panel products due to increased
          competition. Mitsui Chemicals is our primary customer in the electronic
          display
          market. Sales to Mitsui decreased $1.9 million from $4.2 million in the
          second
          quarter of 2004 to $2.3 million in the same period in 2005 due to lower
          demand
          for our product in the flat panel display, or FPD market.  In addition, we
          phased out our unprofitable anti-reflective product lines and stopped selling
          these products in 2005. We sold $0.3 million anti-reflective products in
          the
          second quarter of 2004.
 
 Our
          net
          revenues in the automotive and architectural markets remained relatively
          the
          same in the second quarter of 2005 compared to the same period in
          2004.
 
 *Cost
          of revenues* .
          Cost of
          revenues consists of materials and subcontractor services, labor and
          manufacturing overhead. Cost of revenues was $9.8 million in the second
          quarter
          of 2005 compared to $8.9 million in the same period of 2004. The increase
          in
          cost of nrevenues was primarily due to an increase in materials cost related
          to
          our increased sales.
  *Gross
          profit and gross margin* .
          Our
          gross profit decreased $0.2 million from $5.6 million in the second quarter
          of
          2004 to $5.4 million in the same period of 2005. As a percent of sales,
          gross
          profit decreased from 38.6% in the second quarter of 2004 to 35.5% in the
          same
          period in 2005. The decrease related to lower average selling prices in
          all
          products lines in the second quarter of 2005 due increased competition,
          which we
          expect to continue.
 
 *Operating
          expenses*
  *Research
          and development* .
          Research and development expenses increased $0.2 million from $0.8 million
          in
          the second quarter of 2004 to $1.0 million in the same period of 2005.
          The 31.9%
          increase from year to year was due in part to an increase in labor and
          employee
          benefits costs as a result of the 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 addition, we
          spent
          more on research and development materials in the second quarter of 2005
          than in
          the same period in 2004. We expect to continue to hire new scientific and
          engineering positions in the third and fourth quarters of 2005, which will
          increase our research and development expense.
 
 *Selling,
          general and administrative* .
          Selling, general and administrative expenses consist primarily of corporate
          and
          administrative overhead, selling commissions, advertising costs and occupancy
          costs. Selling, general and administrative expenses decreased $0.2 million
          from
          $2.5 million in the second quarter of 2004 to $2.3 million in the same
          period of
          2005. The decrease in general and administrative expenses in 2005 was primarily
          due to higher legal, consulting and accounting expenses of $0.4 million
          in the
          second quarter of 2004, partially offset by higher Sarbanes-Oxley compliance
          expenses of $0.2 million in the second quarter of 2005.
 
 *Impairment
          recoveries from long-lived assets.* In the
          second quarter of 2004, we sold
          a
          production machine, which was impaired in the third quarter of 2003, from
          our
          Tempe manufacturing facility to a third party. The sale value was $1.7
          million,
          which included the price of the production machine, other miscellaneous
          hardware, training to be provided by us and operating software to run the
          machine. By June 27, 2004, all of our obligations were completed and we
          recognized a gain in the second quarter of 2004 of $1.4 million representing
          90%
          of the sale value less the book value of $0.1 million. There were no such
          recoveries in the second quarter of 2005.
 
 *Income
          from operations* .
          Income
          from operations decreased $1.7 million from $3.7 million in the second
          quarter
          of 2004 to $2.0 million in the same period of 2005. The decrease was a
          result of
          the impairment recoveries from long-lived assets and higher gross margin
          in the
          second quarter of 2004.
 
 *Interest
          expense, net.* Interest
          expense decreased by $0.3 million from $0.6 million in the second quarter
          of
          2004 to $0.3 million in the same period of 2005. The decrease in interest
          expense was primarily attributable to less outstanding debt during the
          second
          quarter of 2005.
  *Costs
          of warrants issued.* In
          the second quarter of 2004, the Company incurred $1.5 million in warrants
          expense as a result of the re-measurement of all outstanding warrants and
          other
          financial instruments. There was no warrants expense recorded in the second
 quarter
          of 2005.
 
 *Other
          income, net* .
          Other
          income, net, reflects foreign exchange transaction gains and losses in
          the
          second quarter
          of 2004 and 2005. Some of our transactions with foreign customers are
          denominated in foreign currencies, principally the Euro. As exchange rates
          fluctuate relative to the U.S. dollar, exchange gains and losses
          occur.
 
 *Income
          (loss) before provision for income taxes* .
          We
          recorded a pre-tax profit of $1.6 million in the second quarter of 2005
          and $1.5
          million in the second quarter of 2004.
 
 *Provision
          for income taxes* .
          The
          provisions for income taxes in the second quarters of 2005 and 2004 were
          primarily related to our German subsidiary, Southwall Europe GmBH (SEG).
          The
          decrease in the provision for income taxes during the second quarter of
          2005
          compared to the same period in 2004 was due to lower taxable income in
          SEG in
          the 2005 period.
 
 12
 *Table
                of Contents*
 
 *Net
          income (loss).* Net
          income for the second quarter of 2005 and 2004 was $1.4 million and $1.2
          million, respectively.
 
 *Deemed
          dividend on redeemable preferred stock.* We
          incurred $0.1 million of deemed dividend on redeemable preferred stock
          in the
          second quarter of 2005. The holders of our secured convertible promissory
          notes
          converted those notes to shares of Series A redeemable preferred stock
          in
          December 2004. The Series A shares accrue cumulative dividends at the rate
          of
          10% per annum.
 
 *Net
          income (loss) attributable to common stockholders.* Net
          income attributable to common stockholders for the second quarter of 2005
          was
          $1.3 million and $1.2 million for the second quarter of 2004.
 
 
 **Six
          Months Ended July 3, 2005 compared with Six Months Ended June 27,
          2004**
 
 **Results
          of Operations**
 
 *Net
          revenues.* Our net
          revenues for the six months ended July 3, 2005 and June 27, 2004 were $30.8
          million and $25.6 million, respectively.
 
 Our
          net
          revenues in the window film market increased by $5.5 million, or 150.1%,
          from
          $3.6 million in the first six months of 2004 to $9.1 million in the same
          period
          in 2005. Revenues from our Solis products for the first six months of 2005
          increased to $6.4 million from $2.0 million in the same period of 2004.
          In
          addition, revenues from our TX products for the first six months of 2005
          increased to $2.5 million from $1.6 million in the first six months of
          2004 as a
          result of a change in the supply chain to improve the company’s profitability.
          We expect future revenues from TX products to be at the same level as
          2004.
 We
          sell
          our window film products primarily to customers located in the Pacific
          Rim and
          the Middle East. We believe our sales to this market during the first quarter
          of
          2004 were negatively affected by the SARs epidemic and the conflicts in
          Iraq and
          Afghanistan.
 
 Our
          net
          revenues in the automotive market increased by $1.3 million, or 12.9%,
          from
          $10.0 million in the first six months of 2004 to $11.3 million in the same
          period in 2005. The increase was due to higher demand from both our Original
          Equipment Manufacturer, or OEM, and Automotive Replacement Glass, or ARG
          accounts in the first quarter of 2005.
 
 Our
          net
          revenues in the electronic display market decreased by $1.8 million, or
          20.0%,
          from $9.2 million in the first six months of 2004 to $7.4 million in the
          same
          period of 2005. The decrease was primarily due to lower demand for our
          sputtered
          thin film filter products for Plasma Display Panel products due to increased
          competition. Sales to Mitsui, our primary customer in the electronic display
          market, decreased $1.8 million from $9.2 million in the first six months
          of 2004
          to $7.4 million in the same period in 2005 due to lower demand for our
          product
          in the flat panel display, or FPD market.  In addition, we phased out our
          unprofitable anti-reflective product lines and stopped selling these products
          in
          2005. We sold $0.3 million anti-reflective products in the first six months
          of
          2004.
 
 Our
          net
          revenues in the architectural markets remained relatively the same in the
          first
          six months of 2005 compared to the same period in 2004.
 
 *Cost
          of revenues* .
          Cost of
          revenues was $21.1 million in the first six months of 2005 compared to
          $17.4
          million in the same period of 2004. The increase in cost of revenues was
          primarily due to an increase in materials cost related to our increased
          sales.
  *Gross
          profit margin* .
          Our
          gross profit increased $1.5 million from $8.2 million in the first six
          months of
          2004 to $9.8 million in the same period of 2005. As a percent of sales,
          gross
          profit decreased from 32.1% in the first six months of 2004 to 31.7% in
          the same
          period in 2005. The decrease related to lower average selling prices in
          automotive, electronic display and architecture products lines in first
          six
          months of 2005 due to increased competition, which we expect to
          continue.
 
 *Operating
          expenses*
  *Research
          and development* .
          Research and development expenses increased $0.1 million from $1.6 million
          in
          the first six months of 2004 to $1.7 million in the same period of 2005.
          The
          8.3% increase from year to year was due in part to an increase in labor
          and
          employee benefits costs as a result of the 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.
          We
          expect to continue to hire new scientific and engineering positions in
          the third
          and fourth quarters of 2005, which will increase our research and development
          expense.
 
 *Selling,
          general and administrative* .
          Selling, general and administrative expenses decreased $1.2 million from
          $5.6
          million in the first six months of 2004 to $4.4 million in the same period
          of
          2005. The decrease in general and administrative expenses in 2005 was primarily
          due to higher legal and accounting fees of $0.9 million, outside services
          expense of $0.3 million and compensation expense of $0.2 million in the
          first
          six months of 2004, partially offset by higher Sarbanes-Oxley compliance
          expenses of $0.2 million in the first six months of 2005.
 
 *Impairment
          recoveries from long-lived assets.* In the
          June 2004, we sold
          a
          production machine, which was impaired in the third quarter of 2003, from
          our
          Tempe manufacturing facility to a third party. The sale value was for $1.7
          million, which included the price of the production machine, other miscellaneous
          hardware, training to be provided by us and operating software to run the
          machine. By June 27, 2004, all of our obligations were completed and we
          recognized a gain in the second quarter of 2004 of $1.4 million representing
          90%
          of the sale value less the book value of $0.1 million. There was $0.2 million
          impairment recoveries from long-lived assets in the first six months of
          2005.
 
 13
 *Table
                of Contents*
 
 *Income
          from operations* .
          Income
          from operations increased $1.4 million from $2.5 million in the first six
          months
          of 2004 to $3.9 million in the same period of 2005. The increase was a
          result of
          higher revenues, partiallyoffset by the decrease of recoveries for long-lived
          assets.
 
 *Interest
          expense, net.* Interest
          expense decreased by $0.7 million from $1.2 million in the first six months
          of
          2004 to $0.6 million in the same period of 2005. The decrease in interest
          expense was primarily attributable to less outstanding debt in the first
          six
          months of 2005.
  *Costs
          of warrants issued.* In
          the first six months of 2004, the Company incurred $6.3 million in warrants
          expense as a result of the re-measurement of all outstanding warrants and
          other
          financial instruments. There was no warrants expense recorded in the first
          six
          months of 2005.
 
 *Other
          income, net* .
          Other
          income, net, reflects foreign exchange transaction gains and losses in
          the first
          six months of 2004
          and 2005. Some of our transactions with foreign customers are denominated
          in
          foreign currencies, principally the Euro. As exchange rates fluctuate relative
          to the U.S. dollar, exchange gains and losses occur. Other net income,
          net for
          the first six months of 2005 included an energy rebate from our German
          subsidiary of approximately $0.4 million relating to the prior
          year.
 
 *Income
          (loss) before provision for income taxes* .
          We
          recorded a pre-tax profit of $3.4 million in the first six months of 2005
          compared to a pre-tax loss of $4.8 million in the same period of
          2004.
 
 *Provision
          for income taxes* .
          The
          provisions for income taxes in the first six months of 2005 and 2004 were
          primarily related to our German subsidiary, Southwall Europe GmbH (SEG).
          The
          decrease in the provision for income taxes during the first six months
          of 2005
          when compared to the same period in 2004 was due to lower taxable income
          in SEG
          in 2005.
 
 *Net
          income (loss).* Net
          income for the first six months of 2005 was $3.1 million compared to net
          loss of
          $5.5 million in the same period of 2004.
 
 *Deemed
          dividend on redeemable preferred stock.* We
          incurred $0.2 million of deemed dividend on redeemable preferred stock
          in the
          first six months of 2005 as a result of the conversion of our secured
          convertible promissory notes to shares of Series A redeemable preferred
          stock in
          December 2004. The Series A shares carry a 10% cumulative dividend
          rate.
 
 *Net
          income (loss) attributable to common stockholders.* Net
          income attributable to common stockholders for the first six months of
          2005 was
          $2.9 million compared to a net loss of $5.5 million during the same period
          in
          2004.
 
 **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 increased $3.1 million during the first six months
          of 2005.
          Cash provided from operations for the first six months of 2005 of $4.2
          million
          was primarily the result of net income of $3.1 million, non-cash depreciation
          of
          $1.1 million, and decreases in accounts receivable of $0.2 million, in
          inventories of $1.3 million and in other current and non-current assets
          of $0.4
          million partially offset by impairment recoveries from long-lived assets
          of $0.2
          million and a decrease in accounts payable and accrued liabilities of $1.8
          million. Our
          cash
          and cash equivalents increased by $0.3 million in the first six months of
          2004. Cash used in
          operating activities of $1.6 million for the first six months of 2004 was
          primarily the result of non-cash depreciation, cost of warrants issued
          and gain
          from impairment recoveries from long-lived assets, offsetting the net
          loss.
  Cash
          provided by investing activities for the first six months of 2005 of $0.001
          million was primarily the result of a decrease in restricted cash of $0.2
          million and proceeds from the sale of fixed asset of $0.2 million, partially
          offset by capital expenditures of $0.4 million. Cash
          provided from investing activities during the six months ended June 27,
          2004 was
          $0.8 million, primarily from the proceeds from the sale of fixed assets
          partially offset by capital expenditures during the first half of 2004.
 
 Cash
          used
          in financing activities for the first six months of 2005 of $1.0 million
          primarily the result of repayments under capital leases and principal payment
          on
          borrowings of $1.0 million. We
          increased cash from financing activities by $0.6 million during the first
          six
          months of 2004, primarily as a result of issuing $4.5 million in convertible
          promissory notes during the first quarter of 2004, which was partially
          offset by
          a reduction of $2.3 million in our line of credit facility, $1.0 million
          in term
          debt payments and $0.6 million in repayment of a loan payable.
 
 14
 *Table
                of Contents*
 
 We
          entered into an agreement with the Saxony government in May 1999 under
          which we receive investment grants. As of December 31, 2004, we had
          received 5.0 million Euros or $6.8 million of the grants and accounted for
          these grants by applying the proceeds received to reduce the cost of our
          fixed
          assets of our Dresden manufacturing facility. Additionally, as of December
          31,
          2004, we had a balance remaining from the government grants received in
          May 1999
          of 0.4 million Euros or $0.5 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. We did not receive
          any
          grants during the first six months of 2005. If we fail to meet certain
          requirements in connection with these grants, the Saxony government has
          the
          right to demand repayment of the grants. The total annual amount of investment
          grants and investment allowances that we are entitled to seek varies from
          year
          to year based upon the amount of our capital expenditures that meet certain
          requirements of the Saxony government. Generally, we are not eligible to
          seek
          total investment grants and allowances for any year in excess of 33% of
          our
          eligible capital expenditures in Germany for that year. We expect to continue
          to
          finance a portion of our capital expenditures in Dresden with additional
          grants
          from the Saxony government and additional loans from German banks, some
          of which
          may be guaranteed by the Saxony government. However, we cannot guarantee
          that we
          will be eligible for or will receive additional grants in the future from
          the
          Saxony government.
 
 *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 provides for two
          facilities. All amounts borrowed under both facilities under the Credit
          Agreement must be repaid on or before May 31, 2006.
 
 The
          first
          facility is 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 first 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 July 3, 2005.
 
 The
          second facility is formula line under which we may from time to time borrow
          up
          to $3 million, subject to certain conditions, with advances of up to 80%
          of
          eligible accounts receivable. Amounts borrowed under the second facility
          bear
          interest at the prime rate minus 0.25% per annum. We may borrow under the
          second
          facility only if we meet certain financial covenants. As of July 3, 2005,
          we met
          these financial covenants. In addition, all borrowings under both facilities
          under the Credit Agreement are subject to the satisfaction of the additional
          financial covenants.
 
 All
          borrowings under both facilities are collateralized by our inventory,
          receivables, raw material, works in progress and other assets. In addition,
          the
          first facility under the Credit Agreement is collateralized by a letter
          of
          credit posted by Needham & Company, one of our stockholders.
 
 The
          terms
          of the Credit Agreement, among other things, limit our ability to (i) incur,
          assume or guarantee additional indebtedness in excess of $13.5 million
          (other
          than pursuant to the Credit Agreement), (ii) pay dividends or repurchase
          stock
          (except up to $0.6 million per year of dividends on preferred stock), (iii)
          incur liens upon the collateral pledged to the bank, (iv) make any loans
          or
          advances to, or investments in, any person or entity outside the ordinary
          course
          of business, (v) merge, consolidate, sell or otherwise dispose of substantially
          all or a substantial or material portion of our assets, (vi) enter into
          transactions with affiliates, and (vii) make acquisitions other than up
          to an
          aggregate amount of $3 million and (viii) to make capital expenditures
          in any
          fiscal year in excess of $1.5 million.
 
 The
          Credit Agreement provides for events of default, which include, among others,
          (a) nonpayment of amounts when due (with no grace periods), (b) the breach
          of
          our representations or covenants or other agreements in the Credit Agreement
          or
          related documents, (c) payment defaults or accelerations of our other
          indebtedness, (d) a failure to pay certain judgments, (e) the occurrence
          of any
          event or condition that Bank believes impairs or is substantially likely
          to
          impair the prospects of payment or performance by us, and (f) certain events
          of
          bankruptcy, insolvency or reorganization. Generally, if an event of default
          occurs, the Bank may declare all outstanding indebtedness under the Credit
          Agreement to be due and payable.
  The
          foregoing description does not purport to be a complete statement of the
          parties' rights and obligations under the Credit Agreement and the transactions
          contemplated thereby or a complete explanation of the material terms
          thereof.
 
 *Capital
          expenditures*
 
 We
          anticipate spending approximately $1.1 million in capital expenditures
          in 2005,
          primarily to maintain and upgrade our production facilities in Dresden.
          We spent
          approximately $0.4 million in capital expenditures during the first six
          months
          of 2005.
 
 15
 *Table
                of Contents*
 
 *Future
          payment obligations*
 
 Our
          future payment obligations on our borrowings pursuant to our term debt,
          capital
          lease obligations, non-cancelable operating leases and other non-cancelable
          contractual commitments are as follows at July 3, 2005 (in
          thousands):
  GreaterLess
                      than
                  
                  
                  
                  
                  
                  ThanTotal
                  
                  1
                      Year
                  
                  1-3
                      Year
                  
                  4-5
                      Year
                  
                  5
                      YearContractual
                      Obligations:Term
                      debt (1)
                  
                  $
                  10,879
                  
                  $
                  1,242
                  
                  $
                  2,167
                  
                  $
                  4,782
                  
                  $
                  2,688Line
                      of credit
                  
                  
                  2,996
                  
                  
                  2,996
                  
                  
                  --
                  
                  
                  --
                  
                  
                  --Capital
                      lease obligations
                  
                  
                  38
                  
                  
                  38
                  
                  
                  --
                  
                  
                  --
                  
                  
                  --Operating
                      leases (2)
                  
                  
                  1,981
                  
                  
                  437
                  
                  
                  1,471
                  
                  
                  73
                  
                  
                  --Total
                      contractual cash obligations
                  
                  $
                  15,894
                  
                  $
                  4,713
                  
                  $
                  3,638
                  
                  $
                  4,855
                  
                  $
                  2,688
  (1)
                Represents
                    loan agreements with Portfolio Financing Servicing Company, Bank
                    of
                    America and Lehman Brothers, and several German
                    banks.
  (2)
                Represents
                    the remaining rents owed on building we rent in Palo Alto,
                    California.
  16
 *Table
                of Contents*
  **Item 3--Quantitative
          and Qualitative Disclosures about
          Market Risk**
  We
          are
          exposed to the impact of interest rate changes, foreign currency fluctuations,
          and changes in the market values of our investments.
 
 *Financing
          risk:* Our
          exposure to market rate risk for changes in interest rates relates primarily
          to
          our line of credit which bears an interest rate equal to 1.0% above the
          bank
          LIBOR rate (which was 4.375% at July 3, 2005) and is calculated based on
          amounts
          borrowed under the facility. In addition, the interest rate on one of our
          German
          loans was reset to the prevailing market rate of 5.75% on December 31,
          2004 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 would have had an effect of about $21,000
          on
          our interest expense for the second quarter of 2005.
 
 *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 of any of our floating rate securities would have had an
          adverse
          effect of less than $10,000 for the second quarter of 2005.
 
 *Foreign
          currency risk:* International revenues (defined as sales to customers located outside of
          the
          United States) accounted for approximately 74% of our total sales in the
          second
          quarter of 2005. Approximately 46% of our international revenues were
          denominated in Euros relating to sales from our Dresden operation in the
          second
          quarter of 2005. The other 54% 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 less
          than
          $0.5 million on net revenues for the second quarter of 2005 and the effect
          on expenses of a 10% fluctuation in the Yen exchange rate would have been
          minimal.
 
 17
 *Table
                of Contents*
  **FORWARD-LOOKING
          STATEMENTS**
 
 This
          Quarterly Report contains forward-looking statements, which are subject
          to a
          number of risks and uncertainties. All statements other than statements
          of
          historical facts are forward-looking statements. These statements are identified
          by terminology such as "may," "will," "could," "should," "expects," "plans,"
          "intends," "seeks," "anticipates," "believes," "estimates," "potential,"
          or
          "continue," or the negative of such terms or other comparable terminology,
          although not all forward-looking statements contain these identifying words.
          Forward-looking statements are only predictions and include statements
          relating
          to:
 
 ·
                our
                    ability to remain as a going
                    concern;
  ·
                our
                    strategy, future operations and financial plans, including, without
                    limitation, our plans to install and commercially produce products
                    on new
                    machines;
  ·
                the
                    success of our restructuring
                    activities;
  ·
                the
                    continued trading of our common stock on the Over-the-Counter
                    Bulletin
                    Board;
  ·
                our
                    projected need for, and ability to obtain, additional borrowings
                    and our
                    future liquidity;
  ·
                future
                    applications of thin-film technologies and our development of
                    new
                    products;
  ·
                our
                    competition;
  ·
                statements
                    about the future size of markets;
  ·
                our
                    expectations with respect to future grants, investment allowances
                    and bank
                    guarantees from the Saxony
                    government;
  ·
                our
                    expected results of operations and cash flows;
  ·
                pending
                    and threatened litigation and its outcome; and
  ·
                our
                    projected capital expenditures.
  You
          should not place undue reliance on our forward-looking statements. Actual
          events
          or results may differ materially. In evaluating these statements, you should
          specifically consider various factors, including the risks outlined below
          under
          "Risk Factors." 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.
 
 18
 *Table
                of Contents*
 
 **RISK
          FACTORS**
 
 **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 2004, 2003 and 2002 and negative cash flows from
          operations in 2003 and 2002. These factors together with our working capital
          position and our significant debt service and other contractual obligations
          at
          July 3, 2005, 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,
          including the restatement in 2000 of our consolidated financial statements
          for
          prior periods, operating losses in 1998, 1999, 2000, 2002 and 2003, 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.
 
 *The
          transactions with Needham and Dolphin may have a negative effect on us
          or our
          stock price* .
 
 As
          a
          result of the consummation of the financing transactions in December 2003
          and
          February 2004 with Needham & Company and its affiliates and Dolphin
          Direct Equity Partners, L.P, our shareholders suffered material dilution.
          As our
          largest stockholder and the guarantor of our line of credit, Needham could
          prevent us from seeking additional borrowings or alternative sources of
          financing that we require for future operations or otherwise control the
          company
          in ways that might have a material adverse effect on the company or our
          stock
          price.
 
 *Covenants
          or defaults under our credit and other loan agreements may prevent us from
          borrowing or force us to curtail our operations.*
 
 As
          of
          July 3, 2005, we had total outstanding obligations under our credit and
          other
          loan agreements of $13.9 million. Our inability to make timely payments
          of
          interest or principal under these facilities could materially adversely
          affect
          our ability to borrow money under existing credit facilities, to secure
          additional borrowings or to function as a going concern. Our current credit
          facilities contain financial covenants that will require us to meet certain
          financial performance targets and operating covenants that limit our discretion
          with respect to business matters. Among other things, these covenants restrict
          our ability to borrow additional money, create liens or other encumbrances,
          and
          make certain payments including dividends and capital expenditures. Many
          of
          these loans contain provisions that permit the lender to declare the loans
          immediately due if there is a material adverse change in our business.
          These
          credit facilities also contain events of default that could require us
          to pay
          off indebtedness before its maturity. The restrictions imposed by these
          credit
          facilities or the failure of lenders to advance funds under these facilities
          could force us to curtail our operations or have a material adverse effect
          on
          our liquidity.
 
 *Our
          ability to borrow is limited by the nature of our equipment and some of
          our
          accounts receivable* .
 
 Our
          equipment is custom designed for a special purpose. In addition, a large
          portion
          of our accounts receivable are from foreign sales, which are often more
          difficult to collect than domestic accounts receivable. As a result of
          the
          nature of our equipment and accounts receivable, lenders will generally
          allow us
          to borrow less against these items as collateral than they would for other
          types
          of equipment or domestic accounts receivable, or require us to provide
          additional credit enhancements.
 
 *If
          we
          default under our secured credit facilities and financing arrangements,
          the
          lenders could foreclose on the assets we have pledged to them requiring
          us to
          significantly curtail or even cease our operations* .
 
 In
          connection with our current borrowing facilities and financing arrangements,
          we
          have granted security interests in and liens on substantially all of our
          assets,
          including our production machines and our Dresden facility, to secure the
          loans.
          If our senior lenders were to repossess one or more of those machines,
          our
          ability to produce product would be materially impaired. Our revenues,
          gross
          margins and operating efficiency would also be materially adversely affected.
          Our obligations under our secured credit facilities contain cross-default
          and
          cross-acceleration provisions and provisions that allow the lenders to
          declare
          the loans immediately due if there is a material adverse change in our
          business.
          If we default under the credit facilities or financing arrangements the
          lenders
          could declare all of the funds borrowed thereunder, together with all accrued
          interest, immediately due and payable. If we are unable to repay such
          indebtedness, the lenders could foreclose on the pledged assets. If the
          lenders
          foreclose on our assets, we would be forced to significantly curtail or
          even
          cease our operations.
 
 *Our
          quarterly revenue and operating results are volatile and difficult to predict.
          If we fail to meet the expectations of public market analysts or investors,
          the
          market price of our common stock may decrease significantly.*
 
 19
 *Table
                of Contents*
 
 Our
          quarterly revenue and operating results have varied significantly in the
          past
          and will likely vary significantly in the future. Our revenue and operating
          results may fall below the expectations of securities analysts or investors
          in
          future periods. Our failure to meet these expectations would likely adversely
          affect the market price of our common stock.
 
 Our
          quarterly revenue and operating results may vary depending on a number
          of
          factors, including:
 
  ·
                fluctuating
                    customer demand, which is influenced by a number of factors,
                    including
                    market acceptance of our products and the products of our customers
                    and
                    end-users, changes in product mix, and the timing, cancellation
                    or delay
                    of customer orders and shipments;
  ·
                the
                    timing of shipments of our products by us and by independent
                    subcontractors to our customers;
 
 ·
                manufacturing
                    and operational difficulties that may arise due to, among other
                    things,
                    quality control, capacity utilization of our production machines,
                    unscheduled equipment maintenance, and the hiring and training
                    of
                    additional staff;
 
 ·
                our
                    ability to introduce new products on a timely basis; and
 
 ·
                competition,
                    including the introduction or announcement of new products by
                    competitors,
                    the adoption of competitive technologies by our customers, the
                    addition of
                    new production capacity by competitors and competitive pressures
                    on prices
                    of our products and those of our customers.
 
 *We
          expect to be subject to increased foreign currency risk in our international
          operations.*
 
 In
          2003
          and 2004 and during the first six months of 2005, approximately 34%, 34%,
          and
          29% 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.
 
 *Our
          suppliers and subcontractors may impose more onerous payment terms on
          us.*
 
 As
          a
          result of our financial performance and voluntary delisting from NASDAQ,
          our
          suppliers and creditors may impose more onerous payment terms on us, which
          may
          have a material adverse effect on our financial performance and our liquidity.
          For example, one of our subcontractors has required us to provide it with
          a
          security interest in all of our inventory held by it and has limited the
          amount
          of unpaid invoices we may have outstanding with it at any time.
 
 **Operational
          Risks**
 
 *We
          depend on a small number of customers for nearly all of our revenues, and
          the
          loss of a large customer could materially adversely affect our revenues
          or
          operating results.*
 
 Our nine
          largest customers accounted for approximately 80%, 77%, 76% and 84% of
          net
          revenues during the first six months of 2005 and in fiscal years 2004,
          2003, and
          2002, respectively. We have contracts extending past 2005 with only two
          of these
          customers. We expect to continue to derive a significant portion of our
          net revenues 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 2002 and 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.
 
 *We
          must continue to develop new products or enhance existing products on a
          timely
          basis to compete successfully in a rapidly changing
          marketplace.*
 
 Our
          future success depends upon our ability to introduce new products, improve
          existing products and processes to keep pace with technological and market
          developments, and to address the increasingly sophisticated and demanding
          needs
          of our customers, especially in the electronic display and automotive markets.
          Technological changes, process improvements, or operating improvements
          that
          could adversely affect us include:
 
 ·
                the
                    development of competing technologies to our anti-reflective
                    and silver
                    reflector films for liquid crystal displays in the flat panel
                    display
                    industry;
 
 20
 *Table
                of Contents*
 
 ·
                changes
                    in the way coatings are applied to alternative substrates such
                    as
                    tri-acetate cellulose, or TAC;
 
 ·
                the
                    development of new technologies that improve the manufacturing
                    efficiency
                    of our competitors;
 
 ·
                the
                    development of new materials that improve the performance of
                    products that
                    could compete with our products; and
 
 ·
                improvements
                    in the alternatives to the sputtering technology we use to produce
                    our
                    products, such as plasma enhanced chemical vapor deposition,
                    or PECVD.
 
 Our
          research and development efforts may not be successful in developing products
          in
          the time, or with the characteristics, necessary to meet customer needs.
          If we
          do not adapt to technological changes or process or operating improvements,
          our
          competitive position, operations and prospects would be materially adversely
          affected.
 
 *Our
          ability to successfully identify suitable target companies and integrate
          acquired companies or technologies may affect our future
          growth.*
 
 A
          potential part of our continuing business strategy is to consider acquiring
          companies, products, and technologies that complement our current products,
          enhance our market coverage, technical capabilities or production capacity,
          or
          offer other growth opportunities. Our ability to successfully complete
          acquisitions requires that we identify suitable target companies, agree
          on
          acceptable terms, and obtain acquisition financing on acceptable terms.
          In
          connection with these acquisitions, we could incur debt, amortization expenses
          relating to identified intangibles, impairment charges relating to goodwill,
          or
          merger related charges, or could issue stock that would dilute our current
          shareholders' percentage of ownership. The success of any acquisitions
          will
          depend upon our ability to integrate acquired operations, retain and motivate
          acquired personnel, and increase the customer base of the combined businesses.
          We cannot assure you that we will be able to accomplish all of these goals.
          Any
          future acquisitions would involve certain additional risks,
          including:
 
 ·
                difficulty
                    integrating the purchased operations, technologies, or products;
 
 ·
                unanticipated
                    costs, which would reduce our profitability;
 
 ·
                diversion
                    of management's attention from our core business;
 
 ·
                potential
                    entrance into markets in which we have limited or no prior experience;
                    and
 
 ·
                potential
                    loss of key employees, particularly those of the acquired business.
 
 *If
          one of our customers is able to enforce a European automotive film patent,
          we
          may be restricted from using the methods present in such patent to produce
          some
          of our products.*
  On
          March
          3, 2005, the European Patent Office allowed a European patent owned by
          Pilkington Automotive GmBH entitled "Method for producing a laminated glass
          pane
          free of optical obstruction caused by warping, use of a particular carrier
          film
          for the production of the laminated glass pane and carrier films particularly
          suitable for the method of use." This European patent covers certain laminated
          films and methods of using them which may prevent us from producing certain
          films designed for the automotive markets. Our inability to use this technology
          could adversely affect our ability to provide a full range of products
          to the
          automotive film market. We participated in opposing the European patent
          and have
          appealed the European Patent Office decision.
  *Failure
          to meet the volume requirements of our customers may result in a loss of
          business or contractual penalties.*
 
 Our
          long-term competitive position will depend to a significant extent on our
          manufacturing capacity. The failure to have sufficient capacity, to fully
          utilize capacity when needed or to successfully integrate and manage additional
          capacity in the future could adversely affect our relationships with customers
          and cause customers to buy similar products from our competitors if we
          are
          unable to meet their needs. For example, we believe that we lost substantial
          potential architectural products sales in 2001 because we did not have
          the
          capacity to manufacture the required amounts of products. Also, our failure
          to
          produce required amounts of products under some of our contracts will result
          in
          price reductions on future sales under such contracts or penalties under
          which
          we would be required to reimburse the customer for the full cost of any
          product
          not delivered in a timely manner, either of which would reduce our gross
          margins.
 
 *We
          depend on our OEM customers for the sale of our products.*
 
 We
          sell a
          substantial portion of our products to a relatively small number of original
          equipment manufacturers, or OEMs. The timing and amount of sales to these
          customers ultimately depend on sales levels and shipping schedules for
          the OEM
          products into which our products are incorporated. We have no control over
          the
          volume of products shipped by our OEM customers or shipping dates, and
          we cannot
          be certain that our OEM customers will continue to ship products that
          incorporate our products at current levels or at all. We currently have
          long-term contracts with only two of our OEM customers. Failure of our
          OEM
          customers to achieve significant sales of products incorporating our products
          and fluctuations in the timing and volume of such sales could be harmful
          to our
          business. Failure of these customers to inform us of changes in their production
          needs in a timely manner could also hinder our ability to effectively manage
          our
          business.
 
 21
 *Table
                of Contents*
 
 *We
          rely upon our OEM customers for information relating to the development
          of new
          products so that we are able to meet end-user demands.*
 
 We
          rely
          on our OEM customers to inform us of opportunities to develop new products
          that
          serve end-user demands. If our OEM customers do not present us with market
          opportunities early enough for us to develop products to meet end-user
          needs in
          a timely fashion, or if the OEMs fail to anticipate end-user needs at all,
          we may fail to develop new products or modify our existing products for
          the
          end-user markets for our products. In addition, if our OEM customers fail
          to
          accurately anticipate end-user demands, we may spend resources on products
          that
          are not commercially successful.
 
 *We
          depend on a distributor for the sale of our after-market
          products.*
 
 We
          primarily use one independent distributor to sell our after-market products.
          We
          have a distribution agreement with Globamatrix Holdings Pte. Ltd., or
          Globamatrix, under which we granted an exclusive worldwide license to distribute
          our after-market applied film in the automotive and architectural glass
          markets.
          Failure of Globamatrix to achieve significant sales of products incorporating
          our products and fluctuations in the timing and volume of such sales could
          be
          harmful to our business. We believe that the success of our after-market
          products will continue to depend upon this distributor.
 
 *We
          face intense competition, which could affect our ability to increase our
          revenue, maintain our margins and increase our market share.*
 
 The
          market for each of our products is intensely competitive and we expect
          competition to increase in the future. Competitors vary in size and in
          the scope
          and breadth of the products they offer. We compete both with companies
          using
          technology similar to ours and companies using other technologies or developing
          improved technologies. Direct-to-glass sputtering represents the principal
          alternative technology to our sputter-coated film products. Direct-to-glass
          is a
          mature, well-known process for applying thin film coatings directly to
          glass,
          which is used by some of our current and potential customers to produce
          products
          that compete with our products. This technology is commonly used to manufacture
          products that conserve energy in buildings and automobiles. Many of our
          current
          and potential competitors have significantly greater financial, technical,
          marketing and other resources than we have. In addition, many of our competitors
          have well-established relationships with our current and potential customers
          and
          have extensive knowledge of our industry.
 
 *We
          are dependent on key suppliers of materials, which may prevent us from
          delivering product in a timely manner.*
 
 We
          manufacture all of our products using materials procured from third-party
          suppliers. We do not have long-term contracts with our third-party suppliers.
          Certain of the materials we require are obtained from a limited number
          of
          sources. Delays or reductions in product shipments could damage our
          relationships with customers. Further, a significant increase in the price
          of
          one or more of the materials used in our products could have a material
          adverse
          effect on our cost of goods sold and operating results.
 
 *We
          are dependent on a few qualified subcontractors to add properties to some
          of our
          products.*
 
 We
          rely
          on third-party subcontractors to add properties, such as adhesives, to
          some of
          our products. There are only a limited number of qualified subcontractors
          that
          can provide some of the services we require, and we do not have long-term
          contracts with any of those subcontractors. Qualifying alternative
          subcontractors could take a great deal of time or cause us to change product
          designs. The loss of a subcontractor could adversely affect our ability
          to meet
          our scheduled product deliveries to customers, which could damage our
          relationships with customers. If our subcontractors do not produce a quality
          product, our yield will decrease and our margins will be lower. Further,
          a
          significant increase in the price charged by one or more of our subcontractors
          could force us to raise prices on our products or lower our margins, which
          could
          have a material adverse effect on our operating results.
 
 *We
          are dependent on key suppliers of production machines, which may prevent
          us from
          delivering an acceptable product on a timely basis and limit our capacity
          for
          revenue growth.*
 
 Our
          production machines are large, complex and difficult to manufacture. It
          can take
          up to a year from the time we order a machine until it is delivered. Following
          delivery, it can take us, with the assistance of the manufacturer, up to
          six
          additional months to test and prepare the machine for commercial production.
          There are a very limited number of companies that are capable of manufacturing
          these machines. Our inability in the future to have new production machines
          manufactured and prepared for commercial production in a timely manner
          would
          prevent us from delivering product on a timely basis and limit our capacity
          for
          revenue growth.
 
 *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, due to the deteriorating
          economic
          environment, sales by flat cathode ray tube manufacturers decreased in
          2002 and
          further in 2003, contributing to our electronic display product revenues
          declining by 11% in 2002, and another 3% for 2003. During the first six
          months
          of 2005, we experienced a decrease 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 our window film
          products and agreed with our customers to own this process. This resulted
          in
          higher revenues on our TX products as our customers bought more products
          to fill
          their production lines. We expect higher revenues from the TX product line
          to
          continue through the end of 2005.
 
 22
 *Table
                of Contents*
 
 *Performance,
          reliability or quality problems with our products may cause our customers
          to
          reduce or cancel their orders.*
 
 We
          manufacture our products based on specific, technical requirements of each
          of
          our customers. We believe that future orders of our products will depend
          in part
          on our ability to maintain the performance, reliability and quality standards
          required by our customers. If our products have performance, reliability
          or
          quality problems, then we may experience:
 
 ·
                delays
                    in collecting accounts receivable;
 
 ·
                higher
                    manufacturing costs;
 
 ·
                additional
                    warranty and service expenses; and
 
 ·
                reduced
                    or cancelled orders.
 
 *If
          we
          fail to recruit and retain a significant number of qualified technical
          personnel
          we may not be able to develop, enhance and introduce our products on a
          timely
          basis, and our business will be harmed* .
 
 We
          require the services of a substantial number of qualified technical personnel.
          Intense competition and aggressive recruiting, as well as a high-level
          of
          employee mobility characterize the market for skilled technical personnel.
          These
          characteristics make it particularly difficult for us to attract and retain
          the
          qualified technical personnel we require. We have experienced, and we expect
          to
          continue to experience, difficulty in hiring and retaining highly skilled
          employees with appropriate technical qualifications. It is especially difficult
          for us to recruit qualified personnel to move to the location of our Palo
          Alto,
          California offices because of the high-cost of living. If we are unable
          to
          recruit and retain a sufficient number of qualified technical employees,
          we may
          not be able to complete the development of, or enhance, our products in
          a timely
          manner. As a result, our business may be harmed and our operating results
          may
          suffer.
 
 *We
          may be unable to attract or retain the other highly skilled employees that
          are
          necessary for the success of our business.*
 
 In
          addition to our dependence on our technical personnel, our success also
          depends
          on our continuing ability to attract and retain other highly skilled employees.
          We depend on the continued services of our senior management, particularly
          Thomas G. Hood, our President and Chief Executive Officer. We do not have
          employment contracts with any of our officers or key-person life insurance
          covering any officer or employee. Our officers have technical and industry
          knowledge that cannot easily be replaced. Competition for similar personnel
          in
          our industry where we operate is intense. We have experienced, and we expect
          to
          continue to experience, difficulty in hiring and retaining highly skilled
          employees with appropriate qualifications. If we do not succeed in attracting
          or
          retaining the necessary personnel, our business could be adversely
          affected.
 
 *If
          we
          are unable to adequately protect our intellectual property, third parties
          may be
          able to duplicate our products or develop functionally equivalent or superior
          technology.*
 
 Our
          success depends in large part upon our proprietary technology. We rely
          on our
          know-how, as well as a combination of patent, trademark and trade secret
          protection, to establish and protect our intellectual property rights.
          Despite
          our efforts to protect our proprietary rights, unauthorized parties may
          attempt
          to copy aspects of our products or to obtain and use information that we
          regard
          as proprietary. Policing unauthorized use of our products is difficult.
          Our
          means of protecting our proprietary rights may not be adequate. In addition,
          the
          laws of some foreign countries do not protect our proprietary rights to
          as great
          an extent as do the laws of the United States. In the next three years,
          one of
          our U.S. patents relating to our architectural products will expire. Expiration
          of this patents or our failure to adequately protect our proprietary rights
          may
          allow third parties to duplicate our products or develop functionally equivalent
          or superior technology. In addition, our competitors may independently
          develop
          similar technology or design around our proprietary intellectual
          property.
 
 *Our
          business is susceptible to numerous risks associated with international
          operations.*
 
 Revenues
          from international sales amounted to approximately 75%, 83%, 89% and 85%
          of our
          net revenues during the first six months of 2005 and fiscal years 2004,
          2003 and
          2002, 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:
 
 23
 *Table
                of Contents*
 
 ·
                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.
 
 *If
          we
          fail to comply with environmental regulations, our operations could be
          suspended.*
 
 We
          use
          hazardous chemicals in producing our products and have air and water emissions
          that require controls. As a result, we are subject to a variety of local,
          state
          and federal governmental regulations relating to the storage, discharge,
          handling, emission, generation, manufacture and disposal of toxic or other
          hazardous substances used to manufacture our products, compliance with
          which is
          expensive. Our failure to comply with current or future regulations could
          result
          in the imposition of substantial fines on us, suspension of production,
          alteration of our manufacturing processes, increased costs or cessation
          of
          operations.
 
 *We
          rely on our domestic sales representatives, without whom our architectural
          product sales may suffer.*
 
 We
          use
          independent sales representatives to promote our Heat Mirror products to
          architects in the United States. If some or all of our sales representatives
          experience financial difficulties, or otherwise become unable or unwilling
          to
          promote our products, our business could be harmed. These sales representatives
          could reduce or discontinue promotion of our products. They may not devote
          the
          resources necessary to provide effective marketing support to us. In addition,
          we depend upon the continued viability and financial resources of these
          representatives, many of which are small organizations with limited working
          capital. These representatives, in turn, depend substantially on general
          economic conditions and other factors affecting the markets for the products
          they promote. We believe that our success in this market will continue
          to depend
          upon these sales representatives.
 
 *We
          may experience unanticipated warranty or other claims with respect to our
          products, which may lead to extensive litigation costs and
          expenses.*
 
 In
          the
          ordinary course of business, we have periodically become engaged in litigation
          principally as a result of disputes with customers of our architectural
          products. We have settled some of these suits and others are pending. We
          may
          become engaged in similar or other lawsuits in the future. Some of our
          products
          that have been the basis for lawsuits against us could be the basis for
          future
          lawsuits. An adverse outcome in the defense of a warranty or other claim
          could
          subject us to significant liabilities to third parties. Any litigation,
          regardless of the outcome, could be costly and require significant time
          and
          attention of key members of our management and technical personnel.
 
 *We
          may face extensive damages or litigation costs if our insurance carriers
          seek to
          have us indemnify them for settlements of past and outstanding
          litigation.*
 
 Several
          of our insurance carriers have reserved their rights to seek indemnification
          from us for substantial amounts paid to plaintiffs by the insurance carriers
          as
          part of settlements of litigation relating to our architectural products.
          Our
          insurance carriers in a case in which the plaintiff alleged we were responsible
          for defects in window products manufactured by others have advised us that
          they
          intend to seek reimbursement for settlement and defense costs. Any claims,
          with
          or without merit, could require significant time and attention of key members
          of
          our management and result in costly litigation.
 
 24
 *Table
                of Contents*
  **Item
          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 officer and acting chief financial
                    officer,
                    we conducted an evaluation of the effectiveness of the design
                    and
                    operation of our disclosure controls and procedures, as defined
                    in Rules
                    13a-15(e) and 15d-15(e) under the Securities Exchange Act of
                    1934, as
                    amended, as of July 3, 2005 (the “Evaluation Date”). Based on this
                    evaluation, our chief executive officer and acting chief financial
                    officer
                    concluded as of the Evaluation Date that our disclosure controls
                    and
                    procedures were effective such that the information relating
                    to the
                    Company, including our consolidated subsidiaries, required to
                    be disclosed
                    in our Securities and Exchange Commission ("SEC") reports (i)
                    is recorded,
                    processed, summarized and reported with the time periods specified
                    in SEC
                    rules and forms, and (ii) is accumulated and communicated to
                    our
                    management, including our chief executive officer and acting
                    chief
                    financial officer, as appropriate to allow timely decisions regarding
                    required disclosure.
  *b.*
                *Report
                    on Internal Control Over Financial Reporting*.
                    We will be required by the Sarbanes-Oxley Act to include an assessment
                    of our internal control over financial reporting and an attestation
                    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, 2006.
  *c.*
                *Changes
                    in Internal Controls*.
                    There were no changes during the quarter ended July 3, 2005 in
                    our
                    internal controls over financial reporting that have materially
                    effected,
                    or are reasonably likely to materially affect, the internal controls
                    over
                    financial reporting.
 
 25
 *Table
                of Contents*
  **PART
          II--OTHER INFORMATION**
  **Item
          1--Legal Proceedings**
 
 Litigation
          filed against the Company was described under Item 3 in the Company's Form
          10-K
          filed on March 30, 2005. No other material developments have occurred with
          respect to the litigation described therein.
 
 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,
          results of operations or cash flows.
  **Item
          2-- Unregistered Sales of Equity Securities and Use of
          Proceeds**
 
 None.
  **Item
          3--Defaults upon Senior Securities**
 
 Not
          applicable.
  **Item
          4--Submission of Matters to a Vote of
          Stockholders**
  On
          May
          26, 2005, we held our Annual Meeting of Stockholders. The
          number of shares outstanding and eligible to vote as of March 30, 2005,
          the
          record date, were 26,778,482 shares. The following matters were voted
          upon:
  1.
                Our
                    stockholders elected William A. Berry, George Boyadjieff, Thomas
                    G. Hood,
                    Jami K. Nachtsheim, Joseph B. Reagan and Walter C. Sedgwick as
                    directors
                    to serve until the 2006 Annual Meeting of Stockholders and until
                    their
                    successors are elected.
  The
          vote
          for each director was as follows:
  Director
                For
                WithheldWilliam
                    A. Berry
                25,326,043
                36,249George
                    Boyadjieff
                25,322,843
                39,449Thomas
                    G. Hood
                25,300,843
                61,449Jami
                    K. Nachtsheim
                25,323,043
                39,249Joseph
                    B. Reagan
                25,208,618
                153,674Walter
                    C. Sedgwick
                25,205,718
                156,574
  There
          were no votes abstaining, n or
          were
          there any broker non-votes, in the election of directors.
  2.
                Our
                    stockholders ratified the selection of Burr, Pilger & Mayer LLP, our
                    independent registered public accounting firm for the fiscal
                    year ending
                    December 31, 2005.On
                    the matter, there were 25,292,314 votes "FOR", 57,533 votes "AGAINST",
                    12,445 votes "ABSTAINING", and no broker non-votes.
  **Item
          5--Other Information**
 
 None.
 
 26
 *Table
                of Contents*
 
 **Item
          6--Exhibits**
  (a)
                Exhibits
 
 
 ExhibitNumber
                Item31.1
                Certification
                    of Principal Executive Officer pursuant to Exchange Act Rules
                    13a-14 and
                    15d-1431.2
                Certification
                    of Principal Financial Officer pursuant to Exchange Act Rules
                    13a-14 and
                    15d-1432.1
                Certification
                    of Principal Executive Officer pursuant to 18 U.S.C Section
                    135032.2
                Certification
                    of Principal Financial Officer pursuant to 18 U.S.C Section
                    1350
 
 27
 *Table
                of Contents*
  **SIGNATURES**
  Pursuant
          to the requirements of the Securities Exchange Act of 1934, the registrant
          has
          duly caused this report to be signed on its behalf by the undersigned thereunto
          duly authorized.
  Dated:  
                    August 5, 2005**Southwall
                    Technologies Inc.**By:
                /s/
                    Thomas G. HoodThomas
                    G. Hood*President
                    and Chief Executive Officer*By:
                /s/
                    Sylvia KamenskiSylvia
                    Kamenski*Acting
                    Chief Financial Officer*




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