----

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**SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

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**FORM 10-Q**

**(MARK ONE)**
| ý | **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO  FEE REQUIRED]** |
|--------|-----------------------------------------------------------------------------------------------------------------|

**For the quarterly period ended July 1,2001**
| o | **TRANSITION REPORT PURSUANT  TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE  REQUIRED]** |
|---|------------------------------------------------------------------------------------------------------------------|

**For the transition period from              to             **

**Commission File Number: 0-15930**

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**SOUTHWALL TECHNOLOGIES INC.**(Exact name of registrant as specified in its charter)

 

| **DELAWARE**                                                          | **94-2551470**                                 |
|-----------------------------------------------------------------------|------------------------------------------------|
|  (State  or other jurisdiction of incorporation or organization) |  (I.R.S.  Employer Identification Number) |
|                                                                  |                                           |
| **1029 Corporation Way, Palo Alto,  California**                      | **94303**                                      |
| (Address  of principal executive offices)                             |  (Zip  Code)                              |

Registrant'stelephone number, including area code:**(650) 962-9111**

----

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

             As ofAugust 3, 2001 there were 8,187,722 shares of the Registrant's Common Stockoutstanding

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**SOUTHWALL TECHNOLOGIES INC.**

**INDEX**

 

**PART I FINANCIALINFORMATION**

 

| **Item 1**                     | **Financial Statements:**                                                                                                                   |   |
|--------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                           | Unaudited Consolidated  Balance Sheets–July 1, 2001 and December 31, 2000                                                    |   |
|                           | Unaudited  Consolidated Statements of Operations–Three month and six month periods ended  July 1, 2001 and July 2, 2000 |   |
|                           | Unaudited  Consolidated Statements of Cash Flows–Three month and six month periods ended  July 1, 2001 and July 2, 2000 |   |
|                           | Notes to Unaudited  Consolidated Financial Statements                                                                                       |   |
| **Item  2**                    | Management's  Discussion and Analysis of Financial Condition and Results of Operations                                                      |   |
| **Item  3**                    | Quantitative  and Qualitative Disclosures about Market Risk                                                                                 |   |
| **PART II OTHER  INFORMATION** |                                                                                                                                        |
| I**tem 1**                     | Legal  Proceedings                                                                                                                          |   |
| **Item 2**                     | Changes in Securities                                                                                                                       |   |
| **Item 3**                     | Defaults  Upon Senior Securities                                                                                                            |   |
| **Item  4**                    | Submission  of Matters to a Vote of Stockholders                                                                                            |   |
| **Item  5**                    | Other  Information                                                                                                                          |   |
| **Item 6**                     | Exhibits and Reports on Form 8-K                                                                                                       |   |
|                           | Signatures                                                                                                                                  |   |
|                           |                                                                                                                                        |   |

**PART I FINANCIAL INFORMATION**

**Item 1–Financial Statements:**

**SOUTHWALLTECHNOLOGIES INC.CONSOLIDATED BALANCE SHEETS**(in thousands,except per share data)

|                                  | July  1,2001                                                                                           |    | December  31,2000 |          |
|---------------------------------------|--------------------------------------------------------------------------------------------------------|---------|-------------------|---------------|
|                                  |                                                                                                        |    |                   |          |
|                                  | (Unaudited)                                                                                            |    |              |          |
| ASSETS                                |                                                                                                   |    |              |          |
| Current Assets                        |                                                                                                   |    |              |          |
|                                  | Cash and cash equivalents                                                                              | $       | 558               |          | $ | 61 |   |
|                                  | Restricted cash                                                                                        | 391     |              | 1,849         |   |
|                                  | Accounts Receivable, net of allowance  for bad debts of $469 and $640                                  | 12,315  |         | 13,317        |     |
|                                  | Inventories, net                                                                                       | 6,391   |              | 10,174        |   |
|                                  | Other current assets                                                                                   | 2,004   |              | 2,008         |   |
|                                  |                                                                                                   |         |              |               |   |
|                                  | Total current assets                                                                                   | $       | 21,659            |          | $ | 27,409 |   |
|                                  |                                                                                                   |    |              |          |
| Property, plant and  equipment, net   | 48,128                                                                                                 |    | 49,884            |          |
| Other assets                          | 3,173                                                                                                  |    | 3,169             |          |
|                                  |                                                                                                        |    |                   |          |
|                                  | Total assets                                                                                           | $       | 72,960            |          | $ | 80,462 |   |
|                                  |                                                                                                   |         |              |               |   |
|                                  |                                                                                                   |    |              |          |
| LIABILITIES AND  STOCKHOLDERS' EQUITY |                                                                                                   |    |              |          |
| Current liabilities:                  |                                                                                                   |    |              |          |
|                                  | Bank line of credit                                                                                    | $       | 7,247             |          | $ | 8,719 |   |
|                                  | Accounts payable                                                                                       | 12,800  |              | 16,857        |   |
|                                  | Accrued compensation                                                                                   | 2,000   |              | 1,915         |   |
|                                  | Other accrued liabilities                                                                              | 5,094   |              | 4,551         |   |
|                                  | Government grants  advanced                                                                            | 889     |              | 1,085         |   |
|                                  | Current portion  long-term debt                                                                        | 7,150   |              | 5,806         |   |
|                                  | Long-term debt  reclassified to current                                                                | 16,443  |              | 20,624        |   |
|                                  |                                                                                                   |         |              |               |   |
|                                  | Total current liabilities                                                                              | 51,623  |              | 59,557        |   |
|                                  |                                                                                                   |    |              |          |
| Other                                 | 753                                                                                                    |    | 767               |          |
|                                  |                                                                                                        |    |                   |          |
|                                  | Total liabilities                                                                                      | 52,376  |              | 60,324        |   |
|                                  |                                                                                                   |         |              |               |   |
|                                  |                                                                                                   |    |              |          |
| Stockholders' equity:                 |                                                                                                   |    |              |          |
|                                  | Common stock, $0.001 par value, 20,000 shares authorized;  issued and outstanding 8,311 and 7,889 | 8       |              | 8             |   |
|                                  | Capital in excess of par value                                                                         | 52,623  |              | 51,764        |   |
|                                  | Less cost of treasury stock, 123 and 166 shares  outstanding                                      | (620    | )                 | (839          | ) |
|                                  | Notes receivable                                                                                       | (107    | )                 | (99           | ) |
|                                  | Other Comprehensive Income                                                                             |    |              |          |   |
|                                  | Translation loss on subsidiary                                                                         | (828    | )                 | (151          | ) |
|                                  | Accumulated deficit                                                                                    | (30,492 | )                 | (30,545       | ) |
|                                  |                                                                                                   |         |              |               |   |
|                                  | Total stockholders' equity                                                                             | 20,584  |              | 20,138        |   |
|                                  |                                                                                                   |         |              |               |   |
|                                  | Total liabilities and  stockholders' equity                                                            | $       | 72,960            |     | $ | 80,462 |     |
|                                  |                                                                                                   |         |              |               |   |
|                                       |                                                                                                        |         |                   |               |  |  |  |  |  |

Seeaccompanying notes to consolidated financial statements.

**SOUTHWALL TECHNOLOGIES INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS******(in thousands,except per share data)(Unaudited)

|                                                                             | Three  Months Ended                 |   | Six  Months Ended  |   |
|----------------------------------------------------------------------------------|-------------------------------------|--------|--------------------|--------|
|                                                                             |                                |   |               |   |   |   |   |   |
|                                                                             | July  1, 2001                  |   | July  2, 2000 |   | July  1,2001 |   | July  2, 2000 |     |
|                                                                             |                                     |   |                    |   |  |   |  |   |
|                                                                             |                                |   |               |   |   |   |   |   |
| Net revenues                                                                     | $                                   | 21,946 |               | $      | 20,928 |   | $ | 39,659 |   | $ | 38,037 |   |
|                                                                             |                                     |   |                    |   |  |   |  |   |
|                                                                             |                                |   |               |   |   |   |   |   |
| Costs and expenses                                                               |                                |   |               |   |   |   |   |   |
|                                                                             | Cost of sales                       | 16,320 |               | 16,922 |   | 31,169 |   | 31,705 |   |
|                                                                             | Research and development            | 1,184  |               | 1,578  |   | 2,609 |   | 3,089 |   |
|                                                                             | Selling, general and administrative | 3,057  |               | 3,102  |   | 5,713 |   | 5,094 |   |
|                                                                             | Legal settlement                    | – |               | 402    |   | – |   | 402 |   |
|                                                                             |                                |        |               |        |   |  |   |  |   |
|                                                                             | Total costs and expenses            | 20,561 |               | 22,004 |   | 39,491 |   | 40,290 |   |
|                                                                             |                                |        |               |        |   |  |   |  |   |
|                                                                             |                                |   |               |   |   |   |   |   |
| Income (loss) from  operations                                                   | 1,385                               |   | (1,076             | )      | 168 |   | (2,253 | ) |
|                                                                             |                                |   |               |   |   |   |   |   |
| Interest (expense),  net                                                         | (781                                | )      | (607               | )      | (1,538 | ) | (1,020 | ) |
|                                                                             |                                |   |               |   |   |   |   |   |
| Other Income (expense), net                                                      | 500                                 |   | 77                 |   | 1,364 |   | 20 |   |
|                                                                             |                                |   |               |   |   |   |   |   |
| Income (loss) before  provisionfor income taxes                                  | 1,104                               |   | (1,606             | )      | (6 | ) | (3,253 | ) |
|                                                                             |                                |   |               |   |   |   |   |   |
| Provision for income  taxes                                                      | (80                                 | )      | 41                 |   | (59 | ) | 77 |   |
|                                                                             |                                     |   |                    |   |  |   |  |   |
|                                                                             |                                |   |               |   |   |   |   |   |
| Net income (loss)                                                                | $                                   | 1,184  |               | $      | (1,647 | ) | $ | 53 |   | $ | (3,330 | ) |
|                                                                             |                                     |   |                    |   |  |   |  |   |
|                                                                             |                                |   |               |   |   |   |   |   |
| Net income (loss) per  share:                                                    |                                |   |               |   |   |   |   |   |
|                                                                             | Basic                               | $      | 0.15               |   | $ | (0.22 | ) | $ | 0.01 |   | $ | (0.44 | ) |
|                                                                             | Diluted                             | $      | 0.15               |   | $ | (0.22 | ) | $ | 0.01 |   | $ | (0.44 | ) |
|                                                                             |                                |   |               |   |   |   |   |   |
| Weighted average  shares of common stock  and dilutive common stock equivalents: |                                |   |               |   |   |   |   |   |
|                                                                             | Basic                               | 8,066  |               | 7,631  |   | 7,904 |   | 7,599 |   |
|                                                                             | Diluted                             | 8,086  |               | 7,631  |   | 7,918 |   | 7,599 |   |
|                                                                             |                                |   |               |   |   |   |   |   |
|                                                                                  |                                     |        |                    |        |  |  |  |  |  |  |  |  |  |  |

See accompanying notes to consolidated financialstatements.

**SOUTHWALL TECHNOLOGIES INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS******(in thousands)(Unaudited)

|                                                       | Six  Months Ended,                                                                        |   |
|------------------------------------------------------------|-------------------------------------------------------------------------------------------|--------|
|                                                       |                                                                                           |   |
|                                                       | July  1,                                                                                  |   | July  2, |   |
|                                                       | 2001                                                                                      |   | 2000 |   |
|                                                       |                                                                                           |   |  |   |
| Cash flows (used in)  or provided by operating activities: |                                                                                      |   |   |   |
|                                                       | Net (loss)                                                                                | $      | 53 |   | $ | (3,330 | ) |
|                                                       | Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |   |   |   |   |
|                                                       | Depreciation and amortization                                                             | 2,779  |   | 2,413 |   |
|                                                       |                                                                                      |   |   |   |   |
|                                                       | Decrease (increase) in accounts receivable, net                                           | 1,003  |   | (1,791 | ) |
|                                                       | Decrease (increase) in inventories, net                                                   | 3,783  |   | (4,054 | ) |
|                                                       | Decrease (increase) in other current and  non-current assets                              | 4      |   | 58 |   |
|                                                       | Increase (decrease) in accounts payable,  and accrued liabilities                         | (3,443 | ) | 5,793 |    |
|                                                       |                                                                                           |   |  |   |
| Cash provided by  operating activities                     | 4,179                                                                                     |   | (911 | ) |
|                                                       |                                                                                           |   |  |   |
| Cash flows from  investing activities:                     |                                                                                      |   |   |   |
|                                                       | (Increase) decrease in restricted cash                                                    | 1,458  |   | (465 | ) |
|                                                       | Expenditures for property, plant and equipment  and other assets                          | (1,032 | ) | (8,985 | ) |
|                                                       |                                                                                           |   |  |   |
| Net cash used in  investing activities                     | 426                                                                                       |   | (9,450 | ) |
|                                                       |                                                                                           |   |  |   |
| Cash flows from  financing activities:                     |                                                                                      |   |   |   |
|                                                       | Proceeds from borrowings                                                                  | -      |   | 7,109 |   |
|                                                       | Proceeds from sale of stock                                                               | 970    |   | - |   |
|                                                       | Principal payments on borrowings                                                          | (4,309 | ) | - |   |
|                                                       | Repayment of stockholder's note receivable                                                | (7     | ) | 724 |   |
|                                                       | Issuance of common stock upon exercise  of stock options, net                             | (80    | ) | - |   |
|                                                       | Issuance (purchase) of treasury stock, net                                                | 190    |   | 805 |   |
|                                                       |                                                                                      |        |   |  |   |
| Net cash provided by  (used in) financing activities       | (3,236                                                                                    | )      | 8,638 |   |
|                                                       |                                                                                           |   |  |   |
|                                                       | Foreign exchange fluctuation                                                              | (872   | ) | - |   |
|                                                       |                                                                                           |   |  |   |
| Net increase  (decrease) in cash and  cash equivalents     | 497                                                                                       |   | (1,723 | ) |
|                                                       |                                                                                      |   |   |   |
| Cash and cash  equivalents, beginning of year              | 61                                                                                        |   | 1,772 |   |
|                                                       |                                                                                           |   |  |   |
|                                                       |                                                                                      |   |   |   |
| Cash and cash  equivalents, end of period                  | $                                                                                         | 558    |   | $ | 49 |   |
|                                                       |                                                                                           |   |  |   |

 

Seeaccompanying notes to consolidated financial statements.

 

SOUTHWALL TECHNOLOGIES INC. NOTES TOCONSOLIDATED FINANCIAL STATEMENTS (in thousands) (Unaudited)

**Note 1–Interim Period Reporting:**

             Whilethe information presented in the accompanying consolidated financial statementsis unaudited, it includes all adjustments (consisting only of normal recurringadjustments) which, in the opinion of management, are necessary to presentfairly the Company's financial position and results of operations, and changesin financial position as of the dates and for the periods indicated.

             Certaininformation and footnote disclosures normally contained in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted. It is suggested that these consolidated financialstatements be read in conjunction with the financial statements contained inthe Company's Form 10-K\A for the year ended December 31, 2000 filedon April 11, 2001. The results of operations for the interim periods presentedare not necessarily indicative of the operating results of the full year.

**Note 2–Balance Sheet:**

*RestrictedCash*

             Restricted cash consists of the unapplied portion ofgrants received from the German government to co-finance the costs of theconstruction of the Company's German facility. In the event the Company failsto meet certain conditions related to the grants, the German government has theright to reclaim the grant. (See Note 6)

*Inventories,net*

             Inventoriesare stated at the lower of cost (determined by the first-in- first-out method)or market. Inventories consisted of the following:

|             | July  1, 2001     |   | December  31, 2000 |   |
|------------------|-------------------|--------|--------------------|--------|
|             |                   |   |                    |   |
| Raw Materials    | $                 | 3,220  |               | $      | 4,394 |   |
| Work-in-progress | 2,570             |   | 4,799              |   |
| Finished goods   | 601               |   | 981                |   |
|             |                   |   |                    |   |
|             | Total inventories | $      | 6,391              |   | $ | 10,174 |   |
|             |              |        |               |        |   |

**Note 3–Net income (loss) pershare:**

             Basicnet income (loss) per share is computed by dividing income available to commonshareholders (numerator) by the weighted average number of common sharesoutstanding (denominator) for the period. Diluted net income (loss) per sharegives effect to all dilutive potential common shares outstanding during theperiod. The computation of diluted earnings per share uses the average marketprices during the period. During each of the periods presented there were nodifferences between the numerators used for calculation of basic and dilutednet income (loss) per share. The total amount of the difference in the basicand diluted weighted average shares of common stock and common stockequivalents in the periods where there is net income is attributable to theeffect of dilutive stock options. In net loss periods, the basic and dilutedweighted average shares of common stock and common stock equivalents are thesame because inclusion of stock options would be anti-dilutive.

**Note 4–Financing Line of Credit:**

             TheCompany has a $10 million receivable financing line of credit with a bank.Availability under the line of credit is based on 80% of the approved accountreceivable balance and bears a finance fee of 0.088% per month of the averagedaily account balance outstanding during the settlement period. In connectionwith the line of credit, the Company has granted the bank, a continuing lienupon and security interest in, and right of set off with respect to all of theCompany's rights, title and interest in all accounts receivable, inventory,monies, remittances and fixed assets. There was $7.2 million of borrowings outstandingunder this line of credit at July 1, 2001. (See Note 9–Going Concern and Loan Covenants)

**Note 5–Long-term debt:**

             TheCompany's long-term debt consisted of the following at July 1, 2001:

| Description               | Rate                                             |          | Balance  at  July 1, 2001 |   | Remaining  AnnualPrincipalAmortization |   |
|---------------------------|--------------------------------------------------|---------------|---------------------------|--------|----------------------------------------|--------|
|                           |                                                  |          |                           |   |                                        |   |
| Financing Line of  Credit |                                             |          | $                         | 7,247  |                                   | -      |   |
|                      |                                             |          |                      |   |                                   |   |
| Long-term debt            |                                             |          |                      |   |                                   |   |
|                      | Promissory note dated May 6, 1997                | LIBOR  +.4375 |                      | 8,750  |                                   | $      | 1,250 |   |
|                      | Sales-leaseback agreement dated July 19, 1999    | 13.0          | %                         | 2,321  |                                   | 711    |   |
|                      | Sales-leaseback agreement dated October 19, 1999 | 13.0          | %                         | 2,446  |                                   | 1,374  |   |
|                      | German bank loan dated May 12, 1999              | 6.1           | %                         | 2,450  |                                   | 144    |   |
|                      | German bank loan dated May 28, 1999              | 7.1           | %                         | 2,114  |                                   | -      |   |
|                      | German bank loan dated May 28, 1999              | 3.8           | %                         | 1,328  |                                   | 121    |   |
|                      | German bank loan dated December 1, 1999          | 7.2           | %                         | 1,794  |                                   | 50     |   |
|                      | German bank loan dated August 14, 1999           | 5.8           | %                         | 1,427  |                                   | -      |   |
|                      | German bank loan dated June 29, 2000             | 5.8           | %                         | 548    |                                   | 84     |   |
|                      | German bank loan dated July 20, 2000             | 7.1           | %                         | 396    |                                   | 72     |   |
|                      | Other equipment financings                       |          |                      | 19     |                                   | 3      |   |
|                      |                                             |          |                      |        |                                   |        |   |
|                      | Total long-term debt                             |          |                      | 23,593 |                                   | 3,809  |   |
|                      | Less current portion                             |          |                      | 7,150  |                                   |   |   |
|                      | Less long-term portion-reclassified to current   |          |                      | 16,443 |                                   |   |   |
|                      |                                             |          |                      |        |                                   |   |   |
|                      | Long-Term Debt                                   |          |                      | $      | 0                                      |   |   |   |
|                      |                                             |          |                           |   |                                   |   |
|                           |                                                  |               |                           |        |                                        |        |  |  |  |  |

             The promissory note dated May 6, 1997 is payable toa Sanwa Bank. The note payments are guaranteed by Teijin Limited in Japan(Teijin), a stockholder and supplier of the Company. The Teijin guarantee iscollateralized by certain equipment located in the Company's Tempemanufacturing facility and inventory, to the extent necessary to provide 120%net book value coverage of the outstanding loan balance. The interest rate onthe loan is re-set semi-annually at LIBOR plus 0.4375% (5.25% and 7.45% at July1, 2001 and July 2, 2000 respectively). The Company is also subject to certainfinancial covenants. A loan guarantee service fee is payable to Teijinsemi-annually on the outstanding balance at the rate of 0.5625%. The noteprovides for semi-annual payments of interest only during the first four years,followed by semi-annual installments plus interest for the four  year term. The remaining scheduled principalpayments for 2001 are $1.25 million. Teijin also received warrants in 1997to purchase 158,000 shares of the Company's common stock at $9 per share. Thesewarrants were not exercised and expired on May 30, 2000. At July 1, 2001the Company was not in compliance with certain of the financial covenants withTeijin, the guarantor, pertaining to this promissory note. The Company receiveda waiver from Teijin through October 1, 2001. Teijin did not agree toextend the waiver beyond this date. Accordingly, the Company has reclassifiedthe balance from long-term debt to current liabilities in the balance sheet.(See Note 9 - GOINGCONCERN AND LOAN COVENANTS)

             During 1999, the Company entered into two equipmentsale-leaseback agreements with a leasing company ("Lessor"). Becausethe Company has an option to purchase the equipment at a price to be determinedbetween the Company and the Lessor at the end of the lease period, thesale-leaseback agreements have been treated as financing. One lease agreementhas a lease term of three years and the other lease agreement has aninitial lease term of two years with an option to extend it for anadditional year. At July 1, 2001, the Company had a total of $4.8 millionoutstanding under these leases. The leases are collateralized by the leasedequipment and certain other production equipment of the Company. The effectiveinterest rate of both leases is approximately 13% per annum and they arerepayable over their lease term commencing in May 2000. Additionally, theCompany has provided the Lessor an irrevocable standby letter of credit in theamount of $0.5 million to collateralize all of the Company's obligationsunder these agreements. The letter of credit shall not expire beforeJanuary 1, 2002. In addition, $1 million of the amounts due from theLessor was not funded, but will be released upon the Company satisfying certainfinancial conditions. Due to the uncertainty of compliance with these financialconditions, the Company has classified this amount under non-current"Other Assets." However, the amount payable to the Lessor under thecapitalized leases includes the unfunded amount of $1.0 million.  (See Note 9—GOING CONCERN AND LOAN COVENANTS)

             OnMay 12, 1999, the Company entered into a loan agreement with a German bankthat provides for borrowings up to $2.9 million (DM 6.0 million).Under the terms of this agreement, the funds were used solely for the purposeof capital investment by the German subsidiary. The term of the loan is for aperiod of 10 years and the principal is repayable in Deutschemarks afterthe end of one year in 36 quarterly payments. The loan bears interest at 6.1%per annum for the first five years, and will be adjusted to the prevailingrate at the end of the fifth year. At July 1, 2001, the amount outstandingunder this bank loan was $2.4 million. (See Note 9 - GOING CONCERN AND LOANCOVENANTS)

             OnMay 28, 1999, the Company entered into a general loan agreement with aGerman bank. Under the terms of the loan agreement, funds are available inthree tranches, and shall be used solely for the purpose of capital investmentby the German subsidiary. The first tranche provides for borrowings of $2.2 million(DM 4.89 million) for a term of twenty years. The principal isrepayable after ten years in ten equal, semi-annual payments. The loanbears fixed interest of 7.1% per annum for the first ten years. At July 1,2001, the amount outstanding was $2.1 million. The second tranche provides forborrowings of $1.5 million (DM 3.35 million) for a term ofseven years and the principal is repayable after one year in twelve equal,semi-annual payments. The loan bears fixed interest at 3.8% per annum for theperiod of seven years. At July 1, 2001, the amount outstanding was$1.3 million. The third tranche, dated December 1, 1999, provides forborrowings of $1.87 million (EURO 2.121 million) for a term often years, and the principal is repayable after one year, in thirty sixequal quarterly payments. The loan bears fixed interest of 7.15% per annum forthe first five years. At July 1, 2001, the amount outstanding was $1.8million. All of the proceeds from the loans were received during 1999. (SeeNote 9 - GOING CONCERN AND LOAN COVENANTS)

             OnAugust 14, 1999, the Company entered into a loan agreement with a Germanbank that provides for borrowings up to $1.7 million (DM3.3 million). Under the terms of this agreement, the funds will be usedsolely for the purpose of capital investment by the German subsidiary. Theprincipal balance is due in a single payment on June 30, 2009 and bearsinterest at a rate of 5.8% per annum. The interest is payable quarterly inDeutschemarks. 50% of the loan proceeds are restricted in an escrow account forthe duration of the loan period and are classified as non-current "OtherAssets." At July 1, 2001, the amount outstanding under this bank loan was$1.4 million. (See Note 9 - GOING CONCERN AND LOAN COVENANTS)

             OnJune 29, 2000, the Company entered into a loan agreement with a Germanbank that provides for borrowings up to $481 (DM 1.0 million). Under theterms of this agreement, the funds will be used solely for the purpose ofcapital investment by the German subsidiary. The principal balance is repayablein 12 quarterly payments beginning June 2001 and bears interest at a rateof 5.8% per annum. The interest is payable quarterly in Deutschemarks. At July1, 2001, the amount outstanding under this bank loan was $0.5 million. (See Note9 - GOING CONCERN AND LOAN COVENANTS)

             OnJuly 20, 2000, the Company entered into a loan agreement with a Germanbank that provides for borrowings up to $480 (EU 511). Under the terms of thisagreement, the funds will be used solely for the purpose of capital investmentby the German subsidiary. The principal balance is repayable in 12 quarterlypayments beginning June 2001 and bears interest at a rate of 7.1% perannum. The interest is payable quarterly in EURO dollars. At July 1, 2001, theamount outstanding under this bank loan was $0.4 million. (See Note 9 - GOINGCONCERN AND LOAN COVENANTS)

             Thepreceding German bank loans are collateralized by the production equipment,building and land owned by the German subsidiary.
             Otherlong-term debt consists of capitalized leases related primarily to certaincomputer equipment used by the Company.

             Scheduled principal reductions oflong-term debt for the balance of 2001 and the fours years following andthereafter, are as follows:
YearAmount  2001$3,809 20025,606 20034,217 20043,348 2005729 Thereafter5,884   Total$23,593   
             The Company incurred total interest expense of million$0.8 million and $1.26 million in second quarter of 2001 and 2000,respectively. Of these amounts, the Company capitalized $0.0 million and $0.73million in the second quarter of 2001 and 2000 respectively as part of thecosts related to the construction of new production machines and facilities.

**Note 6–Government Grant:**

             The Company has an agreement to receive a grant award(the "Grant"), which was approved by the State Government of Saxonyin Germany (the "Grantor") in May 1999. The agreement provides forinvestment grants to a maximum amount of $9.9 million (DM 20.3 million).As of July 1, 2001, the Company had received approximately $4.9 million(DM 9.7 million) under this Grant and accounted for the Grant by applyingthe proceeds received against the cost of the German manufacturing facility.During 2000, the Company also received $1.0 million (DM 2.1 million)in investment allowances from the German government and those proceeds wereapplied against the cost of the German manufacturing facility. The Companyexpects to receive an additional $1.0 million in investment allowancesfrom the German government in 2001 although no assurances can be given. Thosefunds will also be applied against the cost of the German manufacturingfacility. Additionally, the Company has received $0.9 million of governmentgrants that have been recorded as an advance until the Company earns the grantthrough future expenditures. The Company’s total investment in the Germanoperations at July 1, 2001 was $15.4 million (DM 36.0 million), net of grantsreceived from the German government.

             TheGrant is subject to the following requirements:
a)The grant is earmarked  to co-finance the costs of the construction of a facility to manufacture Heat  Mirror XIR® film  for the automotive glass industry, located at Grossroehrsdorf, Germany.  b)The construction period  for the project is from March 15, 1999 to March 14, 2002.  c)The total investment  should be at least $39.2 million (DM 80.3 million).  d)The project must create  at least 143 permanent jobs and 7 apprenticeships by March 15, 2002.
In the event that the Company fails to meet the aboverequirements, the Grantor has the right to reclaim the Grant. The Company doesnot currently have financing in place to purchase a third machine in Germanyand it has postponed the placing of this order until financing can be secured. Presently,the Company can not determine the total investment that will be made in theGerman facility and is in the process of reviewing the total investment andtiming thereof with the Grantor. The Company believes that it will not meet allof the conditions to the Grant due to the lack of availability of the equipmentmanufacturer to provide the equipment in time to meet the schedule, and theCompany's ability to obtain sufficient financing at this time. The Company hashad informal discussions with the Saxony government, but is unable to predictthe outcome and the impact, if any, on the Company’s obligations under thegrant.

             TheCompany is eligible for additional investment allowances from the Germangovernment amounting to $3.7 million (DM 7.7 million) calculated based on acapital investment of $39.2 million (DM 80.3 million), subject toEuropean Union regulatory approval.

             Theinvestment allowance is subject to the following requirements:
a)The movable and immovable assets which acquisition costs are taken  into account in determining the investment allowance shall be employed within  the subsidized territory for a period of at least five years following  the acquisition or production.  b)The movable assets  which acquisition costs are taken into account in determining the increased  investment allowance shall remain in a business that is engaged in the  processing industry, or in a similar production industry for a period of at  least five years following the acquisition or production.
             In theevent that the Company fails to meet the above requirements, the investmentallowance must be paid back, with interest.

**Note 7–Segment Reporting:**

             In 1998, the Company adopted Statement of FinancialAccounting Standards No. 131 ("SFAS 131"), "Disclosures aboutSegments of an Enterprise and Related Information." SFAS 131 supercedesSFAS 14, "Financial Reporting for Segments of a Business Enterprise"replacing the "industry segment" approach with the"management" approach. The management approach designates the internalorganization that is used by management for making operating decisions andassessing performance as the source of the Company's reportable segments. SFAS131 also requires disclosures about products and services, geographic areas,and major customers. The Company is organized on the basis of products andservices. The Company considers itself to operate in one segment which is inthe advanced film coatings. The Company derives revenue from three sources. Thetotal net revenues for the Electronic Display, Automotive Glass and Buildingproduct lines were as follows:
 Three  Months Ended Six  Months Ended  July  1, 2001 July  2, 2000 July  1,  2001 July  2,   2000          Electronic display$8,782 $12,397 $15,506 $20,674 Automotive glass9,367 4,817 17,374 9,773 Architectural3,797 3,714 6,779 7,590       Total net revenues$21,946 $20,928 $39,659 $38,037      
The following is a summary of netrevenues by geographic area for the first quarter of 2001 and 2000respectively.
 Three  Months Ended Six  Months Ended  July  1, July  2, July  1, July  2,  2001 2000 2001 2000          United States$2,216 $2,534 $5,427 $5,380 South America181 70 317 303 Pacific Rim3,472 3,584 5,444 6,095 Japan7,382 9,278 12,371 15,652 Europe8,568 4,923 15,863 10,028 Canada127 539 237 579       Total net revenues$21,946 $20,928 $39,659 $38,037      
** **

**Note 8–Contingencies:**

             The company is a defendant in an action filed onApril 5, 1996, Four Seasons Solar Products Corp vs. Black &Decker, Bostik, Inc. and Southwall Technologies, Inc., No. 5 CV 1695,pending in the United States District Court for the Eastern District of NewYork. Plaintiff is a manufacturer of insulated glass units which incorporatethe Company's Heat Mirror®film. Plaintiff alleges that a sealant provided by  co-defendant is defective, asserts causes of action for breach ofcontract, unfair competition, and fraudulent concealment, and seeks monetarydamages of approximately $36.0 million for past and future replacementcosts, loss of customer goodwill, and punitive damages against all defendants.The Company has filed a motion to dismiss. The Court has dismissed the unfaircompetition and fraudulent concealment claims against the Company.  It still has under advisement the Company'smotion to dismiss the breach of contract claim. The Company believes the claimto be without merit and will vigorously defend the action, should the breach ofcontract claim survive the motion to dismiss.

             TheCompany was named a defendant in a class action lawsuit filed on March 9,1998 by Richard McKernan in the Superior Court of California, County of SantaClara. The Company has reached a settlement with plaintiffs in the amount of$3.75 million. The entire amount will be funded by Southwall's insurancecarrier. That settlement received final approval and statutory approval as agood faith settlement from the Court on February 22, 2001. The time toappeal that order has lapsed. Claims under the settlement will be processed upto and until August 22, 2001. The insurance carrier has not indicated whetherit intends to pursue Southwall for reimbursement of the settlement amount. Thedefense of the McKernan action is being paid by the Company's insurer.

             TheCompany's German subsidiary is a defendant in a lawsuit filed by one of itssuppliers on March 21, 2000 in a German court to seek payment of $0.9 millionfor engineering services rendered in connection with developing the initialplans for the German facility. The Company issued letters of award to theplaintiff amounting to $0.3 million prior to terminating plaintiff'sservices for not meeting the Company's expectations. The plaintiff claims feesfor services rendered, including the costs of significant modifications andrevisions requested by the Company calculated in accordance with the GermanFederal Schedule of Architects' fees. The plaintiff further alleges that theCompany utilized plaintiff's planning work in further developing the plant. TheCompany believes that the suit is without merit and intends to vigorouslydefend its position. Although the Company believes that it will prevail, a $0.3 millionportion of the claim was accrued as a liability on the December 31, 2000balance sheet as it is likely that this amount will be awarded to theplaintiff.

             InAugust 2000, the Company, its Chief Executive Officer, Thomas G. Hood, andformer Chief Financial Officer, Bill R. Finley, were named as defendants inseven lawsuits, all filed in the United States District Court for the NorthernDistrict of California (Docket Nos: C-00-2792-MMC; C-00-2795-BZ; C-00-2834-SC;C-00-20856-EAI; C-00-3007-EDL; C-00-3027-JCS; and C-00-3079-MMC) (the"Actions") all alleging violations of the federal securities laws.Each of the plaintiffs in the Actions alleges that he purchased shares of theCompany's common stock and seeks to represent a class of shareholders whopurchased shares during the period July 26, 2000 through August 1, 2000,such dates constituting the period from the Company's release of its financialresults for the first quarter of FY 2000, to the date that it issued its pressrelease announcing that it would be restating its financial statements for thatquarter. The substantive allegations in each of the Actions are essentially thesame, i.e., that the defendants knew, or were reckless in not knowing, that theCompany's first quarter financial statements were in error and violatedGenerally Accepted Accounting Principles, and that as a result the putativeclass members purchased stock at artificially inflated prices and weredamaged.  The parties have reachedagreement on a settlement, in the amount of $4.2 million, which has receivedpreliminary approval from the court. A hearing on final approval of thesettlement is scheduled for September 14, 2001. The negotiated settlement willbe paid entirely by the Company’s insurers.

             InOctober 2000, the Company was served with a complaint entitled HurdMillwork, Inc. v. Southwall Technologies, Inc., et. al., United StatesDistrict Court, Northern District of California, Case No. C00-3820 (CRB). Hurdis a manufacturer of insulated glass units which incorporate Heat Mirror® film. Hurd alleges thatvarious failures and deficiencies associated with the insulated glass unitsgive rise to warranty and other consumer claims. Hurd is seeking monetarydamages for past and future replacement costs, litigation expenses, and punitivedamages. The complaint alleges $32 million in damages and $25 millionin restitution. The Company believes Hurd's action to be without merit andintends to strenuously defend against it. The Hurd action is still in the earlydiscovery phase and the Company is awaiting receipt of Hurd’s production ofrelevant documents to support the suit. The Court has scheduled the trial forMarch 4, 2002. The defense of the Hurd action is being paid, in part, by theCompany’s insurers. Southwall has agreed to pay the difference between itsagreed rate structure and the insurance company’s rate structure. No amount hasbeen accrued, however, we believe the differences in the fee structures will beimmaterial.

             Inaddition, the Company is involved in certain other legal actions arising in theordinary course of business. The Company believes, however, that none of theseactions, either individually or in the aggregate, will have a material adverseeffect on the Company's business or its consolidated financial position orresults of operations.

**Note 9–Going Concern and LoanCovenants**

*LoanCovenants*

             Pursuant to the guaranty, the German bank loans, andlease agreements listed above, and related terms, conditions and covenants theCompany requested waivers from Teijin Limited, the German banks and the leasingcompany as discussed below, related to the Company's default, or event ofdefault pursuant to these respective agreements or otherwise arising inconnection with the Company's requirement to restate prior financial periods,the financial position of the Company reflected in such restated financialstatements, the Company's failure to file its Form 10-Q for the secondquarter of 2000 in a timely manner and trading halts or other actions taken orthreatened to be taken by NASDAQ, or any law suits filed or threatened to befiled in connection with such restatements or late filings.
             OnSeptember 7, 2000, Teijin provided Southwall with a letter waiving anydefaults through October 1, 2001 arising out of the Company's failure tocomply with the Minimum Quick Ratio and Maximum Debt-to-Tangible Net Worthfinancial covenants. Further, Teijin waived any Event of Default related to theCompany's requirement to restate prior financial periods, the financialposition of the Company to be reflected in such restated financial statements,the Company's failure to file its Form 10-Q for the second quarter of 2000in a timely manner, any trading halts or other actions taken or threatened byNASDAQ, or any lawsuits filed or threatened in connection with suchrestatements or late filings or otherwise. Teijin has not agreed to extend thiswaiver beyond the October 1, 2001 date. As a result, the Company hasreclassified the Sanwa Loan, to which this guaranty applies, from long-term tocurrent liabilities in the balance sheet.

             TheCompany received in October, 2000 from the German banks a waiver of theEvents of Default pursuant to the agreements but the German banks did notprovide a waiver of the Events of Default or any rights it may have withrespect to any further material adverse change in the financial condition ofthe Company resulting from the Events of Default and the German banks havereserved the right to terminate the loan agreements if the expectationsrelating to turnover and profit as provided by the Company do not occur andprovide a cause for termination. The Company cannot currently determine withreasonable certainty whether it will be able to comply with these provisionsand accordingly has reclassified these loans from long-term to currentliabilities in the balance sheet.

             InNovember, 2000, the Company received from the leasing company for thesale-leaseback agreements dated July 19, 1999 and October 19, 1999 apartial waiver of the Events of Default pursuant to the agreements. However itreserved its right to declare an Event of Default based on the Company'sfinancial condition. Accordingly, the Company has reclassified these agreementsfrom long-term to current liabilities in the balance sheet.

**GoingConcern**

             Theseconsolidated financial statements have been prepared assuming that the Companywill continue as a going concern. The Company has experienced recurring lossesfrom operations, has significant current and long-term debt containing certaincovenants, with which the Company has not complied, requiring the Company toobtain waivers and to classify, as a current liability, the debt for whichwaivers have not been obtained. The Company must meet certain commitments fordebt service payments that raise substantial doubt about its ability tocontinue as a going concern. The financial statements do not include anyadjustments that might result from the outcome of this uncertainty. As a resultof this uncertainty, the Company may not be able to meet its debt serviceobligations without additional financing. However, the Company can give noassurances it will be successful in obtaining the required additional financingand cash from operations.

**Note 10 – Subsequent Events**

             OnJuly 12, the Company entered into a Sublease agreement with Digeo, Inc., underthe Company’s Master Lease dated October 14, 1999, with C&J DevelopmentCo.. Digeo, Inc. will sublease office space located at the Company’s Palo Altofacility for a rent of  $0.2 million peryear. The agreement will expire on December 31, 2002.

**Item 2–Management's Discussionand Analysis of Financial Condition and Results of Operations:**

             Exceptfor the historical information contained herein, certain matters discussed inthis Form 10-Q Report are forward-looking statements that involve risksand uncertainties, including those discussed below under “Risk Factors” and inthe Company's Annual Report on Form 10-K/A. Actual results may differmaterially from those projected. These forward-looking statements represent theCompany's judgment as of the date of the filing of this Form 10-Q Report.The Company disclaims, however, any intent or obligation to update theseforward-looking statements.

*General*

             We area designer and manufacturer of technologically advanced thin-film coatings thatselectively absorb, reflect or transmit light and electromagnetic and infraredemissions. Our products are used in a number of electronic, automotive andbuilding products to enhance optical and thermal performance characteristics,improve user comfort and reduce energy costs. From our founding in 1979 throughthe early 1990's, we developed and produced thin-film coated substratesprimarily for residential and commercial buildings, and for militaryapplications. In the early 1990's, we began to develop products for theelectronic display and automotive markets.

             In1996, we realized our first material revenue from the electronic display andautomotive markets. For the six months ended July 1, 2001 the automotive sectoraccount for 44% of our revenues, with the electronic display productscontributing 39% of our revenues and the Architectural market accounting forthe balance. We expect most of our revenue growth to come from the electronicdisplay and automotive markets.

             Severalfactors affect our gross margins, including manufacturing efficiencies, productmix, product differentiation, inventory management, volume pricing, and thestart-up of equipment and new plants. Over the past several years, each ofthese factors has contributed to margin volatility as we have added newcapacity to meet the demand of our electronics and automotive markets.

 
**Three Months Ended July 1, 2001 Compared with ThreeMonths Ended July 2, 2000**
*Netrevenues*

             Netrevenues increased by $1.0 million, or 4.8%, to $21.9 million for thesecond quarter of 2001, from $20.9 million for the second quarter of 2000.Sales to the Automotive market increased by $4.6 million, or 95.8%, to $9.4million for second quarter of 2001, from $4.8 million for the second quarter of2000. This increase was primarily attributable to the fact that, in the secondquarter of 2001, the Company realized revenues of $4.3 million from its Germanoperations. Sales to the Electronic Display market decreased by $3.6 million,or 29.0%, to $8.8 million for the second quarter of 2001, from $12.4 millionfor the second quarter of 2000. The decrease was the result of an on-going,worldwide slowdown in the sale and manufacture of personal computers. Sales tothe Architectural market increased $0.1 million, or 2.7%, to $3.8 millionfor the second quarter of 2001, from $3.7 million for the second quarter of2000. The decrease was primarily the result of the diversion of manufacturingcapacity, previously used to produce products for the Architectural market, tomanufacture products for the Automotive market.

*Cost and expenses*

*Cost ofsales.*  Cost of sales expense consists primarily ofmaterials, production labor and machine overhead. Cost of sales decreased$0.6 million, or 3.6%, to $16.3 million for the second quarter of2001, from $16.9 million in the second quarter of 2000. As a percentage ofnet revenues, cost of sales decreased to 74.4% of net revenues for the secondquarter of 2001, from 80.9% of net revenues in the second quarter of 2000. Thehigher costs in 2000, as a percentage of revenues, was due to greater start-upcosts in the Company’s Tempe and German operations, and higher display revenueswhich have higher costs.

*Researchand development expenses.*  Research and development spending decreased$0.4 million, or 25.0%, to $1.2 million in the second quarter of2001, from $1.6 million in the second quarter of 2000. Research and developmentexpenses decreased to 5.5% of net revenues for the second quarter of 2001, from7.7% of net revenues for the second quarter of 2000. The reduction was theresult of cost containment measures taken by the Company.

*Selling,general and administrative expenses.*  Selling, generaland administrative expenses normally consist primarily of corporate andadministrative overhead, selling commissions, advertising costs and occupancycosts. Year over year, these expenses remained flat at $3.1 million. Selling,general and administrative expenses decreased to 14.2% of net revenues for thesecond quarter of 2001, from 14.8% of net revenues for the second quarter of2000. The decrease in the second quarter 2001, over last year, was due to costcontainment measures taken by the Company.

*Income(loss) from operations*

             The Company realized a profitof  $1.4 million for the secondquarter of 2001, compared to a loss of $1.1 million for the second quarterof 2000. The profit was due to improved manufacturingefficiency, largely attributable to the Company’s German operations, and cost savings resulting from the reduction inforce of the Tempe and Palo Alto operations during Q1 of 2001.

*Interest(expense), net*

             TheCompany incurred interest expense on borrowings of $0.8 million and $1.3million in the second quarter of 2001 and 2000, respectively, and capitalizedinterest incurred in connection with construction in process of $0.0 millionand $0.7 million for the second quarter of 2001 and 2000, respectively. Theincrease in interest expense principally results from the completion ofconstruction in process related to the German plant in late 2000.

*Otherincome (expense), net*

             Otherincome (expense), net includes rental income, interest income and foreignexchange transaction gains and losses. The Company recorded other income of$0.5 million in the second quarter of 2001 compared with $0.08 million in thecorresponding 2000 period. Certain transactions with foreign suppliers aredenominated in foreign currencies rather than U.S. dollars. As exchange ratesfluctuate relative to the U.S. dollar, exchange gains and losses occur. 

*Income (loss) before provision for income taxes*

             The Company reported a pre-taxprofit of $1.1 million for the second quarter of 2001, compared to apre-tax loss of $1.6 million for the second quarter of 2000.  The improvement in performance was primarilydue to additional revenue generated by the Company’s German operations, tightercost controls and foreign currency gains.

*Legal Settlement.* In the second quarter of 2000, a settlement in theamount of $0.4 million was reached on a legal matter.

**Six Months Ended July1, 2001 Compared with Six Months Ended July 2, 2000**

*Net revenues*

             Net revenues increased $1.7million, or 4.5%, to $39.7 million for the first six months of 2001, from $38.0million for the first six months of 2000. Sales to the Automotive marketincreased by $7.6 million, or 77.6%,  to$17.4 million for the first six months of 2001, from $9.8 million for the firstsix months of 2000. This increase is primarily attributable to the fact that inthe first six months of 2001, the Company realized revenues of  $6.3 million from its German operations,which began limited production of commercial automotive product in December2000. Sales to the Electronic Display market decreased by $5.2 million, or25.1%, to $15.5 million for the first six months of 2001, from $20.7 millionfor the first six months of 2000. The decrease was the result of the worldwideslowdown in the sale and manufacture of personal computers. Sales to theArchitectural market decreased $0.8 million, or 10.5%, to $6.8 million for thefirst six months of 2001, from $7.6 million for the first six months of 2000The decrease was primarily the result of the loss of a North Americanmanufacturer that represented approximately 6% of the Company’s Heat Mirrorsales, and the diversion of manufacturing capacity previously used to produceproducts for the Architectural market, to manufacture products for theAutomotive market.

*             Cost ofsales. *Costof sales expense consists primarily of materials, production labor and machineoverhead.  Cost of sales decreased $0.5million, or 1.6%, to $31.2 million for the first six months of 2001, from $31.7million in the first six months of 2000. As a percentage of net revenues, cost of sales decreased, to 78.6% ofnet revenues for the first six months of 2001, from 83.4% of net revenues in thefirst six months of 2000.  The highercosts in 2000, as a percentage of revenues, was due to greater start-up costsin the Company’s Tempe and German operations, and higher display revenues,which generally yield lower margins as a result of outside processing costs.

*             Researchand development expenses. *Ourresearch and development spending decreased $0.5 million, or 16.1%, to $2.6million in the first six months of 2001, from $3.1 million in the first sixmonths of 2000.  Research anddevelopment expenses decreased to 6.6% of net revenues for the first six monthsof 2001, from 8.2% of net revenues for the first six months of 2000.  The decrease in the first six months of 2001was primarily attributable to reduced headcount and cost control measures introducedby the Company.

*             Selling,general and administrative expenses.*Selling, general and administrative expenses consist primarily of corporate andadministrative overhead, selling commissions, advertising costs and occupancycosts.  These expenses increased $0.6million, or 11.8%, to $5.7 million in the second quarter of 2001, from $5.1million in the first six months of 2000. Selling, general and administrative expenses, as percentage of revenue,increased , to 14.4% for the first six months of 2001, from 13.4% for the firstsix months of 2000. The increase in the first six months of 2001 was primarilyrelated to higher personnel costs in the Company’s German operations, andhigher consulting costs incurred in the first quarter of 2001.

*             Income(loss) from operations.*Income from operationswas $0.2 million for the first six months of 2001 compared to a loss of $2.3million for the first six months of 2000, due to improved manufacturingefficiency, largely attributable to the Company’s German operation, partiallyoffset by severance payments resulting from the reduction in force of the Tempeand Palo Alto operations.

*Interest  (expense),net*

             TheCompany incurred interest expense on borrowings of $1.6 million and $2.4million for the first six months of 2001 and 2000, respectively, andcapitalized interest incurred in connection with construction in process of$0.04 million and $1.5 million for the first six months of 2001 and 2000,respectively. The increase in net interest expense principally results from thecompletion of construction in process related to the German and Tempe plants inlate 2000.

*Otherincome (expense), net*

*            *Otherincome (expense), net includes rental income, interest income and foreignexchange transaction gains and losses. The Company recorded other income of$1.4 million for the first six months of 2001, compared with $0.02 million inthe corresponding 2000 period. Certain transactions with foreign suppliers aredenominated in foreign currencies rather than U.S. dollars. As exchange ratesfluctuate relative to the U.S. dollar, exchange gains and losses occur.

*Income (Loss) before provision for income taxes*

             TheCompany incurred a pre-tax profit of $0.01 million for the first six months of2001, compared to a pre-tax loss of $3.3 million for the first six months of2000, due to additional revenue generated by the Company’s German operations,higher revenues from the Automotive market, partially offset by a decrease inrevenue from the Electronic Display market.

*             LegalSettlement.*In the second quarter of2000, the Company accrued $0.4 million in settlement of a legal matter.

**Liquidity and Capital Resources**

*Capitalexpenditures*

             Since 1998, we have used borrowings, German governmentgrants and cash from operations to fund our capital expenditures. During 1999,we invested approximately $24.0 million in capital expenditures, includingapproximately $13.5 million of progress payments for our new manufacturingfacility and first production machine (PM8) in Germany, approximately $7.5 millionfor two new production machines (PM6 and PM7) and leasehold improvements forour Tempe facility, and approximately $2.5 million for the upgrade of twoproduction machines (PM1 and PM2) in Palo Alto. These investments were financedby $13.6 million of short and long-term debt, $4.9 million in Germangovernment grants, $4.5 million of cash from operations, and cash on hand.The German government grants subject us to a number of covenants. (See Note 5to Notes to Consolidated Financial Statements.)

             Wespent approximately $12.9 million for capital expenditures in 2000,including $9.8 million in our German facility, of which $7.0 millionrepresented final progress payments on our two new production machines (PM8 andPM9) in Germany and the completion of our German facility. We financed ourcapital expenditures in Germany primarily through the receipt of$4.0 million of additional bank loans and $1.0 million of subsidiesfrom the German government and the release of $2.6 million of cashrestricted by the German government to use in financing the completion of ourGerman facility. The German government may reclaim the grants if we fail tomeet any of the covenants. (See Note 6 to Notes of the Consolidated FinancialStatements.) We invested an additional $3.1 million in our Tempe and PaloAlto operations for leasehold improvements, computer equipment and improvementson our production machines.

             In thefirst quarter of 2000, our second machine at Tempe (PM6) began to producelimited amounts of film for commercial use. An additional machine (PM7) wasdelivered to Tempe in the third quarter of 2000. Additionally, we tookpossession of our new facility in Germany in May 2000, where PM8 wasinstalled in the third quarter and the PM9 installation is expected to be completedin 2001. PM8 commenced production of commercial product in December, and PM9began limited commercial production in the second quarter of 2001. The Companyexpects that the remaining installments on the machines will be paid fromcommitted German bank loans. The Company does not currently have financing inplace to purchase a third machine in Germany and it has postponed the placingof this order until financing can be secured. Presently, the Company can notpredict the total investment that will be made in the German facility and is inthe process of reviewing the total investment and timing thereof. The Companybelieves that it will not meet all of the conditions to the Grant. The Companyis unable to predict the outcome of discussions with the Saxony government, andthe impact, if any, on the Company’s obligations under the grant. See"Risk Factors - Our ability to meet future cash requirements may depend onour ability to retain grants received to date from the German Government."

             In thefirst six months of 2001, the Company spent approximately $1.0 million incapital expenditures, primarily in its German operations on PM9. The Company’stotal capital expenditures in 2001 are expected to be less than $4.0 million,and the expenditures are expected to be used to expand production capacity,acquire personal computers for additional employees and upgrade the Company’scomputer network.

**Liquidity**

             Operatingactivities used $2.1 million during the first six months of 2000. In thefirst six months of 2001, operating activities generated $4.2 million in cash.Included in capital lease obligations on the balance sheets are $1.0 million ofproceeds from a sale-leaseback transaction in 1999. This amount was withheld bythe lessor and classified in “Other Assets”, and will not be released until theCompany meets certain financial covenants. Furthermore, 50% of the proceedsfrom a $1.6 million loan from a German bank are restricted in an escrowaccount for the duration of the loan period and are classified in "OtherAssets." The Company has reclassified to "Restricted Cash" thatportion of cash,  $0.4 million,that is restricted to payments for the facility in Germany.

The following table sets forth thematerial terms of our short and long-term indebtedness at July 1, 2001:
DescriptionRate Maturity Balance  at July 1, 2001 RemainingAnnualPrincipalAmortization Start  Date      Financing Line of  Credit    $7,247   -            Long-term debt           Promissory note dated May 6, 1997LIBOR  +.4375 (1)8,750 $1,250 May  2001  Sales-leaseback agreement dated July 19, 199913.0%(2)2,321 711 April  2000  Sales-leaseback agreement dated October 19, 199913.0%(3)2,446 1,374 March  2000  German bank loan dated May 12, 19996.1%(4)2,450 144 March  2001  German bank loan dated May 28, 19997.1%(5)2,114 - December  2009  German bank loan dated May 28, 19993.8%(6)1,328 121 March  2001  German bank loan dated December 1, 19997.2%(7)1,794 50 December  2001  German bank loan dated August 14, 19995.8%(8)1,427 - June  2009  German bank loan dated June 29, 20005.8%(9)548 84 June  2001  German bank loan dated July 20, 20007.1%(10)396 72 June  2001  Other equipment financings    19 3             Total long-term debt    23,593 3,809    Less current portion    7,150      Less long-term portion-reclassified to current  (11)    16,443                 Long-Term Debt    $0               (1)We are required to make  equal semi-annual repayments from May 2001 through November 2004.  (2)We are required to make  equal monthly principal payments over the 36-month term of this financing.  (3)We are required to make  equal monthly principal payments over the 24-month term of this financing.  (4)We are required to make  equal quarterly principal payments over the 9-year repayment term of this  financing starting March 31, 2001.  (5)We are required to make  equal semi-annual principal payments for ten years from  December 2009 through June 2019.  (6)We are required to make  semi-annual principal payments for six years from March 2001 through  September 2006.  (7)We are required to make  equal quarterly principal payments for nine years from  December 2001 through September 2010.  (8)We are required to make  one principal payment on June 2009.  (9)We are required to make  equal quarterly principal payments for three years from July 2001 through  June 2005.  (10)We are required to make  equal quarterly principal payments for three years from June 2001  through July 2004.  (11)Represents the portion  of long-term debt that has been reclassified into current liabilities as a  result of lenders not granting waivers for failure to meet certain covenants.
 

             We have granted the lender of the financing line ofcredit a security interest in our receivables, inventory and other assets nototherwise collateralized. Our loans from German banks also subject us tocovenants, including covenants relating to the progress of and investment inthe development of our Dresden facility and the minimum number of our employeesat Dresden by 2002. We have granted the German banks security interests in ourDresden facility and the assets located at the facility.

             Thepromissory note dated May 6, 1997 is payable to a bank and guaranteed byTeijin Limited, a stockholder and one of our suppliers. The Teijin guarantee iscollateralized by certain equipment in the Company's Tempe manufacturingfacility, and our inventory to the extent necessary to cover 120% of theoutstanding loan balance based on the net book value of the inventory. Theguarantee subjects us to certain financial and other covenants, including covenantsrelating to our tangible net worth, our debt to tangible net worth,profitability and the ratio of our cash, cash equivalents and short terminvestments to our total current liabilities. At December 31, 2000, wewere not in compliance with the financial covenants relating to our minimum networth, the ratio of our debt to equity, the ratio of our cash, cash equivalentsand short-term investments to current liabilities, and the requirement thatCompany be profitable. The Company received a waiver for failure to comply withthese covenants through October 1, 2001. Teijin did not extend the waiver.Accordingly, the Company has reclassified the long-term balance from long-termdebt to current liabilities in the balance sheet. Beginning in 2001, the Companyis obligated to make two principal payments of $1.25 million each inMay and November. The Company made the first principal payment of $1.25million on May 7, 2001, and will pay the second installment of  $1.25 million in November 2001. The Companywill also make principal payments of $2.5 million each in 2002, 2003 and2004.

             Wehave provided the lessor under our sales-leaseback financings a$0.5 million irrevocable standby letter of credit to collateralize ourobligations under the sales-leaseback agreements. The letter of credit will notexpire before January 1, 2002. In addition, $1.0 million of theamount to be received from the lessor was withheld pending our meeting certainfinancial conditions.

**LoanCovenants**

             Pursuantto the guaranty, the German bank loans, and lease agreements listed above, andrelated terms, conditions and covenants the Company requested waivers fromTeijin Limited, the German banks and the leasing company as discussed below,related to the Company's default, or event of default pursuant to theserespective agreements or otherwise arising in connection with the Company'srequirement to restate prior financial periods, the financial position of theCompany reflected in such restated financial statements, the Company's failureto file its Form 10-Q for the second quarter of 2000 in a timely mannerand trading halts or other actions taken or threatened to be taken by NASDAQ,or any law suits filed or threatened to be filed in connection with suchrestatements or late filings.

             OnSeptember 7, 2000, Teijin provided Southwall with a letter waiving anydefaults through October 1, 2001 arising out of the Company's failure tocomply with the Minimum Quick Ratio and Maximum Debt-to-Tangible Net Worthfinancial covenants. Further, Teijin waived any Event of Default related to theCompany's requirement to restate prior financial periods, the financialposition of the Company to be reflected in such restated financial statements,the Company's failure to file its Form 10-Q for the second quarter of 2000in a timely manner, any trading halts or other actions taken or threatened byNASDAQ, or any lawsuits filed or threatened in connection with suchrestatements or late filings or otherwise. Teijin has not agreed to extend thiswaiver beyond the October 1, 2001 date. As a result, the Company hasreclassified the Sanwa Loan, to which this guaranty applies, from long-term tocurrent liabilities in the balance sheet.

             TheCompany received in October 2000 from the German banks a waiver of theEvents of Default pursuant to the agreements but the German banks did notprovide a waiver of the Events of Default or any rights it may have withrespect to any further material adverse change in the financial condition ofthe Company resulting from the Events of Default and the German banks havereserved the right to terminate the loan agreements after the third and fourthquarter of 2000 if the expectations relating to turnover and profit as providedby the Company do not occur and provide a cause for termination. The Companycannot currently determine with reasonable certainty whether it will be able tocomply with these provisions and accordingly has reclassified these loans fromlong-term to current liabilities in the balance sheet.

             InNovember 2000, the Company received from the leasing company for thesale-leaseback agreements dated July 19, 1999 and October 19, 1999 apartial waiver of the Events of Default pursuant to the agreements. However itreserved its right to declare an Event of Default based on the company'sfinancial condition. Accordingly, the Company has reclassified these agreementsfrom long-term to current liabilities in the balance sheet.

**GoingConcern**

             Theseconsolidated financial statements have been prepared assuming that the Companywill continue as a going concern. The Company has experienced recurring lossesfrom operations, has significant current and long-term debt containing certaincovenants, with which the Company has not complied, requiring the Company toobtain waivers and to classify, as a current liability, the debt for whichwaivers have not been obtained. The Company must meet certain commitments fordebt service payments that raise substantial doubt about its ability tocontinue as a going concern. These consolidated financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.As a result of this uncertainty, the Company may not be able to meet its debtservice obligations without additional financing. However, the Company can giveno assurances it will be successful in obtaining the required additionalfinancing and cash from operations.

**Item 3–Quantitative andQualitative Disclosures about Market Risk**

             The Company is exposed to the impact of interest ratechanges, foreign currency fluctuations, and changes in the market values of itsinvestments.

             **FINANCINGRISK.**  The Company's exposureto market rate risk for changes in interest rates relates primarily to theCompany's term loans which are tied to the London Interbank Offered Rate("LIBOR") and bank line of credit which is tied to the prime rate.The Company's German subsidiary also has several fixed-rate term loans that aredenominated and repayable in Deutschemarks. Fluctuations in interest rates mayadversely impact the interest expense expected for the Company. At July 1,2001, the Company had one loan with a variable interest rate. The effect of a10% fluctuation in the interest rate for this loan would have an adverse impactof less than ($0.1) million. The effect of interest rate fluctuations onthe Company during the first six months of 2001 was not material.

             **INVESTMENTRISK.**  The Company investsits excess cash in certificates of deposit and money market accounts and, bypolicy, limits the amount of exposure to any one institution. Investments inboth fixed rate and floating rate interest earning instruments carries a degreeof interest rate risk. Fixed rate securities may have their fair market valueadversely impacted due to a rise in interest rates, while floating rate securitiesmay produce less income than expected if interest rates fall. The effect of a10% fluctuation in the interest rate of any floating rate securities would havean adverse impact of less than $0.1 million.

             **FOREIGNCURRENCY RISK.**  Internationalrevenues amounted to 86% of the Company's total sales in the first six monthsof 2001 and, by policy, the Company limits foreign currency risk by requiringall sales to be denominated in U.S. dollars. Sales from the German subsidiaryare currently denominated in U.S. dollars, but will likely be denominated inEUROs beginning in 2002. The Company's international business is subject torisks typical of an international business, including, but not limited todiffering economic conditions, changes in political climate, differing taxstructures, other regulations and restrictions, and foreign exchange ratevolatility. Accordingly, the Company's future results could be materiallyadversely impacted by changes in these or other factors.

**RISK FACTORS**

             **Ourquarterly revenue and operating results are volatile and difficult to predict.If we fail to meet the expectations of public market analysts or investors, themarket price of our common stock may decrease significantly.**

             Ourquarterly revenue and operating results have varied significantly in the pastand will likely vary significantly in the future. Our revenue and operatingresults may fall below the expectations of securities analysts or investors infuture periods. Our failure to meet these expectations would likely adverselyaffect the market price of our common stock.

             Ourquarterly revenue and operating results may vary depending on a number offactors, including:
 •manufacturing and  operational difficulties that may arise due to, among other things, expansion  of our production capacity, the transfer of equipment and personnel to our  international manufacturing facility, and the hiring and training of  additional staff;    •our possible ability to  introduce new products and technologies on a timely basis, and the increased  research, development and engineering costs and marketing expenses associated  with new product introductions;    •fluctuating customer  demand, which is influenced by a number of factors, including general  economic conditions in the sputtered thin-film coatings industry, market  acceptance of our products and the products of our customers and end-users,  changes in the product mix demanded and offered, and the timing, cancellation  or delay of customer orders and shipments;    •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; and    •the timing of our  recognition of revenues from product orders which can materially affect our  operating results on a quarterly basis due to the size of a particular order.
**Futuregrowth of our business may place a strain on our financial, management andproduction resources.**

             Inorder to grow, we must expand our manufacturing capacity by adding additionalproduction machines, which will place a strain on our financial resources.Unless the Company secures additional financing, it will not be able to expandits manufacturing capacity. We will need to finance a large portion of thesefuture expenditures through external sources, including borrowings. We do nothave credit facilities in place to provide this financing. We cannot assure youthat we will be able to secure credit facilities or other sources of financingthat will address our future capital needs or that such credit facilities willnot be on terms less favorable to us than we have budgeted.

             Inaddition, growth of our business will increase the work load andresponsibilities of our existing management and require us to expand ourmanagement team. We cannot assure you that the present size of our managementteam will enable us to expand our business or that we will be able to recruitenough experienced managers.

             Manyof our machines are the only manufacturing sources for certain of our productsand are running at or near capacity. We do not have plans to develop redundancyfor much of our production capability. Therefore, a breakdown or catastrophicdamage to certain machines would severely and adversely affect our business. Inaddition, it can take up to 12-18 months to replace certain productionmachines. If our plans to expand our manufacturing capacity are not implementedon a timely basis, we could face production shortfalls. Rapid increases inproduction levels to meet unanticipated demand could result in higher costs andother expenses. These higher expenditures could lower our profit margins.Further, if production is increased rapidly, there may be decreasedmanufacturing yields, which may also lower our margins.

**Our ability to meet our future cashrequirements may depend on our ability to retain grants received to date fromthe German government.**

             TheCompany has an agreement to receive a grant award (the "Grant"),which was approved by the State Government of Saxony in Germany (the"Grantor") in May 1999. The agreement provides for investment grantsto a maximum amount of $9.9 million (DM 20.3 million). As of July 1, 2001, theCompany had received approximately $4.9 million (DM 9.7 million) under thisGrant and accounted for the Grant by applying the proceeds received against thecost of the German manufacturing facility. The Company has received $0.9million of Grants that has been recorded as an advance until the Company earnsthis portion of the Grant through future expenditures. 

             TheCompany believes that it may fail to meet certain requirements in connectionwith the grants (see Note 6 - Government Grant), in which event the Grantorwould have the right to reclaim the Grant. In particular, the Company can notdetermine whether the total investment that will be made in the German facilitywill satisfy the condition to the Grant, but expects that it will not and is inthe process of reviewing the total investment and timing thereof with theGrantor. The Company has had informal discussions with the Saxony government,but is unable to predict the outcome of these discussions, and the impact, ifany, on the Company's obligations under the grant. If the Company breaches thecovenants under the Grant, the Grantor may withhold the remaining portions ofthe Grant, or seek repayment of amounts previously granted. Either event wouldhave a material, adverse effect on the Company.

**We maynot be able to bring new machines online effectively in our manufacturingoperations to meet increasing capacity requirements.**

             Weexpanded our manufacturing capacity through the purchase of two new productionsmachines for our Tempe facility in 1999, one of which began production in thefirst quarter of 2000 and the other of which is scheduled to begin productionin the second half of 2001. The first machine in our new Dresden manufacturingfacility began commercial production in the fourth quarter of 2000. The secondmachine began production in the second quarter of 2001. In the past, we haveexperienced significant problems during the initial phases of operating a newmachine. We have taken substantial write-offs of inventory and incurred substantialexpenses in connection with the resolution of these problems. If we encountersimilar problems with new machines, our production capability and our operatingresults will suffer.

**Oursuccess will depend on our ability to service our borrowings and maintaincredit facilities.**

             Wehave financed a large portion of our capital expenditures through borrowingsand expect to continue to do so. Our inability to make timely payments ofinterest or principal under these facilities could materially adversely affectour ability to borrow money under existing credit facilities or to secureadditional borrowings. In addition, our current credit facilities contain, andour future credit facilities will contain, financial and operating covenantsthat will limit our discretion with respect to business matters. Among otherthings, these covenants will restrict our ability to incur additionalindebtedness, create liens or other encumbrances, and make certain paymentsincluding dividends and investments. These credit facilities will also containfinancial covenants and events of default that could require us to pay offindebtedness before its maturity. The restrictions imposed by these creditfacilities or the failure of lenders to advance funds under these facilitiescould adversely affect us. You should read the sections entitled"Loan Covenants"; "Liquidity"; and "GoingConcern" in the "Management's Discussion and Analysis of FinancialCondition and Results of Operations" for more information.

**We dependon a small number of customers for a substantial portion of our sales, and theloss of a large customer could hurt our revenues or operating results.**

             Ourten largest customers accounted for approximately 74%, 69% and 85% of netproduct sales in 1998, 1999 and 2000, respectively. During 2000, our threelargest customers were Mitsubishi Electric Corporation, Sekurit St. Gobain andSamsung, each of which accounted for more than 10% of our net product sales. Weexpect to continue to derive a significant portion of our net product salesfrom a relatively small number of customers. Accordingly, the loss of a largecustomer could materially hurt our business, and the deferral or loss ofanticipated orders from a small number of customers could materially damage ourrevenue and operating results in any period. In addition, we do not havelong-term contracts or purchase orders with many of our customers, andcustomers may cancel their orders, change production quantities from forecastvolumes or delay production for any reason.

**We dependon our OEM customers for the sale of our products and for information relatingto the development of new products.**

             Wesell a substantial portion of our products to a relatively small number oforiginal equipment manufacturers, or OEMs. The timing and amount of sales tothese customers ultimately depend on sales levels and shipping schedules forthe OEM products into which our products are incorporated. We have no controlover the shipping dates or volume of products shipped by our OEM customers, andwe cannot be certain that our OEM customers will continue to ship products thatincorporate our products at current levels or at all. Failure of our OEMcustomers to achieve significant sales of products incorporating our productsand fluctuations in the timing and volume of such sales could be harmful to ourbusiness. Failure of these customers to inform us of changes in theirproduction needs in a timely manner could also hinder our ability toeffectively manage our business.

             Inaddition, we rely on our OEM customers to inform us of opportunities to developnew products that serve end-user demands. If our OEM customers do not presentus with market opportunities early enough for us to develop products to meetend-user needs in a timely fashion, or if the OEMs fail to anticipate end-userneeds at all, we may fail to develop new products or modify our existingproducts for our end-user markets. In addition, if our OEM customers fail toaccurately anticipate end-user demands, we may spend resources on products thatare not commercially successful.

**We aredependent on key suppliers of materials which may prevent us from deliveringproduct in a timely manner.**

             Wemanufacture all of our products using materials procured from third-partysuppliers. Certain of these materials are obtained from a limited number ofsources. For example, the substrates we use in the manufacture of our HeatMirror product is only currently available only from one qualified source,Teijin, holder of approximately 8.2% of our common stock. The substrates usedin the manufacture of our anti-reflective film is currently available from onlytwo qualified sources, Teijin and Di Nippon Printing. The loss of either ofthese current sources could adversely affect our ability to meet our scheduledproduct deliveries to customers. In addition, any interruption in theoperations of vendors of certain other materials could also adversely affectour ability to meet our scheduled product deliveries to customers. If we areunable to obtain a sufficient supply of materials from our current sources, wecould experience difficulties in obtaining alternative sources quickly or inaltering product designs to use alternative materials. In the case of severalmaterials, it takes a great deal of time to qualify new suppliers. Delays orreductions in product shipments could damage our relationships with ourcustomers. Further, a significant increase in the price of one or more of thesematerials could have a material adverse effect on our operating results.

**We aredependent on key suppliers of production machines which may prevent us fromdelivering an acceptable product on a timely basis.**

             Ourproduction machines are large, complex and difficult to manufacture. It cantake 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, upto six additional months to test and prepare the machine for commercialproduction. There are a very limited number of companies that are capable ofmanufacturing these machines. Our inability in the future to have newproduction machines manufactured and prepared for commercial production in atimely manner would have a material adverse effect on our business.

**We mustcontinue to develop new products or enhance existing products on a timely basisto compete successfully in a rapidly changing marketplace.**

             Themarket for thin-film coated glass and coating equipment is characterized byrapid change, especially in the electronic display market. Our future successdepends upon our ability to introduce new products, improve existing productsand processes to keep pace with technological and market developments, and toaddress the increasingly sophisticated and demanding needs of our customers.Technological changes, process improvements, or operating improvements thatcould adversely affect us include:
 •the development of new  technologies that improve the manufacturing efficiency of our competitors;    •changes in product  requirements of our customers;    •changes in the way  coatings are applied to alternative substrates such as tetra acetate  cellulose, or TAC;    •the development of new  materials that improve the performance of thin-film coated glass; and    •improvements in the  alternatives to the sputtering technology we use to produce our products,  such as plasma enhanced chemical vapor deposition, or PECVD.
             We maynot have sufficient funds to devote to research and development, or ourresearch and development efforts may not be successful in developing productsin the time, or with the characteristics, necessary to meet customer needs. Ifwe do not adapt to technological changes, or process or operating improvements,our competitive position, operations and prospects would be materially adverselyaffected.

**We faceintense competition, which could affect our ability to increase our revenue,maintain our margins and increase our market share.**

             Themarket for each of our products is intensely competitive and we expectcompetition to increase in the future. Competitors vary in size and in thescope and breadth of the products they offer. Many of our current and potentialcompetitors have significantly greater financial, technical, marketing andother resources than we have. In addition, many of our competitors havewell-established relationships with our current and potential customers andhave extensive knowledge of our industry. Current and potential competitorshave established or may establish cooperative relationships among themselves orwith third parties to increase the ability of their products to addresscustomer needs.

*ElectronicInformation Display Market.*  Competitors in the anti-reflective coatingsmarket include customers who have the capability to use wet coating technology,as well as competitors, who supply sputter coated films similar to thoseproduced by us. One of the largest manufacturers of flat-face computer displaytubes, or CDTs, Sony Corporation of Japan, has its own sputter coating filmtechnology which is used to provide anti-reflective characteristics on its ownCDTs. Customers' selection of anti-reflective products is driven by quality,price and capacity.

*AutomotiveGlass Market.*  Solar control products in the automotive OEMmarket are provided by large, worldwide glass laminators who typically havedivisions also selling products to the commercial flat glass industry. Severalof these companies, such as PPG, Pilkington PLC, Sekurit St. Gobain, Asahi,Guardian, and Glaverbel, have direct to glass sputtering capability. In theapplied film segment of the automotive market, companies such as 3M, MaterialSciences Corporation, CP Films, and Courtaulds PLC produce competitive solarcontrol products that are widely accepted in the market.

*Residentialand Commercial Window Market.*  Products thatprovide solar control and energy conservation have been available to thismarket for almost 20 years. Since our introduction of our Heat Mirrorsuspended film product in 1979, large glass producers like Guardian, PPG,Viracon, Glaverbel, and Asahi, have produced their own direct-to-glasssputtered products that perform similarly to our Heat Mirror product.

**If wefail to recruit and retain a significant number of qualified technicalpersonnel, we may not be able to develop, enhance and introduce our products ona timely basis, and our business will be harmed.**

             Werequire the services of a substantial number of qualified technical personnel.The market for skilled technical personnel is characterized by intensecompetition and aggressive recruiting, as well as a high-level of employeemobility. These characteristics make it particularly difficult for us toattract and retain the qualified technical personnel we require. We haveexperienced, and we expect to continue to experience, difficulty in hiring andretaining highly skilled employees with appropriate technical qualifications.It is especially difficult to recruit qualified personnel to move to thelocation of our in Palo Alto, California, offices because of the high-cost ofliving. If we are unable to recruit and retain a sufficient number of qualifiedtechnical employees, we may not be able to complete the development of, orenhance, our products in a timely manner. As a result, our business may beharmed and our operating results may suffer.

**We may beunable to attract or retain the other highly skilled employees that arenecessary for the success of our business.**

             Inaddition to our dependence on our technical personnel, our success also dependson our continuing ability to attract and retain other highly skilled employees.We depend on the continued services of our senior management, particularlyThomas G. Hood, our President and Chief Executive Officer, and Robert Freeman,our Chief Financial Officer, and other personnel. We do not have any key personlife insurance covering any officer or employee. Competition for personnel inour industry where we operate is intense. We have experienced, and we expect tocontinue to experience difficulty in hiring and retaining highly skilled employeeswith appropriate qualifications. If we do not succeed in attracting orretaining the necessary personnel, our business could be adversely affected.

**Oursuccess depends in part upon our ability to protect our intellectual property,but we may not be able to do so adequately.**

             Oursuccess depends in large part upon our proprietary technology. We rely on ourknow-how, as well as a combination of patent, trademark and trade secretprotection, to establish and protect our intellectual property rights. In addition,we seek to avoid disclosure of our know-how and trade secrets through a numberof means, including requiring those persons with access to our proprietaryinformation to execute nondisclosure agreements with us. We seek to protect ourtechnology, documentation and other written materials under trade secret andcopyright laws, which afford only limited protection. We have 28 patents and 6patent applications pending in the United States that cover materials,processes, products and production equipment. We also have patents and patentapplications pending in various foreign countries covering the same technology.Some foreign countries in which we may do business provide significantly lesspatent and proprietary rights protection than the United States.

             Despiteour efforts to protect our proprietary rights, unauthorized parties may attemptto copy aspects of our products or to obtain and use information that we regardas proprietary. Policing unauthorized use of our products is difficult. Inaddition, the laws of some foreign countries do not protect our proprietaryrights to as great an extent as do the laws of the United States. Our means ofprotecting our proprietary rights may not be adequate. In addition, ourcompetitors may independently develop similar technology, duplicate ourproducts, or design around our proprietary intellectual property.

**Ourbusiness is susceptible to numerous risks associated with internationaloperations.**

             Wehave expanded our operations and hired additional personnel to addressinternational markets for the thin-film coatings industry. Internationalrevenues amounted to 68%, 77% and 86% of our net revenues during 1998, 1999 and2000, respectively. The distance between California and Dresden createlogistical and communications challenges. In addition, to achieve acceptance ininternational markets, our products must be modified to handle a variety offactors specific to each international market as well as local regulations. Wemay also be subject to a number of other risks associated with internationalbusiness activities. These risks include:
 •unexpected changes in  and the burdens and costs of compliance with a variety or foreign laws and  regulatory requirements;    •currency exchange rate  fluctuations;    •tariffs, export controls  and other trade barriers;    •longer accounts  receivable payment cycles and difficulties in collecting accounts receivable;    •difficulties in managing  and staffing international operations;    •potentially adverse tax  consequences, including restrictions on the repatriation of earnings; and    •global economic  turbulence and political instability.
             Ourinternational sales are currently invoiced and collected in U.S. dollars. Astrengthening in the dollar relative to the currencies of those countries inwhich we do business would increase the prices of our products as stated inthose currencies and could hurt our sales in those countries. Significantfluctuations in the exchange rates between the U.S. dollar and foreign currenciescould cause us to lower our prices and thus reduce our profitability. Thesefluctuations could also cause prospective customers to delay orders because ofthe increased relative cost of our products.
             Weexpect that, within the next twelve months, the customers of our Dresdenoperation will begin to make payments in EUROs or other foreign currencies. Inaddition, in the future, other of our customers may also make payments inforeign currencies. Such transactions may require us to begin to hedge foreigncurrencies in order to reduce the risk to us of fluctuating exchange rates.

**Performance,reliability or quality problems with our products may cause our customers toreduce their orders.**

             Wemanufacture our electronic display and automobile glass products based onspecific, technical requirements of each of our customers. We believe thatfuture orders of our products will depend in part on our ability to maintainthe performance, reliability and quality standards required by our customers.If our products have performance, reliability or quality problems, then we mayexperience:
 •delays in collecting  accounts receivable;    •reduced orders;    •additional warranty and  service expenses; and    •higher manufacturing  costs.
**We mayface costly damages or litigation costs if a third party claims that weinfringe its intellectual property.**

             It ispossible that third parties may claim that we or our current or potentialfuture products infringe upon their intellectual property. Any claims, with orwithout merit, could be time consuming, result in costly litigation, causeproduct shipment delays or require us to enter into royalty or licensingagreements. Royalty or licensing agreements, if required, may not be availableon terms acceptable to us or at all, which could seriously harm our business.

**If wefail to comply with environmental regulations, our operations could besuspended.**

             We usehazardous chemicals in producing our products. As a result, we are subject to avariety of local, state and federal governmental regulations relating to thestorage, discharge, handling, emission, generation, manufacture and disposal oftoxic or other hazardous substances used to manufacture our products,compliance with which is expensive. Our failure to comply with current orfuture regulations could result in the imposition of substantial fines on us,suspension of production, alteration of our manufacturing processes orcessation of operations.

**We relyon our international and domestic sales representatives, without whom our salesmay suffer.**

             Wesell our products in Japan, China and Korea through sales representatives. Wealso market and sell our Heat Mirror products in North America primarilythrough sales representatives. These sales representatives could reduce ordiscontinue sales of our products. They may not devote the resources necessaryto provide effective sales and marketing support to us. In addition, we dependupon the continued viability and financial resources of these representatives,many of which are small organizations with limited working capital. Theserepresentatives, in turn, depend substantially on general economic conditionsand other factors affecting the markets for the products they sell. We believethat our success will continue to depend upon these sales representatives. Ifsome or all of our sales representatives experience financial difficulties, orotherwise become unable or unwilling to promote and sell our products, ourbusiness could be harmed.

**Our stockprice could fluctuate widely in response to various factors, many of which arebeyond our control.**

             Thetrading price of our common stock may be highly volatile. Our stock price couldfluctuate widely in response to factors such as the following:
 •actual or anticipated  variations in our quarterly revenues or operating results;    •announcements of new  products or services by us or our competitors, or new competing technologies;    •our addition or loss of  significant customers;    •changes in financial  estimates or recommendations by securities analysts;    •announcements by us of  significant acquisitions or strategic partnerships;    •additions or departures  of our key personnel;    •future equity or debt  offerings by us or our announcements of such offerings; and    •general market and  economic conditions.
 

             Inaddition, in recent years the stock markets in general, and the NasdaqNational Market and the market for technology companies in particular, haveexperienced large price and volume fluctuations. These fluctuations have oftenbeen seemingly unrelated or disproportionate to the operating performance ofthese technology companies. These market and industry factors may materiallyand adversely affect our stock price, regardless of our operating performance.In the past, securities class action litigation has often been brought againsta company following periods of volatility in the market price of its stock.Securities litigation could result in substantial costs or large judgmentsagainst us and divert management's attention and resources.

**Recentaccounting pronouncements**

             InJune 1998, the Financial Accounting Standards Board issued SFAS No.133,"Accounting for Derivatives and Hedging Activities" ("SFAS133"). SFAS 133 was effective for all fiscal quarters beginning with thequarter ending June 30, 1999. SFAS 133 establishes accounting andreporting standards of derivative instruments, including certain derivativeinstruments embedded in other contracts, and for hedging activities. In July 1999,the Financial Accounting Standards Board issued SFAS No. 137 "Accountingfor Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASBStatement No. 133" ("SFAS 137"). SFAS 137 deferred the effectivedate until the first fiscal quarter for fiscal years beginning afterJune 15, 2000. The Company has not engaged in hedging activities orinvested in derivative instruments.

 

**PART II OTHER INFORMATION**

 

**Item 1-Legal Proceedings and OtherMatters**

             Litigationfiled against the Company was described under Item 3 in the Company'sForm 10-K/A filed on April 11, 2001. Subsequent to such filing, nomaterial developments have occurred with respect to the litigation describedtherein.

             In addition, the Company is involved in certain otherlegal 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 the Company's business or itsconsolidated financial position or results of operations.

**Item 2-Changes in Securities**

             OnApril 23, 2001, the Company issued to GMX Associates, a Singapore company,422,119 shares of the Company’s common stock for $1.0 million in cash inreliance on the exemption to registration provided by Section 4(2) of theSecurities Act of 1933 as amended (the “Act”). The securities sold to GMX havenot been registered under the Act, or under the securities laws of any otherjurisdictions. The securities sold to GMX may not be transferred or resold exceptas permitted under the Act and the applicable state securities laws, pursuantto registration or exemption therefrom. In connection with the issuance, theCompany agreed to provide GMX certain rights with respect to the registrationfor resale of the shares purchased. The shares purchased by GMX representsapproximately 5.2% of the outstanding shares of the Company.

**Item 3-Defaults upon Senior Securities**

             Notapplicable

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

             Nomatters were submitted to a vote of security holders during the quarter endedJuly 1, 2001.

**Item 5-Other Information**

             Notapplicable

**Item6-Exhibits**

             (a)         Exhibits
**Exhibit   Number****** **Item******11 Digeo, Inc. sublease  agreement.
(b)        Reportson Form 8-K–None

**SIGNATURES**

             Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

Dated: August 8, 2001 Southwall Technologies Inc.

 
By:/s/ THOMAS G. HOOD Thomas G. Hood *President and* *Chief Executive Officer*By:/s/ ROBERT R. FREEMAN  Robert R. Freeman *Sr. Vice President and* *Chief Financial Officer*