PHOTON DYNAMICS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 205499

FORM 10-Q

(Mark One)


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

For the quarterly period ended June 30, 2003


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

For the transition period from to

Commission file number: 0-27234

PHOTON DYNAMICS, INC.

(Exact name of registrant as specified in its charter)


California (State or other jurisdiction of incorporation or organization)		94-3007502 (I.R.S. Employer Identification No.)

17 Great Oaks Blvd.
San Jose, California 95119-1202
(Address of principal executive offices including zip code)

(408) 360-3550
(Registrant’s telephone number, including area code)

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

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

As of July 31, 2003, there were 16,167,400 shares outstanding of the Registrant’s Common Stock, no par value.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	ITEM 1. Financial Statements
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED 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
	ITEM 4. Controls and Procedures
PART II. OTHER INFORMATION
	ITEM 1. Legal Proceedings
	ITEM 2. Changes in Securities and Use of Proceeds
	ITEM 3. Defaults Upon Senior Securities
	ITEM 4. Submission of Matters to a Vote of Security Holders
	ITEM 5. Other Information
	ITEM 6. Exhibits and Reports on Form 8-K
SIGNATURES
Exhibit Index
EXHIBIT 10.29
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

INDEX


		Page

PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of June 30, 2003 and September 30, 2002		3
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended June 30, 2003 and 2002		4
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended June 30, 2003 and 2002		5
	Notes to Condensed Consolidated Financial Statements		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		19
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		32
Item 4.	Controls and Procedures		33
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings		34
Item 2.	Changes in Securities and Use of Proceeds		34
Item 3.	Defaults Upon Senior Securities		34
Item 4.	Submission of Matters to a Vote of Security Holders		34
Item 5.	Other Information		34
Item 6.	Exhibits and Reports on Form 8-K		35
Signatures			36

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS


			June 30,			September 30,
			2003			2002

			(unaudited)
			(in thousands)
ASSETS
Current assets:
	Cash and cash equivalents		$	17,837		$	25,580
	Short-term investments			98,514			144,563
	Accounts receivable, net			13,396			16,579
	Inventories			10,041			18,650
	Other current assets			7,805			6,367

		Total current assets		147,593			211,739
Land, property and equipment, net				12,053			12,404
Other assets				3,159			2,925
Intangible assets, net				6,643			3,554
Goodwill				10,626			18,537

		Total assets	$	180,074		$	249,159

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	7,885		$	10,610
	Other current liabilities			10,754			10,637
	Deferred revenue			5,965			304

		Total current liabilities		24,604			21,551

Other liabilities				779			1,465
Commitments and contingencies
Shareholders’ equity:
	Common stock, no par value			274,457			288,833
	Accumulated deficit			(120,500	)		(63,500	)
	Accumulated other comprehensive income			734			810

		Total shareholders’ equity		154,691			226,143

		Total liabilities and shareholders’ equity	$	180,074		$	249,159

See accompanying notes to condensed consolidated financial statements.

PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)


			Three Months Ended						Nine Months Ended
			June 30,						June 30,

			2003			2002			2003			2002

			(in thousands, except per share data)
Revenue			$	17,996		$	14,965		$	46,216		$	36,387
Cost of revenue				11,789			7,581			31,267			19,757

Gross margin				6,207			7,384			14,949			16,630

Operating expenses:
	Research and development			6,313			3,066			16,219			7,785
	Selling, general and administrative			3,176			2,324			10,020			6,955
	Acquired in-process research and development			625			—			2,474			—
	Amortization of intangible assets			408			—			1,035			—

		Total operating expenses		10,522			5,390			29,748			14,740

Income (loss) from operations				(4,315	)		1,994			(14,799	)		1,890
Interest income and other, net				952			902			2,446			2,066

Income (loss) from continuing operations				(3,363	)		2,896			(12,353	)		3,956
Loss from discontinued operations				(5,607	)		(2,779	)		(44,647	)		(8,815	)

Net income (loss)			$	(8,970	)	$	117		$	(57,000	)	$	(4,859	)

Net income (loss) per share from continuing operations
	Basic		$	(0.21	)	$	0.17		$	(0.77	)	$	0.25

	Diluted		$	(0.21	)	$	0.16		$	(0.77	)	$	0.24

Net loss per share from discontinued operations
	Basic		$	(0.35	)	$	(0.16	)	$	(2.78	)	$	(0.56	)

	Diluted		$	(0.35	)	$	(0.16	)	$	(2.78	)	$	(0.56	)

Net income (loss) per share
	Basic		$	(0.56	)	$	0.01		$	(3.55	)	$	(0.31	)

	Diluted		$	(0.56	)	$	0.01		$	(3.55	)	$	(0.31	)

Weighted average number of shares:
	Basic			16,003			17,031			16,036			15,564
	Diluted			16,003			17,999			16,036			16,536

See accompanying notes to condensed consolidated financial statements.

PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


				Nine Months Ended
				June 30,

				2003			2002

				(in thousands)
Cash flows from operating activities:
	Net income (loss) from continuing operations			$	(12,353	)	$	3,956
	Adjustments to reconcile net income (loss) from continuing operations to net cash used in operating activities from continuing operations:
		Depreciation			1,648			1,268
		Amortization of intangible assets			1,592			—
		Acquired in-process research and development			2,474			—
		Stock ownership expense			142			275
		Changes in assets and liabilities:
			Accounts receivable		(2,488	)		(7,196	)
			Inventories		1,900			1,770
			Other current assets		(189	)		(4,254	)
			Other assets		(463	)		617
			Accounts payable		(447	)		2,053
			Other current liabilities		(2,112	)		958
			Deferred revenue		5,943			(1,343	)

	Net cash used in operating activities from continuing operations				(4,353	)		(1,896	)
	Net cash used in operating activities from discontinued operations				(10,947	)		(9,405	)

	Net cash used in operating activities				(15,300	)		(11,301	)

Cash flows from investing activities:
		Purchase of property and equipment			(1,588	)		(645	)
		Acquisition of Rapid Thermal Processing Division from Intevac, Inc.			(20,000	)		—
		Acquisition of Summit Imaging, Inc.			(1,629	)		—
		Purchase of short-term investments			(419,293	)		(462,739	)
		Redemption of short-term investments			465,292			389,742

	Net cash provided by (used in) investing activities from continuing operations				22,782			(73,642	)
	Net cash provided by (used in) investing activities from discontinued operations				(923	)		1,247

	Net cash provided by (used in) investing activities				21,859			(72,395	)

Cash flows from financing activities:
		Issuance of common stock, net			3,160			111,998
		Repurchase of common stock			(17,678	)		—
		Long-term debt activity, net			253			—
		Repayment of lease obligations			(11	)		(21	)

	Net cash provided by (used in) financing activities from continuing operations				(14,276	)		111,977

	Effect of exchange rate changes on cash and cash equivalents				(26	)		(91	)

	Net increase in cash and cash equivalents from continuing operations				4,127			36,348
	Net decrease in cash and cash equivalents from discontinued operations				(11,870	)		(8,158	)

	Net increase (decrease) in cash and cash equivalents				(7,743	)		28,190
	Cash and cash equivalents at beginning of period				25,580			16,528

	Cash and cash equivalents at end of period			$	17,837		$	44,718

See accompanying notes to condensed consolidated financial statements.

PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1-Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Photon Dynamics, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the results for the interim periods presented have been included. Operating results for the three and nine months ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ending September 30, 2003. This financial information should be read in conjunction with the financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2002.

The condensed consolidated balance sheet as of September 30, 2002, is derived from the Company’s audited consolidated financial statements as of September 30, 2002, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

Certain prior year and prior quarter balances have been reclassified to conform to the current financial statement presentation. These reclassifications had no impact on previously reported results of operations or shareholders’ equity.

Description of Operations

Through January 14, 2003, the Company conducted business in three operating segments: flat panel display products, cathode ray tube display and high quality glass inspection products and printed circuit board assembly inspection products. The Company’s flat panel display products include test, repair, inspection and rapid thermal process equipment. The Company’s flat panel display test and inspection equipment identifies and characterizes defects at early stages of the manufacturing process so that the panels may be repaired before the next stage, or, if necessary, discarded, minimizing the loss of time and materials. The Company’s flat panel display test and inspection products gather comprehensive data that enable flat panel display manufacturers to control and refine their manufacturing processes. The Company’s rapid thermal process equipment enables manufacturers of flat panel displays to thermally activate low temperature poly-silicon films at temperatures that would otherwise distort or destroy underlying glass substrates. The Company’s cathode ray tube display and high quality glass inspection products allow cathode ray tube display manufacturers to locate and characterize defects and glass manufacturers to detect and identify defects such as scratches, pits, bubbles, stones, inclusions and distortions, thereby increasing yields and quality and reducing costs. The Company’s printed circuit board assembly inspection products enable printed circuit board assembly inspection manufacturers to detect and identify defects, thereby increasing yields and quality and reducing costs.

In January 2003, the Company implemented a plan to exit the printed circuit board assembly inspection business. In June 2003, the Company implemented a plan to exit the cathode ray tube display and high quality glass inspection businesses. Accordingly, the operating results of these business segments have been presented as discontinued operations in accordance with the provisions of Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” (“FAS 144”) and the Company’s condensed consolidated financial statements and related footnotes have been reclassified to conform with the current period’s basis of presentation. Accordingly, in the condensed consolidated statements of operations, the operating results of these businesses have been classified as “Loss from discontinued operations,” for the three and nine month periods ended June 30, 2003 and 2002. The cash flows from these businesses have been presented as “Net cash flows from discontinued operations” in the operating, investing and financing sections of the condensed consolidated statements of cash flows.

Revenue Recognition

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured.

The Company accounts for certain of its product sales, including sales to a value-added reseller, as arrangements with multiple deliverables. For arrangements with multiple deliverables, the Company recognizes revenue for the delivered items if the delivered items have value to the customer on a standalone basis, the amount of revenue for delivered elements is not subject to refund, the Company has met defined customer acceptance experience levels for the delivered items, and the fair value of undelivered items, such as installation and system upgrade rights, can be reliably determined. The Company allocates revenue to the delivered items based on the amount due and billable upon shipment, with the remaining amount recognized after installation and acceptance when the final amount becomes due. The Company recognizes all other product sales upon customer acceptance. The Company recognizes revenue from the sale of spare parts upon shipment.

The Company records a provision for estimated sales returns in the same period as the related revenue is recorded, which is netted against revenue. These estimates are based on historical sales returns and other known factors. If the historical data the Company uses to calculate these estimates does not properly reflect future returns, additional provisions may be required.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), an Interpretation of Accounting Research Bulletin No. 51 “Consolidated Financial Statements”. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company believes that the adoption of this standard will have no material impact on the consolidated financial statements.

In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”). This statement amends FAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The Company is in the process of assessing the effect of FAS 149 and does not expect the adoption of it, which is effective for contracts entered into or modified after June 30, 2003, to have a material effect on its financial condition or results of operations.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“FAS 150”). FAS 150 establishes standards on the classification and measurement of financial instruments with characteristics of both liabilities and equity. FAS 150 will become effective for financial instruments entered into or modified after May 31, 2003. The Company is in the process of assessing the effect of FAS 150 and does not expect the implementation of it to have a material effect on its financial condition or results of operations.

NOTE 2-Discontinued Operations

Printed Circuit Board Assembly Inspection Business

The Company’s printed circuit board assembly inspection products enabled printed circuit board assembly inspection manufacturers to detect and identify defects, thereby increasing yields and quality and reducing costs. The Company previously sold its products for the printed circuit board assembly industry primarily through sales representatives and distributors. The Company generally recognized revenue from the sale of its printed circuit board assembly inspection products upon shipment; as such product sales were not subject to customer acceptance provisions. In January 2003, the Company implemented a plan to exit the printed circuit board assembly inspection business. Accordingly, the operating results of this business segment have been reclassified as a discontinued operation for all periods presented. The Company is attempting to liquidate the operation’s remaining inventory through a third-party auctioneer and is attempting to sublease the facilities associated with the discontinued operations, but there can be no assurances that the Company will be successful in recovering any costs associated with this discontinued operation.

The following table summarizes the results of discontinuing the printed circuit board assembly inspection products reporting segment:


			Three Months Ended						Nine Months Ended
			June 30,						June 30,

			2003			2002			2003			2002

						(in thousands)
Revenue			$	795		$	2,768		$	3,622		$	8,969
Cost of revenue				290			2,252			11,465			7,162

Gross margin				505			516			(7,843	)		1,807

Operating expenses:
	Research and development			—			986			3,693			2,886
	Selling, general and administrative			1,083			1,275			6,536			5,106
	Goodwill impairment charge			—			—			15,083			—
	Purchased intangibles and long-lived assets impairment charge			—			—			5,405			—
	Amortization of intangible assets			—			287			195			860

		Total operating expenses		1,083			2,548			30,912			8,852

Loss from discontinued operations			$	(578	)	$	(2,032	)	$	(38,755	)	$	(7,045	)

The loss from discontinued operations for the nine months ended June 30, 2003, includes a write-off of inventory of approximately $7.8 million, a write-off of accounts receivable of approximately $1.7 million, and a write-off of licensed technology of approximately $1.9 million. The nine month loss also includes impairment charges of approximately $15.1 million of goodwill, $2.9 million of purchase intangibles and $2.5 million of long-lived assets recorded during the three months ended December 31, 2002, as a result of management’s assessment of indicators of impairment that existed prior to the Company’s formal decision to discontinue the operations of this segment. Such impairment charges were recorded in accordance with the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” (“FAS 142”) and FAS 144.

The following summarizes the assets and liabilities of the printed circuit board assembly inspection products discontinued operations:


			June 30,		September 30,
			2003		2002

			(in thousands)
ASSETS
Current assets:
	Accounts receivable, net		$	432	$	4,916
	Inventories			—		4,844
	Other current assets			700		1,443

		Total current assets		1,132		11,203
Land, property and equipment, net				—		1,896
Intangible assets, net				—		3,076
Goodwill				—		15,083

		Total assets	$	1,132	$	31,258

LIABILITIES
Current liabilities:
	Accounts payable		$	123	$	1,827
	Other current liabilities			917		467
	Deferred revenue			—		104

		Total current liabilities		1,040		2,398
Other liabilities				209		883

		Total liabilities	$	1,249	$	3,281

Other current liabilities at June 30, 2003 include approximately $179,000 related to current operating lease obligations, approximately $200,000 related to warranty obligations and approximately $538,000 related to potential vendor obligations. Other liabilities of approximately $209,000 relate entirely to non-current operating lease obligations. Lease obligations are to be paid out through December 2006. The Company is terminating a total of 46 employees and expects to pay out all severance and related benefit amounts by September of 2003. Remaining severance and related benefit amounts at June 30, 2003 are not material.

Cathode Ray Tube Display and High Quality Glass Inspection Business

The Company’s cathode ray tube display and high quality glass inspection products allowed cathode ray tube display manufacturers to locate and characterize defects and glass manufacturers to detect and identify defects such as scratches, pits, bubbles, stones, inclusions and distortions, thereby increasing yields and quality and reducing costs. The Company previously sold its products for the cathode ray tube display and high quality glass inspection industry primarily through sales representatives and distributors. The Company generally recognized revenue from product sales upon customer acceptance. In June 2003, the Company implemented a plan to exit the cathode ray tube display and high quality glass inspection business. Accordingly, the operating results of this business segment have been reclassified as a discontinued operation for all periods presented and the Company now conducts business in one segment. The Company is attempting to sell the assets associated with this discontinued operations, but there can be no assurances that the Company will be successful in recovering any costs associated with this discontinued operation.

The following table summarizes the results of discontinuing the cathode ray tube display and high quality glass inspection products reporting segment:


			Three Months Ended						Nine Months Ended
			June 30,						June 30,

			2003			2002			2003			2002

						(in thousands)
Revenue			$	400		$	1,587		$	2,185		$	5,465
Cost of revenue				2,989			1,119			4,235			3,312

Gross margin				(2,589	)		468			(2,050	)		2,153

Operating expenses:
	Research and development			303			753			637			2,259
	Selling, general and administrative			1,649			462			2,717			1,664
	Long-lived assets impairment charge			488			—			488			—

		Total operating expenses		2,440			1,215			3,842			3,923

Loss from discontinued operations			$	(5,029	)	$	(747	)	$	(5,892	)	$	(1,770	)

The loss from discontinued operations for the three months ended June 30, 2003, includes a write-off of inventory of approximately $2.0 million, a write-off of accounts receivable of approximately $365,000, and a write-off of fixed assets of approximately $490,000. The three month loss also includes approximately $460,000 in lease-related charges associated with excess facilities, and approximately $979,000 in employee severance and related benefit charges accounted for in accordance with Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The Company expects to incur approximately $200,000 in additional severance costs, and all severance costs are expected to be paid out by the end of the fourth quarter of fiscal 2003.

The following summarizes the assets and liabilities of the cathode ray tube display and high quality glass inspection discontinued operations:


			June 30,		September 30,
			2003		2002

			(in thousands)
ASSETS
Current assets:
	Accounts receivable, net		$	213	$	1,994
	Inventories			—		1,943
	Other current assets			237		246

		Total current assets		450		4,183
Land, property and equipment, net				—		561
Other assets				—		229

		Total assets	$	450	$	4,973

LIABILITIES
Current liabilities:
	Accounts payable		$	89	$	690
	Other current liabilities			1,702		659


			June 30,		September 30,
			2003		2002

			(in thousands)
	Deferred revenue			—		178

		Total current liabilities		1,791		1,527
Other liabilities				305		314

		Total liabilities	$	2,096	$	1,841

Other current liabilities at June 30, 2003 include approximately $612,000 related to employee severance and related benefits, approximately $321,000 related to non-severance employee benefits, approximately $236,000 related to warranty obligations, approximately $460,000 related to operating lease obligations, and approximately $73,000 in miscellaneous other accrued amounts. Lease obligations are to be paid out through March of 2008. The Company is terminating a total of 40 employees and expects to pay out all severance and related benefit amounts by September of 2003.

Other liabilities of approximately $305,000 relate to a loan payable to the National Research Council of Canada. The loan was an advance under a program for pre-commercialization assistance in the development of glass inspection technology. Under the agreement, the loan was to be repaid based on a percentage of gross revenue earned, on a quarterly basis, through July 1, 2004. The loan amount is expected to be settled by September 30, 2003.

NOTE 3- Stock Ownership Expense

As permitted by Statement of Financial Accounting Standards No. 148, “Accounting for Stock Based Compensation Transition and Disclosure,” the Company has elected to continue to follow the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), to account for stock options issued to employees under the Company’s employee stock option and stock purchase plans and amortizes deferred compensation, if any, over the vesting period of the options. The stock ownership expense resulting from issuance of fixed term stock option awards is measured as the difference between the exercise price of the option and the fair market value of the underlying share of common stock subject to the option on the award’s grant date. The Company has elected to make pro forma disclosures as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”). The Company estimates the fair value of its stock-based awards to employees using the Black-Scholes multiple option approach pricing model. The value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model for the multiple option approach with the following weighted-average assumptions:


		Three Months Ended				Nine Months Ended
		June 30,				June 30,

		2003		2002		2003		2002

Stock option plan:
	Expected stock price volatility		0.90		0.96		0.94		0.96
	Risk free interest rate		1.95		4.05		2.14		3.44
	Expected life of options (years)		3.0		3.0		3.0		3.0
Stock purchase plan:
	Expected stock price volatility		0.96		1.02		0.90		1.02
	Risk free interest rate		2.13		4.39		2.15		4.39
	Expected life of options (years)		2.0		1.3		1.2		1.3

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock option and employee stock purchase plans have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not provide a reliable measure of the fair value of the Company options.

For purposes of pro forma disclosures required by FAS 123, the estimated fair value of the options is amortized to expense over the vesting periods applicable to the options. The Company’s pro forma information for the three and nine months ended June 30, 2003 and 2002, is as follows:


		Three Months Ended						Nine Months Ended
		June 30,						June 30,

		2003			2002			2003			2002

		(in thousands, except per share data)
Net loss - as reported		$	(8,970	)	$	117		$	(57,000	)	$	(4,859	)
	Plus: stock ownership expense recorded under APB 25		100			—			142			275
	Less: FAS 123 stock ownership expense		(2,038	)		(3,378	)		(3,804	)		(6,770	)

Net loss - pro forma		$	(10,908	)	$	(3,261	)	$	(60,662	)	$	(11,354	)

Basic net loss per share - as reported		$	(0.56	)	$	0.01		$	(3.55	)	$	(0.31	)
Dilutive net loss per share - as reported		$	(0.56	)	$	0.01		$	(3.55	)	$	(0.31	)
Basic net loss per share - pro forma		$	(0.68	)	$	(0.19	)	$	(3.78	)	$	(0.73	)
Dilutive net loss per share - pro forma		$	(0.68	)	$	(0.19	)	$	(3.78	)	$	(0.73	)

NOTE 4-Inventories

Inventories are stated at the lower of cost (on a first-in, first-out basis) or market. The components of inventories were as follows:


		June 30,		September 30,
		2003		2002

		(in thousands)
Raw materials		$	3,884	$	6,782
Work-in-process			4,644		7,008
Finished goods			1,513		4,860

	Total	$	10,041	$	18,650

NOTE 5-Other Current Liabilities

The components of other current liabilities were as follows:


		June 30,		September 30,
		2003		2002

		(in thousands)
Warranty (see Note 13)		$	2,268	$	2,383
Accrued compensation			2,386		4,094
Commissions			772		998
Due to Akcron shareholders in connection with the acquisition of a business			1,035		1,642
Obligation to a manufacturing subcontractor in connection with inventory purchases			337		—
Accrued closing costs associated with discontinued operations			1,391		—
Other accrued expenses			2,565		1,520

	Total	$	10,754	$	10,637

NOTE 6 – Derivative Instruments

Under its foreign currency risk management strategy, the Company utilizes derivative instruments to protect its interests from unanticipated fluctuations in earnings and cash flows caused by volatility in currency exchange rates. This financial exposure is monitored and managed by the Company as an integral part of its overall risk management program which focuses on the unpredictability of financial markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on its operating results. During the current quarter, the Company hedged certain of its anticipated foreign currency exposures with hedging instruments having maturities of up to sixteen months.

The Company accounts for its derivatives instruments according to Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), which requires that all derivatives be recorded on the balance sheet at fair value. Changes in the fair value of derivatives which do not qualify, or are not effective as hedges must be

recognized currently in earnings. The Company does not use derivative financial instruments for speculative or trading purposes, nor do we hold or issue leveraged derivative financial instruments.

The Company’s international sales are primarily denominated in U.S. dollars. For foreign currency denominated sales, however, the volatility of the foreign currency markets represents risk to the Company’s margins. The Company defines its exposure as the risk of changes in the functional-currency-equivalent cash flows (generally U.S. dollars) attributable to changes in the related foreign currency exchange rates. Upon forecasting the current quarter exposure, the Company hedged certain transactions with forward sales contracts with critical terms designed to match those of the underlying exposure. The Company did not qualify these current forward sales contracts as hedging instruments, as defined by FAS 133, and, as such, records the changes in the fair value of these derivatives and the underlying hedged instruments in “Interest income and other, net” in the Company’s Condensed Consolidated Statements of Operations. The Company records the fair value of its derivative instruments within “Other current liabilities” in the Company’s Condensed Consolidated Balance Sheet. At June 30, 2003, the Company had foreign exchange forward contracts maturing throughout fiscal 2003 and 2004 to sell approximately 720 million Japanese Yen. Losses from changes in fair values at June 30, 2003 were not material.

NOTE 7-Acquisitions

In November 2002, the Company acquired certain assets relating to rapid thermal processing technology (the “RTP Assets”) from Intevac, Inc. (“Intevac”). The acquired technology is used to activate low temperature poly-silicon films during the manufacturing process for flat panel displays and expands the Company’s product offerings to its current customer base into process equipment. The purchase price was $20.0 million of cash, of which $18.0 million was paid to Intevac at closing and an additional $2.0 million was placed into escrow, which can be released either to the Company or to Intevac depending on the occurrence of certain future events during the escrow period as follows: $1.2 million related to the attainment of a certain level of sales by the Company of equipment included in the RTP Assets acquired from Intevac, $500,000 related to the re-issuance of a former rapid thermal processing patent in Japan for certain acquired technology and $300,000 for indemnification and reimbursement should Intevac breach any representations and warranties under the acquisition agreement. The Company’s preliminary allocation of the purchase consideration (see below) excludes the contingent consideration of $2.0 million and accordingly, amounts allocated to goodwill may increase based on the outcome of these events. In addition, the Company assumed approximately $350,000 of liabilities and incurred approximately $500,000 in acquisition-related expenses, consisting primarily of consulting, legal and accounting fees. The identifiable assets acquired primarily included accounts receivable, inventory and fixed assets. The funds used to purchase the RTP Assets came out of the Company’s working capital.

In May 2003, the Company acquired substantially all of the assets of Summit Imaging, Inc. (the “Summit Assets”). Summit Imaging, Inc. (“Summit”) designed and manufactured cooled cameras for the capital equipment industry. The purchase price was $1.5 million of cash. In addition, the Company assumed approximately $15,000 of liabilities and incurred approximately $130,000 in acquisition-related expenses, consisting primarily of consulting, legal and accounting fees. The identifiable assets acquired consisted primarily of inventory. The funds used to purchase the Summit Assets came out of the Company’s working capital.

The acquisitions of both the RTP Assets and Summit Assets were accounted for under the purchase method of accounting. The purchase prices were allocated by management to the assets acquired and liabilities assumed taking into account an independent appraisal of their respective fair values. To determine the value of the developed and core technologies, the expected future cash flows attributed to all existing technology were discounted, taking into account risks related to the characteristics and application of the technology, existing and future markets and assessments of the life cycle stage of the technology. The value attributed to the RTP backlog was related to purchase orders that had been received prior to the close of the acquisition, determined as the expected discounted cash flow resulting from the revenue related to the shipment of such orders, less normal profit margins.

The value of in-process research and development for both acquisitions was determined based on the expected cash flow attributed to the in-process projects, taking into account revenue that was attributable to previously developed technology, the level of effort to date in the in-process research and development, the percentage of completion of the project and the level of risk associated with the in-process technology. The projects identified as in-process were those that were underway as of the acquisition date and that will, after the applicable closing date, require additional effort in order to establish technological feasibility and have no alternative future uses. These projects have identifiable technological risk factors that indicate that even though successful completion is expected, it is not assured. The value of in-process research and development has been included in the Company’s results of operations.

The Company applied discount factors to the projected cash flows of the acquired technology in order to determine the present value, based on discount rates with inherent risk and expected growth of the developed, core and in-process technologies. The discount rates used for the RTP Assets were 15%, 20% and 25% for the developed, core and in-process technologies, respectively. The discount rates used for the Summit Assets were 50% and 60% for the core and in-process technologies, respectively.

A summary of the preliminary allocation of the purchase price is as follows:


		RTP		Summit

		(in thousands)
Acquired core technology		$	3,764	$	565
Acquired developed technology			2,673		—
Backlog			557		—
Acquired in-process research and development			1,849		625
Non-compete Agreement			—		199
Goodwill			7,386		106
Net fair value of acquired tangible assets and assumed liabilities			2,621		163

	Total	$	18,850	$	1,658

The acquired core technology and acquired developed technology from RTP and Summit are being amortized over five years and four years, respectively. The RTP backlog was amortized to cost of sales at the time revenue was recognized for the related customer orders. The Summit non-compete agreement is being amortized over two years.

The following pro-forma information presents the results of continuing operations of the Company for the nine months ended June 30, 2003 and 2002 as if the RTP Assets and Summit had been acquired as of October 1, 2001. The pro-forma information does not purport to be indicative of what would have occurred had the acquisition been made as of these dates or of results that may occur in the future.

The pro forma results exclude nonrecurring charges, such as the write-off of purchased in-process research and development, which resulted directly from these transactions. The unaudited pro forma information is as follows:


		Nine Months Ended June 30,

		2003			2002

		(in thousands, except per share data)
Total revenue		$	47,753		$	41,395
Net income (loss) from continuing operations			(9,620	)		1,471
	Net loss		(54,267	)		(7,344	)
Pro forma income (loss) per share from continuing operations:
	Basic and diluted	$	(0.60	)	$	0.09
Pro forma loss per share:
	Basic and diluted		(3.38	)		(0.47	)

NOTE 8-Goodwill and Other Long-Lived Assets

Goodwill

In accordance with FAS 142, the Company is required to review goodwill for impairment of value, at least annually, and in certain circumstances between annual tests if there are indicators of impairment. The goodwill impairment test involves a two-step process. Step one consists of a comparison of the fair value of a reporting unit with its carrying amount, including the goodwill allocated to the reporting unit. If the carrying amount is in excess of the fair value, step two requires the comparison of the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. Any excess of the carrying value of the reporting unit goodwill over the implied fair value of the reporting unit goodwill will be recorded as an impairment loss.

Changes in the carrying amount of goodwill for the nine months ended June 30, 2003, are as follows:


		Flat Panel			Discontinued
		Display			Operations			Total

		(in thousands)
Balance as of September 30, 2002		$	3,454		$	15,083		$	18,537
	Goodwill acquired during the period		7,492			—			7,492
	Adjustments to goodwill, net		(320	)		—			(320	)
	Goodwill impairment charge		—			(15,083	)		(15,083	)

Balance as of June 30, 2003		$	10,626		$	—		$	10,626

In conjunction with the acquisitions of the RTP Assets in November 2002 and the Summit Assets in May 2003, the Company recorded goodwill of approximately $7.3 million and $106,000, respectively.

In conjunction with the Company’s acquisition of Akcron Corporation Ltd. (“Akcron”) in September 2002, the Company established a $1.7 million liability for a portion of the purchase price to be held by the Company as security for indemnification should Akcron breach any of its representations and warranties. In the nine month period ended June 30, 2003, adjustments of $770,000 were made to the Akcron liability, consisting of $320,000 for a breach of warranty related to the collectibility of a receivable and $350,000 related to the non-occurence of a certain event.

For the nine month period ended June 30, 2003 goodwill has decreased $320,000. This change results from the aforementioned $350,000 reduction to the Akcron liability which reduced the purchase price with no change to the net assets acquired, and other miscellaneous adjustments that increased goodwill by $30,000, primarily associated with the RTP acquisition.

In the first quarter of fiscal 2003, based on further deterioration of business conditions from the fourth quarter of fiscal 2002 when the Company recorded impairment of goodwill, the Company performed an interim analysis of the fair value of the printed circuit board assembly reporting unit. As a result of this analysis, the Company determined that the goodwill remaining in the printed circuit board assembly reporting unit was impaired and recorded an impairment charge of $15.1 million in the quarter ended December 31, 2002. The valuation was done as of December 31, 2002, using established valuation techniques, specifically, the income and market approaches.

Intangible Assets

In accordance with FAS 144, the Company performs tests for impairment of its long-lived assets, including intangible assets whenever events or circumstances suggest that such assets may be impaired. FAS 144 requires the Company to assess whether the carrying value is recoverable from undiscounted future cash flows. If the assets are not recoverable, the impairment is calculated by the difference between the carrying value of the assets and their fair value which is generally determined based on discounted future cash flows. Accordingly, in the first quarter of fiscal 2003, based on certain indicators of impairment in the printed circuit board assembly inspection division, the Company performed an impairment analysis of purchased intangible assets and certain other long-lived assets associated with the printed circuit board assembly inspection reporting unit. As a result, the Company recorded impairment charges of approximately $2.9 million related to the unamortized portion of the acquired developed and core technology intangible assets and approximately $2.9 million related to certain other long-lived assets to reduce the carrying values of purchased intangible assets and other long-lived assets to their respective estimated values.

Information regarding the Company’s intangible assets is as follows:


											Non
		Developed			Core						Compete
		Technology			Technology			Patents			Contract			Backlog			Total

		(in thousands)
Balance as of September 30, 2002		$	557		$	2,878		$	119		$	—		$	—		$	3,554
	Originating from acquisition of business during the period		2,673			4,329			—			199			557			7,758
	Amortization during the period		(489	)		(527	)		(2	)		(17	)		—			(1,035	)
	Amortization during the period included in discontinued operations		(16	)		(173	)		(6	)		—			—			(195	)
	Amortization of backlog to cost of revenue during the period		—			—			—			—			(557	)		(557	)
	Impairment charge related to discontinued operations		(470	)		(2,332	)		(80	)		—			—			(2,882	)


							Non
	Developed		Core				Compete
	Technology		Technology		Patents		Contract		Backlog		Total

	(in thousands)
Balance as of June 30, 2003	$	2,255	$	4,175	$	31	$	182	$	—	$	6,643

NOTE 9-Earnings Per Share

Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding. Diluted earnings per share is computed in the same manner and also gives effect to all dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of stock options issued to employees under employee stock option plans and warrants.

The following table sets forth the computation of basic and diluted net income (loss) per share:


				Three Months Ended						Nine Months Ended
				June 30,						June 30,

				2003			2002			2003			2002

				(in thousands, except per share data)
Net income (loss) from continuing operations				$	(3,363	)	$	2,896		$	(12,353	)	$	3,956
Net loss from discontinued operations					(5,607	)		(2,779	)		(44,647	)		(8,815	)

Net income (loss)				$	(8,970	)	$	117		$	(57,000	)	$	(4,859	)

Basic net income (loss) per share:
	Net income (loss) from continuing operations			$	(0.21	)	$	0.17		$	(0.77	)	$	0.25
	Net loss from discontinued operations				(0.35	)		(0.16	)		(2.78	)		(0.56	)

	Net income (loss) per share			$	(0.56	)	$	0.01		$	(3.55	)	$	(0.31	)

Diluted net income (loss) per share:
	Net income (loss) from continuing operations			$	(0.21	)	$	0.16		$	(0.77	)	$	0.24
	Net loss from discontinued operations				(0.35	)		(0.16	)(2)		(2.78	)		(0.56	)(2)

	Net income (loss) per share			$	(0.56	)	$	0.01		$	(3.55	)	$	(0.31	)(2)

Weighted average shares for net income (loss) per share:					16,003			17,031			16,036			15,564
		Effect of dilutive securities:
			Employee stock options		—			968			—			972

Weighted average shares for diluted net income per share					16,003	(1)		17,999			16,036	(1)		16,536

(1) The effect of dilutive securities from employee stock options and warrants to purchase 493,562 and 445,111 shares of common stock for the three and nine months ended June 30, 2003, respectively, was not included in the computation of diluted earnings per share as the effect is anti-dilutive due to net losses.

(2) The effect of dilutive securities from employee stock options and warrants to purchase 968,000 and 972,000 shares for the three and nine months ended June 30, 2002, respectively, was not included in the computation of diluted earnings per share as the effect is anti-dilutive due to net losses

During the three and nine month periods ended June 30, 2003, options to purchase 834,374 and 1,103,799 shares, respectively, were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of common shares for the respective periods. During the three and nine month periods ended June 30, 2002, options to purchase 242,012 and 215,089 shares, respectively, were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of common shares for the respective periods.

NOTE 10- Geographic Information

Through January 14, 2003, the Company conducted business in three operating segments: flat panel display products, cathode ray tube display and high quality glass inspection products and printed circuit board assembly inspection products. In January 2003, the Company implemented a plan to exit the printed circuit board assembly inspection business. In June 2003, the Company implemented a plan to exit the cathode rate tube display and high quality glass inspection businesses. Accordingly, the operating results of these business segments have been reclassified as discontinued operations and the Company now conducts business in one segment.

The Company sells its products for the flat panel display industry directly to customers in Korea and Taiwan and through both direct sales and a value-added reseller, Ishikawajima-Harima Heavy Industries Co., Ltd. in Japan.

The following is a summary of revenue by geographic area based on location where the product was shipped:


			Three Months Ended				Nine Months Ended
			June 30,				June 30,

			2003		2002		2003		2002

			(in thousands)
Revenue:
	Korea		$	13,802	$	9,143	$	36,955	$	21,557
	Taiwan			3,925		5,345		8,431		10,553
	Japan			269		477		830		4,277

		Total	$	17,996	$	14,965	$	46,216	$	36,387

Sales to individual unaffiliated customers in excess of 10% of total revenue were as follows:


	Three Months Ended						Nine Months Ended
	June 30,						June 30,

	2003			2002			2003			2002

Customer A		75	%		37	%		56	%		36	%
Customer B		21	%		*			15	%		11	%
Customer C		*			14	%		19	%		*

* Customer accounted for less than 10% for the period

Accounts receivable from individual unaffiliated customers in excess of 10% of total gross accounts receivable were as follows:


	June 30,			September 30,
	2003			2002

Customer A		37	%		32	%
Customer B		*			18	%
Customer D		22	%		*
Customer E		13	%		*

* Customer accounted for less than 10% for the period

NOTE 11-Comprehensive Income

The components of comprehensive income were as follows:


			Three Months Ended						Nine Months Ended
			June 30,						June 30,

			2003			2002			2003			2002

			(in thousands)						(in thousands)
Net income (loss)			$	(8,970	)	$	117		$	(57,000	)	$	(4,859	)
Other comprehensive income (loss):
	Change in unrealized gain on investments			(124	)		1			(50	)		(112	)
	Currency translation adjustments			(99	)		(52	)		(26	)		(91	)

		Other comprehensive income (loss)		(223	)		(51	)		(76	)		(203	)

Total comprehensive income (loss)			$	(9,193	)	$	66		$	(57,076	)	$	(5,062	)

NOTE 12-Restructuring Charges

During the fourth quarter of fiscal 2002, the Company implemented a restructuring plan to reduce its workforce, consolidate and close certain facilities and write-off related fixed assets in accordance with a management-approved plan. The Company recorded a restructuring charge of $2.6 million, which was comprised of approximately $550,000 for employee severance and related benefits, $1.3 million related to excess facilities and $700,000 of abandoned assets with no future economic benefit. The charge for excess facilities relates to rent obligations under long term operating lease agreements which are to be paid in cash through December 2006. In the three month period ended March 31, 2003, the Company renegotiated the terms of the lease obligation related to one of the excess facilities, resulting in a reduction to the liability of approximately $237,000. In the three-month period ended June 30, 2003, the

Company subleased a portion of one of the excess facilities, resulting in a reduction to the liability of approximately $483,000. These benefits were taken as part of the discontinued operations. As of June 30, 2003, the remaining liability associated with the restructuring plan was approximately $388,000, which consisted of operating lease obligations associated with excess facilities. Management settled all employee severance and related benefits in the second quarter of fiscal 2003.

During the fourth quarter of fiscal 2001, the Company implemented a restructuring plan as a result of several initiatives, including the integration of Intelligent Reasoning Systems, Inc. into the printed circuit board assembly inspection division, the combining of sales and service into one organization and the Company’s continuing strategy to outsource manufacturing. As of June 30, 2003, the remaining liability associated with this restructuring plan was approximately $296,000, which represented contractual payments to be paid to a former executive officer of the Company through March 2004. There have been no adjustments to the liability.

NOTE 13-Warranty Obligations

The Company generally offers warranty coverage for a period of one year from the date of final customer acceptance. Upon product shipment, the Company records the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment. Factors that affect the Company’s warranty liability include the number of installed units under warranty, product failure rates, material usage rates and the efficiency by which the product failure is corrected. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amount as necessary.

Changes in the Company’s product liability during the nine month period ended June 30, 2003, were as follows:


		June 30,
		2003

		(in thousands)
Balance at September 30, 2002		$	2,383
	Estimated warranty cost of new shipments during the period		1,458
	Warranty charges during the period		(1,359	)
	Changes in liability for pre-existing warranties, including expirations		(364	)
	Liability assumed as a result of the acquisition of the RTP Assets		150

Balance at June 30, 2003		$	2,268

NOTE 14-Stock Repurchase Program

In August 2002, the Company’s Board of Directors approved a stock repurchase program authorizing the Company to repurchase up to an aggregate of $25.0 million of the Company’s common stock. The repurchase program was terminated on January 15, 2003. The repurchases were made from time to time on the open market at prevailing prices, in negotiated transactions off the market or pursuant to a 10b5-1 plan adopted by the Company. The 10b5-1 plan allowed the Company to repurchase its shares during a period in which the Company was in possession of material non-public information, provided that the Company communicated share repurchase instructions to the broker at a time when it was not in possession of such material non-public information. During the period October 1, 2002 through January 15, 2003, the Company repurchased 903,032 shares for an aggregate repurchase price of approximately $17.7 million. As of January 15, 2003, the Company had purchased a total of 1,253,932 shares for an aggregate repurchase price of approximately $24.6 million.

NOTE 15-Shareholders’ Equity

On February 4, 2003, at the Company’s Annual Meeting of Shareholders, the Company’s shareholders approved an increase of 400,000 shares reserved for grant under the Company’s Amended and Restated 1995 Stock Option Plan from a total of 2,590,943 shares to 2,990,943 shares and an increase of 250,000 shares authorized for issuance under the Company’s 1995 Employee Stock Purchase Plan from a total of 1,000,000 shares to 1,250,000 shares

NOTE 16-Legal Proceedings

The Company filed a lawsuit captioned Photon Dynamics, Inc. vs. PanelVision Technology and Guillermo Toro-Lira, No. CO202563PJH filed on May 28, 2002, in the U.S. District Court for the Northern District of California, County of Santa Clara. The Company is alleging infringement of a U.S. Patent owned by it and seeking full compensatory damages and an injunction against the defendants. On July 17, 2002, the defendants answered the Company’s complaint and asserted a counterclaim alleging damages of at least $6.0 million in compensatory damages for loss of business. The Company believes that the counterclaims are without merit and intends to vigorously contest the counterclaims. On January 23, 2003, the Company added Shimadzu Corporation as an additional defendant. On April 23, 2003, the defendants added additional counterclaims against the Company alleging violations of the antitrust laws and requesting the damages sought to be trebled. Subsequently, the court bifurcated the antitrust claims of Toro-Lira and Shimadzu Corporation against the Company, thus deferring any consideration of these claims until the conclusion of the patent infringement issues. An adverse determination in this litigation may have a material adverse effect on the financial condition or results of operations of the Company.

The Company has been named as defendant in a lawsuit captioned Thomason v. Photon Dynamics, Inc., No. 02CC03568, filed on February 28, 2002 in the Superior Court of the State of California, County of Orange. The plaintiff in this action has purported to assert that he was wrongly not allowed to exercise certain stock options and is seeking damages of approximately $900,000. On March 29, 2002, the Company responded to the lawsuit and filed a counterclaim against the plaintiff for breach of a general release agreement. On December 19, 2002, the Company filed a motion for summary judgment. While the Company intends to vigorously

contest the action, it cannot predict the outcome of this litigation. The Company believes that an adverse determination in this litigation would not have a material adverse effect on its financial condition or results of operations.

The Company and certain of its directors and officers have been named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The plaintiff, who previously served as one of the Company’s officers, has asserted several causes of action arising out of alleged misrepresentations made to plaintiff regarding the existence and enforcement of the Company’s insider trading policy. The plaintiff is seeking damages of approximately $17.7 million for defendants’ alleged refusal to allow plaintiff to sell shares of the Company’s stock in May of 2000, plus unspecified emotional distress and punitive damages. On December 6, 2001, the court granted defendants’ motion to dismiss the complaint for failure to allege facts sufficient to state a cause of action, with leave to file an amended complaint. On January 17, 2002, plaintiff filed his amended complaint and defendants again moved to dismiss the action. On June 27, 2002, the court issued an order granting in part and denying in part the motion, and further granted plaintiff an opportunity to restate certain claims. On October 1, 2002, plaintiff filed his Second Amended Complaint, which was heard on April 8, 2003, and defendants again moved to dismiss the action. On April 21, 2003, the court granted in part and denied in part the Company’s motion. The pleadings have been finalized and certain claims against the Company and the individual defendants will proceed. The Company believes the plaintiff’s case is without merit and intends to defend this action vigorously. Although the Company cannot predict the outcome of this litigation, the Company believes that any adverse judgment in this litigation would not have a material adverse effect on the Company’s financial condition or results of operations.

NOTE 17 -Subsequent Events

In April 2003, the Company extended its bank line of credit until June 2003, and, in June 2003, further extended its line of credit until July 2003. In July 2003, the line of credit was renewed through July 2004. The line of credit is secured by substantially all of the Company’s assets and contains certain financial and other covenants. The Company has not made any drawings under this line as of June 30, 2003.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties, including the risk factors set forth in this discussion, especially under the caption “Factors Affecting Operating Results” and elsewhere in this Form 10-Q. Generally, the words “anticipate”, “expect”, “intend”, “believe” and similar expressions identify forward-looking statements. The information included in this Form 10-Q is as of the filing date with the Securities and Exchange Commission and future events or circumstances could differ significantly from the forward-looking statements included here. Accordingly, we caution readers not to place undue reliance on such statements. We expressly disclaim any obligation to update or alter our forward-looking statements, whether, as a result of new information, future events or otherwise.

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto in Item 1 above and with our financial statements and notes thereto for the year ended September 30, 2002, contained in our Annual Report on Form 10-K.

Overview

We are a leading provider of yield management solutions to the flat panel display industry. Our test, repair and inspection systems are used by manufacturers to collect data, analyze product quality and identify and repair product defects at critical steps in the manufacturing process. We recently acquired rapid thermal processing technology, which enables manufacturers of flat panel displays to thermally activate low temperature poly-silicon films at temperatures that would otherwise distort or destroy underlying glass substrates. We also recently acquired substantially all of the assets of Summit Imaging, Inc., which supplies cooled cameras for our manufacturing process. These acquisitions support our strategy of owning key technologies which will positively impact our products’ technology content and lower the cost of our products.

Through January 2003, we offered yield management solutions for the printed circuit board assembly industry; however, in January 2003, we implemented a plan to exit the printed circuit board assembly inspection business. Through June 2003, we offered yield management solutions for cathode ray tube display and high quality glass industries; however in June 2003, we implemented a plan to exit the cathode ray tube display and high quality glass business. Accordingly, the operating results of these business segments have been presented as discontinued operations and our results of operations for the prior periods have been reclassified to conform to the current period’s presentation.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to accounts receivable, inventories, purchase order commitments, warranty obligations, intangible assets and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured.

We account for certain of our product sales, including sales to a value added reseller, as arrangements with multiple deliverables. For arrangements with multiple deliverables, we recognize revenue for the delivered items if the delivered items have value to the customer on a standalone basis, and the amount of revenue for delivered elements is not subject to refund, we have met defined

customer acceptance experience levels for the delivered items, and the fair value of undelivered items, such as installation and system upgrade rights, can be reliably determined. We allocate revenue to the delivered items based on the amount due and billable upon shipment, with the remaining amount recognized after installation and acceptance when the final amount becomes due. We recognize all other product sales upon customer acceptance. We recognize revenue from the sale of spare parts upon shipment.

We record a provision for estimated sales returns in the same period as the related revenue is recorded, which is netted against revenue. These estimates are based on historical sales returns and other known factors. If the historical data we use to calculate these estimates does not properly reflect future returns, additional provisions may be required.

Accounts Receivable

We maintain an allowance for the inability of our customers to make required payments. These estimates are based on historical data, the length of time the receivables are past due and other known factors. If a single customer returned a product or was unable or unwilling to make payments, additional allowances may be required as certain of our products have selling prices in excess of $1.5 million per unit. Accordingly, a single customer could have a material adverse effect on our results of operations.

Inventories

We make purchase commitments for inventory based upon existing backlog and sales forecasts. To mitigate supply constraints and to fulfill orders for non-standard configurations, we maintain certain inventory levels especially for parts with long lead times.

Inventories consist of raw materials, work-in-process and finished goods and are stated at the lower of cost or market. Cost is computed using currently adjusted standards which approximate actual costs on a first-in, first-out basis. We assess the recoverability of all inventory and purchase commitments to determine whether write-downs are required. Inventory which is obsolete (defined as inventory that will no longer be used in the manufacturing process) or in excess of the forecasted usage is written down to its estimated fair value based on projected demand, historical usage and other known factors. If actual demand is lower than our forecast, additional inventory write-downs may be required.

Warranty Obligations

Our warranty policy generally states that we will provide warranty coverage for a period of one year from final acceptance. We record the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment, upon product shipment. Our warranty obligation is affected by the number of installed units under warranty, product failure rates, material usage rates and the efficiency by which the product failure is corrected. Should actual product failure rates, material usage and labor efficiencies differ from our estimates, revisions to the estimated warranty liability would be required.

Goodwill

We account for goodwill and other intangible assets resulting from our acquisitions in accordance with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” (“FAS 142”). FAS 142 prohibits the amortization of goodwill and intangible assets with indefinite useful lives. FAS 142 requires that these assets be reviewed for impairment at least annually and more frequently if indicators of impairment exist. The process for evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. In estimating the fair value of the reporting unit with recognized goodwill, we make estimates and judgments about the future cash flows of the reporting unit. Our cashflow forecasts are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying business. We also consider our market capitalization (adjusted for unallocated monetary assets such as cash, marketable debt securities and debt) in determining the fair value of the respective businesses. Should actual results differ from our estimates, revisions to the recorded amount of goodwill could be reported.

Long-Lived Assets and Intangible Assets

Intangible assets with finite lives and other long-lived assets are amortized over their estimated useful lives and subject to evaluation for impairment. We review long-lived assets including intangible assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable, such as a significant industry downturn, significant decline in the market value of the company, or significant reductions in projected future cash flows. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and

its eventual disposition is less than its carrying amount. An impairment charge, if any, is determined using discounted cash flows. In assessing the recoverability of long-lived assets including intangible assets we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.

Restructuring Costs

We have accounted for restructuring costs incurred prior to December 31, 2002, in accordance with the provisions of Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Restructuring costs, associated with the discontinued operations, occurring subsequent to December 31, 2002, have been accounted for under the Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities”. These accruals include estimates pertaining to employee separation costs and related abandonment of excess equipment and facilities. Actual costs may differ from these estimates.

Contingencies and Litigation

We make an assessment of the probability of an adverse judgment resulting from current and threatened litigation. We accrue the cost of an adverse judgment if, in our estimation, the adverse settlement is probable and we can reasonably estimate the ultimate cost of such litigation. We have made no such accruals at June 30, 2003.

Results of Operations

The percentage of net revenue represented by certain line items in our consolidated statement of operations for the periods indicated, are set forth in the table below.


			Three Months Ended						Nine Months Ended
			June 30,						June 30,

			2003			2002			2003			2002

Revenue				100.0	%		100.0	%		100.0	%		100.0	%
Cost of revenue				65.5			50.7			67.7			54.3

Gross margin				34.5			49.3			32.3			45.7

Operating expenses:
	Research and development			35.1			20.5			35.1			21.4
	Selling, general and administrative			17.6			15.5			21.6			19.1
	Acquired in-process research and development			3.5			—			5.4			—
	Amortization of intangible assets			2.3			—			2.2			—

		Total operating expenses		58.5			36.0			64.3			40.5

Income (loss) from operations				(24.0	)		13.3			(32.0	)		5.2
Interest income and other, net				5.3			6.1			5.3			5.6

Income (loss) from continuing operations				(18.7	)		19.4			(26.7	)		10.8
Loss from discontinued operations				(31.2	)		(18.6	)		(96.6	)		(24.2	)

Net income (loss)				(49.9	)		0.8			(123.3	)		(13.4	)

Revenue

Revenue for the three months ended June 30, 2003 was approximately $18.0 million compared to approximately $15.0 million in the same period of the prior fiscal year, representing an increase of approximately $3.0 million, or 20%. This increase was primarily due to increased shipments of our ArrayChecker 3500 and 3500 upgrades. Revenue for the nine months ended June 30, 2003, was approximately $46.2 million compared to approximately $36.4 million for the nine months ended June 30, 2002, representing an increase of approximately $9.8 million, or 27%. This increase was primarily due to an increase in Array Checker unit volumes compared to the same period in the prior fiscal year and approximately $3.6 million of revenue contributed by the rapid thermal processing products which is based on the technology we acquired in November 2002.

Our international revenue is derived primarily from customers in Korea, Taiwan and Japan. International revenue represented 100% of our revenue in the three and nine month periods ended June 30, 2003 and 2002. For the three month period ended June 30, 2003, revenue from Taiwan and Japan, collectively, decreased approximately $1.6 million while revenue from Korea increased approximately $4.7 million compared to the same period of the prior fiscal year. For the nine months ended June 30, 2003, revenue from Japan and Taiwan decreased approximately $5.6 million while revenue from Korea increased approximately $15.4 million over the same period of the prior fiscal year. These fluctuations are due to the buying patterns of our customers, which have been uneven in fiscal 2003, primarily due to overriding market conditions.

Gross Margin

Gross margin decreased to approximately 35% in the three month period ended June 30, 2003, from approximately 49% in the three month period ended June 30, 2002. For the nine month period ended June 30, 2003, gross margin was 32% as compared to 46% for the same period of the prior fiscal year. The overall decrease in gross margin for the nine months ended June 30, 2003 was attributed to the contribution of lower margins from end-of-life pricing on the ArrayChecker 2000 systems, manufacturing inefficiencies resulting from the introduction of our new ArrayChecker 3500 product and 3500 upgrades, and lower modulator yields. In addition, non-recurring charges related to the amortization of backlog acquired in our acquisition of rapid thermal processing backlog from Intevac, Inc. had a negative impact on gross margin of 1% for the nine months ended June 30, 2003.

Research and Development

Our research and development expenses consisted primarily of salaries, related personnel costs, depreciation, prototype materials, patent filing costs and fees paid to consultants and outside service providers, all of which relate to the design, development, testing, pre-manufacturing and improvement of our products. Research and development expenses were approximately $6.3 million and $3.1 million, or 35% and 21%, of net revenue in the three months ended June 30, 2003 and 2002, respectively, reflecting an increase of approximately $3.2 million. For the nine months ended June 30, 2003 and 2002, research and development expenses were approximately $16.2 million and $7.8 million, or 35% and 21%, of net revenue, respectively, reflecting an increase of approximately $8.4 million. The increases in both the three and nine months ended June 30, 2003, as compared to the same periods in fiscal 2002, were primarily attributable to higher spending on prototype materials and engineering headcount to support additional funding requirements for our generation 5, 6 and 7 platforms and cell and module product development, and to higher levels of spending associated with the acquisitions of Akcron and the rapid thermal processing technology. We expect research and development expenses to remain a high percentage of revenue as we continue to concurrently develop our generation 5, 6 and 7 systems.

Selling, General and Administrative

Our selling, general and administrative expenses consisted primarily of salaries and related expenses for marketing, sales, finance, administration, human resources personnel, legal and accounting, commissions, insurance and other corporate expenses. Selling, general and administrative expenses were approximately $3.1 million and $2.3 million, or 18% and 16% of net revenue, in the three months ended June 30, 2003 and 2002, respectively. For the nine months ended June 30, 2003 and 2002, selling, general and administrative expenses were approximately $10.0 million and $6.9 million, or 22% and 19% of revenue, respectively. The increases in selling, general and administrative expenses of approximately $852,000 and approximately $3.1 million from the three and nine month periods ending June 30, 2002, respectively, were primarily attributed to increases in legal, accounting and directors’ and officers’ insurance expenses, expenses related to corporate governance requirements, and severance expenses. We have embarked on several selling, general and administrative expense reduction initiatives with a goal to reduce our selling, general and administrative expenses in coming quarters.

Acquired In-Process Research and Development

In November 2002, we completed our acquisition of certain assets from Intevac, Inc. related to Intevac’s rapid thermal processing technology used for activating low temperature poly-silicon during the manufacturing process for flat panel displays. In May 2003, we acquired substantially all of the assets of Summit Imaging, Inc. The purchase price of both acquisitions has been allocated in accordance with FAS 141, “Business Combinations,” including in-process research and development charges of approximately $1.8 million and $625,000, respectively. These charges were expensed on the acquisition date as they represented ongoing research and development projects that had not yet reached technological feasibility and had no alternative future uses.

Acquired in-process research and development was identified and valued through interviews with acquired company executives, analysis of data concerning developmental products and their stage of development, the time and resources needed to complete the projects, their expected income generating ability, target markets and associated risks. The income approach, which includes an analysis of the markets, cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing in-process research and development. We discounted back to their present value projected incremental cash flows using discount rates of 25% and 50% for the Intevac technology and Summit Imaging asset purchase, respectively, which was determined after consideration of our weighted average cost of capital and the weighted average return on assets.

In-process research and development projects related to Intevac included a new transport system for more efficient handling of larger glass, redesign of the lamphouse for selective heating of the film and enhancement of low oxygen technology. As of June 30, 2003, these projects have been substantially completed.

In-process research and development related to Summit Imaging involves the design of the next generation cooled cameras for the Company’s ArrayChecker tools. At the time of acquisition, the project was approximately 65% complete, and is expected to be completed by the end of fiscal 2004.

Risks associated with our acquired in-process research and development include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. The nature of the efforts required to develop the acquired in-process research and development into commercially viable products principally relate to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the products can be produced to meet their design specifications, including functions, features and technical performance requirements. As such, the timing of completion and ultimate commercial application are affected by the successful completion of these activities and ultimately, market acceptance.

Amortization of Intangibles

The identified intangible assets are being amortized over a two to five year period, commencing on the date of the acquisitions. We have recorded related amortization expense of approximately $408,000 and $1.0 million for the three and nine months ended June 30, 2003, respectively.

Interest Income and Other, Net

Interest income and other, net consisted primarily of interest income, foreign currency exchange gains and losses, changes in the fair value of derivative financial instruments and other miscellaneous income and expense. Interest income and other, net was approximately $952,000 and $902,000 for the three months ended June 30, 2003 and 2002, respectively and approximately $2.4 million and $2.1 million for the nine months ended June 30, 2003 and 2002, respectively. The increase in both the current quarter and the nine months ended June 30, 2003 was primarily attributable to increased exchange gains due to currency fluctuations and realized gains on securities.

Discontinued Operations

In January 2003, we implemented a plan to exit the printed circuit board assembly inspection business. The loss from discontinued operations related to the disposition of the printed circuit board assembly inspection business for the nine months ended June 30, 2003 included a write-off of inventory of approximately $7.8 million, a write-off of accounts receivable of approximately $1.7 million, a write-off of licensed technology of approximately $1.9 million, and impairment charges of approximately $15.1 million of goodwill, approximately $2.9 million of purchased intangibles and approximately $2.5 million of long-lived assets.

In June 2003, we implemented a plan to exit the cathode ray tube display and high quality glass inspection business. The loss from discontinued operations related to the disposition of the cathode ray tube display and high quality inspection business for both the three and nine months ended June 30, 2003, included a write-off of inventory of approximately $2.0 million, a write-off of accounts receivable of approximately $460,000, and a write-off of operating leases of approximately $388,000.

Loss from discontinued operations for the three and nine month periods ended June 30, 2003 and 2002 were as follows:


		Three Months Ended						Nine Months Ended
		June 30,						June 30,

		2003			2002			2003			2002

		(in thousands)
Loss from discontinued operations Printed circuit board business		$	(578	)	$	(2,032	)	$	(38,755	)	$	(7,046	)
	Cathode ray tube display and high quality glass inspection business		(5,029	)		(747	)		(5,892	)		(1,769	)

Loss from discontinued operations		$	(5,607	)	$	(2,779	)	$	(44,647	)	$	(8,815	)

Liquidity and Capital Resources

We have financed our operations primarily by a combination of cash flows from operations and public stock offerings. At June 30, 2003, we had approximately $116.4 million in cash, cash equivalents and short-term investments. This is a decrease of approximately $53.8 million from $170.1 million at September 30, 2002.

Operating Activities of Discontinued Operations

In January 2003, we implemented a plan to exit the printed circuit board assembly inspection business and in June 2003, we implemented a plan to exit the cathode ray tube display and high quality glass inspection business. Accordingly, the operating results of these business segments have been reclassified as discontinued operations. Cash used by discontinued operations during the nine month period ended June 30, 2003 is as follows:


		Nine Months Ended
		June 30,

		2003			2002

		(in thousands)
	Printed circuit board business	$	(10,756	)	$	(5,267	)
	Cathode ray tube display and high quality glass inspection business		(1,114	)		(2,891	)

Net cash used in discontinued operations		$	(11,870	)	$	(8,158	)

Operating Activities

During the first nine months of fiscal 2003, net cash used in operating activities from continuing operations was approximately $4.4 million. Significant components of this use of cash from continuing operations were a net loss of approximately $12.4 million, offset in part by approximately $5.8 million of non-cash charges such as acquired in-process research and development, amortization of intangibles, depreciation and stock ownership expenses. Other components included an increase in accounts receivable of approximately $2.5 million, a reduction in other current liabilities of approximately $2.1 million and an increase in deferred revenue of approximately $5.9 million.

During the first nine months of fiscal 2002, net cash used in operating activities from continuing operations was approximately $1.9 million. The primary components of this use of cash from continuing operations were increases in accounts receivable of approximately $7.2 million and other current assets of approximately $4.3 million, a decrease in deferred revenue of approximately $1.3 million, offset in part by an increase in accounts payable of approximately $2.1 million, and a decrease in inventory of approximately $1.8 million.

Investing Activities

During the first nine months of fiscal 2003, net cash provided by investing activities from continuing operations was approximately $22.8 million. Cash provided by investing activities was primarily the result of the redemption of short-term investments of approximately $465.3 million, offset in part by the purchase of short-term investments of approximately $419.3 million, the acquisition of certain assets from Intevac, Inc. for $20.0 million, the acquisition of substantially all of the assets of Summit Imaging for approximately $1.6 million and approximately $1.6 million in purchases of capital equipment.

During the first nine months of fiscal 2002, net cash used in investing activities from continuing operations was approximately $73.6 million. Cash used by investing activities was primarily the result of the purchase of short-term investments of approximately

$462.7 million, offset in part by the redemption of short-term investments of approximately $389.7 million and approximately $645,000 in purchases of capital equipment.

Financing Activities

During the first nine months of fiscal 2003, cash used by financing activities from continuing operations was approximately $14.3 million. This was the result of repurchases of common stock of approximately $17.7 million, offset in part by employee exercises of stock options of approximately $3.2 million.

During the first nine months of fiscal 2002, cash provided by financing activities from continuing operations was approximately $112.0 million. This was primarily the result $107.0 million from the public sale of common stock, approximately $4.6 million of employee exercises of stock options, and approximately $360,000 from the exercise of a warrant to purchase 21,285 shares.

The timing of and amounts received from employee stock option exercises are determined by the decisions of the respective option holders, and are not controlled by us. Therefore, funds raised from the issuance of common stock upon the exercise of employee stock options should not be considered an indication of additional funds to be raised in future periods.

In August 2002, our Board of Directors approved a stock repurchase program authorizing us to repurchase up to an aggregate of $25.0 million of our common stock. The stock repurchase program was terminated on January 15, 2003 and as of that date we had repurchased 1,253,932 shares for an aggregate of approximately $24.6 million.

Contractual Obligations

The following table summarizes the approximate contractual obligations that we have at June 30, 2003. Such obligations include both non-cancelable obligations and other obligations that are generally non-cancelable except under certain limited conditions.


				Payment due by Period

				Less Than		1-4		After
Contractual Obligations		Total		1 Year		Years		4 Years

		(in thousands)
Operating lease obligations		$	8,837	$	2,351	$	6,397	$	89
Capital lease obligations			14		13		1		—
Purchase obligations			10,955		10,955		—		—

	Total	$	19,806	$	13,319	$	6,398	$	89

The table above includes purchase orders that we have recently placed with Sanmina-SCI Corporation under the terms of our manufacturing outsourcing agreement with Sanmina-SCI, the terms of which requires us to place orders covering a minimum period of 90 days.

Working Capital

We believe that existing liquid capital resources and funds generated from operations combined with the ability, if necessary, to borrow up to $4.0 million under our line of credit, which was recently extended through July 2004, will be sufficient to meet our operating and capital requirements and obligations for at least the next twelve months. However, this forward-looking statement is based upon our current plans and assumptions, which may change, and our capital requirements may increase in future periods. In addition, we believe that success in our industry requires substantial capital in order to maintain the flexibility to take advantage of opportunities as they may arise. We may, from time to time, invest in or acquire complementary businesses, products or technologies and may seek additional equity or debt financing to fund such activities. There can be no assurance that such funding will be available to us on commercially reasonable terms, if at all, and if we were to proceed with acquisitions without this funding or with limited funding it would decrease our capital resources. The sale of additional equity or convertible debt securities could result in dilution to our shareholders.

Impact of Accounting Pronouncements

entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We believe that the adoption of this standard will have no material impact on our consolidated financial statements.

In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”). This statement amends FAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. Management is in the process of assessing the effect of FAS 149 and does not expect the adoption of it, which is effective for contracts entered into or modified after June 30, 2003, to have a material effect on our financial condition or results of operations.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“FAS 150”). FAS 150 establishes standards on the classification and measurement of financial instruments with characteristics of both liabilities and equity. FAS 150 will become effective for financial instruments entered into or modified after May 31, 2003. Management is in the process of assessing the effect of FAS 150 and does not expect the implementation of it to have a material effect on our financial condition or results of operations.

Factors Affecting Operating Results

We have recently sustained losses and we may not be able to return to profitability.

We reported net losses and a decrease in revenue for each of the fiscal years ended September 30, 2002 and 2001, as well as a net loss for the nine months ended June 30, 2003. In the future, our revenue may decline, remain flat or grow at a rate slower than expected, especially in light of the continuing economic slowdown. Our ability to regain profitability on an annual basis is dependent in part on our customers’ recovery from this slowdown and the success of our efforts to reduce operating expenses as a percentage of revenue through our ongoing cost-cutting measures, including our recent restructuring and the discontinuance of our printed circuit board assembly and cathode ray tube and high quality glass inspection operations. In addition, if we determine that the goodwill, intangible assets and other long-lived assets of one of the businesses we acquired have been impaired, then we would need to decrease the carrying value of these assets, which would decrease our net income, or increase our net loss, during the period in which we determined that the assets were impaired. Our operating results are difficult to predict, and there is no assurance that we will be successful in achieving increased revenue, positive cash flows or profitability.

Our operating results are difficult to predict and may vary from investors’ expectations, which could cause our stock price to drop.

We have experienced and expect to continue to experience significant fluctuations in our quarterly results. Consequently, past financial results may not be indicative of future financial results. A substantial percentage of our revenue is derived from the sale of a small number of yield management systems ranging in price from $400,000 to $1.85 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results. Moreover, customers may cancel or reschedule shipments, and production difficulties could delay shipments. For example, as we announced in December 2002, we experienced technical delays with respect to the introduction of our next generation ArrayChecker 3500 system. This delay had a significant impact on the timing of both our revenue and net income for the second quarter of fiscal 2003. As a result, our backlog at the beginning of each quarter does not necessarily determine actual sales for the quarter or any succeeding period.

Other factors which may influence our operating results in a particular quarter include:

• the timing of the receipt of orders from major customers;

• our product mix;

• competitive pricing pressures;

• our ability to obtain components from our single or limited source suppliers in a timely manner;

• continued or worsened financial markets or economic instability in Asia or the world in general;

• any write down in the value of acquired goodwill in the event that we determine that the goodwill has been impaired;

• our ability to design, manufacture and introduce new products on a cost-effective and timely basis;

• the delay between expenses to further develop marketing and service capabilities and the realization of benefits from those improved capabilities; and

• the introduction of new products by our competitors.

If we experience difficulties in any of these areas, our operating results could be significantly and adversely affected and our stock price could decline. In addition, it is possible that in some future quarter our operating results may be below the expectations of public market analysts and investors, which could cause our stock price to fall.

If our products experience performance, reliability or quality problems, our customers may reduce their orders.

We believe that future orders of our products will depend in part on our ability to satisfy the performance, reliability and quality standards required by our customers. Particularly as customers seek increased yields, greater throughput and higher quality end products, we must continually redesign our products to meet the needs of our customers. As with the introduction of any new product, our customers may experience yield loss. For example, with our ArrayChecker 3500, certain customers have experienced yield loss higher than expected. If our products have performance, reliability or quality problems, then we may experience:

• delays in collecting accounts receivable;

• reduced orders;

• additional warranty and service expenses; and

• higher manufacturing costs.

If we are unable to meet the requirements of our customers, our revenue may decrease and our business could be harmed.

In addition, we typically provide a limited warranty on our products for a period of one year from final acceptance by customers. We may incur substantial warranty claim expenses on our products and actual warranty claims may exceed recorded allowances, resulting in harm to our business.

Capital investment by manufacturers of flat panel display products can be highly cyclical and may decline in the future.

Our business depends in large part on capital expenditures by manufacturers of flat panel display products, which in turn depends on the current and anticipated market demand for the end products in that industry. The market for flat panel display products is highly cyclical and has experienced periods of oversupply resulting in significantly reduced demand for capital equipment. For example, the flat panel display industry experienced a downturn in 1998, which led many flat panel display manufacturers to delay or cancel capital expenditures. Additionally, in 2001, due to the general deteriorating economic environment, flat panel display and electronics manufacturers reduced capital expenditures resulting in a decrease in revenue for all segments of our business. If the flat panel display and other markets in which we sell our products do not recover sufficiently or experience further slowdowns in the future, it could cause our revenue to decrease significantly. In addition, the need to invest in the engineering, research and development, and marketing required to penetrate targeted foreign markets and maintain extensive service and support capabilities limits our ability to reduce expenses during these downturns.

We depend on sales to a few large customers in the flat panel display industry, and if we lose any of our large customers our revenue could decrease significantly.

The flat panel display industry is extremely concentrated with a small number of manufacturers producing the majority of the world’s flat panel displays. If one or more of our major customers ceased or significantly curtailed their purchases, our revenue could drop significantly. We may be unable to replace sales to these customers. Sales of flat panel display products to our largest customer represented 56% of our revenue for the nine months ended June 30, 2003. Our three largest customers collectively accounted for 90% of our total revenue, and each in excess of 10% of our total revenue, in the nine months ended June 30, 2003.

We rely upon sales of a limited range of products, and if demand for one product decreases for any reason it could cause our revenue to decline significantly.

Substantially all of our revenue comes from a limited range of products for the flat panel display industry and we expect that these products will continue to account for substantially all of our revenue, particularly given our recent exits from the printed circuit board assembly inspection business and the cathode ray tube display and high quality glass inspection businesses. Any decline in demand for, or failure to achieve continued market acceptance of, our primary products or any new version of these products could harm our business. Continued market acceptance of our array test and array repair products is critical to our success.

We may not be able to develop and introduce new products that respond to evolving industry requirements in a timely manner, which could reduce our ability to compete effectively.

The markets for our products are characterized by rapidly changing technologies and frequent new product introductions. The failure to develop new products and introduce them successfully and in a timely manner could harm our competitive position and results of operations. We believe that our future success will depend in part upon our ability to continue to enhance our existing products and to develop and manufacture new products. For example, the size of glass plates for flat panel displays and the resolution of flat panel displays have changed frequently and may continue to change, requiring us to redesign or reconfigure our flat panel display products.

We expect to continue to incur significant research and development costs. There can be no assurance that we will be successful in the introduction, marketing and cost effective manufacture of any of our new products, that we will be able to timely develop and introduce new products and enhance our existing products and processes to satisfy customer needs or achieve market acceptance, or that the new markets for which we are developing new products or expect to sell current products will develop sufficiently. For example, we recently experienced technical delays relating to the introduction of our next generation ArrayChecker 3500 system causing us to reschedule several shipments from the first quarter to the second quarter of fiscal 2003. We depend on close relationships with our customers and the willingness of those customers to share information with us, and the failure to maintain these relationships could harm our development efforts.

If we are not able to obtain critical components from our single or limited source suppliers, we may experience significant delays in producing our products, which could decrease our revenue for an extended period of time.

We obtain some equipment for our systems from a single source or a limited group of suppliers. For example, we currently obtain materials handling platforms and high-speed image processing systems from single source suppliers. Although we seek to reduce dependence on our sole and limited source suppliers, alternative sources of supply for this equipment may not be available or may be available on unfavorable terms. The partial or complete loss of our sole and limited source suppliers could at least temporarily delay our shipments or otherwise harm our results of operations and damage customer relationships. Further, a significant increase in the price of one or more of these pieces of equipment could harm our results of operations.

All of our revenue is derived from sales to companies located outside the United States, which exposes us to risks that we would not experience with domestic sales.

We expect sales to foreign countries to continue to represent 100% of our revenue. A number of factors may adversely affect our international sales and operations, including:

• political instability and the possibility of hostilities or war;

• imposition of governmental controls;

• fluctuations in the United States dollar, which could increase the foreign sales prices of our products in local currencies;

• export license requirements;

• restrictions on the export of technology;

• limited foreign protection of intellectual property rights;

• trade restrictions;

• changes in tariffs; and

• difficulties in staffing and managing international operations.

If any of these factors occur, our operating results and revenues could be materially and adversely affected.

The outbreak of severe acute respiratory syndrome, or SARS, may impact our operations or adversely affect our customers and therefore harm our business.

The outbreak of SARS has recently had, and may continue to have in the future, a significant impact on a number of countries, particularly in Asia, in which we sell our products. Risks related to the outbreak of SARS include but are not limited to temporary closure of operating facilities in affected locations, travel restrictions and delays, difficulties generating new business opportunities and increased political and social tension. Especially if any of our employees, or any of the employees of our customers, become infected with SARS, we may experience reduced sales and increased costs and our operating results may be harmed.

We may have difficulty integrating the businesses we recently acquired or other businesses or assets we may acquire in the future, and we may not realize the benefits that we expect from these acquisitions.

We have recently consummated several acquisitions, including acquisitions of Intelligent Reasoning Systems, Inc. in July 2001, Akcron Corporation, LTD in September 2002, certain assets from ART Advanced Research Technologies Inc. in July 2002, Intevac, Inc. in November 2002, and substantially all of the assets of Summit Imaging, Inc., in May 2003. We may acquire other assets or companies in the future. Integrating businesses can be a complex, time-consuming and expensive process. If we are not able to do so effectively, we will not be able to realize the benefits that we expect to receive from our past and future acquisitions. For each acquisition, we must integrate separate technologies, product lines, business cultures and practices, employees and systems. Acquisitions are subject to numerous risks, including:

• difficulties in the assimilation of the technologies and products of the acquired company;

• entering markets in which we have no or limited direct prior experience;

• loss of key customers of the acquired company;

• diversion of management resources from the business of the combined company;

• incompatibility of business cultures or practices;

• loss of key employees of the acquired company;

• costs and delays in implementing common systems and procedures;

• potential inefficiencies in delivering services to the customers of the combined company; and

• assumption of unknown or undisclosed liabilities.

Any of these difficulties could increase our operating costs and harm our financial performance. In addition, we may also elect to change our strategic direction and may no longer have need for certain acquired businesses or technologies. For example, we recently exited the printed circuit board assembly inspection business. As a result, some or all of the technologies acquired in connection with certain of our prior acquisitions, including ART Advanced Research Technologies Inc. and Intelligent Reasoning Systems, Inc. have been abandoned. Future acquisitions may also result in potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities and amortization expenses related to acquired intangible assets, which could harm our profitability.

Any failure of, or other problems at or with, Sanmina-SCI Corporation or other third party manufacturers could delay shipments of our flat panel display products, harm our relationships with our customers or otherwise negatively impact our business.

If Sanmina-SCI Corporation or any other third party that we use to manufacture our products is unable to satisfy our quality requirements or provide us with the products and services in a timely manner, our shipments of these products may be delayed, our customer relationships may be harmed and our results of operations may be adversely impacted. There can be no assurance that our relationship with Sanmina-SCI or any other third party that we use to manufacture our products will result in a reduction of our expenses or enable us to satisfy our customers’ quality requirements or to deliver our products to our customers in a timely manner.

If we do not compete effectively in our target markets, we will lose market share.

The markets for yield management systems in the flat panel display industry are highly competitive. We face substantial competition from established competitors that have greater financial, engineering and manufacturing resources than us and have larger service organizations and long-standing customer relationships. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. Competitive pressures may force price reductions that could harm our results of operations. Our customers may also develop technology and equipment that may reduce or eliminate their need to purchase our products. Although we believe we have certain technological and other advantages over our competitors, maintaining and capitalizing on these advantages will require us to continue a high level of investment in engineering, research and development, marketing and customer service support. There can be no assurance that we will have sufficient resources to continue to make these investments or that we will be able to make the technological advances necessary to maintain our competitive advantages.

IHI has determined to exit the market as a value-added reseller of flat panel display products in Japan. We have previously relied on our relationship with IHI to sell our flat panel display products in Japan, and if we are not able to continue to access this important market, our business will be harmed.

We believe that Japanese companies competing with us in sales to the flat panel display industry have a competitive advantage in Japan because of the preference of some local customers for local equipment suppliers. Foreign companies frequently have found it difficult to penetrate the Japanese market and often depend upon local sales channels to sell their products in Japan.

Historically, IHI has been a significant value-added reseller with respect to sales of our flat panel display products in Japan. In the nine months ended June 30, 2003, fiscal 2002 and fiscal 2001, 2%, 8% and 13% of our total revenue came from sales to IHI, respectively. We are currently in discussions with IHI regarding our on-going relationship with IHI and expect that IHI will cease to sell and support our flat panel display products in Japan in the future. If we are unable to negotiate a favorable termination of this relationship with IHI, and to support existing customers or develop new customers in Japan without IHI, our business will be harmed.

IHI’s rights to serve as our exclusive value-added reseller in Japan are currently unresolved. IHI may have the right to market some or all of our products in Japan on an exclusive basis, even exclusive as to us. Consequently, if we are unable to negotiate a favorable termination of this relationship with IHI, we may not be able to compete effectively in Japan. Although IHI must purchase certain critical components from us, IHI may manufacture competing array test systems based on our technology. If this occurs, our business could be harmed. We also have granted IHI the non-exclusive right to manufacture and sell array test systems based on our technology, excluding technology incorporated into some critical components, in Korea, Taiwan and several other countries. Although IHI has neither manufactured these products, nor sold these products in countries other than Japan, our business could be harmed if IHI manufactures and sells array test systems in competition with our own in these countries.

Our success depends in large part on the strength of the active matrix liquid crystal display in the flat panel display industry.

While our technology is applicable to other flat panel display technologies, our experience has been focused on applications for active matrix liquid crystal displays, the most prevalent and one of the highest performance flat panel displays available today. In the nine months ended June 30, 2003, we derived 100% of our revenue from sales of flat panel display products, substantially all of which were based on the active matrix liquid crystal display technology. An industry shift away from active matrix liquid crystal display technology to existing or new competing technologies could reduce the demand for our existing products and require significant expenditures to develop new products, each of which could harm our business.

Our business could be harmed if we fail to properly protect our intellectual property.

Our success depends largely on our ability to protect our intellectual property. While we attempt to protect our intellectual property through patents, copyrights and trade secrets in the United States and other countries, there can be no assurance that we will successfully protect our technology or that competitors will not be able to develop similar technology independently. We cannot assure you that the claims allowed on any patents held by us will be sufficiently broad to protect our technology against competition from third parties with similar technologies or products. In addition, we cannot assure you that any patents issued to us will not be challenged, invalidated or circumvented or that the rights granted thereunder will provide competitive advantages to us. Moreover, the laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States and we could experience various obstacles and high costs in protecting our intellectual property rights in foreign countries. If we are unable to obtain or maintain these protections, we may not be able to prevent third parties from using our intellectual property.

We also rely on trade secrets, proprietary know-how and continuing technological innovation to remain competitive. We have taken measures to protect our trade secrets and know-how, including the use of confidentiality agreements with our employees. It is possible that these agreements may be breached and that the available remedies for any breach will not be sufficient to compensate us for damages incurred.

Litigation may be necessary to enforce or defend against claims of intellectual property infringement, which could be expensive and, if we lose, could prevent us from selling our products.

Litigation may be necessary in the future to enforce our patents and other intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Any litigation, regardless of the outcome, could be costly and require significant time and attention of key members of our management and technical personnel.

Our domestic and international competitors, many of which have substantially greater resources and have made substantial investments in competing technologies, may have patents that will prevent, limit or interfere with our ability to manufacture and sell our products. We have not conducted an independent review of patents issued to third parties. Third parties may assert infringement claims, successful or otherwise, against us, and litigation may be necessary to defend against claims of infringement or invalidity. An adverse outcome in the defense of a patent suit could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease selling our products. Even successful defenses of patent suits can be costly and time-consuming.

We must attract and retain key employees and our management team and employees must work effectively together to maintain and grow our business.

Our future success depends in part on our ability to retain key personnel, particularly senior management and engineers. We also need to attract additional skilled personnel in significant areas of our business to grow. There can be no assurance that we will be able to retain our existing personnel or attract additional qualified employees in the future. We generally do not have employment contracts with our employees and do not maintain key person life insurance on any of our employees.

In addition, our management team recently has experienced significant personnel changes. Elwood H. Spedden recently became our President and Chief Executive Officer when Vincent Sollitto resigned. Jeffrey A. Hawthorne, previously Vice President of Development, recently became Chief Operating Officer and Richard Okumoto recently became our Chief Financial Officer and Secretary when Richard Dissly resigned. In addition, Jon Hopper, former Senior Vice President of our sales and support organization and Bernard T. Clark, former President of the flat panel display business recently resigned. If our management team experiences high attrition or does not work effectively together, it could seriously harm our business.

Earthquakes may damage our facilities.

Our corporate and manufacturing facilities in California are located near major earthquake faults which have experienced earthquakes in the past. In addition, some of our customers in Asia are located near fault lines. In the event of a major earthquake or other disaster in or near the San Francisco Bay Area, our facilities may sustain significant damage and our operations could be harmed. Similarly, a major earthquake in Asia, like the one that occurred in Taiwan in September 1999, could disrupt our operations or the operations of our customers, which could reduce demand for our products.

Our stock price may fluctuate significantly.

The market price of our common stock could fluctuate significantly in response to variations in quarterly operating results and other factors, such as:

• announcements of technological innovations or new products by us or by our competitors;

• government regulations;

• developments in patent or other property rights; and

• developments in our relationships with our customers.

In addition, the stock market has in recent years experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stock is traded. Broad market fluctuations, general economic condition and specific conditions in the flat panel display and cathode ray tube display and high quality glass industries may adversely affect the market price of our common stock.

Some anti-takeover provisions may affect the price of our common stock.

Our Amended and Restated Articles of Incorporation authorize our board of directors to issue up to 5,000,000 shares of preferred stock. The board also has the authority to determine the price, rights, preferences and privileges, including voting rights, of those shares without any further vote or action by the shareholders. The rights of our shareholders will be subject to, and may be impaired by, the rights of the holders of any preferred stock that may be issued in the future. These and other provisions contained in our charter documents and applicable provisions of California law could serve to depress our stock price or discourage a hostile bid in which shareholders could receive a premium for their shares. In addition, these provisions could make it more difficult for a third party to acquire a majority of our outstanding voting stock or otherwise effect a change in control of us.

We do not anticipate paying cash dividends.

We have never declared or paid any cash dividends on our capital stock and do not anticipate paying cash dividends in the foreseeable future. We have also agreed not to pay cash dividends under our current bank line of credit. Instead, we intend to apply any earnings to the expansion and development of our business.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Exchange Rate Risk

We are exposed to changes in foreign currency exchange rates primarily related to the operating results of our foreign affiliates. Actual changes in foreign exchange rates could adversely affect our operating results or financial condition. The potential impact depends upon the magnitude of the rate change. We believe our exposure to changes in foreign currency exchange rates for our cash, accounts receivable and accounts payable is immaterial as substantially all of our cash, accounts receivable and accounts payable are denominated in U.S. dollars.

We purchased forward exchange contracts in the third quarter of fiscal 2003 to hedge certain anticipated foreign currency denominated transactions expected to occur during the next year. Gains and losses on these contracts are being recognized in income at June 30, 2003. Because the effect of movements in currency exchange rates on forward exchange and currency option contracts generally offsets the related effect on the underlying items being hedged, these financial instruments are not expected to subject us to risks that would otherwise result from changes in currency exchange rates. Net foreign currency gains and losses were not material for the three or nine months ended June 30, 2003.

Market Risk

The primary objective of our investment activities is to preserve principal while maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we may invest in may be subject to market risk. To minimize this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit.

Our exposure to market risk relates primarily to interest rate fluctuations in connection with our cash and cash equivalents and short-term investment portfolios. We enter into financial instruments for non-trading purposes and do not have derivative financial instruments in our portfolio.

ITEM 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures. Subject to limitations described below, our management, with the participation of our chief executive officer and chief financial officer has concluded that our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) were effective as of June 30, 2003.

Changes in Internal Control Over Financial Reporting. There was no change in our internal control over financial reporting during the quarter ended June 30, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Limitations on the Effectiveness of Disclosure Controls and Procedures. Our management, including our chief executive officer and our chief financial officer, does not expect that our disclosure controls and procedures will necessarily prevent all error and all fraud. A control system, no matter how well conceived and operated, can only provide reasonable, not absolute, assurance that the objectives of the control system are met. Any control system will reflect inevitable limitations, such as resource constraints, a cost-benefit analysis based on the level of benefit of additional controls relative to their costs, assumptions about the likelihood of future events and human error. Because of the inherent limitations in a cost effective control system, misstatements due to error or fraud may occur and may not be detected. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the objectives of our disclosure control system are met and, as set forth above, our principal executive officer and principal financial officer have concluded, based on their evaluation as of June 30, 2003, that our disclosure controls and procedures were effective to provide reasonable assurance that the objectives of our disclosure controls and procedures were met.

PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

We filed a lawsuit captioned Photon Dynamics, Inc. vs. PanelVision Technology and Guillermo Toro-Lira, No. CO202563PJH filed on May 28, 2002, in the U.S. District Court for the Northern District of California, County of Santa Clara. We are alleging infringement of a U.S. Patent owned by us and seeking full compensatory damages and an injunction against the defendants. On July 17, 2002, the defendants answered our complaint and asserted a counterclaim alleging damages of at least $6.0 million in compensatory damages for loss of business. We believe that the counterclaims are without merit and intend to vigorously contest the counterclaims. On January 23, 2003, we added Shimadzu Corporation as an additional defendant. On April 23, 2003, the defendants added additional counterclaims against us alleging violations of the antitrust laws and requesting the damages sought to be trebled. Subsequently, the court bifurcated the antitrust claims of Toro-Lira and Shimadzu Corporation against us, thus deferring any consideration of these claims until the conclusion of the patent infringement issues. An adverse determination in this litigation may have a material adverse effect on our financial condition or results of operations.

We have been named as defendant in a lawsuit captioned Thomason v. Photon Dynamics, Inc., No. 02CC03568, filed on February 28, 2002 in the Superior Court of the State of California, County of Orange. The plaintiff in this action has purported to assert that he was wrongly not allowed to exercise certain stock options and is seeking damages of approximately $900,000. On March 29, 2002, we responded to the lawsuit and filed a counterclaim against the plaintiff for breach of a general release agreement. On December 19, 2002, we filed a motion for summary judgment. While we intend to vigorously contest the action, we cannot predict the outcome of this litigation. We believe that an adverse determination in this litigation would not have a material adverse effect on our financial condition or results of operations.

We and certain of our directors and officers have been named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The plaintiff, who previously served as one of our officers, has asserted several causes of action arising out of alleged misrepresentations made to plaintiff regarding the existence and enforcement of our insider trading policy. The plaintiff is seeking damages of approximately $17.7 million for our alleged refusal to allow plaintiff to sell shares of our stock in May of 2000, plus unspecified emotional distress and punitive damages. On December 6, 2001, the court granted our motion to dismiss the complaint for failure to allege facts sufficient to state a cause of action, with leave to file an amended complaint. On January 17, 2002, plaintiff filed his amended complaint and we again moved to dismiss the action. On June 27, 2002, the court issued an order granting in part and denying in part the motion, and further granted plaintiff an opportunity to restate certain claims. On October 1, 2002, plaintiff filed his Second Amended Complaint, which was heard on April 8, 2003 and we again moved to dismiss the action. On April 21, 2003, the court granted in part and denied in part our motion. The pleadings have been finalized, and certain claims against us and the individual defendants will proceed. We believe plaintiff’s case is without merit and intend to defend this action vigorously. Although we cannot predict the outcome of this litigation, we believe that any adverse judgment in this litigation would not have a material adverse effect on our financial condition or results of operations.

ITEM 2. Changes in Securities and Use of Proceeds

None.

ITEM 3. Defaults Upon Senior Securities

None.

ITEM 4. Submission of Matters to a Vote of Security Holders

None.

ITEM 5. Other Information

In May 2003, Richard Okumoto was appointed our Chief Financial Officer and Secretary, replacing Richard Dissly, who resigned to pursue other interests. Also in May 2003, Scott Brouse was named our new Vice President of Customer Support and Andrew M. Hawryluk, Ph.D. was named our new Vice President of Engineering.

In June 2003, we implemented a plan to exit the cathode ray tube display and high quality glass inspection business, as more thoroughly described in Note 2 in the notes to condensed consolidated financial statements in this Quarterly Report on Form 10-Q.

ITEM 6. Exhibits and Reports on Form 8-K

(a) Exhibits


Number		Exhibit

3.1(1)		Amended and Restated Articles of Incorporation of the Registrant.

3.2(1)		Certificate of Amendment to Articles of Incorporation of the Registrant.

3.3(2)		Bylaws of the Registrant and amendments thereto.

3.4(3)		Certificate of Determination of Series A1 Preferred Stock of the Registrant.

4.1		Reference is made to Exhibits 3.1, 3.2 and 3.3.

10.22 (4)		2001 Equity Incentive Plan, as amended.

10.29		Offer Letter, dated April 21, 2003, between Richard Okumoto and the Registrant.

31.1		Certification required by Rule 13a-14(a) or Rule 15d-14(a).

31.2		Certification required by Rule 13a-14(a) or Rule 15d-14(a).

32.1*		Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350).

Key to Exhibits:

(1) Previously filed as the like-numbered exhibit to the Registrant’s Registration Statement on Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission on January 14, 2002, as amended, and incorporated herein by reference.

(2) Previously filed as the like-numbered exhibit to the Registrant’s Annual Report on Form 10-KSB for the fiscal year ended September 30, 1998 as filed with the Securities and Exchange Commission on December 18, 1998, and incorporated herein by reference.

(3) Previously filed as the like-numbered exhibit to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 29, 2000, and incorporated herein by reference.

(4) Previously filed as the like-numbered exhibit to the Registrant’s Quarterly Report on Form 10-Q as filed with the Securities and Exchange Commission on May 9, 2003, and incorporated herein by reference.

* The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.

(b) Reports on Form 8-K

On April 15, 2003, we filed a Current Report on Form 8-K, furnishing the press release announcing our preliminary results for the quarter ended March 31, 2003.

On May 6, 2003, we filed a Current Report on Form 8-K, furnishing the transcript of our presentation at the Merrill Lynch Hardware Heaven Technology Conference on April 29, 2003.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


		PHOTON DYNAMICS, INC.

		By:		/s/ RICHARD OKUMOTO

		By:		Richard Okumoto
		Chief Financial Officer and Secretary
		(Duly authorized and principal financial officer)

Dated: August 14, 2003

Exhibit Index


Number		Exhibit

3.1(1)		Amended and Restated Articles of Incorporation of the Registrant.

3.2(1)		Certificate of Amendment to Articles of Incorporation of the Registrant.

3.3(2)		Bylaws of the Registrant and amendments thereto.

3.4(3)		Certificate of Determination of Series A1 Preferred Stock of the Registrant.

4.1		Reference is made to Exhibits 3.1, 3.2 and 3.3.

10.22 (4)		2001 Equity Incentive Plan, as amended.

10.29		Offer Letter, dated April 21, 2003, between Richard Okumoto and the Registrant.

31.1		Certification required by Rule 13a-14(a) or Rule 15d-14(a).

31.2		Certification required by Rule 13a-14(a) or Rule 15d-14(a).

32.1*		Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350).

Key to Exhibits:

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	(1)		The effect of dilutive securities from employee stock options and warrants to purchase 493,562 and 445,111 shares of common stock for the three and nine months ended June 30, 2003, respectively, was not included in the computation of diluted earnings per share as the effect is anti-dilutive due to net losses.

	(2)		The effect of dilutive securities from employee stock options and warrants to purchase 968,000 and 972,000 shares for the three and nine months ended June 30, 2002, respectively, was not included in the computation of diluted earnings per share as the effect is anti-dilutive due to net losses

	•		the timing of the receipt of orders from major customers;

	•		our product mix;

	•		competitive pricing pressures;

	•		our ability to obtain components from our single or limited source suppliers in a timely manner;

	•		continued or worsened financial markets or economic instability in Asia or the world in general;

	•		any write down in the value of acquired goodwill in the event that we determine that the goodwill has been impaired;

	•		our ability to design, manufacture and introduce new products on a cost-effective and timely basis;

	•		the delay between expenses to further develop marketing and service capabilities and the realization of benefits from those improved capabilities; and

	•		the introduction of new products by our competitors.

	•		delays in collecting accounts receivable;

	•		reduced orders;

	•		additional warranty and service expenses; and

	•		higher manufacturing costs.

	•		political instability and the possibility of hostilities or war;

	•		imposition of governmental controls;

	•		fluctuations in the United States dollar, which could increase the foreign sales prices of our products in local currencies;

	•		export license requirements;

	•		restrictions on the export of technology;

	•		limited foreign protection of intellectual property rights;

	•		trade restrictions;

	•		changes in tariffs; and

	•		difficulties in staffing and managing international operations.

	•		difficulties in the assimilation of the technologies and products of the acquired company;

	•		entering markets in which we have no or limited direct prior experience;

	•		loss of key customers of the acquired company;

	•		diversion of management resources from the business of the combined company;

	•		incompatibility of business cultures or practices;

	•		loss of key employees of the acquired company;

	•		costs and delays in implementing common systems and procedures;

	•		potential inefficiencies in delivering services to the customers of the combined company; and

	•		assumption of unknown or undisclosed liabilities.

	•		announcements of technological innovations or new products by us or by our competitors;

	•		government regulations;

	•		developments in patent or other property rights; and

	•		developments in our relationships with our customers.

(1)		Previously filed as the like-numbered exhibit to the Registrant’s Registration Statement on Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission on January 14, 2002, as amended, and incorporated herein by reference.

(2)		Previously filed as the like-numbered exhibit to the Registrant’s Annual Report on Form 10-KSB for the fiscal year ended September 30, 1998 as filed with the Securities and Exchange Commission on December 18, 1998, and incorporated herein by reference.

(3)		Previously filed as the like-numbered exhibit to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 29, 2000, and incorporated herein by reference.

(4)		Previously filed as the like-numbered exhibit to the Registrant’s Quarterly Report on Form 10-Q as filed with the Securities and Exchange Commission on May 9, 2003, and incorporated herein by reference.

*		The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.

(b)		Reports on Form 8-K