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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended September 30, 2003

OR

For the transition period from                          to                         

Commission File Number 0-27234

PHOTON DYNAMICS, INC.

(Exact name of registrant as specified in its charter)

17 Great Oaks Boulevard

San Jose, CA 95119

(Address of principal executive offices, including zip code)

(408) 360-3550

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value per share

(Title of class)

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  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

As of March 31, 2003, the aggregate market value of the voting stock held by non–affiliates of the registrant, computed by reference to the last sale price of such stock as of such date on the NASDAQ National Market, was approximately $140,574,871. Excludes an aggregate of 7,555,563 shares of common stock held by officers and directors and by each person known by the registrant to own 5% or more of the outstanding common stock as of March 31, 2003. Exclusion of shares held by any of these persons should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the registrant, or that such person is controlled by or under common control with the registrant.

As of December 1, 2003, there were 16,480,946 shares of the registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement for the 2004 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K, are incorporated by reference in Part III, Items 10-14 of this Form 10-K.

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PHOTON DYNAMICS, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2003

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K 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. All statements included or incorporated by reference in this Annual Report on Form 10-K other than statements of historical fact, are forward-looking statements. You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “could,” “anticipate,” “expect,” “intend,” “believe,” “continue” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to such statements

Our actual results could differ materially from those projected in the forward-looking statements included herein as a result of a number of factors, risks and uncertainties, including the risk factors set forth under the caption “Factors Affecting Operating Results” in Part II Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K and elsewhere in this Annual Report on Form 10-K. The information included in this Annual Report on Form 10-K 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 herein. Accordingly, we caution readers not to place undue reliance on such statements and we expressly assume no obligation to update the forward-looking statements included in this report after the date hereof.

PART I

Item 1.    Business

Introduction

Photon Dynamics, Inc. (“Photon Dynamics”) is a California corporation incorporated on March 1, 1983. We are a leading provider of yield management solutions to the flat panel display industry. Manufacturers in this industry use our solutions to collect data, analyze product quality and identify and repair product defects at critical steps in their manufacturing processes. Our customers use our test, repair and inspection systems to increase manufacturing yields of high performance flat panel displays used in a number of products, including notebook and desktop computers, televisions and advanced mobile electronic devices such as cellular phones, personal digital assistants and portable video games.

We also offer process equipment solutions designed for low cost, high throughput rapid thermal processing (“RTP”) of thin films on glass substrates. Our technology facilitates activation of low-temperature polysilicon films using substrate heating technology in manufacturing low temperature poly-silicon (“LTPS”) and liquid crystal displays (“LCD”).

During fiscal 2003, we acquired certain assets relating to rapid thermal processing technology from Intevac, Inc. and substantially all of the assets of Summit Imaging, Inc. For further details of these and our fiscal 2002 and 2001 acquisitions, see “Business Combinations,” below.

During fiscal 2003, we implemented a plan to exit both the printed circuit board assembly inspection business and the cathode ray tube display and high quality glass inspection businesses. As a result, we now operate in one reportable business segment – the flat panel display industry. Accordingly, the operating results of both the printed circuit board assembly inspection business and the cathode ray tube display and high quality glass inspection 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. As a result, sales of our flat panel display products represent 100% of our revenues in all fiscal years presented. For further details of our discontinued operations, see Note 3 of our “Notes to Consolidated Financial Statements” included under Part II Item 8. “Financial Statements and Supplementary Data.”

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In the fourth quarter of fiscal 2003, as a result of limited opportunities in the inverter market and uncertainty with regard to flat panel manufacturers’ commitment to LTPS technology, Photon Dynamics performed an impairment analysis of the goodwill and the purchased intangible assets and certain other long-lived assets associated with the RTP reporting unit. As a result of this analysis, Photon Dynamics recorded impairment charges of approximately $7.3 million related to goodwill and $2.7 million related to the unamortized portion of the acquired developed technology, core technology and patent intangible assets. See Note 5 of our “Notes to Consolidated Financial Statements” in Part II, Item 8. “Financial Statements and Supplementary Data” for further information, which is incorporated by reference.

Additional information about Photon Dynamics, Inc. is available on our website at www.photondynamics.com. We make available free of charge, on or through our website, our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after electronically filing such reports with the Securities and Exchange Commission. Information contained on our website is not part of this Annual Report on Form 10-K or our other filings with the SEC.

Industry

Flat Panel Display Industry Background

Continuous innovations in microelectronics and materials science have enabled flat panel displays with sharper resolution, brighter pixels and faster imaging to be produced in varying sizes for differing applications. Similar innovations have led to the introduction of a broad array of electronic devices with increasing performance and decreasing size characteristics. Manufacturing these highly engineered products requires complex, multi-stage production processes, increasing the potential for defects and errors associated with equipment failures, contamination of materials, drift in process parameters, human error and other related factors. Manufacturing complexity also increases investment in work-in-progress inventories and lengthens production cycles. To better manage and enhance their yields and reduce product costs, manufacturers are increasing their emphasis on automated testing, inspection and repair at various points in the manufacturing process. As production processes become more complex and reducing material and labor costs becomes increasingly important, we believe that ongoing yield management solutions provides manufacturers with an important competitive advantage.

Growth in the mobile electronic devices market, the desktop computer market and the television market have driven the demand for flat panel displays, which offer reduced size, weight, power consumption and heat emission and better picture quality as compared to cathode ray tube displays, the current standard technology for stationary display devices. In addition to their dominance of high-performance mobile applications, flat panel displays offer similar advantages for stationary display applications even though they are currently more expensive than cathode ray tube displays with comparable viewing areas.

The active matrix liquid crystal display, the most prevalent and one of the highest performance flat panel displays available today, produces full color images and operates at much faster refresh rates than earlier passive monochrome liquid crystal displays. The color capability, resolution, speed and picture quality of active matrix liquid crystal displays currently make these displays the preferred choice for high-performance mobile applications, such as portable computers, multimedia and other applications requiring the display of video and graphics.

Manufacture of Active Matrix Liquid Crystal Displays.    The manufacture of active matrix liquid crystal displays is an extremely complex process, which has been developed and refined for different panel sizes and resolutions through research and development, pre-production prototyping and commercial production. Manufacturing an active matrix liquid crystal display involves a series of three principal phases. The first phase of the process, array plate and color filter plate, is the fabrication of an array of thin-film transistors (“TFT”), each of which is connected to a transparent sub-pixel, the smallest addressable unit in the display. Three sub-pixels are combined to produce a pixel, millions of which are fabricated, using semiconductor processes, on large

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glass substrate. A similar process is used to fabricate an array of color filter sub-pixels on a large glass substrate. The second phase, cell assembly, is the joining of the TFT array plate and the color filter plate with liquid crystal material. The third phase, module assembly, involves packaging the display and attaching the electronics and illumination, or backlight, which will allow the device to display text, graphics and video images.

At various points in this manufacturing process, the flat panel display manufacturer uses test and inspection equipment to identify defects to permit repair and to avoid wasting costly materials on continued manufacturing of a defective product. In addition, test and inspection systems can provide qualitative feedback to the flat panel display manufacturer and enable the manufacturer to address yield problems and to optimize the manufacturing process.

Challenges Faced by Flat Panel Display Manufacturers.    The ability of flat panel display manufacturers to improve yields of active matrix liquid crystal displays and other flat panel displays depends, in large part, on their ability to test, repair and inspect displays during the manufacturing process and to use the resulting data to refine the manufacturing process. The ability to test, repair and inspect helps manufacturers address a number of challenges, including:

Products

Today’s market dynamics demand that flat panel display manufacturers leverage the latest yield management and process tools. We focus specifically on delivering yield management solutions to decrease material costs and improve throughput and process equipment solutions that help to improve the quality of flat panel displays.

Yield Management Products

Our flat panel display yield management products include test and repair equipment. Our test equipment can identify and characterize defects at early stages of the manufacturing process so that the panels may be repaired

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before the next stage or, if necessary, discarded, minimizing the loss of time and materials. Our test and repair systems use similar software-based controls, processing and graphical user interfaces. Products can be networked together so that defect data can be stored, analyzed and used throughout the manufacturing process. Our systems are also compatible with a variety of material handling automation systems. Sales of our Yield Management products accounted for 94%, 100% and 100% of our revenues in fiscal 2003, 2002 and 2001, respectively.

Flat Panel Display Array Test Systems.    Our ArrayChecker test systems detect, locate, quantify and characterize electrical, contamination and other defects in active matrix liquid crystal displays after array fabrication. These systems use our proprietary non-contact voltage imaging technology to provide a high-resolution voltage map of the entire display and our proprietary image analysis software converts this voltage map into complete pixel defect data. The ArrayChecker test systems determine whether individual pixels or lines of pixels are functional and also find more subtle defects such as variations in individual pixel voltage. These defect data files are then used for repair and statistical process control.

Flat Panel Display Array Repair Systems.    Our ArraySaver repair systems utilize multiple wavelength laser technology to repair defects in flat panel displays during and after array fabrication. Our systems can use defect data files downloaded from our array test systems or other test and inspection systems to automatically position the panel for repair, thereby eliminating the time spent by operators locating defects.

The ArraySaver system includes a high-precision materials handling platform and a user-friendly graphical interface allowing for high throughput. Our high-precision materials handling platform fully automates the precise positioning of the plate for each successive repair, thereby substantially increasing throughput. Our graphical user interface and software supports semi-automated setup of repair programs for common types of defects so that repairs can be executed rapidly and accurately. These programs provide a series of actions that the system automatically executes to repair the particular defect type.

Process Equipment Products

We supply process equipment solutions designed for low cost, high throughput rapid thermal processing of thin films on glass substrates. Our technology facilitates activation of low-temperature polysilicon films using substrate heating technology in manufacturing low temperature poly-silicon LCD displays. Sales of our RTP products accounted for 6% of our revenues in fiscal 2003, the year in which we acquired the technology.

Our RTP solutions are designed for low cost, high throughput rapid thermal processing of thin films on glass substrates. This technology has “activates” LTPS films most commonly used in thin film transistor LCD displays. Our patented RTP technology enables manufacturers to change, or activate, the properties of the thin films by thermally processing the poly-silicon layer at temperatures that would otherwise distort or destroy the underlying glass substrate.

Our RTP system employs a combination of substrate pre-heating and rapid transient film heating to provide process performance at a lower cost of ownership and higher throughput compared to competing techniques. The modular design easily adapts the system’s process capabilities to specific manufacturing requirements. A full robotic interface provides completely continuous operation. Our patented Xenon arc lamp and reflector assemblies offer dual-spectrum heating, which selectively and safely heats thin films above the temperature limits of glass substrates.

Customers

We sell our products to manufacturers in the flat panel display industries. All of our flat panel display customers are located in Korea, Taiwan and Japan, where flat panel display production is concentrated. We derive most of our revenue from a small number of customers, and we expect this to continue for the foreseeable future. Sales to our top three unaffiliated customers in each of the last three fiscal years accounted for 79%, 70% and 68% of revenue in fiscal 2003, 2002 and 2001, respectively. During fiscal 2003, sales to AU Optronics

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Corp., LG Phillips LCD Co. Ltd. and Samsung America, Inc. each accounted for more than 10% of our total revenues. See Note 12 of our “Notes to Consolidated Financial Statements” in Part II, Item 8. “Financial Statements and Supplementary Data” for further information, which is incorporated by reference, regarding sales to our major customers.

Our business depends upon the capital expenditures of flat panel display manufacturers, which in turn depend on the current and anticipated market demand for products utilizing flat panel displays. We do not consider our business to be seasonal in nature, but it is cyclical with respect to the capital equipment procurement practices of flat panel display manufacturers and is impacted by the investment patterns of these manufacturers in different global markets. Downturns in the industry or slowdowns in the worldwide economy could have a material adverse effect on our future business and financial results.

Sales and Service

Our sales and marketing strategy is to provide our customers with increased manufacturing yields and throughput, improved quality and greater overall efficiency in their manufacturing process. Our sales, service and marketing efforts are focused on building long-term relationships with our customers. We sell our products for the flat panel display industry directly to our customers in Korea and Taiwan, and through Ishikawajima-Harima Heavy Industries Co., Ltd.(“IHI”), our value-added distributor in Japan. We service our products worldwide directly, except in Japan, where IHI has historically serviced our flat panel display products. IHI has indicated that it may cease to sell and support our products in the future. As a result, we are currently in discussions with IHI to modify the terms of our agreement with them, and we have begun to provide sales and service directly to certain customers in Japan. IHI may retain the rights to resell our products to one particular customer in Japan for a period of time, until we can become a qualified vendor for that customer. We would have primary responsibility for providing service to that customer.

Sales of our flat panel display products represented 100% of our revenue, as reclassified (see Note 1 of our “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data”) in fiscal 2003, 2002 and 2001, and all of this revenue was derived from sales to companies located outside of the United States. International sales expose us to risks that are not experienced with domestic sales, such as export license restrictions, political instability, trade restrictions and currency fluctuations. These and other risks relating to our business are detailed under the caption “Factors Affecting Operating Results” in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” See Note 12 of our “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data” for additional geographic information, which is incorporated herein by reference, including long-lived assets by geographic area as well as revenue from external customers attributable to geographic areas during the last three years.

Our sales terms are typically 80% to 90% of the sales price due upon shipment with the remaining amount due after installation and upon final customer acceptance. We typically provide a limited warranty on our products for a period of 12 months from final acceptance. Our field service personnel provide customers with repair and maintenance services, primarily warranty related. As of September 30, 2003, we had 60 sales and service personnel, 37 of whom were located in Asia-Pacific region and 23 of whom were located in North America.

Research and Development

The market for integrated yield management systems is characterized by rapid and continuous technological development and product innovation. We believe that it is necessary to maintain our competitive position through continued and timely development of new products and enhancements to existing products. Accordingly, we devote a significant portion of our human and financial resources to research and development and seek to maintain close relationships with customers to remain responsive to their needs. For information regarding our research and development expenses during the last three years, see Part II, Item 7. “Management Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K, which is incorporated here by reference.

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We are focusing our current research and development on increasing the performance of our array test, repair and inspection systems, enabling manufacturers to minimize the loss of time and materials in the production.

Manufacturing

Our flat panel display products are primarily manufactured in San Jose, California. Our manufacturing activities consist primarily of final assembly and test of components and subassemblies, which are purchased from third party vendors.

We have utilized suppliers of fully or partially assembled and tested subsystems for many years. In December 2001, we entered into a three-year manufacturing outsourcing agreement with Sanmina-SCI Corporation. Under this and related agreements, Sanmina-SCI was to provide a significant portion of the procurement of raw materials, manufacturing, assembly and test operations for our yield management products. We continued to purchase from other vendors and manufacture some of the proprietary and more complex pieces of our equipment, such as our modulators. Under the terms of this agreement, Sanmina-SCI leased 15,000 square feet of our San Jose facility and leased and operated certain equipment, expanded our San Jose clean room, and purchased a substantial portion of our existing raw materials inventory. In the fourth quarter of 2003, we terminated our relationship with Sanmina-SCI, shifted production of components to other vendors, and assumed in-house purchasing activities formerly provided by Sanmina-SCI. See Note 11 of our “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data” for additional information on the termination of our relationship with Sanmina-SCI.

We schedule production based upon customer purchase orders and anticipated orders during the planning cycle. We generally expect to be able to accept a customer order, build the required machinery and ship to the customer within approximately 26 weeks for our flat panel display products. We maintain quality control through inspection of components, in-process inspection during equipment assembly and final inspection and operation of all manufactured equipment prior to shipment. Although we assemble some components and final test our systems under limited clean room conditions, most of our manufacturing occurs in standard manufacturing space.

Under the terms of our relationship with IHI, IHI has the right to manufacture, assemble and sell array test systems; however, we have retained the exclusive right to manufacture some critical components based on technology not shared with IHI and to sell these components to IHI at prices that are mutually established from time to time. To date, we have manufactured all array test systems sold by IHI. Furthermore, IHI has sold products only in its capacity as our distributor in Japan. As noted above, IHI has indicated that it may cease to sell and support our products in the future.

Suppliers

We obtain some equipment for our systems from a single source or a limited group of suppliers. For example, we currently obtain material handling platforms and laser assemblies from single source suppliers. Although we seek to reduce dependence on our single source and limited group suppliers, alternative sources of supply for certain pieces of equipment may not be available or may be available on unfavorable terms. The partial or complete loss of a single source or limited group of suppliers or any delay in shipment from a single source or limited group of suppliers could at least temporarily 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. To date we have not experienced the loss of any single source or limited group of suppliers or any related delays in shipment.

Intellectual Property

We protect our proprietary technology through various methods such as patents and patent applications, trademarks, non-disclosure agreements and trade secrets. We have filed and obtained a number of patents in the

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United States and abroad and have also jointly filed patent applications in Japan with IHI. As of November 17, 2003, we have been issued 41 patents in the United States that are in force. The normal expiration dates of these patents range from 2005 to 2021. As of November 17, 2003, there are 11 pending patent applications in the United States. As of November 3, 2003, we have been issued 25 non-U.S. patents that are in force and there are 23 non-U.S. pending patent applications.

Our patents relate to various aspects of our yield management and rapid thermal processing solutions as set forth in the following table (as of November 17, 2003):

We intend to continue to pursue the legal protection of our technology through intellectual property laws. However, we cannot be certain that the steps we have taken to protect our intellectual property rights will be adequate or that third parties will not infringe or misappropriate our proprietary rights.

Backlog

Our backlog consists of orders for which we have accepted purchase orders and assigned shipment dates within the next twelve months and which are reasonably expected to be filled within that time frame. All orders are subject to delay or cancellation with limited or no penalty to the customer. Because of possible changes in product delivery schedules and cancellation of product orders, among other factors, our backlog may vary significantly and, at any particular date, is not necessarily indicative of actual sales for any succeeding period. Our backlog as of September 30, 2003 and 2002 was approximately $45.4 million and $52.0 million, respectively.

Competition

The worldwide market for integrated yield management systems is highly competitive. We face substantial competition from established companies, many of which have greater financial, engineering and manufacturing resources, larger service organizations and long-standing customer relationships with key existing and potential customers. We may also face future competition from new market entrants from other overseas and domestic sources or if IHI elects to begin competing with us.

Our competitors primarily include Micronics Japan Co. Ltd., Applied Komatsu Technology, Inc. and Shimadzu Corporation in array testing, NEC Corporation, NTN Corporation, Contrel Limited, Charm Engineering Co., Ltd and Hoya Continuum Corporation in array repair and several competitors in the RTP and cell and module inspection market. We may also face future competition from new market entrants from other overseas and domestic sources or if IHI elects to begin competing with us.

We expect our competitors to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. In addition, our customers may choose to develop proprietary technology that may obviate or lessen their need to purchase our products. Moreover, increased competitive pressure may necessitate price based competition, which could harm our business, financial condition and results of operations.

We believe that we can compete effectively with our competitors by building on our substantial installed customer base, providing technologically superior, competitively priced products and emphasizing our easy-to-use user interfaces and customer support. However, realizing and maintaining such advantages will require a

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continued high level of investment by us in engineering, research and development, marketing and customer service and support. We may not have sufficient resources to continue to make such investments. Even if sufficient funds are available, we may not be able to make the technological advances in a timely manner necessary to maintain such competitive advantages.

Employees

As of September 30, 2003, we employed 292 persons. No employees are represented by a labor union or covered by a collective bargaining agreement. We consider our relationships with our employees to be good.

Competition is intense in the recruiting of personnel in the flat panel display industry. Our future success may depend in part on our continued ability to hire and retain qualified management and technical employees.

Business Combinations

In May 2003, we acquired substantially all of the assets of Summit Imaging, Inc., a privately held designer and manufacturer of cooled cameras for the capital equipment industry. This acquisition has enabled us to reduce our flat panel display yield management product costs while improving performance.

In October 2002, we purchased certain assets from Intevac, Inc. related to Intevac’s Rapid Thermal Processing Division. The rapid thermal processing systems use a patented technology designed to activate low temperature poly-silicon films utilizing a precise heating process critical to the manufacture of advanced active matrix, thin film transistor liquid crystal displays and organic light emitting diodes. This acquisition has expanded our flat panel display product offering.

In September 2002, we acquired Akcron Corporation, LTD., a privately held manufacturer of automated optical inspection equipment, image processing hardware and software algorithms and high-performance liquid crystal display backlight inverters for flat panel displays. The acquisition of Akcron has expanded our cell and module inspection capabilities.

In July 2002 we purchased certain assets from ART Advanced Research Technologies Inc. related to ART’s Infrared Screening and Inspection Solutions Division. In July 2001, we acquired Intelligent Reasoning Systems, Inc., a designer and manufacturer of in-line, advanced optical inspection equipment for the electronic manufacturing markets. In December 2000, we acquired Photon Dynamics Canada Inc., formerly known as Image Processing Systems Inc., a Canadian company. All of the assets related to these latter three acquisitions have been written off in fiscal 2003 as part of our discontinued operations. For further details regarding our discontinued operations, please see Note 3 of “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data.”

For further details regarding our business combinations, please see Note 4 of “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data.”

Executive Officers of the Registrant

Our executive officers, their ages and their positions as of November 30, 2003, are as follows:

Malcolm J. Thompson has been a member of our Board of Directors since 1992 and has served as the Executive Chairman of our Board of Directors since October 2003. Since April 2003, Dr. Thompson has served

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as the interim Chief Executive Officer of Vitex Systems, Inc., a provider of components for flat panel displays. From November 2001 to May 2002, he was a member of the Technical Advisory Board of Novalux, Inc., a laser module provider for optical networks. From 1998 through November 2001, he was President and Chief Executive Officer of Novalux, Inc., a provider of laser modules for optical networks. From 1996 to 1998, he was President and Chief Executive Officer of dpiX, Inc., a digital image capture and display products company, and from 1981 to 1996, he was the Chief Technologist for Xerox PARC. He also has served as Chairman of the Board of the United States Display Consortium, an industry-government consortium of over 135 member companies. Dr. Thompson received a B.S. and a Ph.D. in Applied Physics from the University of Brighton, Sussex in the United Kingdom.

Jeffrey A. Hawthorne has been our President and Chief Executive Officer since October 2003, and has been a member of our Board of Directors since December 2003. From July 2003 to October 2003, Mr. Hawthorne was our Chief Operating Officer. From November 2001 to July 2003, Mr. Hawthorne was our Vice President and President, Image Processing Systems Division. Mr. Hawthorne joined us in 1991 and has held a series of other management positions including Vice President, Development from September 1994 to November 2001. Mr. Hawthorne received a B.S. degree in Engineering Physics from the University of Colorado and an M.S. degree in Optical Engineering from the University of Rochester.

Richard Okumoto has been our Chief Financial Officer and Secretary since May 2003. From December 2002 until May 2003, he was Vice President of Administration and Chief Financial Officer at ESI, a manufacturer of semiconductor capital equipment. From October 2001 to December 2002, Mr. Okumoto was executive Vice President of The Garrett Group, a technology financial services firm. From May 2000 to May of 2001, Mr. Okumoto was Senior Vice President and General Manager of the I.C.E. division of Credence Systems Corporation. From October 1998 to May 2000, Mr. Okumoto was President and Chief Executive Officer of TMT, Inc. From March 1993 until January 1998, Mr. Okumoto was Executive Vice President and Chief Financial Officer for Credence Systems Corporation. Mr. Okumoto brings over 20 years of financial experience in the semiconductor test industry. Mr. Okumoto received a B.S. degree in Business Administration at San Jose State University.

Steve Song has been our Vice President of Worldwide Sales since November 2003. From August 1998 to November 2003, Mr. Song was our Vice President of Sales. Mr. Song joined us in April 1994 as our Korean sales and support manager. He was promoted to director of Korean operations in August 1995 and established our Korean subsidiary. Mr. Song received a B.S. degree in Electrical Engineering from Korea University in Seoul, Korea.

Item 2.    Properties

Information regarding our principal properties at September 30, 2003 is as follows:

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We also lease office space for other, smaller sales and service offices in Colorado Springs, Colorado, USA; Tokyo, Japan; Hsinchu, Taiwan; Seoul, Korea; and Beijing and Shanghai, China. In August 2003, we signed a lease agreement for a 128,520 square-foot building in San Jose California into which we plan to consolidate our San Jose facilities. The current lease in San Jose will terminate concurrently on January 11, 2004, with the inception date of the new lease.

Our operating leases expire at various times through December 2010, with renewal options at the fair market value for additional periods up to five years. Additional information on these leases is incorporated by reference from Note 9 of the “Notes to Consolidated Financial Statements” in Part II, Item 8. “Financial Statements and Supplementary Data.” We believe our properties are adequately maintained and suitable for their intended use and that our production facilities have adequate capacity for our current needs.

Item 3.    Legal Proceedings

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 and punitive damages in an unknown sum. 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. The court issued a tentative ruling denying the motion on October 23, 2003, and a hearing on the matter was held on December 3, 2003 at which time a motion was set for further hearing on January 9, 2004 and the trial date was reset for April 12, 2004. 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 defendants’ 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 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 defendants’ motion. The pleadings have been finalized and certain claims against us and the individual defendants will proceed. The parties currently are engaged in discovery, and the Court has yet to set a trial date. We believe the 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.

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 were alleging infringement of a U.S. Patent owned by us and were 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. 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

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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. This lawsuit and all related lawsuits were subsequently settled on October 16, 2003. For further details, please see Note 15 of the “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data.”

From time to time we are subject to legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these proceedings and claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on our results of operations or financial condition.

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

No matters were submitted to a vote of our security holders during the quarter ended September 30, 2003.

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PART II

Item 5.    Market for the Registrant’s Common Equity and Related Stockholder Matters

Common Stock Market Price

Our common stock commenced trading on the NASDAQ National Market on November 15, 1995 under the symbol “PHTN.” The following table sets forth the high and low bid prices of our common stock as traded on the NASDAQ National Market for the periods indicated. The stock prices shown represent quotations among dealers without adjustments for retail markups, markdowns, or commissions and may not represent actual transactions.

The closing price for our common stock as reported by the NASDAQ National Market on December 1, 2003 was $41.80 per share. As of December 1, 2003, there were approximately 156 shareholders of record of our common stock.

We have never declared or paid any cash dividends to our shareholders and we have agreed not to pay cash dividends under our current bank line of credit. We do not presently plan to pay cash dividends in the foreseeable future and intend to retain any future earnings for reinvestment in our business.

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 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 us. The 10b5-1 plan, allowed us to repurchase our shares during a period in which we were in possession of material non-public information, provided that we communicated share repurchase instructions to the broker at a time when we were not in possession of such material non-public information. As of January 15, 2003, we had repurchased a total of 1,253,932 shares for an aggregate repurchase price of approximately $24.6 million.

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Item 6.    Selected Financial Data

The following selected consolidated summary financial data should be read in conjunction with Part II, Item 8. “Financial Statements and Supplementary Data,” and with Part I, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K. The consolidated statement of operations data for the years ended September 30, 2003, 2002 and 2001, and the consolidated balance sheet data as of September 30, 2003 and 2002 are derived from the audited consolidated financial statements included elsewhere in this report. The consolidated statement of operations data for the years ended September 30, 2000 and 1999, and the consolidated balance sheet data as of September 30, 2001, 2000 and 1999 are derived from audited consolidated financial statements not included in this report.

In fiscal 2003, we discontinued operations in two business segments – the printed circuit board assembly inspection business and the cathode ray tube display and high quality glass inspection business. Accordingly, the operating results of these businesses have been reclassified as discontinued operations for all periods presented.

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and the related “Notes to Consolidated Financial Statements” in Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. This discussion 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 Annual Report on Form 10-K. Generally, the use of words such as “may,” “will,” “could,” “anticipate,” “expect,” “intend,” “believe,” “continue” or the negative of such terms, or other comparable terminology and similar expressions identify forward-looking statements. The information included in this Form 10-K 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 herein. Accordingly, we caution readers not to place undue reliance on such statements.

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. In fiscal 2003, we acquired rapid thermal processing technology from Intevac, Inc., 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 acquired substantially all of the assets of Summit Imaging, Inc., which supplies cooled cameras for our array checker products. These acquisitions support our strategy of owning key technologies which will positively impact our products’ technology content and lower the cost of our products. For further details of these and our fiscal 2002 and 2001 acquisitions, see Note 4 of the “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data.”

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 also 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. For further details of our discontinued operations, see Note 3 of the “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data.”

Impact of Staff Accounting Bulletin Number 101

Our fiscal 2001 financial statements reflect our adoption of the Securities and Exchange Commission’s (“SEC”) Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”). The SEC addressed several issues in SAB 101, including the timing of revenue recognition for sales that involve contractual customer acceptance provisions and installation of the product if these events occur after shipment and transfer of title. Our previous revenue recognition policy was to recognize revenue at the time the customer takes title to the product, generally at the time of shipment.

We changed our revenue recognition policy effective October 1, 2000 based on guidance provided in SAB 101. 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 primarily derive revenue from sales of equipment and spare parts. Certain of our product sales are accounted for as multiple-element arrangements. If we have met defined customer acceptance experience levels

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with the specific type of equipment, we recognize revenue for a portion of the total contract price due and billable upon shipment, with the remainder recognized after installation and acceptance. All other product sales with customer acceptance provisions are recognized upon customer acceptance. Revenue from the sale of spare parts is recognized upon shipment. The adoption of SAB 101 had no impact on the revenue recognition policy for the sale of spare parts.

We have reported this change in accounting principle in accordance with Accounting Principles Board Opinion No. 20, “Accounting Changes” (“APB 20”), as a cumulative effect adjustment. Because we adopted SAB 101 in the fourth quarter of fiscal 2001, no cumulative effect of the change is included in net income for the fourth quarter of fiscal 2000. Instead, APB 20 required that the change be made as of the beginning of the year and that financial information for interim periods of fiscal 2001 reported prior to the change be restated by applying SAB 101 to those periods.

In accordance with guidance provided in SAB 101, we recorded a total non-cash charge to continuing operations of $6.6 million, or $0.50 per share in fiscal 2001, to reflect the cumulative effect of the accounting change as of the beginning of fiscal 2001. The decrease to operating results from continuing operations before the cumulative effect of the accounting change as a result of the adoption of SAB 101 amounted to $2.7 million or $0.20 per diluted share for fiscal 2001.

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. 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, goodwill, 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.

We believe the following critical accounting policies are subject to 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, 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.

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Allowance for Doubtful Accounts.

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, inability of a single customer to make required payments could have a material adverse effect on our results of operations.

Inventories.

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 approximates actual costs on a first-in, first-out basis. We assess the recoverability of all inventory and purchase commitments to determine whether adjustments for excess and/or obsolete items are required. We make purchase commitments for inventory based upon existing backlog and sales forecasts. We maintain certain inventory levels to mitigate supply constraints and to fulfill orders for non-standard configurations, especially for parts with long lead times.

We review the adequacy of our inventory valuation on a quarterly basis. For production inventory, our methodology involves matching our on-hand inventory with our build forecast over the next twelve months. We then evaluate the parts found to be in excess of the twelve-month demand and take appropriate reserves to reflect the risk of obsolescence. Based on our past experience, we believe the twelve-month time period to best reflect the reasonable and relative obsolescence risks. If actual demand or usage were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory may be required.

Warranty.

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, when the related revenue is recognized. Our warranty obligation is affected by product failure rates, consumption of field parts 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 and Intangible Assets.

We have accounted 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” (“FAS142”). FAS 142 prohibits the amortization of goodwill and intangible assets with indefinite useful lives and requires that these assets be reviewed for impairment at least annually. 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 goodwill associated with the Akcron and RTP reporting units for the purposes of our fiscal 2003 financial statements, we made estimates and judgments about the future cash flows of those reporting units. Our cash flow forecasts were based on assumptions that were consistent with the plans and estimates we are using to manage the underlying business. We also considered 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.

Intangible assets with finite lives and other long-lived assets are amortized over their estimated useful lives and are also subject to evaluation for impairment.

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Impairment of Long-Lived Assets.

We review long-lived assets including intangible assets with finite lives 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. Impairment, if any, is assessed 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 the 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 and based on the advice of legal counsel, the adverse settlement is probable and we can reasonably estimate the ultimate cost of such a judgement. We have made no such accruals at September 30, 2003.

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Results of Operations

Fiscal Years Ended September 30, 2003, 2002 and 2001

The following table sets forth, for the periods indicated, the percentage of revenue of certain items in our Consolidated Statement of Operations.

Revenue.    Revenue increased 36% to $67.2 million in fiscal 2003 from $49.3 million in fiscal 2002. Revenue increased 29% to $49.3 million in fiscal 2002 from $38.3 million in fiscal 2001. Sales of flat panel display products represented 100% of our revenue in all fiscal years. Sales of rapid thermal processing products, which is based on the technology we acquired in November 2002, represented $3.8 million, or 6% of our revenue in fiscal 2003. The increase in revenue in fiscal 2003 was primarily due to increased shipments of our ArrayChecker products, as compared to fiscal 2002, as well as RTP products that we acquired in fiscal 2003. This increase in revenue was partially offset by a decrease in the number of ArrayRepair systems shipped in fiscal 2003 as compared to fiscal 2002. Unit shipments of our array checker products increased approximately 43% in fiscal 2003 as compared to fiscal 2002, while unit shipments of our array repair products decreased approximately 45% in the same period. The increase in revenue in fiscal 2002 as compared to fiscal 2001 was due primarily to increased sales of our array checker products due to customer expansion of manufacturing capacity. Unit shipments of our array checker products increased approximately 35% in fiscal 2002 as compared to fiscal 2001, while unit shipments of our array repair products decreased approximately 39% in the same period. International revenue represented 100% of our revenue in all fiscal years. Our international revenue is derived entirely from customers in Korea, Taiwan and Japan.

Gross Margin.    Gross margin decreased to 34% in fiscal 2003 from 48% in fiscal 2002. Gross margin increased to 48% in fiscal 2002 from 41% in fiscal 2001. The overall decrease in gross margin in fiscal 2003 as

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compared to fiscal 2002 was primarily due to the contribution of lower margins from manufacturing inefficiencies and additional costs incurred to meet product delivery dates and resolve quality problems as a result of technical design issues related to the release of our ArrayChecker 3500 product. Additionally, end-of-life pricing on the ArrayChecker 2000 systems, competitive pricing pressures, particularly on the ArraySaver product, and lower modulator yields contributed to lower gross margins. The overall increase in gross margin in fiscal 2002 as compared to fiscal 2001 was primarily the result of increased manufacturing efficiencies attributable to higher sales volumes and to higher capacity utilization.

Research and Development.    Our research and development expenses consist primarily of salaries and related personnel costs, depreciation, non-recurring engineering charges and prototype costs and fees paid to consultants and outside service providers, all of which relate to the design, development, testing, pre-manufacturing and significant improvement of our products. We expense our research and development costs as they are incurred. Research and development expenses were $22.8 million, $10.9 million and $12.0 million, or 34%, 22% and 31% of our revenue in fiscal 2003, 2002 and 2001, respectively. The increase in research and development expenses in fiscal 2003 compared to fiscal 2002 was 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 Corporation and the rapid thermal processing technology from Intevac, Inc. The decrease in research and development expenses in fiscal 2002 compared to fiscal 2001 was primarily attributable to a reduction in spending on prototype materials and reduced overhead expenses. We expect our research and development expenses to be flat to slightly up in absolute dollars as we continue to concurrently develop our generation 5, 6 and 7 systems.

Selling, General and Administrative.    Our selling, general and administrative expenses consist primarily of salaries and commissions and related expenses for executive, sales, finance, accounting, and human resources personnel, professional fees and other corporate expenses. Selling, general and administrative expenses were $13.8 million, $8.9 million and $8.7 million, or 21%, 18% and 23% of our revenue, in fiscal 2003, 2002 and 2001, respectively. The increase in selling, general and administrative expenses in fiscal 2003 compared to 2002 was primarily attributable to increases in legal, accounting and directors’ and officers’ insurance expenses, expenses related to corporate governance requirements, and severance expenses. Selling, general and administrative expenses remained relatively flat in fiscal 2002 as compared to 2001.

Goodwill Impairment.    Statement of Financial Accounting Standards 142, “Goodwill and Other Intangible Assets” (“FAS 142”) requires goodwill and other intangible assets that have indefinite useful lives to no longer be amortized; however, these assets must be reviewed at least annually for 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.

In the fourth quarter of fiscal 2003, as a result of limited opportunities in the inverter market and uncertainty with regard to flat panel manufacturers’ commitment to LTPS technology, we performed an impairment analysis of the $3.5 million and $7.4 million of goodwill associated with the acquisitions of Akcron and the RTP assets respectively. The valuations were done as of July 1, 2003, using established valuation techniques, specifically, the income and market approaches. As a result of these analyses, we recorded goodwill impairment charges of $2.7 million and $7.3 million associated with the Akcron and RTP asset goodwill, respectively.

Impairment of Purchased Intangibles.    We evaluate the carrying value of our long-lived assets and perform tests for impairment, including intangible assets, whenever events or circumstances suggest that such assets may be impaired in accordance with the provisions of Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment loss is recognized when estimated future cash flows expected to result from the use of the asset, including disposition, is less than the carrying value of the asset.

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In the fourth quarter of fiscal 2003, we also performed an impairment analysis of purchased intangible assets associated with the acquisitions of Akcron and the RTP assets. As a result, we recorded a write-off of $2.0 million and $1.5 million related to the acquired core and developed technologies of the Akcron and RTP assets, respectively.

Restructuring Charges.    During the fourth quarter of fiscal 2001, we recorded a $976,000 restructuring charge associated with a reduction in workforce and a reorganization of our divisions. These charges were the result of several initiatives, including the establishment of a sales and service organization and downsizing our capacity to then current shipment levels. As of September 30, 2003 the remaining liability associated with this restructuring plan was approximately $242,000, which represents contractual payments to be paid to a former executive through March 2004.

Acquired In–Process Research and Development.    In May 2003, we acquired substantially all of the assets of Summit Imaging, Inc. In November 2002, we completed our acquisition of certain assets from Intevac related to Intevac’s RTP technology. In September 2002, we completed our acquisition of Akcron. The purchase price for each has been allocated in accordance with FAS 141. The resulting in–process research and development charges in fiscal 2003 included $1.8 million and $625,000 for the asset purchases from Intevac and Summit, Imaging respectively. The resulting in-process research and development charge in fiscal 2002 was $410,000 for the Akcron acquisition. All amounts were expensed on the acquisition date as they represent 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. Projected incremental cash flows were discounted back to their present value using a discount rate of 25%, 60% and 25% for the Intevac RTP asset purchase, the Summit Imaging asset purchase and the Akcron acquisition, respectively, which were 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 September 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. As of September 30, 2003, this project had been substantially completed.

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 Intangible Assets.    The identified intangible assets (other than goodwill) related to the Intevac RTP asset purchase, the Summit Imaging asset purchase and the Akcron acquisition are being amortized over two to five year periods, commencing on the dates of the acquisition. We have recorded a related

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amortization expense of $1.2 million for the year ended September 30, 2003. Remaining intangibles assets, after amortization and impairment write-offs, of approximately $2.9 million at September 30, 2003 will be amortized over varying periods ranging from one to four years.

Non-Recurring Acquisition Charges.    In December 2000, we acquired all the capital stock of Image Processing Systems, Inc. (“IPS”) in a pooling of interests transaction, in exchange for approximately 1,139,000 shares of our common stock. We incurred $2.3 million in professional fees consisting of legal, accounting and integration costs in connection with the acquisition of IPS.

Interest Income and Other, Net.    Interest income and other, net consists primarily of interest income and expense, foreign currency exchange gains and losses and other miscellaneous income and expense. Interest income and other, net was $3.0 million, $2.9 million and $5.0 million in fiscal 2003, 2002 and 2001, respectively. The decrease in interest income and other, net in fiscal 2002 was primarily attributable to lower overall yields on investments as compared to fiscal 2001, partially offset by the impact of higher cash balances in fiscal 2002 resulting from the net proceeds of the underwritten public offering of our common stock in February 2002.

Provision for Income Taxes.    The fiscal 2003, 2002 and 2001 effective tax rates were all 0%. The effective tax rate in fiscal 2003 is lower than the statutory rate due to tax net operating losses not being recognized. The effective tax rate in fiscal 2002 is less than the statutory federal income tax rate primarily as a result of an election reducing our tax benefits arising from acquired net operating losses and increasing tax bases in various purchased intangible assets. The effective tax rate in fiscal 2001 is lower than the statutory rate primarily due to tax benefits arising from net operating losses and tax credit carryforwards not being recognized.

We record a valuation allowance against our net deferred tax assets. Realization of our deferred tax assets depends on our generating sufficient taxable income in future years in appropriate tax jurisdictions to obtain benefit from the reversal of temporary differences and from net operating loss and credit carryforwards. Due to the uncertainty of the timing and the amount of such realization, management concluded that a full valuation allowance was required at September 30, 2003.

Our future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of our pre-tax income, non-tax deductible expenses incurred in connection with acquisitions, amounts of tax-exempt interest income and research and development credits as a percentage of aggregate pre-tax income, and the effectiveness of our tax planning strategies.

Discontinued Operations

Through January 14, 2003, We 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, we implemented a plan to exit the printed circuit board assembly inspection business. In June 2003, we implemented a plan to exit the cathode ray tube display and high quality glass inspection businesses. Accordingly, the operating results of these former business segments have been presented as discontinued operations for all periods presented.

Printed Circuit Board Assembly Inspection Business    Losses from discontinued operations from the former Printed Circuit Board Assembly Inspection Business were $38.6 million, $24.6 million and $2.1 million in fiscal 2003, 2002 and 2001, respectively.

The loss from discontinued operations for the year ended September 30, 2003, includes a write-off of inventory of approximately $7.6 million, a write-off of accounts receivable of approximately $2.0 million, and a write-off of licensed technology of approximately $1.9 million. The fiscal 2003 loss also includes impairment charges of approximately $15.1 million of goodwill, $2.9 million of purchase intangibles and $2.5 million of

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long-lived assets recorded during the three months ended December 31, 2002, as a result of our assessment of indicators of impairment that existed prior to our formal decision to discontinue the operations of this segment.

The loss from discontinued operations for the year ended September 30, 2002 includes a restructuring charge of approximately $2.6 million recorded in the fourth quarter of fiscal 2002 associated with a reduction in workforce, consolidation and closing of facilities and a write-off of related fixed assets. The fiscal 2002 loss also includes impairment charges of approximately $11.2 million of goodwill and $1.0 million of purchased intangibles recorded during the fourth quarter of 2002, as a result of our assessment of indicators of impairment related to the acquisition of IRSI. In addition, we recorded approximately $244,000 of acquired in-process research and development charges related to the acquisition of ISIS.

The loss from discontinued operations for the year ended September 30, 2001 includes approximately $1.3 million of acquired in-process research and development charges related to the acquisition of IRSI.

Cathode Ray Tube Display and High Quality Glass Inspection Business    Losses from discontinued operations from the former Cathode Ray Tube Display and High Quality Glass Inspection Business were $6.0 million, $3.4 million and $2.1 million in fiscal 2003, 2002 and 2001, respectively.

The loss from discontinued operations for the year ended September 30, 2003, includes a write-off of inventory of approximately $1.8 million, a write-off of accounts receivable of approximately $152,000, and a write-off of fixed assets of approximately $490,000. The fiscal 2003 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.

The loss from discontinued operations for the year ended September 30, 2001, includes a restructuring charge of approximately $253,000 recorded in the fourth quarter of fiscal 2001 associated with a reduction in workforce and the consolidation of facilities. The fiscal 2001 loss also includes approximately $896,000 of non-recurring acquisition charges related to the acquisition of IPS.

Liquidity and Capital Resources

We have financed our growth primarily by a combination of cash flows from operations and public stock offerings. Working capital was $125.6 million as of September 30, 2003, compared to $190.2 million as of September 30, 2002. A major component of working capital is $116.5 million of cash, cash equivalents and short-term investments as of September 30, 2003, compared to $170.1 million as of September 30, 2002.

Operating Activities of Continuing Operations    Cash used in operating activities from continuing operations was $6.7 million and $1.9 million in fiscal 2003 and 2001, respectively, while cash provided by operating activities was $2.3 million in fiscal 2002. The increase in cash used in operating activities in fiscal 2003 compared to fiscal 2002 was primarily due to the $27.8 million net loss generated in fiscal 2003, as compared to the $6.2 million net income generated in fiscal 2002 partially offset by increases in deferred revenue and decreases in accounts payable. The increase in deferred revenue related to shipments occurring in the fourth quarter, while the decrease in accounts payable corresponded to a decrease in inventory levels. The increase in cash provided by operating activities in fiscal 2002 compared to fiscal 2001 was primarily due to the $6.2 million net income generated in fiscal 2002, as compared to the $7.7 million net loss generated in fiscal 2001. This net income was partially offset by a $3.6 million decrease in accounts receivable and inventories

Investing Activities of Continuing Operations    Cash provided by investing activities from continuing operations was $21.9 million and $17.7 million in fiscal 2003 and 2001, respectively, while cash used in investing activities was $83.0 million in fiscal 2002. The increase in cash provided by investing activities in fiscal 2003 compared to fiscal 2002 was primarily due to increases in the redemption of our short-term investments to fund our operations, offset by the purchase of the Intevac and Summit Imaging assets. The

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increase in cash used in investing activities in fiscal 2002 compared to fiscal 2001 was due primarily to the purchase of short-term investments with the cash provided by our public offering of shares of our common stock in February 2002. Additionally, we used cash of $2.6 million in the acquisition of Akcron. Capital expenditures were $2.6 million, $2.1 million and $7.4 million in fiscal 2003, 2002 and 2001, respectively. Capital expenditures in fiscal 2001 included the purchase of our corporate headquarters building and have decreased in fiscal 2002 and 2003 due to reductions in capital spending as a result of a slowdown in our business.

Financing Activities of Continuing Operations    Cash used in financing activities was $9.8 million in fiscal 2003, while cash provided by financing activities was $105.5 million and $3.2 million in fiscal 2002 and 2001 respectively. The increase in cash used in financing activities in fiscal 2003 was primarily due to $17.7 million used to repurchase our common stock in the open market, partially offset by $7.9 million generated from sales of our common stock. The increase in cash provided by financing activities in fiscal 2002 compared to fiscal 2001 was mainly due to our public offering of shares of our common stock. In February 2002, we sold 2,500,000 shares of common stock at a price of $40.14 per share. Additionally, the underwriters in the offering exercised their option to purchase an additional 375,000 shares to cover over-allotments. Our net proceeds after the underwriters’ discount and expenses of the offering aggregated approximately $107.0 million. The cash provided by the February 2002 public offering was partially offset by $6.9 million used to repurchase our common stock in the open market.

In March 2000, we entered into a bank line of credit (“line of credit”) which had an initial term of one year. We have renegotiated the line of credit on an annual basis and currently have a $4.0 million borrowing capacity on the line of credit, expiring in July 2004. The line of credit is secured by substantially all of our assets and contains certain financial and other covenants. At September 30, 2003, no amounts were outstanding under the line of credit.

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 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 us. The 10b5-1 plan, allowed us to repurchase our shares during a period in which we were in possession of material non-public information, provided that we communicated share repurchase instructions to the broker at a time when we were not in possession of such material non-public information. During the period October 1, 2002 through January 15, 2003, we repurchased 903,032 shares for an aggregate repurchase price of approximately $17.7 million. As of January 15, 2003, we had purchased a total of 1,253,932 shares for an aggregate repurchase price of approximately $24.6 million.

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

We believe that existing liquid capital resources and funds generated from operations will be sufficient to meet our operating and capital requirements and obligations for at least the next twelve months. We believe that success in our industry requires substantial capital in order to maintain the flexibility to take advantage of

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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.

Operating, Investing and Financing 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. Net cash used by discontinued operations during fiscal 2003, 2002 and 2001 is as follows:

Impact of Accounting Pronouncements

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). This issue addresses determination of whether an arrangement involving more than one deliverable contains more than one unit of accounting and how arrangement consideration should be measured and allocated to the separate units of accounting. EITF 00-21 became effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of this standard has had no material impact on our consolidated financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 “Consolidation of Variable Interest Entities,” (“FIN 46”) an Interpretation of ARB No. 51. 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 December 15, 2003. The adoption of this standard is not expected to have a material impact on our consolidated financial statements.

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Factors Affecting Operating Results

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

We reported net losses for each of the fiscal years ended September 30, 2003, 2002 and 2001. In the future, our revenue may decline, remain flat or grow at a rate slower than expected, especially to the extent that the general economic conditions do not significantly improve. 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 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 fall.

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.

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

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.

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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:

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 manufacturers reduced capital expenditures resulting in a decrease in our revenue. If the flat panel display 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 two largest customers represented 66% of our revenue, and each in excess of 10% of our total revenue, for the year ended September 30, 2003. Our two largest customers collectively accounted for 61% of our total revenue, and each in excess of 10% of our total revenue, for the year ended September 30, 2002.

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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.

All of our revenue is expected to come from a limited range of products for the flat panel display industry. As a result, we are heavily reliant on the flat panel display industry, 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 from a single source supplier. 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 customers in foreign countries to continue to represent 100% of our revenue in the foreseeable future. A number of factors may adversely affect our international sales and operations, including:

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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 substantially all of the assets of Summit Imaging, Inc., in May 2003, certain assets from Intevac, Inc. in November 2002, Akcron Corporation, LTD in September 2002, certain assets from ART Advanced Research Technologies Inc. in July 2002, Intelligent Reasoning Systems, Inc. in July 2001 and Image Processing Systems, Inc. in December 2000. 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:

Any of these difficulties could increase our operating costs or result in impairment of purchased assets, which could 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 and high quality glass inspection businesses. As a result, some or all of

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the technologies acquired in connection with certain of our prior acquisitions, including ART Advanced Research Technologies Inc. Intelligent Reasoning Systems, Inc. and IPS 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 our 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 any 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 any 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 fiscal 2003, fiscal 2002 and fiscal 2001, 2%, 10% and 24% 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. In addition, even if we are able to negotiate a favorable termination of this relationship with IHI, we may not be

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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 fiscal 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 there under 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

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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. Jeff Hawthorne, previously Chief Operating Officer, became our President and Chief Executive Officer in October 2003, when Elwood H. Spedden resigned for health reasons. Mr. Spedden had previously replaced Vincent Sollitto who resigned as President and Chief Executive Officer in January 2003. Richard Okumoto recently became our Chief Financial Officer and Secretary in May 2003 when Richard Dissly resigned. Bruce Delmore, previously Vice President of Marketing also recently 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 both resigned in early fiscal 2003. Steve Song, previously Director of Korean operations, recently became our Vice President of Worldwide Sales. If our management team experiences high attrition or does not work effectively together, it could seriously harm our business.

Terrorism and international political instability may negatively affect our operations

The threat of terrorism targeted at the regions of the world in which we do business increases the uncertainty in our markets and may delay any recovery in the general economy, which could threaten our business.

Increased international political instability, particularly resulting from the threat of terrorist attacks, and further enhanced security measures as a result of the threat of terrorist attacks may hinder our ability to do business and may increase our costs of operations. Such continuing instability could cause us to incur increased costs in transportation, make such transportation unreliable, increase our insurance costs and cause international markets to fluctuate. This instability could have the same effects on our suppliers and their ability to timely deliver their products to us. If this international political instability continues or increases, our business and results of operations could be harmed.

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 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. It could also significantly delay our research and engineering efforts for the development of new products, most of which is conducted at our California facilities.

In addition, some of our customers in Asia are located near fault lines. 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:

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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 industry 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.

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Item 7A.    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 limited as substantially all of our cash, accounts receivable and accounts payable are denominated in U.S. dollars.

As of September 30, 2003, we had forward exchange contracts to sell approximately $2.8 million in foreign currency in order to hedge certain anticipated foreign currency denominated transactions expected to occur during the next year. None of these contracts were held for trading purposes. Detail of these securities is included in Note 7 of our “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplemental Data.” Gains and losses on these contracts were recognized in income at September 30, 2003. Losses from changes in fair values at September 30, 2003 were approximately $208,000. We did not have any forward sales contracts at September 30, 2002.

Our forward exchange contracts are subject to exchange rate risk and will fluctuate with the changes in exchange rates. A hypothetical 10% immediate and uniform adverse move in all currency exchange rates affecting the contracts from the rates at September 30, 2003 would decrease the fair value of the contracts by approximately $341,000.

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. The following table presents principal amounts and related weighted average interest rates by year of maturity for our short-term investment portfolio, substantially all of which is held in U.S. dollars:

These securities, as with all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase.

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Item 8.    Financial Statements and Supplementary Data

Index to Consolidated Financial Statements

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REPORT OF ERNST & YOUNG LLP,

INDEPENDENT AUDITORS

The Board of Directors and Shareholders

Photon Dynamics, Inc.

We have audited the accompanying consolidated balance sheets of Photon Dynamics, Inc. as of September 30, 2003 and 2002, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended September 30, 2003. Our audits also included the financial statement schedule listed in the index at Item 15(a)(2). These financial statements and schedule are the responsibility of the management of Photon Dynamics, Inc. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Photon Dynamics, Inc. as of September 30, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole presents fairly in all material respects the information set forth therein.

/s/    ERNST & YOUNG LLP

Palo Alto, California

October 22, 2003

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PHOTON DYNAMICS, INC.

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

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PHOTON DYNAMICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS